Progress Report on Tranche Release

This consultant’s report does not necessarily reflect the views of ADB or the government concerned. [For PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project’s design.]

Program Number: 37164-01 Loan Number: 2279 December 2011

Bhutan: Financial Sector Development Program

CURRENCY EQUIVALENTS (as of 18 November 2011)

Currency Unit – ngultrum (Nu) Nu1.00 = $0.019629

$1.00 = Nu50.9450

ABBREVIATIONS AAS – accounting and auditing standards AASB – accounting and auditing standards board ADB – Asian Development Bank AML – anti-money laundering BOBL – Bank of Bhutan Limited CIB – credit information bureau CFT – combating the financing of terrorism DHI – Druk Holding and Investment FIU – financial intelligence unit FRSD – Financial Regulation and Supervision Department FSA – financial services act GDP – gross domestic product MOU – memorandum of understanding RICBL – Royal Insurance Corporation of Bhutan Limited RMA – Royal Monetary Authority SDR – special drawing right TA – technical assistance

NOTES

(i) The fiscal (FY) of the government and its agencies ends on 30 June. ―FY‖ before a calendar year denotes the year in which the fiscal year ends, e.g., FY2010 ends on 30 June 2010.

(ii) In this report, ―$‖ refers to US dollars.

Vice-President X. Zhao, Operations 1 Director General S. H. Rahman, South Asia Department (SARD) Director B. Carrasco, Financial Sector, Public Management and Trade Division,

SARD Team leader Team members

S. Shah, Senior Financial Sector Specialist, SARD J. Versantvoort, Senior Counsel, Office of the General Counsel L. Rueda, Associate Project Analyst, SARD V. Panis, Senior Operations Assistant, SARD A. Bravo, Operations Assistant, SARD

In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

CONTENTS

Page I. INTRODUCTION 1

II. RECENT DEVELOPMENTS AND IMPLICATIONS FOR THE PROGRAM 1

III. STATUS OF PROGRAM IMPLEMENTATION 4

A. Summary of Compliance Status 4

B. Program Implementation 4

C. Review of the Implementation of Project Loan 8

D. Review of the Associated Technical Assistance 9

IV. CONCLUSION 10

V. THE PRESIDENT’S DECISION 10

APPENDIXES

1. Key Economic Indicators 12

2. Chronology of Review Missions under Financial Sector Development Program 13

3. Status of Compliance with the Third–Tranche Release Policy Actions 14

4. Status of Compliance with the Non–Tranche Release Policy Actions 16

5. Detailed List of Training Programs Undertaken in Project Loan 17

I. INTRODUCTION

1. On 7 December 2006, the Asian Development Bank (ADB) approved program and project loans totaling the equivalent of $13 million to Bhutan for the Financial Sector Development Program.1 ADB has so far provided (i) a program loan of SDR7,472,000 ($11 million) to support vital policy reforms in the financial sector, (ii) a project loan of SDR1,359,000 ($2 million) to facilitate program implementation; and (iii) an associated technical assistance (TA) grant of $250,000 to institutionalize skills and capacity development in the financial sector and promote the sector’s growth (footnote 1). 2. The program’s aim was to (i) reduce legal, regulatory, and supervisory constraints on the financial sector; (ii) strengthen corporate governance and promote greater commercial orientation in financial institutions; (iii) establish a surveillance system for anti–money laundering (AML) and combating the financing of terrorism (CFT) to support security and stability in the financial sector; (iv) develop national accounting and auditing policies and standards for reliable financial reporting; and (v) establish a credit information bureau to improve credit decisions. The associated TA was intended to sustain capacity development by developing and setting up a training institute for the financial sector. 3. The program loan was to be released in three tranches, subject to government compliance with conditions for each tranche release. The first tranche of the equivalent of $4.1 million was disbursed on loan effectiveness on 4 June 2007. The second tranche (equivalent to approximately $4.2 million) was to be released within 18 months of loan effectiveness. This tranche release was delayed during the implementation of constitutional reforms that transformed Bhutan from an absolute monarchy to a constitutional monarchy and the passage of important laws and regulations laying the institutional foundations for a parliamentary democracy.2 The completion deadline for the program loan, originally June 2010, was therefore extended to June 2012. The second tranche was eventually disbursed on 21 December 2010. The third tranche was to be released 18 months after the second tranche, subject to satisfactory fulfillment of the corresponding tranche release conditions. 4. This progress report gives (i) a brief overview of the country’s economic development, financial sector development, and recent political transformation,; and (ii) details regarding the country’s compliance with policy actions for the release of the third tranche of SDR2,038,000.

II. RECENT DEVELOPMENTS AND IMPLICATIONS FOR THE PROGRAM

5. Macroeconomic overview. Gross domestic product (GDP) growth is estimated to have accelerated to 7.0% in FY2010 from 5.7% in FY2009. Services, accounting for nearly two-fifths of GDP, contributed the bulk of the GDP gain, mainly construction related. Construction revived with work on the Punatsangchhu I and Dagachhu hydropower stations. Agriculture’s growth was solid. Despite generating only about 16% of GDP, it engages over 65% of the labor force. The electricity and water sector—nearly a quarter of GDP—did not contribute to the expansion, as

1 ADB. 2006. Report and Recommendation of the President to the Board of Directors: Proposed Loans and

Technical Assistance Grant to the Kingdom of Bhutan for the Financial Sector Development Program. Manila (Loans 2279-BHU and 2280-BHU and TA 4885-BHU).

2 These included, among others, the Local Government Act (2007), the Public Finance Act (2007), the Election Act

(2008), the Public Election Fund Act (2008), the National Council Act (2008), the Parliamentary Entitlements Act (2008), and the National Assembly Act (2008).

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no additional generation capacity has been added since Tala hydropower station came online in FY2007. Tourism was also a drag on growth due to the global downturn: visitor arrivals dropped by 9.3% and foreign exchange earnings by 12.4%. 6. The budget deficit in FY2010 is estimated at around 6% of GDP, reflecting revisions that sharply raised capital expenditure despite a fall in nontax revenue. These adjustments stemmed from additional construction spending, including a monastery and other public buildings. Nontax revenue declined because of a 1-year gap in dividend receipts. Druk Holding and Investments was set up to own all major state-owned enterprises, including Tala Hydroelectric Project Authority, such that dividends were not immediately passed through to the budget. The fiscal deficit in FY2011 is estimated at 4.4% of GDP. A civil service wage hike effective January 2011 will increase current spending in FY2011 and FY2012. 7. The trade deficit is estimated to have worsened to 21.5% of GDP in FY2010 from 7.5%, as growth in merchandise imports accelerated markedly. Imports climbed by 39.0%, mainly because of heavy needs for machinery, transport vehicles, and base metals for the hydropower projects and housing. Exports rose by only 5.5% as sales of hydropower to India (about two-fifths of total exports) were flat as capacity production has been reached. A jump in budgetary grants, mainly from India, held the current account deficit to 13.5% of GDP in FY2010 from 1.6% the previous year. As Bhutan is closely linked with India through trade (93.5% of exports and 77.7% of imports) and a currency peg, rising consumer prices in India tend to spill over. Year-on-year inflation rose to 6.1% in the fourth quarter of FY2010 from 3.0% a year earlier. 8. With a pickup in economic activity, growth in broad money accelerated to 30.1% from 24.6%, as domestic assets expanded. Domestic credit, primarily to the private sector, grew by 38.6% in FY2010 from 31.1% in the previous year, reflecting surging personal loans and credit to manufacturing. The Royal Monetary Authority (RMA, the central bank) reacted by maintaining tight monetary conditions such as keeping the mandatory cash reserve requirement (CRR) at 17% (the CRR was revised from 15% to 17% in August 2008). Under prudential measures, provisioning requirements of sub-standard and doubtful loans of financial institutions were maintained at 30% and 60% respectively, for the highest exposed sectors. Similarly, the capital base of banks and non-banking financial institutions (NBFIs) were maintained at Nu300 million and Nu100 million respectively. An estimated 50,000 young people will enter the labor market, and another 20,000 people will migrate from rural to urban areas by 2011. The Government therefore places a high priority to private sector development to diversify economic activity, stimulate economic growth, and generate employment. To achieve this, developing the country’s financial sector is necessary to improve access to finance, diversify existing financial services, and enhance the investment environment. The program loan has played an integral role in invigorating the private sector and promoting economic growth by developing a better-regulated and effectively enforced financial system that operates under the principles of good governance. The latest key economic indicators are in Appendix 1. 9. Overview of the financial sector. Though still small and predominantly bank-based, Bhutan’s financial sector has been expanding quite rapidly. According to data released by the RMA, Bhutan’s financial sector recorded its fastest rate of growth ever in 2010, aided by the entry to the sector of two new commercial banks, Druk PNB Limited and T bank, during the year. The total balance-sheet size of the financial sector stood at Nu72.6 billion at the end of 2010, an increase of 29.2% year on year. This was driven mainly by a 38.4% increase in net loans and advances. Of total financial sector assets, commercial banks accounted for 91.5%, whereas NBFIs held only 8.5%. However, in the year the combined assets of commercial banks expanded by 26.6%, while NBFIs’ assets rose by 65.3%. The financial sector’s exposure to off-

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This consultant’s report does not necessarily reflect the views of ADB or the government concerned. [For PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project’s design.]

balance-sheet items (such as letters of credit, performance bonds and other forms of guarantee) increased substantially in 2010 to Nu6.3 billion, from Nu4.1 billion in 2009. 10. Total financial sector lending at end-2010 was Nu36.0 billion, a 37% increase from Nu26.3 billion at end-2009, boosted by a supportive macroeconomic environment. The growth was mainly on account of new lending to the housing, services and tourism sectors. Housing finance rose by 35.1% year on year, while credit to the services and tourism sector increased by 58.8%. Total loans and advances of commercial banks increased by 33.1%, while those of NBFIs increased by 67.7%. Housing loans represented the highest proportion of total credit (at 24.8% of the total), followed by loans to the manufacturing and industrial sector (16.5%) and lending to the trade and commerce sector (16.4%). Credit quality improved as nonperforming loans as a share of the total narrowed to 10.1% in June 2010 from 18.3% the previous year, reflecting a fall in such loans in manufacturing, where several export-oriented firms saw an upswing in sales. In 2010 the net profits of the financial sector rose to Nu.1.1 billion, a 4.3% increase compared with 2009. The rise came mainly from a 13.5% rise in the profits of NBFIs to Nu220 million, compared with a 2.3% rise in the net profits of banks, to Nu910 million. 11. Banking services are provided by five commercial banks: Bhutan National Bank Limited (BNBL), Bank of Bhutan Limited (BOBL), Druk PNB Limited (DPNBL), T bank, and Bhutan Development Bank Limited (BDBL). BOBL is a state-owned bank3, while BNBL is a privately owned bank4

in which the Government holds a minor share. BDBL, formerly called Bhutan Development Finance Corporation, focuses on the rural market. BDBL is engaged in lending to private sector industrial clients, agricultural businesses, as well as micro, small and medium-sized enterprises. The Royal Monetary Authority Act of Bhutan was enacted in June 2010 under which the RMA was deemed to be an autonomous body as well as the regulatory authority over all banks, insurance companies, reinsurers, and all companies offering financial services including the stock exchange, the pension/provident funds and companies in the securities business. The Financial Services Act (FSA) was enacted in June 2011 under which banking, insurance, and securities activities were brought under a unified legislative, regulatory, and supervisory framework (paras. 17, 19, 23). In particular, the RMA was given powers to address shortcomings and issues in regulation, supervision, and penalty or prosecution in case of violations. Developments in the financial market have generally been positive and the entry of two banks (T Bank and DPNBL) into the financial sector during the program loan period is expected to bring greater competition, new technology, and better access to essential and diversified financial products in Bhutan. The program loan engendered competition and encouraged the development of more efficient and commercially oriented financial institutions by improving governance of the financial sector and enhancing efficiency of financial intermediation. 12. Parliamentary democracy. The years 2007 and 2008 were historic for Bhutan, bringing a successful transformation to democracy and constitutional monarchy. Bhutan officially became a parliamentary democracy on 18 July 2008 when the Constitution was signed by His Majesty the Fifth King of Bhutan, all National Assembly representatives, and all National Council members. Two political parties operate within a democratic system of governance, with universal suffrage and general elections every 6 years.

3 The Government owns 80% of BOBL, and the rest is owned by the State Bank of India.

4 The Government currently owns about 13.6% of BNBL, ADB 10.0%, National Provident and Pension Fund 25.7%, Bhutan Trust Fund 10.0%, Royal Insurance Corporation of Bhutan 2.1%, and the public 38.6%.

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III. STATUS OF PROGRAM IMPLEMENTATION

A. Summary of Compliance Status

13. The government has remained strongly committed to the program’s policy reforms and all nine policy actions required for release of the third loan tranche have been complied with. All the 6 non–tranche release policy actions have also been complied with. 14. ADB staff has closely monitored program implementation. Eight dedicated loan review missions were fielded in 2007–2011 (Appendix 2). The confirmed progress in overall program implementation and compliance with the policy actions required for the release of the third tranche justify the release of the tranche. Appendixes 3–4 provide details on third tranche policy actions and non-tranche policy actions.

B. Program Implementation

15. All policy actions for the release of the third tranche have been complied with. The following is the progress made under each tranche release action, classified according to the focus of reform.

1. Improve the Regulation and Supervision of the Financial Sector

16. The RMA to issue regulations to set up a standard chart of accounts to be followed by all banks and their external auditors (fully complied with). A chart of accounts for all financial institutions (banks and non-banks) and their auditors has been modified. The new chart of accounts has been adopted and implemented by the RMA’s integrated central banking system, which is an information technology system developed by the RMA. The integrated central banking system has 10 modules and is used by the RMA’s 10 departments for collecting data from outside as well as generating reports for analysis. The chart of accounts formats and reporting requirements were stipulated in the amended Prudential Regulations 2002 (PR 2002/V3-2010) on 20 July 2009 and compliance was enforced from March 2010. 17. RMA to issue and initiate the implementation of revised regulations under the Financial Services Act (FSA), to include (i) banking operations; (ii) insurance regulation and supervision; and (iii) securities exchange operations, as set out in the second tranche conditions (fully complied with). To fill gaps in the regulation and supervision of the financial sector in Bhutan, the RMA, as the single regulator, was required to be empowered to license, regulate, and supervise all financial service providers. These gaps were especially pronounced in laws and regulations for insurance and securities exchanges. A comprehensive FSA was therefore recommended to bring banking, insurance, and securities activities under a unified legislative, regulatory, and supervisory framework. Since the FSA is an integrated financial services bill, chapters have been drafted to align with current international standards in banking, insurance, and securities—for example, the Core Principles for Effective Banking Supervision, Objectives and Principles of Securities Regulation, and Insurance Core Principles and Methodology.5 These regulations include: (i) banking regulations pertaining to the ratio of

5 Basel Committee on Banking Supervision. 2006. Core Principles for Effective Banking Supervision. Basel.

Switzerland; International Organization of Securities Commissions. 2010. Objectives and Principles of Securities

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This consultant’s report does not necessarily reflect the views of ADB or the government concerned. [For PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project’s design.]

capital to risk assets (raising the capital to risk assets ratio to 10%) and to phased-in loan classification, provisioning, income recognition, inspection procedures to cover both on- and off-site examination to measure and manage exposure to various risks (credit, liquidity, interest rate, asset quality, and foreign currency among others), using a CAMELS framework (capital adequacy, asset quality, management, earnings, liquidity, and sensitivity to market risk) (ii) insurance operations and supervision pertaining to definition of solvency margins and admissibility of assets as well as establishing new off-site financial reporting formats and reporting standards, (iii) securities exchange operations including setting out trading and settlement procedures with regard to a proper matching and delivery versus payment, (iv) written procedures for on-site inspections of securities exchanges by RMA as well as inspections of brokers by the securities exchange and RMA, (v) issuer disclosure on control and related-party disclosure and expanded remedies for defective disclosure, and (vi) introducing internal controls and inspections for the depository. The FSA was approved during the summer parliamentary session in June 2011. The FSA was granted Royal Assent on 5 July 2011 after which RMA’s Board approved the revised regulations on 9 September 2011. The revised regulations were posted on RMA’s website for a period of 30 days to receive and incorporate comments from the public before RMA issues these regulations. The RMA issued the revised regulations on 21 October 2011. 18. RMA to issue and initiate implementation of enforcement and compliance regulations (fully complied with). After conducting stakeholder consultations concerning enforcement and compliance regulations, the RMA in 2009 issued and initiated implementation of enforcement and compliance regulations defining corrective actions and providing for specific timetable for implementation to be taken by financial institutions and corresponding penalties for financial institutions’ non-compliance. Specifically, the regulations of enforcement and penalty framework were finalized and issued in the amended Prudential Regulations 2002 (PR 2002/V3-2010, Annexure I).

2. Strengthen the Corporate Governance Structure and Operations of Financial Institutions

19. RMA to issue and initiate implementation of regulations and guidelines on corporate governance for financial institutions (substantially complied with). The corporate governance regulations prepared by RMA for all financial institutions include (i) a fit and proper test for boards of directors, (ii) structure and composition of the board, (iii) conflict of interest rules and (iv) restriction on cross shareholdings. With regard to structure and composition of the board, the regulations stipulate a requirement of at least 2 independent directors on the board of financial institutions which falls slightly short of the minimum 50% private sector participation recommended by ADB. This stipulated regulation is deemed sufficient by RMA since the prevailing norm in Bhutan’s financial sector is for the boards of financial institutions to have a majority of private sector participation in the composition of the boards of financial institutions. Currently, all financial institutions in Bhutan have a majority of private sector participation in the composition of their boards except BOBL. The regulations and guidelines on corporate governance for financial institutions were finalized by RMA in August 2010. The issue and initiation of these regulations and guidelines were undertaken after parliament approval of FSA followed by specific procedural steps. Following Royal Assent of the FSA, RMA’s Board approved the regulations and guidelines on 9 September 2011. The regulations and guidelines were posted on RMA’s website for a period of 30 days to receive and

Regulation. Madrid. Spain; International Association of Insurance Supervisors. 2003. Insurance Core Principles and Methodology. Basel. Switzerland.

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incorporate comments from the public before RMA issues these regulations. The RMA issued the revised regulations on 21 October 2011. 20. Signing of MOU between Ministry of Finance and Bank of Bhutan Limited (BOBL) to commercialize BOBL’s operations (fully complied with). At the time of program preparation, the BOBL, the bigger of the two banks then existing in Bhutan, was operating inefficiently and lacked a good governance structure. This led to downside risks to the bank’s balance sheet and, given its size (49% of all financial sector assets at the time), to the development of the banking sector. The lending market and the quality of financial services were also suffering, partly because 20% of the BOBL’s considerable assets were idle funds earning no interest. The program therefore included an agenda for reforming the BOBL and thereby promoting the financial sector’s overall development. Since the program began in 2007, the BOBL’s corporate culture, operating efficiency, and performance have improved remarkably. During 2010, the BOBL recorded a record income of Nu1.4 billion that included an 8.31% annual growth in its profit after tax. The management of BOBL, Druk Holding and Investment (DHI), and MOF signed a MOU in 2008 agreeing to work together to carry out important reforms to improve BOBL operating efficiency and performance. Two factors drove this improvement. First, shortly after it issued new regulations for the establishment of commercial banks, the RMA received five applications for new banking licenses. The BOBL had to change and improve its business to retain market share. Second, the government established DHI, a government holding company, in 2008 to manage and safeguard businesses it owned. As a result, government shares in the BOBL were transferred to DHI in 2008 and the BOBL came under DHI’s management. 21. In 2008, the BOBL developed a new 5-year business plan with clear performance targets, a new organization structure, and innovative business approaches, including an information technology upgrade and small and medium-sized enterprises banking. Each year, the BOBL management negotiates a new compact with DHI that sets clear financial performance targets and specifies activities to be undertaken or products to be launched during the year. These are evaluated at year-end. The management of the BOBL and DHI signed a memorandum of understanding (MOU) in 2008 agreeing to work together to further commercialize BOBL’s operations including time-bound performance targets and the preparation of rolling business plans that define parameters and performance indicators against which BOBL management performance is to be evaluated. Such performance indicators include, among others, (i) linking remuneration to performance (BOBL has been operating such a performance-based incentive system since March 2009), (ii) improving recruitment and performance evaluation policies and processes for staff, and (iii) developing a new human resource strategy (BOBL developed a new human resource strategy that centered not only on skills development through training and scholarship programs but also on gender diversity). 22. Royal Insurance Corporation of Bhutan Limited (RICBL) to implement the rationalization plan (fully complied with). The program sought to reinforce the organizational structure of the RICBL in accordance with the core principles of the International Association of Insurance Supervisors 6 and with the RMA’s new insurance regulations and supervision guidelines. Under the RMA’s supervision and with project loan support, the RICBL studied the feasibility of rationalizing its business operations. The rationalization plan was finalized in 2008. Implementation is to be done in phases. In the first phase under implementation since November 2008, the RICBL is operating as a composite insurance company, following

6 International Association of Insurance Supervisors. 2003. Insurance Core Principles and Methodology. Basel,

Switzerland.

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This consultant’s report does not necessarily reflect the views of ADB or the government concerned. [For PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project’s design.]

International Association of Insurance Supervisors principles. The RICBL completely segregated the accounts into general insurance, life insurance, and credit and investment along the lines of 3 separate entities (but not as separate legal entities). It retains all three of its lines of business—general insurance, life insurance, and credit and investment—until Bhutan’s capital market becomes more developed and the RICBL can have a wider choice of instruments to invest in. Separate investment policies for the three operations will ensure proper management and monitoring of target rates of return, liabilities, and risk controls. In the second phase that will commence after Bhutan’s capital market becomes more developed, a full rationalization plan will be adopted by the RICBL with viable long-term investment opportunities to match its equitable liability.

3. Consolidate and Improve the Anti-Money Laundering and Combating the Financing of Terrorism Regime

23. Financial Intelligence Unit (FIU) to commence operations (fully complied with). For the enhanced safety and stability of Bhutan’s financial system, the program aimed to improve the existing anti-money laundering (AML) and combating the financing of terrorism (CFT) polices, procedures, and coordination mechanism. Although Bhutan is not yet fully integrated into the international financial systems, it has lacked effective reporting and monitoring procedures and a coordinated regulatory AML and CFT framework. This heightened the risks of money laundering and the financing of terrorism. The program has therefore supported the government in strengthening and coordinating the AML and CFT regime and making it as comprehensive as possible by establishing institutional arrangements, regulations, and procedures. The FIU was established in October 2010 under the RMA’s Financial Regulations and Supervision Department. The FSA Bill provided the legislative authority for the establishment of the FIU and its powers and functions (sections 141 to 149 of the FSA 2011). The AML and CFT regulations are part of the FSA Bill. The FIU has taken charge of financial reporting requirements and procedures for AML/CFT supervision of financial institutions particularly concerning Know Your Customer and suspicious transactions.

4. Develop National Accounting and Auditing Policies and Standards

24. The AASB to develop an implementation plan and timeframe for adopting the new Bhutanese national GAAP and GAAS (fully complied with). To address problems of insufficient transparency and poor comparability of reports and performance records of financial institutions in Bhutan, the program sought to develop the uniform, consistent, international-quality national accounting and auditing standards that the country lacked. With no financial statement guidelines or disclosure requirements for companies, institutions, and their auditing firms, reports and performance records were highly opaque and could not be compared. The program supported the creation of generally accepted accounting principles for Bhutan in line with international accounting and financial reporting standards and generally accepted auditing standards in line with international auditing standards. In May 2010, the cabinet and the Ministry of Finance issued orders establishing an accounting and auditing standards board (AASB). Details of the board’s structure, roles, responsibilities, and corporate governance were finalized. The AASB was given the authority to develop and implement the necessary standards, ensuring consistency with international accounting and financial reporting standards, and international auditing standards, where applicable. The AASB is also empowered to examine, regulate, and provide interpretations and guidance on Bhutan’s generally accepted accounting and auditing standards. It is also be responsible for an assessment of training needs, facilitating the establishment of an institute of chartered accountants in Bhutan, and liaising with educational

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institutions to align curriculum with chartered accountancy courses. In keeping with the mission of the AASB to promote high quality financial reporting and auditing standards that are consistent with international best practices, the AASB produced a set of accounting standards called Bhutanese national GAAP that are essentially International Financial Reporting Standards (IFRS). The standards are divided into three time phases. The first phase is from 2012-2014, the second phase is from 2016-2017, and the final phase from 2018-2019. In the first phase 18 standards would be issued, 9 in the second phase and 10 in the final phase. Since Phase 1 of accounting standards will be issued and implemented only from January 2012, it is planned to implement auditing standards after accounting standards are fully functional, at least two years after implementing accounting standards. This will ensure that a proper basis for auditing is established since audit firms will then be cognizant of which accounting standards to audit. The AASB conducted final discussions in May 2011 with regard to adoption of Phase One of the new Bhutanese national GAAP and GAAS. On behalf of the government, the implementation plan was formally submitted to ADB on 10 October 2011 by the Department of Public Accounts at the Ministry of Finance.

5. Strengthen Information Disclosure in the Financial Sector

25. Credit Information Bureau (CIB) to commence operations (fully complied with). To lower the cost of borrowing, facilitate financial transactions, expedite loan applications, and improve credit risk assessment, the program supported the creation of an effective credit information bureau (CIB) to improve information disclosure in the financial sector. The previous system for the sharing of credit information by financial institutions was slow and inefficient and the establishment of a CIB with a sound legal and regulatory framework was aimed at making financial transactions more efficient, promoting competitive services, and achieving good credit growth. The RMA established an advisory board in 2007 to supervise the CIB’s establishment. In 2008, ADB provided additional assistance for the design and procurement of the CIB’s information technology infrastructure, including hardware and software. 7 The CIB was inaugurated on 9 September 2009 under the management of the RMA. With a staff of six, it is fully operational. In addition, as of July 2011, 94% of the credit data of all the financial institutions in Bhutan had been captured by the CIB; 3494 credit reports had been pulled from the CIB on the requests of financial institutions in July 2011.

C. Review of the Implementation of Project Loan

26. The project loan was processed together with program loan (footnote 1). Its five components corresponded with the five objectives of the program. Its main purpose was to provide TA and support for project implementation and for sustaining the policy reforms. All the consulting packages have been procured and the TA is ongoing; the services of 10 consultants have been engaged for approximately 38 person-months. Capacity-building activities, including equipment procurement related to the establishment of a CIB and the improved disclosure of securities information, are complete. The three remaining activities—capacity building to strengthen corporate governance, the strengthening of the AML and CFT regime, and accounting and auditing reforms—are ongoing and is scheduled to be completed by December 2011. All the consulting packages have been procured in accordance with ADB’s Guidelines on Consultants (2010, as amended from time to time).

7 ADB. 2008. Technical Assistance to the Kingdom of Bhutan for the Strengthening of the Credit Information Bureau.

Manila (TA 7084-BHU).

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This consultant’s report does not necessarily reflect the views of ADB or the government concerned. [For PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project’s design.]

27. Arrangements for the project’s secondment program in financial supervision changed during implementation. It was originally to involve only four senior staff members of the RMA’s financial regulation and supervision department (FRSD). Now all FRSD staff members are able to obtain supervisory skills and experience from practitioners in regional supervisory bodies or authorities. In addition, the FRSD is being provided with more training opportunities in areas relevant to its operations, including insurance and securities regulation. So far, 18 training programs have been conducted. The impact has been evident in the strong FRSD staff ownership of the FSA bill and staff handling of revisions during sessions of the National Assembly. The training program for insurance underwriting has also been expanded to cover not only the six staff members of one insurance company originally envisaged but all concerned officers of both insurance companies in Bhutan. About 63 regulators and officers in the FRSD and insurance sector have been trained in 27 training programs in general insurance, life insurance, and other areas of insurance, including underwriting and claim management. The secondment and training programs conducted for the FRSD and the insurance sector are in Appendix 5.

D. Review of the Associated Technical Assistance

28. The associated TA, which was closed on 30 June 2011, was designed to help the government set up a permanent, sustainable training institute to meet the present and future capacity-building needs of the country’s financial sector (footnote 1). Although it was delayed by an unforeseen change in the consulting arrangement for the task, establishment of the training institute has progressed smoothly with strong sector backing. 8 Training needs have been assessed and are guiding the ongoing development of the institute’s curriculum. Rather than being established and owned by the RMA, as the TA originally suggested, the training institute has been created and owned through a national organization by all the financial institutions in Bhutan.9 It has started out as an autonomous body within the RMA under a board of directors of at least six members—three from the RMA and three from financial institutions.10 Within 3 years of its establishment, it will be spun off as a fully independent institution owned by the Bhutan Financial Institutions Association Board. In the long term, participation may be extended to the private sector. This change in the institute’s design was intended to broaden ownership and make the institute more efficient, sustainable, and responsive to financial sector stakeholders. 29. A detailed investment plan for the training institute has been prepared and a pilot training program was undertaken in May 2011. The pilot training program improved knowledge of banking and finance for all market participants. Both the government and the financial institutions remain committed to the institution. The long term commitment by the financial institutions is evident from their agreement to initiate groundwork measures through the Bhutan Financial Institutions Association Board to procure land for the physical construction of the institution.

8 The International Trade Institute of Singapore was hired in early 2008 to provide consulting services. By late 2008,

however, the institute had ceased its consulting operations after its divestment from its parent company. Project implementation arrangements under the TA were later changed to accommodate the hiring of an individual consultant instead of a team of two for the remaining work.

9 The funding plan seeks support from the RMA, financial institutions, donors and development partners, including

ADB, during the initial establishment period. Each financial institution will take an equity stake in the training institute; the amount would vary according to asset size or number of employees. The suggested fund amount to cover initial operating costs of the institute is Nu300 million, staggered over a 3 year period in installments of Nu100 million that began in December 2010.

10 The members from the financial institutions will be rotated every 2–3 years.

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IV. CONCLUSION

30. Despite the challenges posed by political transformation and the impact of the financial crisis, the government and the agencies concerned have remained committed to the program and have shown strong ownership of its reform measures. The first and second tranche release policy actions continue to be met. With all the reform measures already undertaken, the program has reached important milestones in strengthening the governance of the financial system through an improved legal, regulatory, and supervisory framework for all financial services and institutions. The passage of the revised RMA Act (2010) addressed the issue of the RMA’s autonomy and will allow it to function as an independent central bank with a governance structure in line with international best practices. The passage of the FSA bill in June 2011 moved Bhutan closer to having a complete and coherent legal framework for the entire financial sector and empowering the RMA as its sole regulator. The program has addressed the governance issue in the financial sector comprehensively. 31. The government has achieved other key goals, including the enhancement of existing AML–CFT framework, improving information disclosure in the financial sector, and developing national accounting and auditing standards. The FSA bill incorporates an important legal framework for AML/CFT regulations, supervision, and inspection to improve the integrity, safety, and stability of the financial system. An FIU has also been set up and has been empowered since the enactment of the FSA legislation. A CIB has also has been established and its legal and regulatory framework was finalized in the FSA bill. Both the FIU and the CIB have begun operations and fulfilled their mandates, as recommended by the program’s third tranche policy actions. 32. The program has set in motion the crucial effort to develop generally accepted accounting principles and auditing standards in Bhutan that are in line with international standards, where applicable. This is essential to make financial information transparent and promote good corporate governance. The government has endorsed a suitable implementation plan for developing national accounting and auditing standards and policies. 33. In summary, the reform measures undertaken under the program have significantly strengthened the regulation and supervision framework of the financial sector as a whole. They have enabled the financial markets to be deepened, with greater market competition, enhanced corporate governance in the banking system, and improved financial stability. The passage of the FSA bill in June 2011 ensured full compliance in terms of overall program implementation. In line with performance indicators under the design and monitoring framework, the program has promoted a better-regulated financial system more effectively enforced that operates under the principles of good governance and so encourages the development of more efficient and commercially oriented financial institutions. It has engendered competition and thereby invigorating the private sector, promoting economic growth, and reducing poverty.

V. THE PRESIDENT’S DECISION

34. In view of the progress made in the implementation of Financial Sector Development Program, as evidenced by the substantial compliance with one tranche release condition and full compliance with the other tranche release conditions, the President is satisfied with the overall implementation of the Financial Sector Development Program, and that the necessary conditions for release of the third tranche have now been fulfilled. In accordance with

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This consultant’s report does not necessarily reflect the views of ADB or the government concerned. [For PPTAs: Also, all of the views expressed herein may not be incorporated into the proposed project’s design.]

established procedure, the President will authorize the release of the third tranche in the amount of SDR2,038,000. The release of the third tranche will be effective not less than 10 working days after the circulation of this progress report to ADB Board of Directors.

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KEY ECONOMIC INDICATORS

Item

Fiscal Year

2006 2007 2008 2009 2010

A. Income and Growth

1. GDP per Capita ($, current) 1,352 1,769 1,831 1,814 2,140

2. GDP growth (%, in constant prices) 7.8 12.6 10.8 5.7 7.0

a. Agriculture 1.8 1.7 0.8 1.7 —

b. Industry 8.6 25.4 20.4 4.8 —

c. Services 11.3 7.1 5.3 9.1 —

B. Saving and Investment (% of GDP)

1. Gross fixed capital formation 47.2 39.2 47.0 53.6 —

2. Gross domestic saving 32.5 35.2 52.2 63.6 —

C. Money and Inflation (annual % change)

1. Consumer price index 4.9 5.2 6.7 7.1 4.8

2. Total liquidity (M2) 26.3 8.6 2.3 24.6 30.1

D. Government Finance (% of GDP)

1. Revenue and grants 35.0 35.7 35.2 40.4 39.4

2. Expenditure 35.9 35.1 34.4 38.6 45.4

3. Overall fiscal surplus (deficit) (0.8) 0.6 0.8 1.8 (6.0)

E. Balance of Payments

1. Merchandise trade balance

($ million) (122.9) 46.7 (72.4) (90.5) (298.8)

2. Current account balance

(% of GDP) (4.5) 14.4 (2.1) (1.6) (13.5)

3. Merchandise export ($) growth

(annual % change) 47.2 83.7 4.4 (13.8) 5.5

4. Merchandise import ($) growth

(annual % change) (5.6) 21.1 27.4 (9.6) 39.0

F. External Payments Indicators

1. Gross official reserves

(months of imports of goods) 13.8 12.8 12.4 15.4 12.2

2. External debt service

(% of exports of goods and services) 7.6 3.6 18.3 30.5 29.5

3. Total external debt (% of GDP) 90.9 71.0 63.5 65.5 59.6

G. Memorandum Items

1. GDP (current prices, ngultrum millions) 33,393 45,065 52,084 57,968 65,852

2. Exchange rate (ngultrum/$, average) 44.74 44.19 40.37 47.78 46.65

3. Population (million) 0.65 0.66 0.67 0.68 0.70

( ) = negative, GDP = gross domestic product. Sources: Royal Monetary Authority of Bhutan. Annual Report 2009/2010. Thimphu; ADB. 2010. Key Indicators 2010. Manila. FYI 2010 GDP data is ADB projection.

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CHRONOLOGY OF REVIEW MISSIONS UNDER FINANCIAL SECTOR DEVELOPMENT PROGRAM

Source: Asian Development Bank.

Type of Mission

Dates

Mission Duration

(days)

No. of

Travelers

Total Field Days

Person-Months

Inception 20–28 Aug 2007 2 3 6 0.20 Total 2007 6 0.20 Review 18–28 Feb 2008 3 1 3 0.10

Total 2008 3 0.10 Review 1–9 Sep 2009 3 2 6 0.20

Total 2009 6 0.20 Review 18–22 Jan 2010 5 2 10 0.33 Review 14 May 2010 1 2 2 0.07

Total 2010 12 0.40 Review 23 Feb–3 Mar

2011 2 3 6 0.20

Review 4–6 Jul 2011 2 1 2 0.07 Review 6–7 Sep 2011 2 1 2 0.07

Total 2011 10 0.34 Total 37 1.24

14 Appendix 3

STATUS OF COMPLIANCE WITH THE THIRD-TRANCHE POLICY ACTIONS

Focus of Reform Policy Conditions Assessment of Progress (with supporting Documents)

A. Improve regulation and supervision of the financial sector

1. RMA to issue regulations to set up a standard chart of accounts to be followed by all banks and their external auditors.

Fully complied with. The regulations were issued by RMA at the end of July 2011 to set up a standard chart of accounts under the integrated central bank system.

2. RMA to issue and initiate the implementation of revised regulations under the FSA, to include (i) banking operations; (ii) insurance regulation and supervision; and (iii) securities exchange operations, as set out in the second tranche conditions.

Fully complied with. The FSA was approved during the summer parliamentary session in June 2011. The FSA was granted Royal Assent on 5 July 2011 after which RMA’s Board approved the revised regulations on 9 September 2011. The revised regulations were posted on RMA’s website for a period of 30 days to receive and incorporate comments from the public before RMA issues these regulations. The RMA issued the revised regulations on 21 October 2011.

3. RMA to issue and initiate implementation of enforcement and compliance regulations.

Fully complied with. In 2009, RMA issued and initiated implementation of enforcement and compliance regulations defining corrective actions and penalties for non-compliance by financial institutions.

B. Strengthen the corporate governance structure and operations of financial institutions

4. RMA to issue and initiate implementation of regulations and guidelines on corporate governance for financial institutions.

Substantially complied with. The regulations and guidelines on corporate governance for financial institutions were finalized by RMA in August 2010. However, the issue and initiation of these regulations and guidelines could only be undertaken after parliament approval of FSA followed by specific procedural steps. The FSA was approved during the summer parliamentary session in June 2011. The FSA was granted Royal Assent on 5 July 2011 after which RMA’s Board approved the regulations and guidelines on 9 September 2011. The regulations and guidelines were posted on RMA’s website for a period of 30 days to receive and incorporate comments from the public before RMA issues these regulations. The RMA issued the revised regulations on 21 October 2011.

5. MOU signed.

Fully complied with. The management of BOBL, Druk Holding and Investment (DHI), and MOF signed a MOU in 2010 agreeing to work together to improve BOBL operating efficiency. DHI is a government holding company under which government shares in BOBL were transferred in 2008 and BOBL came under DHI’s management. Under the MOU, important reforms are being undertaken to improve BOBL’s operating efficiency

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and performance.

6. RICBL to implement the rationalization plan.

Fully complied with. The rationalization plan was finalized in 2010. Implementation is to be done in phases. In the first phase, the RICBL will operate as a composite insurance company, following International Association of Insurance Supervisors principles. The RICBL will completely segregate the accounts into general insurance, life insurance, and credit and investment along the lines of 3 separate entities (but not as separate legal entities). It will retain all three of its lines of business—general insurance, life insurance, and credit and investment—until Bhutan’s capital market becomes more developed and the RICBL can have a wider choice of instruments to invest in. Separate investment policies for the three operations will ensure proper management and monitoring of target rates of return, liabilities, and risk controls.

C. Consolidate and improve anti-money laundering (AML) and combating the financing of terrorism (CFT) regime

7. FIU to commence operations.

Fully complied with. The FIU commenced operations in April 2011 after finalization of the reporting formats and training of the reporting entities.

D. Develop national accounting and auditing policies and standards

8. AASB to develop an implementation plan and timeframe for adopting the new Bhutanese national GAAP and GAAS.

Fully complied with. The AASB conducted final discussions in May 2011 with regard to adoption of Phase One of the new Bhutanese national GAAP and GAAS. The implementation plan was finalized on 10 October 2011.

E. Strengthen information disclosure in the financial sector

9. CIB to commence operations.

Fully complied with. CIB was inaugurated on 9 September 2009 under the management of the RMA. With a staff of 6, it is fully operational. As of July 2011, 94% of the credit data of all the financial institutions in Bhutan had been captured by the CIB; 3494 credit reports had been pulled from the CIB on the requests of financial institutions in July 2011.

16 Appendix 4

STATUS OF COMPLIANCE WITH THE NON-TRANCHE RELEASE POLICY ACTIONS

Form of Reform Policy Actions

Assessment of Progress (with Supporting Documents)

A. Improve regulation and supervision of the financial sector

1. RMA to draft and issue regulations on a continuous basis as needed to include:

setting up a standard charts of accounts to be followed by insurance companies, securities dealers and brokers, and other non-bank financial institutions and their external auditors and

licensing and related requirements in screening potential domestic and foreign applicants for insurance companies, securities exchange dealers and brokers and other non-bank financial services.

Complied with. The regulations were issued by RMA at the end of July 2011 to set up a standard chart of accounts under the integrated central bank system. Complied with. Licensing regulations for financial services providers were issued on 21 October 2011.

B. Strengthen the corporate governance structure and operations of financial institutions

2. Business plan approved by the BOBL board of directors.

Complied with. The management of BOBL, Druk Holding and Investment (DHI), and MOF signed a MOU in 2010 agreeing to work together to improve BOBL operating efficiency.

3. BOBL to implement business plan as measured through semi-annual performance reports.

Complied with. Under the MOU, important reforms are being undertaken to improve BOBL’s operating efficiency and performance as measured through annual performance reports.

4. RICBL to adopt business plans for each of its operations post-rationalization as agreed with MOF and RMA.

Complied with. The rationalization plan was finalized in 2008. Implementation is to be done in phases. In the first phase, the RICBL will operate as a composite insurance company, following International Association of Insurance Supervisors principles. The RICBL will completely segregate the accounts into general insurance, life insurance, and credit and investment along the lines of 3 separate entities (but not as separate legal entities). It will retain all three of its lines of business—general insurance, life insurance, and credit and investment—until Bhutan’s capital market becomes more developed and the RICBL can have a wider choice of instruments to invest in. Separate investment policies for the three operations will ensure proper management and monitoring of target rates of return, liabilities, and risk controls.

C. Consolidate and improve anti-money laundering (AML) and combating the financing of terrorism (CFT) regime

D. Develop national accounting and auditing policies and standards

5. AASB to initiate the development of the Bhutanese GAAP and GAAS in consultation with stakeholders and to promote the development of the accounting and auditing professions.

Complied with. The AASB conducted final stakeholder consultations in May 2011 with regard to adoption of Phase One of the new Bhutanese national GAAP and GAAS. The implementation plan was finalized on 10 October 2011.

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DETAILED LIST OF TRAINING PROGRAMS UNDERTAKEN IN PROJECT LOAN

Table A5.1: Secondment and Training Programs for Strengthening Financial Supervision

No Title Duration

1

Attachment in Banking and Insurance Regulation with Bank Negara Malaysia

19–30 Jan 2009

Attachment in Banking Regulation with Bank of Thailand, OIC and SEC Thailand

2–14 Feb 2009

2 Training on Insurance and Securities Regulations, Taipei,China 23 May–7 Jun 2009

3 Ninth MAS Banking Supervisors Training Program, Singapore 25 May–5 Jun 2009

4 Training on Bank Fraud Detection, APEC, Hong Kong, China 16–20 Nov 2009

5 Microfinance Policymakers Workshop Forum, Malaysia 2–3 Dec 2009

6 Seminar for Senior Bank Supervisors from Emerging Economies, United States

19–30 Oct 2009

7 Attachment with ADB on Project Implementation, Philippines 1–5 Feb 2010

8 Regional Seminar on Bank Analysis and Examining School, Philippines

22–26 Feb 2010

9 On-Site and Off-Site Examination for Insurance Supervisors, Indonesia

12–15 Apr 2010

10 Seminar on Risk Management for Securities Regulations, Philippines

17–21 May 2010

11 Training on Risk Management for Insurance Regulators, Singapore 2–5 Aug 2010

12 Seminar on Enhancing Transparency, Kuala Lumpur, Malaysia 23–24 Sep 2010

13 Training on Securities Market Operations, Mumbai, India 25–29 Oct 2010

14 APG Typologies Meeting, Dhaka, Bangladesh 25–29 Oct 2010

15 Study Tour, Australia 22 Nov–11 Dec 2010

16 9th APRC Annual Meeting and International Conference, Bangkok,

Thailand 19–21 Jan 2011

17 Training on Banking Analysis, Manila, Philippines 11–15 April 2011

18 Visit to FIU India, New Delhi, India 13–14 June 2011 ADB = Asian Development Bank, APEC = Asia-Pacific Economic Cooperation, APG = The Asia/Pacific Group on Money Laundering, APRC = Asia/Pacific Regional Committee, FIU = Financial Intelligence Unit, OIC = Office of the Insurance Commission, MAS = Monetary Authority of Singapore, SEC = Securities and Exchange Commission Source: Asian Development Bank.

Table A5.2: Training Program for Enhancing Insurance Underwriting and Other Relevant Skills

No Title Duration

1 General Insurance Foundation Course, College of Insurance, India 1–30 Sept 2009

2 Advanced General Insurance Management, Malaysian Insurance Institute, Malaysia

26 Oct–6 Nov 2009

3 Life Insurance Foundation Course, College of Insurance, India 1–28 Feb 2010

4 Asia Insurance Review, Singapore 23–25 Mar 2010

5 Advanced Life Underwriting and Claims Management, Malaysian Insurance Institute, Malaysia

8–19 Mar 2010

6 Advance Accounting and Financial Management, Sunrise Training Institute, India

22 Mar–9 Apr 2010

7 Web Designing and Networking, Sunrise Training Institute, India 22 Mar–9 Apr 2010

8 Credit and Political Risk Insurance, Singapore College of Insurance, Singapore

3–4 May 2010

9 Property Valuation, Thai Real Estate Business School, Bangkok, Thailand

12–23 May 2010

10 Life Underwriting and Claims Management, Global Advanced 26 May–6 June 2010

18 Appendix 5

Service Management

11 Life Underwriting and Claim Management, Thailand 9–20 Aug 2010

12 Internal Audit Course for Government Corporation, Philippines 12–13 Aug 2010

13 General Insurance Foundation Course, College of Insurance, India 1–30 Sep 2010

14 Sixth International Longevity Risk and Capital Market Solution Conference, Australia

9–10 Sept 2010

15 Insurance Management System, Philippines 30 Aug–6 Sept 2010

16 Frontline Marketing Strategies, India 13–18 Sept 2010

17 Comprehensive Technical Programme in General Insurance, National Insurance Academy, Pune, India

8–27 Nov 2010

18 New Product Development, Insurance Companies, Kathmandu, Nepal

19–25 Dec 2010

19 Life Insurance Foundation Course 1–28 Feb 2011

20 Effective Claims Management, National Insurance Academy, Pune, India

7–12 Feb 2011

21 Reinsurance Management, National Insurance Academy, Pune, India

14–15 Feb 2011

22 HRD for Lines Managers, National Insurance Academy, Pune, India 30 May–4 Jun 2011

23 Insurance Contract Law, Singapore College of Insurance 30 may–1 Jun 2011

24 47th International Insurance Summit, International Insurance Society 19–22 Jun 2011

25 General Insurance Underwriting and Claims Management, Malaysian Insurance Institute, Malaysia

20 Jun–1 Jul 2011

26 Induction Programme on Loan Appraisal and Bank Guarantees, LCIMF, Kolkata, India

29 Jun–4 Jul 2011

27 Behavior and Soft Skill Training, LCIMF, Kolkata, India 1–4 Aug 2011 Source: Asian Development Bank.