Document of

The World Bank

FOR OFFICIAL USE ONLY

Report No. 11572-CE

STAFF APPRAISAL REPORT

SRI LANKA

PRIVATE FINANCE DEVELOPHENT PROJECT(PFOP)

MARCH 19, 1993

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Cotutry Operations and Industry & Finance DivisionCoutry Department IIISouth Asia Region

| Th document has a "retited disibti"on d may be used by recipet only in the performance oftheir offcici dues. Its cons may not otherwise be dislosed without Wodd Bank authzation.

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CURRENCY EOUIVALENTS(As of December 1992)

Sri Lanka Rupee (Rs) - 100 pai.aUS$1.00 - Rs 46.0Rs 1.00 - US$0.022

FISCAL YEAR

Government of Sri Lanka January 1 to December 31

Commercial Banks January 1 to December 31

DFCC April 1 to March 31

National Development Bank January 1 to December 31

FOR OMCLFAL USE ONLY

ABBREVIATIONS AND PRINCIPAL ACRONYMS

ADB Asian Development BankAWn Average Weighted Prime RateAWDR Average Weighted Depoeit Rate

BDD Banking Development DepartmentBIS Bank for International SettlementsBOC Bank of CeylonBSD Bank Supervision Department

CBOC Comercial Bank of CeylonCBSL Central Bank of Sri LankaCeA Central Environmental AuthorityCIBSL Credit Information Bureau of Sri Lanka

DFCC Development Finance Corporation of CeylonDPI Development Finance lIstitution

ElA Environmental IMpact AssessmentEMS Environmental ement StrategyUPF Employees' Provident FundEPL Envirormental Protection LicenseEPZ Export Processing ZoneETF Employees' Trust Fund

FCBr Foreign Currency Banking UnitFD' Poreign Direct InvestmentP^L"s Foreign Investment Adviaery Service

GC&C Greater Coolambo Economic CommissionG9 Governrent of The NetherlandsaOSL Government of Sri Lank.

mNB Hatton National Bank

ICASL Institute of Chartered Accountnt. of Sri LankaICSL Insurance Corporation of Sri LankaIDA International Development Association

MB Monetary BoardHEIP Metropolitan Environmental Improvement ProgramMPA Ministry of Environment and Parliamentary AffairsMOF Ministry of Finance

UBFISD Non-Bank Financial Institutions Supervision DepartmentNDB National Development Bank of Sri LankaUESC National Environmental Steering CoamitteeNGO Non-Covernment OrganizationsNIC Newly Industrialized CountryJSs National Savings Bank

PB People's BankPCAP Pollution Control and Abatement FundPCT Participating Credit InstitutionPnlE Public Manufacturing Enterprlses

This documant has a restricted distribution and may be used by recipients only in the perform 0nceof their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

MEMAC Public Manufacturing Intevpites Adjustment Credit

RRDB Regional Rural Development Banks

$CB State-owned Commercial BankSCOPE Sheme for Control of Pollution frcom Xisting IndustriesgMI Small and Medium Industry5HIB State Mortgage and lawvetment BsakSO Statement of Expe.se

TA Technical AssistanceTAP Technical Assistance FundTOR Tenm of Reference

UDA Urban Development ActUNDP United Natiane Development ProgramUSAID United States Agency for International Development

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STTFcm

Credit and Project Sumary . . . . . . . . . . . . . . . . . . . . . . 1-1it

I- TBRIOLISR * o*ooooo ... * ** l a .1

A. Recent lconDOic Performance * . . .0.6.6. 1Grloth P.rforIaNc *...... . .I. .0. .. . 1iscal Deficit 0 . 000.01

Inflation 0 0 0**0** *** * * 0 2Ezternal Sctor Developamet. . . . . . . . . . . . . . 2Export .0 * 0 . 0 . . 2Izteral Aid 00000 00D.velopmet of Infretructure . . . . . . . . . . . . . . . 3Efforts for Poverty Reduction *. . a * * . . * . . . . * 3

S. Towards Macroeconomic Stabity . .0 0 0 0 0 0 . 0. 0. 0. 4C. Tatrd. a Private Sector-Led Opn Economy . . . . . . . . . . SD. IDAStrategy nd Ratioale for Ivolv.met .. .. . . 6

Thaed PropaedPmect .Role of IC andG 0 00 0 0 08

it. 9Z INDUSTAL SECTOR 9

II . F A 0 0 0 0 1 0 0

A. Overviw and Policy lraem ork . . . . . . . . . . .1S. Pinancial sector luoas 13o o oo oo .13

Dometic Rleource )hbilizatio for Tesm Lending 13Contractual Svwing. Institutions * . * . . . . . . 14Goveriment'. Role In the inancial Sector . . . . . . . . . 17Developmeat Fla nce Coepant . . . . . . . . . . . . . . .. 17State-Owned Commercial Sauk*. . * . . . . . . . . . . i .sDebt Recovery Legielation . . . . . . . . . . . . . . . . 20Accounting nd Audit Standard. ad Euore m nt . 20Bankig Supervi.ion * 0 0 0 0 0 * * ... *21

This report vas prepared by Messre. V. Rohil Nefees end Rakesh Engia (SLSCI)following an appral,al isieion to Sri Laka to December 1992. This report ba.be w *ndorsed by Kosoer. Isenuan (Director, SA3DR), Pefalver (Chbif, SAUCI)and Wormser (Unit Chlef, Industry and Finance Unit, SA3C) * Per Reviawguidance ba. been provided by Mr. David Grove (S&1DR) and Kb. Mar1l1u Uy(CaWR)

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IV. IHE PROJECT. . . . . . . . . . . . . . . . . . . . . . * . . . .23

A. ObjectiveT . . . . . . . . . . . . . . . . . . . . . . . . . . 23

D.roecDescr..t........................3

A. Tems and Condition. , . . . . . . . . . . . . . . . . . . . . 26Aumont and Maturity ..... . . . . . . . . . . . . . . 26Interest Rate . . . . . . . . . . . . . . . . . . . . . .26Subproject Financing Criteria . . . . . . . . . . . . . .27Subloan Sie, Free Lmits nd UDReview ...... . 27Terms for On-lending by the GSL to the PCIs . . . . . . .27Terms of Repayment by the PCIs to the GOSL . . . . . . . .28

B. Adm istration of the Credit ............. . . . .28Administrative Unit and its Structure . . . . . . . . . . . 28Functions . . . . . . . . . .. . . . . . . . . . . . . . . 28Existing Arrangements . . . . . . . . . . . . . . . . . . 29

C. Participating Credit Institutions (PCI.) . . . . . . . . . . . 29P=oteutial PCIs ................................... 29Eligibility Criteria for the PCIs . . . . . . . . . . . . . 29Evaluation of the PCIs . ......... . . . . . . . .30Commercial Bank of Ceylon . . . . . . . ... . . . .. . . . 30Hatton National Bank .. . ..... . .. .. .. . 31Sampath Bank Limited . .................. 3 2Seylan Bank Limited . . . . . . . . . . . ........ . 32

D. Environmental Considerations . . . . . . . . ... . . . . . . .34Environeatal Factors and Compliance Requirements . . . . . 34Administration of the Pollutiori Control and Abatemnt Fund. 34

3* Teebhical Assistance Component . . . . . . . . . . . . . . . .34Institutional and Policy Developm t . . . . . . . . . . . 35

Domestic Resource Mobilization for Term Lending. . . . 35Financial Sector Reform sad Restructuring

of State-Owned Commercial Banks . . . . . . . . . . .35Accounting and Auditing . .............. . 35

Financial Intermediation . . . . . . . . . . . . . . . . .35Assistane to the PCTa . . . ........... . 35

F * Procurement .. .. .a . .o. . .... . 36G. Disbursements .. .. . . ... . .. . . . . . . . . . . . .36R. Project Monltoring, Reporting and Audlting . . . . . . . . . . 37

VI.* PRWJECT B34TS AND RISM . . . . . . . . . . . . . . . . . . . 38

VII. AGREEMENTS REACHED AND OECOMMENDATION . . . . . . . . . . . . . . 39

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1. Disbursement Schedule . 422. The Government of Sri Lanka'o Statement of Financial Sector

Policy . .. 433. Interest Rate Structure (December 1986-December 1992) . . .494. Bligibilitv Criteria for PCIos . . . a . . . . . . . . . . .505. Administrative Unit - Structure and Terms of Reference . . . 526. Kvaluation of the PCIs . . . . . . * . . . . . . . . . . . .567. Reostructuring of State-Owned Commercial Banks . . . . . . .66

8. Composition of the Financial and Banking Institutions . . .729. Envirommental Concerns . . . . . . . . . . . . . . . . . 7310. Technical Assistance . ................... 8511. Terms of Reference for the Formation of Investment Policy and

Operating Guidelines for the Management of InvestmentPortfolio for Contractual Savings Institutions . . . * . .91

12. The Bank Group's Intermediary Operations . . . . . . . . . . 9413. Terms of Reference for the Modernization of Sri Lanka's

Treasury Securities Market . .. * .. . .. . . . . . .. . .9714. Supervision Plan ..................... . 10315. Selected Documents and Data Available: Project File . . .105

Credi and Projet Sir

DbgTC"-Xt Democratic Socialist Republic of Sri Lanka.

2en*giahagLg:s Development finance institutions (DIs.) and domestic¢cmercial banks meeting the eligibility criteria forparticipation. The credit component will support privateenterprises, without limitation to their size or subsector. Atechnical assistance (TA) component will assist selectedpublic and qus"i-public agencies and the participating creditinstitutions (PCIs) In implementing the key elements of theProject.

AmotgELs SOR 43.2 million (US$60 million equivalent).

S raJs Standard IDA terms with 40 years maturity.

Iluandin The Government of Sri Lanka (GOSL) will on-lend the creditXnma' proceeds to PCIs for up to 15 years, i3cludiug a maximum five-

yeur grace period, at a variable rate equivalent to theAverage Weighted Deposit Rate (41DR) of all Interest-bearingterm deposits of the Greater Colombo branches of domesticcomercial banks (excluding the National Savings Bank). Thebs"e for the Interest rate from the GOSL to the PCIs issubject to annual retiew by IDA. It is expected to be changedfrom the AMDR to the Treasury bill rate or another appropriateindex at the Mid-Term Review of the project when the bond andmosey markets are expected to be sufficiently mature toprovide this benchmark. Eligible subloans will be financed ona first-come, first-served basis. The PCIs will have fullautonomy to price the loan to enterprises according toperceived risk, maturity and to cover their intermdiationcost.. Repayment by the PCI. to the GOSL will be based on acomposite subproject amortization schedule. The PMDPAdministrative Units to be placed in the National DevelopmentBank (NDB), will administer the project on a fee basis(expected to be one percent on the credit amount disbursed andoutstanding). The Unit will also be responsible for theadmlnistration of the TA component of the project, includingthe Pollution Control and Abatement Fund (PCAP). As interestrates will be market based and variable, the rates obarged toend users will Indirectly reflect the foreign exchange as wella the credit risk. The GOSL will bear the direct foreignexchange risk of the credit. The PCI. will meet eligibilitycriteria consistent with IDA guidelines related to finacialstrength and credit appraisal and monitoring capabilities.

Ot9hr Financing of about US$12 million, on a grant basis, from theZIaNaDs United States Agency for International Development (USAID) and

the Government of The Netherlands (GON) is expected to be

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mobilized for this project. The USAID ie expected to provideabout US$7 million on a parallel basis for the development ofthe bond market and upgrading enforcement mechanisms foraccounting and audit standards. The GON's efforts vlll focuson assisting with ervironmental issues, and IDA is expected tobe the administrator for the grant funds for this component.

ftjosct The proposed project has four objectives: (i) improveDesciatlos the efficiency of financial intermediation in Sri Lanka by

supporting policy and regulatory reforms In the financialsectort (Wi) assist in domestic resource mobilization forlong-term investment by stimulating the development of localbond markets; (iii) enable the private sector to respond tothe changing economic environment by providing investmentfinance; and (iv) help deepen the financial system andstrengthen the key players, including the contractual savingsinstitutions, the CBSL, the Ministry of Finance (e 21), theInstitute of Chartered Accountants of Sri Lanka (iCASL) andthe PCIs.

Major elements of the proposed project would be (a)Improvements in the policy and regulatory framework,especially in areas affecting mobilization of domesticresources for term investment through commercial channels; (b)a credit component, on-lent by the COSL to the PCIs forfinancing private sector investments; and (c) a TA componentto provide assistance for the preparation and impleme-tationof various po'icy reforms including establishing a viable bondmarket; preparing the state-owned commercial banks (SCBC) forrestructuring and recapitalization; providing support forimplementing new accounting and auditing standardstoperationalizing debt recovery courts; enhancing bankingsupervision at the Central Bank of Sri Lanka (CBSL) andsupporting implementation of the new environmental industrialstandards.

Benefite and With recent increases in rrivate sector investment inRisks: manufacturing, and prospects for continuation of this trend,

the country's financial sector is experiencing a shortage offunds for term lending. While this is partly due to largegovernment demand for loanable funds, it is also partly due tolack of investment skills by institutional savers, andinsufficient efforts to mobilize term resources by financialintermediaries. The proposed project will not substitute forthe necessary efforts to mobilize domestic resources but willencourage and complement these efforts. The provision of termfinance to the private sector will enable these enterprises totake advantage of the changing economic '-vironment and retooltheir operations, Improve efficiency and expand their markets.The project will lay the groundwork for the development of newfinancial instruments, including medium and long-term bonds,and will encourage the existing financial institutions to

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diversify their funding sources. It will also provideassistance for the restructuritg of the SCBs and support theGOSL'a efforts to improve financial sector efficiency. TA andcredit to firms for environmental investments vill help easethe environmental burden of the country's industrial sector,particularly in the Greater Colombo area. The main risks tothe projact's success lie In the overall investment climate inSri Lanka. If the ethnic disturbances escalate significantly,commitment and disbursement rates for the project wouldsuffer, and repayment rates of subloans to PCIs could also beadversely affected. However, private investment in recentyears hao been high and the PCIs forecast a rising demand forinvestment finance. Sustainable improvements in the PCIs'ability to mobilize domeotic resources will depend tn theGOSL's success with maintaining macroeconomic stability,containing the public sector's borrowing requirements andpricing public sector borrowing at market-determined rates.

nvAironmental The Project is rated "W". To minimize the risk of adverseImDacts environmental effects, all subprojects will be required to

conform to the general environmental guidelines issued by theGOSL and monitored by the Central Environmental Authority(CEA). PCIs will coordinate closely with the AdministrativeUnit and CIA througbout project implementation. As mentionedabove, the TA component and cofinancing will provide creditand technical expertise to enterprises undertakingenvironmental investments.

Estimated Cost: Local Foreign Total Local Foreign Total(Re billion) ----- -----(US$ million)-----

Credit Component 3.6 2.8 6.4 78.7 61.2 139.9Technical Assistance 0.1 0.6 0.7 2.9 10.8 13.7

Total 2.4 2.3 4.7 81.6 72.0 153.6

Financing Plan:IDA 0.0 2.8 2.8 0.0 60.w' 60.0Co-financiers 0.0 0.6 0.6 0.0 12.0 12.0PCIs 1.8 0.0 1.8 38.3 0.0 38.3Entrepreneurs 1.9 C.0 1.9 43.3 0.0 43.3

Total 3.7 3.4 7.1 81.6 72.0 153.6

Disbursements:

IDA Fiscal Yedr: FY94 FY95 FY96 FY97 FY98

Annual 6.6 13.8 21.0 13.2 5.4Cumulative 6.6 20.4 41.4 54.6 60.0Percentage 112 34% 691 911 1002

fthe No. IBRD 23009

PRIVATE nIZARCI DRVELOPMT PROKCT

STAm? APPRAISAL REPOX?

1. TEE ECON!HIC SETTING

1.01 For over fifteen years, Sri Lanka has tried to dismantle theiaward looking development etrategy that followed independrAce. After theinitial reform push of 1977, economic management oscillated between periods ofslow and more rapid reform, but both state ownership and Intervention ineconomic activity remained extensive. Stabilization and adjustmentperformance has been mixed, particularly following the beginning of the civilconflict in 1983. Throughout the 1980s, the government maintained a strongrole In the economy, domuiating the Import substituting industrial sector,employing half of the non-agriculture labor force and accounting for half ofCDP. Production In agriculture grew slowly, influenced by policies of foodself-sufficiency ir ice and major staples, and government intervention inexport-crop agricultvre. Structural reform efforts accelerated after 1989 andsubstantial progress has been achieved in the last three years.

A. Recent gconoMic Performance

1 02 Growth Performance. Although a severe drought adversely affectedagricultural output and hydroelectric production in the first half of 1992,economic growth is expected at 4 percent to 5 percent reflecting strong growthand private sector investment. Much of the improved growth performance in theprevious year (5 percent) arose from good weather, the abatement ofhostilities and increased private investment. While private manufacturingcontinued to grow, public non-oil manufacturing sector output declined. Totalinvestment remained at about 22 to 23 perceni of GDP, but the balance betweenpublic and private sector shares shifted, with public sector investmentdropping to about 9 percent of GDP. The current account deficit improved from8.5 percent of GDP in 1988 to 5.4 percent in 1990, but increased again to 7.6percent in 1991. Furthermore, the impact of higher priced oil due to the Gulfcrisis was moderated by (i) higher remittances by Middle Eastern migrantworkers, thus increasing private transferst and (ii) increased tea exports(volume and price). These developments, coupled with increased die5ursementsof balace of payments aid, led to an overall balance r4rplus and increasedgross official reserve coverage to two months of imports. The balance ofpayments performance in 1991 showed some weaskening due to a drop in tea prices(a delayed effect of the Gulf crisis) and an increase in imports, especiallyin consumer durables, reflecting a more liberalized import environment. Thesefactors and the purchase of an aircraft by Air Lanka increased the currentaccount deficit in 1991 to about 6.6 percent of GDP.

1.03 Fiscal Deficit. The government's fiscal deficit improved from 16percent of GDP in 1988 to 10 percent in 1990, but increased to almost 12percent in 1991 due to unanticipated large security-related spending and thehigh cost of severance packages for workers retrenched as part of publicsector restructuring. However, in 1992, the deficit improved to 8.6 percent

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of GDP, and the government met the PFP fiscal targets. This improvement cameabout, however, by suppressing public investments in lnfrastructure (a vellas other areas), with potentially negative effects on private lnvestment.

1.04 Inflation, at 22 percent, was high in 1990, due to 1) the removalof distortions in prices, ouch as the devaluation and elimination ofsubsidies; (ii) higher imptrt costs induced partly by the Gulf crisis (oilprices); and (iii) localized problems in production and transportation ofagricultural goods, particularly vegetables. Inflation had dropped to about10 percent by October 1991, as these factors were short-term in their effect,and increased to 11 percent in 1992. Inflationary expectations remain stronghowever, reflecting concerns about continued government spending. Netdomestic bsnk borrowing by the government was larger than projected.Moreover, the government has allowed private credit to grow as well. Thus,the demand for credit showed no sign of abatement despite a real interest raterise from negative four percent in 1990 to a positive four to six percent in1991. In 1991, the government did not retire credit to the domestic bankingsystem as anticipated, contributing to a 22 percent growth in domesticliquidity, compared with the 15 percent target. The impact of the monetaryexpansion was in part offset, however, by an increase in real interest rateswhich became positive during the second half of 1991.

1.05 Monetary policy improved in the context of a new system of reservemoney management. Under the PFP, specific 14iits were imposed on credit toseveral large public corporations and further actions were taken to limitresident borrowing from foreign :urrency banking units. By June 1992,monetary growth had decelerated to la percent On an annual basis. Despiterecent progress public enterprises continued to exrt economic and financialpressures on the domestic resource base. Public enterprise borrowing led tothe precar .ous portfolio position of the state-owned financial institutions.Moreover, the budgetary support together with persisting state interference inenterprise management crowded out private sector activity.

1.06 External sector develonments mirror fiscal performance. Thecurrent account deficit was reduced from 8.5 percent of GDP in 1988 to 5.4percent in 1990, but increased again in 1991 to 7.5 percent of GDP. In 1992external sector developments were in line with the targeted reduction in thecurrent account deficit to about 6.4 percent of GDP. Imports surged duringthe first seven mowihs of 1992, reflecting Increased grain imports--a resultof the drought--and increased demand for Imported investment goods. Strongergrowth in textiles and other industrial exports offset the drought-relateddecline in tes exports. In addition, with high levels of capital (mostly aid)inflows 9 gross official reserves strengthened to 3.4 months of imports,reaching by October the end-1992 target. With a comfortable reserve positionand a debt service of 17.6 percent of exports, Sri Lanka can sustain theliberalization of the trade and service accounts by mid-1993 agreed under theESAF.

1.07 Bxorts. Despite an observable shift of resources into relativelabor-intensive manufacturing, and high growth rates, exports remain narrowlybased on few products: tea, rubber, and clothing, which has become SriLanka's primary export. Moreover, littl diversification within these

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categories has taken place. Tea continues to be exported in its leastprocessed form, and the share of higher value-added garments in total garmentexports remains insignificant. A larger share of high vAlue items is neededto make export flows less vulnerable to external developments, and exportreceipts more responsive to economic incentives rather than special tradearrangements. Export prices of Sri Lankan garments have increased relativelyless than prices of imported textiles, the major intermediate input to thegarment Industry and Sri Lanka has suffered a marked deterioration in itsinternational terms of trade (about 15 percentage points) between 1985 and1991. With tea and rubber prices falling in 1991 and 1992 the country has notbeen able to realise gains from lower petroleum and food prices. High levelsof external aid and worker remittances helped neutralize these adversemovements.

1.08 External Aid. In both 1990 and 1991, aid disbursements were 8percent of GNP, exceeding the current account deficit, and well above the 2.8percent of GNP average for low income countries. The 1990-91 levels of aid toSri Lanka have been helpful in the short-term but are not sustainable in themedium-term. Thus Sri Lanka should coninue with its structural reforms tosafeguard competitiveness.

1.09 Development of Infrastructure. Reduction in public spending hasbeen achieved tarough reductions in the level of public investment. Althoughthis was necessary initially, the cuts may have been so drastic thatinfrastructure and provision of basic social services have lagged,jeopardiziug the development of private sector activity and long term socialbalance. Furthermore, some retained public investments are not based onefficiency criteria and nay not be necessary for ensuring a successfuldevelopment program. There is room to improv, the efficiency of publicinvestment towards the support of activities that promote long-term socialbalance, facilitate private sector growth, and complement private investment.To promote industrial development for exports, a furtber concentration ofproduction activities in the Greater Colombo area may be unavoidable and thestrategy for infrastructure investment developed accordingly. To diversifyagriculture and give it a greater export orientation, access to markets andmarket information vill be key. Priority areas should include theestablishment of a well-maintained intercity road network; developingcommercial refrigerated transportation and storage systems; and improving thequality and coverage of the domestic and international telecommunicationsystems.

1.10 Efforts for Poverty Reduction. The strong focus of Sri Lankasfdevelopment strategy on human resources is reflected in unusually good socialindicators, and high standard of living, relative to its level of per capitaincome. A variety of welfare or "safety net" programs justified by thegovernment on explicit poverty alleviation grounds have used large portions ofpublic funds but have been generally poorly targeted. A Poverty Assessment,currently under preparation, will review the efficiency of these programs andexamine Whether the fiscal adjustment has bad (or is likely to have)significant adverse effects on basic social services critical to the poor,especially primary health care and general education.

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B. Towards Macroeconomic Stabilty

1.11 Macroeconomic performance has been improving since 1989, whenadjustment efforts resumed and a stabilization program wae put in place. Thisprogram, reflected in the second- and third-year PlPs, included an across-the-board cut in budgetary outlays, removal of major agricultural subsidies, and asignificant devaluation. The government pledged to privatize all commerciallyoriented public enterprises and reduce central sad provincial government staffby ten percent. IDA supported these actions with the first EconomicRestructuring Credit, approved in May 1990, and the Public ManufacturitgEnterprises Adjustment Credit (PHEAC), approved in November 1990. In 1991,the unfortunate pattern of adopting bold policy reforms followed by a periodof hesitancy reappeared. Macroeconomic management weakened, underminingprogress on economic stabilization. High expenditures associated with thecivil conflict in the North and the East and the costs related to the 1990civil service retrencement brought government expenditures to 31.8 percent ofGDP, up from 31 percent In 1990, but still well below the peak of 34.5 percentin 1988. Notwithstanding an adequate revenue effort, the fiscal deficitIncreased to 11.5 percent of GDP in 1991. Despite slippages, inflation wasreduced from about 22 percent in 1990 to 12.2 percent in 1991, while growth inmnn-conflict areas exceeded 6 percent in 1990 and approached 5 percent in1991.

1.12 Prudent economic management was reinstated in early 1992. Thegovernment implemented fiscal and monetary measures necessary for achievingthe fifth-year PFP macroeconomic objectives. Monetary and externaldevelopments continue to be favorable and as of November 1992 all PEP targetswere met. Monetary policy has improved with the elimination of creditceilings and the adoption of a new system of reserve money management.Domestic liquidity growth declined from 22 percent at end-1991 to anannualized rats of about 10 percent through the third quarter of 1992, despitea substantial increase in net foreign assets. This was brought about by asharp reduction in public sector credit. Specific limits were imposed oncredit to several large public corporations and further actions were taken tolimit resident borrowing from foreign currency banking units. Inflationremained stable in 1992, fluctuating between 10 percent and 11 percent averageannual rate, slightly above the PIP target of 10.2 percent. Fiscal policyalso appears on track and the preliminary estimates for the 1992 budget yearare in line with a deficit of less than 9 percent of GDP. Although a seversdrought adversely affected agricultural output and hydroelectric production inthe first half of the year, economic growth in 1992 is estimated at about 4.5percent reflecting strong export growth and private sector investment.

1.13 Sri Lanka has followed a mixture of the interventionist policyapproach of most South Asian economies and the export-led growth fueled byprivate investment of the East-Asian countries. In the last three years theneed to accelerate reforms to encourage private sector export-led growth hasbeen recognized. This translates into three inter-related objectivess (i)the reduction of macroeconomic imbalances; (ii) the development of efficientprivate sector activities; and (iII) the balancing of welfare distributionacross ethnic groups and regions. Sri Lanka has made initial progress ln therationalization of public sector expenditures, the most significant source of

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macroeconomic Imbalances, and In setting up a framework for more efficientprivate sector resource allocation and economic management.

1.14 Sustainable, export-led growth requires the government to (1)maintain tight mcroaconomic manageet, particularly in the area of fiscalmanagement; (it) continue to rationalize the public sector; (iii) move forward

ith the rationalization of poverty reductioa programs and (iv) provide anappropriate environment for private sector investment. A primary objective isto boost the role of market-determined inctntives in resource allocation.Revenue mobilization efforts need to rely on Improved tax administration andtaz reforms which broaden the tax base and increase the system's efficiency.Close consultation with the D1P Is expected for exchange rate management toassure end maintain export competitiveness.

C. Touads a Prlvate Sector-Led Oen IcononM

1.15 A prlmry objective of the reform in recent years has been toadvance the role of the private sector and of market-determined incentives inresource allocation. ince 1990, the domestic economy has been graduallyexposed to increased competition from asroad by the significant reduction inthe scope of non-tariff barriers to trade and lower nominal tariffs. This hasallowed for domestic price decontrols, reduction in state monopolies, andremoval of consuer subsidies. The pritciples for a major tax reform havebeen defined and reforms initiated for correcting relative price distortionsrooted tn the tax regime.

1.16 in spite of the civil conflict and policies that at times haveraised perceived lv estment risks, the private sector has become the principalsource of income and employment growth. Gross fixed private investmentincreased from 10.7 percent of GDP in 1988 to 14.4 percent in 1991. The shareof gross manufacturing exports in total exports increased from 32 percent in1980 to 60 percent in 1991. Not g8rment exports almost doubled between 1989and 1990 but stagnated in 1991 and again in 1992 as local value added laggedbehind increases in input prices. Since 1990, the domestic economy has beengradually exposod to increased competition from abroad by significantreduction in the scope of ro-tariff barriers to trade and lower nominaltariffs. Exposure to international competition has allowed for domestic pricedecontrols, reduction In state monopolies, and removal of most consumersubsidies.

1.17 Sinc the 1st major devaluation in September 1989, the governmenthas followod cautious external payment. policies. The rupee depreciatedagainst the US dollar by about 6 percent, In nominal terms, during 1991 and bya further 3 percent in the first half of 1992; in real effective terms, theexchange rate appreciated by about 3.5 percent between end-1990 and June 1992.since theon ecbhange rate istability in neighboring countries and in Europe(particularly the devaluation of the pound sterling), bave again raisedquestions on the adequacy of exchange rate realignments for the country'scompetitiveness and export drive. In mid-December the pace of the nominaldevaluation of the rupee accelerated substantilly.

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1.18 The expectation is that fiec-.l policy will continue to be aimed atreducing the overall deficit and achieving a surplus on current operations.The overall fiscal deficit reduction, would allow a reduction In thegovernment's domestic financing requirements and help meet the needs of anexpanding private sector. To achieve these objectives and concurrently reducethe inflation rate from 12 percent in 1991 to 8 percent in 1993 and 6 percentby 1995, the government vill adopt a restrained stance on monetary policy.

1.19 Efforts to stimulate private sector investment are dependent fortheir success on an efficiently functioning financial sector. Priority shouldbe attached to reducing the inefficiencies in the exiating financialinstitutions, most notably, the two State-Owned Comercial Banks (SCB).Other reforms (as discussed in the following chapters) include developing thebond markets to provide a mechanism for domestic resource mobilization;improving enforcement of accounting and auditing standardst strengthening thebanking supervision function at the CBSL; and facilitating debt recovery.

D. IDA Stgratev and Rationale fo Involvement

1.20 Sri Lanka's overall macroeconomic reform package is beingsupported by the IKR (through an ESAP) and the Bank through its ongoing andproposed adjustment operations. The promotion of Sri Lanka's industrial andfinancial sector has long been an objective of IDA's sectoral policy. TheFinancial Institutions study, conducted by IDA in 1991, in conjunction withthe interim reports of the COSL's Presidential Commission on Banking andFinance, further defined the changing role of the financial sector andoutlined the necessary sequence of reforms. Prior to 1977, IDA pursued itslimited industrial and financial sector objective's through four intermediaryoperations channelled through DPCC. However, after 1977, ID.s lendingoperations progressed from direct financial intermediation to a muiti-institutional financial sector approach, with operations channelled throughtwo specialized DPIs - 1DB and DICC. Since 1979, when IDA approved the firstof its more sectoral focused operations, intermediary operations have beenused as a vehicle for policy and institutional reform programs Each projecthas supported the development and implementation of the GOSL's evolvingprogram of trade and industrial reform. Apart from the Second Small andMedium Industries Project (SMI-II, Cr. 1182-CE) which was affected by civildisturbances in the southern provinces and initial problems with loan pricing,all of the projects have been disburbed ahead of schedule, with a cumulativecollection rate of more than 80 percent. The SMI projects alone have beeninstrumental in creating more than 65,000 jobs at a relatively low capitalcost, particularly in areas of non-traditional exports.

1.21 PCREs and PPAR. for the pre-1977 operations noted that the projectshad provided valuable insight into the working of a small DPI and financialintermediary operation in an expanding liberalized financial system. ThePPARs indicated that the Bank-group financing was particularly Important inthe development of the industrial sector and had helped catalyze the programof trade and industrial policy reform that vere to come. The most recentlycompleted industrial projects focused mainly on the initial actions necessaryto develop the tariff reform program, rationalize the industrial and exportincentive structures, improve the overall operational viability of the two

DFIs and broadening the number of financial intermediaries. A 1991 OEDreport' noted that the Sri Lanka SMI projects had succeeded in attaining theanticipated flow of credit to the target group of borrowers, although wherefunds have moved slowly (SKI-I) this has been due to depressed businessconditions, and not to any faulty assessment of particular demand or of PCIcapacity. The ORD report also noted that the SMI projects also generated ahigh level of resource additionality.

:.22 The last of the intermediation projects (SMI-IV, SDR 33.3 million)became effective on September 30, 1991. Although the two SCBs have beenexcluded since April 1992 from further commitments of subprojects from SHI-IVbecause of their failure to satisfy the capital adequacy requirements, bothcommitments and disbursements have been proceeding ahead of schedule (about 40percent is committed and more than 20 percent disbursed). In addition,several policy reforms includings (i) reduction of SCB'e shareholdiug in DFCC;(ii) provisioning policies to be adopted by the PCI.; (iii) introduction ofAWDR as a reference rate; (iv) completion of the first phase in strengtheningthe debt recovery legislation; (v) refining reserve requirements and removalof credit ceilings; (vii) establishing a credit information bureau; and (vi)strengthening of the accounting regulatory framework have already beencompleted. Other reforms such as the privatization of NDB, rationalizationand restructuring of NSB and the ICSL, and strengthening Bank supervision andregulation are progressing satisfactorily.

1.23 The Proposed Proiect. IDA has, for some time, been pursuing apolicy reform dialogue with the GOSL aimed at further strengthening of thefinancial sector. Although a number of important actions have already beentaken as noted above, further reforms are needed to increase mobilization ofdomestic resources for term investments by the private sector and reduce thedetrimental effects of Treasury borrowings at managed rates. IDA will supportreforms of the policy and regulatory environment in the 4inancial sector,especially the revitalization of nonbank financial institutions, thedevelopment of an efficient market for public and private debt instruments andthe expansion of the private banking sector. The GOSL is now ready toinplement the steps necessary to address these issues and the proposed projectwill support these reforms.

1.24 Although the financial performance of the two DFIs, DPCC and 1DB,has been commendable, they have remained dependent on the GOSL andmultilateral donors for funding. Until recently, they have focused theiractivities on term lending, making them particularly vulnerable tomacroeconomic changes and increased competition engendered by the GOSL'sfinancial sector liberalization. There is a need to develop a clear plan tobroaden the resource base and activities of both institutions. Bothinstitutions have made limited progress in this regard; however, furtherdiversification of their activities has been constrained by the GOSL'sdominant sbareholding ln 5DB and the SCB's shareholding in DFCC. In 1991, theshareholding of each of the SCBs' in DFCC was further reduced to 15 percent.

11 World Bank Support for Small and Nedium Scale Industry in SelectedCountries.

NDB was privatized in March 1993 with Institutional participation of the ADD,CDC, Citicorp and the NIP. The reforms, supported through the proposedproject, are expected to help the DPis begin to develop alternative sources offunds for their operations.

1.25 A major remaining concern in the financial sector is theperformance of the two SCBs - BOC and PB who dominate the banking system interms of size and act as market leaders in establishing interest rates. Thebanks are being used to funnel off-budget subsidies to commercially non-viablesectors of the economy. Based on a 1991 external audit it is estimated thatan infusion of more than Rs 24 billion is required to recapitalize these twobanks to internationally accepted standards. Private sector ownership,combined with professional management and a commercial focus, would be themost effective way of addressing these problem_. Nowever, politicalconstraints have prevented the COSL from privatizing the SCBs. While thisremains a medium term objective-of the GOSL, the OSL has decided to undertakea number of interim measures which would lend a commercial focus to the SCBs,and legal and administrative reforms are being implemented. These includodealing with existing "bad" loans, reconstituting the Board of Directors whileproviding increased autonomy, requiring that the SCBs provide plans detailinghow quarterly profitability targets would be achieved, improving creditstandards and efficient allocation of manpower including reducing employeecosts and measures to I=,rove staff utilization.

1.26 SCBs will not be eligible for participation under the proposedcredit. The ongoing reforms are expected to help address some of the problemsfacing the SCBs but are unlikely to remove ths major causes of poorperformance, particularly government interference. A number of the remainingprivate comsercial banks and the two privatized DFIs are sufficiently strongand experienced in investment finance to carry out the objectives of thisproject. This will also assist the private sector commercial banks and theDFIs to increase their market share of profitable commercial term lending.

1.27 Role of IFC and MIGA. IDA's support for private sectordevelopment is being pursued with 1FC's cooperation and involvement. Bank andIFC staff are currently cooperating in the preparation of a Private SectorAssessment, to establish a commonly-agreed base for action. IPC isintensifying its business promotion efforts, focusing on promising exportsectors (gems, ceramies, garments, food processing, etc.) to expand itsportfolio of six projects. It is also assisting the government in the area ofprivatization (e.g., Air Lanka), is active in capital market development (aventure capital fund was approved in FY91 and a unit trust in FY92) and isproviding assistance for the commercialization of pension funds and insurancecompanies and for developing a secondary market in government bonds. The NIGAForeign Investment Advisory Services staff have assisted the government inredrafting foreign investment guidelines and in implementing a more effectiveinvestment promotion strategy.

II. THE IUDISTRIAL SECTOR

2.01 Although Sri Lanka has a limited industrial base, themanufacturing sector accounts for about 15 percent of GDP and 45 percent of

total exports. The sector's structure, except for relatively recent and rapidgrowth in garment manufacturing, has remained relatively unchanged. Largeenterprises, mainly public corporations, are concentrated in cement,chemicals, petroleum, textiles, steel and wood products. There are about 30medium to large scale public manufacturing enterprises (PM8s) which are in theprocess of being privatized. The private manufacturing sector consists ofmore than 400 large-scale, 6,000 small- to medium-scale, and 95,000 smallagro-industrial handicraft and industrial service units.

2.02 The GOSL policy has had a significant impact on industrialperformance. The first set of measures taken in 1977 towards liberalizationof trade and industry initially contributed to strong industrial growth,although the real rate of growth in industry slowed to an annual average of 6percent in the decade 1978-88. The appreciation of the exchange rate after1978 adversely affected the production of traded goods, however, importtariffs and quantitative restrictions continued to provide high and variedprotection for the manufacturers. Due to the size of the local market, thegrowth opportunities created by these inward looking policies were limited.Since 1979, however, the GOSL and IDA have worked closely through a number ofoperations to develop and implement a phased program of industrial policyreform. The focus of the reform program was on: rationalization of tariffslremoval of import licensing requirements; reduction of foreign exchangecontrols; elimination of quotas/bans on imports of non-agricultural products;and privatization of public manufacturing enterprises.

2.03 There has been a wide variation in the performance of the publicand private sector enterprises. During 1977-89, public manufacturingenterprise production grew at an annual rate of about 1 percent in real terms,compared to more than 13 percent per year for private enterprises. During thelast two years this disparity has grown wider. The private sector isdominated by garments and leather products (almost 35 percent) while food,beverages and tobacco account for almost 40 percent of the balance. The valueof industrial output, which grew by 14 percent in real terms in 1990,increased by another 10 percent n 1991 (the 1991 growth was due entirely tothe private sector). The public sector output in 1991 declined by 8 percentlargely due to a sharp drop in production of the Ceylon Leather Products,Ceylon Petroleum Corporation and the National Textile Corporation - the lasttwo together accounted for more than 75 percent of the total public sectoroutput. In contrast, the private industrial sector grew by about 14 percent.While the private sector recorded substantial increaseos in the output oftextiles, wearing apparel and leather products, largely as a result of therapid expansion of the export oriented garment industry, public sector outputof the same goods registered a decline. A similar trend has been observed inthe case of food, beverages and tobacco where the public sector outputdeclined by about 20 percent as well as in chemicals, petroleum, rubber andplastic products. The public sector enterprises that recorded an increase inoutput during 1991 were Distilleries Company (57 percent), Ceylon Steel (39percent), National Paper (16 percent), Sri Lanka Cement (9 percent) and StateMining and Mineral (6 percent). Distilleries and most of the assets of theState Mining and Mineral have since been privatixed. The total budgetarytransfer to public sector Industrial enterprises during the year was about Rs40 million - a decrease of more than 60 percent compared to the previous year.

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This amount was received entirely by the National Textile Corporation ascapital transfers.

2.04 Since 1989 the COSL has taken measures to rationalize the publicsector and improve the economy's overall efficiency. The divestitur6 ofvarious public enterprises, the "peoplization" of the bus company, and theprivate management contracts of tree-crop plantations have increased thesector's efficiency and reduced the burden on the budget. Based on therecommendations of the Administration Reform Committee, the GOSL is continuingwith further divestiture of commercially oriented public enterprises andcorporations. IDA has provided assistance for GOSL's overall economic reformsthrough two adjustment operations (ERC-I and PMIEAC) and is expected tocontinue its assistance through further adjustment lending.

2.05 Sri Lanka boasts a strategic location and low to moderate vages -yet there is a paucity of foreign direct investments (PDI). While the civilconflict is partly to blame, the lack of consistent, coordinated policiescoupled with approval procedures are also responsible. With a view toincreasing FDI inflows further in the domestic economy, the government has,since 1989, taken several steps aimed at strengthening the policy environmentfor FDI. The gathering momentum of economic reform gave a new rise to FDIpromotion. It was recognized that past policies emphasizing FDI promotionmainly within the export processing zones (EPZs) no longer met the increaseddemand of the economy. The valuable resources (surplus of an educated andpotentially productive labor force) remains largely under-exploited, partlydue to the relative scarcity of capital and technological resources at home.In this context, the GOSL has requested assistance from the Foreign InvestmentAdvisory Services (FIAS) in developing a new investment promotion strategy,building upon earlier PIAS assistance on the FDI policy environment. Thestudy will provide a framework for a more focused promotion strategy based onthe country's sources of comparative advantage, policy environment for FDI andthe institutional framework needed to carry out ane facilitate promotionactivities.

2.06 The GOSL industrialization strategy is aimed at further improvingthe overall economic outlook and, more specifically the prevailing businessclimate. The GOSL hes identified four primary objectives: (i) transform thedomestically oriented industry to an export oriented one; (ii) provide greateremployment and income opportunities to a growing population; (iii) diversifythe economy and strengthen the balance of payments; and (iv) ensure a moreequitable distribution of wealth, thereby Improving the quality of life forthe people. The strategies, to assist in attaining these objectives are: (i)adopt prudent macro-economic policies in order to stabilize the economy,contain inflation and promote productive economic activity; (ii) grant specialincentives for investments and exports, wherever the general economicincentives are considered inadequate; (iii) mobilize greater savings - bothdomestic and foreign; (iv) encourage foreign investment with a view toincreasing capital inflows, acquiring technology and achieving market access;(v) establish neutrality between public and private sector ownership, reformpublic enterprises by commercialization, peoplization and contracting outmanagement; (vi) promote export oriented industries by special incentives andby making existing industries internationally competitlve; (vii) establish

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linkages between large investore/industri,s end small producers, particularlyto promote exports and small industrial activity and to ensure that benefitsof development are better distributed among the peoplet (viii) promote moreresearch and training of human resources and raise the productivity of labor;and (ix) remove administrative barriers by eliminating the need forentrepreneurs to seek admiuistrative clearances such as import licenses,permits, etc.

2.07 At the request of the GOSL, IDA and JIAS have advised theGovernment on the need to reduce the use of tax and other special incentivessad to increase its efforts in facilitation, improving market incentives,deregulation of economic activity and liberalization of factor markets. In acountry with strong socialist practices, private sector development is noteasy. Yet, this is the way the government has chosen t3 achieve its goal tojoin the ranks of "Newly Industrialized Countries" (NICe). Sri Lanka hasundertaken trade policy reforms well ahead of other countries in the region.The GOSL is also beginning to address some of the other issues related tobureaucratic procedures, cumbersome legislation, and deterrent labor laws andregulations. These reforms, coupled with the steps already undertaken by theGOSL, will move Sri Lanka towards its objective of faster export-led growth.

111. THE JINANCIAL SECTOR

3.01 Sustained economic growth requires a financial sector thatefficiently mobilizes and allocates financial resources to areas where returnsare highest. Sri Lanka's financial institutions are relatively diverse andsophisticated and are capable of reaching private borrowers with at leastshort-term working capital lending. Yet, there are a number of problems - thelarge size of the two SCBe and its effect on the sector3 inability to mobilizeloag-term domestic resources for term-lending; weaknesses in debt recoverylegislation; lack of enforcement of accounting and auditing standards; andinsufficient banking supervision. These issues and their effect on thedevelopment of the financial sector are discussed in the following paragraphs.

A. Overview and Policy Framework

3.02 Sri Lanka's commercial banking system, although relativelysophisticated and diverse, is dominated by two SCBs, Bank of Ceylon (BOC) andPeoples Bank (PB), which still control about 60 percent of the bankingsystem's total loans and advances (down from 75 percent in 1980). In additionto the two SCBs, the banking system includes the Central Bank of Sri Lanka,four private domestic commercial banks, 17 foreign banks, a National SavingsBank (EBB), 12 regional rural development banks (RRDBs), two developmentfinance institutions and a state mortgage and investment bank (SMIB). Financecompanies have undergone a difficult period and have been reduced in numberfrom about 70 a few years ago to 27. There are also government-sponsoredprovident funds -- the Employees' Provident Fund (EPP), the Employees' TrustFund (ETI), and a number of private provident funds. The EPF, ETP, NSB andthe insurance companies mobilize large pools of long-term resources, whichhave largely gone toward financing the government budget to date. The SriLankan financial system, despite its size and sophistication, still remains

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largely under the influence of the government. Capital markets -- equity andbonds -- remain small and undeveloped.

3.03 Between 1989 and 1991 total domestic credit increased at anaverage rate of 9.4 percent. The private sector captured an increasing shareof this credit, rising from 50 percent as of December 1990 to 57 percent inDecember 1991. Although the credit to the goverrment grew more slowly thanthat to the private sector, a substantial portion of government creditconsisted of loans and advances from CBSL. This increase, coupled with anincrease of about five percent from the commercial banking sector, resulted inan expansionary impact on monetary aggregates. Government credit growth,which had been minimal in 1989 sad 1990, increased to about 16 percent in1991, fueled by a larger than expected government deficit. Inflation rose toabout 22 percent in 1990 but has since abated to 11.4 percent as of November1992. While inflation began to drop in 1991 because of chnges Inadministered prices, the growth of government credit in 1991 provided a newimpetus to refueling inflation. Reining in expenditures and tighteningcontrol over monetary conditions, therefore, are critical to reducinginflation and maintaining a sound macroeconomic framework for privateinvestment.

3.04 Interest rates in Sri Lanka are largely market-determined,particularly for short-term lending and deposits. However, the two SCBs arealso the market leaders in establishing interest rates. The large levels ofnon-performing loans and high administrative costs in these two banks havelead to significant intermediation costs resulting in higher interest ratesthroughout the financial sector. Pending the development of a more market-determined rate for allocation of funds, the government introduced the use ofthe Average Weighted Prime Lending Rate (AfPR) as the market reference forterm lending operations. This was later cbanged to AWDR to reflect the directcost of mobilizing funds. As of December 31, 1992, the AUDR stood at 13.9percent. At present, interest rates are positive in real terms and remainhigh due to continued inflationary expectations, high demand for credit fromboth the public and private sector and the high intermediation costs of theSCBs which dominate the market. Annex 3 outlines developments in 13y interestrates over the past six years.

3.05 During 1991, the Central Bank took several steps to curb monetaryexpansion. The policy measures included an upward revision of the Bank rate,rationalization of refinance schemes, an increase in the non-interest bearingcash reserve ratio of commercial banks and further use of open marketoperations through the Treasury bill market The Bank rate was increased from15 percent to 17 percent in January 1991. In addition, the non-interestbearing cash reserve ratio of commercial banks was increased from 10 to 13percent on all types of deposit liabilities. At the same time, the facilityof holding part of the reserve requirement in the form of Treasury bills waswithdrawn to improve the effectiveness of the reserve requirement as a policyinstrument for monetary control rather than as an instrument for funding thegovernment. The open market operations remain modest, but further steps weretaken to enhance their use (the creation of a Monetary Operations Unit in theCBSL, restricting the use of the "tap" system to individuals, excludingcaptive sources from bidding at the prinary auctions). The Central Bank has

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continued to auction Treasury bills on a weekly basis in the primary marketand yields have been allowed to reflect market conditions. At the time ofappraisal, the GOSL had started to issue small smounts of longer term debt.

B. TIMMncial Sector Issues

3.06 Domestic Resource Mobilization for Term Lendin.. Virtually allfinancial institutions in Sri Lanka with access to primary term savings arepublicly controlled and invest their funds on either a short-term basis or inlonger dated public securities issued at managed rates. There is littlesecondary market activity and the institutions normally hold the securities tomaturity. Insufficient access to term savings,-,lack of a secondary market indebt instruments and virtually no market determined pricing of longer datedpublic securities make it difficult for private1 entrepreneurs to obtaindomestically funded term loans. Thus, funds provided through multilateralagencies have been the major source of term lending through commercialchannels.

3.07 In order to facilitate the development of an efficient market forthe issuance of both public and private debt instruments, a series of reformsneed to be implemented. The near-term objective of these reforms is todevelop market-driven procedures for the issuance of debt instruments and theremoval of the requirement for publicly controlled savings institutions toinvest virtually all their funds in public securities. At the same time, thedevelopment of a trading and settlement infrastructure and regulatoryframework is necessary to develop a market in such instruments with sufficientdepth and liquidity to encourage the mobilization of domestic savings andtheir use in financing productive investments.

3.08 The outstanding longer-dated instruments have been issued mainlyto a captive market of publicly controlled institutions at administeredprices. The GOSL, however, has issued Treasury bills of maturities up to oneyear on a somewhat competitive basis for more than a year. This system ofissuing treasury debt2 involves an artificial segmentation of public debtinto maturity components and results in a distorted pattern of yields on longvs. short-term public debt, thus sending inaccurate economic signals to otherpublic and private issuers of debt instruments.

3.09 In its efforts to lengthen the maturity structure of itscompetitively priced debt instruments, the GOSL modified the legislationgoverning the issuance of Treasury bills to permit issuance of Treasury billsof maturities longer than a year. The CBSL has successfully auctioned smallamounts of Treasury bills of longer maturities (2 year term) since October1992. During November 1992, the GOSL modified the legislation governing theissue of Rupee Securities to allow for the issue of coupon-bearing Treasurysecurities through competitive procedures and has indicated its intention to

at Treasury bills have been issued on market basis without coupon withmaturities up to one year. Rupee Securities have been issued formaturities longer than one year, with a coupon rate arrived atadministratively.

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continue to increase both the volume as well as the maturity (3 and 4 yearterms) of these Instruments. During negotiations, agreement was reached withthe OOSL on its commitment to increasing the maturity structure of itscompetitively priced debt instruments (both Treasury bills and RupeeSecurities) In a manner that will result in at least four billion Rupees worthof these securities (competitively priced and with maturity longer than ayear) to be issued within one year of Project effectiveness. This volume willthen be increased to at least Rupees ten billion within thirty months ofProject effectiveness.

3.10 To enable the COSL and CBSL to successfully carry out the programof lengthening the maturity structure of competitively priced debtinstruments, efforts are initially required tot (i) make the necessary changesin the regulations governing the operation of primary and secondarydealerships to promote the development of secondary markets; (vi) define thetreasury calendar; (iii) ensure that sufficient volumes are placed in themarket to sustain secondary trading and to establish a meaningful yield curve.Technical assistance is already being provided through the Federal ReserveBank of New York to address such matters as instrument design, dealerregulations, auction systems and withholding taxes (see annex 13 for detailedterms of reference). The GOSL has indicated its intention to implement therequired changes as soon as the technical work is completed. Rupee SecuritiesOrdinance is expected to be modified before July 1993. A detailed timetablefor implementation of the remaining program will be developed within sixmonths of the Project effectiveness including establishing a task force anddevising an action plan to automate the post-trade handling of all Treasurypaper transactions.

3.11 Contractual Savints Institutions. Sri Lanka's contractual savingsinstitutions' have successfully raised large pools of long-term capital.However, they are engaged in reverse term transformation, wherein they investlong-term funds almost exclusively in short-term securities, thus divertingscarce long-term resources available in Sri Lanka. The current investmentdirectives undermine the potentially valuable role these institutions can playin mobilizing long-term funds for further development of the industrialsector.

3.12 As of December 31, 1991, the two major employee funds, the EPF andETF, had about Rs 52 billion (US$1.2 billion) in assets. Governmentdirectives, however, have required that nearly all of this money be investedin short-term government securities. The average monthly net inflow intothese two institutions is more than Rs 700 million. The growth in assets ofthese two funds represents a pool of long-term resources that can beeffectively channeled to provide term finance for productive investment in SriLanka. Therefore, a revision in the investment policies of the pension fundsand insurance companies is needed to allow for appropriate diversification

A/ The term "contractual savings institutions" refers collectively to theEmployees' Provident Fund, the Employees' Trust Fund, the NationalSavings Bank and the Insurance Corporation of Sri Lanka.

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and, to the extent appropriate, provide funding to the private sector for newinvestuent.

3.13 The SPY, instituted in 1958, is administered by the Department ofLabor and funded by contributions from employers and employees. Everyemployer and employee wmut contribute either to the EPP or an approved privateprovident fund. Employees can withdraw funds only at retirement; however,they can benefit by borrowing against their accounts prior to retiremet.Currently, employer contributions amount to 12 percent, with the employeecontributing 8 percent of the employees' salary. It covers almost fivemillion employees and more than 80,000 employers.

3.14 At the end of 1991, EPY had about Re 46 billion in total assets,more than 85 percent of which vere invested in Rupee Securities and debenturessold by the State Mortgage and Investment Bank (SMIB). During 1991, theaverage monthly net inflow wa almost Re 680 million and the reported returnon assets was 11.5 percent. The funds are invested under the direction of theMonetary Board (MB). The investment policies are decided in consultation withthe MOT. The MOF reviews the GOSL's requirements for budgetary financing, andrequests the MB to invest specified amounts in government securities. Thus,the pressure to reduce interest costs and finance the government deficit hastaken precedence over maximizing the return to employees covared under theSPY. Consequently, the SPF has reported negative real returns to its membersover the past few years.

3.15 The ITF, established in 1981, is administered by the Employees'Trust Fund Board and is funded by contributions from employers (3 percent ofthe employees' salaries). Employees can withdraw funds upon termination oftheir existing employment. The average net monthly inflow is more than it 30million. STF reported a rate of return of 12.5 percent in 1991. The IT!Board is responsible for its investment portfolio. Although in principle STFis autonomous and free to invest in shares, securities and other assets inorder to maximize return to its members, it has been directed to invest aminimum of 70 percent of its investible funds in Treasury bills. Its boardconsists largely of members appointed by the GOSL. As of September 31, 1992,ETF had about Re 6.45 billion in total assets, mostly invested in Treasurybills (57 percent), housing finance institutions (19 percent) and Defensebonds and Rupee Loans (13 percent). Although eight percent of its portfoliois comprised of equities, thess securities are largely investments in publicsector companies. Due to a lack of expertise in investment analysis andportfolio management, the Fund has been extremely risk averse. Recently, inan effort to diversify its holdings, it decided to appoint 3 fund managers tomanage portfolios of Re 100 million each on a commercial basis.

3.16 The National Savings Bank (NSB) was established in 1971 byamalgamating the Ceylon Savings Bank, the Post Office Savings Bank and theSavings Certificate Fund. Its diverse branch network and the post officesavings help mobilize deposits throughout the country. As of June 30, 1992,it had more than Rs 30 billion (US$652 million) in its investment portfoliowith almost 45 percent invested in securities and about 37 percent in Treasurybills. Deposits were backed by a government guarantee, (and earning, on thesewere tax exempt), allowing the NSB to enjoy a high level of public confidence.

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Despite the withdrawal of the tax benefit in April 1991, Its deposit basecontinues to grow.

3.17 N8B's investment guidelines mondate that it. Snvestments Insecurities, stocks, debentures and Treasury bills of, or gusranteed by, theGOSL shall constitute no less than 60 percent of its deposits and savingsaccounts. The MOF is permitted to change this percentage by order publishedin the Gaxette. The NS3 has, however, become another source of captive fundsfor the GOSL and invested in long-term government securities with below marketyields. The losses incurred by the N83 were partially compensated by the GOSLby means of a subsidy. Since 1989, the proportion of Rupee Securities in theinvestment portfolio of the NSB has decllned and the proportion invested InTreasury bills has increased. The NS3 has also taken limited Initiatives toiiversify its investments to debentures and shares, resulting In an increasein the average return on investment (15 percent in 1991 vs. 14 percent in1990). NSB expects to sustain itself without the GOSL subsidy, which wasphased out in 1992.

3.18 The Insurance Corporation of Sri Lanka (ICSL) is the largest ofthe five insurance companies (two public and three private) operating in SriLanka, with a market share of about 65 percent. In December 1992, it wasconverted into a company operating under the Companies Act, with a view toeommence privatixation by December 1993. All five insurers conduct both lifeand general insurance business. The substantial long-term resources mobilizedby the insurance industry are a captive source of funds for the GOSL. Theinvestment guidelines of the two public sector insurers were governed by therespective laws under which they were established as well as by the GOSLdirectives. The investments of the three private insurance companies aregoverned by the Insurance Companies Act, which stipulates that at least 50percent of the life and 30 percont of the general funds be Invested ingovernment guaranteed securities and the remainder In approved securities suchas public companies, 5MIB, EDPC and deposits with commercial banks. During1991, virtually all of ICSL's investible funds were invested in Treasurybills. At the end of 1991, its investment portfolio Included Treasury bills(42 percent); equities -- mainly public sector enterprises (21 percent)gdefense bonds, rupee loans and housing finance (13 percent); and term depositsin commercial banks (12 percent). At the end of 1991, it had total assets ofRe 5.7 billion, with an average monthly net inflow of Rs 40 million.

3.19 All of these publicly controlied contractual savings institutionscontributed to the diversion of term savings away from the private sectorthrough mandatory transfers to government securities. As part of its programof financial sector reform, the GOSL's litention is to develop investmentguidelines for the rFf, ZTF, ICSL and NSB that allow for gradualdiversification of their investment portfolios and permitting t'eseinstitutions to invest in non-government securities consistent with theirroles. Work on developing these guidelines is to commence after Projecteffectiveness. EPP and ITF will invest at least 52 of their inflow in non-government securities in 1993, increasing to at least 1OZ by June 1995. NSBhas already started the process of diversifying its investments. By the endof 1993, at least 101 of its investments will be in non-govermment securities.Thereafter, the proportions are to be increased in consultations with IDA and

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in light of the experience galnd from the initial phase, with a view tocomplete livestment autonomy for these lnstitutions within five year. ofi-roject effectiveness. At the end of this five year period, the proportion offunds lnvested by these institutions In government securities will not be anyhigher than what is consistent with the institution's independent investmentobjective.

3.20 As the GOSL reduces its demand for mandatory investment in publicsecurities, these institutions will need to develop expertise in managingtheir portfolios, including the formulation and implementation of investmentguidelines and a mechanism to control and monitor portfolio performance. Theproposed project supports a significant program of TA and training for theseinstitutions to enable them to carry out their changing responsibilities. Itwill also support the development of a regulatory framework for the insuranceindustry and provide assistance in the privatization process.

3.21 Government's Role in the Financial Sector. Until 1969 Sri Lankadid not have any private domestic commercial banks. BOC (created in 1939) andPB (created in 1961) were the only two domestic commercial banks until CBOCwas created in 1969 as the first privately owned domestic commercial bank fromthe operations of Standard Chartered (a foreign bank operating in Sri Lanka atthe time), followed by Hatton National Bank in 1970. There were no newprivate commercial banks for another seventeen years until Sampath Bank wasestablished in 1987 and Seylan Bank in 1988. Along with the foreign banks,the private domestic commercial banks now account for approximately 40 percentof the market share of total advances, and the state-owned banks, althoughstill dominant players in the market, have been losing market share steadily.A similar situation exists with DPI.. DPCC, created in 1956, reained undersignificant public control through the 39 percent shareholding of BOC and PBin the institution until 1991, when this holding was reduced to 31 percent(further reduced to 30 percent In 1992). Also by 1992, public sectorrepresentation in its board was reduced to four, out of eleven. NDB, theother DPI in Sri Lanka, wa created in 1979 as a wholly public institutionallowing, until quite recently, a very daoinant and direct role for the publicsector in provision of long term finance. This role has steadily diminishedover the recent years with reduction of its influence on DFCC, and is expectedto be further reduced with the privatization of NDB.

3.22 Development Finance Comnanies. DFCC's main objectives are "toassist in the promotion, establishment, expansion and modernization of privateindustrial agricultural and commercial enterprises in Sri lanka, and toencourage and promote the participation of private capital, both internal andexternal, in such enterprises*. From its modest beginnings with an initialsubscribed capital of Rs 8 million, its share capital increased to Rs 170million In 1992 (a public issue was made in October 1991). At the end of itsfiscal year 1992, it had assets of more than Rs S billion and a record Re 266million In profits. Its outstanding investment portfolio comprised 83 percentloans, 7 percent investment securities, and 10 percent financial leases anddiscounted bills.

3.23 The National Developmoent Bank (IDB) was established as adevelopment bank in 1979 by a special act of parliament with a subscribed

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capital of more than Re 600 million. Its main objectives are "to promote theindustrial, agricultural, commercial and other development of the economy inSri Lanka having regard inter *Ila to the development of the ruralsector....", similar to those of the DFCC, except for the emphasis on therural sector. The IND was privatized in March 1993. At the end of 1991 ithad assets of Re 7 billion and net profit of Rs 250 million. Its return onassets was 4.1 percent and return on equity of 15.3 percent.

3.24 Despite the initial concept of self-sustaining, multi-serviceinstitutions, the DFIs involved in the project (DFCC and NDB) have remaineddependent on the GOSL and multilateral donors for funding, and until recently,have focused their activities only on term lending, making them particularlyvulnerable to macroeconomic changes and increased competition engendered bythe GOSL's financial sector liberalization. Diversification programsinitiated by both the DFCC and NDB under previous intermediation projects haveattempted to address these concerns but there is a need to develop a clearplan for broadening the resource base (e*g., through mobilization of termsavings, bond issues, capital subscription, etc.) and activities of bothinstitutions. Limited progress has been made in this respect; e.g., DFCC hasraised funds through the private placement of debentures and successfullylaunched its first unit trust. It holds almost 30 percent of shares in aventure capital company and is increasingly engaged in underwriting shares.However, further diversification of activities has been constrained by theGOSL's dominant shareholding in NDB and the SCB's shireholdings in DFCC. Thereforms supported through the proposed project are expected to help the DFIsbegin to develop alternative sources of funds for their operations.

3.25 State-Owned Commercial Banks. Sri Lanka's two SCBs, BOC and PB,dominate the banking system in terms of size and act as market leaders inestablishing interest rates. BOC, the largest bank in Sri Lanka (about 240branches and almost 40 percent of total deposits), was established as a state-aided bank in 1939 and operates under the Bank of Ceylon Ordinance. Most ofits branches (about 65 percent) are in the Greater Colombo and Randymetropolitan areas. Its board is appointed by the MOF, and while it appearsto have autonomy in many operating areas, its decision making is often subjectto considerable political pressure. Since it was initially established with acommercial orientation (mainly to serve trade and commerce), it has always hada more urban focus, larger loans, more large industrial and public enterpriseclients, etc. than PB. It has two foreign branches and can thus provide avider range of services than PB. BOC also plays a more active role in inter-bank lending, and is often the largest supplier of funds to that market.

3.26 PB was established in 1961 under the People's Bank Act in responseto the GOSL's desire to create a new apex bank to serve cooperatives and toreplace the Cooperative Federal Bank which had failed to combine commercialbanking operations with its cooperative support functions. Its formalobjectives (in the Act) do not include making profits or operating on afinancially viable basis. As an institution, its staff clearly have a more"developmental" rather than commercial focus. PB has often acted more as agoternment agent to implement programs such as Janasaviya, even if itundermines its commercial viability. It has more than 300 branches, about 30

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percent which are in urban areas. Since PB does very little "middle-market"lending, its average deposit end loan sizes are smaller.

3.27 A recently completed external audit of the financial condition ofPB and BOC revealed that both institutions incurred large operating lossesand, as of December 31, 1991, were technically bankrupt. A capital infusionof more than Re 24 billion is required to recapitalize these banks tointernationally accepted (BIS) standards as wall as to provide adequately fortheir under-funded pension obligations. Moreover, PB and BOC have advancedlarge sums of money to a number of state-owned businesses which hase defaultedon their loans. The banks, in effect, are being used to funnei off-budgetsubsidies to the sectors of the economy that are commercially non-viable.

3.28 Private sector ownership, combined with professional managementand a commercial focus, would be the most effective way of addressing theseproblems. The GOSL, however, has been slow to embrace this strategy, citingpolitical constraints to privatization. To ensure that the SCBs becomecommercially viable Institutions, the GOSL needs to: (i) amend the relevantacts to enable the SCBs to function as autonomous commercial organizationsa(ii) reconstitute the Board of Directors and nominate individuals from boththe private and public sector with commercial focus and a high degree ofprofessional experience; (iii) develop a mechanism to deal with the troubledassets of the SCBs, which may involve establishing an agency to resolve non-performing assets; (iv) establish and enforce performance criteria for theSCMs; (v) require that the SCBs prepare action plans indicating quarterlyinterim targets and how they will be achieved, efficient allocation ofmanpower including voluntary retirement schemes, measures to improve staffutilization ete (vi) improve appraisal procedures and management informationsystems in the SCBs; (vii) establish branch level budgeting and accounting andclose loss-making branches. The GOSL believes that these measures, furtherdetailed in Annex 7, would lend a commercial focus to the SCBs.

3.29 The SCBs participated in previous IDA Credits as PCI.. However,both BOC and PB were suspended, and remain suspended, from utilizing thecredit component of SMI IV (IDA Credit 2250-CS) as they failed to maintaincapital adequacy requirements for eligibility as PCI for that Credit. SCB. donot meet the eligibility requirements of the PPDP and will not be PCIs for theproposed project. IDA considers that, as a minimum, the following conditionsmust be satisfied before a review could be undertaken to consider theeligibility of the SCB! !or the proposed project: (i) steps noted in theprevious paragraph are completed; (11) the 8CBs are recapitalized tointernationally acciepted norms; and (III) independent reviews of financialdata, conducted un4er internationally accepted standards, show that the SCBshave achieved prof_'tability targets and return on assets that are at paritywith the private commercial banks for two consecutive years, on a cumulativebasis under fair market conditions. In particular, the profit targets shouldexclude any interest income from the recapitalization bonds utilized toaugment the capital base of the SCBs from zero to 8 percent. Legislation,enabling the SCB! to function as autonomous coamercial organizations andlevelling the playing field betwieen state-owned and private commercial bankshas been submitted to the Cabinet for approval. It is expected that thelegislation will be presented to the Parliament for approval by May 1993 and

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implemented by August 1993. GOSL has also confirmed its intention to enterinto binding agreements with the SCBs covering their profit targets, interimmeasures needed to control administrative costs, credit discipline andrestrictions on asset growth. A draft of the main terms of the agreement isincluded in Annex 7.

3.30 Debt Recovery Leeislation. The development of Sri Lanka'sfinancial Institutions is hampered by debt recovery problems. In order toensure stability of the financial system and safeguard the public deposits, asound debt recovery system is necessary.

3.31 While a series of wide ranging debt recovery laws were introducedin 1990, the need for further strengthening of the legislation has beenrecognized for some time. Since 1990, a committee chaired by the Chairman ofthe NDB and the Presidential Commission on Finance and Banking have reviewedthis matter and submitted their reports to the MOP. In response, a committeeto examine the debt recovery law and procedure was appointed by the CabinetSubcommittee on Monetary Affairs. This committee, chaired by the Secretary,Ministry of Justice, Mr. Herat, has submitted its recommendations to theCabinet Subcommittee on October 19, 1992. The Cabinet Subcommittee hasadopted the recommendations and final Cabinet approval followed by appropriatelegislation is expected by August 1993. As a result of these recommendations,the GOSL will initially establish one special debt recovery court and onecommercial court. If necessary, another special debt recovery court may beestablished later. The debt recovery courts will deal exclusively with casesfiled by financial institutions, where the disputed amount exceeds a specifiedthreshold. The commercial court will have jurisdiction relating to ordinarytransactions of merchants, traders, mercantile agencies and insurance,intellectual property, etc. Although knowledgeable in local laws, the judgesfor these courts need to have exposure to debt recovery procedures in moredeveloped economies and training for legal staff is needed to expedite courtprocedures. Technical assistance funds from this Project will be provided forphysical infrastructure to support the special debt recovery court,familiarization of debt recovery judges to procedures in more developedfinancial markets and training of legal staff.

3.32 Accountina and Audit Standards and Enforcement* Pinancialinformation has a significant role in the process of modernizing financialinstruments markets, with extensive linkages to other economic areas.Published financial statements are an important output of the accountingsystem, and the only one regularly available to external users. The qualityof those statements is reflected in their perceived and actual quality ofinformation, relevance, timeliness and reliability. Their quality has animpact on resource mobilization, allocatiou and management. If financialstatements are not of a consistently high quality and are generally perceivedto be deficient, there are substantial actual and potential negative impacts:corporate tax collection process becomes cumbersome and arbitrary,privatization is made difficult, development of a capital market is hamperedand bank lending decisions become increasingly collateral oriented.

3.33 Problems with the quality and reliability of financial statementsexist in Sri Lanka, despite the fact that it has an active and relatively

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competent accounting profession. This appears to be primarily due to a lackof an adequate mechanism for the enforcement of eristing auditing andaccounting standards rather than serious shortcomings In the standard.themselves.

3.34 The Institute of Chartered Accountants of Sri Lanka (ICASL) is theprimary professional accounting body and has the authority to set theaccounting and auditing standards for its members. The ICASL has adopts' allof the lnternational accounting and audit standards and is working with theMOP On proposals requiring all listed and large unlisted companies includingfinancial Institutions to prepare their financial statements in accordancewith these standards (currently only the listee companies need follow theaccounting standards as part of their listing requirements). There is also aneed to strengthen licensing requirements for auditors to prevent unqualifiedaccountants from becoming public accountants. In addition, the MOF, withassistance from ICASL, is working to establish a separate body (an AccountingStandards Board) to monitor and enforce compliance with accounting standards,investigate cases of non-compliance and recommend appropriate actions. GOSLconfirmed its commitment to IDA tos

(a) amend the legislation to require that financial statementsof listed and large unlisted companies, including financialInstitutions, be audited by a qualified chartered accountantin accordance with standards issued by the ICASL by December1993;

(b) establish an Accounting Standards Board to enforce technicalstandards on public accountants, provide sanctions fornoncompliance, and recruit senior technical staff to manageand supervise the compliance program by December 1993; and

(c) take other steps to strengthen the profession, including astudy of the feasibility of introducing compulsorymalpractice insurance for all practicing accountants. Thestudy will commence by October 31, 1993 and be completed byMarch 31, 1994.

3.35 Bankina Supervision. Th new competitive environment is expectedto increase the need for efficient bank supervision. Efficient supervisiondepends largely upon accurate, reliable and rapid returns based on theaccounts of the financial institutions. These returns facilitate peercomparisons that could serve as early warning signals. Besides peercomparisons, analysis of various ratios such as liquidity, solvency, capitaladequacy, profitability as well as time-series comparisons of principal itemsand percentage changes should also be conducted. These analyses andcomparisons would not only constitute the backbone of the off-site supervisionof the banking supervision function, but also provide for more focused on-siteinspections rather than the present two-year inspection cycle for each bank.

3.36 At present, three departments of CBSL are involved in thesupervision of the financil systems the Bank Supervision Department (BSD) isresponsible for the supervision of 23 commercial banks, 2 DFIs and the 16

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RtDBo. the Eon-Bank Financial Institutions Supervision Department (NBFISD) isresponsible for supervising 27 finance companies; and the Banking DevelopmentDepartment (BDD) is responsible for evaluating requests for licensing of newbanks and bank branches. Banking supervision In Sri Lanka has severalweaknesses: (a) coverage of supervision; (b) coordination between the threedepartments; (c) staffings and (d) inadequate rules and regulations:

(a) Coverage of Supervisions The Foreign Currency BaLking Units(PCBUs) were allowed by regulation in 1979 to attractforeign currency investments from nonresident Sri Lankans.These investments have grown rapidly and now constitutemore than 25 percent of the total assets of the domesticbanks. Although the FCBUs report to the BSD in the sameformat as the domestic banking unite (DBUs), they are notsubject to similar prudential regulations or on-sitesupervision. The two merchant banks have been broughtunder the purview of the BSD supervision and have beenreporting since January 1992. The prudential regulationsapplicable to these two banks have not yet been formulated.The CBSL needs to begin on-site inspections and formulateadequate prudential regulations for both the FCBUs and themerchant banks.

(b) Coordination Between the Three Departmentes Experienced andknowledgeable supervisors are a valuable and scarcecommodity at CBSL. The three departments need to maximizethe use of these resources by facilitating exchange withindepartments, developing common reporting formats whereverpossible, etc. Coordination between the three departmentsmay also be strengthened by a clear organizationalstructure and reporting relationships. It is importantthat these departments report to the same ExecutiveDirector. A review of the current organizationalstructure, and other issues related to institutionalstrengthening need to be identified and resolved.

(c) Staffing: The departments lack sufficiently qualifiedstaff. Emphasizing off-site supervision will help the CBSLkeep track of the financial system in a way that recognizesits current instttutional weaknesses. In this respectcomputers can assist enormously by performing repetitivetasks, calculating key ratios, checking adherence,performing peer-group comparisons, etc. This would freeanalysts to perform the actual analysis, and identify keybanks where on-site supervision may be required urgently. Adetailed analysis of the departments' automationrequirements and a training program for staff needs to bedeveloped and implemented urgently.

(d) Rules and Regulations: While some of the prudentialguidelines have been made effective (suspension of intereston non-performing assets, provisioning), others amwit

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drafting. Urgent attention should be given to enforcingthe new capital adequacy guidelines (in line with the BISrequirements), open foreign exchange positions andliquidity requiremonts. In additiou, guidelines for thetreatment of overdrafts for the purpose of classificationand provisioning need to be determined and enforced.

3.37 The Banking Supervision Department has, in consultation with CBSL,initiated the process of institutional strengthening by examining its manpowerrequirements. IDA has been requested, under the aegis of this project, toprovide technical assistance to CBSL to rationalize the supervision functionand enhance the quality and efficiency of the supervision. The GOSLreconfirmed its commitment to initiate this work within three months of theProject effectiveness, with a view to completion of the first phase within sixmonths. The overall program of strengthening the CBSL supervision function isexpected to take two years. In addition, a separate study to help develop theregulatory framework for the insurance industry will be undertaken at the sametime.

IV. THE PROJECT

A. Obiectives

4.01 The proposed project seeks to:

(a) improve the efficiency of financial intermediation in SriLanka by supporting policy and regulatory reforms in thefinancial sector;

(b) assist in domestic resource mobilization for long-terminvestment by stimulating the development of local bondmarkets; 4

(c) enable the private sector to respond to the changingeconomic environment by providing investment finance; and

(d) help deepen the financial system and strengthen the keyplayers including the contractual savings institutions, theCBSL, the HOP, the GOSL, the ICASL and the PCIs.

S. Pro@iet Description

4.02 To achieve these objectives, the Proj_ct comprises:

(a) Improvements in Policy Framework: As noted above, theProject will support wide ranging reform of the policy andregulatory environment in the financial sector, especiallyin areas affecting mobilization of domestic resources forinvestments through commercial channels. Significantelements being supported through this project includes

(i) developing market oriented procedures for issuingdebt instruments and removing the requirements for

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publicly controlled savings institutione to investvirtually all their funds in public socurities;

(i1) extending the maturity structure of governmentsecurities and ending the Issuance of managed rateRupee Securities;

(III) establishiug a task force and devising an actionplan to automate the post-trade handling of allTreasury paper transactions;

(iv) modernizing the system for generating tax data foruse by Inland Revenue and phasing out the currentsystem of withholding taxes on debt instruments;

(v) development of investment guidelines for the EPF,ETF, ICSL and USI that allow for gradualdiversification of their investment portfolios andpermitting these institutions to invest in non-government securities consistent vith their roles.The targets for the funds to be invested aecordingto the new investment guidelines and in non-government securities are 5 percent of monthlyinflow in 1993, increasing to over 10 percent byJune 1995 for UP! and ITF. Target for NSB, whichhas already the process of diversifying is 10percent of assets by the end of 1993. Thereafter,the proportions are to be incteased in consultationswith IDA and in light of the experience gained fromthe initial phase, with a view to completeinvestment autonomy for these institutions withinfive years of Project effectiveness. This means theproportion of investment funds to be invested ingovernment securities will not be any higher thanwhat is consistent with the institution'sindependent inves%ment objectives;

(vi) the development of a regulatory framework for theinsurance Industry and restructuring andprivatization of the state-owned insurancecorporations;

(vii) requiring that all listed companies and largerunlisted companies be audited by qualified CharteredAccountants in accordance with ICASL adoptedstandards, setting up of an Accounting StandardsBoard and studying the feasibility of introducingmalpractice insurance for practicing accountantsg

(viii) commercializing the SCBs including setting andenforcing of profitability targets for their boards,modifying legislation governing the operation ofSCBs to remove privileges and constraints, andensuring accounting and disclosure of the results ofSCBs operations In accordance with internationallyaccepted standards;

(ix) implementation of legislation coveringrecommendations of the Herat Committee and settingup of additional debt recovery courts; and

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(a) strengthening Dank Supervision function In the CBSL.

The GOSL provided IDA with a letter of aectoral policyduring negotiations (Annex 2), outlining the actions to betaken under this Project. In addition, IDA agreed with theGOSL on specific actions on the major financial sectorIssues described In Chapter III above. Progress inimplemeating thee. reforms will be monitored throughout thecommitment and disbursement period of the loan. Several ofthese action. are already underway. Moreover, IDA providedtechnical asietance and bilateral support will also aslstIn fulfilling thee. conditions in a timely manner. IDAwill conduct a formal Mid-Term Review of the Project toensure that these reform. are proceeding satisfactorily.Unsatisfactory progress In implementing the overall reformprogram being supported through thie project will result insuspension of further cammitment of fund. under theProject.

(b) Invletment Credit Component (US$57.5 million equivalent):The credit component will make fund. available to PCI. toprovide term loan. to private enterprisea, withoutlimitation to their size or subsector. Funds will be on-lent by the GOSL directly to the PCI., on a variable basis,at the Average Weighted Deposit Rate (adjusted for CBSLreserve requirement.) to be reset once every three or sixmonths. The on-lending rate will be revieved periodicallyand changed to the Troasury bill rate or anotherappropriate index when the secondary market develops. PCIswill be free to determine the final variable rate to sub-borrovers In addition, the project will increase theextent to which PCIs are to mobilize domestic resources byfinancing only 60 percent of the loan amount. Although thedirect foreign exchange risk will be carried by the GOSL,the variable and market determined final lendint rate willtransfer the risk to the sub-borrowers. The PYOPAdministrative Unit in DDB will administer the component onbehalf of the government on a fee basis. Each PCI willhave a specified free-limit. Subloans in excess of thefree limit will require IDA's clearance. IDA participationIn a specific subloan will be limited to US$2.0 million.

The project will support creation of a Pollution Controland Abatement Fund to provide Investment funds to existingindustries to help them comply with enwironmentalstandards. The subloans vill be provided at zero realinterest rates (inflation was 11 percent at the end ofDecember 1992). The nominal Interest Income will beearmarked for monitoring compliance with environmentalstandards. The rate of interest will be determined at thetime of the first disbursement for the oubloan and will bebased on the latest published rate of Inflation. Funding

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for the PCAP is being provided by the Government of TheNetherlands on a grant basis.

(c) Tecbnical Asositance Component (US$2.5 million equivalent)sThis component will provide assistance for the preparationand implementation of various policy reforms, including:(i) establishing a viable domestic bond market, includingdeveloping the legal and regulatory framework, providingassistance to contractual savings institutions indeveloping portfolio manaegment capacity, creating thetrading and settlement infrastructure end training for allprivate and government participants; (it) preparing thestate-owned commercial banks for restructuring andrecapitalization; (iii) implementing the new accounting andauditing standards, debt recovery legislation andstrengthening the banking supervision function within theCBSL; (iv) continuing to upgrade the capabilities of thePCIs (expected to be disbursed within two years of projecteffectiveness), including risk management; and (v)supporting implementation of environmental standards by theentrepreneurs, PCIs and regulatory agencies. The PPDPAdministrative Unit in NDB will administer this componenton behalf of the GOSL.

V. THE CREDIT

A. Terms and Conditions

5.01 Amount and Maturity. The proposed Credit of SDR 43.2 million(US$60 million equivalent), including the credit and technical assistancecomponents, will be made to the GOSL on standard IDA terms, with 40 yearsmaturity and a grace period of ten years. The Credit is expected to be fullydisbursed in five years. The GOSL will on-lend the proceeds of the creditcomponent (US$57.5 million equivalent) to PCIs for a period not exceedingfifteen years, including a maximum of five-years grace period. The proceedsof the TA component (US$2.5 million equivalent) will be transferred as a grantto the respective institutions receiving the assistance.

5.02 Interest Rate. The proceeds of the credit component will be on-lent by the GMSL to PCIs at the Average Weighted Deposit Rate (AWDR) on avariable rate basis. The AWDR is the weighted average cost on all interest-bearing term funds including savings accounts (not including NSB accounts),fixed deposits and certificates of deposit, adjusted for foregone interest onCBSL reserve requirements* A rolling six-month AWDR, currently being computedby CBSL, will be published on a weekly basis. The AWDR is proposed as theinterest rate reference point pending further development of the Sri aenkanTreasury bill market. The interest rate basis is subject to review by IDA andmay be changed to the appropriate Treasury bill rate or snother index afterthe Treasury bill market has developed. This change is expected to occur atthe Mid-Term Review of the project. The PCIs will have full autonomy to pricethe loans to enterprises according to perceived risk, maturity and to covertheir intermediation costs. AA interest rates will be market oriented and

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variable, the rates charged to end users will indirectly reflect the foreignexchange risk. The Government vill beer the direct foreign exchange risk ofthe credit.

5.03 Suborolect Finanlina Criteria. A miaimum of 30 percent ofsubproject costs vill be provided by the sponsor in the form of equity, toencourage sound capital structurest the actual equity contribution will bedetermined by the PCI on a case-by^case basis. Experience under the ongoingSNI projects indicates that sponsors typically provide about 30 percent oftotal project costs. To encourage the PCIs to mobilize funds domestically,the Credit will finance no more than 60 percent of the total PCI loan amount.IDA's financing of any one subprojecr will be limited to a maximm of US$2.0million equivalent.

5.04 Eligible subprojects will finace investment in new or existingprivate firnm for modernization, rehabilitation, restructuring or expansion.All subprojects will need to be financially and economically viable asassessed by the PCIs and must meet the environmental regulations establishedby the CEA. No limitations will be set on the size of individual enterprisesor their subsectors, other than a prohibition against using credit proceeds tolend to other financial institutions. All subprojects will need to meot theGOSLIIDA environmental standards (see para. 5.25) and will require anenvironmental protection license (EPL). Working capital financing viil beallowed only as part of a fixed investment subloan and for permanent workingcapital needs, since seasonal vorking capital financing is available fromothor sources.

5.05 Sublo.n Sige. Free Limits and IDA Review, Based on theirdemonstrated capacity under the previous projects to select suitable projectsponsors and appraise and supervise investment projects, the PCIs will begiven a free limit appropriate to their capabilities and operations. The free14m4ts will be reviewed by IDA on an annual basis and modified as appropriatein light of the PCIs performance. At the time of Project effectiveness, freelimits for the PCIs are expected to be in the range of US$100,000 toUS$300,000. Subloans in excess of these free limits will be evaluated by IDA.Subloans (both above and below the free limits) will also be reviewed by IDAon an ex-poste basis during supervision missions.

5.06 Terms for On-lending by the GOSL to the PCIes. Credit funds vill beon-lent by the GOSL to the PCIs on a variable rate basis, adjustable everythree or six months, at the AWDR. The reset period will be Selected by thePCI, but once selected, it cannot be changed for a period of one year and villapply to all subloans granted the PCI in that year. Based on the mix ofinterest-bearing term deposits held by the domestic comercial banks as ofDecember 31, 1992, the effective AWDR vas about 13.9 percent compared vithinflation of about 11.4 percent. The GOSL will on-lend to the PCIs in Rupees.Subloans will be financed on a first-come, first-served basis. The lendingrates and mechanism will be reviewed at least once annually with IDA to ensurethat they remain a reliable market proxy. It is expected that with thedevelopment of the capital market, this rate will be changed to an appropriateTreasury securities rates at the Mid-Term Review of the project. The PCIswill be free to charge sub-borrowers a market-determined interest rate on

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subloans financed under the project. The PCIs will be expected to makesubloans on a variable b"ais, linked to any index acceptable to the PCI adits borrower. Iowsver, the PCI will need to satisfy IDA aout the mechanismthat it ha adopted to amnitor and control the interest rate risk that Itassumes. Subloas one whch no disbutemento have been made for twelvo monthswill be reviewed and, unless a case could be made to the contrary, canceled tofacilitate project completion and promote a full utilisation of project fund.

5.07 Terms of Repayment by the PCIe to the GOSL. The PCIa will repaythe GOWL on a composite amortization schedule (aggregated from the individualsubloans) with a maxtimm of 15 years, Including a maximum of five-year graceperiod. The maturity of itdividual subloans will be deterained by the PCIas,based on the merits of the subproject, but will not exceed ten years,including a maxtium two year grace period. PCIs will report their projectaccounts regularly to the PIDP Administrative Unit. Overall, the commitmentperiod Is expected to be about three year.

S. Administ_atIon of the Credit

5.08 AmInistratIve Unit and itM Structure. Under the previous SKIoperatiosm, NDB had been the choice a. Apex Agency. The design of theproposed project is such that most function., normally performed by the ApexAgency, have been eliminated, except for the project administrationresponsibilitie. (accounting, auditing, reporting, coordination of PCIdevelopment effort, marketing, etc.). There is no float to be managed by anApex Agency and all subproject above the free-l4m4t, will be reviewed by IDA.In order to accommodate the requirements of the proposed projects In the mostefficient uanner, and to eliminate the potential for any conflict of interest,the GOSL ha agreed that there will be no Apex Agency for the project and onlyadministrative functions will be performed by an Administrative Unit. Afterconsidering the Institutions that may be able to undertake the administrativefunctions, Including the two DPI., the GOSL decided that 3DB should performthese duties, on a foe bssis. If in the future there is any evidence of UDI'sinability to discharge its functions In a manner satisfactory to IDA, anotberinstitution will be selected mutually by the GOSL and IDA to undertake thiswork.

5.09 lunctlons. The Administrative Unit will monitor operations underthe credit and carry out the administrative and reporting requirements of theProject. bor loans In excess of the Individual free limits, PCIs will sendtheir applications directly to IDA for subloan review. In addition, from timeto time the Unit will assist IDA in performing ex-post. reviews and 4ampleanalyses of subloans sanctioned below the individual free limits to ensurethat appropriate appraisal standards are being maintained on these smallersubprojects. The Unit will also administer the technical assistance componentfunds and the Pollution Control and Abatement Fund (PCAP). To cover the costsof these activities EDB will be reimbursed by the GOSL throuSh an annual fenot exceeding one percent of the credit amount disbursed and outstanding, withthe rate subject to annual review and adjustment. The signirg of thesubsidiary administration agreement between the Administrative Unit and theGOSL, discussed during negotiations, and acceptable to IDA, will be acondition of effectiveness. The Unit will operate a Special Account In the

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CISL, from which reimbursoement requests will be paid. The account wili beaudited annually by an independent auditor satisfactory to I11.

S.10 Wg.stinf Arraneaments. The Administrative Unit, currentlyoperating for the SKI projects In UDs, is organized Into six main sections.The Analysis and Review Section reviews PCIs' appraisals and refinancoapplications. The Reporting and Liaison Section prepares periodic reports anthe credit institutions' lending, supervision and collection performance. TheFinance and Disbursement Section disburses refinance, collects repayments,administers project funds for the techiacal service components and maintainsaccounts. Three other sections are responsible for monitoring andsupervision, training and subsector analysis. Although in the past publicownership had strained 1DBo. ability to recruit and retain good staff, NDB hsadministered the ongoing projects competently and professionally, and Itsrecent privatization will allow for sany further improvements needed. INDB hasemphasized the development of procedures, review of reimbursement applicationsand upgrading PCIs' appraisal standards through training. Although notdirectly needed for this project, it is worth noting that NDB has alsostreamlined and improved the subloan review process from the PCIs. PCIsordinarily receive prompt responses to thelr reimbursement applications. Thepolicies and procedures for the Administrative Unit (Annex 5) have beenreviewed with IDA staff and are satisfactory. Any future modifications of thepolicies and procedures, or the selection of the Institution to perform theadministrative functions, will require prior COSL and IDA approval.

C. Particinatin- Credit Institutions

5.11 Potential PCIs. The experience with the first four SMI projectshas demonstrated PCI capacity for selecting, appraising and supervising SKIprojects. Increasingly, these institutions have begun to extend term loans tolarger euterprises and have demonstrated their ability to manage this sectoreffectively. Subject to fulfilling the conditions of participation as agreedwith IDA, some of the PCIs which have participated in previous Credits --CBOCs DFCC, 1DB, Hatton, Sampath and Seylan, are expected to be the mainbeneficiaries of the proposed project. Bank of Ceylon (BOC) and People's Bank(PB), which had participated previously in similar credits do not mast theeligibility criteria for this project due to public ownership and theirfinancial/management weaknesses resulting from political interference. Inaddition to a comprehesive restructuring of their operations, satisfactory toIDA, the SCBs must be able to demonstrate profitability equal to that ofprivate comercial banks in Sri Lanka for a period of two years before IDAcould consider a review of their eligibility for participation in the Project.Any other private commercial bank (local or foreign-owned) incorporated in SriLanka and accredited by the CBSL which meets the eligibility conditions couldalso apply to participate.

5.12 Ulisibilitv Criteria for the PCIs. Eligibility criteria for PCI'sparticipation in the proposed Project will take into account the overallfinancial viability of the PCI and strength of its operating structures,rather than confine itself to the evaluation of its ability to deal with termlending. Each PCI will sign a Participation Agreement with the COSL(satisfactory to IDA), including an undertaking that it will at all times

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comply with the eligibility criteria and maintain the minimum ratios as shownin Annex 4.

5.13 A subsequent review of a PCI'. eligibility to continue toparticipate will be triggered if it fails to achieve any of these criteria. Ifthe failure is on account of collection ratios, the review will concentrate onestablishing whether the PCI meets the minimau specified profitability ratiosafter fully providing for the troubled loans which are causing the collectionratios to fall below the minimum required. Unless a case could be made for awaiver supported by calculations of alternative break-even collection levelsbased on a PCI's spreads, terms of its subloans, administrative costs and theopportunity cost of the PCI's own funds, the PCI will be suspended until suchtime as it demonstrates, on the basis of data verified by an externallyaudited financial statement prepared in accordance with standards acceptable,to IDA, that it can maintain minimum collection levels and do so in asustainable manner. During the period of suspension, collection performanceand portfolio infection status will continue to be reviewed by IDA.

5.14 Rvaluation of the PCIs. As of December 1992 all of the proposedPCIs were in compliance with CBSL guidelines and with the condition. ofparticipation under the ongoing SKI projects. However, under the morecomprehensive and stricter eligibility criteria used for this Project, therewere two banks (Seylan and Sampath) that were unable to meet the capitaladequacy requirements based on their December 1991 financial statements andone bank (Hatton) did not meet the minimum collection requirements. The restmet all the criteria. Data for the interim 1992 results indicate that bothSeylan and Sampath are expected to meet the capital adequacy requirements byend-December 1992. Hatton's collection ratio problem may however take alittle longer to correct. PCIs that participated in the ongoing SW projectswill also need to continue to meet the participation criteria for thoseprojects in order to remain eligible to participate in the proposed Project.As a condition of effectiveness of the Project, at least two PCIs should haveestablished their eligibility to participate in the project by meeting theeligibility criteria for the PCIs and signing participation agreements withthe GOSL. Of all the domestic commercial banks and DPI'., the two state ownedcommercial banks (BOC and PB) did not meet the pre-appraisal criteria andwere, therefore, not included for detailed evaluation. The role andperformance of the two DPIs were discussed in Chapter III. Evaluation of theremiaining four private domestic commercial banks is summarized below anddetailed in Annex 6.

5.15 Commercial Bank of Ceylon. CBOC was established in 1969 as apublic company with 40 percent equity participation by Standard CharteredHoldings UK Limited which still retains a representation on the board. CBOCis generally well regarded in banking circles and is considered to have goodquality assets in its portfolio. In 1991 it bad Rs 7.4 billion in its loansplus bills portfolio, which amounted to 77 percent of its total assets.Dictated by prudence it has built loan loss reserves which now stand at 3.8percent of its loan book. CBOC maintains a good mix between term lending andshort term exposures. Its term loans were 54 percent of its loan portfolioand short term bills 18 percent. Its position as the biggest lender amongstprivate domestic commercial banks was at the cost of a high advances to

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deposits ratio wvlich in 1991 stood at 90 percent while its peers weremaintaining significantly lower advances to deposits ratios mostly in therange of 65 percent to 75 percent. Its share capital was doubled in 1989 fromRs 50 million to Rs 100 million which improved its capital adequacy ratios.

5.16 Like some other private domestic commercial banks, CBOC alsosuffers from the quality of its manpower resources. It urgently needs tofurther streamline its systems and procedures and concentrate on training itsstaff. CBOC's net intermediation margin of 6.4 percent was on the lower sideamongst private domestic commercial banks, but despite lower margins it hadthe best before and after tax profits of all private domestic commercialbanks. Return on paid up capital was 143 percent and on shareholders funds itwas 20 percent.

5.17 During the year, CBOC opened two new branches bringing the totalbranch network to 21. Its deposits grew by 33 percent from 5.2 billion to 6.9billion over the year giving 33 percent growth. Advances increased by 24percent to 7.3 billion and total assets increased by 30 percent to 9.6billion. The 30 percent increase in CBOC's asset base was primarily deposit-led.

5.18 Hatton National Bank. Hatton was created in 1970. In 1974 itacquired the business of Mercantile Bank and in 1989 that of Emirates Bank andby 1991 had become Sri Lanka's largest private domestic commercial bank interms of both total assets and customer deposits. It is controlled by twobusiness (trading) houses which own 60 percent of its share capital, remainingshares are held by the public. Although Hatton is not the largest bank interms of number of branches, it ranks largest in terms of its staff strength.These higher staff numbers indicate a low degree of automation and the needfor some streamlining of the management structure. This is also evidenced byHatton's low fixed assets per employee and low profits per employee.

5.19 Hatton has the lowest issued share capital of all private domesticcommercial banks. In 1991, its issued share capital was only 0.6 percent ofits assets, but as the oldest of the private domestic commercial banks withlarge retained earnings, its capital adequacy ratios are reasonable. Hattonhas developed its expertise in providing short-term trade and export financeand positioned itself such that it captures good export business from localtraders and blue chip companies. Its short-term exposure was high at 26percent of its loar portfolio and its term loan portfolio, which was at its 3year low, is small at 39 percent. Although this ratio did improve in 1992, itreflects management's focus on trade finance.

5.20 Hatton's loans plus bills portfolio was an acceptable 69 percent oftotal assets but it was disconcerting to see 9.5 percent of its loanscategorized as non-performing. Loan loss reserves were 3.1 percent of itsloan portfolio: although about the average for private domestic commercialbanks, is considered low due to high portfolio infection rate and lowcollection ratios. Hatton has been cautiously developing its leasingbusiness. In 1991 it had the largest exposure of all private domesticcommercial banks (0.7 percent of its total loans). Hatton is the largestmobilizer of deposits amongst private domestic commercial banks and it manages

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to do so at the lowest cost (cost of deposits was 7.9 percent). It hasreasonable capital adequacy ratios and acceptable profitability ratios butneeds to concentrate on its debt recovery programs and on strengthening itscredit team, if it is to develop its term lending portfolio.

5.21 Samnath Bank Limited. Sampath Bank was established in 1987. FY91was its fourth year in business and it brought major changes for the bank.During 1991 Sampath's founder, chairman and four other directors resigned fromthe board and problems were reported in its loan book. A new chairman wasbrought in after intervention by the Central Bank and a time of austerity setin. The new board decided to consolidate the bank's position. No newbranches were opened during the year and no additions in staff were made.Tough cost reduction and control measures were adopted, including the cuttingback of the bank's rather ambitious program of automation and AIMs. The toughnew policies paid off and bank profits before tax went up from Rs 17 millionto Rs 59 million. Sampath's low return on assets is attributable mainly tohigh operating costs and not to low margins. Its net intermediation marginwat ;he second highest at 8.7 percent. Its operating costs of 6.1 percent ofassets were highest of the four private domestic commercial banks while otherprivate domestic commercial banks costs were in the range of 3.1 percent to3.9 percent. Loan loss reserves were increased by a sizeable amount to reacha level of 3.3 percent of the loan portfolio up from 2.2 percent the yearbefore. Its resolve to sort out its problems with the loan book has resultedin the strengthening of its credit department and improvements in itscollection ratios. In 1991 collection ratio for principal stood at 93 percentand for principal plus interest at 89 percent. Sampath's high portfolioinfection rate of 18.8 percent needs attention.

5.22 Sampath's priorities now lie with its problem loans, installing anaggressive loan recovery team and paying attention to monitoring and controlsystems. It also has to carefully evaluate the policy for branch expansion,because during its period of consolidation other banks have entered most ofthe geographical areas which had potential and were under-banked. It hasadopted a course of tight cost control and technology to gain market share andlaunch the more profitable products and services. Sampath had the highestterm lending portfolio of the four private domestic commercial banks with termloans standing at 63 percent of its total loans. Sampath's leading marketrole in term lending puts it at an advantageous position to utilize the PPDPfacility.

5.23 Sevlan Bank Limited. In 1991, the fifth year of its establishment,Seylan Bank had become the largest private domestic bank in terms of branchnetwork, with 46 branches. Towards the end of 1991 Seylan entered into anagreement with the Central Bank to take over ex-BCCI operations in thecountry. The financial results of the acquisition were not incorporated inthe books until 1992. The June 1992 consolidated results show a surge inSeylan's business, assets and depouits. The terms of the agreement enabledSeylan to acquire assets at a discount amounting to over Rs 1.1 billion. Itsdeposit base more than doubled to reach Rs 3.5 billion, total assets increasedby 71 percent and loans portfolio by 52 percent. These ratios partly reflectits fresh loan portfolio and partly the fact that a substantial part of itsportfolio is of short-term nature which does not entail the usual risks of

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project financing. Seylan's loan loss reserves are low at 1.1 percent of itsloan portfolio. Although there to no evidence of problems with its loan book,mangement agroes that an incroee In loan loss reserves is urgently needed.

5.24 In terms of profitability, Seylan bad the highest netintermediation margin of all private domestic commercial banks (9.1 percent)and lowest operating costs (3.1 percent of a"sets) making it the most tightlyrun privat, domestic comercial bank. Seylan intends to beeome the marketleadr in providing new fimnanial products and services. It has alreadyIntroduced long opening hours as well as weekend opening for selectedbranches, forcing some of the other banks to follow. The bank has anggressive and forward loolkng marketing and senior management team, but itsuffers noticeably from the lack of automation, systems and good qualitysupport staff. Seylan has the potential to increase its market role, profileand profitability In all of its markets if It can resolve issues relating toIts low capital base and urgent need to Improve Its manpower resources,systems and procedures.

Key Fianclal and Ooerational Data for Potential PCIsYear Inded December 1991

me 4 cm CBOC SNo snus

No. of treaches 2 1 21 41 13 46go. of Ebployeee 199 183 19432 1,874 616 794Total Assets (Rs mLilon) 5,013 6,987 9,575 9,936 4,428 5,479Shareholders Funds (Rs m1illon) 932 1,888 715 558 436 283Net Profit After Tas (Res Aillion) 266 2I0 143 137 40 55Advances as I of Deposits N.A l.A 90.5 75.5 76.2 65.2Interest Cost of Deposits N.A l.A 9.3 7.9 8.4 7.9Profit After TezllhsrehoLdera lands 28.6 13.2 20.0 24.6 9. 19.6Capital/Rsk Adjusted Asseto (2) 20.6 33.3 11.2 10.1 7. 6.5'Cash Collectio tkatoo (2)

Pricipal Only 83.1 83.9 82.2 58.17 93.0 93.3Principal and Intret 80.9 80.5 80.4 76.0 89.5 93.8

Portfolio Infection Ratlo (2) 17.1 11.1 10.7 9.5 18.8 0.9Debtl/quity Batlo 3.8 2.5 1.6 1.2 0.1 0.6Earnings per Slur (Ms) 179 84 14 22 1 3Total Asets per Dmployee (Re '000) 25,192 38,181 6,686 5,302 7,188 6,901After Tax Profit per hployee (Rs '000) 1,338 1,366 100 73 66 70Personne Costs per Employee (Re '000) 189 220 113 97 109 so

4/ DFCC data is for year ended 3131/92.

ji Sampath Bank's capital adequacy ratio for June 1992 was 10.72.

JI Seylan Bank's capital adequacy ratio for June 1992, after consolidatingBCCI assets and liabilities was 19.92.

ZI Hatton's cash collection ratios for June 1992 were, for principal only57.42 and for principal and interest 75.9Z.

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D. nviroomental Considerations

5.25 Environmental FactorA and Comoliance Reagirements. As noted inAnnex 9, Sri Lanks has enjoyed a long history of attention to theenvironmental lmpact of industrial development. IDA hao had satisfactoryexperience with the GQSL and the CEA In carrying out previous Industrialprojectes, including, most recently, SMI-IV. The project has an overallenvironmental rating of Bi, although the environmental Impact may vary fromsubproject to subproject. To minimize the risk of adverse enviromentaleffects, all subprojects will be required to conform with the generalenvironmental guidelines issued by the GOSL in October 1992 and monitored bythe CRA. PCIs will coordinate closely with the Administrative Unit and CIAthroughout project implementation. Under the proposed Project, the CIA,assisted by the Administrative Unit, will be responsible for: (a) maintainingthe environmental review process established under SKI-IV, which include.assistance to PCIs to identify industries which require EPLe, specifying Termsof References for ZIA of individual industries; (b) developing the technicalcapacity to help industries incorporate waste treatment and waste minimizingmeasures in their process design; (c) identifying financial requirements forindustrial waste abatement; and (d) supporting the development andimplementation of CEA guidelines and standards for selected industrialsubsectorse To mini-ize delays in the project approval process, the PCIs willbe delegated "environmental clearance" authority of projects that are deemedto have no adverse environmental impact, or for projects with a limitedenvironmental impact after the sponsor ha. agreed to appropriate adjustmentsof the production process to meet emission standards or introduce appropriateprevention/mitigation options. All projects vith potentially adverse andsignificant environmental impacts will require the CEA's positive clearancewhich will be given within two months of submission to the CIA. In caseswhich require CEA clearance, sponsors could access the PCAP to engagespecialized technical assistance to reformulate the project proposal toinclude those measures necessary to meet the CEA's environmental guidelines.

5.26 Administration of the Pollution Control and Abatement Fund. ThePollution Control and Abatement Fund (PCAF), totaling US$5.0 millionequivalent, will be financed by the Government of The Netherlands (GON) toassist individual enterprises in making the r operations less harmful to theenvironment while preserving economic efficiency (Annex 9 gives a descriptionof the PCAP's operations). The Administrative Unit in NDB will administer thePCAF and make subloans and technical assistance available to qualified PCIs.A total of US$3.75 million equivalent will be available for subloans underthis facility and US$1.25 million will be available for technical assistance.In addition, any interest income earned by the PCAF can also be used to fundtechnical assistance activities.

B. Technical Assistance Comonent

5.27 The TA component, totaling US$2.5 million, will finance thefollowing activities:

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a. Institutional and Policy Develoument (USS2.0 Million)

5.28 Domestic Resource Mobilization for TeOr Lendina. The GOSL intendsto lengthen the maturity structure of its debt listruments. To complete thisprocess successfully, four tasks are necessarys (i) strengthening the systemof issuing the appropriate long term debt instruments, including thedevelopment of a trading and settlement infrastructure; (ii).development andimplementation of a regulatory framework, covering both primary and secondarymarkets; (iii) developing portfolio management capabilities of the contractualsavings institutions and permitting these institutions to invest their fundsin accordance with their own investment goals; and (iv) training for the staffof HOF, CBSL, primary and secondary dealers, as vell as general public. Someof the assistance needed is already provided under SMI-IV. In addition, USAIDwill provide TA in its parallel operation for this purpose.

5.29 Piasncial Sector Reform and Restructuring of State-Owned CommercialBanks. The restructuring of the SCB is important to the efficient operationof the banking sector in Sri Lanka. While the government has been slow toembrace privatization as a strategy for restructuring these institutions, anumber of tasks are being supported through this project that can helprestructure and comercialize these banks. Technical assistance funds fromthis Project are proposed to assist. ins (i) strengthening credit management;(ii) rationalization of the branch network; (iii) improving staff utllization(iv) conducting an international comparison of salaries in the banking sectorand (v) provide training for the staff of the banks. This portion of the TAis expected to be utilized within two years of Project effectivweness. Inaddition, the CBSL needs help in strengthening its bank supervision function.The GOSL and PCIs may also need ssistance in implementing the provisions ofthe revised debt recovery legislation.

5.30 Accountin and Auditing. The ICASL recently proposed measures toImprove the enforcement of accounting and au#iting standards to the GOSL.These measures have been reviewed by IDA and found to be satisfactory. TAwill be required to assist with the implementation of these measures, as wellas for investigating practical steps for introducing malpractice insurance forall practicing chartered accountants. USAID will provide TA in its paralleloperation for setting up an Accounting Standards Board end training for theprofessionals. Funds from IDA will be used for the institutionalstrengthening of the ICASL, assistane with introducing malpractice insurancefor the practicing accountants and providing technical expertise to AccountingStandards Board.

b. Financial Intermediation (USSO.5 million)

5.31 Assistance to the PCI.. Under the ongoing SI projects, funds wereprovided to PCIs to assist them in building their project finance capabilitiesthrough staff training and systems development. This assistance will becontinued. Assistance is particularly required in the area of HIS developmentand risk management and pricing. Since this project will introduce the use ofvariable rates, training will include the development of mechanisms forisolating, managing and pricing of Interest rate risk. This assistance willis expected only for the first two years of Project implementation.

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F. Ptocur oet

5.32 Procurement of goods, works and serviee dill be carried out Inaccordance with Bank guidelines. Procurement practices followed under thepast and ongoing intermediary operations (three IDPo and four SKIs) have beensatisfactory, and vill be continued in this project. The PCI. will berequired to maintsin details of the procurement methods used by sub-borrower.and to monitor the utilization of subloan funds for procurement throughregular site supervision visit.; NDB staff and IDA field supervision miselonsvill continue to review implementation of those procedures. All procurementsexceeding US$1 million will be subject to international competitive biddingprocedures. The selection of consultants will follow the Guidelines for theUse of Consultants by World Bank Borrowers. Contracts for goods under the TAcomponent are not expected to exceed US$200,000, and will consist of suchsmall Items as computers, overhead projectors, precision laboratory equipment,and packaging technology. Therefore, they will be procured following localcompetitive bidding procedures which are acceptable to IDA. Procurement ofcivil vorks for the debt recovery courts under the TA component Is limited toUS$200,000 and vill also be carried out under local coetitive biddingprocedures satisfactory to IDA. Contracts for goods costing less thanUS$50,000 and not exceeding US$1 million in aggregate, may be procured throughlocal shopping.

5 33 The provisions of the Consultant Guidelines requiring prior Bankreview or approval of budgets, short lists, selection procedures, letters ofInvitation, proposal., evaluation reports and contracts shall not apply tocontracts estimated to cost les than US$100,000 equivalent eah. However,this exception to prior Bank review shall not apply to the terms of referencefor such contracts nor to the employment of individuals, to single sourceselection of firms, to assignments of a critical nature as reasonablydetermined by the Bank and to amendments of contracts raising the contractvalue to US$100,000 equivalent or above.

G. Disbursemeg

5 34 As under the ongoing SMI projects, the closiug date for submittingfinancing applications under the Project will be three years, with a projectedfive-year disbursement period after Credit effectiveness. IDA will reimbursethe PCIs for 60 percent of eligible subloan expenditures. To facilitatereimbursement of expenditures by the PCIs, the Administrative Unit willreimburse the PCI on the basis of proform documentation with fulldocumentation to be submitted to the Unit sad IDA on final disbursement. Ifthe documentation is not provided by the PCI, or is deemed to be inaccurate,the amount of unsubstantiated claims will be deducted from generalreimbursement claims The Unit will retain PCI documentation for inspectionduring IA's eupervision missions. In turn, IDA will disburse oan the bsis ofcertified statements of expenditure submitted by the Administrative Unit forexpenditures incurred up to 120 days prior to the reimbursement application.All statements of expenditure, together with supporting documentation, will beaudited annually by the Auditor General of Sri Lanka or another lndependentauditor satisfactory to IDA. 1

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5.35 Prior authorization by IDA for a11 goods and services under thetechnical assistance components w.ll be required and IDA will disburses

(a) 100 percent of expenditures for foreign and local consultants andtralning;

(b) 100 percent of foreign expenditures for equipment imported directlyand 100 percent of the ex-factory cost of locally manufacturedequipment; and

(c) 80 percent of expenditures for other equipment procured locally.

Requests for IziA disbursement against contracts exceeding US$5,000 will befully documented, while disbursement. for contracts below that amount will bemade on a SOB. Withdrawal applications will be channeled through theAdministrative Unit. To facilitate disbursement of TA charges and paymentapplications of less than US$250,000, GOSLIIDA will establish a SpecialAccount in US Dollars with an initial deposit of about US$2 million.

S. Pro1ect MonLtorim. Reuortina and Auditi -

5.36 The proposed Project will Include periodic monitoring of performanceagainst project objectives. Thio monitoring will be accomplished through: thesubmission of quarterly reports by the Administrative Unit; the semiannualreview of the interest rate structure; and a detailed review of all aspects ofthe Project'. implementation, and particularly compliance with policyconditions. Supervision Plan for the Credit is included as Annex 14. A Mid-Term Review of the Project will be carried out within two years of Crediteffectiveness or after 50 percent of the Credit proceeds have been comitted,whichever occurs first. The Mid-Term Review will focus on the progress inachieving Project objectives, suitability of an appropria- Treasury bill rateas a basis for on-lending the proceeds of the credit component to the PCIs,efficiency of the administrative arrangements and effective use of technicalassistance funds. The Administrative Unit will submit quarterly reports tothe MHO and IDA on lending activities as well as progress under the TAcomponents in a format acceptable to IDA. The reports will be based onaggregation of the PCI.' quarterly reports which will cover project lending,staffing, training, collection and arrears performance and portfolio data aswell as icluding estimates of the impact of lending activities on employment,productivity and exports. TA reports will summarize progress inimplementation on aspecto outlined In agreed action programs, and steps to betaken during the next quarter. In addition, the Administrative Unit willsubmit a quarterly report on its own staffing and evaluation ofcharacteristics of the funded projects. Reports will have a form and contentsatisfactory to IDA and will be submitted within 45 days of the end of eachquartere

5.37 Ac a condition of participation under the proposed Project, PCIswill be required to meet and the msaintain their operating performance withinthe criteria specified for eligibility of PCIs. PCIs must also submit auditedfinancial statemsnts to IDA within four months of the end of the fiscal year,and continue to comply with CBSL guidelines (experience of compliance with

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audit requirements in past IDA operations has been satisfactory). The GOSLwill take steps to ensure that the Auditor General or a designated privateauditing firm, will submit a report on the Project Accounts in a formsatisfactory to IDA, not later than four months after the close of each fiscalyear. The audit and opinion on the use of the Project Account will also coverdisbursements against Statements of Expenditure and the use of SpecialAccounts. Project accounts of each implementing agency will be audited aspart of the audit of that agency, but no separate audit opinion need to besent to IDA in respect of each agency that has beeu supported through the useof technical assistance funds from this Project. If the Auditor Generaldesignates a private auditing firm to carry out the audit of the ProjectAccount, the firm will need to be satisfactory to IDA. Within six months ofProject completion, the COSL and the Administrative Unit shall prepare a draftProject Completion Report conforming to IDA guidelines.

VI. PROJECT BENITS hED RISKS

6.01 Benefits. The proposed project will further support the GOSL'sefforts to carry out financial sector reforms. In particular, this projectwill lay the groundwork for the development of new financial instruments,including medium and long-term bonds and will encourage the existing financialinstitutions to diversify their funding nources. It will also provideassistance for restructuring the SCBs and thus support the government'sefforts to improve financial sector efficiency. The provision of termfinance to the private sector will en-.le the enterprises to take advantage ofthe changing economic environment and retool their operations, improveefficiency and expand their markets.

6.02 The TA component will provide much needed expertise to the GOSL,CBSL and affiliated agencies in revising the debt market operations, improvingenforcement of auditing and disclosure standards and implementation ofenvironmental guidelines. Assistance to the PCIs will help ensure that fundsare used effectively and that the PCIs develop appropriate systems forappraising projects in a more competitive environment. The Pollution Controland Abatement Fund will encourage firms to undertake the in esttments necessaryto Improve the environmental standards of their operations.

6.03 Risks. The main risks to the Project's success are associated withthe overall climate for investment in Sri Lanka. If the ethnic disturbancesescalate significantly, commitments and disbursements could stall and thegovernment may be slow to adopt the envisaged policy reforms. Repayment ratesof the subloans will also be adversely affected by any deterioration in thebusiness climate. On the other hand, recent financial intermediation projectsin Sri Lanka have proceeded satisfactorily and the PCIs continue to forecaststrong demand for investment finance. The ability of PCIe to mobilizedomestic resources will depend on the pace of the adjustment program, adecrease in the public sector's borrowing requirements and an end to thegovernment's preferential borrowing rates.

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VII. ACGREHEUTS REACHED AND RECOMEN.DAT2IN

7.01 During negotiations, agreement was reached with the GOSL ons

(a) on-lending terms and conditions, subproject eligibility criteria andfunding arrangements for the credit component (para. 5.01 to S.07)J

(b) a draft letter of financial sector policy (para. 4.03 and Annex 2),laying out its goals for improving the efficiency and effectivenessof the financial sector, including specific monitorable actionsrelated tot

Mi) strengthening the maturities of government securities andencouraging the development of primary and secondary marketsin public and private bonds;

(ii) maintaining an appropriate interest rate structure, keepinginflation in check and reducing the government's financingrequirements;

(iii) maiutaining an appropriate regulatory framework for thebanking system, improving banking supervision andstrengthening the enforcement of accounting, auditing anddisclosure standards;

(iv) further reduction of GOSL's ownership in NDB to less than 20percent (initial divestiture of 61 percent of IDB sharesdone in March 1993);

(v) revising the investment guidelines of the contractualsavings institutions;

(vi) its commitment to the introduction of variable rate lending;

(vii) measures to further strengthen debt recovery legislation;

(viii) procedures for rational asset management of the contractualsavings institutions (FPP, 8TP, NSB and ICSL); and

(ix) interim measures designed to lend a greater commercial focusto the operations of the SCBs.

(c) the use of the average weighted deposit rate (AWDR) of interest-bearing term deposits of the Greater Colombo branches of thedomestic commercial banks as the initial on-lending reference ratefor the credit component and the adoption of a market-basedbenchmark, such as the Treasury bill rate, after the market isdeveloped (pars. 5.02);

(d) conditions of PCI participation, including compliance with riskasset classification and provisioning requirements for non-performing loans, collection ratios, profitability, capital

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adequacy, management capacity and audit and accounting requirements(par&. 5.11 to 5.14);

(e) procedures for procurement, disbureement, subproject review,periodic reporting and accounting and auditing for credit andtechnical assistance components (para. 5.32 to 5.37)t

(f) torms of reference for the activities being supported through theProject and funded through the technical assistance component (inconsultation with other cofinanclors), including:

(i) strengthening the system of issuing the appropriate longterm debt instruments, including the development of atrading and settlement infrastructure (para. 3.09 and 3.10);

(ii) development and implementation of a regulatory framework,covering both primary and secondary markets (para. 3.10);

(1ii) building portfolio management capacity in the contractualsavings institutions (par&. 3.19);

(iv) training programs for the various agencies and Institutionsinvolved in the development of the bond market; for PCIs inthe pricing and management of variable rate loans and thedevelopment of HIS; and for the CBSL in strengthening itsbanking supervision function (para. 5.28, 5.31 and 3.36)g

(v) strengthening credit management, rationalixing the branchnetwork, improving staff utilization and conducting aninternational comparison of salaries in the banking sectorin conjunction with the messures taken to restructure theSCBs (pars. 3'.29 and 5.29);

(vi) implementing the provisions of the revised debt recoverylegislation (para. 3.31);

(vii) creation of an Accounting Standards Board, extending therequirement to comply with accounting standards and appointqualified Chartered Accountants as auditors for larger non-listed companies and studying the feasibility of introducingof malpractice insurace for practicing accountants(para. 3.34); and

(g) the responsibilities and obligations of the Administrative Unit,including compensation for Its operations under this Project, itsreporting requirements vis-a-vis IDA and the GCOSL and themecebnism for shifting the Administrative Unit from the MDB, ifneeded (para. 5.08 to 5.10, 5.36 and 5.37);

(h) the form and content of the participation agreements between theGOSL and the PCIs and the agreement between MDB and the Governmentregarding its role as Administrative Unit (para. 5.09 and 5.12).

41 -

7.02 The followlog conditions should be mt prior to crediteffectivenessJ

(a) esgniag of an adminletratilo agresemet, satisfeatory to IDA, betweenGOSL and 1DB (par&. 5.08 and 5.09)t and

(b) si$ning of participation agreements and demonotration of compliancevith conditions of participation, satisfactory to IDA, between GMSLand at loet two *ligible PCIs (pars. 5.11 and 5.12).

7.03 With the above agreements, the proposed Project constitutes asuitable bs"io for a Development Credit of ODM 43.2 million (US$60 mllionequivalent) On standard IDA ters vith a maturity of 40 years to theDemocratic Socialist Republic of Sri Lanka.

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U 1

PRIVATE FINANCE DEVELOPMNRT PROJECT (PFDP)

DISBURSENENT SCNEDUIZ

FISCAL YEAR PROFILE

US$ MILLION US$ MILLION PERCENT

SEMI-ANAL CMULATIVE ,

FY94 December 31 2.4 2.4 4

.___ _ June 30 4.2 6.6 11

FY95 December 31 6.6 13.2 22

______ ______ June 30 7.2 20.4 34

FY96 December 31 10.2 30.6 51

.________ June 30 10.8 41.4 69

FY97 December 31 . 6.6 48.0 80

.__ _ June 30 6.6 54.6 91

FY98 December 31 3.0 57.6 96

June 30 2.4 60.0 100

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ARME 2Pge 1 of 6

March 5, 1993

PRATE NC DELOPT PROJECT (PFDP)

TME Ml SRI LAUWAS S-TATEMENT 0I FIANCIAL SECTOR POLICY

Mr. D. Joseph Wood, Vice PresidentSouth Asia RegionThe World Bank1818 H Street, N.W.Washington, D.C. 20433

Dear Mr. Woods

RES Statement of Financial Sectogr pli

As you are aware, the Government of Sri Lanka (GOSL) is workingclosely with the International Development Association (IDA) to develop andImplement a comprehensive program of financial sector reforms We have hadconsiderable success in addressing issues such as rationalization of monetarypolicy, liberalization of Interest rates, Introduction of prudentialregulations for banks, reduction of directed credit, reduction of publicsector ownership and removal of public sector control over development financeInstitutions (DPIs), strengthening of debt recovery legislation and adoptionof international accounting and auditing standards Since 1989 theGovernment's reform efforts addressed issues in four areas: economicstabilization, public sector rationalization, poverty alleviation, and privatesector development. In its efforts to continue a sustainable growth policybased on export, the GOSL intends to continue to puroues (i) tightmacroeconomic management especially fiscal management through better controlof recurrent expenditure; (ii) rationalization of the public sector and thepoverty alleviation program; and (iII) the provision of an environment whichwould further develop the private sector. The GOSL would also continue itsmobilization effort based on improved tax administration and tax reforms thatbroaden the tax base and increase the efficiency of the system.

In my letter of April 11, 1991 to you, I outlined in more detail thesteps our Government intended to take tot (i) rationalize monetary policy;(1i) refine reserve requirements; (III) strengthen bank supervision andregulation; (iv) restructure and strengthen the two state commercial banks(People's Bank and Bank of Ceylon); (v) rationalize and improve the operationsof the National Savings Bank (NSB); (vi) reduce the GOSL's shares in theNational Development Bank (NDB) and also reduce the shares of the StateCommercial Banks in the Development Finane Corporation of Ceylon (DFCC);

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(vii) rationalize the legialative, regulatory and intitutional tructure ofthe state Insurance corportiLons; (vii1) strengthen the accounting regulatoryframework and capital market; and (ix) monitor the impact of debt recovorylegislation enacted In 1990. I am glad to report to you that to date ve haveachieved meny of tho reform indicated in that letter. for expleo, we havIssued guideline to the banking oector to bring their operational policiesand procedures In lten with international standards, particularly thoserelating to capital adequcy ratios, in tome. of the guideline as recomamededby the Bank of International Settlemeto (Basic Accord). These guidelineswill be enforced within six month of the recapitalization of the StateCommercil1 Banks. We bave further trenthn d the bank supervision andregulation, and altbough som actions awalt implementation, tbse would beco1upleted soon, as indicated below. Both DPIM, DB and DFCC have beensuccessfully privatised. A set of reforms e4md at stre gthening the debtrecovery system hs beea iplemeted. Further reforms in this area areunderway. The required legislation has been recently pased and specilcourts to deal exclusively with the debts of the financial itaittutions are inthe process of being establibhed. Finally, Sri Lanka now bas a functioningCredit Information Bureau (CIBSL) which would belp the financial sector intheir appraisal of their prospective clients.

Although we take prid in what we have already achieved, we realisethat a lot sore remains to be done. In our efforts to provide a frameworkwithin which private sector Investment can be promoted, we realise that thefinancial sector is still not equal to the task and needs considerable furtherimprovement We are aware that an efficient and functioning financial sectoris a prerequisite for a private sector-led growth. In this regard, we arefocusing our efforts oan improving the efficenicy of the financial system as awhole by introducing a more competitive enviroament, whch vould assslt us inthe mobilisation of savings, reduction of financial intermediation costs,efficiAet allocation of credit and enable us to mak credit available atacceptable rates of Interest.

Whil the steps alredy taken are significant in establishing afinancial system more conducive to industrial development, we realize that thot"ak ahead will require considerable effort in order to steer the presentfinancial system in the right directlon. We, tbhrefore, propose to continueour present financial reform efforts and implement the rest of the financialsector progra as described. In addition, in the context of the proposedPrivate Finane Development Project, we propose to take action which wouldfurther: (i) improvo the efficiency and depth of the financial sectorg (11)enable the private sector to expeditiously respond to the changing economicenvironment; (III) assit in domestlc resource maobilization for long-terminvestmeots; and (iv) help strengthen institutions regulatitg the financialsector. To assist us In this tsk, we have etablished the Financial SectorReform Committee to oversoe the restructuring and commercialization of theSCB. and the 18B. In addition, the Committee will examin and advise onfurther steps to be taken to strengthen and deepen the market for medium- and

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AM=EX 2Page 3 of 6

long-term capital, to reform the insurance industry and to Improve enforcementof accounting and auditing standards, and related financial sector lssues.

RestructurinM of the State Commercial Banks *CDs) We are In therestructurlng phase of the 8QBs. With IDA's assistance, the 1991 accountswere audited by international auditors based on CBSL's prudential regulationsand international accounting standards. The auditors also analyzed the 8CBs'accounting systems and controls and prepared plans for financial restructuringof the banks. We Intend to lmplement a series of reforms to enforcecommercial discipline and improve the profitability of the two state banks.Amendment. to the legislation under which the 8CBs function are being made.These amendments would enable the 8CBs to function as autonomous commercialorganizations and would level the playing field between the SCB. and privatecommercial banks operating in Sri Lanka. The Board of Directors for each ofthe SCBs will be strengthened by appointin4 a number of new members who willbe persons with relevant professional qualifications and/or extensive businessexperience. We Intend to appoint three now members to the Board of Bank ofCeylon (total strength of the Board is seven members) and three new members onthe Board of Peopl9's Bank (total strength of the Board is ten members). Weare also in the process of establishing a mechanism for dealing vith thelarger bad loans of the SCBs. Steps are being taken to control theadministrative costs of the SCBs and to Improve credit discipline in theirlending. We espect that the SCBs will be able to reduce their intermediationcosts and achieve profitobility levels comparable to those of the privatebanks operating in t8w Lanka within two years of their recapitalization. Theprofit targets set for the SCBs exclude interest income from therecapitalization bonds, and the corresponding amount of bonds, utilized toupgrade the capital base of the SCBs from zero to the Internationallyacceptable standard#,.of capital adequacy (8 percent). We believe that thesuccessfil restructuring of the SCBs will ensure that these banks develop acommercial focus and convert themselves into independent commercially viableand profitable institutions. Additionally, we wish to re-confirm ourcommitment to continue with our policy of refraining from any interference inthe commercial operations of private sector banks.

The Role of Develomnent Finance Institutions (DPls). In order tostrengthen the resource base of DIIs and reduce the public sector role in thefinancial sector, the GOSL allowed the DPIs to sell their shares to foreigntechnical partners, enter Into joint ventures with private domestic banks,borrow in the domestic markets, and issue long-term debentures. It alsoreduced the 8CBs' shares in DPCC to the level stipulated in the Banking Act.Wo experienced some delay in the privatization of NDB, caused by issuesrelating to share valuation and the proportion of shares to be placed throughthe Stock Exchange. The initial sale of 61 perc0nt of the ordinary shares of3DB has now been completed, and the number of public sector directors OAn DB'.Board has been reduced to three out of ten members. The new Chairman will beselected by the Board as provided for In the amended 3DB act. The Governmentintends to further reduce its direct and indirect share holding in the NDB to

- 46 -

ANRME 2Page 4 of 6

lesa than 201 in accordance with the terms of the offer of sale of UDB shares.At that time, the number of board members appointed by the government orgovernment-controlled institutions vill be reduced to two out of ten.

Increase the Maturity Structure of Government Market Borrowinas.Over the last two years most of the GOSL's borrowings made through theTreasury bills at market rates were in the form of short-term instruments(with maturities of nen year or less). The limited maturity structure of themarket instruments used by the government along with same regulatoryconstraints hampered the development of an active secondary market in Treasurybills, and this in turn hindered the development of a market for debtsecurities from the private sector. The GOSL has now begun a program tolengthen the maturity structure of public debt instruments and to remove theregulatory constraints which had impeded the development of a secondary marketin Treasury instruments. Legislative provisions have already been made topermit issue of Treasury bills with maturities longer than one year, and RupeeSecurities Ordinance is being amended to allow issuance of Rupee Securities(Treasury debt instruments with interest coupon) at market determined rates.A number of primary dealers were appointed to deal with the purchase anddistribution of Treasury bills in July 1992. The CBSL is in the process ofimplementing a series of regulatory changes to promote the development of asecondary market in public debt instruments* We expect that these reformswill not only decrease the economic costs of public sector borrowings but willalso directly help in the development of a private sector bond markets byestablishing a yield curve for use by the private sector as benchmark to priceits debt, and help to develop a secondary market infrastructure for thepromotion of a liquid market for debt instruments We expect to achieve, inthe medium-term, more stable macroeconomic conditions and to effect areduction In inflation rates, as already envisaged in the Policy FrameworkPaper. These reforms will, we believe, create the necessary conditions forthe development of deep end efficient financial and capital markets.

The current system of withholding tax on treasury securities isdesigned for efficient collection of taxes without due regard to its effect onthe development of a secondary market in these socurities and the consequenceson overall borrowing costs. The GOSL intends to review the present system ofcollecting withholding taxes on financial instruments with a view to makingthe necessary amendments to remove its adverse effects on development ofsecondary trading In _inancial instrumonts.

The Emulovee Provident and EmDloyees Trust Fund (EPP and ETF) andNational Savinsts Bank tNSB). EPP and ET7 are two major funds that represent ahuge and rapidly growing pool of long-term resources which could contribute tothe financing of productive investments in our economic development. In thepast, savings in these institutions have primarily been invested in short- tomedium-term public debt instruments issued at managed rates, creating highfinancial costs to the private sector by denying it access to term savings in

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the country. The 6OSL will review the role that EPF and ETP will play In theliberalized finanial environment and will modernize, and institutionallystrengthen the EPP and ITF, consistent with their redefined roles. At thesame time, we are lmplementing a program to gradually increase the amount ofcontractual term savings from these institutions to be made available for theuse of private sector investments. As part of this program, EPF and ETP willinvest at least 5 percent of their inflow in non-government securities in1993, rising to 10 percent by June 1995. NSB has already started the processof diversifying its investments end we expect that by the end of 1993 at least10 percent of its investments will be in non-government securities.Thereafter, the proportions are to be Increased in light of experience gainedby GOSL and IDA from the initial phase. The GOSL intends to allow completeinvestment autonomy for these institutions so that the proportion of fundsinvested by these institutions in government securities are not any higherthan what is consistent with the institutions' independent investment goals tofulfil their designated objectives.

nsurance ComDanies. Like the pension funds, public sectorinsurance companies mobilize large pools of long-term resources of whichinsignificant amounts are providing term finance for productive investment.The GOSL would address the underlying problems by: (i) introducing a newInsurance Act which vould improve and strengthen the regulatory frameworkunder which the insurance industry functions; (ii) allowing insurancecompanies to pursue more sophisticated portfolio management techniques; and(iiI) reducing market segmentation and Increasing competition. Recently, theGOSL removed the special privileges of the state-owned insurance corporationsby converting them into companies operating under the Companies Act andproposes to coumence privatizing the two state insurance companies by December1993.

Bank Sunervision and Retulation. The Government, through the CBSL,strengthened the banking supervision and regulation by: (i) enforcing theminimum capital adequacy ratio of 8 percent of risk adjusted assetss (ii)designing, issuing and implementing a more rigorous loan classification systemand provision requirements; and (iII) focusing inspection on the accuracy andclassification information provided by the banks. However, we need to furtherstrengthen the laws and regulations as well as CBSL supervision capacity andmaximize the use of our resources. CBSL wLll review the currentorganizational structure of its three supervision departments with a view torationalize and coordinate the current structure and upgrade the technicalcapability of its staff.

Accountina Regulations and Financial Disclosures. As a result ofchanges in their regulatory framework implemented at the beginning of 1992,banks are required by CBSL to comply with a prescribed format which usesinternational accounting standards for reporting and disclosure. TheInstitute of Chartered Accountants of Sri Lanka (ICASL) has adopted all of theinternational accounting and auditing standards issued to date. The GOSLintends to give these standards legal force, and extend the coverage of thesestandards, which currently only apply to listed companies, to larger unlisted

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AMf 2Pag. 6 of 6

companies and to improve Its enforcement of these standards by setting up anAccounting Standards Board. The board will be set up as a statutory body andstaffed with technical expert.. It will be responsible for Investigatingcases of non-compliance with accounting standards and to recommend appropriateaction by various bodies that have specific jurisdiction over ladividualcases, e.g., SIC, ICASL, DM, etc. We are also in the process ofinvestigating the feasibility of Introducing compulsory malpractice insurancefor auditors to encourage market pressures for compliance with auditingstandards and to provide assets in case of losses suffered due to negligenceon the part of the auditors.

Debt Recovery Measures. In 1990, the 0OSL changed the legalframework of debt recovery In order to remove the weaknesses Identified atthat time. In the same year, the Credit Information Bureau was created toassist In improvement of credit decisions by the financial lntermediarie.Since then the government has strengthened the operational capacity of theBureau and has enacted wide ranging legislative changes to improve debtrecovery laws. We are also in the process of establishing special.courtsexclusively for debt recovery to reduce the backlog of such cases,,nd toexpedite settlement of future claims.

Introductlion of Variable Interest Rates. In support of theobjectives of the project, we would initiate action to on-lend the proceeds ofthis loan at variable rates only. In order to facilitate the on-lending byPCIs at variable rates, we have instructed the CBSL to publish, on aweeklybasis, the Average Weighted Deposit Rate (AIDR) that could be used by the PCIsas a reference rate. Since lenading and on-lending on a variable rate are notcoummon in the Sri Lankan banking system, banks will need technical assistanceto enable them to monitor and control their interest rates risks and todevelop appropriate instruments for hedging themselves against the risk thatthey do not wish to assume. The GOSL intends to provide this assistance tothe PCIs from the proceeds of this Credit.

We believe that the measures outlined above will help develop astrong financial sector responsive to the needs of our industrial development.The measures taken by the GOSL over the past two years have already had apositive Impact on the financial and industrial sector and the response can benoted in the increased financing needs of the sector. In this regard the GOSLrequests the rapid processing of the proposed project of US$60 million.

Democratic Socialist Republic of Sri Lanka

Yours sincerely,

Is/R. Paskaralingan

Secretary to the Treasury

49 -

ARM 3

. 1

M&VAIX 1JUN03C DRv3LOmU P1ORCT (MP?)

ITZREST RATE 8TRUMM DECENIM 1986-DECEH 1992

(in percait per ===)

D e~zb 31 1964 1967 1968 1969 1990 1991 1992

Cmam BDak Rat it 10 10 14 n. 17 17

*. Priuu 11 t0A1 18.18.9 152-173 15S-17.6 118-149 14317.1. s qmwoy mado. it 113 23 205 2Q5 16.75 18

coammuw Banbtam PiemAvaqe Palm lA q14.8 14.2 169 18 19.2 19A6 20.2Stewed Lom & Ovsidia 1236 9.8.26 9.8-26 9.82 10-25 9.30 2-30

SahVipDepxsI 6-12 6.11 5.11 5-14 5-14 4.75.14 3.25-14Time Deposts- 6 mantI 73-13 7-13 8-115 8-16 8-20 12-18 11-185- 12 maNts 8.5-14 8.5-14 9-15.5 11-20.5 11-21 10 13.5-20

NaMo.i Seiwho Dak Deposit Raft -Sswho Depodis 112 112 112 14 16.2 14 14

11 ~-6 - ___

-1-mosath Phed DepIbt 12-13 M1 I 1-1- 115-17 17-18.5 17-18.5

Idda Rate of QruilstIauMdam S* eM wfe Ia Oa2 8-20 8-20 W169 16-19 19-20.5 20.5

AD etC e 14-18 14-19 14-19 14-19 14-19 14-19 14219-ND- 7-14 7-14 82-15 103-17.5 7-8 7-8 113-18.5

of Iii. uw -p by mhe Cemud Dak cm atvnm~ to cosamemb ban tar tb*i tanpoany liquiity purposaL

I-0 Rcenn aet Coltlm

Samou:c Ceut Bank of Sa tAnka - Mmy 1990; 1bS 10, 11,12 of CGtal &* MAydkh b JUp 1992).

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AMNI 4Page I of 2

MVATE NI BE LOTIT PEgg= IMP)

ELIGINIUTY CRITERnA 10 PCI.

In order to become eligible to participate in this credit and to maintaintheir eligibilUty, credit institutions must be privately owned and controlled,and meet the following criteriat

1. IDA should receive a satisfactory statement from the Board of Directorsof the institution outlining:

(a) listitution's business strategy and operating policies;

(b) details of their existing term lending progras and portfoliomanagement schemea, If any;

(c) proposal a to how they would plan to utilize the facilityincluding anticipated sectorwise exposure, how would they getInternally organised to market the scheme, evaluate the proposalsand manage subsequent follow up monitoring and recoveries; and

(d) ame the senior officer who is made in charge of this project andkey staff of his tesm.

2. A satisfactory audit report from the external auditors acceptable to IDAconfirming that they had carried out their audit of the creditinstitution In accordance with the accounting and auditing standardsadopted by the ICASL.

3. Compliance ith Ministry of Finance/Central Bank guidelines onprudential regulations, capital adequacy, classification of risk assets,provisioning against non-performing loans, sector exposure limits, anddisclosure and reporting requirements.

4. A confirmation that the credit institution continues to maintain itseligibility as a participating credit institution under any otherdevelopment credit agreements that It may have signed such as The ThirdSmall and Medium Industries Project February 10, 1988 (SKI-III), TheFourth Small and Medium Industries Project dated July 15, 1991 (SMI-IV)and The Third Industrial Development Project dated September 19, 1988(IDP-III).

5. A confirmation from the external auditors that, at the date of itsapplication for participation and subsequently at the end of itsfinancial year, the credit institution mat the following financial

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criteria, ratio requirements and ewposure limits calculated Inaccordance with IDA standard guidelines:

(a) a minimum total cash collection ratio of principal and Interestcalculated on a rolling twelve month bae"i of 80 percent;

(b) a minimum total caesh collection ratio of principal onlycalculated on a rolling twelve month baso_ of 80 percentt

(c) a minim=m after tax profit equivalent to 92 p.a on averageshareholders funds.

(d) a minimum debt service cover ratio of 1.25 times:

(e) a maximum portfolio infection rate of 201;

(f) a maximum debt equity ratio of 8tl:

(g) minmulm capital adequacy ratios of 42 and 8S for tier-i andtier-2, reepectively as required by CBSL guidelines;

(h) loans to any one party or to any one group of compantes must notexceed 102 of PCI's total "sets.

(i) loans to any one sector, as defined In the UN StandardClassification of Economic Activities, must not exceed 301 ofPCI's total loan portfolio.

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pose 1 of 4

PRIVATE EINANCI DH OJECT EiIDP)

AMINJITRAflV3 USIT - STRUCTURI AND TURKS GE UElinENME

Obiectives

1. The purpose of the credit funds being provided through the PCI. 1. tofacilitate access to credit by private businesses, starting sound endeconomically viable projecto, without negative environmetal effects, byencouraging and assisting credit institutions to waske loans oan the basi ofproject appraisals rather than solely on collateral security and providingpartial financing for such loans on appropriate terms and conditions.

Eligible Credit Institutions

2. Private cammercial Banks and Development finance Institutions, approvrdby the CBSLIMOF, which enter Into a Participation Agreement with the GOSL willbe eligible for financing. These agreeenats ill specify: theresponsibilities of the credit institutions for project promotion, apprlaal,supervision, repayment of financing provided, and for compliance with CBSLINIoperational guidelines and PCI policies acceptable to the GOSL and IDA. Thoseagreements will provide the. contractual basis on whieh loans will be financed.The Administrative Unit will on behalf of the GOSL prepare these agrements Inconsultation with the PCI. for signing by the GOSL.

9litiblo Suburolects

3. Loans made to private enterprises engaged in productive operations adservices, but excluding the provision of financial services uch a leasing ormoney lending, would be eligible for finaucitg provided thats

(a) the project is financially sound and economically viable, withdue account taken of such factor as equity/debt ratio, with thepromoter contributing at le"at 3* percent of equity. Thesubproject makes due use of local resources including labor andraw material, and is expected to be profitablo ia a competitiveenvironment;

(b) the project will result in the creation of new productivecapacity, allow the enterprise to itcrease Its level ofproduction, or improve the quality or price competitiveness ofits products;

(c) the project will be designed, constructed, operated andmaintained In accordance with Internationally accepted safety

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AMNEX 5Pag8 2 of 4

codes and inspection standards, as well as environmentalprotection controls as defined by CEAg and

(d) the loan to be financed on term, and conditions approved by IDA.

Direction and Manatement

4. Overall reeponsibility for establishing operational and financialpolicies of the use of the Credit will be determined by the GOSL in closeconsultation with the IDA. The Administrative Unit will be responsible toimplement these policies and monitor compliance of the policies by PCIo. Theoperations of the Administrative Unit will be managed by a manager appointedby the Board of Directors of MDI In consultation with IDA. The GeneralManager of the Administrative Unit will be responsible for:

(a) processing requeets for financing for loans appraved by PCIeunder their free limit, and processing requests for financing

"for loans excseding PCIs free limit approved by IDA;

(b) processing requests for technical assistance funds afterobtaining IDA approval for its use in each instances

(c) recruiting and managing an adequate support staff;

(d) promoting improvemento in the project appraisal capabilities ofPCI., through supervision, monitoring, and training, andproviding assistance with the procurement of any goods financedunder this project, ensuring compliance with relevant IDAprocurement guidell.es as specified for this project;

(e) informing IDA from time to time regarding the progress of theproject, providing regularly reports regarding the progress ofthe project, assisting monitoring and/or evaluation missians;

(f) providing Technical Assistance to PCIs to lmprove theirknowledge and undrstsanding regardiag the environmental impactof subprojects and acquiring the knowledge to carry out and/orsupervise environmental assessment studies as appropriates and

(g) performing such other task and functions as are necessary toachieve the objectives of the project.

Terms of Finance

S. The terms and conditions under which finsacing will be provided will beestablished from time to tim by the GOSL in consultation with the IDA,according to the following principless

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ANE SPage 3 of 4

(a) the project sponsor and the credit institutions should make acontribution to financing the project which for the sponsorshould nct be lees than 30 percent equity and for the PCI notless than 40 percent of the loan amounts

(b) interest rates paid by the enterprises being financed shouldreflect competitive rates paid in the sector and would beadjusted every three or six months depending on agreementbetween PCI and the COSL, taking account of the interest ratevariability in PCIs borrowings of Project proceeds from theGOSL, based of an index acceptable to IDA;

(c) the interest rate charged to credit institutions on financedloans should at least equal to the average weighted deposit rate(AWDR), or any such index as IDA and the GOSL decide. The AWDRis the weighted average cost on all interest-bearing term funds,including savings accounts (not including NSB accounts), fixeddeposits, certificates of deposit, adjusted by foregone intereston CBSL reserve requirements. This rate will be published byCBSL on a weekly basis. The interest rate is subject to reviewby IDA and may be changed to an appropriate Treasury securityrate at the Mid-Term Review, or any other appropriate timeduring the course of the project implementation. New base forinterest rates will apply to new loans only;

(d) interest due from PCIs to the GOSL shall accrue on a day to daybasis based on a year of 360 days and shall be calculated on theloan account for each separate interest period. Interest periodshall be a period of three or six months. First interest periodshall commence from the date of first disbursement and shall endthree or six months therefrom. Interest period for alldisbursements, other than the first disbursement, shall commencefrom the date of such disbursement and end on the date thecurrent interest period ends. At the end of an interest period,all disbursements (attracting separate interest rates) shall bemerged together and shall be rolled over as one amount for thenext interest period; and

(e) loan maturities and grace periods should reflect the repaymentcapacity of the project to be financed but should not be morethan ten years with a maximum grace period of two years.

Credit Risks and Maturities

6. The credit institutions shall be responsible for repaying subloanamounts to the GOSL according to the agreed schedule, regardless ofwhether the credit institution has received repayment from theenterprise to which the subloan was made. Unless otherwise agreed bythe GOSL, the repayment schedule for the subloans financed shall extend

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ANNEX 5Pag. 4 of 4

for the smne period as the loan financed and shall include a similargrace period for the repayment of principal, provided the grace periodis appropriate in the circumstances and does not exceed two years andthe maxiium period for repayment of principal shall not exceed tenyears.

Other Resnonaiblilties of Credit Institutions

7. Participation Agreements between the GOSL and the Credit Institutionwill require the Credit Tnstitutions to:

(a) ensure that financing provided is applied fully and exclusivelyfor the purpose agreed when the loan was uade; and

(b) provide such information on the progress of the projects andenterprises financed to the Administrative Unit as the GOSL inconsultation with the IDA may reasonably request.

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AS= 6Pags 1 of 10

PRIVATE FINANCE DEVELOPaNzT INOJECT (MPTP)

EVALUATION OF TIn PCI.

1. Of all the domestic commercial banko and DPI'o, the two publicly-ownedcommercial banks (BOC and PB) did not meet the pre-appraisal criteria andwere, therefore, not Included for detailed evaluation. Evaluation of theremaining four private domestic commercial banks namely, CBOC, Hatton, Sampathand Seylan and the two DPI's, namely DPCC and ND!, is noted below.

DEVELOPMENT PIIANCE CORPORATION OF CEYLO (DMCO)

2. DPCC was created by a special act of Parliament in 1956, some 36 yearsago. For years it remained a closely held organization with Its shareslargely awned by institutions and the government. During 1991/92 DFGC's paidup capital was increased from Re 100 million to Rs 169 million partly bycapitalization of reserves (bonus issue) and partly by the Issue of new sharesat a premium. This new public issue has now in¢reases the number of itsshareholders to well over 12,000 and includes small individual shareholdersand private businesses. As a result of Its increased capital base, DFCC'stier-I ratio was 18.4Z and tier-2 was 20.6% as of March 1992.

3. During its most recent fiscal year (ending March 1992)4 DFCC showed asignificant increase in its after-tax profits which increased by 742 over theyear to an all tim high of Rs 266 million. Its earnings on its shareholders'funds amounted to 28.2Z and dividends to 32.6S. DPCC's total assets also grewby 352 from Rs 3.7 billion to Re 5 billion. Most of this increase was fundedby increased borrowings and fresh capital raised from the market. Althoughits asset base is not as big as some of the private domestic commercial banks,DPCC plays a critical role in providing finance to sectors where commercialbanks would not otherwise lend. Over the years it has traditionally beenactive in providing medium- and long-term credit and making equity investmentsin the private sector enterprises. Recently however, it his also diversifieditself in the non-funded fee based income activities. In December 1991, DPCCsuccessfully launched its first unit trust. It is also engaged inunderwriting of share Issues and in 1991192 it underwrote shares orth Re 158million. DPCC has also floated a venture capital company in which it owns 29Zof share capital. Other partners include ADS & Nippon Investment. Otherequity investments by DPCC went up significantly from Re 182 to Rs 352million.

4. DPCC has been raising funds from the local market through privateplacements of its debentures. It intends to use this vehicle moreaggressively in the coming years to provide itself vith an alternative sourceof funds. Its present borrowings, like its main competitor NDB, mainly comfrom credit lines from international development agencie.

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AN= 6Pago 2 of 10

5. A signficant change in DPCC's Income strem was an ireaingcontribution camg frce leiln activities. During 1991192 lesng Incomegrew to 81 of its total icome. In cming years DICC intends to concentratemore on this activity. DMCC conduct Its entire operations from its headoffice and through two of its branche. where it has a total staff of 199. Thebank ts efficiently run and tightly maaged. Its systems are satisfactory andIt has a trained and well qualified team. DPCC wvs the most profitableamongst all DPI'. and private domestic commercial banks In the country with a5.32 return on assets. During the previous year, DCC was also the mostprofitable bank but with a return on asets of 4.1S. 1PCC' noetintermediation margin was only 4.32 which wa sgnificaently low when comparedwith 3DB's and that of private damestic commrcial banks. It Is to DPCC'scredit that despite low margins DFCC was able to become the most profitablebank.

6. DPCC's debt to equity ratio was 3.8:1 and Its debt service cover was 2.8tines. As DFCC does not have a customer deposit base, it was able to maintainlower liquidity ratios whch for 1991/92 was only 4.72 of its assets, 872 ofwhich were in the fora of loaus. Its prinipaLl cash collection ratio was 832,principal plus interest collection ratio was 80.92, and portfolio infectionratio was 17.12. Its loan loss roserves were rather small at 2.2Z of loanbook. With a strong balance shoeet and a well directed dtrategy for incomegeneration, DFCC is well placed to grow from this position of strength. Withsome assistance, it may be possible for it to go to international markets forraising long-term funds which it can well utilize because of its strong creditand investment banking toeas.

NATIONAL DEVILOftKU DAM (3DB)

7. 3DB was established in 1979 under an act of Parliament with a subscribedcapital of Rs 600 mllnion of which Rs 450 millon were paid up in cash and thebalance Rs 150 million comprised of promissory notes payable on demand by thegovernment. Betor privatizatiou, 672 of its subscribed capital was held bythe GOSL, 172 by CBSL, 82 by SOC and 8S by PB. Privatization of 3DB wascompleted in Match 1993. The GOSL divested 612 of the shares in 3DB through apublic offering. Of the remaining 392, 151 shall be held by the government,10 by Central Bank, and 72 each by the Bank of Ceylon and People. Bank.

8. During 1992 and in preparation for the privatization, tbe GOSL & 3DBagreed to cancel the Rs lS0 million promissory motes that were used tosubscribe its share capital thereby effectively reducing 3DB'o capital base.Before this capital reduction, 3DBI' capital adequacy ratios were 24.62 and33.32 for tier-i and tier-2, respectively. After the capital reduction In1992, the ratios fell to 19.71 end 27.32 respectively. Despite the reductionsthese ratios were well above the mialfim= required.

9. 3DB's main activities include providing of wedium- and long-ternfinance, equity and debenture finance, guarantees and underviting, issuingletters of credit, mobilizing internal and external capital resources as well

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as stimulating development of capital markets directly and through the actionsof its subsidiaries. VDE's cama funding comes from refinance facilitiesprovided by the international development agencies through the GOSL. Despitethis relative ease of securing debt, 3DB has disciplined itself to remainwithin reasonable debt equity ratios. In 1991 its debt equity ratio was 2.5:1and its debt service cover was a good 2.7 times. Borrowings accounted for 66Gof its total funds. Internal cash generation in terms of retained earningswas over 172. NDB produced an after-tax return on assets of 3.62 In 1991 upfrom 2.92 the year before. Its return on paid up share capital was 41.72 andon total shareholders' funds 13.22. Due to relatively undemanding publicownership, it was able to again pay a low dividend of 4.52 and maintain a highdividend cover of 9.3 times.

10. NDB's loan portfolio was 94.82 of its assets, most of which were termloans. In 1991, IDB's collection ratios had improved as compared to previousyears. Cash collections of principal stood at 83.91 and collection ofprincipal & interest at 80.51, 11.11 of this portfolio was affected byarrears. *DB had a generous level of loan loss reserves which amounted to9.11 of its loan portfolio. NDB ti well managed and operates as an efficientorganization. Its staff is well trained and well qualified and staff numbershave been kept under control. As a result its per employee figures arehighest on all counts. For example, profit after-taxlemployee was Re 1.3million, total assets/employee were Rs 38.1 million and fixed assets/employeewere Re 739,000.

11. In 1991, profits after-tax grew by 541 to Re 250 million making it thesecond most profitable bank amongst DFI's and private domestic cominrcialbanks. During the year ended December 1992, NDB's loan portfolio grew by 49Zto Rs 6.6 billion and its investments in subsidiaries and other compaaies grewby 272 to Re 320 million. This made IDB the largest lender and investor inthe market.

COMNERCIAL BANK OF CEYLON (CEOC)

12. CBOC was established in 1969 as a public company with 401 equityparticipation by Standard Chartered Soldings UK Limited which still retains aproportional representation on the boatrd. In 1991 with return on assets of1.51, CBOC was the most profitable private domestic commercial bank in thecountry. CBOC is generally well regarded in banking circles and Is consideredto have good quality assets in its portfolio. In 1991 it had Rs 7.4 billionin its loans plus bills portfolio, which amounted to 77.31 of its totalassets. DictAted by prudence it has built loan loss reserves which now standat 3.81 of its loan book, the largest amongst private domestic commercialbanks. CBOC maintains a good mix between term lending ana short termexposures. Its term loans were 541 of its loan portfolio and short term bills181. Its position as the biggest lender amongst private domestic commercialbanks was at the cost of a high advances to deposits ratio which in 1991 stoodat 90.51 while its peers were maintaining significantly lower advances to

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deposits ratios mostly in the range of 65Z to 752. Its share capital vssdoW.oled in 1989 from Rs 50 million to Rs 100 million which tmproved itscapital adequacy ratios. Its tier-I ratio in 1991 was 6.41 and tier-2 stoodat 11.22.

13. Like some other private domestic commercial banks, CBOC also sufferedfrom the quality of its mampower resources. It urgently needs to furtherstreamline its systems and procedures and concentrate on training its staff.CBOC had the lowest fixed assets per employee indicating a lower level ofautomation and computerization as campared to other private domesticcommercial banks, even though it had a high level of assets per employee. CBOChad the highest personnel costs of private domestic commercial banks. Itscost per employee in 1991 was Rs 113,500. CBOC's net intermediation margin of6.41 vas on the lower side amongst private domestic comercial banks, butdespite lower margins it had the best before and after tax profits of allprivate domeatic commercial banks. Return on paid up capital was 1432 and onshareholders funds it was 202. It incressed its dividend by 5S to 251. Thislevel of dividend still left it with a decent dividend cover. CBOC had thehighest costing deposits amongst private domestic commercial banks. Itsinterest cost of deposits was 9.31 while other private domestic commercialbanks were raising cheaper deposits costing between 7.91 to 8.4Z. CBOC's debtto equity ratio was 1.5s1 and its debt service cover was 1.3 times. Its cashcollection ratio for principal was 821, for principal plus interest the ratiowas 80.41 and 10.71 of CBOC's portfolio was infected with arrears.

14. During the year CBOC opened two new branches bringing the total branchnetwork to 21. Its deposits grew by 331 from 5.2 billion t> 6.9 billion overthe year giving 331 growth. Advances increased by 241 to 7.3 billion andtotal assets increased by 301 to 9.6 billion. The 301 increase in CBOC'sa"set base was primarily deposit-led. CBOC also substantially increased itscontingent liabilities which went up from 6.4 to 10.3 billion, an increase of611 over the year. Although CBOC's total income was up by 201, there was noincrease In its after-tax profits which actually dropped by 61 over the year.CBOC's profitability has been consistently dropping for the last three years.Its after-tax return on assets in 1989 was 2.61 which fell to 2.11 in 1990 andthis year it further fell to 1.51. Even at this level CBOC Was the mostprofitable domestic comercial bank.

BATTON NATIONAL BAND

15. Hatton Was created in 1970 out of the amalgamation of two branches ofGrindlays Bank Ltd. In 1974 it acquired the business of Mercantile Bank andin 1989 that of Emirates Bank Intern-ational. By 1991 Hatton had become SriLanka's largest privAtt domestic commercial bank in terms of both total assetsand customor deposits. Its asset base was bigger than that of two DFI's.altton is controlled by two business (trading) houses who between them own 601of its share capital. The rmaining shares are held by the public. Hattonhas been growing its branch network in a slow but sure mnnner. For the lastthree years it has opened new branches at a rate of only 3 a year while some

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of the other new beaks have apended their branch network In a big way. Atthe end of 1991 Ratton had establised a network of 41 braches. AlthoughBatton was not the largest beak in teos of wmber of branhes, it did ranklargest in term of its staff strength. These higher staff numbers indicatelow degree of automation end need for som streamlining of Batton's managementstructure. This Is also evidenced by Batton's low fied ssets per employesand low profits per employee figures.

16. Batton has the lowest Issued share capital of all private domeoticcommercial banks. In 1991 its issued share capital was only 0.6Z of Itsassets. Rowever, because Natton Is the oldeat of the private domesticcommercial banks, it bhe accunlated large retaimed earnings end reserveswhich make its capital adequacy ratios look reasonable. Both tier-i and tier-2 ratios standting at 6.2Z and 1O.lS were above the mdnimum required by 8I8.Perhaps becauso of Its owners' background, Batton appears to have developedits expertise in providing short-term trade and export finace. It haspositioned itself such that It captures good export business from localtraders and blue chip companies. As a result of this policy, Its short-termexposures were high at 26Z of its loan portfolio making it the leader amongstthe private domestic commercial banks in that segment of the market. Its ternloan portfolio, which was at Its 3 year low, is rather small at 392 of totalloasm. Although this ratio did improve In 1992, it reflects that management'sfocu is primarily oan trade finance. The bank will have to concentrate itsefforts In building a strong credit team to take full advantage of itsparticipation In the PPDP credit line for tern financing.

17. Although Hatton's loans plus bills portfolio wso an acceptable 692 oftotal assets, it was disconcerting to see 9.52 of its loass categorized asnon-performing. It also had a low cash collection ratio for principal of 58Sand for principal plus interest of 762 (without taking into account any loanvrite-offa). Ratton's loan loss reserves were 3.1Z of its loan portfolio.Although as a ratio it is about the average for private domestic co mercialbanks, it is considered low becauso of Ratton's rather high portfolioInfection rate and its low collection ratios. Despite its low collectionratios, Rattan appears to have allowed its loan loss reserves to decline overthe last three years from a high in 1989 of 5.62 of loans to the present levelof 3.12. Ratton's liquidity ratio of 232 represents assets In the form ofcash plus due from other bsaks. It had very little exposure in the capitalmarkets. Its investment portfolio was les then 12 of assets. Rattan'sadvances to deposits ratio of 752 Is about the Industry average for privatedomestic commerecia banks. Its also bas a good deposits to assets ratio. Itsdeposits were 73Z of total assets.

18. Rattan has been cautiously developing its leasing business an In 1991 ithad the largest exposure of all private domestic commercial banks (0.72 of itstotal loans). It had a rather high debt in its balance sheet, which despiteits high level of profitability, gives it an uncomfortable lebt service coverof 1.6 times. Ratton bad a net intermdiation margin of 5.82, but had thesecond highest after-tax profit figures at 1.42. Due to its rather small

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equity base, Hattou's return on paid up capital was 2292 and on shareholdersfunds was 25S. -A high return on paid up capital resulted in a high rate ofdividend of 402. But despite high dividend rate, Ratton managed to maintaingood dividend cover of 5.7 times.

19. Rattoan is the largest mobilizer of deposits amongst private domesticcommercial banks and it mwaages to do so at the lowest cost. Batton'sInterest cost of deposits was only 7.92 while other private domesticcommercial banks costs of deposits were higher. As Batton's loan book istrade related and is of short-term nature, it gives Batton rather low interestlicome. Hatton's interest income on loans at 15.62 was lowest of privatedomestic commercial banks. Now that Batton has reasonable capital adequacyratios and acceptable profitability ratios, what it needs to concentrate on isits debt recovery programs. Simultaneously it will have to concentrate onatrengthening its credit team If It is to develop its term lending portfolio.A general Improvement in the quality of its staff and an improvement in itsoperating systems and procedures is also required.

SANPATE DM LUIITED

20. Sampath Bank was established in 1987. FY91 was its fourth year inbusiness and it brought major changes for the bank. During 1991 Sampath'sfounder, chairman and four other directors resigned from the board andproblems were reported In its loan book. A new chairman was brought in afterintervention by the Central Bank and a tine of austerity set in. The newboard decided to consolidate the bank's position. No new branches were openedduring the year and no additions in staff were made. Tough cost reduction andcontrol measures were adopted includting the cutting back of the bank's ratherambitious program of automation and ATMs. The tough new policies paid off andbank profits before tax went up from Rs 17 mi11ion to Rs 59 million giving2432 increase over the year. Despite this increase, Sampath remained theleast profitable bank amongst the four private domestic commercial banks withan after-tax return on assets of O.9S (other private domestic commercial banksreturns were in the rang of 12 to 1.52). Sampath's low return on assets isattributable mainly to high operating costs and not to low margins. Its netintermediation margin was the second highest at 8.72. Its operating costs of6.12 of assets were highest of the four private domestic commercial bankswhile other private domestic commercial banks costs were in the range of 3.12to 3.9Z. Its personnel costs at Rs 109,000 per employee were the secondhighest in absolute terms.

21. With 13 branches in 1991 and lternal restrictions on their expansion,it rem_ined the smallest of the four private domestic commercial banks.However, despite handicaps its deposit base grew over the year by 171 givingit a deposits to assets ratio of 742. The bank's loan portfolio also grew byas much as 262. Loan loss reserves were increased by a sizeable amount toreach a level of 3.3Z of the loan portfolio up from 2.22 the year before.

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22. The bank was unable to improve Its capital adequacy ratios despitedoubling of its paid up capital two years ago. Its tier-I ratio in December1991 stood at 62 and tior-2 ratio at 7.72 as against required min4imm of 42and 82, respectively. At ito present level of operations the bank needsfresh injection of capital if it is to grow. Due to its diversifiedshareholder base, with more than 12,000 shareholders on the register and noone holding more than 102, its ability to launch a successful rights issue isdependent on the buoyancy of the Sri Lankan equity markets.

23. The previous problem with Its loan book and its resolve to sort themout has resulted in the strengthening of its credit department andimprovements in its collection ratios. In 1991 collection ratio for principalstood at 932 and for principal plus interest at 892. Sampath's portfolioinfection rate of 18.82 is highest amongst all private domestic commercialbanks and DPI's and needs attention. Sampath had the highest term lendingportfolio of the four private domestic commercial banks with its term loansstanding at 632 of its total loans. Sampath's leading role in the market interm lending puts it at an advantageous position to utilize the PFDP facility.Sampath funds its asset growth largely from the increase in its deposit baseand not from borrowings. This has enabled it to keep its debt equity ratio atthe negligible levels.

24. Sampath's prioritle3 now lie with its problem loans, making adequateloan loss provisions, installing an aggressive loan recovery team, payingattention to monitoring and control systems. Only then can it get on with thejob of reclaiming its market position and market share, for both deposits andassets, Which have slipped over the last year. It may have to carefullyevaluate the policy for branch expansion because during its period ofconsolidation other banks have gone in most of the geographical areas whichhad the potential and were under-banked. Its emphasis on technology may infact be tbe most desirable course for it to follow which may eventually helpit take the market lead and launch the more profitable products and services.

SEYLAN BARR LIMITED

25. In 1991, the fifth year of its establishment, Seylan Bank had become thelargest private domestic bank in terms of branch network, with 46 branchesspread over the country and still expanding in 1992. Its deposit base morethan doubled to reach Re 3.5 billion, total assets increased by 712 and loansportfolio by 52Z. Seylan provides short-term finance largely throughoverdrafts which are renewed on an annual basis and trust receipts for importswhich are usually for one to three months. Its term lending was low at 292 ofits loan book and most of it was under donor supported finance schemes.

26. Seylan had the best collection ratios amongst private domesticcommercial banks. Its total collection ratios for principal was 93.32 and forprincipal plus Interest was 93.82. Also, it had the lowest portfolioinfection rate amongst private domestic commercial banks (0.92 of itsportfolio was effected by arrears). These ratios partly reflect the fact that

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its loan portfolio is rather fresh (the bank was created only four years agoand real incidence of bad loans has not yet filtered through) and partlybecause a substantial part of it is of short-term nature which does not entailthe usual risks of project financing.

27. Seylan's loan lose reserves are low. Its LIR amounts to only 1.11 ofIts loan portfolio which Is the lowest of the four banks. Although there isno evidence of any problems with its loan book, management agrees that anincrease in loan loss reserves is urgently needed. Although at the time ofits incorporation Seylan had the second largest paid up capital of all privatedomestic commercial banks, its overall capital base remains very small. In1992 Seylan increased its capital by a Rs 25 million (12.51 of its paid upcapital) but did not materially improve its capital adequacy ratios. In 1991its capital adequacy ratios stood at 5.5S and 6.51 for tier-I and tier-2,respectively, the lowest amongst private domestic commercial banks and belowthe minimum BI8 standards. In terms of profitability, Seylan had the highestnet intermediation margin of all private domestic commercial banks of 9.1S.This did not however make it the most profitable bank of the four. Its after-tax return on assets was 1X. Its operating costs, however, were lowest at3.11 of assets making it the most tightly run private domestic comercialbank.

28. Towards the end of 1991 Seylan entered into an agreement with theCentral Bank for the taking over of ex-BCCI operations in the country. Thefinancial results of the acquisition were not incorporated in the books until1992. The June 1992 consolidated results show a surge in Seylan$s business,assets and deposits. The terms of the agreement enabled Seylan to acquireassets at a substantial discount amounting to over Rs 1.1 billion. Faced witha high tax liability, beylan now wishes to make substantial loan lossprovisions but such treatment has not yet been agreed by the auditors, theCentral Bank or Internal Revenue Department. This acquisition at deepdiscount has in effect given Seylan an infusion of additional capital. To theextent that this discount is paid out in the form of dividends, it will affectSeylan's otherwise inadequate capital adequacy ratios which could move from5.51 and 6.51 in 1991 to 4.51 and 19.91 in June 1992 for tier-i and tier-2,respectively.

29. Seylan lntends to become market leader in providing new financialproducts and services including international banking facilities. It hasalready introduced long opening hours as well as weekend opening for selectedbranches which has forced some of the other banks to do the same. Seylan hadno involvement in the leasing market at the end of 1991 nor did it have anysizeable involvement in the term lending under donor supported financeschemes. Its involvement in the securities markets was also very small. Thebank has an aggressive and forward looking marketing and senior managementteam, but it suffers noticeably from the lack of automation, systems and goodquality support staff. Seylan has the potential to increase its market role,profile and profitability in all of its markets if it can resolve issues

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relating to its under capitalizstion and attend to the urgent need to lmproveits manpower resource., system. and procedures.

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A S 6Page 10 of 10

RE-U _ ZD21

19= a11nK; A 11 SAT R

No. Of got m" us 1,432 1.5 616 W4E fiNACIAL flownTOta AISO (ft 0144in 5IM 6$7 9VIM 9.*9 4.428 5,479Paid Up Capital (fst illio) UV 0 10 40 354 200aNer"dedrs Furm% (Re m11iUio) 93 I'm6 715 "5a 434 26Net Profit Afte Tat (Rt IlUm) am 80 to 137 40 55MD BALANC 86? RATIO

PA Mwmes ofSlto NA N.A 90.5 5 76.2 5.2AS of Totlt AOtLiqd_d Masts*4.7 4.2 10. a.0 2742 3L11-0s0t -r l 7.0 4.6 9.8 0.7 0.2 6SBlie & Loam Potfottlo W.0 94.8 77.3 69.0 63.0 48.9Oeposits l.A .A 72.4 12.7 73.9 65.5As Z of Lowe PrtfolioLow LuL Res- 2.2 9.1 3.8 3.1 3.3 1.1tOM L_s 91.5 73.0 54.1 39.3 63.4 29.0S1tis Portfolo 2.2 0.0 18.0 2.? 10.2 14.UV POUITOLStTt At1OS

Net tremdiotlon Nwain 4.3 5.4 6. 5.8 8.7 9.1Iatrsut C st Of d "site NA N.A 9.3 7.9 6.4 7.9Iaet I_a an LOOPS 12.7 13.5 164 15.6 17.5 16*.6.t. of lvldu - 199t 32 . 45 25.0 40.0 5.0 12.0Olwdu Cove 4.8 9.3 5.7 5.7 2.3 2.3As d Of Total AS"s

P-M _ lCGM" 0.8 0.6 1.7 1.8 1.5 1.2tot cps ertfwn _EP_mo 1.8 1.0 3.9 3.9 6.1 3.1Not Prft Aftr Tax 5.3 3.6 1.5 1.4 0.9 1.0Not Aft TaXt Poft as oftfaid Up CPital 156 41.7 14.4 2.2 11.6 27.8_kabeldors Ftda 3.6 13.2 20.0 24.6 9.4 19.6CAPITAL ADUUMLTRATIOS (n

Ti-I 8. 24.6 6. 6.2 6.0 S.5aTier-2 Z.6 3A 3 11.2 10.1 7.7 6.5WTAL CA$ GUCTlN RATINO () Pruuipst 0dy 3.1 .9 82.2 58.111 90.0 93.3Ptrispe a Interst 80.9 80.5 60.4 76.0 89.5 93.8

pal to ImMIO an (oportfolio Aff_sl by Arrm 17.1 11.1 10.7 9.5 1L 0.9

AtRR aSSKIMOs U?8 5.3 3.6 1.5 1.4 0.9 1.0AUn TAOt UX 3 MM uAu ROD 2R3 13.2 20.0 24 9.4 19.6lOsetiT RTAO 3.a1 2.5t1 lt6 1.2:1 0.1:1 0.6t:OmS SCIRIC RI 2. 2.7 1.3 1.6 9.9 2.4OTI IMY DATA

mi mtValw pers eO( R) 100 100 10 10 10 I0EarninP per heo (R) 179 84 14 22 1 3BookValueperl herperst ) 5.5 3.1 7.2 9.3 1.2 1.4Total MAsts pr * pen (s '0003 2192 36,18 6, 502 7,188 6.901Altr t trofit w UpLee_ (Is $0001 1t3, 10, 73 6$ 70Poscel Costs pwr l} tus 2O) la 113 97 109 so

fta for Dam relat to its flimi wr N ah 31 1992.

fi aeSes I _ s* _apiste adeu or dm13 IIS "a 8.12 SW 10.75 for tie-I udtiar-2, respatiwely.

1W m*, ,*'s italt a__iy raties far t. 1992, alaAatsd on Me bass of cemeidtu esutsifwiaW 1C tl _ ll*ll - IlNa tof ties We 4.5 ad 1. fo tieri auldteZ. ruIptIWly.

I/ latli Ust_Ua 's totwal ceesZtm ratios for d_ 1992 We, for prlipl wly 57.42 d trprinspsad I 1st a- .95L

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ANNE 7Paig 1 of 6

SRI UA

PRIVATE FIARCE DEVELOPHENT PROJECT (PMDP)

RESTRUCTURING OF STATE-OWNED COMMERCIAL BANKS

1. Introductiou. A recently completed external audit of thefinancial condition of the People's Bank (PB) and Bank of Ceylon (BOC)revealed that both institutions have incurred large operating losses and, asof December 31, 1990, were technically bankrupt. These banks control about 60percent of Sri Lanka's banking sector loan and advance. Because of highoperation costs, combined vith their large market share, they have alsoencouraged the remaining institutions to engage in high interest marginlending, thus raising the interest costs for all Sri Lankan businesses.Moreover, PB and BOC advanced large sums of money to a number of state-ownedbusinesses which have defaulted on their loans. The banks, in effect, arebeing used to funnel off-budget subsidies to the non-commercial sectors of theeconomy.

2. Private sector ownership, combined with professional managementand a commercial focus, would be the most effective way for addressing theseproblems. The GOSL, however, has been slow to embrace this strategy, citingpolitical constraints to privatization. Meanwhile, a number of interimmeasures have been proposed to move these banks towards commercializationwhich are discussed below.

3. Institutionalization of Internationally Acceitable Audits and LoanLoss Provisionint. To ensure meaningful economic and financial analysis andreporting of their operations, both banks should be subject to publiclydisclosed annual audits and quarterly reviews, conducted under internationallyacceptable Auditing Standards by reputable private auditors. Investment, loanclassification and loan loss provisioning to cover their known and foreseeablelosses on troubled assets should be carried out in accordance withinternationally acceptable practices.

4. Profit Objectives. Once the banks are properly recapitalized,both banks should be required to move rapidly toward achieving profit marginscomparable to their private sector counterparts. As an interim goal, bothbanks should be responsible for generating pre-tax profits no later than sixmonths after recapitalization. At the end of their first fiscal year afterrecapitalization, they should yield a return on assets (ROA) of at least 50percent of the average ROA of the private domestic commercial banks (PDBs).Their ROA should increase to match the ROA reported by the PDBs by the end ofthe second fiscal year.

5. In their corporate strategy plan submitted to the GOSL, the SCBsshould outline interim quarterly profitability targets and their strategy to

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ultimately reach or exceed the end-of-fiscal year targets outlined above. Incomputing the profits for the SCBes, earnings from the bonds used to augmentthe SCBe' capital base from zero to internationally acceptable levels (8percent of risk adjusted assets) should be excluded. Should any quarterlytargets for profits or average return on assets be missed (usinginternationally acceptable standards), the respective bank must reduce itsassets to meet the target. The GOSL should replace the top management of therespective bank for failing to meet the agreed targets to provide therequisite credibility to the commercialization exercise.

PROPOSED TERMS OF AGREMEMNT BeTNW THE GOSLAND THE STATE-OWNED COa(ERCI[AL BANKS

SECTION I

Terms Aareed to by the GOSL

Recalitalizing the State-Owned Commercial Banks (SCBs) and Providina ComileteOperatint Autonomy

6. The GOSL will issue long-term Government bonds to recapitalize the twoSCBs to ensure their capital base is at least 8 percent of their risk-adjusted assets, in compliance with the capital adequacy requirementsstipulated by the Basle Coamittee Accords. The bonds would have a 30-year term and be non-transferable to ensure that the monetary impact issterilized, except for the interest payments. The value of the bonds tobe issued, based on the international audit of the 1991 accounts of thetwo Banks will be Rs. 13p5?7 billion in the case of the Bank of Ceylonand Rs. 10,541 billion in the case of the People's Bank. The bondswould carry interest at 12 percent per annum, payable semi-annually.

7. The GOSL will amend the Bank of Ceylon Ordinance and the People's BankAct to enable the SCBs to function as autonomous commercialorganizations, on the same terms and conditions as the privatecommercial banks in Sri Lanka. The GOSL will also provide freedom tothe SCBs to establish salary/compensation policies, performance basedbonuses, staffing at all levels and all other human resource decisions.

8. The GOSL will not intervene in the daily operations of the SCBs, thusgranting complete autonomy and independence to ensure commercial focus.In cases where the GOSL requires the SCBs to grant any loan which wouldnot normally be granted on the basis of purely commercial criteria, GOSLwill provide a time-bound written guarantee for the amount of theprovisioning which has to be made in respect of the loan in terms of theCentral Bank guidelines on loan-loss provisioning. Where there is acost to the Bank of such non-commercial lending (e.g., where the lendingis at a lower rate of interest than would be normally applicable), GOSLwould provide the Banks with an appropriate subsidy. GOSL would also

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make payment for any non-comercial activities which the Banks undertaeon behalf of the Goermnt (e.g, paymet of teachere' alarie andpensions). In the event of theo Gvoermt not paying literest In repectof any loan guaranteed by Goverment i ch is in default, the Bankconcerned ould be entitled to deduct such interest from any amount duefrom them to the Government.

Dealina with xistina "Bad" Loao

9. The GOSL will establish a mechanism and procedures for dealing with theexisting troubled assets. This may lnclude the establishment of aseparate restructuring and collection agency (BACA). Details of thetroubled assets are outlined In the 1991 International audit.

Reconstitutina Board of Directors

10. The GOSL will reconstitute the Board of Directors consistent with theexpected role of the SCBs by appointing tbree new Board members who willbe persons with appropriate professional qualifications or persons withextensive managerial experience In larger co.mercial enterprises. Theselection of these ane directors will be from both the public andprivate sector, and bssed on their background and professionalexperience.

11. The General Manager will have the right to be present and participate atall Board meetings. The Board of the bank will not take any decision onfinancial facilities granted by the bank vithout cousidering the writtenrecomiendation of the Genoral Manager, which must be provided for allsuch matters. In case where the Board decides to over-ride therecommendation of the General Manager, the reasons for doing so will bedocumented In the minutes of the Board meeting.

Monitorina of the Operations of the lan

12. The Conittee on Pinancial Sector Reformes ould monitor the operationsof the SCB. and advise the GOSL on the progres of the restructuring sadcomercialization efforts. The Committe will, with sstane-sce fromindependent auditors, conduct quarterly reviews to asses progresstoward meeting profit targets.

Terms Are_et to by the Bank of Ceylon and tbe PeoDules Rank

Conductint Annual Internationally Acceotable Audits

13. The SCIs will be subject to publicly disclosed annual audits byreputable private auditors. The udilts wtil conform to Internationalaccounting and auditing standards and will enoui that sufficient loanloss provisions are made to cover their kown and foreseeable losses oan

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troubled ssets. In addition, the 8CB will ensure that brach levelbudgeting asnd accounting re adopted, and book specific provisions outhe books of each branch.

Prevarin MNaemt Actio Plan (IMPS)

14. Prior to recapitalization, the SCBe wIll present to the GOSL a planoutlining both medium- and loWg-term corporate atrategy. The MAPS willinclude inter alias (1) the quarterly Interim targets and how they willbe achieved; (Ii) steps to improve manpower utilization; (III) branchrationalization; (iv) the establishenbt of clear business goal.; and (v)performance improvemet measures The NAPS will ensure that the totalnumber of branches wil not exceed the December 1991 level. (specificnew branches for whlch Moetary Board approvals had been granted beforeFebruary 28, 1993 will be excepted). If possible, they should alsoprovide an nitial list of possiblo bracb closure, based on duplicativerural branches If the 8CBs require assistance In developing the MAPS,GOSL wil request IDA for technicl assistsace.

Imorovin Credit Standards and Manatement Reportitn

15. The 8C.s will apply rigorous credit standards for all future loans, andensure that the procedures stipulated in the credit manual are strictlyobserved. They will develop credit systems and set up appropriateinstitutional arrangc nts to ensure efficient monitoring of theapprovwl9 disburseseat and recovery of all loans If further assistanceis required, GOSL will request IDA for teebnical assistance.

160 At the end of each quarter, the SCB8 will provide detailed managementreports disclosing details of new loans approved, rescheduled loans,loan classificatio, specific provisions provided against possible baddebts, and legal actions taken or planned against defaulters. If in theimplementation of thebs planning and performance management systems,help is required, GCOL will request IDA for technical assistance.

Reducing Emolovee Related Cost

17. A significant component of the high Intermediation costs are theadministrative costs. In order to reduce these costs, the SCBs willenforce a hiring freeze for all positions, except for specified skillpositions approved by the Board. However, the total strength of allstaff in each 5CB will not exceed the December 1991 levels. Inaddition, the SCBs will prepare a feasible plan Indicating the phasedmanner In whicb the staff expenses to total assets ratio will matchtkese of the private domestic commercial banks (PDBs) withn 3 years.Staff expense include all employee related costs including each SCB'.contribution to the employee pension plans. The plan will Include bi-annual interim tatgats.

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18. The SCBs will initiate a study of their pension plans with a view tomaking them viable and affordable. The recomendations of this studymust be implemented within a year of recapitalization. The contractualretirement age must be enforced for all employees, and exceptions mustbe made only for specified skill position with approval from the Board.

Re2avMents to G08L

19. The GOSL reserves the option of allowing the SCBs to retain any level ofprofits after tax. All profits after deduction of tax, loan loseprovisions and any such portion for reserves, if any, as the GOSL shalldetermine will be issued as dividends to GOSL at the end of each fiscalyear.

Achievint AUreed Profitability Targets

20. The 8CBs will generate profit which will be comparable to the profitlevels of private commercial banks operating in Sri Lanka. As aninterim goal, both Banks will be required to generate pre-tax profitsnot later than six months after recapitalization. At the end of theirfirst fiscal year after recapitalization, they will yield a return onassets (ROA) of at least 50 percent of the average kOA of the privatedomestic commercial banks (PDBs). Their RQA should increase to matchthe RQA reported by the PDBs by the end of the second fiscal year. Intheir corporate strategy plan submitted by GOSL, the SCBE will outlineinterim quarterly profitability targets to ultimately reach or exceedthe end-of-fiscal year targets outlined above. In computing the profitsas a percentage of the assets of the SCBs, earnings from the bonds usedto augment the 8CB's capital base from zero to internationallyacceptable levels (8 percent of risk adjusted assets) and the capitalvalue of these assets, will be excluded. The GOSL retains the option ofrequesting the independent auditors to reconfirm the quarterly results.

21. If any of the quarterly targets as identified in the MAPS for profits oraverage return on assets remain unfulfilled at either Bank, therespective Bank will take the necessary steps to reduce its costs and/orreduce its assets through sale or termination of selected operation soas to reach the specified targets. The closure of selected operationswill be identified based on branch level budgeting, interestaccrual/suspense accounting, profitability, and other considerations.

Redemption of the Recavitalization Bonds

22. The Secretary to the Treasury will determine in consultation with theBanks, what part (if any) of the profits of the Bank to be paid to theGOSL as dividends may be retained by the Bank and an equivalent amountof the recapitalization bonds canceled in lieu. No part of the profitcould be retained by the Bank in lieu of cancellation of an equivalentamount of recapitalization bonds unless the tax and dividends paid Is at

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least equal to the interest on the bonds Issued by GOSL for therecapitalization of the SCBs.

SECTION III

23. In case profit targets fixed are not fulfilled by the end of each fiscalyear, the Board of Directors agreee to submit their resignations to SOSLwithin one month of the dieclosure of the results.

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AM=Y 8

PRIVATE FINAN V UOPHEn nRE (MP)

CONPOSITION 07 TES FIONCIAL AIAD RAM=ING lInTLMJTIOIS

Instituticns Total Asset. Total Assets(as of 12/31180) (as of 12131191)

ik VA I la no I

Banking Sector 49,433 73.1 251,196 60.6Central Bank 22,832 33.8 95,835 23.1Commercial Banks 26,601 39.3 155,361 37.5state Banks 20,244 29.9 100,582 24.3Private Banks L 6,357 9.4 54,779 13.2

Deposit Taking Inst.s 6,300 9.3 45,934 11.1ISI ' 5,329 7.9 30,081 7.3Finance Companies 636 0.9 9,862 2.4Rural Banks 335 0.5 4,572 1.133DBs -- 1,419 0.3

Long-Term Lendtng Inst. 405 0.6 13,882 3.3Dev. Fin. lust.: 278 0.4 - 0,688 2.6DFCC 278 0.4 3,701 0.9IDB 6,987 1.7

smIB 127 0.2 3,194 0.8Contractual Savings Inst. 7,711 11.4 61,191 14.8Insurance Inst. 2,660 3.9 6,056 1.5State Corporations 2,660 3.9 5,154 1.2Private Ins. Companies -- -- 902 0.2

spF 5,051 7.5 49,174 11.9ETF -- -- 5,961 1.4

Specialized Financial Inst. 3,796 5.6 42,283 10.2FCBUs 3,796 5.6 39,365 9.5Leasing Companies -- -- 1,028 0.2Merchant Banks - -- 1,212 0.3TCCs -- - 678 0.2

TOTAL 67,645 100.0 414,486 100.0

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ANNEX 9Page 1 of 12

PRIVATZ FINUC DEVELOPEN PROJECT (PP

mMao,,oL CO

Environmental Concerns

1. According to OD 4.01, gavironmental Assessment, the proposed project ioa category "Bn. some subprojects to be financed through tho loan wouldrequire environmental treatment. For this reason, the environmental policyand legislative environment in Sri Lanka has been reviewed. In addition, thecapacity of PCIs has been evaluated.

2. The GOSL has made considerable progress towards the implementation oflegislation and activities to protect the onvironment. For the proposedproject it is important to note that under the Environmental ProtectionLicense Scheme (EPLS) any polluting industry requires a license (see para. 4).In addition it is epected that before this project is effective, the GOSLwill have passed legislation, acceptable to IDA, regarding the EnvironmentalAssessment procedures (see par.. 10). The legislation will require that anymajor project i4 subject to Environmental Assessment Review.

3. The GOSL has also been active in the International field ofenvironmental protection. Among others, it has signed the Vienna Conventionof 1985 and CITES, lodged the proposal to ratify the Bs!a-s Convention andunderwritten the Montreal protocol.

EXISTING ENVIRONMWNTAL LEGISLATION AND ADMINISIRATIVE RNWK IN SRI LANKA

4. Sri Lanka, when compared to othor countries in the region, has anoutstanding record in environmental protection. Early legislation wasprovided in the Urban Development Act (UDA) of 1979, and in the GreaterColombo Economic Commission Act of 1978. The National Environmental Act of1980 established the Central Environmental Authority (CE) in 1981 as a policymaking and coordinating body. The 1988 Amendments to the Act travnformed theCMA into an enforcement agency. The first regulations derived from this Act,(the EPLS), to control the discharge of pollution from stationary sources wereenacted in February 1990 and came into force in July 1990. The CabinetMinistry of Environment and Parliamentary Affairs was created in March 1990and at the same time a subject-specific Ministry for Environment wa alsoestablished.

S. The Board of Investment-formerly known as the Greater Colombo EconomicCommission (GCEC)-and the tDA also wield enforcement powers to curbonvironmental degradation in the Colombo metropolis. The environmentalquality standards framed In 1978 by the OCEC are the forerunners to the

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ANNEX 9Page 2 of 12

present National Standards listed in the recent regulations. Municipality by-laws too are used to a limited extent to prosecute nuisance-related offenses.

6. The GOSL in 1991 established the National Environmental SteeringCommittee (UESC). This Inter-Ministerial Committee consists of policy-makersof key development sectors and is headed by the Secretary, Ministry of PolicyPlanning and Implementation. UESC provides policy guidance and direction forseveral environmental initiatives including the Metropolitan EnvironmentalImprovement Program (MEIP; see para.. 7). The NESC has already established theMElP Technical Working Group (MEXY-TWG) under the leadership of the CIAChairman and is represented bys M2.nistry of Policy Planning audImplementation, Ministry of Transport and Highways, Ministry of Industries,Science and Technology, Ministry of Environment and Parliamentary Affairs,UDA, GCEC, Colombo Municipal Council, National Building Research Organization,Urban Program Unit, National Housing Development Authority and the NationalWater Supply and Drainage Board. The TWG thus consists of an array ofinstitutions ranging from urban planning, municipal management to pollutioncontrol. Other relevant agencies will be included as and when required.

Metropolitan Environmental Imirovement Pronram

7. The HEIP is a UNDP-funded, World Bank executed initiative to incorporateenvironmental perspectives in the development strategies of theurban/lindustrial sector of Asian countries. The basic objective of theprogram is to focus attention on the need for developing more attractive,efficient and stable urban environments in Asia and attempt to slow and, ifpossible, reverse the process of industrial pollution and neglect of theenvironmental context within which economic development takes place.

8. The Program assists participating country governments and municipalauthorities in developing cost effective Metropolitan Environmental ActionPlans, wbich would provide the framework and guidance for sectoral andsub-sectoral investments for environmentally sustainable inaustrial and urbandevelopment. The Program will assist the participating countries Instrengthening their pollution control and enviromental planning andmonitoring agencies, prioritize investment decisions, mobilize the technicaland financial resources needed to Implement the plans and involve the privatesector and nongoveranmental organizations in the overall effort for betterenvironmental management.

9. In Colombo, HEIP functions under the Ministry of Policy Planning andImplementation and in collaboration with the Ministry of Environment andParliamentary Affairs. The Program is managed and directed by the Office ofthe National Program Coordinator.

The GOSL's Environmental Mananement Strategy (EMS) and Action Plan for GreaterColombo Metropolis

10. A study, financed by TA funds from MEIP and bilateral donor support,

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ANNEX 9Page 3 of 12

("Environmental Management Strategy and Action Plan for Greater ColomboMetropolis"') evaluating existing environmental standards is expected to becompleted before project effectiveness. The study vill integrate availablestrategy documents compiled by the ('OSL (e.g.,, National Conservation Strategyand its Action Plan, Urban Sector Profile, Transport Sector Study and Policy,New Industrialization Strategy, Environmental Action Plan, OCEC Negombo LagoonMaster Plan) and studies prepared through bi-lateral donor support, amongothers those of NAREPP and the CON. The study's objectives ares

(a) to define priority problems for environmental management in terms ofpresent and projected degradation of vater, air and land;

(b) to describe the present and projected costs of environmentaldegradation, to the extent possible, in quantitative, preferablyeconomic terms for each medium;

(c) to assist the GOSL in selecting a realistic set of environmental qualitytargets for water and land, described in terms of benefits and costs;

(d) to formulate least-cost management strategy leading to prevention offurther natural resource degradation and a beneficial reduction inpresent air, water and land pollution;

(e) to develop an action plan to carry out the strategy, including: (i)specific guidance to sectoral agencies; (ii) inputs to CMP and theColombo City Development Plan; (iii) strengthening the pollution controlplans and measures relating to the Environmental Protection LicensingScheme; (iv) guidance to Provincial Councils, Municipal Councils andUrban Councils regarding environment management functions needed atpeovincial level and local level administration;

(f) to define institutional arrangements and necessary strengtheningmeasures (staffing, training, etc.) for Action plan implementation atall levels of government, with emphasis on provincial and localagencies;

(g) to estimate the benefits and costs of plan implementation; and

(h) to define any additional studies needed.

Environmental Protection License Scheme (EPLS)

11. The Environmental Protection License Scheme promulgated in July 1990 isthe first regulatory instrument derived from the 1988 amended NationalEnvironmental Act to control the discharge of pollutants into the environment.Existing and proposed industries with potential for pollution are also

/ Detailed Terms of References for this study are in the project files.

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ANMEX 9Page 4 of 12

required to obtain the EPL prior to commencement of operatione. Around 350Industries received licenses during the first year of Implementation of thisscheme. The EPL regulations also specify concentration specific dischargestandards for all industrios.

anzs"= Mo2mdaM s

12. The procedure to obtain an EL for existing and new ndustries asprescribed in the guidelines issued by the CRA is outlined below:

12.1 Ixistmnt Industries

(a) Complete and submit the application form to the CIA or therelevant local authority;

(b) Upon receipt, the CZA will classify the industry/activity onthe basis of the nature and extent of pollution which couldarise from Its operation;

(c) CIA will administer the EPL scheme for high pollutingindustries, %vhile the medium and low polluting industries itwill be handled by the local authority;

(d) CIA inopects the industry and aakes a scientific assessmentof the pollutants being discharged/deposited and associatedenvironmental impact that has arisen as a consequence of itsoperationg and

(e) upon such assessment, if the CIA is satisfied that theoperation of the industry is being conducted In accordancewith the proscribed standards and criteria, then it issuesan 2L. The annual fee for the license is R. 750. If theCIA is not satisfied, It will enter into a time boundprogram with the industry to reduce pollution to therequired norms.

12.2 NRw Industries

(a) Complete and submit the application form to the CIA or therelevant local authorityg

(b) CEA will Inspect the proposed site to assess Itssuitability. If the CIA is satisfied with the site it willgrant approavl with conditions that need to be adhered toduring the implementation of the project; and

(c) one month prior to the commencement of commercialoperations, the CEA, on the request of the developer, willinspect the industry to examine whether the project

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ANhX 9Pasg 5 of 12

development conditions have been implemented. If satisfiedthe CIA will issue the EPL.

13. The CIA issued 14 Industrial sub-sectoral pollution control guidelines,when Introducing the lL schem. These guidelines have been recently reviewedby a IDA/CON assisted effort (see next para.).

14. CIA recently with the sslstance of the WOM has developed pollutioncontrol guidelines for eight (saom of the earlier mentioned 14 have beenrevised) Industrial sub-sectors -- natural rubber, latex processing,desiccated coconut, leather, dairy, textile processing, pesticide formulationand metal finishing. The coverage of the guidelines Include in-plant controlmeasures, end-of-the-pipe treatment methods and the recommended discharge andemission standards. Another output of the CON Assistance is the formulationof draft ambient air and water quality standards.

15. The recently published National Environmental Action Plan (SEAP) 1992-96, considers the following as important areas which require immediateattentions

(a) Tools for environmentally-sensitive industrial siting;(b) Economic Instruments for industrial pollulAon management;(c) Waste abatement expertise and facilities; andCd) Eavironmental quality monitoritg and related pollution lesues.

16. The regulatory aeasures introduced for pollution control have not beencamplemented by the availability of economic instruments - charges, subsidiesand incentives. The non-availability of such instruments has so far severelyrestricted the implementation of the IPL scheme.

Eavironmental Imnact Assessment ReoIgred of New Prosects

17. Environmental Impact Assessment (ZIA) was Virst made mandatory fordevelopment projects In 1984 by a decision of the Cabinet of Ministers. Theamendment to the ML In 1988, gave broader statutory effect to this decisionand required opportunity for public review of and comment on elAs. Theregulations for the application of tIA In development project plannin hasbeen formulated and will become effective later this year. The regulation hasidentified a range of industrial, mining, construction and resort developmentactivities as prescribed projects requiring to submit Initial EnvironmentalExamination or EIA reports as per the procedure specified. Small scaleindustrial projects have been excluded from the purview of this procedure.Such projects are to be assessed either through the IPL scheme or the Planningand Building Requirements of the UD. Nowever Medium to high pollutingprojects located in defined "sensitlve' areas are included.

18. The NBRO developed an Enwironmental Assessment Procedure and Manual forthe use of the UDA and the Urban Local Authorities (ULA) In 1988. Thecoverage of the manual Included ldustrial and infrastructural projects and

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ANNEX 9Page 6 of 12

was to be used In conjunction with the Planning and Building Requirements. Astep-by-step procedure wa developed for industrial projects, begimning with aclaosification of Industries into light, moderate and heavy polluters, andgiving the guidelines and checklists for siting. The mnuial providesinformation on legal and technical measures to aid decision-making. Theprocedure also specifies the level of decision-making for different categoriesof proj ct., with the heavy polluting category requiring CUA clearance.Additional environmental guidelines for Infrastructure projects have also beendefined. This manual finds limited use as training of the staff at the ULAsin the application of the procedure was not effective, however the UDA usesthe manual as a guideline. In order to correct this situation broader ZIAguidelines will be developed with the assistance of the USAID NAREP project.

19. HEIP recently developed an outline approach for the environmentalassessment of new industrial projects combining the three planning tools -EPLS, PB requirements and the proposed LIA regulations. The concept of thisapproach is derived from the NBRO manual and defines the use of the aboveplanning tools In the assessment of both polluting and non-pollutingindustries. This plan has been endorsed by the Environment Committee of theIndustrialization Commission and subsequently approved as the Scheme for theControl of Pollution from Existing Industries (SCOPE) at a forum consisting ofNESC member institutions, Industrialists and environmental NGOs In October1992.

Lo¢al InstitutIonal Canacitv for Environmental Imnact Asessment

20. While Sri Lanka has an actlve environmental NGO commnity, such as thelocal affiliate of the World Wild Life Fund, the Environmental Foundstion, theSri Lanka Environment Congress, the Save the Trees Foundation, the Sri LankaWorking Journalist Environmental Forum end the Environment Forum, the profitoriented private sector has not yet entered the market for technicalassistance to local industry. Universities have a limited capacity forresearch end development in environmental aspects, mainly due to lack offunds. Although some local firms have administered environmental assessments,in particular in the rubber, textile and coconut fibre subsectors, they workedmostly with international experts. The USAID funded RAREP project iscurrently providing substantial training In Sri Lanka for university andprivate sector personnel to upgrade local capacity in BIAs. This project willestablish a mechanism for private consulting firms to enter this market.

Pollution Testina Laboratories

21. The laboratories of CEA, NBRO, CISIR, lARk, WS&DB, GcEC, Division ofOccupational Health and Universities of Colombo, Moratuwa and Kelaniya offer arange of pollution testing and monitoring facilities. In addition there are afew privately owned laboratories which also undertake testing work. The CIAhas twice conducted inter-laboratory standardization among these laboratories.The CIA envisages to upgrade this to a reliable Labo:atory AccreditationScheme. This will enable the CEA to delegate Its testing functions to

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AMEN 9Page 7 of 12

accredited laboratories, although the nature and extent of monitoring by CZA,and its delegation to others has not yet been clearly established. Theselaboratories employ manual to semi-automatic techniques to analyze industrialeffluents. The need for strengthening these laboratories and establiohingeffective, uniform testing protocols and procedures, is urgent. In additionto this component IDA through S14-IV and the Japan Grant Facility is providingair and water pollution testing equipment to NBRO and CISIR respectively.

Cagacitv of inancial Intermediaries

22. Under existing IDA projects (SKI-11 and IV), progress has been made toincrease the capacity of PCIs to deal vith environmental concerns. As part ofbecoming PCIa, all participating PCIs will have had the opportunity to trainstaff members in the existing environmental procedures and regulations and inscreening subprojects, developing TORe for assessments, and in reviewingassessments. TA provided in this project will also provide for training inmonitoring the implementation of assessment recommendations.

SECTION II

ENVTRONHENTAL COMPONENT OF PROPOSED PROJECT

The Pollution Control anLd Abatement Fund - Conceot. Objective and Scone

23. The creation of a Pollution Control and Abatement Fund (PCAJ) aims atwaste minimization, resource recovery and pollution abatement in new andexisting enterprises. The legal framework is provided through licensingregulations issued by CIA and prepared, among others, by the Committee on theEnvironment of the National Industrialization Commission and NESC. Currentstandards will form the basis for this project. All industries are requiredto conform to the nw standards within 5 years of approval of this Scheme.Industries will be required to submit their plans of waste treatment andpollution abatement within 2 years of commencement of the scheme. Each planwill identify: pollution concentration, waste load, waste streams, treatmentplant requirements with local and foreign currency cost, mode of financing,schedule of implementation and performance guarantee.

24. The PCAP consists of a TA Component of US$1.25 million and a creditcomponent of US$3.75 million. Fund from CON will be made available on a non-reimbursable basis to the GOSL. The TA component consists of training forstaff of PCIo and some lndustries, TA to CEA to establish and maintain asystem of accrediting local environmental consulting firms, development ofstandard TORs for Environmental Assessment Reviews (EARs) of enterprises in 9to 10 sectors, and direct technical assistance to enterprises to cover thecost of an EAR with detailed recommendations and specifications ofrequirements for the enterprise to comply with CEA standards. Existingenterprises will be entitled to reimbursement of up to 75 percent of the cost,(subject to a maxmw- of US$10,000), while new enterprises will be entitled toreimbursement of up to 50 percent of the cost (subject to a maximum of

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ANNXE 9Page 8 of 12

US$10,000). In addition, TA for monitoring, training and limited R&Dactivities will be available from the proceeds of the interest payments fromthe PCIs to the Fund. The credit component consists of a credit fund ofUS$3.75 million. Existing enterprises can receive credit from the fund at aninterest rate equal to the official rate of inflation (currently 11 percent),for capital investments. The credit can be extended for a maximum period of Syears inclasive of a maximum grace period of 6 months. The maximum amount ofcredit to be extended for each enterprise unit is US$50,000. The interestrate will be determined at the time of the first disbursement for a subloanand will be based on the latest published official ra:e of inflation. Thezero real rate is proposed as the interest rate, to balance the need not tolend on negative real rates of interest and to provide an Incentive toexisting industry to comply with environmental standards. In most cases theneeded improvements will not lead to increased productivity at the firm level,yet the economic opportunity cost of not making the required adjustments wouldbe significantly higher than the economic costs incurred as a result of thedistortions which will occur due to the provision of financing at lower thanmarket rates.

Demand

25. In 1989 CEA conducted a survey of more than 7,600 industrialestablishments. Of these 4,606 were found to be polluting industries with 291high pollutants, 1,900 medium pollutants and 2,415 low pollutants. In 1991,NDB surveyed out of the 291 high polluting industries those located in theColombo and Gampaha districts". Of the 119 industries, only 20 had decreasedtheir polluting level and/or obtained CFIA licenses. Of the remaining 99, 65percent indicated that they would want to obtain licenses or reduce levels buthad not done so due to lack of funds for TA and/or purchase of equipment.According to estimates from rudimentary data based on the costs ofimprovements to comply with existing standards at the time of data collection(the first half year of 1992), the total financial requirement in Sri Lanka tobring existing industries to acceptable effluent standards would be Rs 2,500million (US$54 million) based on an average of Rs 2 million (US$43,480) forhigh polluting industries and Rs 1.5 million (US$32,610) for medium pollutingindustries'.

Proiect Cost and Financing Plan

26. The estimated nost to upgrade the existing industry to acceptablepollution standards is US$54 million. The PCAP would provide an initialUS$3.75 million.

I/ Available In project ft*..

3/ Data submitted to the Committee on the Emilnweent of the National Industrialization CommIssfon Intheir meetino of June 1992.

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AEW= 9Page 9 of 12

Istimated CostsLocal Porelt Total &oc91 Poroltns Icta-----(Re Million)------ ------ (US$ Million)----

Subproject - 172 172 - 3.75 3.75Technieal Assistance 166 Zu iA 1 25 4.85

166 230 396 3.6 5.00 8.60

aOm - 230 230 - 5.0 5.0Interest Earnings'

166 - 166 3.6 - 3.6

166 230 396 3.6 5.0 8.6

Ou the bais of an estimatod average nvoestment of US$30,000 the project canassist at least 125 enterprises before the Fund is exhausted for the firstround. The TA Component will cover part of the cost of reviews/appraisals for150 existIng enterprises (average US$5,000) and 100 nw enterprises (averageUS$3,500). In addition it will cover costs for consultancies and upgradinglaboratories. The interest income from the fund will cover the costs formonitorIng the compliance of the entorprises s vell as provide some funds forR&D, training and consultancies.

Terms and Conditions

27. The proposed fund of US$5 million vould be provided by the CONunder a co-financig agreement betwee the Bank and GON, to the GOSL. TheGOSL would on-lend US$3 75 milion to qualified PCIs against a base rate ofzero percent real Interest rate inus two percent. For the purpose of thisprojct, the zero real interest equals the latest official inflation rate aspublished by the C8SL at the t$ae of granting of the subloan. The COSL vouldon-lend the funds In Rupees. The CIs would pay Interest to the PCAP on fundsdisbursed and outstanding. Repayment to the GOSL for the lending componentwould be on the basis of a lump-su payment 15 years after project initiation.PCIs wil obtain fund from a special project account. Sine the maximumrepaymnt torm for loan undor the fund is five years, with average subloancommitment of thre years, Inclusive of a maximum grace period of six months,PCIs would on-lend the float as soon as possible but not later than threemonths after final repayment. Due to differences in maturity and size of thesubloans, PCIs might experience a liquidity "build-up* in the project account.

J/ Dsed en intert naem r wa pasitd of 12 vrm sainst U owetUs $.75 mllion.

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ANUX 9Page 10 of 12

PCIs would pay an interest equal to the yield of Treasury bills with amaturity between 180-360 days to the Fund over any amount in the projectaccount in excess of US$50,000.

28. The TA Component (administered by the Administrative Unit in NDB)is comprised of two parts. The first part of US$1.25 million will be passedon to the end-user as a non-repayable development grant on a cost sharingbasis according to proportions described above. This part covers the cost ofT& to enterprises, consultancies, and upgrading of laboratories. The secondpart, the interest income from the fund credit component, estimated to be atleast US$225,000 per year after the third year will be used for monitoring andR&D.

PCI Qualifications

29. In order to qualify for participation, PCIs need to have staff, oraccess to private consulting firms on a fee basis, who are qualifiedenvironmental experts familiar with existing environmental procedures andregulations and trained in screening subprojects for compliance withenvironmental regulations, developing TORs for environmental assessments, andin reviewing assessments.

Subiroiect Elitibilitv

30. Subprojects eligible for financing would involve investments byenterprises which have been in operation since January 1, 1992 in equipmentand material which will facilitate their compliance with environmentalstandards. The maxi4um contribution from IDA/GON sources is US$50,000 perenterprise. There is no maximum regarding the total investment made by theenterprise.

31. Subprojects eligible for technical assistance regarding thepreparation of environmental assessments are all new and existing enterpriseswhich have applied or are applying for an EPL.

Subproject Financina by PCIs

32. Credit funds would be on-lent by PCIs to eligible subprojects atzero real rate of interest. The rate would be determined based on the latestpublished inflation rate and remain fixed for the life of the subloan. Thematurity of subloans would be determined by the PCI but would not exceed fiveyears inclusive of a maximum grace period of six months. Subloans for whichno disbursements have been made for 12 months would be reviewed and whenappropriate, canceled to facilitate full utilization of the Fund.

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AM= 9Page 11 of 12

Repayment Term.

33. PCIs would repay to the 0OSL any funde borrowed under the lendingcomponent at same rate as the underlyins subloane are due for repayment to thePCI but no later than 15 years after project initiation, even if results inone lump-sum payment. Repayment obligation of PCI to the GOSL is independentof actual repayment from the sub-borrower to the PCI.

Interest Payments to the Fund

34. The PCIs would pay Interest quarterly to the PCAE on fundsdisbursed and outstanding. In addition, PCIs will pay to the fund anyinterest earned on funds held by them ln their project account in excess ofUS$50,000 on the basis of Treasury bill yi.elds valid at that time.

Technical Assistance fundint

35. PCI Un2radina/Trainint Programs. Under the ongoing SMI projects,funds were provided to NDB/PCIs to assist them in buildtng their capabilityfor project financing through staff training, systems and operationsimprovement and subsector analysis. This assistance would continua to beprovided from the interest income of the Fund.

36. Cons,ultag ces. In order to strengthen the institutional capacityof organizations concerned with the formulation and implementation ofenvironmental legislation, procedures and regulations, a number ofconsultancies would be required. Tn particular, the fund would finance aconsultancy to assist CEA establish and maintain a system of accreditingqualified private consulting firms and to start and maintain a system ofcompliance monitoring (at source). The recurrent costs for these programswill be financed out of the interest income of the PCAF.

37. Indicative allocation of technical assistance funds is given inthe table below. Based on an average contribution of US$5,000 for TA toexisting enterprises and US$3,333 for new enterprises approximately 150existing enterprises and 100 new enterprises will be able to avail themselvesof this TA.

38. At present, obtaining an IPL is subject to long delays becauselaboratory facilities do not have the necessary testing equipment. In orderto expedite this, the project will provide funding (complementing funding fromother sources), to upgrade the laboratories.

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AMICK 9Pago 12 of 12

Technical Agsistan¢e Suvoorted throuah Proposed GON Coa-Fiancig

Expenses In U8$

TA to existing enterprises 750,000TA to new enterprises 350,000Consultancies 75,000Upgrading of Laboratories 75,000

Total 1.25s.00

39. Trainjng. in the first two years of operation are provided underthe SKI-IV project. This project will complement and continue the funding,financed from the proceeds of the Interest in4co of the PCAP.

40. SMbtorin The Administrative Unit In 3DB will provideinstructions and guidelines to work with the regulatory agencies (Inparticular CU), to establish a system of using private consultants to assistCUA in monitoritg compliance with environuental regulations.

41* In addition to the specific uses metioned under para. 39 and 40,the fund would provide financing for additional activities which ala to atta ithe objectives of the PCAP.

The Administrative Agency

42 *DB has been appointed the administrative agency for the PCAW.They will administer the TA component, and manage the Interest Income from theoutstanding and disbutoed funds.

Donor Coordination

43. In addition to the IDA supported projects, several bilateraldonors have developed programs In support of the OOL pollution controlprograms which deal with TA, training and development of local institutionalcapacity that may overlap and duplication could occur. For this reao"n, amechanism will be created for frequent but Informal donor coordinatingmeetings.

IDA Review and Sunervision

44* The component will be monitored sa part of noral IDA supervision.In addition to the normal accounting and auditing requirements of the Project,missions will from time to time request a local auditing fizu, to audit theprojact accounts of PCIs for this project and on a sample bs4i check approvedloans for compliance with the guidelines of the program.

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ANE 10Ag. I of 6

PRVAE NAC OAR= PROJECT (P70P)

C^MCL A88I8n1C1S

TECHNICAL ASSISTANCE M ICUD CONCEl CONRTS) AVAILABLE UNDER TIEPROJECT

Total technacal assisotance available under the project vould amount toUS$10.75 million of which IDA shall provide US$2.5 million, USAID US$7 millionand GON US$1.25 million. The Individual components for which this technicalassistance shall be avallable are shown in the following table.

(US$ '000)IDA FINANCED TAA. Institutionl and PglicY DevelonmQntDomestic Resouree Mobilisation 500Financial Sector leformllestr. State Banko 1,400Accounting sad I*ditiag 100D. *financal IntermediationPCI Training and Upgrading 500

Total ID Assistnce 2,500

USAID FIANC}D TZStrengthening Debt Market/Pobt Trade Systems 843Bond Market Development 222Training Bond Market Development 124Strengthening Regulatory Framework 547Develop Portfolio Managemet Capacity 395Accounting and Auditing 711Other Activities 2,244Program Management, Audits and Evaluation 1,289Contingencies (152) 625

Total USAID Assistace 7,000

CON FINACED TAConsultancies to comply with EPL 1,175Laboratory Equipment 75

Total 00 Assistanc 1,250

Grand Total Technical Assitlanc 10,750

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ANNEX 10Page 2 of 6

The technical assistance component under IDA credit is US$2.5 million whichshall be available as unders

US$O0oo

A. Institutional & Policy Dev. 2.0B. Financial Intermediation 0.5

2.5

A. Institutional ad Policy Develoumets _(USS2.0 Million)

1. Domestic Resource Mobilization for Term Lendina. The GOSL I-,tendsto lengthen the maturity structure of its debt instruments. To complete thisprocess successfully, four TA tasks are necessarys (i) strengthening thesystem of issuing the appropriate long term debt instruments, including thedevelopment of a trading and settlement infrastructure; (ii) development andimplementation of a regulatory framework, covering both primary and secondarymarkets; (iii) developing portfolio management capacitv of contractual savingsInstitutions; and (iv) training program for institutions such as MOP, CBSL,primary and secondary dealers. Some of the needed sosistance is alreadyprovided under SMI-IV. In addition to TA funds from IDA included in theproposed Projecto USAID is also providing TA. in a parallel operation. Fundingfor strengthening of bank supervision functions, SCB restructuring andimplementation of debt recovery legislation (para 2 below) will be providedfrom IDA funds. Other main activities being assisted through the provision oftechnical assistance (IDA and USAID) are noted below.

(a) Strengtheninag the System of Issuina the Aouronriate Long-term DebtInstruments. Includint the Development of a Tradina and Settl ntmInfrastru-cture. The rapid development of the stock market over the last twoyears necessitates expansion of the computer ¢apacity handlin4; post-tradetransactions, the purchase of an independent back-up processor under controlof the Colombo Stock Exchange (CSE), and linking brokers and broker/dealers ina second-tier market, while also linking dealers in government Treasury bills.The system would provide contract documentation subsequent to the completionof trades, generate market reports for monitoring and for the public, andmaintains a central depository system (CDS), which facilitates paper-lesstrading. The linkages will both Improve the market's ability to processinformation and enable speedy execution of trades. The proposed system willprovide additional collective storage facilities and offer composite softwaremodules which will enable order-taking and recording of trades and will enablefinancial intermediaries to operate simultaneously in several of these

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ANE 10Pago 3 of 6

markets. USAID will finance proprietary computer equipment which will enablean expansion of the current system of 30 on-line terminals with 100 additionalon-line terminals. In addition, US&ID will provide the technical assistancerequired to bring the system on-line, and train the personnel who will workwith the system. By the end of the project it is expected that 130brokersibroker dealers vill be on-line, and that CSE vill have an independentback-up processor in place for all transactions handle by the exchange.

(b) Development of Bond Market and Lona-Term Securities. USAID willprovide the GOSL with assistance to strengthen the secondary market inTreasury bills now being created by the government. Essentially the projectwill develop the PTAICDS computer system to allow issuing of longer termsecurities by the GOSL. Issuing of longer term securities through competitiveprocedures is an IDA condition of disbursement for this loan. In addition theproject will provide technical assistance to develop the feasibility andoperational guidelines for the bond trading system, to obtain institutionalacceptance for the program and to coordinate these activities with thedevelopment of a second-tier market. The T& will also include extensivetraining of the users (both the GOSL and private sector dealers), including atour by Central Bank officials to observe regulation and oversight activity ina developed market which utilizes electronic trading. In addition, IDA willprovide TA for central banking and regulatory expertise, to assist CBSL and

DOP with developing a Treasury bill agenda and long-term money marketplanning. At the end of the project, the GOSL expects to carry out all of itsborrowin&s operations through competitive procedures.

(c) Develoumen and Imlementation of a Regulatory Xram rk. CoverinBoth Primary and Secondary Markets. The Colombo market is regulated by theSecurities and Exchange Comission of Sri Lanka (SEC). Improved regulation isneeded to address a number of imperfections in the present system. A number ofstudies' have indicated the need to strengthen regulatious and staff,especially in the areas of monitoring brokers' capital adequacy and profits,regulation personnel, conflict of interest, customer fraud, conditions ofsale, credit extension and theft, and employee and agent fidelity. USAID willfinance TA for a securities market regulation specialist for a period of 12month. In addition, a number of short-term consultancies will be provided forspecialized activities relating to regulations. TA will also be provided to

If International Science and Technology Instftute (IST1):"Joproving Colotmbo Stock Exchenge Regulatiofn,USAID ColUzbo 1990.Robert N. Bishop: Consolideted Srf Lanka Securities Regulatito", USAID ColoCbo 1990.Estella Tang: "The role of Securities Cwmcit in the Regulation of Narket intermediariees USAIDColotmbo 1990.Aries/Price Waterhouse: A Study of the Regulation of Securities Narkets in Sri Lanka, AsianOevlopment ank. 1991.

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ARM 10Page 4 of 6

finance eight overseas training tours by the regulatory personnel of the CSBand the SPC. At the end of the project it Is expected that a surveillanceunit of the SEC is fully staffed, trained and functional. Shortcomings iu theregulations as identified in the referenced studies will have been addressedand corrected.

(d) Develop Portfollo Manaement Canacilt of Now PinancialInstitutions and Contractual Savines Ingtitutions. Under this project, withIDA funds, the contractual savings institutions (EPP, LTP, ISB,ICSL) willreceive TA up to 12 monthe of expatriate consultancies to diversify and managetheir portfolios, including investment In non-governmental longer terminstruments. USAID will finance up to 15 man months of expatriate technicalassistance to a number of private financial institutions such as the NationalAsset Management Company (NMML), CRN Fund Management Ltd., mutual funds andstarting venture capital companies. In the case of USAID's assistance,services are provided on a cost-sharing basis, with a minimum of 10 percent ofthe tocal costs of the TA being net by the institution concerned. At the endof the project, it is expected that 1PF, ITF, USB and IT! would become activeplayers in the long-term securities market and will manage their investmentportfolios in accordance with their on investment objectives.

(e) Trainint Programs. Both IDA and USAID J.1l provide training. IDAfinanced training is a continuation of the tralinig for PCIs in upgradingtheir appraisal skills, implementing and utilizing control and magementinformation systems, and training In environmental assessment metbodologies.In addition, USAID will provide funding for a series -of in-country trainingseminars for more general skills In portfolio management, such as training forbroker agents and for a mixed group of staff from concerned financialinstitutions. The institution will bear 20 percent of the costs of the USAIDsponsored training programs* In order to promote the use and utilization ofthe second-tier market, USAID will provide financing for a series of in-country training programs for the brokers and brokerldealers, and short-termoverseas placement in U.S. institutions for both the players and theregulators. To develop the financial markets, USAID will also provide fundingfor two in-country training feminars in bond trading, additional short-termcourses for portfolio investors to utilize bonds as a part of their portfolioand financing to facilitate the certification of securities marketsprofessionals.

(f) Other Activities. USAID will also provide assistance with thedevelopment of a second-tier market in an effort to reduce the costs of entryand maintenance in the quoted securities market for medium-sized companies.In implementation, it will initially be set up as an over-the-counter (OTC)market using brokers and brokeridealers. l addition, USAID identified thatwith the rapid growth of the market In recent years, the lack of skilledprofessionals in corporate finance has be¢ome a constraint in the developmentof the Colombo market. It will therefore support the introduction of a

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AM= 10Page 5 of 6

professional CPA program to Sri Lsaka and support up to 45 students during theilitial two years of the project.

2. ank Sunervlsion. Debt Recovery Leaslstion and estructurine ofStgte-Owned Cogmser¢ll saks. Restructuring and commercialized operations ofthe state comercial banks are critical to the efficient and effectiveoperation of the banking sector in Sri Lanka. Uhile the governgt has beenslow to embrace divestituro as a strategy for addressing the weaknesses inthese institutions in a sustainable manner, a number of tasks alm6d atfipo ing comercial discipline on these Institutions are being implemented.

Tecbnical assistance fund. from the Project are proposed to assist In severalof tbase key tasks: (1) strengthening credit management; (ii) rationalizationof the branch networks (LIL) vaproving staff utillzation end (iv) conductingan international comparison of salaries in the banking sector. In addition,the GOSL and CBSL need ssistance i strengthening bank supervision functionand in implementing the provisions of the revised dobt recovery legislation.It is expected that at the end of the project, improved supervision of theCBSL vould have substantially reduced the risks associated with liberalizedfinancial markets, the Improvements In debt recovery procedures would haveminlmized the premium desmanid by savers to Invest in debt instrumento and onof main reasons for high Intermediation costs (unduly bigh administrativecosts of the state owned caemercial banks) would have bea eliaminated.

3. Account&nM and Auditing. The ICASL has recently adopted all ofthe international accounting standards. USAID, will provide assistance todevelop a strategic plan for the institute and for developmental activities inthe areas of standard setting to enable the ICASL to sustain the progress madeso far. The asistance will be provided for a program of loplementing andmonitoring support for a period of 2 year. In addition, through 12 months oftechnical ssistance and 2 two-month consultancies, USAID would assist IC&SLin the development of training program by developing relevant case studiematerials to be used in post qualifying education seminars, training modulesfor students, etc. In addition ICASL, with USAID's assistance, will developobjective methods of examination settitg and system of periodic review ofsyllabi. The ICASL would also be assisted in its efforts to enforce complianceby establisbing a compliane urit to serve as an advisory body on theimplemetation of standards. The ICABL wvil contribute a minomum of 10percent toward the cost ascociated with USAID supported TA. IDA, under thisproject will provide TA for the institutonal strethening of the ICASL,establishmeat of Accounting Standards Board by MOI/IeASL and to assit withthe Introduction of malpractice insurance for all practicing accountant. Atthe end of the project, It is expected that there would be a methodical androutine system for updating accounting standards, a functionlng institution.for dealing with compliance Issues regarding accounting standards, increased

coverage of accounting and auditing standards by extension of accountingstandrds to financials of larger unlisted companies and a system ofmalpractice Insurance for practicing accountants.

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ANIl 10Page 6 of 6

3. linancial !ntermediatio (US80.3 million)

4. Assistance to PCIs. Under the ongoing IDA projects, funds wereprovided to assist PCI8 in building their project finance capabilities throughstaff training and systems development. This assistance will be continued.Assistance Is particularly required in the area of HIS development, riskassessment and pricing of credit. Since this project introduces the us. ofvariable Interest rates, training will include the development of mechanismsfor isolating, controlling and pricing of Interest rate risks. Technicalassistance will also be provided for provision of public information on thebenefit/risks of variable vs. fixed interest rates. At the end of the projectPCIs would have improved their MIS and control systems providing theirrespective managements with necessary information regarding the functioning ofthe banks. In addition, banks will offer clients a range of financinginstruments, appropriately priced, ultimately reducing the cost of financialintermediation over current levels. IDA technical assistance to the PCIsunder this Project is needed f4r the first two years of Implementation only.

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ANNEX ItPAge 1 of 3

SRI JAM

PRIVAE FINANCE DEVELOPMENT PROJECT (PMDP)

IERMS OF REFERENCE FOR

T1E FORKATION OF INVESTMENT POLICY AND OPERATING GUIDELINES

FOR THE MANAGEMENT OF INVESTHENT PORTFOLIO

FOR CONTRACTUAL SAVINGS INSTITUTIONS

1. Most of the Contractual Savings Institutions in Sri Laka :were

established by acts of Parliament and therefore have special rules that governtheir operations. Such rules have generally been modified and amended fromtime to tire by directives from the Ministry of Finance or other regulatoryauthority, especially the rules relating to investments of their funds. Theseinstitutions routinely invest most of their investable funds in public sectorsecurities, some issued at below market rates.

2. The present thinking of the Ministry of Finance on the futureinvestment activit4-s of contractual savings institutions is that:

(a) they &nould continue to operate as institutions geared tofulfilling their declared objectives;

(b) they stould be a provider of investment funds to the privatesector to the extent consistent with their roles;

(c) their charter should be amended to give them more autonomy; and(d) the institutions should separately develop investment guidelines

and portfolio management skills to better fulfill theirobjectives.

Consultant's Profile

3. The ideal investment consulting firm would have had extensiveexptarience in policy formulation for treasury or investment departments oflarge financial institutions such as pension funds, provident funds ornational savings institutions and setting out of operating guidelines for therelevant investment departments. They would also have successfully managedinvestment portfolios of such institutions, showing good performance over aperiod of time, and operating under similar constraints which are likely toexist in Sri Lanka.

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AME 11Page 2 of 3

Consultant js Tms of Reference

PRH%8R I D %MATMONS FOR DEVELOPING PORTPoLIO MAg AGEMENTEXPERTISE II CONACTUAL SAVINGS INSTITUTIONS

46 Consultant would be expected to provide advice on the followaingaspects:

(a) within the constraints of its charter, the limitations of capitalmarkets in the country and consensus obtained after detaileddiscussions with the relevant departments of the government, theconsultant should be able to set out a clear policy statement onthe objectives of the Pund Management Policy that the board of thecontractual savings institutions should approve and adopt;

(b) within the constraints of Fund Management policy, the consultantshould define the role and the objectives of the investmentdepartment so that the board and the dep&rtment itself clearlyunderstand what is expected of thea;

Xc) outline the expertise that vould be required in the investmentdepartment for it to fully perform the functions that have beenspecified for it. This should include detailed job specificationsfor key position.;

(d) prepare an organization chart showing how the department should beorganized internally and to whom it shou 7 report externally;

(e) propose the discretionary dealing limits for each of thetraders Investment officers;

(f) consultant should then be able to recommend a portfolio structurevhich is commensurate with the stated Investment policy of theboard and is appropriate considering the state of the capitalmarkets in the country;he/she shall be expected to give detailed recommendations for,.-ctor allocations, desired maturities profile, desired mixbetween debt equity and other instruments, public and privatecorporate exposure, quoted and unquoted securities, investments inunit trusts and managed funds, etc.;

(C) consultant should propose a detailed strategy for giving funds tooutside fund managers recommending whether such funds should begiven on a discretionary or non-discretionary basis and specifyingthe benchmarks against which each type of fund manager should bejudged; where the portfolio is given on a non-discretionary basisthe consultant should specify in detail the parameters withinwhich the fund manager is expected to invest, using his discretiononly for the selection of individual securities for the portfoliot

(h) consultant vould also be expected to advise on the appropriatebasis of remuneration for the fund managers and for setting theperformance evaluation criteria for them;

(i) he/she would be expected to train staff in the investmentdepartment on how to evaluate the performance of the fund

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AM= 11Page 3 of S

managers, how often It should be done and the aiternatives thatcould be followed, short of termination of contract., if theperformance is below the accepted benchmarks. The consultantshould also propose what would be an appropriate level of funds tobe given to each fund manager and how many outside fund managersought to be used in addition to the in-housetradersIdealerslinvestmemt officers and other necessary expertisethat contractual savings institutions ought to develops

(j) the consultant should advise on controls that should be built inthe system to trigger action If the performance of any of the fundmanagers or that of any of the key staff of the investmentdepartment falls below the specified standard. The objective ofinstituting such jontrols is to find out about the Impendingdisaster before it happens so that losses are not allowed to ariseor are contained at an early stage;

(k) consultant should be able to specify what would be a desirablelevel of trading (turnover) of securities in the portfolio,keeping in mind the objectives of the fuud and the constraints inthe marketplace;

(1) consultant vwuld liaise, Where considered necessary, vith otherin-house or outside experts such as funds actuary, pensionconsultant, legal advisors, etc. to ensure that maturity profilesof its portf oUo do not mismatch its liability profileg and

5. The Consultant should propose any structural changes that heconsiders necessary in a contractual savings institutions, including changesIn its governing las, the decision-making procedures or the structure of thebody corporate itself,, if in his opinion such changes would lead to betterfund management.

Puss ImrI on- MZAZZQAMB

6* It is expected that once the recommendations have been accepted bythe boards of respective institutions and the government, the second phase ofconsultancy would be initiated to help implement the recommendations

7. The second phase would involve the establishment of the investmentdepartment, selection of key staff, their tralning, setting up of proper fundmanagement accounting and reporting systems, design of forms and stationery,etc. The second phase would also include assistance in the operation ofcontrol and mnitoring system for such period of tine as is necessary tosatisfy the board of the contractual savings Institution about the operationand their ability to discharge their oversight responsibilities.

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ANEXE 12Page 1 of 3

SRr L

PRIVATE FINANCE DEVELOPMENT PROJECT (PMDP)

THE BANK GROUP'-S INTERMEDIARY OPERATIONS

Objectives

1. In support of the main elements of the government's PPPs, IDA'smajor objectives in Sri Lanka are to help promote sustained export-led growth,help reduce poverty and upgrade the country's human capital, and to protectthe environment. In pursuing these objectives through its lending andeconomic and sector work, IDA is giving priority to: (a) macroeconomicstability, emphasizing measures which address internal and externalimbalances; (b) addressing medium-term structural issues by improving theincentives regime and by reducing the size of the public sector whileimproving its efficiency; and (c) directly addressing poverty issues,including mitigating the impact of adjustment on the poor, and removing thephysical and human capital constraints to sustainable long-term growth.

Intermediary Operations

2. While IDA has always maintained a fairly strong presence in SriLanka, its support has been largely dependent on the progress in the policydialogue with the country, and was particularly significant during the majorliberalization period after 1977 when assistance in_reased sharply. In the-id-1980s9 when the country faced ethnic proble.;, the inability of thegovernment to pursue a vigorous economic reform program constrained IDA'scountry assistance strategy in terms of lending support. After 1989, theresumption of a more ambitious reform program was supported through a largerassistance program.

3. As of December 31, 1992, IDA had approved credits totaling aboutUS$1.6 billion (net of cancellations). Although disbursement performance isin line with the average for the region, Sri Lanka's record on projectimplementation needs further improvement. Because of the civil conflict andunsettled conditions in certain areas implementation of a number of projectshas been disappointing. With increasing budget constraints, some projectshave suffered from inadequate counterpart funding in addition to cumbersomein country procurement procedures. These developments led to a decline in theproject (investment only) disbursement ratio from about 21 percent in FY86 toabout 15 percent in FY90 before climbing back up to about 25 percent in FY 91-92. This improvement came about through intensified IDA supervision,increased cost-sharing and joint tackling of systemic issues (e.g.,procurement, disbursement procedures).

4. The promotion of Sri Lanka's industrial and financial sector haslong been an objective of IDA's sectoral policy. This has been considered

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ANNEX 12Page 2 of 3

necessary to: create a stable source of growth and employment; strengthen thebalance of payments through the growth of exports and import substitutesl andstrengthen financial institutions as intermediaries for development financing.Prior to 1977, IDA purcued its limited industrial and financial sectorobjectives through fouw operations channelled through DPCC. However, after1977, IDA's lending operations progressed from direct financial intermediationto a multi-institutional financial sector approach, with operations channelledthrough two specialized DPIs - NDB and DFCC. In 1979, IDA approved the firstof its more sectoral focused operations (the First SM1 Project -- Cr. 942-CE)using the project as a vehicle to initiate the preparatory work for policy andinstitutional reform programs. This was followed by a series of five furtheroperations which alternated funding for SMI operations with that for largescale industry. Each project supported the development and implementation oxthe GOSL's evolving program of trade and industrial reform. Credits for SkIdevelopment approved in 1979, 1982, and 1987 were channelled through DFCC, NDBand the commercial banks, and three Industrial Development Projects (IDPs) forlarge scale industrial investment and important elements of policy reform,approved in 1984, 1985 and 1988, were directed "sing the same channels. Apartfrom the Second SMI Project (Cr. 1182-CE) which was affected by civildisturbances in the southern provinces and initial problems with loan pricing,all of the projects have been disbursed ahead of schedule, with a cumulativecollection rate of more than 80 percent. The SMI projects have beeninstrumental in creating more than 65,000 jobs at a relatively low capitalcost, particularly in areas of non-traditional exports.

5. Performance under the TA component has been satisfactory. Projectimplementation support has resulted in the phased introduction of the reformprograms without major dislocations in the operation of the economy, while theinstitutional development programs have resulted in the diversification ofoperations of the DPIe, the involvement of the commercial banks in projectterm-lending operations, and a steady supply of trained staff for the newbanks that have emerged with the removal of restrictions in the financialsector. Currently, the GOSL and the implementing agencies are in fullcompliance with covenants under the ongoing projects.

6. PCRs and PPARs for the pre-1977 operations (Ln 520-CE, Ln 634-CE,Cr. 565-CE and Cr 742-CE) noted that the projects had provided valuableinsight 2.nto the working of a small DPI and financial intermediary operationin an exqsanding liberalized financial system. The PPARs indicated that theBank-gro4p financing was particularly important in the development of theindustr'.al sector and had helped catalyze the programs of trade and industrialpolicy reform that were to come. The most recently completed industrialprojects (IDP-I1 SM¢-I and -II) focused mainly on the initial actionsnecessary to develop the tariff reform program, rationalize the industrial andexport incentive structures, improve the overall operational viability of thetwo DYIs and broadening the number of financial intermediaries. A 1991 OEDreport ("World Bank Support for Small and Medium Scale Industry in Selected

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A£113 12Page 3 of 3

Countries") noted that the Sri Lanka SMI projects had succeeded in attaininagthe anticipated flow of credit to the target group of borrowers, althoughwhere funds have moved slowly (SMI-I) this has been due to depressed businessconditions, and not to any faulty assessment of particular demand or of PCIcapacity. The ORD report also noted that the SMI projects also generated ahigh level of resource additionality. The report noted that while the SIprojects have had a mixed record (depending upon the perceived objectives i.e.access to credit, policy reforms or institutional strengthening), they haveworked well enough to allow future operations to build on past achievement,broadening coverage and fine-tuning. The last of the SMI projects (SWT-IV,Cr. 2250-CR) for SDR 33.3 million bacame effective on September 30, 1991Although the two SCBs have been excluded since April 1992 from furthercounitments of subprojects from SHI-IV because of their failure to satisfy thecapital adequacy requirements, both commitments and disbursements have beenproceeding ahead of schedule (SDR 7 million has already been disbursed). Inaddition, several policy reforms including: (i) reduction of SCB'sshareholding DECC; (li) provisioning policies to be adopted by the PCts; (iii)introduction of AWDR as a reference rate; (iv) remove legal const^iiats todebt recovery legislation; (v) refining refinancing and reserve .r.auirements;(vii) establishing a credit information bureau; and (vi) strengthening of theaccounting regulatory framework; have already been completed. Some otherssuch as the privatization of NDB, rationalizing and restructuring of NSB,strengthening Bank supervision and regulation, etc. are progressingsatisfactorily.

The Proposed Prolect ,

7. IDA has been pursuing a policy reform dialogue with the GMSL aimedat further strengthening of the financial sector for some time. Zn thisrespect, the Financial Institutions Study conducted by IDA in 1991, andinterim reports of the COSL's Presidential Cammission on Banking and Financefurther defined the changing role of the financial sector and outlined thenecessary sequence of reforms. Although a number of important actions havealready been taken, further reforms are needed to increase mobilization ofdomestic resources for term investments by the private sector and reduce thedetrimental effects of Treasury borrowings at managed rates. IDA will supportreforms of the policy and regulatory environment, especially therevitalization of nonbank financial institutions, the development of anefficient market for public and private debt instruments and the expanelon ofthe private banking sector. The GOSL is now ready to implement the stepsnecessary to address these issues and the proposed project will support thesereforms.

J/ An earlier 1989 Ind4stry Sector Paper (No. 20): "Wortd Bank Lending for Seall and Nadiu Entetprises:Fifteen Years of Experiences, noted that the SRI projects in Sri Lanka ranked among the most successful ofthe 70 operationm reviewed in 36 countrfes.

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A3 13Page 1 of 6

.L,3 Ea= DNVRO PIHT PROJKFl(P)

TlSp8 0113== N THE JM= N 0II gm1 LanK'S

igzaw slsclms N&

1. O i. This documet is intended to provide guidance to thetocbhncal assistance team In developing a plan to modernize Sri Lanka'sTreasury Securities markets. The work is to be phs4ed in over several months.In Phase I of the work, the TL consultants should review prior work on thistopic. They should then create and agree upon an action plan for thesodemnisation of Sri Lanka's Treasury Security markets with the Central Bankof Sri Lanka (CBSL). This plan would be Implemented In Phase II.

2. Concertusl Design Obiectives. The objectives of restructuringSri Lanka9' government securities markets may be sumuarized briefly s8followet

(a) To Lengtbn the TerM Structure of OutstaninA Treasurv Debt. Inthe past, GOSL Treasury paper with maturities of over one yearhave generally been placed directly with publicly-controlledinstitutions at uon-competitive prices. These institutions havetraditionally held this paper to maturity and there has been nosecondary trading in public paper of original maturity of over oneyear. A a result, there Is no meaningful Treasury Yield Curve toserve as a benchmark for other public and/or private issuers ofmedium- and long-term debt.

The GOSL ha already comuceod issuance of Treasury bills withmaturities over 12 months, but tbe demand for long-term Treasurybills ha been rather weak. The GOSL has also initiated action toamend law relating to the issuance of Treasury Securities andBond with coupon rates. These amendments will enable the CentralBank to auction such bonds and securities so that the yield rateswould be determined by market forces.

The Central Bank requises the assistance in developing those newinstruments and improvsng the marketing techniques.

(b) To Broaden and D epem the Markets for Treasury and Private SectorflU. A prinary and secondary market for Treasury bills ofmaturitleu up to a ysr exists in Sri Lanka. The GOSL and CBSLexpect that the currently planned restructuring

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AMNRI 13Page 2 of 6

of the government securities and tradLig infrastructure villbroaden and deepon the markwts for Treasury securities by drawinga wider range of domestic and foreign buyers into the market.That, in turn, should help develop the mzarkets for private sectordebt and lower the cost of issuing and carrying public sectordebt.

The opening of domestic financial sector to foreign investors,however, needs to be studied carefully as a part of a totalpolicy reform related to interest rates, exchange rates andcapital transfers abroad. The Central Bank needs guidelines as tohow Intereat rates and exchange rates should be coordinated whenthe financial market and capital transfers are liberalized.

5¢) To modernize the technical ;nfrastructure for creating, issuing,storing and trading government securities in both the primary andsecondary markets.

3. Review of Prior Work. The GOSL and CBSL have beer aware of theneed to modernize the operation of Sri Lanka's Treasury Securities market foirquite some time. The documents attached to this TOR provide backgroundinformation on this subject that should be reviewed by the TA team.

4. Specific Phase One Tasks. To achieve the foregoing objectives,the following specific tasks should be addressed during Phase One of ti'.projects

(a) Debt Instrument Desiiu. Create a brief description of each typeof Treasury debt security that might help to lengthen, broaden anddeepen the markets for such debt. This should include both fixedand floativ, rate securities.

Review the rationale for the present practice of issuing numerousmQdiumllong term debt instruments (e.g. Government Securities,Treasury Cda and government guaranteed debentures, etc.). TheConsultant should also advise as to how the coupon rates onTreasury Bonds and Securities are to be determined in relation totheir miaturities.

(b) Market Research. Describe how the poteutial markets for new kindsof Treasury issues can best be gauged. Design and describe anypublic education programs that might help attract potential buyersto a broader range of GOSL Treasury issues.

(c) Revised Primarv Auction Procedures. Exactly how should thepresent manually-operated system of gathering, assessing, andawarding successful bids be changed?

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AM= 13Page 3 of 6

(d) Desiam Imnroved Primary snd Secondary aiuAetina Procedures.Assess the recently implemented eystem of using 16 Primary Dealers(PD.) to distribute new GOSL Treasury Issues and then trade themin the secondary market. What, exactly, needs to :e done to workout any flaws in the new system? This should cover, among othert,the following:

(i) Nov could equal opportunities be created to a11 AccreditedPrimary Dealers? At present commercial banks which are appointedas APD8 enjoy a distinct advantage over non-bank APDs, mainlybecause of the availability of zero-cost fund. from depositorsand access to the secondary market window of the Ceutral Bank. Isthere a cm 8 for allowing non-bank APDs also to maintainaccounts r:,:h the Central Bank and engage ln discounting and re-discounting with the Central Bank? Should non-bank APDs beallowed temporary short term liquidity from the Central Bank? Ifwe are to do so, what legal institutional and operational changesare needed?

(ii) At present, commercial banks vhich are not APDs have topurchase Treasury bills at the primary auction through a Dealerbut the secondary market window of the Central Bank is open to allcommercial banks. Is this a consistent arrangement?

(III) At present, unsuccessful bidders at the primary auction usethe secondary market window of the Central Bank to purchaseTreasury bills through commercal banks. Is this practiceconsistent with the objective of promoting secondary marketoperations outside the Central Bank? Also, would not thispractice encourage bidders to offer lower prices at the primaryauction? (Because unsuccessful bidders can turn to the secondarymarket window, without baving to vait for the next primaryauction.)

(iv) At present, government and semi-government institutions,which together form a large segmeat of the market, are allowed tobuy Treasury bills directly from the Central Bank withoutsubmitting competitive bids. Also, these institutions are notrequired to buy Treasury bllls through the APDs. Would not thispractice of suppressing the demand artificially raise the cost ofTreasury bills? Alternatively, should not the facility ofsubmitting non-competitive bids be extended to all investors?

(e) Desian and Provide Preliminarv Specifications for an AutomatedTradina System. This should include a plan for expanding thecurrent Central Securities Depository (CSD) to incorporategovernment securities, as well as a computerized trading networkshowing all connected players wbat trades are occurring, as theyoccur.

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AM 13rose 4 of 6

(f) Demsia a Revised Ststem fom Collecation of Towes gn gais CondAllowsn¢e for Losses) fgom lradin of government Securitesg. Thepresent system of withholding taxes on interet earned from theinitial buyer ha. obvious shortcomings. Now, exactly, should thisbe corrected? Also, bow taxes on capital gain8 from intestmentInto such securtlies be collected?

The present system of recovery of withholding taoe. on Tresurybills applies only to the final holders of bills. Will thisaffect the secondary market operations?

(g) Improve Regulation of the Gcvernment Securitleg Markets. What,exactly, needs to be done to guard agalnst collusion, and toensure safety, soundness and capital adequacy In the system?Review existing regulations and Identify areas of potential risksthat need to be covered by strengthening regulatory framework.Also, what specific role(s) ohould CBSL be prepared to play as"lender of last resort"?

There is also a need to develop a system to collect information onthe trading activities of the APDs end closely monitor theiror erations in Treasury bills . The consultants should provideguidelinea to develop a data base and a monitoring system onPrimary Dealers.

5. Prenaration for Phase Two. The Phase One TA team should alsodescribe exactly what kinds of experts will be needed to implement the pla,and what in-country and other donor resources will be required. It shouldalso develop estimated budgets for both the planning and impleamntationpurposes. Moreover, an estimated set to TINM LINeS for completion of theimplementation phase tinould be included, along with appropriate budget andwork progress reporting formats.

6. PMnsasment Pre&arations for Phbse TiM. finally, a detailed planfor managing the entire project should be prepared, early on. It should stforth proposed working relationships with CB8L, the Ministry of Finance andthe Inland Revenue Division (IID).

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ANNEX 13Page 5 of 6

PEASE II UWLzWTAIN

1. Overview. This document spells out the specific tasks to becompleted by the TA team during the implementation phase of the work. Itflows directly from the TOR prepared for Phase I.

2. Implementation Tasks and Timelines. The following specific tasksand tlmelines are suggested for bringing the implementation plan to fruitions

(a) Instrument Desi_n

(i) Conduct market research on proposed new issues.(ii) Review results with CBSL and the GOSL.(iII) Decide on Instruments to be used.

.,A4v) Prepare legally formatted new instruments.i(v) Prepare descriptive brochures, etc. for marketing new

issues.

(b) Inltiate Marketing Activity

Mi) Prepare and schedule meetings and seminars for prospective., buyers.(ii) Conduct the educational meetings and seminars, etc.(iII) Brief the press and other media.(tv) Conduct manual test marketing, using the proposed new

instruments, prior to completion of the fully automatedtrading systems.

(c). Im=l.ment Revised Auction Procedures

(i) Review and refine present manual procedures for issuingTreasury paper -- to permit both manual and book entryissuance of the new types of instruments.

(ii) Implement revised bookkeeping procedures for automatedbidding, awarding, tracking, and interest and principalrepayments on new issues.

(d) Imolement Revised Secondary Narketina Procedures

(i) Correct any flaws detected in the review of operations ofthe new PD system.

(fi) Respond to any valid feedback from Pds.

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AMIE= 13Page 6 of 6

(e) ImDlement the Automated Traditn System

(iM Expand the scope of existing CSD to encompass governmentsecurities.

(ii) Assist in the expansion of the Communication Network toinclude the dealers in the government securities (theexisting system covers the dealers in the Colombo StockExchange).

(f) Imnlement a New System for Taxina Government Securities

(M) Review and redesign the present system for withholding oftaxes on interest earned.

(ii) Advise on modalities for collection of taxes on investmentgains.

(iiI) Prepare and review with the GOSL's Finance Ministryproposed new regulations to provide a basis for changes inthe tax collection mechanism. Also, assist in the draftingof appropriate changes to the tax code manuals used by IRDand domestic accounting firms.

(iv) Create a new system for reporting interest earned and/orcapital gains to the Inland Revenue Division.

(g) Imulement Improved ReaMlation of the Government SecuritiesMarkets

(i) Advise and implement new capital requirements and interestrate risk control systems for the Pds.

(ii) Advise and implement nw PD examination-visitation plans,formats and work schedules for use by the SEC and CBSLexaminers.

(iII) Advise on emergency intervention plans for CBSL to use inits role as lender of last resort.

3. Prolect Mnamgement. Trackinit and Renortina. Finally, as noted atthe end of the Phase I TOR, a management reporting system should beimplemented early. It should provide specific procedures for detecting andreacting to bottlenecks, off-track tasks, etc.

- 103 - ANNEX 14Pag4 1 of 2

SRI

?XVATU FINANCE DEVELOMT PROJECT (MFP)

SUPERVISION PLAN

Bank Superviion into Key ActMtles

ApproxIut. Date. Activity x"Iected Skills (SW)

July 1993 Supervision Wission - Op. Officer (2)(a) finalization of project Fin. Sector Specialist (2)implementing arrangements, Lawyer (2)staff ng and consultancyrequest for CBSL and k0Ft(b) review of progress oanUSAID-flnanced componentg(e) launching techaicalassistance for Debt RecoveryCourts; (d) follow-up oanconditions of effectivenessand disbursements.

October 1993 Supervision I - Op. Officer (2)(a) follow-up on conditions Fin. Sector Specialist (2)of effectiveness anddisbursement; (b) firstreview of progress inregulatory reforms formarket-based issue of publicsecurities and enforcement ofaccounting standards and banksupervisiong (c) revie theIDt's organization andprocadures for Admin4strativeUnit; (d) launebing of TA oanasset managemat forIPFI/TFIICSLINSB; (e) reviewof restructuring of SCBs.

February 1994 Spervision jssi - Op. Officer (2)(a) review of progress oan Economist (2)USAID-financed c _ m t andregulatory modifications forsecondary trading of T-billa;PCAF; (c) ex-post review ofprojects approved under thefree-limits.

July 1994 Supervision Missioa - review Op. Officer (2)progress: (a) development of Lawyer (2)primary and secondary market Consultant (2)in public debt instruments;(b) on-site and off-site banksupervision and experiencewith implementation of legalreforms; (c) progress inenforcement of accountingstandards; (d) assessment ofdemand under creditcomponent.

- 104 - 14P&Se 20of 2

Bank Sup. ion In Key ... it,.s_

t Appre_te Date. ActLivty |- pected SkifLs (SW)

lovemer 1994 sprision 5sina Op. Officer (2)preparation f taile teon Economist (2)of reforence, staffi" an Lawyer (2)schedule of emecutio of Mid-Ter Revlew of projectimplemtatlon. Revlew ofproject Isplmentation.

May 1995 Joint ank/Governmnt ld- Op. Officer (2)Term eview of progres In Lawyer (2)project implementation. Fln. Sector SpeciaUet (2)

Diebursament (1)

September 1995 Suervislon Oission - Cp. Officer (2)presentation $Md review of Lavyer (1)issues, conclusion and Consultat (2)recal_landationv of Mid-TermReview. Preparation offollow-up actien plan and

pslementing calendar.

January 1996 Suuervision Missios - follow- Op. Officer (2)up of Mid-Term Review action Ind./Reg. BEoonomit (2)plan and revised policymatrix. Review of progressIn project imlementation andother reforms and studies.

July 1996 Supervision Mission - reviw Op. Officer (2)of progrss In projectimplmentatioc an ofoutstanding issues.

Janary 1997 Simervision Mission - review Op. Officer (2)of progress In project Consultant (2)implementation.

July 1997 Supervislon Mission - saeme as Op. Officer (2)above.

Februa*y 1998 uarlisB8o - same as Op. Officer (2)

September 1998 Suuervision MIsSio - sam sS Op. Officer (2)above.

June 1999 SuprvisioW ssion - PCR Op. Officer (2)preparation.

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- 1£

PRIAT FnANCE DEYELOIHKU PEO2IC (ZFRP)

SELZCTED D2CCMENTS AID DATA AVAILABZLa P:OJCT t FIE

A. Sectoral Studies

A. IFinacial Institutions Studys 1990A.2 Induetrl*l Strategy Statements -- GOELt 1989A.3 Interest Rate StructureA.4 Study on Interest Rates on Donor Funds and thsir Ipact on

Development of Private EnterpriseA.5 gEvironmetal Policies and Procedures 1990A.6 Export Development -- Future Program: 1990A.7 Policy Framework Paper: 1992A.$ Country Banking Reports 1992A.9 A New Investment Promotion Strategy for Sri Lanka: 1992A. 10 Improving Colombo Stock Exchange Regulations USASID, 1990A.11 Consolidated Sri Lanka Securities Regulation: W9AID 1990A. 12 A Study of the Regulation of Securities ln Sri Lankas ADS, 1991

B. Project Reports

3.1 Bank of Ceylon (BOC)B.2 Central Bank of Sri Lanka (CBSL)3.3 Commercial Bank of Ceylon (CBOC)3.4 Development Finance Corporation of Coylon (DYCO)3.5 Employees' Provident Fund (EPP)3.6 Employees' Trust Fund (STY)3.7 Hatton National Bank (HMI)3.8 Institute of Chartered Accountants of Sri Lanka (ICASL)3.9 TIsurance Corporation of Sri L-aka (ICSL)B.10 National Development Bank of Sri Lsank (EDD)3.11 National Savings lank (3SB)5.12 Peoples Bank (PB)B.13 Sampath BankB.14 Seylan Bank

C. Working Papers

C.1 Format of Periodic ReportsC.2 Draft Participation AgreemetsC.3 Detailed TORK Environmental Manageet Strategy and Actoa Pla

for the Greater Colombo MetropolisC.4 Survey of High Polluting Industries: 1991

IMRD 23009

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