ASIAN DEVELOPMENT BANK RRP:LAO 33359

REPORT AND RECOMMENDATION

OF THE

PRESIDENT

TO THE

BOARD OF DIRECTORS

ON A

PROPOSED LOAN

AND TECHNICAL ASSISTANCE GRANT

TO THE

LAO PEOPLE’S DEMOCRATIC REPUBLIC

FOR THE

BANKING SECTOR REFORM PROGRAM

November 2002

CURRENCY EQUIVALENTS (as of 1 October 2002)

Currency Unit – kip (KN)

KN1.00 = $ 0.00010 $1.00 = KN10,500

ABBREVIATIONS

ADB – Asian Development Bank APB – Agriculture Promotion Bank BCEL – Banque pour le Commerce Exterieur BFSD – Bank and Financial Supervision Department BOL – Bank of Lao PDR BRIC – bank restructuring implementation committee BSRP – Banking Sector Reform Program EU – European Union FMAC – financial management adjustment credit GDP – gross domestic product IBA – international banking advisor IFI – International Financial Institution IMF – International Monetary Fund IT – information technology Lao PDR – Lao People’s Democratic Republic LMB – Lao May Bank LXB – Lane Xang Bank MFI – microfinance institutions MOF – Ministry of Finance MOJ – Ministry of Justice NPL – nonperforming loan PIU – project implementation unit PRGF – poverty reduction and growth facility PRPA – poverty reduction partnership agreement PSD – private sector development SME – small- and medium-sized enterprise SOCB – state-owned commercial bank SOE – state-owned enterprise TA – technical assistance TOR – terms of reference

NOTES (i) The fiscal year (FY) of the Government and its agencies ends on 30 September.

(ii) In this report, "$" refers to US dollars

This report was prepared by a team consisting of: Eric Manes (Team Leader), Brett Coleman, Rita O’Sullivan, Lu Shen, and Samiuela Tukuafu.

CONTENTS

Page

LOAN AND PROGRAM SUMMARY ii

MAP viii

I. THE PROPOSAL 1

II. THE MACROECONOMIC CONTEXT 1

III. THE SECTOR 2 A. Sector Description and Performance 2 B. Issues and Opportunities 5

IV. THE PROPOSED PROGRAM 7 A. Objectives And Scope 7 B. Policy Framework and Actions 7 C. Important Features 15 D. Financing Plan 16 E. Implementation Arrangements 17

V. TECHNICAL ASSISTANCE 20 A. The Technical Assistance Grant 20 B. Related Technical Assistance 21

VI. PROGRAM BENEFITS, IMPACTS, AND RISKS 21 A. Benefits and Impacts 21 B. Risks 22

VII. ASSURANCES 23

VIII. RECOMMENDATION 23

APPENDIXES 1. External Assistance and IFI Coordination in the Banking Sector 24 2. Development Policy Letter 26 3. Policy Matrix 33 4. Program Framework 40 5. Schematics of Implementation Arrangements 46 6. Ineligible Items 47 7. The Technical Assistance Grant 48 8. Poverty Impact Assessment 55

SUPPLEMENTARY APPENDIXES (available upon request) A. Financial Sector Note B. Approach to Restructuring State Owned Commercial Banks C. Draft Governance Agreements for BCEL and TPL (the new bank) D. Medium-Term Fiscal Framework

LOAN AND PROGRAM SUMMARY Borrower The Lao People’s Democratic Republic (Lao PDR) Classification Poverty Classification: Other

Thematic: Economic growth, good governance, private sector development

Rationale The Lao PDR’s financial sector is barely 10 years old, but has

already been through a relatively turbulent period. It is dominated by banks, most of which are state-owned. Until recently, the state- owned commercial banks (SOCBs) have been used as instruments of policy and state-owned enterprise (SOE) financing at the expense of their commercial orientation and financial strength. The Agriculture Promotion Bank (APB) is still considered a policy bank, although the Government’s vision is to transform it into a market-based rural finance institution. Branches of foreign banks in Vientiane maintain limited operations, and serve predominantly foreign clients.

In addition to the large fiscal costs, and associated macroeconomic risk, the legacy of state ownership has contributed to a governance system that may not be fully compatible with sound banking practices. The unpredictable character of the commercial system suppresses the entrepreneurial activity needed to achieve the higher growth path required to graduate from least-developed-country status by 2020.

In a market oriented economy the financial sector is strategically important. The rationale for the Banking Sector Reform Program (BSRP) is therefore the need to open the sector to increased private participation through improved governance and incentives in banks, and a strengthened environment for the enforcement of loan contracts. The Program supports meaningful changes in the way the commercial system operates and addresses conditions to extend financial services to the large part of the population that has no access to such services.

The BSRP loan is embedded in a broad framework of macroeconomic, fiscal, and commercial reform supported by the International Monetary Fund (IMF) through its poverty reduction and growth facility (PRGF) approved in April 2001, and by the World Bank through its financial management adjustment credit (FMAC) approved in June 2002

Environment Assessment

C The environmental implications are minimal.

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Objectives and Scope The objective is to support Government efforts to foster efficient financial intermediation and ensure a sound banking system capable of supporting growth and rural outreach. Specifically, the Program will

(i) support sound banking through improved governance practices;

(ii) mobilize the judiciary to use a strengthened legal system and the Bank of the Lao PDR (BOL) to use an effective prudential regulation system to bring failed borrowers, strategic defaulters, and unsound banks to account;

(iii) foster a competitive, predictable commercial environment for all banks; and

(iv) provide the opportunity for a range of institutional models and methodologies for extending financial sector outreach.

To achieve this objective, the BSRP loan will support programs in

five interdependent areas:

(i) restructuring the banking sector through reducing the number of SOCBs, increasing competition, and operational restructuring of the remaining SOCBs;

(ii) improving the legal framework and judicial capacity to support loan collection and collateral enforcement;

(iii) facilitating access to finance by small- and medium-sized enterprises (SMEs) through a secured transactions system and improved financial disclosure;

(iv) developing a policy and institutional environment conducive to rural and micro finance; and

(v) undertaking strategic planning for the period (2006–2010) beyond the current restructuring program.

Financing Plan The Government has requested the Asian Development Bank

(ADB) to provide a loan of $15 million from ADB’s Special Funds resources. This amount was determined through ADB’s continued dialogue with the Government. It takes into account the depth and scope of the proposed policy reforms, and the estimated short- and medium-term adjustment costs associated with adopting the policy matrix. The Borrower will be the Lao PDR. The loan will have a repayment period of 24 years, including a grace period of 8 years. An interest rate of 1% per annum will be charged during the grace period and 1.5% per annum thereafter. The loan is expected to be utilized over 48 months from loan effectiveness. The proceeds may be used to finance eligible imports for the period 180 days before loan effectiveness.

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Program Period and Tranching

It is proposed that the loan consist of three tranches that will be disbursed when ADB is assured that the conditions for release are satisfied. The first tranche of $5 million will be made available following loan effectiveness. It is envisaged that the second tranche of $5 million will be disbursed within 19 months after the first tranche release, subject to the Government's compliance with conditions. The third tranche of $5 million is expected to be disbursed within 15 months after the second tranche release, subject to the Government's compliance with conditions. ADB and the Government will review progress in implementing specified policy actions set out in the policy matrix 3 months before the scheduled tranche release.

Executing Agency The Executing Agency will be the BOL, which will have overall

responsibility for ensuring timely program implementation and reporting to ADB on progress made, problems encountered, remedial actions taken during the previous quarter, and proposed program activities during the next quarter. Implementing agencies will include BOL, Ministry of Finance (MOF), Ministry of Justice (MOJ), and the SOCBs, which will have responsibility for effective day-to-day implementation of their components under the Program.

Implementation Arrangements

The Executing Agency will establish a bank restructuring implementation committee (BRIC), chaired by the deputy governor of BOL. The BRIC will be empowered to oversee program implementation and ensure that the proposed reforms are undertaken in accordance with the agreed-upon timetable. The members will initially include the chairmen of the four committees that designed the program (Bank Restructuring Committee, NPL Committee, Human Resource Committee, and the Information Technology Committee).

The BRIC will coordinate closely with (i) the implementing

agencies; (ii) other key departments in BOL, such as the Bank and Financial Supervision Department (BFSD) and Internal Audit; (iii) other ministries with interest in the BSRP, such as Ministry of Labor and Social Welfare and Ministry of Security; and (iv) other relevant TA steering and policy committees, particularly the Rural and Micro Finance Committee and the prospective program management unit of the European Union (EU) Bank Training Project. The BRIC will meet at least quarterly to review progress reports and guide program implementation.

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Procurement The loan will finance the full foreign exchange costs, excluding local duties and taxes, of imports procured in and from ADB’s member countries, other than those specified in ADB’s list of ineligible items and items financed by other multilateral and bilateral official sources. Items eligible under ADB loan will be procured through normal commercial practices for procurement by the private sector or standard Government procedures for procurement by the public sector that are acceptable to ADB. In the case of goods commonly traded on international commodity markets, procurement will follow procedures appropriate to the trade and acceptable to ADB.

Counterpart Funds The Government will use counterpart funds to finance the local

currency costs of implementing the Program and other activities consistent with the objectives of the Program.

Program Risks As the Program is based on the assumption of a stable

macroeconomic environment, any violation of this could adversely affect the financial performance of the SOCBs. The macroeconomic risk is being minimized through the monitored fiscal and monetary framework under the IMF’s PRGF, attention to better financial reporting and limits to credit expansion under the World Bank’s FMAC, and the emphasis on sound banking, financial disclosure, and performance monitoring under the proposed BSRP.

The second risk concerns the ability and will of the Government to implement the broad reform program and the possibility that provincial authorities may be opposed to reform. The risk is being mitigated by a continuation of the year-long program of ownership building; strong aid coordination; a front-loaded, performance-based program design; and flexible program parameters. Government commitment to carry out and sustain the range of reforms under the Program is demonstrated by up-front actions of merit already taken.

The third risk is that the proposed reforms will be undertaken by ministries, officials, and bankers that are relatively inexperienced and lacking in technical knowledge. This risk is addressed through a significant amount of TA in the form of resident advisors, coupled with formalized training courses and basic training in standardized loan documents and required financial statements. In addition to resident international banking advisors (IBAs) inside the SOCBs, there will be resident advisors to the BRIC and to the judiciary. The deployment of multiple advisors to help implementation will be balanced with country ownership concerns through care in designing terms of reference, which maintains appropriate accountability.

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The fourth risk is that restructuring the SOCBs may result in redundancies and this could lead to resentment and grassroots resistance, especially in the provincial branches. Consultation and awareness building have begun and will continue throughout implementation. The Government, in consultation with the stakeholders and as agreed upon with ADB, has also committed that mitigation measures will be an integral part of the restructuring program, should there be adverse effects on vulnerable SOCB staff.

Technical Assistance

The Technical Assistance Grant

The objective of the technical assistance (TA) grant is to support the Government’s efforts to implement the reform program. The goal of the TA is effective banking sector restructuring, nonperforming loan (NPL) resolution and legal/judicial capacity building to promote financial sector development. The TA aims to:

(i) strengthen Government oversight of bank restructuring;

(ii) assist SOCBs develop and implement NPL resolution strategies;

(iii) establish the commercial division of the court and strengthen the legislative framework for commercial transactions; and

(iv) assist in refining, disseminating the banking legislative framework and standardizing loan documentation.

Consulting services of 53 person-months–23 international and 30 domestic consultants–will be required. The TA grant consists of $900,000: $750,000 from ADB TA Special Fund and $150,000 from the Canadian Governance Fund to finance judicial training.

Related Technical Assistance

A complementary TA loan of $4 million is being processed in parallel to finance two resident IBAs in each of the two SOCBs for 3 years, and to upgrade information technology for the banks to support the governance improvements, cessation of loss making activities and operational efficiency gains.

Rural finance activities are being supported by a Rural and Micro Finance cluster TA and the secured transactions system will be supported by a private sector development advisory TA in 2003.

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I. THE PROPOSAL

1. I submit for your approval the following report and recommendation on a proposed program loan to the Lao People’s Democratic Republic (Lao PDR) for the Banking Sector Reform Program (BSRP). The report also describes proposed technical assistance (TA) for Banking Sector Reform and Judicial Strengthening, and if the Board approves the proposed loan, I, acting under the authority delegated to me by the Board, will approve the TA.

II. THE MACROECONOMIC CONTEXT

2. The country’s transition to a market-oriented economy was initiated in 1986 with the adoption of the New Economic Mechanism. During the initial period, the Government pursued a number of important reforms, most notably redefining and limiting the role of the state in the allocation of resources. Key actions included price and trade liberalization, introduction of business legislation, the return of agriculture production to private households, privatization of state-owned enterprises (SOEs), and establishment of a two-tiered banking system. The transition had a strong impact on the economy and growth averaged 6-7% during the period. 3. Reform momentum weakened during the middle of the 1990s. Beginning in 1997, on the heels of the Asian crisis, the Government pursued an expansionary fiscal policy financed by central bank credit. Given the already high degree of currency substitution, inflation increased to 128.4% in 1999 and the kip depreciated sharply. Losses accumulated in the banks and enterprises, as unhedged firms and banks were unable to offset the detrimental effect of inflation and currency depreciation. Recognizing the severe cost of high inflation, the authorities embarked on a stabilization program in mid-1999 and, over the next 18 months, reestablished a stable macroeconomic framework. 4. Since 2000, the Government’s macroeconomic management has been successful, although the tenuous fiscal situation and persistent dollarization have kept the macroeconomic stability fragile. In April 2001, the International Monetary Fund (IMF) approved a 3-year arrangement under the poverty reduction and growth facility (PRGF). Macroeconomic performance in the first year of the PRGF was generally satisfactory, as inflation remained at around 7% and the economy expanded at 5.2% despite a slowdown in the regional economy. Preliminary evidence suggests buoyant economic activity in the first half of 2002, contained inflation at 7.5%, and a relatively stable exchange rate. 5. The linkage between macroeconomic stability and bank soundness is particularly acute in the Lao PDR. The financial structure of the state-owned commercial banks (SOCBs) is highly sensitive to price and exchange rate movements due to large exposure in foreign currency assets and growing foreign currency liabilities. Financial sector restructuring, in concert with other sectoral reforms, is therefore needed to prevent the economy from entering into the vicious circle of bank losses exacerbating macroeconomic instability, which, in turn, will create further losses and greater macroeconomic instability. The fragile macrostability and the vulnerability of bank soundness to renewed price and exchange rate pressures make the task urgent. 6. The Government recognizes that sustaining the recent success in stabilizing the economy depends on continued diligence in macroeconomic management and deepening structural reforms to help propel the economy to a higher growth path. Moreover, for wider poverty reduction, increased growth will have to be complemented with increased fiscal resources to enable Government expenditure to address activities with high social return. Fiscal pressure brought on by large losses in the financial sector restricts the Government in fulfilling its social sector mandate.

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7. Looking to the future, the Government and the Asian Development Bank (ADB) signed a poverty reduction partnership agreement (PRPA) on 28 September 2001 that lays out a short- medium- and long-term vision for reducing poverty in the Lao PDR. The PRPA signals ADB’s support for the Government program to develop the economy and assistance to enable the country to graduate from least developed status by 2020. The key pillars include sustained macroeconomic stability, increased growth through an improved commercial environment, development of a financial system that supports private sector growth, considerable improvement in terms of outreach, and promotion of good credit culture. As an integral part of the PRPA and to complement the fiscal, monetary, and structural efforts under the IMF PRGF and World Bank financial management adjustment credit (FMAC),1 activities targeted under the BSRP loan form pillars for a privately driven commercial system that is needed to support new productive activities and increased access to financial services.

III. THE SECTOR

A. Sector Description and Performance

1. Overview

8. The financial sector remains small relative to other countries and the services provided are limited. Financial services reach only a small part of the population. The ratio of broad money to GNP increased from 7.5% in 1990 to around 20% today. The sector is dominated by banks and there is only one insurance company. There are no leasing companies, and no other non bank financial institutions. Financial services reach only a small part of the population and the services delivered, with a few exceptions, are not being provided on a sustainable or efficient basis. 9. Private sector development (PSD) objectives started with efforts to privatize, lease and liquidate a large number of SOEs; establish a legal basis for private production; and build legal and judicial institutions. However, efforts in this area slowed during the mid-1990s. Similar to historical trends in other countries, there is currently in the Lao PDR a pervasive financial indiscipline as many commercial principles taken for granted in post-transition economies are only now being considered as desirable and inalienable. New laws and regulatory frameworks are not well understood and are inconsistently enforced, resulting in a poorly defined and opaque legal framework for business. As a result, rule-based discipline in the economy is weak, leading to weak borrowers and weak banks.

2. Commercial Banking

10. The Lao PDR banking sector is small at around $400 million2 in total assets. It employs around 1,500 people and is dominated by one relatively large and two smaller SOCBs, which account for 70% of the total gross assets of the banking system.3 Branches of several foreign banks started operating in Vientiane in the early 1990s, but deficiencies in the banking environment, particularly the legal framework, and limitations on their activities have contained their contribution to the domestic economy.4

1 The preparation and design of the BSRP loan was coordinated with the PRGF presented to the IMF Board on April

2001 and the FMAC presented to the World Bank Board in June 2002. 2 Banque pour le Commerce Exterieur (BCEL) is the former foreign trade bank (accounting for 50% of total gross

banking assets). Lane Xang Bank (LXB) and Lao May Bank (LMB) account for about 20% of total banking assets. 3 In comparison, the Vietnamese banking sector has $11.7 billion, while Cambodia has $245 million of assets in its

rudimentary banking sector. 4 There is a joint-venture (Lao-Viet) and a private domestically owned bank (Vientiane Bank) but both are very small.

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11. The current state-owned banking sector was initiated in the Lao PDR in March 1988 with Decree no. 11 and finalized with the promulgation of the Central Bank Law in 1990 which established a two-tiered system. Three commercial banks were established immediately on a regional basis, followed by four more in 1990 and 1991 to provide banking services to the provinces. The establishment of the banks came with portfolios of bad assets built up by the old State Bank of Lao. Privatization and liquidation of many SOEs in the early 1990s further eroded the asset quality of the balance sheet. Shortly after issuing the first set of banking regulations5 through Decree 3, the Government capitalized the banks in mid-1993, bringing them to sound levels of capital adequacy with bond and cash injections. 12. SOCB performance since the first capitalization in 1993 has generally fallen short of expectations. In 1999, the Government merged six small unsustainable regional and provincial banks into two new SOCBs (LXB and LMB), and planned to clean up pre-2000 nonperforming loans (NPLs) for them and for BCEL in exchange for governance improvements and measurable operational change. In 2000 and 2001 however, the three SOCBs continued to generate losses. The losses were caused by (i) continuation of asset deterioration due to continued credit indiscipline of banks and borrowers; (ii) large revaluation losses due to currency devaluation effects on unhedged balance sheets, resulting from poor lending practices in the past and the legacy of macroinstability; and (iii) high noninterest expenses for staff, branches, and capital. 13. The principal issues facing the SOCBs today therefore have both stock and flow dimensions. The legacy of foreign currency loans to unhedged customers, directed lending for noncommercial activities, loans to SOEs, and nonpayment of central and provincial authorities to bank customers for government contract work left a $50 million deficit in the balance sheets. On the flow side, despite some recent success in credit policies, NPL collection, and corporate management, the improvements have not been sufficiently deep nor have they been sustained long enough to meet the formidable challenge of a significant change in financial performance. 14. SOCBs continue to suffer from a wide range of fundamental institutional weaknesses. Internal factors range from limited human resource capacity, inadequate information technology, overstaffing, inadequate attention to prudent risk management, to the lack of effective governance structures–boards, committees, policies, and procedures. External factors that have limited improvements on the SOCB financial position include debt overhang from macroeconomic instability prior to 2000, deficiencies in the judicial and loan security system, a historical need to support government policy objectives and SOEs, and private sector borrowers with limited capacity to present bankable projects. 15. The Government deemed improvements to the banking environment and in the institution’s operations (governance improvements) to be prerequisites to reviving the banks’ balance sheets. However, initiation of a comprehensive, front-loaded program of operational restructuring recently took on a new urgency. Improved financial transparency in recent months indicated an unsustainable growth in NPLs since 2000–particularly in one bank–and a worrisome growth in assets of questionable quality in another, raising the specter of accelerated asset deterioration and a significant increase in restructuring cost.

3. Private Sector Provision of and Access to Bank Finance

16. The Government recognizes that inevitably the private sector has a major role to play in future development and that a sound banking system is essential if the private sector is to meet its full potential. Currently, private sector firms are small–over 90% are owner-operated–and

5 The regulation (i) defined the criteria for establishing a commercial bank, (ii) defined the business of a commercial

bank, (iii) defined the rules for the boards of directors, and (iv) gave BOL oversight responsibility.

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only a small proportion of small- and medium-sized enterprises (SMEs) have access to commercial bank financial services. Historically, private enterprises, particularly SMEs, have been crowded out of SOCB financing by larger firms. Private firms also have difficulty obtaining financing from the private banks in Vientiane because of an inadequate system for collateral valuation and enforcement, along with a general lack of capacity to prepare basic financial statements and present bankable projects. 17. In order to address these problems, a secured transactions law was introduced in 1996 and was made operational through an implementing decree in 2000. However, the system has not become functional despite the legal requirements that all bank loans must be securitized. Three problems exist: (i) deficiencies in the original law and implementing decree impede their application and enforcement, (ii) lack of functioning computerized secured transactions registry, and (iii) limited knowledge and training for participants under the new system. Similarly, despite a law requiring that all medium-size companies prepare audited financial statement and despite credit policies and prudential regulations requiring borrower’s financial information as the basis for a loan or a restructuring, preparation of financial statements by banks borrowers is practically nonexistent.

4. Micro and Rural Finance

18. The Lao PDR remains largely agricultural and rural. Eighty-five percent of the workforce is engaged in agriculture, which generates over half of the gross domestic product (GDP) and, 90% of the poor live in rural areas. However, the financial sector in the Lao PDR has, to date, achieved a low level of outreach in rural areas. Surveys estimate that only 11% of rural people have the ability to access formal financial institutions, and only 1% currently save in the banking sector. 19. Government policies and institutional weaknesses also contribute to the low outreach. Current policy to support access to rural finance has been implemented primarily by the Agriculture Promotion Bank (APB). The government subsidizes APB's operations and controls APB’s interest rates. In addition, APB’s lending has been largely directed by the Government, which has contributed to operating losses and a high level of problem loans. The actions distort APB’s service provision to clients and result in misallocation of resources, crowding out of commercial finance by microfinance institutions (MFIs) and other banks, and the need for the Government to periodically recapitalize APB. Furthermore, current restrictions on interest rates and private ownership limit the development of MFIs, hence hindering the development of a competitive marketplace. Institutionally, APB carries out a multitude of financial and non-financial activities, reflecting its mixed mandate as a financial institution and development organ of the state. As a result, its operations are inefficient, and management autonomy and responsibility are limited. Finally, prior to 2002, APB had never been audited and it has never published its financial statements, making its financial situation (and, therefore, costs to the budget) unclear to stakeholders. 20. Given the difficult operating environment for rural finance, the Government envisions a variety of financial service models to support the development of the rural sector. Though still underdeveloped,6 pilot projects are beginning to demonstrate the validity of microfinance in the Lao PDR. To date, however, the growth and sustainability of these pilots have been hindered by lack of clarity (i) in the legal and regulatory environment for rural and micro finance,7 and (ii) regarding the appropriate role of APB in the future development of the sector. 6 Currently, the three largest MFIs collectively reach about 10,000 clients, and an estimated 1,600 village revolving

funds serve about 8,000 active borrowers. Few of these are operating on a sustainable basis because of operational inefficiencies and caps on the interest rates that they charge.

7 There are currently no regulations for MFIs other than the credit cooperative regulations and APB's own credit union regulations.

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B. Issues and Opportunities

21. The Government has adopted a goal of achieving sustained poverty reduction and graduating from least developed country status by 2020. This will require (i) continued price and currency stability, (ii) the development of a sound and efficient financial system, and (iii) a robust private sector operating by commercial rules and reaping commercial rewards. 22. These goals were stated objectives of previous interventions and remain priorities of the Government’s strategy, as they continue to be key prerequisites to sustained growth and poverty reduction. The BSRP loan builds on these past interventions by (i) carrying forward to the next stage areas initiated under previous financial sector operations, such as strengthening the legal and judicial system to support commercial transactions; (ii) revising activities that were less successful but even more urgent than before, such as restructuring the SOCBs; and (iii) supporting reforms in new strategically important areas, such as rural and micro finance. 23. ADB’s support for the Lao PDR’s financial system started at the beginning of the transition. The first program loan8 supported the formulation of the legal, regulatory, and institutional framework for a two-tiered banking system, monetary management, and private sector development. The second program loan9 furthered the initiatives covering monetary management, and financial and legal infrastructure, and extended the financial infrastructure to banking by strengthening prudential supervision and borrower credit information. 24. These programs were successful in (i) helping the Government manage the transition from the monobank directing credit by administrative order to the mixed system of today; (ii) building the basic legal, financial, and institutional infrastructure needed to operate monetary policy through a financial system; (iii) creating greater transparency and directing attention to the financial accountability of institutions; and (iv) improving the skill sets of bankers with extensive technical assistance in credit risk management, financial management and strategic planning. 25. Both programs also sought to build sound state-owned banks by cleaning up their NPL-impaired balance sheets,10 but subsequent performance fell short of expectations.11 Although these programs were successful in many respects, they had limited success in improving governance arrangements both within and without the SOCBs . In addition to detrimental moral hazard issues arising from the approach to balance sheet restructuring, insufficient attention was given to fundamental operational change and to introducing incentives regimes inside the banks. The inability of the judicial and prudential regulatory systems to enforce discipline and ensure soundness12 weakened program outcomes. 26. Because of the limited operational change and the low degree of financial discipline throughout the economy, SOCBs have chronically underperformed and the banking system requires capital support despite capitalization less than 10 years earlier. The current financial 8 ADB. 1990. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Lao

People’s Democratic Republic for the Financial Sector Program . Manila. 9 ADB. 1996. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to Lao

People’s Democratic Republic for the Second Financial Sector Program. Manila. 10 Under the first Financial Sector Program Loan, $14 million of bonds and cash was injected to bring capital

adequacy up to regulatory levels in seven banks. The second Financial Sector Program Loan proposed a $50 million injection to raise capital adequacy back to 8%, contingent on improvements in governance.

11 ADB. 1999. Technical Assistance Performance Audit Report on Selected Financial Sector TAs. ADB. 2001. Project Performance Audit Report on the Financial Sector Program Loan in the Lao PDR and ADB. 2001. Project Completion Report on the Second Financial Sector Program Loan in the Lao PDR . Manila.

12 The legal, regulatory, and supervisory framework was strengthened under the second Financial Sector Program Loan but has not been effectively applied to date.

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position and direction of the SOCBs pose a macroeconomic threat, as restructuring costs are rising at more than 1% of GDP every 2 years. Though possibilities for short-run turnaround is limited given the entrenched NPLs and the highly exposed foreign exchange position, the macroeconomic situation still requires urgent attention to address the long-run health of the banks. 27. Equally importantly, the continuation of NPLs signals that substantial improvement in financial discipline is required to enable the banking sector to reorient itself and provide the conditions to attract private sector participation. Global experience shows that a sudden move toward private ownership of banks immediately following a lengthy period of state ownership could be risky since the level of institutional development and sophistication in the banking environment would be insufficient to attract foreign banks and other reputable domestic investors.13 Thus, simultaneously increasing private bank participation, preparing SOCBs for potential investment and addressing weaknesses in the incentive system would seem to be most prudent strategy. 28. Given the strategic importance of the financial sector, the rationale of the Program is based on a need to sustain the hard-earned macroeconomic stability while improving a commercial incentives regime for banking, strengthening the enabling environment, particularly in the area of loan contract enforcement, and opening the commercial market to increased private participation. At the same time, the lack of access of a large part of the population to financial services makes it imperative to improve the sustainable outreach of the financial sector. The recently enhanced Government awareness of the role of the financial sector in overall macroeconomic stability and growth provides an opportunity to foster meaningful change in the daily operations of the commercial system. 29. To capture this opportunity, the BSRP builds on the successes of previous interventions while incorporating lessons learned from a decade of assistance to the Lao PDR. Such lessons include: (i) the reform must be owned and implemented by the Government; (ii) strong coordination among all aid agencies from design through implementation allows a unified dialogue and supports Government ownership; (iii) moral hazard is minimized only if fundamental operational changes precede financial restructuring; (iv) in the absence of market-based corporate governance, operational restructuring requires performance incentives (rewards and penalties) and a focus on outcomes as success indicators; (v) TA should be deployed alongside a set of policy actions as mutually reinforcing activities; and (vi) SOCB restructuring should be seen as an opportunity to make other parts of the commercial system operate. 30. The current reform effort embodies a strong sense of Government ownership. A high-level policy workshop in February 2001 was the culmination of a Bank of the Lao PDR (BOL)-led in-depth review (Supplementary Appendix A) 14 and policy dialogue on the state of the financial and banking sector in the Lao PDR. The workshop then initiated a year-long series of open, inclusive workshops to build consensus, knowledge, and capacity to design the bank reform program. The result is a multiyear, multisector, Lao-owned reform program that views outcomes, not processes, as the objective. 31. In terms of aid coordination, the strategic importance of the financial sector to the future growth of the Lao PDR economy is evident through the wide interest and support from the aid community. The Government’s consensus-building process involved extensive consultations with the aid community and resulted in a program that actively promotes the deployment of aid agency programs in an integrated and mutually reinforcing way. In particular, the current reform

13 The World Bank, 2001 Finance for Growth: Policy Choices in a Volatile World, Oxford University Press, pp137-138. 14 Bank of Lao PDR, ADB, and the World Bank. 2002. Lao PDR: Financial Sector Note .

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program is being supported by a series of interventions from the three international financial institutions (IFIs) around a common policy matrix. The IMF PRGF provides the overall macroeconomic framework, monitors structural benchmarks, and identifies ADB and the World Bank as assisting the Government in designing and implementing key structural reforms for the banking and enterprise sectors.15 The World Bank FMAC lays the foundation for bank restructuring by focusing on (i) greater transparency and improved reporting; (ii) autonomy of the management in appointing the SOCB management team, deciding on lending and setting interest rates; (iii) limits on credit expansion; and (iv) addressing a major cause of NPLs through its SOE restructuring component. Assistance from other sources is also being deployed within this common framework (Appendix 1).16 32. The goal is to build financial discipline, a credit culture, and corporate governance as the foundation of a commercial system. Specifically, BSRP will (i) cause banks to “earn” replacement of pre-2000 loans as a reward for substantial operational changes that yield measurable results; (ii) administer incentives through performance benchmarks in key governance areas with penalties for underperformance; (iii) improve the effectiveness of human resource capacity building by deploying formal training together with on-the-job training by the international banking advisors (IBAs); (iv) through the NPL resolution process, force NPL cases through the court system to foster a demand for judicial strengthening and an enforcement program; (v) use the experience and scale economies generated by SOCB restruc turing to assist in APB restructuring in the later phases of the program; and (vi) through good credit policies, cause private enterprises to prepare financial statements and business plans, thereby creating a demand for accounting and other business services.

IV. THE PROPOSED PROGRAM

A. Objectives and Scope

33. The objective of the Program is to support Government efforts to foster efficient financial intermediation and ensure a sound banking system capable of supporting economic growth and extending rural outreach. The objective will be achieved through an improved operating environment for the banking sector, the immediate application of commercial principles in SOCB operations, and increased diversity in forms of rural financing, as described in the Government’s development policy letter (Appendix 2). 34. The BSRP loan will support initiatives in four specific areas: (i) restructuring the banking sector, including reducing the number of SOCBs, improving the commercial environment for all sound financial institutions and carrying out an extensive program of operational reform of the remaining SOCBs involving shrinking the balance sheets and aggressive NPL collection; (ii) improving the legal framework for loan collection and collateral enforcement; (iii) improving the secured transactions system, and better financial disclosure; and (iv) developing a market-oriented policy and institutional environment conducive to rural and micro finance. As the Program supports a major step toward future financial and private sector development, strategic planning for the 2006-2010 post-restructuring period will be undertaken. B. Policy Framework and Actions

35. The BSRP supports a framework designed after more than a year of preparation and discussions with the Government, IMF, and World Bank. It was developed with recognition of the duration needed to strengthen implementation capacity, and the urgent need to achieve 15 In addition, IMF is providing TA in support of the program’s banking supervision goals. 16 The Australian Agency for International Development financed audits of SOCBs covering the last 5 years and the

European Union (EU) is providing formal capacity building for SOCB and BOL staff. There is also strong coordination with other aid agency projects in the banking sector.

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measurable and credible change in SOCBs’ performance. As such, the policy matrix (Appendix 3) reflects immediate change in the behavior of the SOCBs, coupled with medium-term reforms in the legal framework, the judiciary, banking supervision regulations, and rural finance. The program framework is in Appendix 4.

1. Develop the Banking Sector

36. Restructuring of the banking sector is a high priority in the Government’s program for macroeconomic stability and private sector development. The BSRP loan will support the Government’s operational strategy of eliminating unsound parts of the system. The strategy entails (i) structural changes in the sector; (ii) major operational change inside the SOCBs, including human resource development; (iii) a capital buildup program for the SOCBs centered on intensive efforts at resolving current NPLs; and (iv) complementary measures in other parts of the environment to build a credit culture and give good borrowers access to finance.

a. Prior Actions

37. Recognizing the urgency of banking reforms, the Government has already taken steps to prepare for restructuring of SOCB operations. Prior actions cover four areas: (i) improved financial disclosure and restraints on credit growth, (ii) improved SOCB governance and autonomy, (iii) broad agreement on and commitment to principles and actions underlying SOCB restructuring, and (iv) initiation of actions to restructure the SOCBs, including NPL collection activities. 38. To limit the moral hazard pressures before restructuring, a set of interim measures was put in place in 2001 and 2002 to (i) strictly apply BOL regulations on loan classification and provisioning, (ii) ensure external audits are conducted and financial reporting to the supervisory authorities is of high quality, (iii) prohibit lending to borrowers in default, and (iv) apply sector-wide ceilings on SOCB credit growth17 as well as bank-specific restrictions in the case of unsustainable asset quality.18 SOCB governance was strengthened through: (i) shareholder commitment to the application of commercial principles to all lending; (ii) increased board and management autonomy in key decision making areas including credit, branch management, and interest rate determination; and (iii) limits on the credit authority of branches. 39. The Government completed preparations for a comprehensive restructuring program for the operations and finances of SOCBs and APB. In the case of SOCBs, restructuring principles were defined in the memoranda of understanding for restructuring signed in March 2002, a business plan framework agreed to in May 2002, culminating with detailed plans committed to in the form of governance agreements. The principles embodied in these agreements include (i) a performance-based approach to restructuring and contingent actions in the case of underperformance; (ii) phased, conditional, and limited capital injections; and (iii) deployment of IBAs in the SOCBs. 40. Implementing the Program for both the SOCBs and APB has begun. The plan for consolidating the two smaller banks has started and the process of appointing new members of the boards and management team of the two banks and their IBAs is at an advanced stage. The NPL resolution plan that began with a comprehensive review of each account has already yielded more than KN40 billion in collections by the three SOCBs this year. For APB, an operational diagnostic and the first ever external audit were completed, and a corporate vision to guide restructuring has been adopted by the APB board of directors.

17 PRGF program requirements include yearly targets on SOCB credit expansion. For 2002, the ceiling is 18%. 18 A FMAC condition prevents any expansion of the net risk portfolio if NPLs are greater than 15%.

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b. Structural Changes in the Banking Sector

41. To achieve structural change in the banking sector, the BSRP loan will support, in the first year, (i) a reduction in the number of SOCBs from three to two, (ii) a shrinking of the balance sheets of the remaining SOCBs, and (iii) a more open environment conducive to sound banking practices. 42. Complementing this shrinkage of the unhealthy parts of the banking sector, the Program supports the development of a forward-looking Government strategy to encourage a diverse, competitive, and commercially oriented financial sector. A key objective of the strategy will be to increase the contribution of private banks to economic growth. Disciplined SOCBs, coupled with reforms in the judiciary and improved financial disclosure of borrowers, will encourage private sector banks to participate more in the Lao economy. In the meantime, the Government has provided some relief from new capital requirements for foreign banks currently operating in the Lao PDR and will introduce a new Decree Law on Commercial Banks, which will promote good banking, good governance, and competitive environment.

c. Operational Restructuring of the Remaining SOCBs

43. Board chairpersons and management teams will take the major responsibility for managing the restructuring while at the same time absorbing intensive, on-the-job training. To guide the restructuring program, the Government and SOCBs are introducing: (i) “governance agreements,” which involve binding commitments on the part of the SOCBs, BOL, and Ministry of Finance (MOF) to carry out certain responsibilities in support of operational and financial restructuring; and (ii) deploying IBAs inside the SOCBs. 44. The governance agreement defines the principles and responsibilities behind the restructuring program, supported by specific performance targets, quantitative benchmarks, performance rating methodology, monitoring and reporting arrangements, and contingent actions in case of underperformance. Compliance with the provisions will be gauged through quarterly reviews and biannual performance ratings, substantiated by yearly external audits. Performance targets and, if necessary, corrective actions will be updated annually considering the past year’s performance and the following year’s goals. 45. To facilitate program implementation, IBAs working in the SOCBs will (i) develop the interim and comprehensive operational policies and procedures for approval by the SOCB boards; (ii) oversee improvements in systems and procedures; (iii) support the new approach to governance and help achieve the performance targets; (iv) provide direct advice on specific individual transactions of material importance to the bank, focusing on large credit decisions; and (v) implement cost-effective right-sizing activities. To ensure efficient and timely restructuring, the Government will borrow from ADB to finance for 3 years, two resident advisors in each SOCB. Outline terms of reference (TORs) for the IBAs are found as an annex to the governance agreements. 46. The first year of operational restructuring will involve a comprehensive program to train the new board of directors and management teams. Board and management committees will be established and governed by comprehensive operational policies and procedures and supported by better operations and reporting methodology. Decision-making will be transparent and based on commercial principles, and systems ensuring accurate recording of decision making and transactions will be installed. Branches will be streamlined and brought into a more centralized organizational structure. Compliance will focus on the adoption and strict implementation of new sets of operational policies and procedures. The initial year’s performance will also be assessed through quantitative benchmarks on key elements such as

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NPL ratios, collection performance, and foreign exchange exposure, with profitability and capital adequacy targets added in subsequent years.

d. Human Resource Development

47. A particularly challenging constraint to financial sector development is the limited human capacity and basic skills in banking and business. Therefore, a key aspect of the Program is the strong emphasis on accelerated development of skills and capacity of the boards, management, and staff within the SOCBs. The human resource development program within the SOCBs will include (i) on-the-job training from working side by side with the IBAs to adopt, manage, and implement more advanced banking procedures and techniques; (ii) formal courses and scholarships through the Program’s potential association with a comprehensive European Union (EU) Bank Training Program19 and other training opportunities; (iii) a performance reward system, which views these prized scholarships as a key incentive for performance and for retaining the best performing employees in the sector; and (iv) a program to match existing staff skills with better defined job requirements. Clients of and service providers to SOCBs will also benefit from the training programs and workshops in specific areas such as preparing financial statements and loan and security contracts, and managing problem loans.

e. Financial Restructuring of the SOCBs

48. The Program supports a phased and conditional buildup of capital in the two remaining SOCBs as a prerequisite to their long-term safety and soundness. Guided by past experience, the Government is following a cautious approach to financial restructuring, recognizing that moral hazard concerns must be addressed for the program to reach sound levels.20 The NPLs in the system will be resolved through a three-pronged approach to capital build-up: (i) SOCB collection of NPLs made during 2000-02 (ii); Government compensation for NPLs which were made prior to 2000; and (iii) additional, non-government capital to bring the capital adequacy rates to sound levels. Table 1 divides the NPL portfolio of the banks into two blocks of loans: NPLs made prior to21 and those made after 1 January 2000. 49. The most urgent task is for SOCBs to actively use creditor–debtor negotiations, supported by threat of legal action, to resolve the high level of NPLs that have built up in the system in the last 3 years – especially those originating from private sector enterprises with a capacity to repay. These NPLs will be addressed through an aggressive program of case-by-case resolution, focusing on cash collection and/or legal action. By encouraging SOCBs to pursue borrowers in default, the Program not only supports improvement in the soundness of the financial system. It will also create demand for a more reliable and active legal and judicial system for debt enforcement. A time-bound NPL resolution plan will include interim resolution targets of resolving 2000-02 NPLs by mid-2005, including at least KN90 billion in cash collections. To track progress and learn lessons from each NPL case, the following will be implemented: (i) resolving private sector cases, through structured negotiation and/or judicial action; (ii) resolving NPLs from SOEs through the SOE restructuring process; and (iii) special handling of accounts that became NPLs due to government arrears on public sector contracts.22

19 The proposed EU-funded (Euro-TAL) Bank Training Program will design and conduct an extensive in-house

training program targeted at SOCB management and functional departments over a period of 24 months beginning in the first quarter of 2003. The training will focus on management training, accounting, some finance skills, and NPL resolution.

20 For example, the possibility is that a balance sheet cleanup could create the perception of releasing banks and borrowers from their past loan obligations.

21 Almost 70% of the pre-2000 NPLs in the SOCBs are to SOEs and/or related to government contracts. 22 One quarter of post-2000 NPLs originating from Government arrears to private sector contractors are to be settled

among the borrower, MOF, and the SOCBs, with the use of intricate process of tripartite discussion, documentation, and review.

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50. As most pre-2000 NPLs are loans to SOEs, and government arrears to contractors or are the result of directed lending, the Government will compensate the SOCBs for pre-2000 NPLs through a conditional and phased issuance of nontransferable, nondiscountable government securities to the banks, following third-party verification of the SOCBs meeting the operational performance targets. The bond injections will take place in four tranches of KN120 billion each: at the beginning of the program (around March 2003), after the first midterm review (prior to October 2003), and after the two end-year performance reviews before May 2004 and May 2005.23 51. To eventually reach acceptable capital levels, the SOCBs will prepare, as part of the medium-term strategy for the banking sector, a credible, time-bound capital buildup plan to comply with BOL regulations on capital adequacy in a reasonable period. Given the difficulty of augmenting capital through growth and retained earnings, the buildup plan will need to include the search for a strategic investor or other nonpublic sources of capital.

f. Prudential Supervision and Audits

52. Existing prudential supervisory regulations cover the key risk activities of the banks and contain sufficient sanctions for imprudent banking activities. However, significant weaknesses in authority and technical capacity prevent the Bank and Financial Supervision Department (BFSD) of BOL from effectively implementing such regulations. The weaknesses in bank supervision have been apparent in the application of a subset of prudential regulations which focus on disclosure regulations for presenting financial accounts,24 and restricting commercial bank activity during the restructuring period.25 53. Effective enforcement of prudential regulations will require application of good policies and procedures in the banks as well as vigorous verification of compliance by the supervisor. The Program will contribute to the reporting and compliance effort from inside the SOCBs by strengthening internal governance procedures, applying formal accounting policies, and introducing better procedures through new information technology (IT) systems. The Program will also activate BFSD’s off-site systems and on-site inspections through (i) measures for prudential reporting incorporated into SOCB operational policies; (ii) effective off-site reports on financial soundness; and (iii) at least two yearly examinations of SOCBs to verify financial reports and qualitative performance targets.26 54. External auditors are expected to provide independent assurance on the reliability of the internal systems and the annual financial reports produced by each SOCB. BOL and MOF will ensure that the SOCBs prepare annual accounts, that the accounts are in accordance with BOL Accounting Decree No. 03, and are audited by external auditors. MOF/BOL will require the auditors to give an opinion on the SOCBs’ compliance with the operational policies and other actions/targets under the governance agreement. In addition to giving objective advice to MOF, BOL, SOCBs, and IFIs on compliance with the governance agreement, the auditors will help set the program activities and performance targets for the coming year.

23 In addition to NPLs made prior to 2000, the LMB deficiency is estimated at KN154 billion as part of the

consolidation plan of LXB and LMB. Since the last issuance is contingent on reconstituting the branch network and appointing the new branch managers, it will be released following the first half-year review.

24 Key regulations include BOL/98, which defines classification methodology, provisioning requirements, and treatment of accrued interest, and BOL 3, which defines risk concentration limits.

25 Key restrictions include yearly ceilings in growth of net domestic assets of SOCBs (total SOCB credit), no net credit growth if NPLs are greater than 15%, and an embargo on capital expenditures, staff hiring, and dividends.

26 Technical assistance to strengthen BFSD is being provided through an IMF advisor under a 2-year program that began in May 2002.

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2. Strengthen the Enabling Legal Environment and Judicial Oversight

55. The expected beneficial effect of restructuring the commercial banking sector will not be forthcoming without improvements in the legal and judicial system for enforcing loan and secured property obligations. Therefore, as a key part of the objective to improve corporate governance and accountability in the financial system, the Program will strengthen the legal and judicial support for good banking through

i. strengthening the understanding and use of basic concepts behind credit discipline by: (a) introducing standardized loan- and security-related legal documentation, and (b) conducting a credit awareness and judicial dissemination campaign;

ii. supporting the establishment of a streamlined judicial approach to dealing with

bad debtors by: (a) introducing a commercial division in the court system dedicated and trained to rule on cases involving debtor/creditor disputes, with streamlined rules and procedures for reaching and executing judgments; (b) strengthening the enforcement framework and processes; and (c) designing a plan for resolving large debts of viable enterprises; and

iii. adopting anti-money laundering measures in recognition of their importance of

promoting good governance in banking to benefit Lao PDR and the global community.

a. Standardized Loan and Security Documentation

56. Efficient/effective credit markets rely on information and certainty about outcomes and are therefore dependent on a sound, consistent legal system. The Program will support legal and regulatory dissemination and active communication to help strengthen the credit culture through consultation among the commercial, judicial, and financial communities of the Lao PDR. This process has already begun27 and will continue throughout program implementation. Second, the current loan and security documentation used by the SOCBs is deficient in responding to the needs of the borrowers and lenders. A review will be undertaken and a set of standardized, simple loan and security contracts will be developed. Commercial judges, bank staff, private legal practitioners and potential borrowers will be trained using the new standardized documentation to ensure consistency in application and interpretation.

b. Commercial Division of Court and Enforcement

57. Support for bank restructuring and better banking in the future means ensuring that the court system is properly equipped to deal with loan and secured property enforcement actions. Currently judges in the Lao PDR have limited training and experience in commercial transactions and associated areas such as debt enforcement arising from a loan transaction, enforcement of securities, and bankruptcy. The Program will assist in establishing a commercial division in the court system. The Ministry of Justice (MOJ) has nominated 18 judges for specialized training in commercial transactions. These judges will later adjudicate all commercial transaction cases.

27 A high-level technical workshop, the first jointly hosted by BOL and MOJ, entitled Legal and Judicial Support for a

Strong Banking Sector, was held on 20 June 2002 and disseminated the findings of the legal and judicial review carried out under the project preparatory TA for the Financial Sector Development Program (PPTA 3737). The workshop was followed by further dissemination of the findings and recommendations of the TA during the Annual Meeting of the Ministry of Justice, 2-4 July, 2002.

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58. A special set of rules of court to govern the conduct of commercial cases will be developed to allow a streamlined process including, as a centerpiece, limiting the appeals for commercial transactions to the People’s Supreme Court.28 Mechanisms for enforcing commercial transactions will be strengthened by giving the enforcement department/units more power and more effective staff to enforce the court decisions. The new judicial process will be reviewed regularly and revisions introduced as necessary. 59. As the credit culture improves from increased borrower awareness and a rising “credible threat” of legal action, a structured voluntary resolution system will (i) provide a less costly and more appropriate venue for the lengthy negotiations that have hindered the effectiveness of judicial action, (ii) initiate enterprise restructuring for financially viable private enterprises, and (iii) provide the authorities with real case lessons regarding systematic causes of credit indiscipline.

c. Anti-Money Laundering

60. BOL has sent representatives to observe meetings held by the Asia Pacific Group on Money Laundering.29 The Government recognizes the importance of combating money laundering, and there is a rising interest, led by BOL and MOJ, in initiating anti-money-laundering measures in the Lao PDR. Money laundering is a major threat not only to the development of a sound financial system, but also the well-being of the global society. Under the 1988 Vienna Convention, all countries are required to set up comprehensive anti-money-laundering regimes. Of critical importance to the regime are measures to (i) enhance awareness on money laundering activities both within the Government and within private businesses, (ii) establish the legal and regulatory basis for combating money laundering, and (iii) devise systems for reporting suspicious transactions. 61. The BSRP will support the establishment of such a regime in the Lao PDR through issuance of anti-money laundering legislation, creation of a financial intelligence unit as provided for by the legislation on anti-money laundering, and seeking to enter into cross-border information- sharing agreements.

3. Enable the Private Sector to Access Credit

a. Secured Transactions System

62. It is difficult to enforce security over land and other collateral under the current financial and legal system. Moreover, to encourage private sector access to finance, there needs to be a greater range of property over which security may be taken. The Program will assist in introducing amendments to the Secured Transaction Law, the Decree on Lease Financing, and other related laws to enhance the enforcement of security; and in strengthening direct enforcement process for lenders. To complement the legal changes, the effectiveness of the secured transactions system will be enhanced by establishing a computerized secured transaction registry, coordinated with the land and motor vehicle registries.

28 Currently, the practice of appealing to the public prosecutor and even the National Assembly is one of the main

reasons final judgments take so long and enforcement actions are routinely delayed. 29 The Asia Pacific Group on Money Laundering was established in 1997 with the objective of facilitating the

adoption, implementation, and enforcement of internationally accepted anti-money-laundering standards as set out in the 40 recommendations of the Financial Actions Task Force. Currently it has 22 members and ADB is an observer.

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b. Financial Disclosure by Borrowers

63. One of the key causes of high NPLs in the SOCBs is lending without the requisite analysis to determine the capability of borrowers to repay their debt from future cash flows. The Program seeks to improve credit culture by ensuring that banks demand the provision of financial information as a condition for assessing all loan financing requests. Such a lending practice will be built into the credit policies and regulations and will be enforced through quarterly biannual reviews of the governance agreements. Guidance from BFSD will reinforce the need for banks to require basic financial statements as part of their credit review process. The resulting demand for financial reporting, coupled with training programs (envisioned under the EU and other programs) to provide basic business skills, should encourage the growth of service providers ready to support enterprises in preparing financial reports.

4. Develop Rural Finance

64. The Program will focus on an agenda of key policy regulatory and institutional measures for developing a rural and micro finance system, including steps in realizing the Government’s goal of transforming APB into a market-oriented rural financial institution and opening micro finance to a variety of models and methodologies. A cluster TA program consisting of six subprojects, including diagnostics and reform of APB, has been under way since 2000 to assist the Government in achieving this goal.30

a. APB: Policy, Regulatory, and Institutional Issues

65. Under the Program, APB will adopt a corporate vision that explicitly includes the goals of market orientation and will implement a phased operational and financial restructuring plan based on good governance principles to achieve that vision. The specific details of the restructuring plan will be developed as an outcome of the ongoing diagnostic review and audit, and will build on the lessons from more than a year of implementation of SOCB restructuring. 66. Given APB’s “development bank” origins, the principal policy issues facing its reform plan include the treatment of noncommercial lending in the form of directed lending and interest rate subsidies. To enable APB to achieve its corporate vision, directed lending and interest rate subsidies will be phased out of its operations and good governance policies will be applied. Through the ongoing operational diagnostic, financial audit, and policy review, the Government will be considering the precise timing of the phase-out and the use of alternative transparent mechanisms, preferably on-budget, through which the Government can channel funds for activities currently financed by policy lending through APB. 67. As part of the good governance approach to APB, the Program will support a continuation of external audits for APB based on international banking standards and BOL 98 loan classification. As a medium-term objective, the Program will assist BOL, in consultation with the IMF-supported program of bank supervision, to prepare and implement an appropriate regulatory framework for prudential supervision of APB in line with its new mandate of commercial operations and market orientation.

b. Micro Finance: Policy, Regulatory, and Institutional Issues

68. The Government will adopt an overall vision for the sector and a strategy to support that vision. A rural and micro finance committee is preparing a vision statement for rural and micro finance, and a time-bound action plan to remove the impediments to that vision as part of the Government’s strategic planning for financial sector development. From this ongoing work, BOL

30 ADB. 2000. Rural Finance Development (TA Cluster). Manila.

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will prepare, adopt, and implement an appropriate regulatory framework for microfinance credit unions and other models to encourage efficient intermediation of small savers’ depositors. To foster growth in the rural and micro finance sector, this framework will (i) allow a variety of MFI models, (ii) foster interest rate autonomy, and (iii) encourage private ownership. 69. Improved capacity for servicing various customer types and diversified lending methodologies are also anticipated program outcomes. The dissemination of lessons from this experience will help the Government, practitioners, potential investors, contributors and other stakeholders form best practice approaches to rural and micro finance.

5. Strategic Planning

70. The Government priorities for the financial sector align with four of the seven focus areas in ADB’s current country strategy for the Lao PDR: (i) governance and capacity building, (ii) rural development and market linkages, (iii) human resource development, and (iv) PSD. The strategy was formulated for the phase of financial sector development being implemented with the preparation of the Financial Sector Note, and continued through a participatory approach to defining the Government’s vision for the financial sector. Strategic development began in earnest with the four building blocks underpinning the BSRP: (i) strategic framework for bank restructuring,31 (ii) the awareness building project for rural and micro finance,32 (iii) the review of legal and judicial enforcement, and (iv) review of policy-based impediments to PSD.33 The Government’s next phase of strategy development (covering 2006–2010) for the sector will be supported under the Program by adopting a financial sector strategy and action plan covering (i) post-restructuring banking; (ii) rural and micro finance based on the action plans currently under development; and (iii) other subsectors such as leasing, insurance, pensions, and private enterprise development. C. Important Features

1. Governance Agreement and International Banking Advisors

71. In the absence of the incentives inherent in a competitive, market-oriented economy, building corporate governance is a difficult challenge. Without the possibility of privatization in the near term to strengthen corporate discipline, the Program takes the middle road by combining in-house advisors with an administratively applied performance framework. The Program recognizes that the Lao PDR is a relatively young economy, retains a legacy of state ownership and policy direction of resources, and has a mixed record of implementing commercial principles in daily business. To support implementation of corporate discipline, individual accountability, and the application of commercial law, the Program design utilizes a combination of the governance agreement to provide a framework for performance-based incentives and on-site resident IBAs to ensure SOCB management capacity. The approach is described in more detail in Supplementary Appendix B. 72. The governance agreements (Supplementary Appendix C) provides (i) a road map for restructuring by defining financial and operational targets, (ii) a business plan for reaching those targets, (iii) a performance measurement system, (iv) objective reviews by international auditors, and (v) a BOL/MOF requirement to impose corrective action in the case of unfavorable outcomes. BOL will be responsible for ensuring that SOCBs achieve strict compliance with the 31 ADB. 2000. Technical Assistance to the Lao PDR for Strengthening Corporate Governance and Management in

State Owned Commercial Banks. Manila. 32 ADB. 2000. Technical Assistance to the Lao PDR for Rural and Microfinance. Manila. 33 ADB. 2001. Technical Assistance to Lao PDR for Financial Sector Development. Manila. Diagnostics of the

environment for loan collection and PSD were developed, disseminated, and reviewed through a series of workshops in March, May, and June 2002.

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governance agreements and will take the lead in applying sanctioned rewards or penalties. Working inside the banks, two IBAs will carry out the sensitive role of coaching and teaching their Lao counterparts while introducing and overseeing the implementation of new governance policies and procedures. The IBAs will consult BOL, MOF, and the IFIs regularly to solve the many complex issues that will inevitably arise in this new and ambitious task. The Government recognizes the importance and sensitivity of exposing international expertise to the SOCBs and has requested a TA loan specifically for this purpose. The governance agreement and the IBAs’ TOR are designed with flexibility to mitigate uncertainties inherent in this type of performance-oriented reform program. As the performance of the SOCB management and the IBAs will be frequently evaluated by BOL, MOF, and IFIs, yearly business plans and recalibrated performance targets will reflect lessons learned during the restructuring period.

2. Social Impact Issues

73. An important concern of the Government and IFIs is the possible social impact on SOCBs staff during the restructuring process. BOL, in consultation with all stakeholders, is preparing a set of actions to alleviate tensions and anxieties among employees during the process of restructuring. With the assistance of international specialists, BOL and the SOCBs will introduce (i) a methodology, conditions, and timing for redeployment and possible retrenchment of SOCB staff; (ii) a consultation process; (ii) an assistance package for staff as provided under the law; (iii) access to existing and future redeployment services; and (iv) monitoring of retrenched workers. Although the SOCB restructuring may provide the first case of retrenching workers, SOE reform and other restructurings will pose similar challenges to the Government. Continued consultation with a wide range of stakeholders during program design, coupled with the delicate balance between expediency and social concerns during implementation will be the guiding principles of the cautious but proactive approach. D. Financing Plan

74. The Government has requested a loan of $15 million from ADB’s Special Funds resources to help finance the Program. The loan will have a repayment period of 24 years, including a grace period of 8 years. An interest rate of 1% per annum will be charged during the grace period and 1.5% per annum thereafter. The total loan amount was determined through ADB’s continued dialogue with the Government. It takes into account the strategic importance of developing the financial sector, the depth and scope of the proposed policy reforms, and the estimated short- and medium-term adjustment costs associated with adopting the policy matrix. These costs are substantial (estimated at $36 million to $43 million equivalent) for the 36 months of program implementation and will comprise the following:

(i) Higher fiscal costs for interest on bonds ranging from $18 million to $20 million over 3 years for the two SOCBs and APB; 34

(ii) Costs associated with compensating and redeploying for displaced workers ($1 million-$2 million);

(iii) Bank consolidation including disposing of unused assets and bank rationalization ($9 million-$10 million);

(iv) Adopting and enforcing higher governance standards (policies and procedures, IT systems, higher disclosure) on banks through the governance agreements ($3 million-$4 million);

34 Though principal payments may be due in future years should performance improve, these bonds will in the short

run, not be transferable nor discountable, so their face value is not included in the adjustment costs .

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(v) Detailed external audits of the SOCBs and APB to ensure compliance with the governance agreements, including staff costs to the SOCBs and APB for preparing to and engaging auditors ($1 million- $2 million);

(vi) Cost of setting up the commercial court and dedicating judges, an enforcement department and enforcement officers, and establishing a secured registry ($0.5 million-$1 million); and

(vii) APB restructuring and alternative financing mechanism for policy lending ($3.5million-$5 million).

75. As the costs are mostly fiscal, the impact on the budget of the restructuring program is provided for in the agreed-upon medium term fiscal framework (Supplementary Appendix D) being supported through additional financing under the IMF’s PRGF and the World Bank’s FMAC. E. Implementation Arrangements

1. Program Management

76. As the Executing Agency for the program loan, BOL will have overall responsibility for ensuring timely program implementation and reporting to ADB on progress made, problems encountered, remedial actions taken during the previous quarter, and proposed program activities during the next quarter. Implementing agencies will include BOL, MOJ, MOF and the SOCBs, which will be responsible for effective day-to-day implementation of their components. MOF will be responsible for monitoring the use of the loan proceeds. 77. To carry out its role, BOL will establish a bank restructuring implementation committee (BRIC), chaired by the deputy governor of BOL, empowered to oversee program implementation for both the program loan and all associated technical assistance, and ensure that the proposed reforms are undertaken in accordance with the agreed-upon timetable. To maintain continuity throughout implementation, the BRIC will initially include the director and deputy director officials in charge of designing the Program, including the chairs of the Bank Restructuring Committee, NPL Committee, Human Resource Committee, IT Committee–and will include the BOL legal advisor as needed. The BRIC will work closely with (i) other key departments in BOL, such as BFSD and Internal Audit; (ii) representatives in other implementing agencies involved in BSRP; (iii) ministries with interest in such as the Ministry of Labor and Social Welfare and the Ministry of Security; and (iv) other relevant committees such as the Rural Finance TA steering committee, the rural and micro finance policy committee, and the prospective program management unit of the EU Bank Training Project. The BRIC will meet at least quarterly to review progress reports and guide program implementation. Appendix 5 depicts the implementation arrangements for the BSRP loan. 78. A program implementation unit (PIU) will be the working secretariat of the BRIC. The PIU will (i) coordinate the implementation of the banking components of the BSRP loan, (ii) carry out administrative and fiduciary support for the MOJ-implemented judicial strengthening component, (iii) support the BRIC and MOF in reporting on the progress of the program and use of the funds, (iv) organize all procurement and recruitment of consultants for the associated TA loan,35 and (v) report to ADB and other IFIs on Program implementation. To assist in building implementation capacity and policy development, the BRIC and its working secretariat will be supported with technical assistance during the first half of the program period.

35 Temporarily, staff from BOL’s Economic and Research Department, with the assistance of ADB, is carrying out

advanced recruitment action for the IBAs.

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2. Procurement and Disbursement

79. The loan will finance the full foreign exchange costs, excluding local duties and taxes, of imports procured in and from ADB’s member countries, other than those specified in the list of ineligible items (Appendix 6) and those items financed by other multilateral and bilateral official sources. Eligible items under ADB’s loan will be procured using normal commercial practices by the private sector or standard Government procurement procedures acceptable to ADB for procurement by the public sector. Goods commonly traded on international commodity markets will be procured in accordance with procedures appropriate to the trade and acceptable to ADB. 80. The loan is expected to be utilized over 48 months from loan effectiveness. The proceeds may be used to finance eligible imports for the period starting 180 days before loan effectiveness. On the basis of ADB’s simplified procedures for disbursing program loans,36 the Borrower will be required to submit with each withdrawal request, a certification confirming the Borrower’s compliance with the following formula for the period covered by the withdrawal request: for each year in which the proceeds are expected to be disbursed, the value of the country’s total imports minus (i) imports from nonmember countries, (ii) ineligible imports, and (iii) imports financed under other official development agencies. This amount must be equal to or greater than the amounts expected to be disbursed during the year. ADB will have the right to audit the use of the loan proceeds and to verify the accuracy of the Borrower’s certification.

3. Counterpart Funds

81. The Government will use counterpart funds to finance the local currency costs of implementing the Program and other activities consistent with the objectives the Program.

4. Monitoring

82. The Government and ADB will continue active policy dialogue throughout BSRP implementation on matters relating to banking and financial sector development. In particular, ADB will closely monitor the implementation and impact of the banking sector reforms covering financial governance and potential staff retrenchment. ADB will give close attention to the poverty impact of policy reforms and adjustment costs. 83. The PIU will coordinate the delivery of the various reports from the SOCBs, the BOL BFSD, MOF and MOJ. The PIU will also submit a consolidated report to ADB on a quarterly basis covering BSRP implementation, particularly policy actions set out in the policy matrix and development policy letter, and on the accomplishment of the BSRP loan objectives. The reports will be submitted in such form and in such detail and within such period as ADB may request, and should include, (i) progress made and problems encountered during the month or quarter in review, (ii) steps taken or proposed to be taken to remedy problems encountered, (iii) the proposed detailed activity for BSRP implementation, and (iv) expected progress during the next 3 months. If retrenchment is proposed for bank staff during the restructuring of the SOCBs, BOL will report what was done under the agreed-upon retrenchment and mitigation plans. In addition, BOL will ensure that the SOCBs have their accounts audited annually by independent and competent auditors acceptable to ADB, with signed audits submitted to ADB within 6 months of the end of the calendar year. At the minimum, audited financial statements will be in English and will include income and expenditures, assets and liabilities, with the accompanying notes to the accounts.

36 ADB. 1998. R50-98: Simplification of Disbursement Procedures and Related Requirements for Program Loans.

Manila.

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84. A program performance monitoring system will be applied to each project component to ensure that the program is realizing its expected benefits. The PIU will develop a comprehensive monitoring system including the establishment of benchmarks, data collection, and analysis. Impacts to be measured are (i) the level of NPL resolution, with attention to cases heard by the commercial division; (ii) the enhanced good governance practices in the SOCBs; (iii) improved cost structures of the SOCBs with attention to the quality of credit analysis; and (iv) more accurate financial reporting and controls. The PIU will submit a plan for monitoring program performance and preparing benchmark information for ADB’s review and concurrence within 6 months of loan effectiveness. 85. ADB will send regular review missions to assess compliance with the program requirements in general and with operational policies and performance targets under the governance agreements in particular. The missions will also review actions to ensure that program implementation remains on course. Within 2 years of the Program’s start, ADB and the Government will jointly undertake a comprehensive midterm review to formulate within the updated sector setting and other changing circumstances the necessary courses of action for the Government and ADB to ensure program implementation. Not later than 3 months from the midterm review and the completion of BSRP, the Government will prepare and furnish to ADB a comprehensive report on the overall impact of the policy reforms implemented. The Government will make the necessary information available to enable ADB to conduct reviews to ascertain that the policies are being implemented and will keep ADB informed of outcomes of policy discussions that have implications for BSRP implementation.

5. Implementation Period and Tranching

86. The loan as proposed will cover an implementation period of 3 years and consist of three tranches that will be disbursed when ADB is assured that the conditions for release are satisfied. The first tranche of $5 million will be made available following loan effectiveness. Subject to the Government’s compliance with conditions, it is envisaged that the second tranche of $5 million will be disbursed