Document of The World Bank

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1 Public Disclosure Authorized Document of The World Bank Report No: BD Public Disclosure Authorized PROJECT APPRAISAL DOCUMENT Public Disclosure Authorized ONA PROPOSED IDA CREDIT IN THE AMOUNT OF SDR MILLION (US$151 MILLION EQUIVALENT) TO THE PEOPLES REPUBLIC OF BANGLADESH FOR THE Public Disclosure Authorized SECOND POVERTY ALLEVIATION MICROFINANCE PROJECT (MICROFINANCE II) Finance and Private Sector South Asia Region December 14, 2000

2 CURRENCY EQUIVALENTS (Exchange Rate Effective November 2000) Currency Unit = Bangladesh Taka (Tk.) Tk.I = US$ US$1 = Tk.55 FISCAL YEAR July 1 June 30 ABBREVIATIONS AND ACRONYMS ADAB Association of Development Agencies in Bangladesh IFADEP Integrated Food-Assisted Development Project ADB Asian Development Bank IGA Income Generating Activities ADP Annual Development Program IGVGD Income Generation for Vulnerable Groups Development ASA Association for Social Advancement ISA Intemational Standards on Auditing ASOD Assistance for Social Organization and Development LAN Local Area Network BBS Bangladesh Bureau of Statistics LCG Local Consultative Group BIDS Bangladesh Institute of Development Studies LFS Labor Force Survey BIPOOL PKSF's Microcredit Program for Big Partner Orgs. LIL Leaming and Innovation Loan BPO Big Partner Organization MES Monitoring and Evaluation Study BRAC Bangladesh Rural Advancement Committee MFI Microfinance Institution BRDB Bangladesh Rural Development Board Microfinance I Poverty Alleviation Microfinance Project CAS Country Assistance Strategy MIS Management Information System CEO Chief Executive Officer MPO Medium-size Partner Organization CIDA Canadian Intemational Development Agency MRRU Microfinance Research and Reference Unit DCA Development Credit Agreement MTR Mid Term Review EA Environmental Assessment NGO Non-Government Organization EHS Environmental Health and Safety OOSA Small and Medium-size Partner Organizations EMP Environmental Management Program PA Project Agreement ERR Economic Rate of Retum PDR Public Demand Recovery ESDO Eco-social Development Organization PKSF Palli Karma-Sahayak Foundation FRR Financial Rate of Retum PO Partner Organization FWP Food for Work Program PROSHIKA Proshika Manobik Unnayan Kendra GDP Gross Domestic Product SAARC South Asian Association for Regional Cooperation GOB Government of Bangladesh SAR Staff Appraisal Report GUK Gram Unnayan Kendra SLGA Subsidiary Loan and Grant Agreement HRD Human Resource Development SOE Statement of Expenditures IAS International Accounting Standards SPO Small-size Partner Organization IASC International Accounting Standards Committee TA Technical Assistance IDA Intemational Development Association TMSS Thengamara Mohila Shabuj Samity IFAC Intemational Federation of Accountants VGD Vulnerable Groups Development Vice President: Country Director: Sector Director: Team Leader: Task Team Leader: Mieko Nishimizu Frederick Thomas Temple Marilou Jane D. Uy Joseph Del Mar Pernia Md. Reazul Islam

3 BANGLADESH SECOND POVERTY ALLEVIATION MICROFINANCE PROJECT (MICROFINANCE ID CONTENTS A. Project Development Objective Page 1. Project development objective 2 2. Key performance indicators 2 B. Strategic Context 1. Sector-related Country Assistance Strategy (CAS) goal supported by the project 2 2. Main sector issues and Government strategy 2 3. Sector issues to be addressed by the project and strategic choices 3 C. Project Description Summary 1. Project components 5 2. Key policy and institutional reforms supported by the project 8 3. Benefits and target population 8 4. Institutional and implementation arrangements 9 D. Project Rationale 1. Project alternatives considered and reasons for rejection Major related projects financed by the Bank and other development agencies Lessons learned and reflected in proposed project design Indications of borrower commitment and ownership Value added of Bank support in this project 15 E. Summary Project Analysis 1. Economic Financial Technical Institutional Environmental Social Safeguard Policies 22 F. Sustainability and Risks 1. Sustainability Critical risks Possible controversial aspects 24 G. Main Loan Conditions 1. Effectiveness Condition 25

4 2. Other 25 H. Readiness for Implementation 29 I. Compliance with Bank Policies 29 Annexes Annex 1: Project Design Summary 30 Annex 2: Detailed Project Description 34 Annex 3: Estimated Project Costs 43 Annex 4: Cost Benefit Analysis Summary 44 Annex 5: Financial Summary for Revenue-Earning Project Entities 47 Annex 6: Procurement and Disbursement Arrangements 48 Annex 7: Project Processing Schedule 57 Annex 8: Documents in the Project File 58 Annex 9: Statement of Loans and Credits 60 Annex 10: Country at a Glance 62 Annex 11: Demand Analysis of Microcredit Borrowers 64 Annex 12: Criteria for Selection of POs and Borrowers for Rural, Urban, and Hard-core 66 Microcredit and Microenterprises MAP(S)

5 BANGLADESH Second Poverty Alleviation Microfinance Project (Microfinance II) Date: December 14, 2000 Country Director: Frederick Thomas Temple Project ID: P Lending Instrument: Financial Internediary Loan (FIL) Project Appraisal Document South Asia Regional Office SASFP Team Leader: Md. Reazul Islam Sector Director: Marilou Jane D. Uy Sector(s): FY - Other Finance Theme(s): Poverty Reduction Poverty Targeted Intervention: Y Project Financing Data [ ] Loan [XI Credit [ ] Grant [ Guarantee [ Other: For LoanslCreditslOthers: Amount (US$m): 151 Proposed Terms: Standard Credit Grace period (years): 10 Years to maturity: 40 Commitment fee: 0.5% Service charge: 0.75% Financing Plan: Source Local Foreign Total BORROWER IDA Total: Borrower: GOVERNMENT OF BANGLADESH Responsible agency: PALLI KARMA-SAHAYAK FOUNDATION (PKSF) Address: House 3 1A, Road 8, Dhamnondi R/A, Dhaka, Bangladesh Contact Person: Dr. Salehuddin Ahmed, Managing Director Tel: Fax: pksf@citechco.net Estimated disbursements ( Bank FYIUS$M): FY Annual Cumulative Project implementation period: 4 years Expected effectiveness date: 04/30/2001 Expected closing date: 06/30/2005 OCS PAThF.,, Rn e. Mart. XOO

6 A. Project Development Objective 1. Project development objective: (see Annex 1) The project will continue the International Development Association's (IDA's) support for poverty alleviation through microcredit by: (a) expanding outreach to reach a greater number of the poor; (b) diversifying microcredit operations to reach the urban poor, the hard-core poor, and microentrepreneurs; (c) providing technical assistance (TA) for building sustainable institutional capacity in Bangladesh's apex microcredit 'wholesaler', the Palli Karma-Sahayak Foundation (PKSF) and its partner organizations (POs)'; and (d) establishing a legal, regulatory and supervisory framework for non-government organizations (NGOs) and microfmance institutions (MFIs) to improve their creditworthiness as well as accelerate their integration with the formal financial market. 2. Key performance indicators: (see Annex 1) Achievements toward these objectives will be assessed by the project's impact on: (a) poverty reduction as reflected in higher GDP, lower unemployment, and better quality of life; (b) achievement of outreach targets by PKSF and POs while maintaining high portfolio quality and gradually attaining financial sustainability; and (c) development of an appropriate regulatory framework for the microfinance sector that promotes prudent growth and integration with the formal financial market. B. Strategic Context 1. Sector-related Country Assistance Strategy (CAS) goal supported by the project: (see Annex 1) Document number: BD Date of latest CAS discussion: 05/24/99 The CAS's main goal is to help Bangladesh reduce poverty by promoting rapid, job-creating economic growth and through interventions that directly assist the poor and promote institution building for sustained poverty reduction. The project will support this goal through microcredit to provide the poor with income-generating activities and employment opportunities through microenterprise development. It will also support institution building in PKSF, POs, and other NGOs-MFIs to improve their sustainability. The project supports the government's poverty reduction strategy through microfmance. This is also in line with the goals of the 1993 Dhaka Declaration for Poverty Eradication of the South Asian Association for Regional Cooperation (SAARC). It will reinforce the government's agenda for social mobilization and empowerment of the poor by enabling them to participate more actively in the mainstream economic activities. Partner Organizations (POs) are enlisted entities of PKSF. They comprise non-government organizations (NGOs), involved in microcredit and various social development programs and microfinance institutions (MFls), involved in microcredit only. There are very few MFIs in Bangladesh. In the project appraisal document (PAD), NGOs-MFIs refer to all NGOs and MFls involved in microcredit. 2. Main sector issues and Government strategy: The main sector issues are: (a) inadequate outreach; and (b) absence of an enabling environment for a financially sustainable growth of the microfinance industry. a. Extent ofpoverty and microcredit outreach: Around half the population (12-13 million households) still live below the poverty line despite modest economic growth in the past decade. Currently, poverty-focused microcredit programs run by NGOs-MFIs and public institutions cover some 8 million people. Although the economy is expected to grow at 4-5% a year in coming years the benefits of growth - 2 -

7 may not reach all of the poor. Therefore, bringing an additional 4-5 million poor people into the NGOs-MFIs microcredit programs would help their ability to participate in growth. The government's poverty reduction strategy is two-fold: (a) a macroeconomic strategy to accelerate economic growth, thereby improving prospects for employment; and (b) limited direct poverty-focused interventions supplemented by NGO activities to alleviate poverty and foster human development. Besides the IDA-financed Poverty Alleviation Microfinance Project (Microfinance I), other public microcredit programs include the Canadian International Development Agency (CIDA) financed Rural Development Program (RD- 12), the Asian Development Bank (ADB) financed Rural Livelihood Project which is implemented by the Bangladesh Rural Development Board (BRDB) and the Food for Work Program (FWP) and food aid for vulnerable groups in society financed under the World Food Program. NGOs-MFIs have also been engaged in numerous direct interventions to alleviate poverty through microcredit, development of community infrastructure in health, education, drinking water and sanitation, social mobilization and empowerment of individuals, and environmental management. The government established PKSF in 1990 as a vehicle for lending funds on concessional terms to NGOs-MFIs, which then on-lend to the poor. PKSF has enlisted 177 NGOs-MFIs as POs, extending microcredit to 2.1 million poor people, about 90% of whom are women. In view of a decline in donor funding, the IDA-financed, PKSF-executed, Microfinance I now funds 90% of PKSF borrowers. b. Enabling environment: NGOs-MFIs, the Bangladesh Bank, the government and donors all see the need for a legal, regulatory, and supervisory framework to promote a prudently growing microfinance sector. A few NGOs-NFIs have developed innovative savings schemes to mobilize resources from members and associate members; however, this is a form of deposit taking that requires regulation. The government is also concerned about what it views as the high lending rates of NGOs-MFIs. Donors, on the other hand, are concerned about the proper use of their funds and the sustainability of NGOs-MFIs. The industry is concerned about government regulations and supervision and their impact on innovation and growth. There is as yet no consensus on what kind of regulatory and supervisory system would be responsive to these seemingly conflicting concerns. 3. Sector issues to be addressed by the project and strategic choices: a. Microcredit outreach: In the next 4-5 years, NGOs-MFIs plan to reach some 4-5 million poor people. W.hile many believe that this would close the microcredit gap completely, some NGOs-MFIs believe that the supply gap will remain as the market size is as many as 10 million borrowers. The Bangladesh Rural Advancement Committee (BRAC) indicated that there is capacity within a household to operate two loans. In fact, Proshika Manobik Unnayan Kendra (PROSHIKA) is providing repeat loans to individual families before they could break out of poverty. Some of PKSF's POs are successfully delivering microcredit to the urban poor with high collection rates and positive results. But their coverage is much lower in urban than in rural areas. Some NGOs have credit programs for the hard-core poor, but strict targeting has been a problem because of high intermediation costs [as in BRAC's Vulnerable Group Development (VGD) program (see Section Clc)]. Innovative methods are needed for increasing outreach while maintaining financial viability. Extending loans to graduate microcredit borrowers and others that are already operating microenterprises can help replace expensive moneylender sources of funds, promote expansion and create employment for the hard-core poor. Although, the unmet outreach is estimated to be 4-5 million poor people, the following needs to be considered in determining the demand for microcredit: * The performance of the economy continues to be inadequate and has been unable to make a significant dent on poverty. It is believed that until the economy has a sustained growth of 7% or above, reduction - 3 -

8 in poverty will be slow. The current situation will not help in decreasing the number of the poor; rather their number will grow, and there could be more than 4-5 million poor people seeking microcredit. * There are concerns that some NGOs-MFIs are pursuing aggressive credit expansion policies. One result is that there has been little social mobilization to improve the borrowers' capacity to undertake microcredit activities. In fact, in a very limited number of cases, the credit is extended to borrowers who are not able to use credit productively. Moreover, some borrowers are given more than one loans by NGOs-MFIs, i.e. there is an overlapping of loans (see project file). The demand analysis for the project has taken full account of the above factors and evaluated PKSF's, POs' and borrowers' absorption capacity through field visits and discussions with stakeholders (see Annex 11 and project file). b. Microfinance regulations: The regulatory regime for MFIs should be designed carefully and the participation of all stakeholders should be ensured in developing a legal, regulatory and supervisory framework for the microfinance industry. The project will build on the work started under Microfmance I, including a Bangladesh Bank-executed study on "Establishing an Appropriate Regulatory Framework and Institutions for Regulating MFIs Engaged in Deposit Taking/Lending and Developing Financial, Institutional and Regulatory Measures to Assist MFIs in Becoming Formal Financial Institutions and Strengthening the Linkage of MFIs with the Formal Financial Sector (1999)". It will also examine the work initiated by ADB under the Rural Livelihood Project and other ongoing initiatives. NGOs-MFIs should be regulated and supervised on the basis of how they fund themselves, i.e. whether they take deposits from the general public or obtain market funding from institutional investors. NGOs-MFIs, which are not engaged in deposit-taking from the public, should be regulated through capital market types of regulation. The supporting infrastructure should include improved disclosure (standardized accounting, auditing and reporting), industry standards, credit rating, and a Credit Bureau. The project will support the government's initiative to develop a regulatory framework which accommodates broad stakeholder consultations and leverages their knowledge. PKSF will develop industry performance standards under the project's technical assistance component. The introduction of a mechanism for compliance with standards is critical. Stakeholders believe that the industry should be regulated through an independent body with representatives from the Bangladesh Bank, PKSF, the Securities and Exchange Commission and industry experts. Findings of the stakeholders' workshop on May 6, 2000 indicate a preference for an independent organization with an exclusive legal mandate to ensure compliance with industry standards and to provide regulatory oversight. The institutional development component will provide IDA technical assistance under the project, through the Ministry of Finance, to the newly created MRRU in Bangladesh Bank, and other institutions to develop policy guidelines and principles for regulatory framework of the microfinance sector (see Annex 2). Prior to the development of an appropriate regulatory framework, the industry should comply with: adequate disclosure standards; uniform accounting and auditing principles and practices; transparent reporting; improved internal control; improved external audits; appropriate industry standards for loan classifications and provisioning; and adequate industry standards for risk mitigating prudential rules. c. Sustainability and commercialization: The project will support microfmance sustainability through NGOs-MFIs' commercialization. The institutional capacity to manage a larger microcredit portfolio by increasing fund absorption capacity and reducing intermediation costs is critical for sustainability. IDA's capacity building effort will be directed to POs that lack the institutional capacity needed to deal with a large loan portfolio. These POs will need to rely on IDA's support for some time before attaining sustainability. Big POs (ASA, PROSHIKA, and BRAC) already have the needed institutional capacity to - 4 -

9 increase efficiency and reduce intermediation costs and should be able to attain sustainability much earlier. Microfmance'sustainability is unlikely to come in the short term. NGOs-MFIs need to attain sustainable institutional capacity to reduce intermediation costs and operate with a smaller interest rate margin. As the overriding objective of Microfinance I was to extend outreach, the impetus on capacity building was limited. Microfmance II will consolidate gains already achieved under Microfinance I, creating an enabling environment, and developing institutional capacity thereby moving the industry towards sustainability. d. Interest Rate Issue: The on-lending rate from PKSF to POs has to take into account that the industry is dichotomous, with large NGOs-MFIs accounting for about four-fifth of the microcredit market. It is strategically importanthat the on-lending rate be increased to encourage POs toward integration with the formal financial market. At the same time, building up their equity capital is equally important to reduce their dependence on donors for resources. Therefore, the on-lending rate from PKSF to POs should be such that it considers the issue of market integration of POs and, at the same time, makes provision for their equity build-up to lessen donor fund dependence. An analysis of PKSF's current interest rate structure shows that adoption of an interest rate of 4.5% for small and medium-size POs, and 7% for big POs with a three to four-year maturity for all POs, would help the industry move towards sustainability. The rationale for adoption of a lower interest rate for small and medium-size POs derives from their need for greater nurturing. Big POs, on the other hand, need to be encouraged to access financial markets sooner. C. Project Description Summary 1. Project components (see Annex 2 for a detailed description and Annex 3 for a detailed cost breakdown): The Second Poverty Alleviation Microfinance Project (Microfinance II) comprises five components: a. Mainstream Microfinance - Rural microcredit: The project will continue to support horizontal and vertical expansion of rural microcredit, to respond to the unmet demand and the need for larger loans per borrower, respectively. Big POs and small and medium-size POs have projected an expansion of 4.1 million and 0.4 million new borrowers, respectively during Given that a rapid expansion requires careful implementation and that the industry is already experiencing some cases of multiple loans extended to the same borrowers, the project will support an increase in rural outreach limited to 530,000 rural borrowers. b. Urban microcredit: There is acute poverty in urban areas as well. A number of PKSF's POs are already involved in urban microcredit (e.g. ASA, PROSHIKA, BRAC, TMSS and ESDO have about 330,000 urban microcredit borrowers). About 6% of PKSF's final borrowers are the urban poor. A PKSF' s special urban microcredit pilot program funded five POs to extend microcredit to over 11,000 urban borrowers. The performance of this program has been highly satisfactory; the program attained a collection ratio of nearly 100%. An IDA survey of 100 urban borrowers shows that the impact of urban microcredit is also very positive in terms of increasing family income and improving the quality of life. The outreach of urban microcredit is limited to less than 15% of the urban poor as against the outreach of over 60% of the rural poor. However, the potential for growing out of poverty through microcredit is high in urban areas, given their closeness to large markets. Since the method of credit delivery and on-lending terms to POs are the same as for rural microcredit, the same field officers and management can successfully undertake the urban microcredit operations. The on-lending terms for POs would be the same as for rural microcredit. PKSF's current policy is, however, not to provide microcredit to the urban poor in the larger cities (Dhaka, Chittagong, Khulna and Rajshahi). The project supports scaling-up of urban microcredit activities and will cover up to 270,000 urban borrowers. -5 -

10 c. Hard-core poor: There is a widespread belief that microcredit programs do not significantly include the hard-core poor. However, evidence shows that around a quarter of microcredit program members are hard-core poor (defined as households with less than 1800 calories per person per day), although these households do not share in the income growth that the better off poor enjoy through microcredit. Moreover, even within this 'hard-core' poor group there is a 'bottom layer' (the'ultra hard-core poor'), which is excluded from such programs. To improve the impact of microcredit on the hard-core poor, changes should be made to the current microcredit delivery system. These could include diversifying financial services and complementing microfinance with non-financial interventions. These would include smaller loan sizes, making flexible installment repayments, different savings products, flexible methods of deposit collection and withdrawal, and institution of insurance products. Major experiments have been undertaken in Bangladesh involving microfinance linkages to safety-net programs. The BRAC Income Generation for Vulnerable Groups Development (IGVGD) programs combine government food aid through the VGD program with specific skill training and small loans over the two-year VGD cycle. Most IGVGD members then graduate to mainstream microfinance programs. The project is an appropriate instrumenthrough which the impact of microfinance services on the hard-core poor can be improved. There is already a significant amount of knowledge within the microfinance commnunity in Bangladesh about innovations that can be made to address constraints faced by the hard-core poor. IDA assistance can be instrumental in catalyzing improved services to the hard-core poor. The project design has been shaped by a detailed review of existing experiences, the Stakeholders Workshop, and discussions with PKSF staff. It will target 400,000 hard-core poor households, formed into groups and given credit on similar terms to BRAC's IGVGD program; i.e. smaller average loan sizes, bi-monthly repayments, no rigid savings requirement, etc. PKSF will build internal capacity for providing services to the hard-core poor. ds Microenterprise lending: This component will help progressive or graduate microcredit borrowers or microentrepreneurs who have entrepreneurial talents to scale-up their activities. It will help create employment for the hard-core poor and contribute to economic growth. Some of these borrowers are already operating microenterprises, but they have to mobilize resources from expensive sources including "moneylenders". A number of POs, including the 3 big POs (ASA, PROSHIKA and BRAC) give loans to graduate microcredit and individual borrowers for microenterprises. Some POs have formed groups of individual microentrepreneurs and are extending microenterprise loans to them. An IDA study of 24 small and medium-size and 3 big POs found that the average enterprise investment was about Tk.69,000. Microcredit only financed 15% of the enterprise costs; the remaining amount was mobilized from own and informal financing sources, including moneylenders. The project will support scaling-up of microenterprises lending and will cover about 19,500 microenterprises. An issue that needs careful consideration is whether microenterprise loans will only be extended to graduate microcredit borrowers or whether similar types of entrepreneurs will be given lateral entry and considered eligible for microenterprise loans. Field evidence shows that POs have already formed groups of entrepreneurs to extend microenterprise loans. The loan size is about Tk. 15,000 (first loan) and the collection rate of such programs is about 100%. PKSF has agreed to consider widening coverage of microenterprise lending beyond microcredit borrowers to include individual entrepreneurs. It will initially select a group of POs which are already extending microenterprise loans and have acquired capacity for implementation of this component. Methods of selection of POs' borrowers, extension of loans, and process of disbursement have been finalized in consultation with the potential borrowers (see Annex 12). POs will build special skills and recruit additional staff to extend microenterprise loans, while PKSF will integrate microenterprise lending with the microcredit operations

11 e. Institutional development: Comprehensive institutional development for PKSF and small and medium-size POs is the key to their sustainability. The component is aimed at strengthening PKSF's and small and medium-size POs' capacity to increase outreach, broaden the range of financial services benefiting the poor and hard-core poor, and improve POs' creditworthiness and sustainability. The strategy will be to outsource implementation for a large number of institutional development components, while PKSF will implement only those components where it has comparative advantage over other institutions. Key elements of the institutional development components include: * Preparation of business plans linking POs' expansion plans to institutional development plans. * Extension of technical support to improve POs' operational efficiency. * Strengthening the Training Cell and outsourcing of training activities through partnerships with competent service providers. * Strengthening PKSF's MIS and its integration with POs. * Strengthening PKSF's financial management system, including the audit function. * Creation of institutional capacity for delivering services to the hard-core poor, urban microcredit and microenterprise loans and undertaking impact assessment on a continuous basis. * Strengthening research and development capacity for studying microfinance issues and impact assessment. * Preparation of HRD policy for career planning, evaluation, and incentives. * Establishment of a Credit Bureau to monitor the borrowers and the industry. To attain sustainable institutional capacity, PKSF discussed contents of the foreign training program, methods of training deliveries, organizational structure, and staff requirement with its staff and participating POs. The Training Cell at PKSF will be managed by a competent manager with relevant experience in the sector to achieve training targets and ensure quality. PKSF will also prepare the TORs for the Credit Bureau for effective implementation. M) Total (U financi) Total Project Costs Total Financing Required Indicative obank % Of COPompol I Sector Costs % of financing ak- i (U"S Rural microcredit Other Finance Urban rnicrocredit Other Finance Hard-core poor Other Finance Microenterprise lending Other Finance Institutional development Other Finance

12 2. Key policy and institutional reforms supported by the project: PKSF's Governing Body has already made a strategic decision to expand PKSF's services to urban areas, graduate borrowers, and the hard-core poor, and to develop performance standards for NGOs-MFIs to support self-regulation. It has revised interest rate policy and adopted a policy which will create incentives for NGOs-MFIs to be cost-efficient and sustainable. PKSF has also readjusted the terms and conditions of the loans to small and medium-size POs and big POs to balance the need for subsidy and the objective of market integration. It has decided to raise funds from the capital market by issuing bonds and has planned to help POs mobilize funds from the market by providing guarantees. PKSF has agreed to the following institutional reforms identified through an Institutional Audit by IDA-financed consultants: * Separate the operations of small and medium-size POs and big POs. Microcredit to small and medium-size POs is managed under PKSF's OOSA department, while microcredit to big POs is managed under BIPOOL wing. * Increase the authority of PKSF staff to help accelerate project implementation. * Enhance the financial authority of the Managing Director. * Create an independent audit department directly responsible to the Managing Director. * Prepare a human resource development (HRD) policy for PKSF and POs. 3. Benefits and target population: a. Benefits: The project will alleviate poverty by integrating the poor into the economy through income generating activities that result in economic growth and create employment. The project will empower beneficiaries, make them more aware of social issues, and promote family welfare. A study commissioned by PKSF and conducted by the Bangladesh Institute of Development Studies (BIDS) and an IDA-sponsored appraisal of 675 borrowers with at least four loans reveal the following: BIDS Study Findings: * More than 40% of rural households participate in microcredit programs, suggesting a sustained increase of microcredit coverage. * The informal credit market persists despite the fact that the microfinance sector coverage has expanded over the years. About 16% of the surveyed households borrow from the informal market, while 31% borrow from both microfinance and informal sources. a Microcredit seems to increase the incidence of cash-based transfer of land (mortgaged in or fixed in rental of land). * Microcredit has enhanced the rural savings rate --- the average savings of program participating households is more than three times the average household savings in rural Bangladesh. * NGOs-MFIs participation has enhanced opportunities and positively affected time spent in self-employment activities for women in terms of participation in income generating activities and responses to fertility and contraceptive behavior. * The incidence of multiple membership, both at the household and individual level, has been a major concern. IDA Study Findings: * Income improved for 98% of borrowers, food intake for 89%, housing conditions for 75% and sanitation conditions for 69%. * Child education improved for 75% of borrowers. * Overall quality of life improved for 95% of borrowers. * Some 29% of borrowers acquired land, and 87% accumulated assets from the income earned as a result of microcredit. -8 -

13 b. Targetpopulation: The target population is men and women whose income is below the poverty line. Traditionally, 90% of microcredit clients have been poor women. The proposed project will have an estimated outreach of 1.2 million new borrowers (about 1.1 million of them women). The new borrowers constitute 0.53 million rural poor, 0.4 million hard-core poor and 0.27 million urban poor. The hard-core poor has been identified by NGOs-MFIs, government, and local level elected bodies as the vulnerable group in the society. Furthermore, the project will support 19,500 microentrepreneurs who can scale-up their microcredit activities to microenterprises for potential economic growth and employment generation. 4. Institutional and implementation arrangements: Implementation period:4 years Executing agency: Palli Karma-Sahayak Foundation (PKSF) PKSF is a successful second-tier financial institution that provides loans to its POs for lending to poor borrowers, predominantly women. Established in 1990 under government sponsorship and registered under the Companies Act of 1913 as a private, nonprofit organization, it has a seven-member Governing Body and a 15-member General Body, most of whom are leaders and social workers of national and intemational repute. The General Body meets annually to provide policy directions, discuss the Governing Body's report, examine PKSF's financial statements, and appoint the auditor. The Governing Body is responsible for overall policies and operations (including loan approval). The government nominates the Chairperson (who cannot be a serving member of the government) and two members; the Governing Body recruits its own Managing Director from the private sector. The internationally renowned members of the Governing Body are one of PKSF's great strengths. The Governing Body is fully autonomous in formulating policies and overseeing operations, including staff recruitment, termination, and compensation. PKSF has 115 staff members, 61 of them are professional staff. The project will largely follow PKSF's current implementation arrangements for rural microcredit, which have proven highly satisfactory, while strengthening PKSF's capacity to expand activities in lending to hard-core poor, urban microcredit and microenterprise lending, and developing human resources. PKSF will continue to apply stringent criteria in enlisting new POs and will intensify its supervision and monitoring activities. Under the credit covenant of Microfinance 1, PKSF's POs have agreed to maintain a collection rate of 95% or better - 90% of them have done so. PKSF provides stringent follow-up supervision of the 10% of POs that fail to maintain this collection rate, and many have subsequently improved their performance. PKSF has agreed to the following implementation changes: * To apply international standards of accounting and auditing to PKSF and big POs. * To undertake audits of at least 75% of eligible small and medium-size POs by PKSF's external auditor. * To create additional staff capacity to implement lending to the hard-core poor, urban microcredit and microenterprise. * To apply eligibility criteria for POs seeking to obtain loans for urban microcredit, microenterprise lending, and lending to hard-core poor. * To implement business plans agreed with small and medium-size POs, and to build their institutional capacity so that they can deliver financially sustainable microfinance services. PKSF has already implemented the following new measures: * Separated the operations of small and medium-size POs and big POs. * Established an independent Audit Department and hired a Deputy General Manager (audit) to -9-

14 introduce strong financial monitoring and control. * Recruited an Advisor with responsibility for big POs and for overseeing the financial management of PKSF. * Initiated decentralization of its supervision and monitoring activities. * Initiated amendments to the Public Demand Recovery (PDR) Act to provide PKSF with legal coverage to collect its loans from POs. Overall Assessment of PKSF and POs for Sustainability: A limited scope due diligence of PKSF and the three big POs (ASA, BRAC and PROSHIKA) was undertaken to determine their creditworthiness, institutional capacity, and long-term ability to comply with eligibility criteria for participation in the project. The available data and analysis suggest that both PKSF and big POs would be able to meet their financial commitments to creditors within the project imnplementation period. Beyond this period, however, there are uncertainties as to the sustainability of PKSF and big POs. In the case of PKSF, continued operations will depend on the availability of long-term financing on soft terms. If soft loans continue to be available, it could attain financial sustainability, i.e., the ability to cover operating and financial costs at market terms, within the project implementation period and up to PKSF will experience growing credit concentration with loan exposure to big POs rising from 71% of the portfolio in FY99, to 79% in FY00, and thereafter to about 90% up to FY10. The identified strengths of PKSF include: GOB, donor and extemal positive support of PKSF's objectives; committed and professional Governing Body, management and staff; strong financial and administrative controls; and developed network of POs to implement microfinance goals. The weaknesses consist of: currently high and growing portfolio concentration; unproven long-term economic sustainability; audited financial statements based on Bangladesh Accounting Standards not on International Accounting Standards (IAS) issued by International Accounting Standards Committee (IASC); scope for extended audit oversight by PKSF's Governing Body over PSKF and POs' operations; and high staff turnover. The opportunities include: fulfilling the demand for quality microfinance; deepening the program to reach the urban poor and hard-core poor; scaling-up the program for microentrepreneurs; continuing institutional development of small and medium-size POs; and PKSF's initiatives in promoting and introducing innovation. The threats include: signs of portfolio stress; absence of collateral position in POs; systematic risks and absence of a regulatory framework; weak governance and staff of POs; and limited scope for POs to adjust interest rate and product diversification. Big POs revealed some cornmon issues, which include: (a) the need in due course to look into questions about the legal basis for their operations outside social development programs; (b) the need to enhance the independence of General and Governing Bodies; (c) the absence of an Audit Committee of the Governing Body in two POs (one PO having recently introduced a mechanism to provide audit oversight); (d) the need to segregate the funding of social and economic development programs in the light of subsidies extended by microfinance operations in favor of social development prograrns; (e) the possible consideration of a governance contract, among other options, between the governing bodies and the management team to highlight transparency, accountability, and performance benchmarking; (f) the overlapping borrowers of POs which reportedly has contributed to unhealthy competition among NGOs-MFIs; (g) the desirability of having audited financial statements prepared in accordance with IAS as issued by IASC; and (h) the adoption of asset/liability policies and structures in view of the deposit-taking functions of POs. Big POs have exhibited during the project implementation period the institutional and financial capacity to intermediate higher levels of IDA funds through PKSF and the ability to service its financial commitmnents. The microfinance operations of big POs appear sustainable, although there is a need to further enhance - 10-

15 their operating efficiencies. Of these POs, ASA is focused principally on microfinance and has demonstrated its ability to attain a certain degree of economic sustainability. Both BRAC and PROSHIKA have successful social development programs, but they are heavily reliant on donor funding and only partly on internal subsidy from their microfmance operations. While BRAC and PROSHIKA have donor commitments for at least the next four years, uncertainties as to future level of donor funding raise questions on their long-run ability to meet financial commitments. Accordingly, these two POs are considering the feasibility of spinning off their microfinance operations to create a "firewall" against the funding requirements of their social development programs. 2The 'ultra hard-core poor' group represents the 'bottom layer', the bottom 5-10% of population. 'PKSF also supports the linkage between microftnance and safety-net programs by financing the credit ccmponent of ASOD, GUK and Grameen Krishi's involvement with IFADEP. Progressive borrowers are graduate borrowers, who qualify for microentreprise loans and will be referred to as "microentrepreneurs". 'The reasons for using existing lending mechanisms for extending microenterprise loans are the following: (a) they are unlikely to be supported by commercial banks as they are unable to provide collateral for loans and the loan size is small (US$ 1,000-2,000); (b) lending to graduate borrowers takes advantage of the long relationship that POs developed with borrowers which provide them with the knowledge of the borrowers' entrepreneurial abilities and history of their credit relationships; and (c) they will create employment for the hard-core poor at the local level. D. Project Rationale 1. Project alternatives considered and reasons for rejection: a. Rationale: [IDA involvement has been justified (OP 8:30) from the criteria discussed in the brainstorming session in Washington on October 4, 1999, see project file]: IDA's continuing assistance for microfinance is justified by the strong impact of Microfinance I on poverty through consumption smoothening, improved quality of life (access to clean drinking water, better health and hygienic conditions), increased school enrollment rates, and enhanced family assets (see Section C3). It surpassed IDA's target outreach of 1.2 million borrowers by about 70%. PKSF's POs have enhanced their institutional capacity to expand microcredit programs through better portfolio performance, delivering cost-effective services, and attaining some degree of financial sustainability. An IDA study of 21 POs shows that almost all POs now meet all financial costs and generate a surplus at current borrowing rates, and 90% achieve the agreed collection rate of 95% or better. PKSF has increased its capacity to strengthen small and medium-size POs, and some of the medium ones have made institutional and financial advances that qualify them as big POs. PKSF fully meets its operational costs, and its provisioning policy meets international standards. Its dependence on soft loans is expected to gradually lessen beyond 2010, as stated in its vision document "PKSF: 2010". b. Lending alternatives: The project contains components which can be classified into two distinct groups: (a) mainstream microcredit comprising of rural microcredit, urban microcredit, and institutional development; and (b) experimentation or new components comprising of credit extension to hard-core poor and microenterprise lending, and a pilot to extend credit to the ultra hard-core poor. Whether IDA's role should only be in scaling-up existing mainstream microcredit operations to improve their efficiency or should it also consider implementing innovative components in terns of design, products, and new methods through PKSF and POs, has been examined. IDA's panel examined various options, including IDA assistance (i) to scale-up mainstream microcredit activities because it has successfully worked and further assistance will promote sustainability; (ii) with the experimentation components only, while the scaling-up could be left with the other donors (bilateral or ADB); (iii) for both the scaling-up and experimentation; and (iv) to implement all components, except for credit to the ultra hard-core poor which could be done through a LIL, involving more social scientists in the preparation as this component will require a large subsidy

16 Scaling-up of microcredit: IDA has comparative advantage in scaling-up mainstream microcredit operations in Bangladesh. The scaling-up is justified because: (a) the implementation experience of Microfinance I has been successful and the impact has been positive; (b) IDA has been the leading donor in financing microcredit, while other donors funds are drying up. Traditional microcredit donors have explained at local donor coordinating group meetings (Microfinance Subgroup) that their governments' current policy is to provide funding through IDA rather than directly; (c) market funds are not available as POs' intermediation costs have been high and they lack adequate institutional capacity; and (d) such help will meet the IDA objective of leading the industry to the market gradually. The scaling-up will also help in increasing borrowers' sustainability through repeat microcredit loans. The borrowers need repeater loans to graduate from nmicrocredit into the mainstream economy on a sustainable basis'. In terms of loan size, Microfinance I SAR stated that "the average loan of current borrowers of PKSF's PO is about Tk.2,500 (1995). By the end of the project (2001), the average loan size is expected to be about Tk.6-7 thousand, compared to minimum loan of Tk.8-10 thousand that a borrower needs to have for a few years to cross the poverty line". Moreover, because of poor economic performance, frequent natural calamities, and the low flow of graduate borrowers, a lot of people fall back into poverty. IDA's continued involvement would enhance POs' creditworthiness, promote borrowers' sustainability, and integrate the microfinance industry with the formal financial market. Innovative microcredit component: (i) Hard-core poor: Inclusion of a component for the hard-core poor will be a positive intervention within the project to sustain the benefits of microcredit already extended to them (see Annex 2). However, PKSF's and PO's institutional capacity needs to be enhanced to provide microfinance services to the hard-core poor. (ii) Ultra hard-core poor: Within the 'hard-core' poor group there is a 'bottom layer' (the 'ultra hard-core poor' or say the bottom 5-10% of the population) who do not even join, let alone benefit, from microcredit program. Although the pre-appraisal mission appraised the 'ultra hard-core poor' as a component of the project, in subsequent discussions with PKSF, it was decided that this component will be separated out of Microfinance II. This is considering the fact that the extension of loans to 'ultra hard-core' poor should be innovative as no proven credit delivery method is available and such credit extension requires a large subsidy element to help these borrowers with subsidized consumption loans and grant element for capacity building. This component has been, therefore, taken out of this project as it should be processed as a Learning and Innovation Loan (LIL) of US$5 million equivalent. An experimental ultra 'hard-core poor' component (e.g. 100,000 'ultra hard-core poor' households) could be designed for whom financial and non-financial products can be offered, depending on a detailed need assessment of their individual condition. A 'hard-core poor grant fund' should be created in PKSF to disburse to POs who provide services for the hard-core poor to meet their additional costs. This grant element could be used for the hard-core poor to stimulate innovative products, finance a 'disaster fund', provide for specific skill training, and fund action research and study tours for POs to gain familiarity with such programs. (iii) Microenterprise lending: Microenterprise loans will meet the objective of helping graduate borrowers attain sustainability. They will promote economic growth and generate employment at the local level for the hard-core poor. Its inclusion as a component will, however, need substantial capacity building and market support. Field studies show that NGOs-MFIs are increasingly mobilizing special groups within the microcredit framework to extend higher amount of loan (2-5 times the size of microcredit) to undertake microenterprise activities. Given the larger size of loans and higher recovery rate, the intermediation costs of such loans are relatively lower than those of microcredit. These financial gains enable NGOs-MFIs to diversify products and improve portfolio quality by risk management, and help them towards financial sustainability and the market. The successful implementation of microenterprise lending will require PKSF to develop its capacity to implement the component. This will include careful selection of POs to build their

17 capacity, design the selection criteria for borrowers, and build training arrangements. c. Funding alternatives: Several factors have prompted consideration of alternative funding methods: (a) PKSF's capacity was not built adequately to meet the institutional development needs of small and medium-size POs; (b) since big POs are already equipped with MIS and training institutions, PKSF's role was limited to channeling of funds; (c) PKSF's loan exposure to big POs is about twice the limit for single borrowers, according to prudential standards for commercial banks; and (d) the government preferred to channel funds to big POs through PKSF. The following options were examined during the pre-appraisal: * Processing a direct loan to big POs under government guarantees. * Re-engineering the way PKSF channels funds to big POs. PKSF could channel the funds on a commission basis so that the funding is off-balance-sheet. The government would bear the credit risk, and the commission could be based on collection performance. These options were rejected and the existing channel mechanism prevailed, for the following reasons: (a) government's reluctance to provide guarantees for direct IDA loans to big NGOs-MFIs, because there is no existing mechanism within the government or in its agencies to supervise such direct loans to big NGOs-MFIs; (b) the govenunent does not consider the concentration of PKSF's loan to big POs as a problem as these loans are guaranteed by it; and (c) PKSF's own sustainability is not considered as a primary objective of the government and the PKSF Board, considering that PKSF is effectively wholesaling microcredit fund according to its chartered obligations. d. IDA strategy: IDA's strategy is to promote microfinance as a market-based operation. The proposed project will work towards this objective by fostering competition among NGOs-MFIs, and by helping NGOs-MFIs achieve creditworthiness. It will help in creating an enabling environment for integrating microfmance with the formal financial sector, and assisting PKSF in developing self-regulating policies for savings and deposits to forestall premature and inappropriate government regulations that could stifle NGOs-MFIs growth and innovation. Given the distinct characteristics of NGOs-MFIs, the IDA strategy would be as follows:. IDA would support the big POs to develop their own instruments for mobilizing funds for microfinance, by establishing banking or non-banking subsidiaries, issuing bonds and debentures, or designing savings instruments. PKSF's vision document "PKSF: 2010" confirms its willingness to provide guarantees to help big POs access the capital markets. * IDA will provide preferential support to small and medium-size POs under the project, since they still need soft funds to survive. Beyond 2010, the vision document envisages meeting substantially the demand for funds for small and medium-size POs from its own resources and from market fnancial instruments

18 2. Major related projects financed by the Bank and/or other development agencies (completed, ongoing and planned). Latest Supervision Sector issue Project (PSR) Ratings :: [(Bank-financed pro pc only) Implementation Development Bank-financed Progress (IP) Objective (DO) The pervasive poverty of the country, Poverty Alleviation HS HS as around 50% of people live below the Microfinance Project poverty line, of whom 36% are absolute (Microfinance I) poor. Reduce public sector dominance in silk Silk Development Project S S production to increase efficiency and competition. Other development agencies Lack of employment opportunities in Asian Development Bank rural areas and promotion of extension (ADB) financed Participatory support. Livestock Development Project Pervasive poverty resulting from lack of ADB financed Rural Livelihood productive jobs. Project IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), HU (Highly Unsatisfactory) 3. Lessons learned and reflected in the project design: Several lessons learned from the ongoing Microfnance I guided the design of the proposed project: 9 Strong institutional development efforts are needed if POs are to become sustainable. e Intensive supervision and monitoring of POs by skilled PKSF staff with sensitivity to clients is essential for maintaining portfolio quality. * A rating system for POs will help PKSF manage risk related to resource allocation and provide early warning of problems. * A "business plan" showing its strategic goals, expansion plans, institutional development needs, and measures to attain them, is a useful management tool for PKSF and POs. * Evaluation of the creditworthiness, institutional capacity, and empowerment efforts of all POs (small to big) in making a sustainable positive impact on borrowers is necessary. * Review of the interest rate policy of POs with respect to sustainability (ability to absorb the cost of funds and to raise capital in financial markets) is essential. * A human resource development (HRD) policy for PKSF and POs is required to promote staff motivation and ensure their career paths for efficiency and sustainability of the sector. 4. Indications of borrower commitment and ownership: The following reflects the borrower's strong commitment to the project: * Poverty alleviation is one of the government's main policy objectives. The Prime Minister has identified access to credit as one of the best instruments for reducing poverty. * The government's commitment to the success of PKSF's microcredit promotion is clear in the

19 government's policy of noninterference in PKSF's activities, its reduced representation in PKSF's Governing Body (from four members to three), and the Governing Body's complete autonomy in operations and in the recruitment of the Managing Director. * The government has kept its loan disbursement to PKSF through the subsidiary loan agreement outside the Annual Development Program (ADP). * Parliament's approval for separating the government microcredit program (RD-12), funded by CIDA (Canada), from BRDB by creating an autonomous Foundation similar to PKSF also demonstrates government ownership of microcredit programs. * PKSF's strong commitment and ownership are reflected in its highly satisfactory implementation of Microfinance I and the attainment of its development objectives. * PKSF's commitment is also reflected in its agreement to build its own institutional capacity and that of its POs, to assist in developing a legal and regulatory framework, and gradually raise capital from financial markets. * PKSF's commitment is also demonstrated through the preparation of the vision document "PKSF: 2010" and approval of it by the Governing Body, which outlines PKSF's future activities, strategic plans, and measures to attain its own sustainability and that of its POs. 5. Value added of Bank support in this project: The proposed project will build on the Bank's role in strengthening Bangladesh's microfinance sector started under the first project, along the following lines: * The CAS objective of poverty alleviation will be met through increased income and improvements in quality of life for the poor as a result of their access to microcredit and new income generating activities. Through improvements in capacity building based on lessons from Microfinance 1, PKSF's operations will be strengthened, enabling it to assist POs and borrowers to achieve sustainability. * As a lead donor in mnicrofmance, the Bank's experience in the sector can contribute to the development of performance standards and the formulation of a legal and regulatory framework to promote accountability, competition, and the creditworthiness needed to integrate the microfmance industry with the formal financial sector. * Innovative methods of lending based on best practices will help to extend outreach to the hard-core poor and develop commercial microenterprise lending, thus generating employment and growth. * By initiating direct dialogue between the Bank and POs, NGOs-MFIs, borrowers, and other stakeholders through participation in meetings, scoping sessions and visits, the Bank can promote its message of empowerment and poverty alleviation to clients. A number of studies have shown that microcredit borrowers need 8-10 repeater loans to graduate out of poverty. E. Summary Project Analysis (Detailed assessments are in the project file, see Annex 8) 1. Economic (see Annex 4): * Cost benefit NPV=US$ million; ERR = % (see Annex 4) O Cost effectiveness O Other (specify) As microcredit loans are typically for one year, calculation of financial rate of return (FRR) or economic rate of return (ERR) is not appropriate. Cost benefit analysis of microcredit activities is complex. Cost and benefit streams are not totally accounted for and the costing of resources employed is often difficult. It will therefore be meaningful to calculate the benefits of microcredit in terms of the following:

20 (a) (b) evaluation of the impact of microcredit activity at the household level in terms of surplus to household income; and calculation of rates of return for a number of major microcredit investments by assuming the investments as one-year investments and comparing their returns with the microcredit effective rate of retum. Impact on households: A study of 85 families conducted for the purpose of project appraisal shows that all families generated surplus (receipts minus payrnents) during the year. This was calculated by taking into account the micro-investments already made, the loan installment already paid and the remaining loans to be paid off fully during the year. Since these families are generating surplus, it is expected that they will be able to repay the remaining loan installments as well. Families spent on an average Tk.83,000 as rnicro-investment. The contribution of microcredit to the family income has been thus found to be significant. On an average it contributed about Tk.37,800 per year as additional income in the form of family labor and profit. The proportion of contribution from microcredit to total family income is very significant; it has been found to be sometimes as high as 90%. Rate of return of microcredit investments: All 85 microcredit investments studied have produced profits. The rate of return varied between 36% to 226%. The overhead cost and hired labor in most of these investments are zero leading to very high rate of return. Activities with short business cycles, where money could revolve over and over within the year (e.g. trading, grocery shops, and restaurants) have very high returns, while activities having long business cycles like poultry, fish farming, cattle fattening have relatively low rate of return. Importantly, the rate of return in all cases has been found to be higher than the effective rate of interest of microcredit, which varies from 18% to 30% annually. 2. Financial (see Annex 4 and Annex 5): NPV=US$ million; FRR = % (see Annex 4) Fiscal Impact: The IDA loan to PKSF for microcredit operations is unlikely to have any revenue implications for the budget, primarily because microcredit lending is targeted at the extreme poor. Income or employment generation for the poor resulting from this support will not generate enough income to produce income tax revenue or enough consumption to produce extra revenue from indirect taxes. The major fiscal implications arise from the projected budgetary support of the government to PKSF over the next five years and beyond. Thus the primary fiscal impact arises from: (a) PKSF's management of its debt service obligations; (b) the govenrment's commitment to lend nearly US$150 million equivalent of budgetary resources between 2000 and 2005; and (c) the opportunity cost of public resources due to the on-lending of US$150 million equivalent at the concessional interest rate of 1%. PKSF is not borrowing comnmercially yet and all its existing debt is concessional. It is, therefore, meeting its debt service obligations quite easily from its operating surplus. In fact, its debt service coverage ratio in FY00 was 6 times. It is projected to rise and remain around 8 times during the project period which is more than adequate. The government plans to contribute around 1% of its development budget every year to PKSF for microcredit in order to move approximately 1.2 million poor people out of poverty. There is an element of subsidy in this loan given that the opportunity cost of public resources is significantly greater than 1%. A transparent budget would have to recognize this as a subsidy directed to the reduction of poverty. 3. Technical: The main thrust of the project is to build upon technically proven methods of microfinance deliveries; hence, the project design is sound and efficient. However, the new components added to the existing

21 microcredit programs, like urban credit, credit extension to the hard-core poor, and microenterprise lending, although not directly financed by PKSF, are credit delivery methods that have already been successfully implemented by some PKSF's POs. They have used various sources of funds, including their own resources, bilateral grants and sometimes PKSF funds. The outcome has been highly successful in terms of collection performance and impact. PKSF's own pilot schemes to evaluate the feasibility of these programs have been highly successful with respect to operational and financial performance. The technical design of the project had full ownership of PKSF and POs because it evolved through implementation experiences, several discussions between PKSF and POs and recognition of the best practices in the industry. PKSF's Governing Body participated fully in the project design process and in the preparation and approval of PKSF's vision document "PKSF: 2010", project concept note and various project documents for project implementation. The viability and soundness of the project was confirmed by over 150 PKSF, POs through various seminars, workshops and scoping sessions. 4. Institutional: Creating sustainable institutional capacity in PKSF and its POs is the key to expanding outreach, diversifying activities, and attaining financial and institutional sustainability. The design of the institutional development component is demand driven and has been constructed based on the implementation experience of Microfinance I and detailed discussions among PKSF, POs and IDA. The program will ensure sustainable institution building of PKSF, POs and borrowers. A Steering Committee will be constituted to oversee efficient implementation and regular progress monitoring of the project's institutional development component. 4.1 Executing agencies: PKSF is the executing agency of the project. Its mnain role is that of an intermediary to wholesale microcredit, while POs retail microcredit to borrowers. PKSF has a strong management, competent and skilled staff with good academic and professional background, good financial management and control, and an effective training program. It has an efficient supervision and monitoring system to keep control over the POs so that they can effectively implement their credit program. PKSF ensures good management of POs credit program through various policies and instruments. These measures have positive impact on POs' management, govemance, credit and saving policies, capacity building and expansion program. 4.2 Project management: The project management comprises PKSF's senior management team under the direct supervision of its Managing Director. PKSF's Governing Body, well recognized for its independence, competence and reputation will provide the overall support and key policy approvals. Management will be supported by competent professionals and supporting staff. PKSF has a well structured management system with a good information flow within the layers. This ensures quick decision making and efficient management. The operations and management structure dealing with small and medium-size POs will be different from that with big POs. The General Manager (Operations) will manage the operations of small and medium-size POs, while the operations of big POs will be directly supervised by the Advisor. The operational, financial and other records will be maintained separately for small and medium-size POs and big POs, which has already been implemented. The project management will be monitored through MIS. MIS capacity will be enhanced through its integration amongst PKSF and various POs so as to have better information flow. PKSF undertakes internal audit of all PKSF POs to ensure their sound operational and management performance. It's own accounts are audited by an independent external auditor. PKSF's external auditor also undertakes financial audit of 75% of PKSF POs as part of management and portfolio audits of PKSF. POs are obliged under the sub-loan agreement to cooperate with PKSF's external auditor to provide operational and financial information. Auditor's terms of reference will include PKSF's audit according to - 17-

22 International Standards on Auditing (ISA), issued by International Federation of Accountants (IFAC). Periodic assessment of PKSF and big POs will be undertaken to ensure their continuous eligibility in PKSF's microcredit program. 4.3 Procurement issues: PKSF's procurement activities will be limited to procuring equipment and services to implement the institutional development component. It will consist of procurement of hardware, software and consultancy services to enhance MIS capacity; establishment of a Credit Bureau; appointment of consultants to undertake studies related to impact assessment of microcredit; establishment of a regulatory framework; and commission of studies of contemporary issues on microfmance. PKSF will also be involved in procurement of books, journals and dissemination of good practices through developing awareness programs. Although, PKSF is going to continue the construction work of its office-cum-training building, which was initially financed by IDA under Microfinance I, the building completion will be financed by PKSF itself. PKSF's current capacity is adequate to undertake procurement activities for institutional development components. However, to enhance PKSF's internal procurement capacity and help accelerate procurement of various components, it has recently appointed a Procurement Specialist on a retainer basis (see Annex 6). 4.4 Financial management issues: a. Financial Management Capacity: PKSF's current capacity is sufficient to operate a proper project financial management system. It has two qualified Chartered Accountants and five trained accountants. PKSF has developed adequate manuals and procedures for proper financial management of both PKSF and POs. A monitoring mechanism is in place to ensure effective monitoring of POs, which are widely dispersed in the country. PKSF prepares periodic financial reports which provide timely, relevant and accurate information on the financial performance. The reporting formats have been re-designed for required project management reports (PMRs), which will be provided to IDA on a quarterly basis during the project implementation period (See Annex 6). b. Financial Management Risks: The main anticipated financial management risk is inadequate internal control over expenditures incurred by smaller POs. PKSF has instituted adequate measures to mitigate such risk. It has an internal audit department headed by a professional accountant. The intemal auditors conduct audit of the POs once a year. Moreover, PKSF's project staff make regular supervision to monitor operational performance and financial management. It has stringent criteria and policy guidelines to ensure strong internal control, good governance, effective MIS and efficient management to undertake microfnance activities. PKSF will ensure through a financial management assessment by qualified PKSF staff, undertaken as part of the selection process, that NGOs-MFIs with weak internal control systems and management are not selected as POs. During supervision, the Bank will also conduct regular SOE reviews. 5. Environmental: Environmental Category: F (Financial Intermediary Assessment) 5.1 Summarize the steps undertaken for environmental assessment and EMP preparation (including consultation and disclosure) and the significant issues and their treatment emerging from this analysis. A meeting of POs was convened by PKSF in March 2000, to discuss environmental issues arising from the project. These issues were further refined during the Stakeholders' Workshop held on May 6, The two main environmental issues identified were as follows: a. Management of Microenterprise Environmental, Health and Safety Risks: Nornal microcredit activities, with supporting loans of less than Tk.50,000, create negligible environmental risks. However, since the project will support lending of up to Tk.200,000 for microenterprise development, some activities may create local Environmental, Health and Safety (EHS) hazards that should be addressed. To this end, project preparation has included development of a Guideline for Management of Microenterprise EHS

23 Risks, which includes checklists for screening such activities and mitigating their inpact. The Guideline is designed to be sufficiently simple for application by PO fieldworkers. The Institutional Development component of the project includes resources to supportraining of PKSF and PO staff in its application. The Guideline has been reviewed by a meeting of POs on September 9, 2000, and has been made publicly available. b Capacity Buildingfor Environmental Management: It was agreed that the project's Institutional Development component will support capacity building for environmental management in PKSF, as well as in small and medium-size POs. The component is not targeted at big POs, which have already benefited from extensive institutional support from bilateral donors. PKSF will prepare training modules and technical assistance for improved environmental management in both microenterprise lending and traditional microcredit operations. This support will be designed to build capacity at both management and field worker levels, and will also promote the development and dissemination of clear environmental messages appropriate to microcredit borrowers. 5.2 What are the main features of the EMP and are they adequate? The EMP consists of two elements, (i) the Guideline for Management of Microenterprise EHS Risks, and (ii) provision for capacity building in environmental management under the project's Institutional Development component. These elements provide sufficient basis both to address the relatively minor environmental risks of the project, and to take advantage of the opportunity for improving environmental awareness and management through the project. 5.3 For Category A and B projects, timeline and status of EA: Date of receipt of final draft: Not applicable 5.4 How have stakeholders been consulted at the stage of (a) environmental screening and (b) draft EA report on the environmental impacts and proposed environment management plan? Describe mechanisms of consultation that were used and which groups were consulted? Identification of environmental issues was undertaken in two stages; fust through a meeting of POs, and second through a stakeholder workshop. The workshop was attended by 50 borrowers, 25 field officers and 25 Chief Executive Officers (CEOs) of 25 POs, as well as GOB officials, PKSF staff, civil society members, and World Bank mission members. Stakeholders discussed a range of issues pertaining to project design and the microfinance sector, and presented results in a plenary session. The final draft of the Guideline for Management of Microenterprise EHS Risks was reviewed in an additional meeting of PKSF staff and selected POs, and the draft was revised accordingly. 5.5 What mechanisms have been established to monitor and evaluate the impact of the project on the environment? Do the indicators reflect the objectives and results of the EMP? Monitoring of microenterprise investment implementation by POs, and monitoring of POs' performance by PKSF will include an assessment of (a) the adequacy of the Guideline for Management of Microenterprise EHS Risks; and (b) the effectiveness of the application of the Guideline. Monitoring and evaluation of capacity building for environmental management will be conducted as part of the supervision of the project's Institutional Development component. These assessments cover the two elements of the EMP

24 6. Social: 6.1 Summarize key social issues relevant to the project objectives, and specify the project's social development outcomes. Social assessment and different studies indicate that there have been strong positive impacts in terms of improving socio-economic status of borrowers, particularly women and the poor. Borrowers and their family members value access to and availability of microfmance services, which has created social cohesiveness and unity among under-privileged groups and promoted their empowerment. The beneficiaries and their families are proud of their achievements and want to keep microfmance institutions sustainable. The social indicators of borrowers, e.g. health, nutrition, education, awareness and participation in social and political activities, are higher than others in the same socio-economic category. Microcredit facilitates women's empowerment by increasing their mobility, income generation and decision making in the family and community, and improving gender relations. Social assessment also found that microcredit does not promote child labor; rather, it contributes towards increasing children's enrollment in school as a consequence of increase in family income. Microfmance II will introduce new groups of beneficiaries, e.g. microenterprise borrowers, the hard-core poor and urban slum dwellers. However, different literature has identified social and gender concerns at the grassroots level which may be aggravated by introduction of microcredit in new areas with new groups. A recent study (BRAC, 2000) indicate that violence against women have increased among groups of new borrowers; nevertheless, when the NGOs-MFIs identified the cause, they expanded social development training for both female beneficiaries and their husbands. Consequently, violence decreased as a result of enhanced social awareness in the community. Sirmilarly, while at the initial period men were controlling the amount of credit and income, with training, skill development and networking, more women were empowered and took control over their investment and income. This had a beneficial impact on the health, nutrition and educational attainment of children. Furthermore, a recent study (PROSHIKA, 2000) found that microcredit has increased women's work burden by only 1.50 hours a day. Therefore, women do not get overburdened nor is there significant welfare loss of children, indicating the possibility of scaling up credit ceilings for beneficiaries, as well as expansion of the program. Sustainability of poverty reduction program, and improved quality of life of beneficiaries and their families are major concerns. POs will need to balance between creating economic opportunities and increasing social awareness of their beneficiaries. The social development outcome of this project would include improved quality of life, sustainable poverty reduction, empowerment of the poor and women, equity and inclusion in society, strengthening of social capital and cohesion, and promotion of accountable and transparent institutions. The empowerment outcome will be measured by key indicators such as mobility, economic security, ability to make small purchases, ability to make larger purchases, involvement in major decisions, relative freedom from domination by the family, political and legal awareness, participation in public protests, and political campaigning. These empowerment indicators would be part of PKSF and POs MIS and would be used to monitor the project's progress towards the empowerment development objective. 6.2 Participatory Approach: How are key stakeholders participating in the project? a. Primary beneficiaries and other affected groups: The project design is based on extensive stakeholder's participation and consultation. A day-long stakeholder workshop with representatives of 151 participating NGOs-MFIs was held on May 1, 1999 to discuss design issues, including: (a) the differing roles of big POs and small and medium-size POs in microcredit outreach, especially to the hard-core poor; (b) the impact of microcredit on borrowers; (c) the financial sustainability of POs and borrower activities; (d) the institutional sustainability of PKSF and POs; (e) the extension of PKSF funds to selected POs for urban microcredit and microenterprise loans; (f) the environmental, social, and child labor concerns; (g)

25 interest rates and lending terms and conditions; and (h) the legal and regulatory framework. Smaller groups were formed to discuss these issues. Findings were presented in a plenary session to evolve concrete recommendations of the stakeholders. The project design largely benefits from the recommendations of the stakeholders' meeting. Stakeholders reconmmended holding a series of scoping sessions with POs' directors, staff and borrowers to discuss issues pertaining to reaching the hard-core poor; social and child labor concems; and the impact of microcredit on the poor. Four sessions involving 56 POs had been held in four regions of the country. Participants (55 directors, 91 staff, and 130 borrowers) actively contributed in these sessions. Findings of these sessions helped improve the design and quality of the project. The project design and scope was further discussed in a workshop held on May 6, 2000 during the pre-appraisal mission, and was participated by over one hundred NGOs-MFIs directors, fieldworkers, and beneficiaries. Participants discussed different mnicrofinance issues including: (a) gender issues in microfinance; (b) importance of social awareness in microfinance; (c) institutional development of PKSF and POs; (d) impact assessment of hard-core poor; and (e) PKSF policies. The project design was refined based on the outcome of this workshop. b. Donor coordination: A high degree of donor coordination has been maintained in Bank-supported microfmance activities. Local Consultative Group (LCG) members were regularly informed about project implementation issues during Microfinance I and design and processing issues for Microfmance II. For example, issues related to microfmance regulations were comprehensively discussed in subgroup meetings from which a broad consensus emerged in favor of self-regulation based on performance standards for the industry. The project's preparation mission held a meeting with key donors in microfinance to inform them about the project's objectives, design, and impact on the targeted poor. 6.3 How does the project involve consultations or collaboration with NGOs or other civil society organizations? The project concept was discussed with other NGOs-MFIs that are not PKSF POs, members of civil society, and experts in microcredit. These discussions also helped in improving project design and prioritization of issues relating to institutional development, legal and regulatory framework, and promotion of market-based microfinance operations. 6.4 What institutional arrangements have been provided to ensure the project achieves its social development outcomes? This project has been developed based on lessons learnt from Microfinance I and studies undertaken by experts. PKSF and POs developed the capacity to identify the needs of beneficiaries and take appropriate interventions. Sustainability of poverty reduction and improved quality of life of beneficiaries and their families are major concems, and POs will provide skill development and social awareness training, and access to market information. The project will also improve the capability of beneficiaries, assist them in selecting appropriate investment, diversify their income generating activities, help them to identify social and community issues, and encourage group action, thereby improving social cohesion and unity not only among beneficiaries, but also in the community. POs will focus on balancing economic and social agenda for sustainable improvement in the quality of life of beneficiaries. They have differentraining modules for the empowerment of beneficiaries, and these will be expanded under this project to increase the sustainability of both vertical and horizontal expansion of microfinance. Furthermore, there will be separate components for institutional development of POs, and for improvement of their capacity in their partnership with beneficiaries

26 6.5 How will the project monitor performance in terms of social development outcomes? Under Microfinance I, a time series study of selected microcredit borrowers is in progress. This study will initially continue to measure the socio-economic impact of the borrowers for four years. Under the project, PKSF will build research and development capacity to continue such kind of survey/study to undertake periodic social assessment during project implementation. An MIS is being developed at PKSF which will create linkage with POs to monitor and analyze operational and social outcomes. A social impact tool kit is also being designed by BIDS which will be installed at PKSF and POs to undertake continuous social impact assessment of microfinance interventions. 7. Safeguard Policies: 7.1 Do any of the following safeguard policies apply to the project? Environmental Assessment (OP 4.01, BP 4.01, GP 4.01) Natural habitats (OP 4.04, BP 4.04, GP 4.04) Forestry (OP 4.36, GP 4.36) Pest Management (OP 4.09) Cultural Property (OPN 11.03) Indigenous Peoples (OD 4.20) Involuntary Resettlement (OD 4.30) Safety of Dams (OP 4.37, BP 4.37) Projects in International Waters (OP 7.50, BP 7.50, GP 7.50) Projects in Disputed Areas (OP 7.60, BP 7.60, GP 7.60) 0 Yes 0 No 0 Yes * No 0 Yes 0 No 0 Yes 0 No 0 Yes 0 No 0 Yes * No 0 Yes 0 No 0 Yes * No 0 Yes 0 No 0 Yes * No 7.2 Describe provisions made by the project to ensure compliance with applicable safeguard policies. There are two level of safeguards in-built in the project to ensure compliance of policies. At the implementation level, PKSF's management ensures adherence to guidelines and policies by its staff and POs. There are a number of policy guidelines on operations, savings, disclosure, governance and other areas, implementation of which the management continuously monitors. The management's compliance with these policies is ensured through internal and external audits and periodic reviews of operations and performance by the Governing Body and annual evaluation by the General Body. IDA ensures compliance with these policy guidelines through regular contact, bi-annual supervisions, and mid-term review of the project

27 F. Sustainability and Risks 1. Sustainability: The project's sustainability beyond implementation depends on: (a) borrowers' graduation from the microcredit program (as a result of increased income, training, and empowerment); and (b) institutional and financial sustainability of POs (ability to assume capital costs and raise capital in the financial market) and PKSF (decreased dependence on soft loans and increased ability to mobilize funds in fnancial markets). The project will ensure a continuous flow of microcredito help borrowers graduate from the program. Graduate borrowers will be eligible for microenterprise loans for activities that will generate growth and employment opportunities for the hard-core poor. Through institution building for small and medium-size POs, the project will enhance their absorption capacity and reduce intermediation costs, enabling them to assume a rising share of capital costs as they move toward sustainability. Big POs which already have the institutional capacity to absorb higher capital costs will borrow at 7% annual interest rate and gradually improve their access to the financial market. PKSF expects to lessen its dependence on soft funds by 2010, as it accumulates capital and relies increasingly on market-based instruments (vision document "PKSF: 2010"). 2. Critical Risks (reflecting the failure of critical assumptions found in the fourth column of Annex 1): Risk Risk Rating Risk Mitigation Measure From Outputs to Objective PKSF's strong commitmento and N PKSF's strong commitment is reflected in its ownership of the project may wane during implementation of many of the recommendations project implementation. of the Institutional Audit of PKSF undertaken jointly by PKSF and IDA to improve operations and management. PKSF's Board members may not be N The government does not interfere in the strong enough to implement policy business of the Governing Body. Government's measures without outside influence. three members (one in active service and two retired civil servants) now represent a minority in the seven-member Board. PKSF may fail to motivate staff to M PKSF has agreed to prepare a human resource dedicate themselves to the mission of development policy covering performance poverty alleviation. evaluation, career development, and creation of a competitive compensation package. The number of POs in default may rise M PKSF is intensifying its supervision and due to poor portfolio quality. monitoring efforts through staff training and is instituting an "early warning system" to ensure reduction in loan default. PKSF's extensive exposure (70% of IDA' M PKSF and IDA jointly conducted a limited s disbursement) to big POs carries greater scope due diligence of big POs (ASA, portfolio risk. PROSHIKA, and BRAC) to improve upon eligibility criteria to ensure their creditworthiness and minimize the risk of exposure. From Components to Outputs -23 -

28 Delays in PKSF disbursements to POs S PKSF has classified POs according to their may lead borrowers to switch to other performance. This allows PKSF to optimize the NGOs-MFIs, causing POs to incur use of supervision resources. PKSF has also financial losses. recruited adequate number of PKSF staff and trained them to ensure timely and quality supervision. Multiple, overlapping loans to the same M PKSF, big POs, Grameen Bank, and the borrowers from POs and various Association of Development Agencies in NGOs-MFIs may increase defaults. Bangladesh, (ADAB), the apex body for NGOs, reached an understanding to act against loan overlapping. PKSF also developed a policy and will establish a Credit Bureau to reduce POs' overlapping. A decrease in the repayment rate and an M PKSF and POs have been complying with the increase in overdue loans may affect the collection rate covenant of 98% and 95%, sustainability of PKSF and its POs. respectively. These standards will be maintained. The amended Public Demand Recovery (PDR) Act will provide PKSF with a legal cover for loan collection from POs. Agreemento formulate a regulatory S The government, the Bangladesh Bank, PKSF, framework to attain sustainability may the Association of NGOs, and the NGO Bureau not be reached. are working through MRRU and the Steering Committee to develop regulatory framework for the microfinance sector to promote accountability and sustainability. IDA will be providing TA to this Committee through the Ministry of Finance and PKSF to formulate framework and develop industry standards. Overall Risk Rating Risk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N(Negligible or Low Risk) 3. Possible Controversial Aspects: The absence of a long-term PKSF plan for M G/M PKSF has prepared a vision document "PKSF: promoting a sustainable microfmance industry 2010" in which it lays out its intentions to by reducing NGOs-MFIs' dependence on donor create a sustainable microfmance industry, funds and mobilizing resources from the market gradually reduce its dependence on donor may undermine PKSF's strategic role as the funds, and increasingly access the market for apex financial institution. commercial sources of funds. Note: For risk type: S = social; E = ecological; P = pollution; G = govemance; M = management capacity; and 0 = other. For risk rating, H = high risk; S = substantial risk; and M = modest risk; and N = negligible or low risk

29 G. Main Loan Conditions 1. Effectiveness Condition The standard requirement for credit effectiveness is submission of legal opinion confirming that the Development Credit Agreement has been duly authorized or ratified by the Borrower and is legally binding upon GOB. The following are additional conditions for Credit effectiveness: (a) (b) (c) the Subsidiary Loan and Grant Agreement has been executed on behalf of the Borrower and PKSF; submission of legal opinion confirming that the Project Agreement has been duly authorized or ratified by PKSF, and is legally binding upon PKSF; and submission of legal opinion confirming that the Subsidiary Loan and Grant Agreement has been duly authorized or ratified by GOB and PKSF, and is legally binding upon both GOB and PKSF. 2. Other [classify according to covenantypes used in the Legal Agreements.] a. Implementation Conditions (i) (ii) (iii) GOB contribution to the project will be given within the project implementation period, according to the schedule provided in the Negotiation Minutes; PKSF and IDA will undertake a mid-term review (MTR) of the project by December 2002; and PKSF will ensure that any microenterprise loans beyond Tk.50,000 are packaged with business management and accounting training of the borrowers and will meet the requirements of the Guidelines for Management of Microenterprise Environmental Health and Safety (EHS) Risks. b. Key Covenants and Eligibility Criteia for PKSF, BPOs, MPOs and SPOs. Note: The determination of the eligibility of PKSF will consider the totality of the eligibility criteria in a manner that will establish acceptable quality of management, profitable and sustainable operations, and soundfinancial position, although PKSF might fall short of some of the eligibility criteria. IDA may, as a result of natural calamities and special circumstances, waive compliance with an eligibility criterion. The same principle would apply in the determination by PKSF of the eligibility of a PO. PKSF (i) the PKSF's Goveming Body and its management carry out a review of the annual business plan; (ii) conduct operations with qualified and experienced management in accordance with sound financial standards/practices and IDA's policies; (iii) minimum loan recovery rates, computed quarterly, and based on the following: 98% minimum cumulative loan collection ratio on total dues: -25-

30 Cumulative recovery as of certain date Cumulative recoverable up to the date % loan collection ratio on current dues (on running 12 month basis): Actual collection during the past 12 months on current dues Collectible on current dues during the last 12 months (iv) annual audit by an independent auditor acceptable to IDA; (v) auditor's opinion on annual financial statements on: quality of general accounting practices, adequacy of MIS and internal audit/control systems, adequacy of loan classification and provisioning policies, accuracy of loan recovery rates and overdues, and accuracy of quarterly reports on the funding of POs; (vi) audited financial statements in accordance with International Accounting Standards (IAS) as issued by the International Accounting Standards Committee (IASC), together with a clean auditor's opinion, the external auditor being a local firm representing a major intemational accounting firm; (vii) adopt plans and take steps, satisfactory to IDA, toward enhancing PKSF's sustainability as an institution in areas pertaining, among others, to the (i) pricing of its loans, (increase service charge to 4.5% for OOSA and 7% for BIPOOL, with possible changes in consultation with IDA), and (ii) adoption of cost-effective operations; (viii) a minimum current ratio of 2.5: 1; (ix) a maximum debt to capital ratio of 4.5:1; (x) a minimum debt service cover ratio of 1.25: 1; and (xi) annual external auditor's certification as to compliance with qualitative and quantitative covenants outlined above. Biy Partner Organizations (BPOs): (i) the PO's Governing Body and its management carry out a review of the annual business plan; (ii) five-year successful track record of running a successfull microcredit program; (iii) minimum loan recovery rates, computed quarterly, and based on the following: 95% minimum cumulative loan collection ratio on total dues: Cumulative recovery as of certain date Cumulative recoverable up to the date % loan collection ratio on current dues (on running 12 month basis):

31 Actual collection during the past 12 months on current dues Collectible on current dues during the last 12 months (iv) at least 100,000 borrowers with strong expansion potential; (v) at least Tk. 100 million in capital (including foreign grants); (vi) a maximum debt/capital ratio of 3.5:1; (vii) a minimum liquidity ratio of 20% of short term liabilities; (viii) a minimum current ratio of 1.5:1; (ix) a minimum capital adequacy ratio of 20% of total liabilities; (x) a minimum debt service cover ratio of 1.25:1; (xi) a minimum rate of return on capital of 2%; (xii) use of strong and transparent MIS and internal audit system; (xiii) annual audit by an independent auditor acceptable to PKSF and IDA; (xiv) audited financial statements in accordance with International Accounting Standards (IAS) as issued by the International Accounting Standards Committee (IASC), together with a clean auditor's opinion, the external auditor being a qualified local firm representing a major international accounting firm; and (xv) annual external auditor's certification as to compliance with qualitative and quantitative covenants outlined above. Medium Partner Oreanizations (MPOs) (i) five-year successful track record of running a successful microcredit program or potential thereof with adequate technical assistance (TA) and capacity building, as determined by PKSF; (ii) at least Tk.2.0 million of its own equity (including foreign grants and surplus); (iii) minimum loan recovery rates, computed quarterly, based on the following: 95% minimum cumulative loan collection ratio on total dues: Cumulative recovery as of certain date Cumulative recoverable up to the date % loan collection ratio on current dues (on running 12 month basis): Actual collection during the past 12 months on current dues Collectible on current dues during the last 12 months

32 (iv) a minimum liquidity ratio of 25% of short term liabilities; (v) a minimum current ratio of 2.0: 1; (vi) a minimum capital adequacy ratio of 15% of total liabilities for POs with more than 6,000 borrowers and 10% of total liabilities for POs with up to 6,000 borrowers; (vii) a minimum debt service cover ratio of 1.25:1; (viii) a rninimum rate of return on capital of 1%; (ix) adequate manpower for intensive supervision and competent management committee; (x) annual audit by an independent auditor acceptable to PKSF; (xi) audited financial statements in accordance with appropriate auditing principles, together with a clean auditor's opinion, the external auditor being a qualified local firm; and (xii) annual external auditor's certification as to compliance with qualitative and quantitative covenants outlined above. Small Partner Organizations (SPOs): (i) demonstrated track record of running a successful microcredit program or potential thereof with adequate technical assistance (TA) and capacity building; (ii) a minimum membership of 400; (iii) minimum loan recovery rates, computed quarterly, based on the following: 95% minimum cumulative loan collection ratio on total dues: Cumulative recovers as of certain date Cumulative recoverable up to the date % loan collection ratio on current dues (on running 12 month basis): Actual collection during the past 12 months on current dues Collectibles on current dues during the last 12 months (iv) a minimum liquidity ratio of 25% of short term liabilities; (v) a minimum current ratio of 2.0: 1; (vi) a minimum capital adequacy ratio of 15% of total liabilities for POs with more than 6,000 borrowers and 10% of total liabilities for POs with up to 6,000 borrowers; (vii) a minimum debt service cover ratio of 1.25:1;

33 (viii) a minimum rate of return on capital of 1%; (ix) adequate manpower for intensive supervision and competent management committee; (x) annual audit by an independent auditor acceptable to PKSF; (xi) audited financial statements in accordance with appropriate auditing principles, together with a clean auditor's opinion, the external auditor being a qualified local firm; and (xii) annual external auditor's certification as to compliance with qualitative and quantitative covenants outlined above. H. Readiness for Implementation 1. a) The engineering design documents for the first year's activities are complete and ready for the start of project implementation. > 1. b) Not applicable. Z 2. The procurement documents for the first year's activities are complete and ready for the start of project implementation. X 3. The Project Implementation Plan has been appraised and found to be realistic and of satisfactory quality The following items are lacking and are discussed under loan conditions (Section G): The procurement documents for the first year's activities are complete and ready from the start of project implementation. (See Annex 6). The financial management system is adequate and ready for implementation (see Annex 6). The Project Implementation Plan (PIP) has been appraised and found to be realistic and of satisfactory quality. 1. Compliance with Bank Policies Z? 1. This project complies with all applicable Bank policies. ; 2. The following exceptions to Bank policies are recommended for approval. The project complies with all other applicable Bank policies. 4 Md. lt azu0slam Marilou Jane D. LJy 4Freden Thomas Temple Team Leader Sector Director V Country Director

34 Annex 1: Project Design Summary BANGLADESH: Second Poverty Alleviation Microfinance Project (Microfinance II) HIrarc oo* Ivi'kUator ;on4fr,g & bvu o CS A l Sector-related CAS Goal: Sector Indicators: Sector/ country reports: (from Goal to Bank Mission) Reduction of poverty in 1. Reduction of poverty * The Household * Continued commitment Bangladesh for people who are Expenditure Survey, the of the Government of living below the Labor Force Survey, and Bangladesh to poverty poverty line: other reports conducted reduction. according to the by BBS. Household * Significant GDP growth Expenditure Survey, * The monitoring and during the project 1995/6, 50% of rural evaluation study period. and 34% of urban commissioned by PKSF population live and conducted by BIDS below poverty line. and other research 2. Reduction in absolute reports prepared by poverty: according to BIDS. Bangladesh Institute of Development Studies (BIDS), 23% of the population live in absolute poverty. 3. Reduction in underemployment: according to the Labor Force Survey (LFS), 1995/96, about 34% of the total population are under-employed; of which 71% are women. 4. Create employment for hard-core poor. 5. Increase in income, assets, savings and the quality of life of beneficiaries

35 Key Perforrnaiice H* of ObJ os e lndlcators Pr tamitoring & Evaluettior Critcal Assumptions Project Development Outcome i Impact Project reports: (from Objective to Goal) Objective: Indicators: Sustainable microfinance 1. Maintain PKSF's * Quarterly reports of * PKSF's strong provided and used by target recovery rate at PKSF. ownership and group. 98% and that of its commitment to the goal POs at 95%. of the project. 2. Extension of Credit * Biannual supervision of to 1.2 million new the project. borrowers. * Continued awareness 3. Increase in loan size building and strong per borrower by about * MTR missions' reports participation of 50% of the current stakeholders in the average of Tk.5,580 project. per borrower. * Other PKSF reports and 4. Provision of related reports from microcredit to about other institutions. * Overlapping of loans to 270,000 urban poor same borrowers by (within the outreach of various NGOs-MFIs will 1.2 million, as in 2). decrease. 5. Extension of microenterprise loans to at least 19,500 graduate borrowers. 6. Design of innovative programs by PKSF and POs to reach the hard-core poor. 7. Compliance of the industry standards ensured by an institution or body acceptable to stakeholders

36 j1k acyo O#v e~fs I ndl 1.tors 7 Monz * orrn & Eveiaio Cri: a Meumpions Output from each Output Indicators: Project reports: (from Outputs to Objective) Component: 1. Sustainable institutional 1. I Implementation of at *PKSF's quarterly report and *PKSF's strong commitment capacity for PKSF and POs least 75% of POs' business biannual supervision of the and ownership to implement built. plan, agreed between POs and project. the project. PKSF. 1.2 Completion of *Training evaluation report, *PKSF's Board implements training of 2,500 days for prepared by PKSF. policy measures without PKSF staff and 20,000 days outside influence. for POs by FY Creation of a *Institutional Assessment *Staff motivation and Training Cell to implement Report. dedication to the mission of the training program. poverty alleviation sustained. *Creditworthiness of big POs 2. Financial management 2.1 Integration of PKSF's and *PKSF's MIS progress report improved. system for PKSF and POs POs' MIS to help in decision and supervision report. established. making in credit operations *Borrowers confidence and and management. willingness to participate 2.2 Strengthening of *PKSF's quarterly and audit increased. the Internal Audit Cell to reports and consultant's undertake 100% audit of report. *Regulatory framework for eligible POs. financial sustainability in % compliance *Evaluation Report on POs place. of accounting and auditing internal audit. system with standards agreed under the project. 3. HRD policy for PKSF and 3.1 Approval of an HRD *PKSF's report and POs developed. policy and its implementation. Institutional Assessment. 4. Microcredit impact 4.1 Development of capacity *PKSF's, IDA's supervision monitoring system at POs level to monitor mission and consultant's established. program's impact. reports on impact monitoring. 4.2 Implementation of a toolkit in the MIS of POs for continuous impact monitoring. 5. Regulatory Framework and 5.i MRRU's formulation of a *PKSF and MTR missions' industry standards established. Regulatory Framework reports and institutional including implementation assessment. arrangements and PKSF's development of industry standards

37 l.rarchy OFJctiv.s Key Pmftma. ictprs nit Mont-p#ing ~vha at on Critscal Asspions Project Components I Inputs: (budget for each Project reports: (from Components to Sub-components: component) Outputs) 1. Mainstream rural US$95.5 million equivalent. Quarterly PKSF report. *No delay in disbursement microcredit. from PKSF to POs. 2. Mainstream urban US$ 16 million equivalent. Quarterly PKSF report. microcredit. 3. Expansion of hard-cote US$16 million equivalent. Quarterly PKSF report. poor programs. 4. Extension of existing US$18 million equivalent. Quarterly PKSF report. microenterprise programs. 5. Institutional strengthening US$5.5 million equivalent. Quarterly PKSF report. of PKSF and POs. ohigh repayment rate and acceptable overdue

38 Annex 2: Detailed Project Description BANGLADESH: Second Poverty Alleviation Microfinance Project (Microfinance 11) The project: The project will scale-up mainstream microfmance, add innovative and new products, build institutional capacity of PKSF and its POs, and help create NGOs-MFIs' regulatory environment for their accountability and integration with the mainstream financial market. Details of the project components are as follows: (a) the mainstream microcredit component comprises rural and urban credit; (b) the new component comprises expansion of microcredit to the hard-core poor and microenterprise lending to graduate borrowers and entrepreneurs; (c) the institutional strengthening component will mainly promote PKSF and POs capacity building, including training, improved financial management and control, MIS building, establishment of a Credit Bureau, implementation of toolkit for continuous impact assessment; and (d) the regulatory environment component will support implementation of a regulatory framework in the industry for transparency, accountability and market integration. The project will support total new borrowers of 1.2 million, comprising 0.53 million rural, 0.27 million urban and 0.4 million hard-core poor, i.e., supporting about 25% of the total demand of the sector. It will also support 19,500 graduate borrowers or microentrepreneurs for microenterprise development. The project also includes completion of PKSF's building construction, which will be financed by PKSF. By Component: Project Component I - US$ million Mainstream rural microcredit The project will continue to support horizontal and vertical expansion of rural microcredit. Big POs (ASA, PROSHIKA and BRAC), and small and medium-size POs have projected expansion of new borrower's by 4.1 million and 0.4 million respectively during As the industry is already experiencing some overlapping of multiple loans extended to some borrowers, the rapid expansion requires careful implementation. IDA will support a sub-set of this total demand, while emphasis will be given to vertical expansion of microcredit as it is needed for borrowers' graduation and sustainability. PKSF currently has an outreach of 2.1 million, of which IDA financed 1.9 million. About 90% of the borrowers are women. Currently, there is a credit supply gap of about 4.8 million borrowers. IDA will support 0.53 million new borrowers under the project. Project Component 2 - US$18.84 million Mainstream urban microcredit The outreach of urban microcredit in Bangladesh is substantially inferior to that of microcredit in rural areas. There will be 1.41 million urban poor in municipal areas and 1.13 million (Dhaka, Chittagong, Khulna and Rajshahi) by the year Less than 15% of the poor are believed to benefit from microcredit in urban areas against over 60% in rural areas. It is also believed that the urban poor tend to live in slums; lending to them is therefore viewed as risky because slums are often dismantled. Some also argue that extension of credit to urban poor may accelerate rural urban migration, which should be avoided. Therefore, programs should be enhanced in peri-urban areas, to entice the poor to move out of the cities. However, evidence shows that the potential for growing out of poverty through microcredit appear to be high in urban areas, given the large market opportunities, particularly in Dhaka (and Chittagong). Moreover, research has also shown that changes in explicit incentives-- such as the peri-urban programs mentioned above to incite the poor to leave the cities-- did not, in fact, have a noticeable impact and that the poor had to be helped wherever they were, including in cities. About 6% of PKSF funded POs' borrowers are urban poor. A PKSF's pilot on urban microcredit program

39 has funded five POs to extend microcredit to over 11,000 urban borrowers. The performance of this program has been highly satisfactory. It has attained a collection ratio of near 100%. The impact of urban microcredit is also very positive in terms of increasing family income and improving quality of life (IDA survey of 100 urban borrowers). Instability of slums is not to be seen as an issue: when slum inhabitants were displaced, they stayed in contact with NGOs-MFIs, and continued their repayments. PKSF's current policy is not to provide microcredit to the urban poor in city corporations (Dhaka, Chittagong, Khulna and Rajshahi). A review of this policy to extend credit to municipalities is needed, as it will help extend the outreach to more than 50% of the urban poor who live in these urban areas. The urban credit component will extend credit to about 270,000 urban borrowers. Initially, only borrowers in peri-urban areas will be served and only POs with well established experience will be involved, and closely monitored. In order to permnit more efficient monitoring, the number of POs could be limited in the first year of the project. The on-lending terms to the POs would be the same as for rural microcredit, but the lending terms to the final borrowers would be adjusted to reflect the different needs of urban borrowers. The same field officers and management can successfully implement the urban microcredit as those involved in rural credit. Project Component 3 - USS million Expansion of hard-core poor programs The consensus in the microfinance field is that the hard-core poor do not benefit from the current microcredit system in Bangladesh. Evidence shows that although around a quarter of microcredit program members are hard-core poor (defined as households with less than 1800 K calories per person per day, which constitutes around 25% of Bangladesh's population and 50% of the total number of poor), these households do not share in the income growth that the better off poor enjoy through microcredit. Moreover, even within this 'hard-core' poor group there is a 'bottom layer' (the 'ultra hard-core poor' or say the bottom 5-10% of the population) who do not even join, let alone benefit, from such programs. Hence the' hard-core poor' component of this project seeks to finance the microcredit component of programs which are tailored so that the hard-core and ultra hard-core poor can join and benefit from such programs. The main constraints/barriers that prevent the hard-core poor from either joining or benefiting from the current microcredit system in Bangladesh are: (a) the lack of multiple income earning sources and hence difficulty in regularly repaying a loan installment; (b) acute seasonal shortfalls in income, especially in more depressed regions and, therefore, seasonal difficulties in loan repayment; (c) lack of a grace period before the beginning of loan repayment; (d) weekly savings requirement; (e) other members screening out a perceived 'higher-risk' member; (f) adverse household demographics;' and (g) a higher incidence of ill-health. The innovations required to address the needs of the hard-core poor can be grouped into three categories: changes to the current microcredit delivery system, diversified financial services, and complementing microfinance with non-financial interventions. The main suggested changes to the current microcredit delivery system include smaller loan sizes, making installment repayment amounts more flexible (e.g. encouraging post-harvest lump sum payments and flexibility during lean seasons), changing the installment repayment grace period, keeping them more in line with the loan-financed investment, relaxing the regular savings requirement, experimenting with bi-monthly meetings and 'doorstep delivery' system, and providing consumption and seasonal loans when required. Providing diversifiedfinancial services is also critical. Experimentation with different savings products and flexible methods of deposit collection and withdrawal needs to be encouraged. Furthermore, experimentation with health, livestock and life insurance products are important to reduce the vulnerability

40 of the hard-core poor to risks. Major experiments have been undertaken in Bangladesh where microfinance linkages to safety-net programs ensure that the hard-core poor also accumulate savings, receive credit, and gain the confidence to "graduate" into becoming members of regular NGOs-MFIs programs in order to make their income gains sustainable. The BRAC Income Generation for Vulnerable Groups Development programs (IGVGD), for example, combine government food aid through the VGD program with specific skill training and small loans over the two-year VGD cycle. Most IGVGD members then graduate to BRAC's regular microfinance program where they can access big loans. The key issue that was examined is whether Microfinance II is an appropriate instrument through which the impact of microfinance services on the hard-core poor can be improved. The main reason for the inclusion of the hard-core poor component in this project is that there already is a significant amount of knowledge within the microfinance community in Bangladesh of the above-mentioned constraints faced by the hard-core poor and of the methods that can be used to overcome some of these constraints. More importantly, this knowledge has also been transmitted into practice as shown by the numerous initiatives already underway that explicitly target the hard-core poor. This project aims to scale up these initiatives. PKSF's issue paper has discussed how it intends to proceed on improving services to the hard-core poor and how IDA assistance at this point can be instrumental in catalyzing this process. The proposed project design has been shaped by a detailed review of existing experiences, stakeholders workshop, and discussions with PKSF staff. The Bank has prepared a more detailed note where targeting mechanisms, operational methods, and the costs of operating a program for the hard-core poor are discussed (see project file). The basic thrust of the hard-core poor component is that 400,000 hard-core poor households will be targeted, formed into groups, and given credit on similar terms to BRAC's IGVGD program; i.e. smaller average loan sizes, bi-monthly repayments, no rigid savings requirement, etc. In other words, the basic principle of providing credit remains but on more flexible terms. Although the Bank appraised the 'ultra hard-core poor' as a component of the project, in subsequent discussions with PKSF it was decided that this component will be separated out of Microfmance II and processed as a Learning and Innovation Loan (LIL) or as a project. This was decided considering the fact that the 'ultra hard-core poor' has a large subsidy element to help these borrowers with subsidized consumption loans and a grant element for capacity building. Project Component 4 - US$21.36 million Expansion of existing microenterprise programs PKSF, POs, and other NGOs-MFIs are already lending to microenterprises within or outside the mainstream microcredit activity. Big POs have significant microenterprise lending programs. For example, ASA is extending microenterprise loans to about 90,000 entrepreneurs. Its average loan size has been Tk. 15,000. BRAC has a small enterprise program; it extends loans to rnicroenterprise projects as well as to small-medium scale enterprises. It has extended about 7,000 loans and the loan size varies from Tk.20,000 to Tk.200,000. Similarly, PROSHIKA has a small enterprise loan scheme, under which about 250 loans were extended to individual entrepreneurs. Loan sizes vary from Tk.20,000 to Tk.400,000. An IDA study of 24 small and medium-size and 3 big POs found that small and medium-size POs provided 1520 microenterprise loans. The average enterprise investment size is about Tk.70,000 and it creates employment for up to three persons. Microcredit only financed 15% of the enterprise costs; the remaining amount came from own and informal financing sources, including "moneylenders". The survey also found that 362,670 borrowers out of 3.6 million POs' borrowers (about 10%) had requested larger loans to invest in microenterprises

41 This component will help progressive/graduate microcredit borrowers who have entrepreneurial capacity to scale-up their activities. Some reasons for targeting progressive borrowers and using existing lending mechanisms are the following: (a) microenterprise borrowers are unlikely to be supported by commercial banks as they are unable to provide collateral for loans and as loan sizes are small (US$ 1,000-4,000); (b) lending to progressive borrowers takes advantage of the long-term relationship that POs already developed with these borrowers which provide them with the knowledge of the borrowers' entrepreneurial ability and the history of their creditworthiness; and (c) microenterprise lending will create employment for the hard-core poor at local level and enhance borrowers' sustainability. PKSF's policy to extend microenterprise loans to only progressive microcredit borrowers needs to be reviewed considering that a number of PKSF POs are already using their own resources to allow lateral entry to borrow for microenterprises. Evidence shows that a large number of POs are extending microenterprise loans to progressive borrowers as well as individual borrowers outside the microcredit net and that the financial performance of these loans are highly satisfactory. PKSF POs are forming special microenterprise loan groups to extend microenterprise loans. Loan size is about Tk. 15,000 (first loan) and the collection rate of such programs is 100%. The project will encourage PKSF's policy review to allow POs to accept borrowers through lateral entry into microenterprise lending. As microenterprise lending has become a second generation lending activity of NGOs-POs, IDA will support its scaling-up. It will finance microenterprise loans to about 19,500 microentrepreneurs. The implementation arrangements should follow: (a) selection of eligible POs that have capacity to extend microenterprise loans; and (b) establishment of a method or methods, selection of microentrepreneurs, and terms and conditions for loan extension (see Annex 12). At PO level, special skills and additional staff will be required to extend microenterprise loans. In PKSF, the program could be integrated with microcredit operations, but its capacity needs to be enhanced to efficiently implement the program. Project Component 5 - US$8.36 million Institutional strengthening of PKSF and POs The institutional development component will help strengthen the capacity of PKSF and its POs in order to: (i) increase the outreach of microfinance services; (ii) broaden the range of financial services benefiting the poor and the hard-core poor; and (iii) improve the creditworthiness and sustainability of POs. During the stakeholder consultation held on May 6, 2000, POs confirmed the value of the institutional development support provided during Microfinance I (technical support, training, goods, etc.). According to POs, this support was key to their success to date. POs expressed a strong demand then to intensify this support during Microfmance II, to help them increase outreach and enable them to become financially viable NGOs-MFIs. PKSF and IDA agreed to use the following strategies for institutional development of small and medium-size POs: (a) on-site technical support; (b) formal training programs and exposure tours; and (c) access to physical assets/goods. These should be linked to each other carefully and be part of an integrated program for POs' capacity building. Small and medium-size POs Institutional development as part ofpos' business plans: PKSF's and POs' approach to institutional development will be based on a business plan prepared between PKSF and POs. It will describe POs' expansion plans and their institutional development needs. This approach should allow tying institutional development support to the lending services provided by PKSF. The business plan format and related institutional diagnostic tools are well-structured instruments, which should provide a solid basis to prepare and deliver institutional development support. In supporting preparation of business plans, significant

42 attention should be given to setting operational efficiency targets. This is important as a way of helping POs access financial markets in the future by helping them improve the efficiency of their intermediation services. The target setting approach for operational efficiency and the way achievement of targets will be linked to PKSF lending decisions are reflected in the plan. The primary responsibility for ensuring preparation of these plans lies with PKSF's staff. However, PKSF will assign a senior manager with coordinating responsibility to prepare the institutional development plans for effective implementation. Technical assistance to POs: PKSF's lending officers do not just provide lending services, they are also responsible for coordinating delivery of institutional development support and providing on-site technical support to POs. Although these services should continue, lending officers will probably not have either sufficient tirne or capacity to deliver them. The implication is that on-site technical support should be seen as one of the instruments to be deployed by PKSF training cell to strengthen POs' capacity in close coordination with lending officers. PKSF will soon make a "quantum" leap in the quantity of training to be delivered to small and medium-size POs, passing from 2,030 trainee-days delivered in FY98-99 to an average of 6,000 trainee-days per year between 2000 and The mission strongly supports PKSF's proposal to strengthen the training cell. It is important that PKSF develops the capacity to strategically manage the training functions, including coordination and quality assurance of all training activities. For this purpose, PKSF has appointed a full-time Training Manager to manage all training activities. Strategic outsourcing of training: PKSF will adopt a pluralistic approach to the delivery of training and on-site technical support, building on the installed capacity that already exists in medium and big mnicrofmance institutions and in other institutes. An approach that would rely primarily on developing this capacity internally could create a burden on PKSF management and on its operational staff and would distract it from its lending responsibilities. Experience during Microfmance I supports this view, as PKSF could not implement its planned training activities. The recommended approach is that PKSF should strategically outsource training programs and on-site technical support to complement on-site support provided by PKSF lending officers. The external providers of training services should make use of PKSF staff as resource persons as and when needed. Some training programs will require intimate knowledge of PKSF lending criteria and procedures, and may be best delivered by PKSF itself. For those programs, PKSF itself could be the provider of training services, although such programs should be restricted in number. However, in all cases, PKSF should coordinate all training and on-site technical support and assure the quality of these services. To appropriately manage the quality of the outsourced training programs and their technical support, PKSF will adopt a partnership approach in managing relationships with external service providers, as opposed to ad hoc relationships. The ownership and quality of services of the providers can be ensured, provided suppliers are closely associated with the services planning and are assured of providing training and on-site technical support services over a meaningful period of time. Extensive discussions and negotiations with selected external providers at the Executive Director level are required in order to establish the main parameters of the partnership. It is important to evolve a modus operandi where these service providers operate in support and in close coordination with PKSF lending officers. Management of these relationships will be the key responsibility of the Head of the PKSF Training Cell. Types of training programs: PKSF's training program for itself and for small and medium-size POs staff planned during the project implementation is adequate and meets quality requirement. The following types of training programs will build PKSF and POs' capacity: (i) study tours for PKSF staff should also be extended to leaders of small and medium-size POs. These will help POs to strengthen their capacity to innovate and to introduce new types of financial products in order to survive in an increasingly competitive industry. The institutional development component will have budget provisions for this purpose; (ii) PKSF staff will not be able to meet all needs of POs for on-site technical support, therefore, support pertaining to training of POs field staff will be substantially outsourced as a training activity; and (iii) PKSF will prepare training modules

43 and TA support in the areas of NGO governance, operational efficiency (i.e. operational cost reductions) and environment management. These three areas do not appear in the list of proposed training programs. Goods and equipmentfor POs: The program of interest-free loans to POs to acquire goods and services for capacity building has added positive value and importance to this program. This assessment is based on findings arrived at while supervising Microfinance I, on the feedback obtained from POs during the stakeholders' consultation on May 6, 2000, on the feedback received from PKSF operational staff, and on the high recovery rate (98.2%) achieved by PKSF until now with this program. This sub-component will be supported under the institutional development component. Big POs Big POs do not need substantial PKSF's assistance in developing MIS and training capacity, since they already benefit from extensive institutional development support from the consortium of bilateral donors. The limited scope due diligence of the big POs however has highlighted a number of institutional development needs of these organizations. Some of these needs appear to cut across the industry, including corporate govemance issues, firewalls between microfinance and other poverty reduction programs, deterioration of borrower quality, audits using international standards, performance standards for microfinance operations, etc. PKSF will make provisions to help address some of these issues through discussions involving leaders of the microfinance sector. PKSF Proposed strategy: PKSF's strategy, as outlined in its vision document "PKSF: 2010" and in supplementary materials to develop capacities within PKSF for achieving increased outreach and sustainability of the microfinance industry in Bangladesh, has been sound. However, PKSF's careful examination is needed with regard to the magnitude of the proposed organizational growth, which could double in size in 2001 from the level of Analysis of the proposed organization chart suggests that most of the future increase would occur in four areas: (a) unit lending to big POs; (b) the audit unit; (c) the training unit; and (d) the administrative support staff across units. Another area that needs attention is the proposed layer of senior managers. For example, in each of the OOSA, BIPOOL and audit units, it is proposed to have four layers of general management, each with only one or two staff under them (e.g. one Deputy Managing Director, one General Manager, one Deputy General Manager, and two Assistant General Managers). However, there is a risk of creating a bureaucracy by introducing layers of management. PKSF will undertake a management review process to reduce layers in management. Strengthening the Training Cell: The head of the training cell will help determine the exact size of the training cell after extensive consultations with potential external providers of training services. These consultations will determine the extent to which PKSF needs to develop an internal training capacity. The proposed organization structure places the training cell under the responsibility of the Administration unit. This raises concern because training and other institutional development assistance should be provided in support of lending activities. As most of the training activity is in support of small and medium-size POs, the appropriate place for the training cell will be under the responsibility of the OOSA unit. An alternative would be to set up the training cell under the supervision of the Managing Director, which could work in a matrix mode to support the small and medium-size POs. Training of PKSF staff. It will be important to invest in training the PKSF staff as a means to increase the capacity of the organization to provide sound lending and non-lending services to expand the outreach and viability of POs. Overall, PKSF's training program for its staff in terms of volume and types is sound, but needs consideration in the following areas: (a) designing an intensive and extended program of training for new officers (2-3 months); and (b) formulation of a quality based foreign training program. Exposure visits to NGOs-MFIs in other countries would be beneficial to leaders of small and medium-size POs who will -39 -

44 need to innovate new products in the future. Development of a regulatory framework for NGOs-MFIs: The need to establish an appropriate regulatory framework for the mricrofinance industry in Bangladesh is recognized by NGOs-MFIs, stakeholders, PKSF and the government. NGOs-MFIs should be regulated and supervised on the basis of how they fund themselves, i.e. on whether they take deposit from the general public or rely on market funding from institutional investors. NGOs-MFIs, which are not engaged in public deposit taking, should be regulated through industry standards. The supporting infrastructure should include improved disclosure (standardized accounting, auditing and reporting), industry standards, credit rating, Credit Bureau, and risk mitigation, such as deposit insurance. Stakeholders' workshop of May 6, 2000 strongly recommended that the industry should be regulated through an independent body with representatives from Bangladesh Bank, PKSF, the Securities and Exchange Conmmission and industry experts. The development of regulations should follow a participatory and deliberative approach, i.e. develop the legal, regulatory and supervisory framework in consultation with industry over, say, 3 to 5 years to accommodate leverages of the stakeholders knowledge and learning from best practices elsewhere. The government has recently created a " Microfinance Research and Reference Unit (MRRU)" in Bangladesh Bank (the Central Bank) to monitor the microfinance sector. This unit will be guided by a Steering Committee, which has eleven members, six from NGOs-MFIs or related sectors and five from the government or its agencies. The project will support the government's initiative to develop a regulatory framework for the microfinance sector. It will support the work of the Steering Committee to develop policy guidelines and principles for a regulatory framework of the sector with the help of inputs from PKSF, industry stakeholders as well as receiving technical assistance funds from PKSF through the Ministry of Finance to undertake research and studies. Formulation of such regulatory framework and recommendation for institutional arrangement to ensure compliance of the standards and the framework is expected to be completed by June 17, 2003 according to the Notification issued by the Secretary, Ministry of Finance on June 18, The final regulatory and supervisory framework for the microfinance sector and the implementation arrangements should be satisfactory to IDA. Organizational requirements for new products: Lending to urban poor: Lending to POs for urban microfinance services can be provided through the same lending window used for rural microcredit, i.e. the existing set up of OOSA will be adequate to handle lending to the urban poor. The skills available in PKSF will meet the need for lending to the urban poor and, therefore, the same credit officer will extend urban microcredit. However, new skills may be required if urban services require introduction of different types of financial products. Lending to hard-core poor: PKSF needs to strengthen its internal capacity to focus on the concerns of the hard-core poor. This could be done by strengthening microcredit operations by opening a separate cell within PKSF with required additional staff members who will be responsible for assessing the services on offer to the hard-core poor, training POs on providing such services, maintaining accounts and MIS, processing funding applications for the hard-core poor credit program, and for the extra costs associated with providing services to the hard-core poor. Such training could be locally obtained, especially from big POs which are now lending to the hard-core poor. Lending for microenterprises: PKSF's lending for microenterprises will be extended to POs to make larger loans (above Tk.20,000) to borrowers for microenterprise activities. The proposed lending process of POs would remain essentially unchanged, with creditworthiness being appraised through the current group process and on the basis of past credit performance of these borrowers. PKSF will initially focus on POs that already have a successful track record in lending to microenterprises. There is no need to create a separate unit to execute this component; the existing operational arrangements of BIPOOL and OOSA will be

45 adequate to implement this component. PKSF will recruit microenterprise credit specialists who would work within operations in support of PKSF staff for relationships with specific POs. Research and Development: PKSF's proposal to establish a research and development (R&D) unit within PKSF will be supported under the institutional development component. The R&D unit in PKSF is necessary as microfinance program has become large and diversified and as there are many issues that need close examination and research. A large part of the activities of the R&D unit will be strategically outsourced to specialized R&D organizations. PKSF will exercise the strategic role of defining the issues to be researched and the modules and publications to be developed. It will closely manage the quality of this outsourced work. PKSF will appoint a senior research professional to lead the R&D function and an additional research analyst. Human Resource Development: The strategy proposed in the vision document "PKSF: 2010" to strengthen the Human Resource Development (HRD) functions within PKSF is credible. However, HRD functions will require establishment of a clear set of performance standards for its employees and introduction of a modern and open evaluation and reward system. The current system of employee evaluation is based on assessments made by supervisors that are often not shared with the employees being evaluated. A clear set of performance standards for PKSF's employees could be linked to its well-developed system of standards regarding the performance of its POs. Employee performance against objective standards could be linked to employee evaluation and to rewards and promotions. The current system of promotions, essentially based on the number of years of experience, require replacement by a performance-based system that would recognize performance as an equally important factor in determining promotions. PKSF will commission a study to design a new HRD policy that will incorporate sound guidelines on staff evaluation and promotions, career planning, and a competitive compensation system. Management Information System (MIS): IDA has financed PKSF's MIS development as a component of Microfinance I. Further enhancement of MIS is required with the increase in number of POs and with the growing credit expansion. The following MIS developments will be addressed under this component of the project: (a) integration of PO and PKSF MIS in the projected 204 POs (phase II); (b) implementation of the "impact assessment tool" designed under Microfinance I, to undertake continuous impact assessment through impact monitoring and evaluation software in POs and PKSF; and (c) up-gradation of hardware and software LAN equipment and installation of these equipment in the PKSF building. A Support Cell will be established using the existing staff to implement computerized MIS in the POs and to install the impact monitoring and evaluation software. Existing MIS capacity needs to be enhanced by foreign training of staff in Oracle database CASE tools as such training is not locally available. This support will enable POs MIS data to be sent in time to PKSF's head office and will allow POs and PKSF to develop their own capacity for monitoring and evaluating the microfinance program. Development of Credit Bureau for MFI borrowers: PKSF will establish a Credit Bureau (credit information system) to track creditworthiness of individual borrowers. The development of a Credit Bureau for NGOs-MFIs borrowers is important as the industry size is expanding, the dynamism is becoming more complex, and as borrowers are engaged in experimenting with various credit instruments, including multiple borrowing, (i.e. overlapping). Multiple borrowing may in some cases prove to be effective in exploiting borrower absorption capacity, but it may also lead to default, anxiety, and welfare loss. It may also result in risking NGOs-MFIs' lending portfolio performance. The institutional development component will fund the design, development, and implementation of the Credit

46 Bureau. This sub-component is in addition to the existing plan to strengthen the MIS. Impact Assessment and needfor further assistance: Findings of the Monitoring and Evaluation Study (MES/Impact Study), conducted under Microfinance I, show that the microcredit borrowers' income and their mobility and time use have increased. Indicators for acceptance of health, education and sanitation facilities and social empowerment have improved. These borrowers have also increased family assets accumulation, compared to non-borrowers controlled groups. A number of outstanding issues that require an in-depth analysis will be conducted under Microfinance II. This will help in learning how and why microcredit programs meet the challenge of poverty reduction on a sustainable basis. Some of these issues are: (i) economic graduation of borrowers; (ii) multiple membership and its impact on program sustainability; (iii) whether and how microcredit help the poor to cope with random shocks such as floods and other natural disasters; (iv) whether and how microcredit programs manage their risks relating to economy-wide shocks such as floods; (v) what the aggregate impact of microcredit is on poverty reduction; (vi) how to link microcredit with other segments of rural credit markets such as informal and formal sectors; and (vii) what the impact of microcredit is on the hard-core poor. PKSF will develop the detailed terms of reference to exarnine the above issues under the project. Construction of PKSF Building: Microfmance I financed construction of PKSF's office building and training center. However, only a portion of the construction will be complete by the closing date of the project (December 31, 2000). It is estimated that US$2.5 million equivalent will be required to complete the building construction. The project cost includes construction of the PKSF building-cum-training center and PKSF will finance the cost of building completion from its own resources without any IDA reimbursement. 'E.g. lack of an adult male who can help in running the business, old age, many small children preventing a member from attending a meeting, etc. PKSF also supports the linkage between microfinance and safety-net programs by financing the credit component of ASOD, GUK and Grameen Krishi's involvement with IFADEP. Another important arg,ument for including a 'hard-core poor' component in Microfinance ll is that this project will lend through PKSF. Any feasible financing for hard-core poor lending will also have to be through PKSF as IDA funds cannot be channeled directly through NGOs-MFIs. Hence, the' transaction costs' on the part of both the Bank and the client will be significantly reduced if the hard-core poor work is subsumed under this project

47 Annex 3: Estimated Project Costs BANGLADESH: Second Poverty Alleviation Microfinance Project (Microfinance II),A. Credit Component (i) Rural Microcredit _78 (iil Urban Mlcrocredit tiii) MkcrocredUt for Hard-core Poor (ivj Microenterprise lending Total B. Institutional Development Component S1. Goods Management Information System Books/Joumals Goods for POs capacity building and Support for POs training center Publications _3'i1. t 04 7 t B2. Services Management _nformaon System Monitoring and Evaluation System (MES) Intemal Training for PKSF and POs Staff Extemal Training & Study Tour for PKSF & POs Staff I. Action Research/Short Studies SeminarstNWorkshops MicrocreditAwareness Building Design and Implementation of Regulatory Framework Consultants Service at PKSF HQs Supervision of PKSF Office Complex-cum-Training Center (Civi W sutme WA-4~~~22.94 &1 i2 iba 83. Works Expansion of PKSF Office Complex Cum Training Center C ivil Works,Total (1i+82+93) J _ , Notes: 1. GOB will share: a) 8.75% of the total cost of credit component b) GOB's share to the total project costs is 11.38%, if grant fund for ID component is included 2. PKSF will share: c) 6.0% of the total cost of institutional development component d) 100% cost of works and services related to expansion of PKSF Office complex e) PKSF, POs and Beneficiaries will share 6.98% of credit component 3. ID grant fund: f) IDA loan of US$5.5 million equivalent to GOB for PKSF' and POs' institutional development component will be provided as grant find to PKSF. -43-

48 Annex 4: Cost Benefit Analysis Summary BANGLADESH: Second Poverty Alleviation Microfinance Project (Microfinance 11) Summary of Benefits and Costs: Microcredit programs are based on assumptions that the rural poor have the capacity to invest and manage micro-businesses and that there are opportunities in the rural economy for such investments. All PKSF's POs provide loans for investments proposed by borrowers. Most investments of microcredit borrowers go to areas such as poultry and livestock rearing, petty trade of numerous items, weaving/handicrafts/pottery, agro-processing and rural transport (rickshaw/van) etc. The petty trade may include any item from shop keeping to seasonal trading. Borrowers are expected to make profits from their investments and repay loan installments from income. Additional income is used for consumption and savings. This process leads to improvement in quality of life and accumulation of assets. Cost benefit analysis of microcredit activities can be complex operations. As the microcredit loans are typically for one year, the calculation of financial rate of return (FRR) or economic rate of return (ERR) would not be a meaningful exercise. Moreover, cost and benefit streams are not totally accounted for and the costing of resources employed is often difficult. It would, therefore, be meaningful to calculate the benefits of microcredit in terrms of the following: (a) Evaluation of the impact of microcredit activity at household level in terms of surplus to household income. (b) Calculation of rates of return for a number of microcredit investments by assuming the investments as one-year tern investments and comparing their returns with the microcredit effective rates of return. Methodology: It is possible to estimate the incremental impact of microcredit on household income. This can be done by developing a receipt-payment profile of the household for a period of one year, and by accounting all cash inflows and outflows of the household for one year, including the inflow due to microcredit borrowing. Microcredit has two inflow items in the forn of income: net profit from an activity and income earned as a labor of family members who usually run the activity. In computing the net profit from the activity an expense component has been estimated for family labor that depends on the amount of time employed by family members and the on-going wage rate in the area. The inflows to the family have been divided into six main categories: (a) income of the family from sources other than microcredit investment; (b) gifts received by the family; (c) additional borrowing from sources other than the PO; (d) contribution from income generating activities such as family labor; (e) borrowing from PO; and (f) net profit from the income generating activity. The outflows have been categorized into: (a) household consumption expenses; (b) micro-investment; and (c) loan repayments. Determination of rate of return: An analysis of 85 microcredit investments has been conducted to determiine the rate of return of each of the activities. Each activity has been analyzed to develop an income expenditure profile. Net profit has been determined by deducting all expenses including family labor from revenue of the activity. First of all revenue and expenses have been deternined for one cycle of business and then annualized based on the number of cycles that can be realistically completed within one year leading to determination of annual profit. The rate of return has been determined using total investment in the activity, both equity and borrowing from the PO. Aside from computing individual rate of return for each of the activity, an average rate of return for each group of activities has also been determined

49 Sample areas, activities and data collection: The nature of micro-investments out of microcredit is that they are numerous and of similar types, involving more or less similar amount of money, and are spread over throughout the country. A sample of 85 borrowers have been randomly selected from four major areas of concentration of PKSF's POs. However, the final analysis were conducted for 85 borrowers. Sample activities have been taken from five broad categories: small trade, poultry and livestock, agro-processing, rural transport and services. The analysis requires information related to income and expenditure, and loan and equity for each micro-project. As normally microcredit borrowers do not keep records of transactions, estimates may contain over or understatement of financial figures because borrowers provide this information based on memory. Since loan disbursements and repayment are made throughout the year, the annual income and expenditure cash flows of borrowers have been prepared accordingly. An estimated cost of family labor has been deducted from revenues. The family labor component is taken as income to the family while constructing cash flows for the family. Impact on households: All 85 families included in the study have generated or are expected to generate surplus (receipts minus payments) during the year. This is considering the loan repayments already made to the PO and micro-investment made during the year. Since the families will be generating surplus, it is expected that they will be able to repay the remaining loan installments as well. Families spend on an average Tk.83,000 as micro-investment. The contribution of microcredit to family income has been found to be significant. On an average it contributes Tk.37,833 per year as additional income in the form of family labor and profit. The proportion of contribution from microcredit to total family income is also very significant and has been found to be sometimes as high as 98% (Table 1). Table 1: Contribution of Microcredit on Family Income Type of activity Number.Average Average annual PISF's Average Intcome of cases annual surplus contribution contribuio from microi generated by from micro- (Tk;) investsent as the famly investments % of total ay.) _I_ baoincome (0/) Tailoring 2 37,195 96,351 20, Rickshaw/van 3 24,496 62,816 21, Scooter (motorized 3 wheeler) 1 68, ,900 12, Paddy husking 3 30,442 86,619 56, Grocery shop 9 41,408 99,759 23, Small trading 24 32,027 80,287 28, Milch cow 6 20,028 41,457 6, Broiler/cattle fattening 7 33, ,268 11, Chick rearing/poultry 2 11,143 41,482 8, Fish farming 2 30,594 78,976 22, Fumiture making/ bamboo 6 37,989 87,690 35, products/ pottery Handloom/embroidery 3 27,123 71,216 30, Restaurant/sweet shop 4 56,345 99,389 33, Veg./agro- rocessing/nursery 9 19,599 65,777 16, Services (painter/ welding 3 28,784 99,028 53, shop/blacksmith Total 85 Avera ,001 25,

50 Rate of return of microcredit investments: Average value of investment varied between Tk.6,000 and Tk.28,000 (in one case Tk.80,000) and the equity contribution was about 58%. PKSF's average loan size was about Tk.8,400 (Table 2). All microcredit investmentstudied have produced profits. The rates of return varied between 36% to 226%, which is expected in case of such family managed micro-investments. The overhead cost and hired labor in most of these investments are zero, leading to a very high rate of return. It has been observed that activities with short business cycles, where money could revolve over and over within the year (e.g. trading, grocery shops, and restaurants) have very high returns. On the other hand, activities having long business cycle like poultry, fish farming, and cattle fattening have relatively low rates of return. Importantly, the rate of return in all cases has been found to be higher than the effective rate of interest on microcredit. Table 2: Rate of Return of Microcredit Investment Type of activity Number Average Average PKSF Average A a of cases Equity Ioan Investment Annual (Tk.) (Tk.) (Trk.) Rate of V P Return Tailoring , Itickshaw/van , Scooter (motorized 3 wheeler) , Paddy husking , Grocery shop , Small trading , Milch cow , Broiler/cattle fattening , Chick rearing/poultry , Fish farming , Furniture making/ bamboo , products/pottery Handloom/embroidery , Restaurant/sweet shop , Veg/agro-processing/nursery , Services (painter/welding , shop/black smith) ( %) Main Assumptions: Sensitivity analysis / Switching values of critical items:

51 Annex 5: Financial Summary BANGLADESH: Second Poverty Alleviation Microfinance Project (Microfinance 11) ~~~Xt 11i iei ::.1:.5 (US$ million e uivalent),i) Credit (ii) Institutional Development Recurrent Costs Total Financing Source (% of Total project costs) IDA Government PKSF, POs & Beneficiaries _ IT* o'

52 Annex 6: Procurement and Disbursement Arrangements BANGLADESH: Second Poverty Alleviation Microfinance Project (Microfinance 11) Procurement For procurement of goods, financed in part or whole from IDA funds, the procedures outlined in the Bank's Guidelines for Procurement under IBRD Loans and IDA Credits, January 1995 (revised in January and August 1996, September 1997, and January 1999) shall apply. Consultants' services financed in part or in whole from IDA funds will be procured in accordance with Bank's Guidelines: Selection and Employment of Consultants by World Bank Borrowers, January 1977 (revised in September 1997 and January 1999). Table A summarizes project components, related cost estimates, and proposed methods of procurement. Amounts in parenthesis show the amounts to be financed by IDA. Table B summarizes thresholds for procurement methods and prior review. Procurement methods (Table A) Credit component (US$ million equivalent): The final borrower's use of loan will be determined by PKSF in consultation with the partner organizations (POs) providing these loans. POs loan award procedures, stringent repayment requirements, weekly meetings with ultimate borrowers' group and their empowermento use this loan productively will ensure that the procurement is economic and efficient. Most of the loans will be used for income and employment generating activities and will have close to 100% local content. PKSF's close supervision and monitoring of POs and implementation of various policy instruments will ensure that microcredit is used for intended purposes and also productively. Credit to POs for equipment (US$1.5 million equivalent): PKSF through Sub-loan agreements will provide a loan of US$1.5 million equivalent at zero percent interest rate and on a three year term to POs to procure motorcycle, bicycle, and various equipmento improve logistic, and effective supervision and monitoring, under the institutional component of the project. The goods will be procured by POs under the guidance of PKSF in accordance with established local private sector or commercial practices. Civil works (US$2.37 million equivalent): PKSF will finance the costs of civil works to complete the construction of PKSF office complex cum training center. IDA procurement guidelines were followed in awarding contracts for civil works and selection of supervision consultants. The work started under Microfinance I, but the remaining works will not be financed under this Credit. Goods (US$O.38 million equivalent): Procurement through the international competitive bidding (ICB) method is not envisaged under this project. The goods comprising mainly computerization of PKSF will be procured in four contract packages estimated at US$237,050 equivalent at different stages of project implementation, depending on the completion and occupancy of the PKSF's own building. Considering that none of these contracts is expected to exceed US$130,000 equivalent, the plan for supply of goods over a number of years and the scope of incidental services are unlikely to attract the interest of foreign suppliers and, therefore, may be procured following the national competitive bidding (NCB) method, acceptable to IDA. The initial requirements of very small quantity of three computers estimated to cost US$2,780 equivalent and four computers and LAN estimated US$9,8 10 equivalent, at the early stage of project implementation, may be procured following the national shopping (NS) method, by obtaining at least three quotations from the qualified suppliers. Books and journals in lots totaling an estimated at US$31,300 equivalent and PKSF's various publications numbering about sixty (60), estimated US$100,000 equivalent, will be procured throughouthe project period, in very small quantities at a time, following the NS method

53 In addition to the above, books and joumals published regularly, each contract costing less than US$2,000 up to an aggregate amount of US$20,000 equivalent, may be procured directly from publishers and/or hawkers. Services (US$4.11 million equivalent): There are a total of fourteen services contract packages planned under the project. Eight contracts with estimated costs ranging between US$32,780 and US$206,110 equivalent will be procured following the Quality- and Cost-Based Selection (QCBS) method. Four contracts (S8.1 through S8.4) with estimated costs ranging between US$37,590 and US$111,850 equivalent, relating to the microcredit awareness building activity, requiring a great deal of innovation and originality in the performance of the contracts, will be procured following the Quality Based Selection (QBS) method. The contract S7, for Seminars and Workshops, numbering six (6) to be organized within the budget allocation of US$115,930 equivalent, rnay be procured following the Selection under a Fixed Budget method. The contract package S9 indicates 868 staff-month of individual consultants, estimated at US$1,201,480 equivalent; these individual consultants will be selected in accordance with Section V of the Bankls Consultants Guidelines. Training institutions for in-country and external training under contract packages SI I through S14 will be selected on a single source (SS) basis. Contract package SI 0, proposed to be procured following the QCBS method, relates to the PKSF's building construction, will not be financed under this Credit. Procurement Capacity Review: All procurement under the proposed project will be handled by PKSF's own staff. PKSF's performances of consultantselection for implementation supervision of the PKSF's office cum training building and awarding building construction contracts was less than satisfactory. However, with regard to procurement of hardware and software components for MIS, and selection of other consultants, it's performance was satisfactory. As IDA will not finance building construction, the risks associated with procurement are moderate. To mitigate the risks, PKSF has appointed an individual consultant on a retainer basis, who has knowledge of the Bank's procurement policies and procedures, to assist and supervise procurement activities. He will be supported by a Procurement Core Team (PCT). Provision has been kept under the project for the training of PKSF's staff, especially PCT members, on the Bank's Procurement Policies and procedures. Procurement and Selection Planning: Procurement requirements for Goods and Services under the project have been identified by PKSF. While the Procurement and Selection Plans have been prepared, detailed processing schedules will be prepared shortly. Prior to issuance of any invitation for (i) bids for procurement of goods, and (ii) expressions of interest for shortlisting of consultants, PKSF shall furnish the Procurement Plan, complete with processing schedules, to IDA for its review and approval in accordance with the provisions of paragraph 1 of Appendix 1 to the Guidelines. Procurement of all goods and selection of all consultantshall be undertaken in accordance with the Procurement Plan as shall have been approved by IDA. PKSF will promptly inform IDA of any delay, or any changes in the scheduling of the procurement or selection process, which could significantly affect the timely and successful implementation of contracts. It will agree with IDA on corrective measures, in accordance with the said paragraph 1 of the Guidelines. Use of Standard Documents: For NCB procurement, the SBD for goods approved by the Association will be used. For selection of consulting firms, the Bank's Standard Request for Proposals, including standard contract forms, will be used. The Bank's Standard Bid Evaluation Form for Goods and Sample Form of Evaluation for Services will be followed for subrnission of bid evaluation reports to IDA

54 IDA prior review thresholds (Table B) Goods: IDA will carry out a prior review of the first contract, irrespective of value, following NCB procedures and all contracts estimated to cost US$100,000 equivalent or more. All other contracts will be subject to selective ex-post review by IDA. The selective ex-post review of contracts below the thresholds will be carried out for approximately up to 20% of the contracts awarded. Services: IDA's prior review will be required for all services' contracts for firms estimated to cost US $100,000 equivalent or more. For individual consultants, estimated to cost US$50,000 equivalent or more, the qualifications, experience, terms of reference (TOR) and terms of employment of the consultants shall be furnished to IDA for its prior review. In addition, IDA's prior review will be required for TORs of all contracts irrespective of contract price. Review of Procurement Performance: The procurement status and its compliance with Bank's Guidelines will be monitored by IDA on a continuous basis. As part of the project's planned mid-term review (MTR) in December 2002, a comprehensive assessment of procurement performance will also be carried out. Based on this assessment, and in consultation with PKSF/GOB, IDA may revise the prior review threshold and procurement and selection methods. Acceptabilitv of NCB In order to ensure economy, efficiency, transparency and broad consistency with the provisions of Section I of the Procurement Guidelines: (i) standard bidding documents approved by the Association shall be used; (ii) invitations to bids shall be advertised in at least one widely circulated national daily newspaper, and bidding document shall be made available to prospective bidders at least 28 days prior to the deadline for the submission of bids; (iii) bids shall not be invited on the basis of percentage premium or discount over the estimated cost; (iv) bidding document shall be made available, by mail or in person, to all who are willing to pay the required fee; (v) foreign bidders shall not be precluded from bidding and no preference of any kind shall be given to national bidders; (vi) qualification criteria (in case pre-qualifications were not carried out) shall be stated in the bidding docurnents, and if a registration process is required, a foreign firm deternined to be the lowest evaluated bidder shall be given reasonable opportunity of registering, without any let or hindrance; (vii) bidders may deliver bids, at their option, either in person or by courier service or by mail; (viii) all bidders shall provide bid security as indicated in the bidding docurnents. A bidder's bid security shall apply only to a specific bid; (ix) bids shall be opened in public in one place preferably immediately, but no later than one hour, after the deadline for submission of bids; (x) evaluation of bids shall be made in strict adherence to the criteria disclosed in the bidding documents, in a format and specified period agreed with the Association; (xi) bids shall not be rejected merely on the basis of a comparison with an official estimate without the prior concurrence of the Association; (xii) split award or lottery in award of contracts shall not be carried out. When two or more bidders quote the same lowest price, an investigation shall be made to determine any evidence of collusion, following which: (A) if collusion is determined, the parties involved shall be disqualified and the award shall then be made to the next lowest evaluated and qualified bidder, or (B) if no evidence of

55 (xiii) (xiv) (xv) (xvi) (xvii) collusion can be confirmed, then fresh bids shall be invited after receiving the concurrence of the Association; contracts shall be awarded to the lowest evaluated bidders within the initial period of bid validity so that extensions are not necessary. Extension of bid validity may be sought only under exceptional circumstances; extension of bid validity shall not be allowed without the prior concurrence of the Association: (A) for the first request for extension if it is longer than eight weeks; and (B) for all subsequent requests for extensions irrespective of the period; negotiations shall not be allowed with the lowest evaluated or any other bidders; re-bidding shall not be carried out without the Association's prior concurrence; and all contractors or suppliers shall provide performance security as indicated in the contract documents. A contractor's or a supplier's performance security shall apply to a specific contract under which it was fiurnished. Table A: Project Costs by Procurement Arrangements (US$ million equivalent) Procurement Method Expondlture Categoryr ICB NCB N.F" Total C:ost 1. Works (0.00) (0.00) (0.00) (0.00) (0.00) 2. Goods (0.00) (0.17) (0.09) (0.00) (0.26) 3. Services (0.00) (0.00) (3.98) (0.00) (3.98) 4. Credit for ID to POs (0.00) (0.00) (1.28) (0.00) (1.28) 5. Credit for Microcredit (0.00) (0.00) (145.48) (0.00) (145.48) Total (0.00) (0.17) (150.83) (0.00) (151.00) " Figures in parenthesis are the amounts to be financed by the IDA Credit. All costs include contingencies 2/ Services' contracts selection arrangements are elaborated further below in Table Al: Consultant Selection Arrangements

56 Table Al: Consultant Selection Arrangements (optional) (US$ million equivalent) ExpCnXlXt.r Q.,, Q8 SFB LC C'Q; ' Othr KgjNBF. TotalCot A. Firms (0.74) (0.30) (0.12) (0.00) (0.00) (1.62) (0.00) (2.78) B. Individuals (0.00) (0.00) (0.00) (0.00) (0.00) (1.20) (0.00) (1.20) Total (0.74) (0.30) (0.12) (0.00) (0.00) (2.82) (0.00) (3.98) 1\ Including contingencies Note: QCBS = Quality- and Cost-Based Selection QBS = Quality-based Selection SFB = Selection under a Fixed Budget LCS = Least-Cost Selection CQ = Selection Based on Consultants' Qualifications Other = Training institute will be selected on a single source basis (US$1.62 million) and individual consultants as per Section V of Consultants' Guidelines (US$1.2 million) N.B.F. = Not Bank-financed Figures in parenthesis are the amounts to be financed by the Bank Credit. Prior review thresholds (Table B) Table B: Thresholds for Procurement Methods and Prior Review Expeiditure Cotract Vatue 7 Procurement Method Contracts Subjet to Prior Review Category (Trshl) ii00.:t00f : S i :t Goods >=US$ 100,000 NCB First contract, irrespective of value, and all contracts equivalent of US$ 100,000 or more. <US$100,000 NCB Ex-Post Review <US$20,000 National Shopping Ex-Post review <US$2,000 Direct Contracting (from Books and Journals below US$2,000 Ex-Post Review Publishers and hawkers) Services >=US$ 100,000 for QCBS, QBS,SS All Firms <US$100,000 for QCBS, QBS, Fixed TORs Firms Budget, SS >=US$ 50,000 for Qualifications, Prior Review Individuals References <US$50,000 for Qualifications, TORs Individuals References

57 Disbursement Allocation of credit proceeds (Table C) Disbursement under the proposed Credit will be made as indicated in Table C, which indicates the percentage of financing for different categories of expenditures of the project. It is expected that IDA funds will be disbursed over a period of four and half years. The fiscal year disbursement estimate is provided on page 2 of the PAD. The Closing Date of the Credit is June 30, Table C: Allocation of Credit Proceeds I Microcredit % of the amount disbursed 2 Goods % of foreign expenditure, 100% local expenditure (ex-factory), 70% of local expenditures for other items procured locally 3 Consultant services %, net of taxes including training 4 Unallocated 15 Total _ i Use of statements of expenditures (SOEs): Until PMR based disbursement is agreed upon, the traditional disbursement procedures will be applicable for withdrawal of funds from the Credit. IDA will require full documentation for prior review for those cases where contracts exceed the equivalent of (a) US$100,000 for goods; (b) US$100,000 for services contracts with firms; and (c) US$50,000 for individuals. Expenditures below the above thresholds and all expenditures under microcredit would be claimed on SOEs. Special account: For utilization of IDA's share of project expenditures, PKSF may open and maintain with Bangladesh Bank a Special Deposit Account in US dollars under terms and conditions satisfactory to IDA. The authorized allocation to the Special Deposit Account will be limited to 3-4 month-estimated expenditures of IDA's share of the proposed project. The authorized allocation will be limited to US$15.0 million equivalent until the PMR based disbursement is agreed upon. At the start of the project the initial deposit will be limited to US$10.0 million equivalent. The remaining amount of US$5 million equivalent of the authorized allocation may be withdrawn once the total withdrawal from the Credit account reaches SDR22.0 million equivalent. The authorized allocation of the Special Deposit Account will be raised to US$30.0 million equivalent, if the project is switched over to PMR based disbursement. Financial Management PKSF is set up as a "not for profit" organization by the government and is functioning as an apex institution to provide loans to partner organizations (POs), which in turn provide collateral free credit to their poor members. It also provides advisory services and training to POs for enhancing their institutional capacity. PKSF is governed under Section 28 of the Companies Act, 1994 and it follows the accrual

58 system of accounting. It is currently implementing the Microfinance I project financed by IDA which will close on December 31, PKSF has demonstrated, in implementing this project, the capability to maintain the required project accounts for IDA funded projects. Under the overall supervision and control of the Governing Body (GB), PKSF will be responsible for ensuring that project funds are being used for the purposes intended, with due care to economy and efficiency. PKSF's Finance Department will be responsible for project accounting, financial reporting, monitoring and analyzing financial information. It will also be responsible for preparing PMR for GB, Ministry of Finance and IDA. Overall Assessment: PKSF's financial management capacity is satisfactory. It has qualified personnel, adequate Manuals and Guidelines to conduct efficient financial management. The Accounts and Audit units of PKSF are part of the management system responsible for overseeing timely disbursement of funds to eligible POs and ensuring proper financial accountability and transparency of funds provided. PKSF's Internal Audit Cell, headed by a professional accountant, ensures proper internal audit. It's computerized accounting system will be able to generate quarterly PMRs. PKSF has agreed to subrmit the full set of PMRs from the beginning of the project. Since PKSF's disbursement is based on strict adherence to performance criteria by its POs, it often withholds disbursement because of non-performance and natural calarmity. Therefore, it prefers to continue the traditional disbursement procedure and claim reimbursement on need basis. During the Microfinance I implementation, PKSF did not encounter any problem with the Bank's disbursement process and found it effective for its operations. However, it would like to keep PMR-based disbursement as an option, so that it has the flexibility to switch to such disbursement during project implementation. Key aspects of the Financial Management are as follows: Staffing: PKSF has adequate qualified financial management staff. However, its personnel may require training to upgrade their skills from time to time so that they can impart continuous training and mentoring to the POs, especially smaller POs, in addition to their responsibilities to PKSF. The project has provided for such training. Accounting: The Governing Body and PKSF management has given priority to develop a sound accounting and auditing system for PKSF and its POs. PKSF prepares its financial statements following the International Accounting Standards (IAS) as adopted by the Institute of Chartered Accountants of Bangladesh. It has agreed to prepare a supplementary adjusted financial statement following full IAS requirements. This would further increase the credibility of PKSF's audited financial statements. PKSF maintains proper books of accounts and records as required and necessary for efficient and transparent project financial management. These are maintained on an accrual basis. The current accounting systems will be permitting PKSF to keep project books of accounts up-to-date on a daily basis and disclosing in PMRs and annual financial statements a true and fair view of the financial state of the project. PKSF has established procedures and records adequate to monitor the progress of the project and control project assets in accordance with sound accounting practices. Activity-based subsidiary records for monitoring the detail accounts/key indicators will also be maintained by the project. The accounting structure shall reflect the relevant chart of accounts. These will be broken down into types of expenditure by project components. PKSF's Accounting Manual needs revision to reflect the MIS integration with the accounting system and up-grade of the accounting system (now Oracle-based). The revision will be completed by September 30, PKSF also has Accounting and Fund Management Manuals for the POs. A Loan Operations and

59 Administration Manual has also been prepared. In addition, PKSF has adequate policies and guidelines for selection of POs, management of savings by POs, management of service charge, classification of loan and reduction in overlapping by loan, assessment of POs' performance through developed criteria, utilization of the disaster management fund, institution of an early warning system by performance indicators, extension of interest free loans and maintenance of debt management reserve. A Debt Write Off Policy and a Liquidity Management Manual are being prepared by PKSF which will further strengthen its effectiveness to efficiently manage microcredit activities. Internal Control and Internal Audit: PKSF has an adequate internal control system in place. The duties of its staff are properly segregated. Governing Body routinely identifies, monitors and controls operational and financial risks. The management and the internal audit staff routinely verify POs' operations on a periodic basis. GB and senior management have been promoting a culture within the organization to demonstrate that all level of staff assign due importance to the internal controls. PKSF's internal audit system is being strengthened. It has expanded the TOR for internal audit. An Internal Audit Manual is being prepared. It has created a separate Audit Cell headed by a professional accountant supported by three mid level and nine junior level auditors. The internal audit cell directly reports to the Managing Director. Financial transactions of the head office are now pre-audited by the internal audit team. Besides its Dhaka office, PKSF has a regional audit office to undertake timely audit of POs. Each PO is audited once a year based on an annual plan. Financial Reporting: PKSF will prepare and submit quarterly PMRs. These include: (a) financial statements with a summary of the project financial status (includes: Sources and Uses of Funds for 'each quarter', 'year to-date', and 'cumulative costs of the project to-date'; usage of funds by project activities; Project Balance Sheet; Cash Withdrawal; Cash Forecast; and a Special Account Statement); (b) Output Monitoring Reports; and (c) Procurement Management Reports. Specific formats for these reports have been prepared and included in the project implementation plan (PIP). Accounting Systems of POs: In the Microfinance II project, more than 70% of the activities would be implemented through three big POs, namely BRAC, PROSHIKA and ASA. These POs have adequate qualified accountants, computerized accounting system and MIS. All these POs have internal audit and monitoring units with well-structured internal control systems. PKSF also extends microcredit through more than 174 smaller and medium-size POs. These POs will require further capacity development. Provisions have been made under the Microfmance II to strengthen their financial management capacities. Flow of Project Funds: IDA fund will be provided for microcredit and institutional development. IDA fund will be deposited in the Special Account to be opened and operated by PKSF with Bangladesh Bank. The fund from Special Account for microcredit will be made available to the POs for microcredit operations comprising rural microcredit, urban microcredit, microcredit to the hard-core poor and microenterprise loans. POs will channel the funds to millions of microcredit borrowers. The funds for institutional development will be used by PKSF and also made available to selected POs for capacity building and establishing regulatory framework of microfinance sector. The project funds will be made available to existing 177 POs and some new POs which will be enlisted by PKSF during the project implementation period. Measures to ensure proper utilization with satisfactory controls and accountability for disbursing funds to POs are the following: (a) development of policies and procedures to ensure smooth flow of funds; (b) signing of a sub-loan agreement between PKSF and PO that requires an acceptable organization structure with an effective Board and efficient management with qualified and experienced staff for intensive operational and financial supervisions; (c) POs' acceptable

60 operating and financial policies, records of periodic, timely and accurate financial reporting, audited annual financial statements, proven financial viability over the last 3 years and demonstrated track record of running successful operations; (d) training of POs' staff on financial management and book keeping; and (e) computerized accounting and MIS. Independent External Audits: PKSF accounts are currently audited by local firms of chartered accountants as part of the requirement under the Companies Act The Act requires the auditor to be a member of the Institute of Chartered Accountants of Banglades holding a practicing certificate. PKSF requires, under the sub-loan agreement, POs' accounts to be audited by extemal auditing firms. It would ensure that the audited accounts of all POs are received by PKSF within six months after the end of each fiscal year. PKSF will provide its entity audited report and project financial statements to IDA, prepared in accordance with International Standards on Auditing (ISA), as is indicated in the audit TORs. Under Microfinance II, PKSF will be required to submit annual audit reports on its (entity) financial statements, on the Project financial statements, including- Special Accounts, and on the Statement of Expenditures against which IDA disbursements are made. PKSF and the big POs (ASA, PROSHIKA and BRAC) will use independent audit firms having affiliation with international audit firms acceptable to IDA to audit their accounts. The annual entity reports for big POs will be submitted to PKSF and IDA for review, during the biannual supervision of the project. For the purposes of the Bank's current Audit Report Compliance System (ARCS) and the following reports will be tracked: (a) Entity; (b) ProjectlSOEs; and (c) Special Account. If and when the project shifts to PMR-based disbursements, audit and ARCS tracking of SOEs will be discontinued and replaced by the audit and tracking of the quarterly PMRs. Management Audit: The statutory auditor will also conduct annual 'limited scope management audits' of PKSF and big POs, based on the TORs agreed between PKSF and IDA. These audit will undertake a thorough review of their microcredit operations. TORs for these audits have already been prepared and agreed between PKSF and IDA. Action plan for improvement of financial management capacity of PKSF PKSF has a proper financial management system and adequate personnel to operate the system. It has, however, agreed to implement the following actions for further development of its financial management system: (a) updating of PKSF's Accounting Manual to reflect the current modernized system by September 30, 2001; (b) preparation of an Internal Audit Manual by June 30, 2001; (c) preparation of a Debt Write-off Policy by December 31, 2001; and (d) preparation of a Liquidity Management Manual by December 31, GOB and IDA will closely monitor the progress in implementing the action plan

61 Annex 7: Project Processing Schedule BANGLADESH: Second Poverty Alleviation Microfinance Project (Microfinance 11) Project Schedule P-annd Actual Time taken to prepare the project (months) 18 First Bank mission (identification) 04/15/99 04/30/99 Appraisal mission departure 09/30/ /30/2000 Negotiations 11/30/ /23/2000 Planned Date of Effectiveness 04/30/2001 Prepared by: Palli Karma-Sahayak Foundation (PKSF) Preparation assistance: BB Funds Bank staff who worked on the project included: Name Speciality Md. Reazul Islam Senior Project Economist (Task Leader) Joseph Del Mar Pemia Lead Financial Sector Specialist (Team Leader) Shamsuddin Ahmad Senior Financial Analyst Victor Barrios Consultant (Financial Analyst) Philippe Dongier Senior Private Sector Development Specialist Hassan Zaman Poverty Specialist (Economist) Salim Hyder Research Analyst Jacques G. Toureille Lead Financial Sector Specialist Joselito Gallardo Microfinance Regulatory Specialist Shahid Khondkar Senior Poverty Specialist Dewan Alamgir Consultant (Microfinance Specialist) Yusuf Islam Consultant (MIS Specialist) Nilufar Ahmad Senior Social Scientist M. Mozammal Hoque Senior Financial Management Specialist M. Aminul Haque Senior Procurement Specialist Mohammad Sayeed Disbursement Officer Paul Jonathan Martin Environmental Specialist Rachel Susan Palmer Program Assistant Bridget Rosalind Rosario Office Administrator

62 Annex 8: Documents in the Project File* BANGLADESH: Second Poverty Alleviation Microfinance Project (Microfinance 11) A. Project Implementation Plan Project Implementation Plan (PIP), prepared by the Palli Karma-Sahayak Foundation (PKSF), October, B. Bank Staff Assessments * Microfinance II: Second Poverty Alleviation Microfinance Project, Preparation Mission: Back to Office Report, April 12, * Microfinance I: Mid Term Review (MTR) Report of the Poverty Alleviation Microfmance Project, April 20, * Microfmance II: Second Poverty Alleviation Microfmance Project, Pre-appraisal Mission: Back to Office Report, July 20, * Hard-core Poor Component by Mr. Hassan Zaman, Pre-appraisal Mission Aide-memoire (Annex 2), July 20, * Pre-appraisal of the Institutional Development Component by Mr. Philippe Dongier, Pre-appraisal Mission Aide-memoire (Annex 3), July 20, C. Other An Analysis of Women's Workload, IDPAA, PROSHIKA (2000). Poverty Alleviation Programs reduce inequities in health: Evidence from Bangladesh, prepared by Bhuiya A. Chowdhury (2000). Profitability Analysis of IGAs of Microcredit Borrowers of Partner Organizations of Palli Karma-Sahayak Foundation (PKSF), prepared by Reazul Islam and Dewan Alamgir, July Demand Analysis: Microfinance II Project, A Bank financed study, conducted by Dewan Alamgir (consultant), Reazul Islam (Bank staff), et. al, May, Microfmance II. Limited Due Diligence of PKSF, A Bank financed study conducted by V. Barrios (consultant), S. Ahmad, M. Hoque and R. Islam (Bank staff), May Microfmance II. Limited Due Diligence of Big Partner Organizations, ASA, PROSHIKA and BRAC, A Bank financed study conducted by V. Barrios (consultant), S. Ahmiad, M. Hoque and R. Islam (Bank staff), May Reaching the Very Poor, Stuart Rutherford, Consultant, A vision document "PKSF: 2010" (December 28, 1999) was prepared by PKSF and approved by its Governing Body on PKSF's future role in the microfinance sector, including its plans to attain sustainability for PKSF and POs. This vision document has been substantially used to prepare the project. Various documents, issue papers, project background papers, etc., prepared by PKSF during the Preparation and Pre-appraisal mission (April, 1999 to September, 2000)

63 A Study on the Sustainability of Partner Organizations of Palli Karma-Sahayak Foundation (PKSF), A Bank financed study, conducted by Dewan Alamgir (consultant), Reazul Islam (Bank staff), et al., April A Study on the Impact of Microcredit on Borrowers of Partner Organization of PKSF, A Bank financed study, conducted by Dewan Alamgir (consultant), Reazul Islam (Bank staff), et al., April, A Background Study of Microenterprise Developmenthrough Partner Organizations of PKSF, A Bank financed study, conducted by Dewan Alamgir (consultant), Reazul Islam (Bank staff), et. al, April, Extension of Microcredito the Urban Poor, A Bank financed study, conducted by Mahbubul Islam (consultant), Reazul Islam (Bank staff), et. al, April, Establishing an Appropriate Regulatory Frame-work and Institutions for Regulating MFIs Engaged in Deposit Taking/Lending, and Developing Financial, Institutional and Regulatory Measures to Assist MFIs in Becoming Formal Financial Institutions and Strengthening the Linkage of MFIs with the Fonnal Financial Sector, prepared by the Development Planners & Consultant (DPC) for the Bangladesh Bank, January Institutional Audit of the Palli Karma-Sahayak Foundation (PKSF), prepared by M. Syeduzzaman, et. al. January *Including electronic files

64 Annex 9: Statement of Loans and Credits BANGLADESH: Second Poverty Alleviation Microfinance Project (Microfinance 11) 1 5-Oct-2000 Difference between expected Original Arnount in US$ Millions and actual disbursements Project ID FY Borrower Purpose IBRO IDA Cancel. Undisb. Orig Frm Rev'd P Bangladesh Agricultural Serv. Innovaton & Reform P Bangladesh Agriculture Research Management P Bangladesh Air Quality Management Project P Bangladesh Arsenic Mitigaton Water Supply ,00 P Bangladesh Bangladesh Integrated Nutrition P Bangladesh Coastal Embankment Rehabilitation P Bangladesh Dhaka Urban Transport P Bangladesh Dhaka Water & Sanitation IV P Bangladesh Export Diversification P Bangladesh Female Secondary School , 4.36 P Bangladesh Financialnstitutions Development P Bangiadesh Forest Resources Management P Bangladesh Fourth Fishenes P Bangladesh Health and Populabon Program P Bangladesh Municpal Services P Bangladesh Nabonal Nutrition Program P Bangladesh Non-Formal Educabon P Bangladesh Poverty Alleviation (Microcrcrdit I) P Bangladesh Primary Education Development P Bangladesh Pnvate Sector Infrastructure Dev P Bangladesh River Bank Protection P Bangladesh Second Road Rehabilitation & Maintenance P Bagnladesh Second Rural Roads & Markets Improvement P Bangladesh Silk Development Pitlo Project P Bangladesh Third Road Rehabilitation & Maintenance Total:

65 BANGLADESH STATEMENT OF IFC's Held and Disbursed Portfolio 1 5-Oct-2000 In Millions US Dollars Committed IFC IFC Disbursed FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic 1997 DBH Dynamic Textile Grameen Phone /95 IDLC /98 IPDC Khulna Scancem Total Portfolio: Approvals Pending Conmuitment FY Approval Company Loan Equity Quasi Partic 2000 Haripur Jalalabad II Khulna Lafarge B Loan Lafarge Surma ULC - Bangladesh USPCL Total Pending Commitment:

66 Annex 10: Country at a Glance BANGLADESH: Second Poverty Alleviation Microfinance Project (Microfinance II) POVERTY and SOCIAL South Low- Bangladesh Asla Incomn Development diamond' 1999 Population, mid-year (mit/ions) t27.6 :t Life expectancy GNP per capita (Atlas method, USS) GNP (Atlas method, US$ billions) Average annual growth Population (%) Labor force (%) Labor force M GNP Gross Most recent estimate (latest year availbbl*, ) capita / enrollment ~~~~~~~~~~~~~~per primary Poverty (% of population below national poverty line) 36 Urban population {% of taotl population) Life expectancy at birth (years) Infant mortality (per 1, 000 live births) Child malnutrition (% of children under 5) Access to safe water Access to improved water source (% ofpopulation) illiteracy (% of population age 15+) Gross primary enrollment (% of school-age population) Bangladesh Male Low-income group Female KEY ECONOMIC RATIOS and LONG-TERM TRENDS Economic ratlos' GDP (US$ billions) Gross domestic investmenvgdp Exports of goods and services/gop Trade Gross domestic savings/gdp Gross national savingstgdp 10, Current account balance/gdp * Domestic Interest payments/gdp Savings ; >1 Investment Total debt/gdp S Total debt service/exports Present value of debt/gdp Present value of debt/exports,,,, Indebtedness " (average annual growth) GDP , sngladesh GNP per capita Low-income group Exports of goods and services STRUCTURE of the ECONOMY Growth of Investment and GDP I%) (% of GDP) Is Agriculture Industry Manufacturing Services o- Private consumption ae 97 as ao General government consumption GDI ' GDP Imports of goods and services Growth of exports end imports (%) (average annual growth) Agriculture so Industry Manufacturing Services ; 5 09 Private consumption o v General government consumption Gross domestic investment Imports of goods and services E ports Imports Gross national product Note: 1999 data are preliminary estimates. The diamonds show tour key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond will be incomplete

67 Banggladesh PRICES and GOVERNMENT FINANCE Infation (%) Domestic prices (% change) 12 Consumer prices Implicit GDP deflator Government finance (% of GOP, includes current grants) Current revenue 9, s9 Current budget balance GDP deflator - CPI Overall surplus/deficit S TRADE Export and Import levels (USS mill.) (US$ millions)1 Total exports (fob) 1,286 5, oooo Jute goods Leather and leather products n500 Manufactures ,515 Total imports (cif)] 3,390 7,525 8,381 _ Food ] 59 Fuel and energy Capital goods 1, ,295 o Export price index (1995=100) ss 9r 97 go so Import price index (1995=100) *Exports *Imports Terms of trade (1995=100) BALANCE of PAYMENTS Current account balance to GOP (%) (US$ millions) Exports of goods and services 724 1,603 5, Imports of goods and services , Resource balance , Net income Net current transfers , Current account balance Financing items (net) Changes in net reserves Memo: Reserves including gold (US$ millions),... 1,739 1,772 Conversion rate (DEC, localluss) EXTERNAL DEBT and RESOURCE FLOWS (USS millions) Composition of 1999 debt (USS mill.) Total debt outstanding and disbursed 3, IBRD F G 250 IDA ,163 6,428 F A33 Total debt service IBRD E 5,097 _6428 IDA Composition of net resource flows Official grants Official creditors Private creditors Foreign direct investment C: 290 Portfolioequity D: 4,527 World Bank program Commitments A - IBRD E - Bilateral Disbursements B - IDA D - Other multilateral F - Private Principal repayments C - IMF G - Short-tem Net flows Interest payments Net transfers Development Economics 8125/

68 Additional Annex No.: 11 Demand Analysis and Funding Needs for the Industry BANGLADESH: Second Poverty Alleviation Microfinance Project (Microfinance 11) Size of the industry: Currently, there are nearly million households who live below the poverty line (2100 calories) and are the target population for microcredit programs. Since, according to a BIDS study, nearly 30% of present members of microcredit programs belong to households marginally above the poverty line (the vulnerable non-poor) the effective target households for microcredit are about million. The hard-core poor (1800 K calories) constitute 25% of the total households, i.e million households belong to this category. It has been found that 25% of the present microcredit borrowers belong to the hard-core poor. But there is a sub-set of the hard-core poor, called the 'ultra hard-core' poor or destitute, who constitute approximately the bottom 10% of the population (i.e. around 2.5 million households), who have been excluded from microcredit programs for various reasons. That is, the actual market for microcredit in 1999 was million households. Similarly, using the same assumptions, the estimated potential size of the microcredit market in 2005 will be 14.1 million households. Microcredit coverage: Up to June 1999, the total membership and borrowers under various organizations were million and 9.73 million respectively. But by excluding 15% for overlapping, the actual number of borrowers was 8.27 million households. That is, there was a potential gap of 4.79 million households who could have qualified for loans in Similarly, the estimated gap will be 5.83 million by the year 2005, consisting of 2.10 million hard-core households, and 3.73 million moderate poor. Distribution between rural and urban areas: There will be million (82%) potential borrowers in rural areas, 1.41 million (10%) in municipal areas and 1.13 million (8%) in metropolitan areas (Dhaka, Chittagong, Khulna and Rajshahi) by the year PKSF's coverage of microcredit borrowers: At the end of September 2000, the total number of borrowers was 2.1 million, of which big POs had 1.5 million, and small and medium-size POs had 0.6 million borrowers. PKSF financed 20% of the total microfinance sector's borrowers. Future demand of microcredit: The mainstream microcredit sector is poised to grow further. This growth will be stimulated mainly by the two big NGOs - BRAC and PROSHIKA since the Grameen Bank has stopped expanding, and ASA's expansion will be limited. PKSF's small and medium-size POs will share a small part of the growth. Assuming that each organizations, or group of organizations, grows fully according to its or their plans, the total estimated number of borrowers will be million. Assuming 15% overlapping, the total number of borrowers will be million, which is 81.5% of the potential market. In other words, by in 2005 the microcredit sector may not reach the state of saturation. Total demandfor funds: The demand for funds for microcredit borrowers (new, existing, urban and hard-core poor) has been estimated for the next five years (FY01-FY05) in the Table below. This shows that the total demand for microcredit funds is about US$433 million equivalent

69 Table: Industry Demand for Microcredit Funds (FYO1-FY05) Rural (excluding Grameen Bank and 2,812, ,491, ,304, NCBs) Urban (normal poor: 13.5% of total) 375, , ,164, Hard-core (25%; both urban and rural) 1,062, ,098, ,156, Sub-total: Microcredit 4,25O, ,375, , Enterprise Loans 25, , Sub-total: with Microenterprise 4,250, ,400,000 34L,2 8,650,000 4*i.2 Ultra Hard-core Poor 100, , Grad Total 4,250, O 4S0, $ Total demand for funds increases to US$473 million equivalent if the assessed needs for microenterprise development and the extension of credit to the ultra hard-core poor are included. The demand analysis conducted for Microfinance II shows that there is a potential market of 25,000 borrowers among graduate microcredit borrowers who could be easily reached. This need significantly increases if microenterprise lending is given to borrowers who make lateral entry to the program. Furthermore, the demand analysis shows that it would be possible to extend microcredit to 100,000 ultra hard-core poor if flexible credit methods are used. This will include consumption loans to meet immediate farnily needs and grant financing for their capacity building so as to integrate them into the mainstream microfmance program

70 Additional Annex No.: 12 Criteria for Selection of POs and Borrowers for Rural, Urban, and Hard-core Microcredit and Microenterprises BANGLADESH: Second Poverty Alleviation Microfinance Project (Microfinance 11) PKSF's Operational Manuals provide guidelines on the selection process for partner organizations, borrowers as well as methods for credit extension. This ensures efficient microfinance operations such as extending credit to rural, urban, hard-core poor and microenterpreneurs. Some key elements of these guidelines and credit methods for extending microcredito various beneficiaries are given below: I. Rural Microcredit (a) Selection of Borrowers: The target of the rural microcredit borrowers is the landless or assetless, having a maximum landholding of 0.5 acre as arable land and the value of the total asset does not exceed the value of I acre of land. (b) IL (a) Method of Credit Extension: The credit will be extended by PKSF through its POs to ultimate member borrower. The loan will be non-collateralized, extended to POs microcredit group members. The group members will be trained by POs to efficiently undertake rnicrocredit activities and also acquire saving habits through group empowerment. There will be weekly or fortnightly or monthly meetings of group members, conducted by POs' Field/Credit Officer. Members will deposit savings in the weekly meetings and also pay installment if they are borrowers. The group peer pressure and empowerment of members are the overriding factors for efficient microcredit operations. Urban Microcredit Selection of Borrowers: (i) target members for urban microcredit should be assetless people residing in urban or semi-urban areas and the monthly income of the target members should be in between Tk.4,000 and Tk.5,000; (ii) (iii) (iv) (v) an eligible member of urban microcredit should be a'resident of the locality or at least residing three years in the particular locality; a member should have a permanent/temporary business in the locality with a good track record of handling previous loans. Members should have adequate knowledge about his/her business; women should be given preference for the membership; and target member cannot be a member of any other organization and should not be receiving -66 -

71 microcredit from such organizations. (7) Method of Credit Extension: (i) (ii) (iii) (iv) (v) (vi) (vii) (viii) (ix) POs must have a policy on urban nicrocredit approved by its Executive Committee; urban microcredit operation should be a group-based or an individualoan program; POs should decide on frequency and how to conduct the meetings of the members; savings of the memnbers should be an integral part of urban microcredit. A member has to save on a weekly/monthly basis; POs should be responsible for the selection of working areas, formation of group members, disburserment of loans to the target members/groups and collection of loans from the members/groups; each borrower gets one loan at a time and new loans should be given only after repayment of previous loan; borrowers should have full freedom to use the loan in any activity other than any illegal activity; to cover unpredictable risk, group fund, group tax or any other forced savings and charges should be permitted during the loan disbursement among the target people. A reasonable amount can be taken for revenue stamp, application form, passbook etc. from group members; and loans should be collateral free. Loan given by PO to each member should be recovered within a period of one to two years and by weekly/monthly installments. III. (a) Hard-core Poor Selection of Borrowers: The selection of the hard-core borrowers will follow the criteria of rural microcredit borrowers. The following characteristics of the potential borrowers will also be ascertained: (i) (ii) (iii) (iv) (v) unemployed with no asset and source of income; female head of the famnily with many children; dependent on temporary job; no homestead and work as home-help; and Participants of the income generating programs which mobilizes the hard-core poor under the Vulnerable Group Development (VGD) to provide food aid from the World Food Program (WFP) and other programs; hard-core poor involved in fisheries and social forestry will qualify as borrowers. (O9 Method of Credit Extension: The method of credit extension would be similar to rural microcredit. However, to improve the

72 impact of microcredit on the hard-core poor, changes are required to the current microcredit delivery system such as diversifying financial services and complementing microfinance with non-financial interventions. These will include smaller loan size, flexible installment repayments, different savings products and flexible methods of deposit collections and withdrawals, insurance products and linkages of hard-core credit program with the safety net programs. IV. Microenterprise (a) Selection of Borrowers: (i) progressive borrowers will be selected fromn the graduate/enterprising participants of microcredit programs of the PO. They should have at least 3 years of good reputation in terms of on time loan repayment. Their potential to expand current income generating activities (IGAs) must be reflected in their present activities; (ii) (iii) there must be scope for expanding their IGAs up to a full-time employment, creating enterprises in the context of the corresponding market; and their equity participation should be at least 20% of total investment in the expanded IGAs. (b) Method of Credit Extension: (i) PKSF will provide fund to selected POs which will be used only for on lending to progressive borrowers; (ii) loan maturity period of each loan fund will be up to 3 years, including a grace period of 6 months. After the grace period, POs will be required to refund the borrowed fund in 10 quarterly installments; (iii) (iv) (v) (vi) (vii) financing the POs for this purpose will be continuous in nature. However, continuity of fimancing on behalf of PKSF will be based on performance of POs; borrowers may borrow from POs while remaining in the same group. They may form separate groups in special cases. Individual borrowing without having affiliation with a group may also be allowed; lower-upper limits of loans for progressive borrowers will be Tk.20,000 to 200,000. Borrowers will be divided into 3 groups according to their performance and length of membership with the PO to get different sizes of loans. Loan maturity periods for capital equipment and working capital will not be more than up to 2 years and up to I year respectively. Loan repayments may be made on weekly/fortnightly/monthly basis; borrowers who borrow over Tk.50,000 for microenterprise loan should obtain training on business management and accounting to enhance effective loan use; and only environment friendly economic activities will be financed under this program. A screening process will be established, based on the Guidelines for Management of Microenterprise Environmental Health and Safety, to avoid financing of economic activities that may have adverse environmental impact

73 MAP SECTION

74

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