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1 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Document of The World Bank FOR OFFICIAL USE ONLY PROJECT APPRAISAL DOCUMENT ON A PROPOSED LOAN IN THE AMOUNT OF US$300 MILLION AND A PROPOSED CREDIT IN THE AMOUNT OF SDR MILLION (US$300 MILLION EQUIVALENT) TO THE REPUBLIC OF INDIA FOR A STRENGTHENING RURAL CREDIT COOPERATIVES PROJECT South Asia Finance and Private Sector Development May 3 1,2007 Report No: IN This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.

2 CURRENCY EQUIVALENTS (Exchange Rate Effective April 30,2007) Currency Unit = Indian Rupees (Rs) Rs41.29 = US$1 US$1.524 = SDR 1 FISCAL YEAR April 1 - Mach31 ABBREVIATIONS AND ACRONYMS ADB APL BR Act CA CAS CCB ccs CFI CRAR CSA cvc DAP DCCB DCRR DEA DFID DLIC DPL ESW FM FRS GDP Go1 GTZ HR IBRD ICR ICB IDA IEG IM IRR IT Asian Development Bank Adaptable Program Loan Banking Regulation Act Chartered Accountant Country Strategy Credit Cooperative Bank (including SCB, DCCB, PACS) Credit Cooperative System Cooperative Financial Institution Capital to Risk-weighted Assets Ratio Cooperative Societies Act Central Vigilance Commission of India Development Action Plan District Central Cooperative Bank Department for Cooperative Reform and Revival Department of Economic Affairs Department for International Development, UK District-level Implementation Committee Development Policy Loan Economic and Sector Work Financial Management Financial Restructuring Support Gross Domestic Product Government of India Deutsche Gesellschaft fur Technische Zusammenarbeit Human Resources International Bank for Reconstruction and Development Implementation Completion Report International Competitive Bidding International Development Association Independent Evaluation Group (of the World Bank) Implementation Manual Internal Rate of Return Information Technology

3 KfW M&E MFI MIS MoF MoU MTR NABARD NCB NICSI NIMC NPL NPV PACS PIE PS QAG RBI RCS RDA RFI RRB RTI SA SCB SIDBI SIL SLIC SLR SWAP TA UCBs UPA VSL FOR OFFICIAL USE ONLY Kreditanstalt fur Wiederaujbau Bankengruppe Monitoring and Evaluation Micro finance Institution Management Information System Ministry of Finance Memorandum of Understanding Mid-Term Review National Bank for Agriculture and Rural Development National Competitive Bidding National Informatics Center Services Inc. National Implementation and Monitoring Committee Non-performing Loan Net Present Value Primary Agricultural Credit Societies Project Implementing Entity Participating States Quality Assurance Group (of the World Bank) Reserve Bank of India Registrar of Cooperative Societies Return on Assets Rural Finance Institution Regional Rural Bank Right to Information Special Audit State Cooperative Bank Small Industries Development Bank of India Specific Investment Loan State-level Implementation Committee Statutory Liquidity Ratio Sector-wide Approach Technical Assistance Urban Cooperative Banks United Progressive Alliance Variable Spread Loan Vice President: Country Director: Sr. Country Manager: Sector Directorhlanager: Task Team Leader: Praful C. Pate1 Isabel Guerrero Fayez Omar Sadiq Ahmed/Simon Bell Priya Basu This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not be otherwise disclosed without World Bank authorization.

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5 INDIA: PROJECT ON STRENGTHENING RURAL CREDIT COOPERATIVES CONTENTS Page A. STRATEGIC CONTEXT AND RATIONALE Country and sector issues Rationale for Bank involvement Higher level objectives to which the project contributes... 7 B. PROJECT DESCRIPTION Lending instrument Project development objective and key indicators Project components Lessons learned and reflected in the project design Alternatives considered and reasons for rejection C. IMPLEMENTATION Partnership arrangements Institutional and implementation arrangements Monitoring and evaluation of outcomes/results Sustainability Critical risks and possible controversial aspects Loadcredit conditions and covenants D. APPRAISAL SUMMARY Economic and financial analyses Technical Fiduciary Social Environment Safeguard policies Policy Exceptions and Readiness Annex 1: Country and Sector or Program Background... 25

6 Annex 2: Major Related Projects Financed by the Bank and/or other Agencies Annex 3: Results Framework and Monitoring Annex 4: Detailed Project Description Annex 5: Project Costs Annex 6: Implementation Arrangements Annex 7: Financial Management and Disbursement Arrangements Annex 8: Procurement Arrangements Annex 9: Economic and Financial Analysis Annex 10: Safeguard Policy Issues Annex 11: Project Preparation and Supervision Annex 12: Documents in the Project File Annex 13: Statement of Loans and Credits Annex 14: Country at a Glance... 96

7 INDIA: PROJECT ON STRENGTHENING RURAL CREDIT COOPERATIVES PROJECT APPRAISAL DOCUMENT SOUTH ASIA REGION SASFP Date: May 3 1, 2007 Country Director: Isabel Guerrero Sr. Country Manager: Fayez Omar Sector Director: Sadiq Ahmed Sector Manager: Simon Bell Project ID: PE-P LEN Lending Instrument: Specific Investment Loan Team Leader: Priya Basu Sectors: General finance sector (100%) Themes: Financial sectorpsd/rural development Environmental screening category: C Safeguard screening category: No impact Project Financing Data [XI Loan [ XI Credit [ 3 Grant [ 3 Guarantee [ 3 Other: For Loans/Credits/Others: IBRD loan US$300 million; IDA credit SDR million (US$300 million equivalent) Total Bank financing (US$m.): 60 (equivalent) Prouosed terms: IDA Credit - Standard: IBRD Loan - Variable %read Loan. Libor +18 basis uoints Source BORROWER/RECIPIENT INTERNATIONAL DEVELOPMENT AS SOCIATION INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT Total: Borrower: India Local Foreign Total Responsible Agency: Department o f Economic Affairs (Banking Division), Ministry of Finance, Government of India, New Delhi & National Bank for Agriculture and Rural Development (NABARD), Bandra Kurla Complex, Mumbai

8 Does the project depart from the CAS in content or other significant respects? Re$ PAD A.3 I No Does the project require any exceptions from Bank policies? Re$ PAD D. 7 [ ]Yes [XINO Have these been approved by Bank management? [ ]Yes c IN0 Is approval for any policy exception sought from the Board? [ ]Yes[X]No Does the project include any critical risks rated substantial or high? Re$ PAD C.5 [XIYes [ ]No Does the project meet the Regional criteria for readiness for implementation? Re$ PAD D. 7 (Note: These criteria will be met during appraisal). [XIYes [ ]No Project development objective Re$ PAD B.2, Technical Annex 3 The project supports the Government of India s (GoI) program to reform and revitalize the country s rural credit cooperative banks (CCBs), which include State Cooperative Banks (SCBs), District Central Cooperative Banks (DCCBs) and Primary Agricultural Credit Societies (PACS). The project will assist in providing CCBs members, including small and marginal farmers, with significantly enhanced access to formal finance (credit, savings, etc.), by ensuring that the potentially viable CCBs in the participating states are transformed into efficient and commercially sustainable institutions. Key performance (outcome) indicators, which capture the desired improvements in the financial performance, as well as the governance, of CCBs in the participating states (PS) will include the following: (a) A rapid and upward trend (increase of 70 percent over the project life) in ground-level financing (credit) extended to farmers through CCBs; (b) A rapid and upward trend in the number of marginal and small farmers who receive credit from the CCBs (increase of at least 50 percent by the end of the project period, relative to the baseline); (c) At least three-fourths of the participating CCBs improve recovery rates by 5 to 10 percent a year, over the project period (relative to the baseline); (d) At least two-thirds of the participating CCBs report increased profitability by the end of the project period (relative to the baseline); (e) Participating CCBs publish election schedules and hold elections on a regular basis (whenever due), over the project period. Project description Re$ PAD B.3.a, Technical Annex 4 The project has the following components: Component I: Capacity building Technical Assistance (TA) (Bank financing: US$20 mn) This component will aim to build up the capabilities of CCBs in all three tiers to strengthen their ability to comply with the new legal, regulatory and supervisory framework, improve performance, and achieve longer term financial sustainability. The focus will be on capacity building of: (a) the Boards, management and staff of CCBs in the following areas: understanding the new legal and regulatory framework and governance codes; improved performance tracking and reporting; implementation of a new and enhanced common accounting system, management information system (MIS), internal controls, and audit mechanisms; enhanced credit appraisal and risk management; business diversification and product development; and human resources (HR) development; and (b) the members of selected PACS, through member education, focused on small and marginal farmers; the latter will involve developing and implementing a strategy, focusing on such areas as financial literacy of PACS members and better awareness of rights and responsibilities, as well as strengthened capacity for self-monitoring.

9 Assistance will be delivered through a combination of tools, including the provision of conventional training programs; training-of-trainers; hands-on, on-the-job training and short-term and medium-term advisory services provided by experts; and study visits/exposure programs. The conventional training programs would be delivered primarily by existing National, Regional, and State-level cooperative training institutions identified by NABARD, which would receive capacity building assistance, including training of their faculty to design and deliver basic training modules for the CCBs in accounting, auditing, governance, HR management, MIS, members duties and rights, etc. At the level of DCCBs and PACS, on-the-job training and advisory services will be provided primarily by a cadre of mobile trainers/consultants/auditors. In addition, on-the-job training and advisory services would be provided to the SCBs, as needed; the consulting resources would be mainly national, although some international expertise may be required, on a short-term basis. 1 Component 11: Information technology (IT) (Bank financing: US$80 mn) This component will support the computerization of CCBs within each o f the five PS (in a manner that i s compatible across states), to enhance the efficiency and transparency of the CCBs through enabling the efficient implementation of the new common accounting system and MIS, and fostering cost efficiencies through facilitating the pooling of costs related to back office transactions. The component will finance: (a) acquisition of applications software and its ongoing maintenance and enhancement; (b) acquisition of hardware; (c) roll-out services, including data entry of the initial database; and (d) users training, provided through conventional training programs as well as on-the-job training and advisory services, which would be provided by a cadre of mobile trainers/consultants. Component III: CCS Financial Restructuring Support (FRS) (Bank Financing: US$495 mn) This component will support the financial restructuring of potentially viable CCBs by providing recapitalization as a grant (not equity) to wipe out the accumulated losses of CCBs, restore the value of members capital in the CCBs, and bring these institutions to a minimum capital to risk weighted assets ratio (CRAR) of 7 percent. While PACS will be required to raise this ratio within three years to 9 percent, DCCBs and SCBs shall raise their CRAR as prescribed by the Reserve Bank of India (RBI). This increase in CRAR shall be met by the CCBs from their own resources. The FRS will start by first bringing the PACS to an acceptable level of financial health through cleansing of their balance sheets and strengthening their capital base, and then move on to the upper tiers. This will enable PACS to clear their dues to the upper tiers and thereby reduce the accumulated losses of DCCBs. The DCCBs will thereafter be provided assistance to clear the balance of accumulated losses, if any, and to reach a minimum norm of capital adequacy. The same process will apply to the SCBs. To ensure prudent use of public resources, only the potentially viable CCBs will be recapitalized. All PACS with a recovery rate of at least 30 percent as on June 30, 2004 will be eligible to receive FRS. State governments will be under obligation to determine the future set up/exit strategy for PACS with recovery rates of less than 30 percent. Provision of funds under the FRS will be linked to the implementation of a set of far-reaching and timebound legal, regulatory and institutional reforms to address the governance and operational weaknesses affecting CCBs. Specifically, prior to any funds from Go1 flowing under this component, the concerned state governments will be required to achieve the following set of initial benchmarks: (a) Special Audits are completed (DCCB-wise); (b) the CSA has been revised; (c) the state government contributes its share of capitalization funding; and (d) PACS, DCCBs and SCBs sign Letters of Undertaking with their remective DLIC and SLIC. The benchmarks for the release of the remaining: recatitalization finds to

10 CCBs are as follows: (a) the CSA is amended or special chapter incorporated; (b) elections to the Boards of CCBs are conducted wherever due; (c) professionals are either elected or co-opted to these Boards as per the fit and proper criteria as may be stipulated by the regulator; (d) professional CEOs satisfying the qualifications as may be prescribed by the regulator are appointed; (e) a sound system o f internal checks and controls put in place by CCBs; and (f) Development Action Plans are signed with NABARD committing them to key performance targets. PACS with recovery rates o f 50 percent or above will immediately qualify for FRS, provided the above benchmarks are achieved. For PACS reporting recovery rates of between percent, the same procedures as above will be followed, but the transfer of funds will be divided into three payments to be made at the end of each implementation year, provided they achieve an incremental increase in their recovery rate by at least 10 percentage points on 30 June 2006 against the benchmark recovery achieved on 30 June 2004, and an annual increase of 10 percentage points over the project period, thereafter. Furthermore, it may be noted that, to ensure that the CCBs have the necessary incentives to continue to improve recovery and overall performance post- recapitalization, they will not be fully compensated for all current losses. The recapitalization amount to be provided under the FRS covers accumulated losses as of 3 1 March 2004, based on the audited balance sheets of the CCBs. To calculate the losses at CCBs (and hence, the recapitalization amount), Special Audits of accounts will be carried out for all the PACS, DCCBs and SCBs based on uniform accounting criteria. The Special Audits will ensure that, in the event of insufficient provisioning made by the CCBs, they do not get under-capitalized. A standard format and contents of the Special Audit reports has been developed, along with a quality assurance system. Component IV: Implementation (Bank Financing: US$5 mn) This component (corresponding to the implementation support envisaged under GoI s package) will cover the following areas: (a) overall capacity building for project implementation; (b) support for the Special Audits; and (c) support for ensuring effective project monitoring and information flows throughout implementation, covering improved disclosure and accountability mechanisms at all levels (central, state, district and village/grassroots levels). Which safeguard policies are triggered, if any? Re$ PAD 0.6, Technical Annex 10 None Significant, nonstandard conditions, if any, for: Re$ PAD C.7 Board presentation: June 26,2007 Loadcredit effectiveness: August 2007 Covenants applicable to project implementation: (a) GOI, NABARD and the Participating States (PS), as the case may be, shall maintain the DCRR, NIMC, SLICs, DLICs with adequate powers, functions and resources; (b) NABARD shall implement the Project in PS in accordance with the provisions of the MOU entered into between GOI, NABARD, and each such PS, and in accordance with the Implementation Manual (IM) agreed with the Bank; (c) NABARD shall ensure that PS PACS, DCCBs and SCBs issue Letters of Undertaking, satisfactory to the Bank, for carrying out their respective activities under the Project, in accordance with the CCS Revival Package, the MOU, and the Implementation Manual; (d) Go1 shall, based on the MOU and the Letters of Undertaking provide funds to CCBs to be utilized for recapitalizatiodloss reduction under arrangements satisfactory to the Bank; (e) NABARD shall monitor progress of the project in accordance with indicators satisfactory to the Bank;

11 The mid-term review of the project shall be carried out in July 2009; Disbursement for recapitalization (under component 111) will be provided in two portions, subject to fulfillment of key benchmarks set-out in the CCS Revival Package and the MoU s; The Project Implementing Entity (NABARD) shall, within one month of effectiveness of the CredidLoan, adopt the design of, and the implementation strategy for, the common accounting, internal control and management information systems, satisfactory to the Association and the Bank, to be implemented by the CCBs pursuant to the respective Letters of Undertaking; The Project Implementing Entity shall implement the action plan to strengthen the procurement capacity required for Component 2 of the Project, and ensure that SLICs have undertaken adequate measures to fully implement such a plan; The Go1 will ensure that the Project is carried out in accordance with prudent financial, banking and economic polices, and will ensure that full autonomy will be provided to the CCBs in all financial and internal administrative matters, set forth in the CCS Revival Package and the MOU; The Go1 will undertake to suspend or terminate the right of the PS to use Credit/Loan proceeds, or obtain a refund of all or any part of the amount of the CredidLoan withdrawn if the PS or the CCBs fail to perform their obligations under the MOU or the Letters of Undertaking.

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13 A. STRATEGIC CONTEXT AND RATIONALE 1. Country and sector issues 1. The Indian economy, now the world s fourth largest, has been one of the best performing economies for a quarter century, but ending poverty remains a central challenge. In recent years, India has recorded unprecedented economic growth, which has averaged about 6.5 percent a year since 1980, and above 8 percent a year since Over the past two decades, the size o f the middle-class has quadrupled to almost 250 million people. Each year, over this period, one percent of the country s poor have risen above the poverty line. With population growth having slowed from historic highs of 2.2 percent to 1.7 percent today, economic growth has also brought large gains in per capita income. Despite impressive inroads in poverty reduction, about 270 million Indians still live on under a dollar a day. Some 75 percent of India s poor people live in rural areas. 2. The Government of India (GoI) is committed to sustaining economic growth at 8 percent a year, and to reducing poverty. India s present coalition government of the United Progressive Alliance (UPA), led by the Congress Party, came to power in May 2004 on a plank of reforms with a human face. The UPA adopted as its guiding framework a comprehensive and well-balanced program that includes, in addition to continued reforms for private sector growth, and an enhanced social protection program, a big push for rural development and poverty reduction. Public policy in the rural space has focused, inter alia, on promoting agricultural productivity, diversification and marketing; strengthening economic infrastructure; improving human development outcomes; creating a social safety net for the rural poor; and, most recently, revamping rural finance. 3. A well-functioning financial sector is viewed by Go1 as a key pillar for sustaining growth and alleviating rural poverty. Go1 fully recognizes that continued financial reforms are critical not just for mobilizing the longer-term savings and investments necessary to sustain and accelerate growth, but also, for promoting equitable growth and better income distribution. By extending the range o f individuals who can get a foothold in the modern economy, finance can play a powerful role in helping India s poor to catch up with the economy as it grows, share in the benefits of growth, and climb out of poverty. Largely thanks to microfinance, there is also a growing appreciation of the empowerment dimension of finance. Empirical evidence from around the world also shows that well-functioning financial systems are associated with more rapid and inclusive growth (Annex 1). 4. Since the early 1990s, India has introduced impressive financial sector reforms that have proceeded steadily, albeit gradually. Interest rates have been mostly liberalized; capital markets have been substantially deregulated and restrictions on capital inflows eased; private entry has been allowed into banking, mutual funds and insurance, prudential norms have been tightened and bank capital bolstered; and supervisory systems have been strengthened. The reforms have resulted in increased financial sector competition, diversification, openness, and depth. The share of private and foreign commercial banks in total financial sector assets has more than doubled in the past decade (although state-owned banks continue to dominate, accounting for about 70 percent of total banking sector assets); capital markets now Key rural development initiatives introduced by Go1 since May 2004 include: a national rural employment guarantee scheme; a major rural infrastructure program; measures to facilitate agricultural marketing and private investment in agriculture; a national rural health mission; and a national education for all program. The Bank is supporting each of these programs, in one form or another. See, for example, Beck, T., A. Demirguq-Kunt and R. Levine (2004), Finance, Inequality and Poverty: Cross-Country Evidence, Washington DC: World Bank; Honohan, P (2004), Financial Sector Policy and the Poor: Selected Issues and Evidence, World Bank Working Paper No. 43, Washington DC: World Bank.

14 play an important role, accounting for over one-half of financial sector assets; the liquidity and depth of the domestic capital markets have increased significantly; and India is becoming increasingly integrated with the global economy via financial channels. Annual portfolio inflows to India more than tripled from 2000 to 2005, to US$ 12 billion. India s financial sector assets now exceed US$1 trillion and the share of financial assets to GDP is estimated at 173 percent, much higher than in countries like Brazil, Indonesia and Mexico, despite their significantly higher per capita incomes (Annex 1) While these achievements should not be underestimated, and they have provided India s growing middle-class with access to a range of increasingly sophisticated financial products and services, reforms in the rural finance sector have been slon rer to take off. India s rural dwellers still have very limitc il access to finance from formal sources, like Figure 1. Access to Finance - RFAS 2003 commercial banks or cooperative banks. (percentage) According to a recent World Bank survey3, 0 some 59 percent of rural households do not 0 have a deposit account and 79 percent have no access to credit from a formal source. 0 The problem is particularly severe for 0 small and marginal farmers (the poorest group among rural dwellers, who own up 0 to 4 acres of land). Some 87 percent of 0 marginal farmers and 70 percent of small Marginal Small Large Commercial Others Total farmers have no access to credit from a.no credit account UNO savings account formal financial institution; 70 percent of marginal farmers and 45 percent of small farmers have no deposit account in a formal financial institution (Figure 1). I - - household income. 6. In the absence of formal finance, small and marginal farmers have had to rely heavily on moneylenders, who tend to charge extortionate rates of interest, ranging from 36 percent to 120 percent a year. At such interest rates, the rural poor risk falling into a debt trap from which recovery seems only a very distant prospect. The rise in farmer suicides in states like Andhra Pradesh and Maharashtra is one manifestation of this serious problem of indebtedness in rural India. 7. Against this backdrop, reforming India s rural finance sector so that it can better serve the needs of the rural poor has emerged as a critical development priority. GoI s strategy for the sector has three major thrusts. First, increased competition among the various providers of rural finance (rural branches of commercial banks, Regional Rural Banks (RRBs), cooperative credit institutions, microfinance institutions, etc.). Notably, with a lowering of restrictions on branch licensing in rural areas, and a recent policy allowing banks to operate through correspondents, private players have begun to expand their rural operations. Policies that restricted competition among banks in rural areas by allowing bank branches to operate only in pre-allocated service areas, of about villages per bank branch, have also been revised. Steps have been taken to facilitate the expansion of microfinance institutions (MFIs). Measures have been announced that provide market-based incentives for banks to lend to MFIs, and promote partnerships between commercial banks and MFIs. A microfinance law, designed to improve the policy and regulatory framework for the sector, has been tabled in parliament. All these measures have helped increase competition among rural finance institutions (RFIs). However, commercial banks and MFIs have been able to make a dent in meeting the needs of small and marginal farmers, because of 1ndia:Scaling-up Access to Finance for India s Rural Poor (2004), Report No IN, Washington DC: World Bank. 2

15 adverse risk perceptions and institutional problems; as such, rural credit cooperatives are the only institutional mechanism available to serve small and marginal farmers (see below). 8. A second thrust of GoI s strategy is to develop products for the better management and mitigation of risks in rural finance, with a focus on: (i) revamping agriculture insurance to provide improved coverage of the risks faced by small and marginal farmers (this is being supported through a Bank technical assistance); (ii) fostering partnerships between government and private sector to pilot weatherindex insurance, which can be a good way for farmers to hedge businesses against imponderable weather risks (scaling up weather insurance pilots and improving product design is also being supported through Bank technical assistance); (iii) developing a negotiable warehouse receipt system, which allows farmers to use their crops as collateral for post-harvest financing, thereby potentially reducing default risk and improving the access of small and marginal farmers to formal financing (a Warehousing Bill has recently been introduced in parliament); and (iv) efforts to develop the commodities futures markets, which would allow better price discovery and make an important contribution to addressing the risk of falling commodity prices, which is among the main sources of farmer default. A model act has been formulated to reform the agricultural produce marketing legislation at the state level; the act could make an important contribution to fostering a single national market for agricultural commodities. 9. A third thrust is the reform of RFIs so that they are better positioned to provide financial services to small and marginal farmers; the immediate focus is on the rural cooperative credit system (CCS), which has the largest network among all types of RFIs in India (one outlet for every six villages in India), and is potentially the best-positioned to serve small and marginal farmer^.^ India s CCS comprises 108,779 village-level Primary Agricultural Societies (PACS), 367 District Central Cooperative Banks (DCCBs) and 3 1 State Cooperative Banks (SCBs). Following years of political interference, poor governance, weak regulation and supervision, and inadequate management capacity, a very large number of CCS institutions-henceforth referred to as rural cooperative credit banks (CCBs)-are severely impaired, and cannot, at present, provide financial services to the poor on a commercially sustainable basis (Figure 2).5 The scale of the problem in the CCBs differs between the states and across institutions, but some common features are discernable: in a very large number of CCBs, elections have not taken place for a long time, Boards are fkequently superseded, State Governments regularly interfere in day-today operational decisions, regulation and supervision is inadequate, internal controls are weak or nonexistent, MIS is absent, etc. 70% 7 Figure 2: State of Rural Credit Cooperatives in India PACS 67% 60% - DCCB6 DCCBS SCBS mk Source: Analysis using NABARD and RBI data for end March 2005, except overdues NA=Not available Another category of rural finance institutions, also in distress, is the group of around 95 RRBs, although they are betterpositioned to serve larger farmers. RRB reforms so far have focused on mergers that has resulted in the number of RRBs reducing from 196. Go1 intends to intensify these reforms in the last annual budget. The term Cooperative Credit Banks (CCBs) is used to include all three levels - state (SCB), district (DCCB) and village (PACS) - although the majority of PACS are currently not formally licensed as banks.

16 10. Go1 recognizes that, while the CCBs are best-positioned to serve the financial needs of small and marginal farmers, the system has a poor track record, and that it needs to be overhauled if it is to become an effective mechanism for the delivery of financial services to the rural poor. While committees appointed by previous governments have spelled out what needs to be done to reform CCBs, the Government has made a major breakthrough by building consensus for far-reaching reforms with stakeholders, key among which are the State Governments, which have joint responsibility (with GoI) for the CCBs, under the Indian Constitution. 11. In January 2006, Go1 announced an assistance package (henceforth referred to as the Go1 Package ) designed to transform the potentially viable CCBs into democratically governed, efficiently managed, financially sustainable, self-reliant entities that can provide a wider range of financial services to the rural poor on more affordable terms (Annex 1). States can access financial and technical assistance under the Go1 Package, provided they agree to implement a set of far-reaching and time-bound legal, regulatory and institutional reforms to address the governance and operational weaknesses affecting CCBs (see Box 1); these are contained in a memorandum of understanding (MoU) that states are required to sign with Go1 and the National Banks for Agriculture and Rural Development (NABARD), as a starting point for participation. Box 1: Legal, Regulatory and Operational Reforms under GoI s Package for Strengthening Rural Credit Cooperatives Legal reforms under the Go1 Package require states to amend their Cooperatives Societies Act (CSA). These amendments are designed to: minimize State Governments ownership stake in CCBs; ensure full voting membership rights for all users (members) of financial services from CCBs, including depositors in PACS; provide operational autonomy to the CCBs in all financial and internal administrative matters, especially in the following areas: (i) interest rates on deposits and loans, (ii) borrowings and investments, (iii) loan policies and individual loan decisions, (iv) personnel policies, staffing and recruitment (the system of cadre secretaries to PACS will be abolished), (v) internal control systems, and appointment of auditors and compensation for the audit; permit CCBs in all three tiers freedom to take loans from any regulated financial institution and not necessarily from only the upper tier and, similarly, placing their deposits with any regulated financial institution of their choice, beyond certain agreed thresholds; minimize the State Government s participation on the Boards of CCBs and limit the powers of State Governments to supersede the Boards of CCBs; ensure timely elections before the expiry of the term of existing Boards; and facilitate the regulatory powers of the Reserve Bank of India (RBI) over SCBs and DCCBs Regulatory reforms under the Go1 Package are designed to significantly enhance the regulation and supervision of CCBs, through the effective enforcement of the central bank s regulations, while reducing the powers currently vested with State Governments. Specifically, under the new regulatory regime: all SCBs and DCCBs are required to adhere to the central bank s prudential norms and corporate governance standards. RBI regulatory prescription will apply in all matters related to elections to the Boards and appointment of Board members, who will be required to comply with the fit and proper criteria as stipulated by the regulator, and matters relating to the supercession of Boards and winding up/liquidation of a DCCB or SCB. Furthermore, professional CEOs who satisfy RBI-prescribed qualifications will be appointed. the powers of State Governments over PACS are to be significantly reduced, with a commensurate enhancement of NABARD s role, including in prescribing prudential norms (including CRAR), criteria for elections to Boards; conditions for the supercession of Boards; payment of dividends by PACS, and so on. The Go1 Package includes a number of measures designed to achieve operational strengthening of CCBs. These require CCBs to (a) install and adhere to enhanced, uniform accounting and financial monitoring systems, internal control systems, improved credit appraisal, risk management, etc.; and (b) implement new staffing and recruitment policies. 4

17 12. Voluntary participation by states ensures self selection of states that are genuinely committed to implementing the reforms deemed necessary to revive potentially viable CCBs on a sustainable basis. As of end-may 2007, the following 11 states had signed MoUs: Andhra Pradesh (AP), Arunachal Pradesh, Bihar, Gujarat, Haryana, Madhya Pradesh (MP), Maharashtra, Orissa, Rajasthan, Uttar Pradesh (UP) and Uttarakhand. A few more states are likely to join before the cut-off date of January The Go1 Package covers assistance for: (a) capacity building to strengthen the managerial and technical capabilities of potentially viable CCBs and improve networking; (b) investments in computerization to support better connectivity among CCBs and enhanced cost efficiency; (c) financial restructuring support to bring the potentially viable CCBs to an acceptable level of health; and (d) support for the overall implementation of the Go1 Package, which is expected to be implemented within a period of three years from the date on which any state signs the MoU with Go1 and NABARD. CCBs that remain ineligible for assistance under the Go1 Package, or cannot comply with the performance targets set by the Package, are to be wound up in a timely manner, through mergers or liquidation. 14. The Go1 Package is underpinned by analysis conducted by a Task Force6 appointed by GoI, and supported by the Bank s economic and sector work (ESW). The Task Force made a compelling case for reviving potentially viable CCBs, pointing to the absence of cost-effective and realistic alternatives that could substitute for their potential outreach to the rural poor within any reasonable timeframe. Indeed, the evidence shows that commercial banks are neither able nor willing to serve the poorest in rural areas; the average loan size of commercial banks rural loans is Rs 3 1,585 (US$765), compared to the average rural loan size of CCBs, which is Rs. 6,637 (US$160). A number of MFIs have emerged over the last decade, but they are concentrated mainly in a few southern Indian states and are currently estimated to reach about 15 million clients; scaling up will take time. In contrast, the total membership of the lowest tier of CCBs (the PACS) is about 127 million; 47 million of these are small and marginal farmers. Despite their weak financial condition, the CCBs still account for 22 percent of formal agricultural credit provision, respectively. In states like Maharashtra, Orissa, Rajasthan, Gujarat, Chhatisgarh and Haryana, the CCBs provide more than 50 percent of the formal credit for agriculture. 15. Consensus quickly emerged in India that the financial and political cost of liquidating the CCBs would be significantly higher than the estimated cost of restructuring the potentially viable institutions, provided these could be selected on the basis of clear and transparent criteria, and provided that CCBs with no turnaround prospects would be wound up. In particular, the cost associated with the undefined pension liabilities of the CCBs and staff redundancies, weak prospects for recovering nonperforming assets in the event of liquidation, and the concurrent fiscal impact on the State Governments providing guarantees to CCB borrowings were judged to be too large, while the economic and social dislocation in terms of income and employment losses for both existing and potential clients were viewed as untenable. 16. Moreover, evidence from India and abroad shows that the benefits of well-functioning Cooperative Financial Institutions (CFIs) could be high. There are examples from many districts in Southern India (e.g., Bidar, South Kanara, Chandrapur, Hassan and Trichy), where isolated reforms of CCBs have enabled them to play an important role in providing financial services to small and marginal farmers in a financially sustainable manner. In addition, India s recent experience with reforming Urban Cooperative Banks (UCBs) through an approach similar to the proposed Go1 Package for rural CCBs has generated a positive impact (Box 2). Among developing countries, Mexico has, in recent years, introduced reforms of the savings and credit cooperative system, resulting in a transformation that is The Task Force was appointed in August 2004 under the Chairmanship of Professor A. Vaidyanathan, to assess the problems in the CCBs and prepare a practical plan for the way forward; its final report was submitted in Basu, Priya (2006), Improving Access to Finance for India s Rural Poor, Directions in Development Series, Washington DC: World Bank; 1ndia:Scaling-up Access to Rural Finance (2004), Report No IN, Washington DC: World Bank. 5

18 allowing the country s financial cooperatives to make a real contribution towards improving access to finance for the underserved; this has been assisted by a Bank-supported program (BANSEFI). On-going studies identify Brazil and Burkina Faso, as well as Ecuador and the Philippines, as additional examples where the credit cooperative sector has made a significant contribution to improved access to finance, including in rural areas. Examples also exist from countries such as Canada, the Netherlands, Germany and the US, where credit cooperative banks have played a key role in extending the outreach of financial services to poorer segments, without compromising financial sustainability. Box 2: Urban Cooperative Banks (UCBs) Reform In 2005, India initiated a set of reforms to strengthen the country s UCBs. The reforms focused on (i) identifying potentially viable UCB s and strengthening their capital base, while dealing with unviable ones; and (ii) rationalizing the regulatory and supervisory framework for UCBs to strengthen RBI s oversight over the system. These reforms included: (a) Signing of MoU between RBI and State Governments to form a State level Task Force for Cooperative Urban Banks (TAFCUB). The TAFCUBs, set-out to identify the potentially viable and unviable weak banks in each signatory state (8-States have signed on so far), grade these institutions according to certain performance criteria, and suggest revival plans for the potentially viable banks and a non-disruptive exit route for unviable/weak banks. The exit route has included mergedamalgamation with strong banks, conversion into society or, as a last resort, liquidation. (b) Introduction of a two-tier regulation system whereby smaller UCBs whose operations are limited to a single district and have deposits of less than Rs.100 crore* have been: (i) allowed to adopt 180-day delinquency norm for classification of assets as nonperforming, (ii) given exemption from maintaining the Statutory Liquidity Ratio (SLR) in Government securities (iii) exempted from the provisioning norms of 0.40 per cent of standard advances which have recently been applied to the larger UCBs. (c) Introduction of a two-tier supervision system where larger UCBs are placed under a composite Off-site Surveillance (OSS) reporting system comprising a set of eight prudential supervisory returns, while smaller banks having deposits between Rs.50 crore and Rs. 100 crore and whose branches are limited to a single district are placed under a simplified reporting system consisting of five returns. The impact of these reforms is already visible. Closer oversight from RBI has improved commercial discipline and the overall performance of the sector. Net WAS for UCBs as a percentage of total advances have decreased from 13 percent in 2003 to 9.6 percent in 2006, while their net profits jumped by 144 percent from to The number of UCBs classified in the top grade has increased, while the number of weak UCBs in the lower two grades has declined in those States which were among the first to sign the MoUs and form their TAFCUBs (such as Andhra Pradesh, Gujarat and Karnataka). In addition, effective resolution strategies for weaker UCBs have resulted in a decrease in the number of UCBs in those states - reflecting a serious process of consolidation. Source: RBI Trends and Progress in Banking in India, * 1 crore = 10,000, Against this backdrop, and recognizing the role that development partners, including the Bank, could play in strengthening the design and implementation of the Go1 Package, as well as in providing financial support, Go1 has requested financial and technical assistance from the Bank, and other development partners, to support its Package. 6

19 2. Rationale for Bank involvement 18. There are many compelling reasons for the Bank to support the Go1 Package. First, the proposed project would allow Go1 to implement its reforms in a more effective and sustainable manner. Through its involvement, the Bank could bring best practices and technical expertise, drawing on extensive experience in the reform of financial cooperatives worldwide and on lessons learned from projects in India (Annex 2). A key feature of the Bank s value addition during project preparation has been to bring in a wide range of international experience, from countries such as Canada, Mexico, the Netherlands, US. Second, Bank involvement in supervision throughout the project period should help augment the impact of the reforms. In particular, the Bank has considerable expertise in designing monitoring and evaluation (M&E) systems for similar projects. Third, the Bank s involvement should contribute towards insulating the reforms from possible political interference during the project period. Fourth, the proposed project would contribute to bringing together the other international development partners who are providing assistance to GoI s reforms. 3. Higher level objectives to which the project contributes 19. By providing small and marginal farmers with improved financial services from a revitalized CCS, the proposed project is expected to help these groups break out of the clutches of usurious moneylenders, reduce indebtedness, diversify their rural economic activities, increase incomes, and improve livelihoods, thereby supporting broad-based rural growth, poverty reduction and equity. These objectives are closely aligned with the Bank s India Country Strategy (CAS), B. PROJECT DESCRIPTION 1. Lending instrument 20. The lending instrument is a Specific Investment Loan (SIL), to be financed by a combination of IDA and IBRD resources, in equal proportion, totaling US$600 million (equivalent). For the IBRD component, the Borrower has opted for a variable spread loan (VSL). This product carries a variable lending rate that consists o f a six-month LIBOR and a variable interest spread. The charges for VSLs include a front-end fee and a commitment fee, apart from the contractual spread. At present, after factoring in the benefits of sib-libor funding costs, current loan charge waivers, the expected disbursement profile of the project, grace period of five years and final maturity of 20 years, the allinclusive (blended) cost for this loadcredit is estimated at 2.67 percent The total costs of implementing the Go1 Package (at the all-india level) have been estimated at Rs. 13,596 crore (a little over US$3 billion). The costs will be shared by the Central Government (estimated at 68 percent), State Governments (estimated at 28 percent) and the CCS (estimated at 4 percent). The Central Government (GoI) will provide its share (a little over US$2 billion) as grants, while the states will meet their share from their budget or through open market borrowing. Bank-financing through the proposed project would be used to fund a part of GoI s contribution. 22. The Bank s funds are expected to flow to such participating states (PS) that have signed MoUs with Go1 and NABARD, possibly including: Gujarat, Haryana, Orissa, Uttarakhand and Uttar This has been waived for the current fiscal year. The cost of the IBRD portion would be 5.44 percent, i.e., LIBOR+18 basis points. lo Should the ultimate cost of the program end up being higher than originally anticipated, Go1 is committed to making the additional resources available. 7

20 Pradesh. The total costs of implementing the Go1 Package in the five PS are estimated at US$l.l billion, of which, the Central Government s (GoI) share is US$750 million, while the State Governments and CCBs will cover the rest (Annex 5). Release of funds by the State Governments will be a condition for the release of funds by GoI. The Bank s loadcredit will fund 80 percent of GoI s total contribution to the Package in each of the five states. 23. Over time, more states could be added to the list of PS, depending upon how the project, and the larger Go1 Package, evolves. Additional Financing (as per the Bank s Revised Guidelines on Additional Financing for Investment Lending, June, 2005) from the Bank could be considered to support the subsequent scaling up of the project s development impact, provided results achieved under the project meet the criteria for Additional Financing. 2. Project development objective and key indicators 24. The project will assist in providing members o f the CCBs, including small and marginal farmers, with significantly enhanced access to formal finance (credit, savings, etc.), by ensuring that the potentially viable CCBs in the Participating States are transformed into efficient and commercially sustainable institutions (Annex 3). 25. Key performance (outcome) indicators, which capture the desired improvements in the financial performance, as well as the governance, of CCBs in PS will include the following: (a) A rapid and upward trend (increase of 70 percent over the project life) in ground-level financing (credit) extended to farmers through CCBs; (b) A rapid and upward trend in the number of small and marginal farmers who receive credit from the CCBs (increase of at least 50 percent by the end of the project period, relative to the baseline); (c) At least three-fourths of the participating CCBs improve recovery rates by 5 to 10 percent a year, over the project period (relative to the baseline); (d) At least two-thirds of the participating CCBs report increased profitability by the end of the project period (relative to the baseline); (e) Participating CCBs publish election schedules and hold elections on a regular basis (whenever due), over the project period. 3. Project components 26. Consistent with the key elements of the Go1 Package, the proposed project has the following components (Annex 4 and 5): Component I: Capacity Building Technical Assistance (TA) (Bank financing: US$20 mn) 27. This component (corresponding to the human resources (HR) development initiative under the Go1 Package) will aim to build up the capabilities of CCBs in all three tiers to strengthen their ability to comply with the new legal, regulatory and supervisory framework, improve performance, and achieve longer term financial sustainability. The focus will be on building up the capacity of: (a) the Boards, management and staff of CCBs in the following areas: understanding the new legal and regulatory framework and governance codes; improved performance tracking and reporting; implementation of a new and enhanced common accounting system, management information system (MIS)/internal controls, and audit mechanisms; enhanced credit appraisal and risk management; business diversification, product development, and networking; and HR development; and (b) members of selected PACS, through member education, focused on small and marginal farmers, the latter will involve developing and 8

21 implementing a strategy, focusing on such areas as financial literacy, and better awareness of rights and responsibilities, among PACS members, as well as strengthened capacity for self-monitoring. 28. Assistance will be delivered through a combination of tools, including the provision of conventional training programs; training-of-trainers; hands-on, on-the-job training and short-term and medium-term advisory services provided by experts; and study visits/exposure programs. The conventional training programs would be delivered primarily by existing National, Regional, and State - level cooperative training institutions identified by NABARD, which would receive capacity building assistance, including training of their faculty to design and deliver basic training modules for the CCBs in accounting, auditing, governance, HR management, MIS, and members duties and rights, etc. At the level of DCCBs and PACS, on-the-job training and advisory services will be provided primarily by a cadre of mobile trainers/consultants/auditors. In addition, on-the-job training and advisory services would be provided to the SCBs, as needed; the consulting resources would be mainly national,, although some presence of international expertise may be required, at least on a short-term basis (Annex 4). Component 11: Information Technology (IT) (Bank financing: US$80 mn) 29. This component (corresponding to the computerization initiative under the Go1 Package) will support the computerization of CCBs within each of the five PS (in a manner that is compatible across states), to enhance the efficiency and transparency of the CCS through enabling the efficient implementation of the new common accounting system and MIS, and fostering cost efficiencies through facilitating the pooling of costs related to back office transactions. The component will finance: (a) acquisition of applications software and its ongoing maintenance and enhancement; (b) acquisition of hardware; (c) roll-out services, including data entry of the initial database; and (d) users training, provided through conventional training programs as well as on-the-job training and advisory services, which, would be provided by a cadre of mobile trainers/consultants (Annex 4). Component 111: CCS Financial Restructuring Support (FRS) (Bank Financing: US$495 mn) 30. This component (corresponding to the recapitalization initiative under the Go1 Package) will support the financial restructuring of potentially viable CCBs by providing recapitalization as a grant (not equity) to wipe out the accumulated losses of CCBs, restore the value of members capital in the CCBs, and bring these institutions to a minimum capital to risk weighted assets ratio (CRAR) of 7 percent. While PACS will be required to raise this ratio within three years to 9 percent, DCCBs and SCBs shall raise their CRAR as prescribed by the RBI. This increase in CRAR shall be met by the CCBs from their own resources. 31. The FRS will start by first bringing the PACS to an acceptable level of financial health through cleansing of their balance sheets and strengthening their capital base, and then move on to the upper tiers. This step will enable PACS to clear their dues to the upper tiers and thereby reduce the accumulated losses of DCCBs. The DCCBs will thereafter be provided assistance to clear the balance of accumulated losses, if any, and to reach a minimum norm of capital adequacy. The same process will apply to the SCBs. 32. To ensure prudent use of public resources, only the potentially viable CCBs will be recapitalized. All PACS with a recovery rate of at least 30 percent as on June 30, 2004 will be eligible to receive FRS. State Governments will be under obligation to determine the future set up/exit strategy for PACS with recovery rates of less than 30 percent. I This however does not mean writing off loans that are yet to be repaid by borrowers; the CCBs will have to continue to make efforts to recover bad loans, post-recapitalization. 9

22 33, Provision of funds under the FRS will be linked to the implementation of a set of far-reaching and time-bound legal, regulatory and institutional reforms to address the governance and operational weaknesses affecting CCBs. Specifically, prior to any funds from Go1 flowing under this component, the concerned State Governments will be required to achieve the following set of initial benchmarks: (a) SAs are completed (DCCB-wise); (b) the CSA has been revised; (c) the State Government contributes its share of capitalization funding; and (d) PACS, DCCBs and SCBs sign Letters of Undertaking with their respective DLIC and SLIC. The benchmarh for the release of the remaining recapitalization funds to CCBs are as follows: (a) the CSA is amended or special chapter incorporated; (b) elections to the Boards of CCBs are conducted wherever due; (c) professionals are either elected or co-opted to these Boards as per the fit and proper criteria as may be stipulated by the regulator; (d) professional CEOs satisfying the qualifications as may be prescribed by the regulator are appointed; (e) a sound system of internal checks and controls put in place by CCBs; and (f) Development Action Plans (DAPs) are signed with NABARD committing CCBs to key performance targets12 (Annex 4, 6, 7). 34. PACS with recovery rates of 50 percent or above will immediately qualify for FRS, provided the above benchmarks are achieved. For PACS reporting recovery rates of between percent, the same procedures as above will be followed, but the transfer of funds will be divided into three payments to be made at the end of each implementation year, provided they achieve an incremental increase in their recovery rate by at least 10 percentage points on 30 June 2006 against the benchmark recovery achieved on 30 June 2004, and an annual increase of 10 percentage points over the project period, thereafter. Furthermore, it may be noted that, to ensure that the CCBs have the necessary incentives to continue to improve recovery and overall performance post- recapitalization, they will not be fully compensated for all current losses. The recapitalization amount to be provided under the FRS covers accumulated losses as of 3 1 March 2004, based on the audited balance sheets of the CCBs. 35. To calculate the losses at CCBs (and hence, the recapitalization amount), Special Audits (SAs) of accounts will be carried out for all the PACS, DCCBs and SCBs based on uniform accounting riter ria.'^ The SAs will ensure that, in the event of insufficient provisioning made by the CCBs, they do not get under-capitalized. A standard format and contents of the special audit reports has been developed. The SAs will be conducted by the audit staff of the State Cooperative Departments, under the supervision of NABARD, and involving the District-level Implementation Committees (DLICs) and State-level Implementation Committees (SLICs) set up to assist with implementation. Quality assurance over the SAs is to be provided by the DLICs, which are required to review the SAs and recommend to the SLICs the recapitalization amount required for the concerned CCBs. Besides representatives from NABARD, the DCCB, and the State Government, each DLIC includes a Chartered Accountant (CA), who is mandated by the Committee to conduct a sample check (15 percent) of the SAs. Based on the recommendation of the DLICs, the SLICs, which also include a CA, have the role of approving the amount of recapitalization funds to be provided to the CCBs. Component IV: Implementation (Bank Financing: US$5 mn) 36. This component (corresponding to the implementation support envisaged under the Go1 Package) will cover the following areas: (a) overall capacity building for project implementation; (b) support for the SAs, and (c) support for ensuring effective project monitoring and information flows throughout These DAPs would specify performance targets to be achieved by the DCCBs and SCBs over a three year period. l3 It may be noted that the SAs are financial reviews (rather than fully-fledged audits), and are designed specifically to recompute the accumulated losses of CCBs, by applying the standard provisioning norms, as prescribed by RBI. The SAs will update previous figures used at the time the GoI s package was being formulated. At that time, the accumulated losses in the system were estimated at Rs. 9,277 crores (a little over US$2 billion), with the breakdown as follows: Rs. 4,595 crores for the PACS, Rs. 4,401 crores for the DCCBs, and Rs. 281 crores for the SCBs. 10

23 implementation, covering improved disclosure and accountability mechanisms at all levels (central, state, district and village/grassroots levels) (Annex 4). 4. Lessons learned and reflected in the project design 37. The design of this project has benefited from the significant body of ESW carried out by the Bank in India over the past four years.14 The approach taken is consistent with various completed and/or ongoing Bank operations for the restructuring of financial cooperatives (e.g., the BANSEFI project in Mexico); other related projects/programs (e.g., Bank Rakyat Indonesia s Unit Desas, which were restructured into a highly profitable entity from a politicized and loss making credit agency for rice farmers; Bank Pertanian Malaysia; Banco Agricola de la Republica in the Dominican Republic; and the Bank for Agriculture and Agricultural Cooperatives in Thailand) (Annex 2). 38. These financial sector operations point to the following key lessons that are critical to achieving sustainable improvements in the performance of financial institutions: (a) project design must be grounded in in-depth financial and institutional analysis; (b) any financial injections to cover losses be accompanied by the necessary reforms in the overall legal, regulatory and governance framework, and TA to strengthen the managerial and technical capabilities of the financial institutions and agencies involved in project implementation; (c) key reforms, that involve upfront commitments to good governance, competition and market discipline, should be front-loaded, so that financial injections are provided after governments and institutions have demonstrated a sufficient level of commitment to the restructuring effort; (d) selectivity is of the essence, so that institutions that have no prospects for turnaround should be identified (based on clear and transparent criteria that are established upfront), and their exit facilitated through such means as closures or mergers, and only the potentially viable institutions should be supported through financial assistance and TA; this will ensure the chances of successful restructuring and minimize fiscal costs to governments; and (e) stakeholder commitment and coordination are essential. These lessons have been incorporated into the project s design. 39. Specific lessons from projects that have involved the restructuring of financial cooperatives have also been incorporated, including the importance o f capacity building for networkmg and IT investments that can help in the pooling of costs and helping these institutions to achieve scale economies. Some Bank funded projects involving large IT investments have not been successful; problems have resulted mainly from inappropriate preparation or weak project supervision, especially in cases where the related software deals with complex or relatively unique business requirements. The IT component under the proposed project is relatively straight forward from a business, technical and implementation perspective, and involves small contracts to be procured at the State-level. The main source of complexity is that of scale; in essence, the need to procure complete solutions for a large number of institutions in parallel. Based on lessons from previous operations, the project addresses this issue by ensuring that CCBs are provided with packaged solutions that include the necessary implementation support under the IT component, to ensure that the sought after business benefits are realized in practice. One way of achieving this is by requiring that the software supplier be contractually obliged to provide a working solution for the acquiring institution (Annex 2). 40. The Bank s rural poverty reduction and livelihoods projects in India, which also include financial sector components, point to some useful lessons, and these have been incorporated into project design. l4 See, for example: World Bank (2004), op. cit.; Basu, Priya and Pradeep Srivastava (2005), Exploring Possibilities: Microfinance and Rural Credit Access for the Poor in India, Economic and Political Weekly Vol XL No. 17, pp ; Basu, Priya (2006). Improving Access to Finance for India s Rural Poor, Directions in Development Series, Washington DC: World Bank; National Agriculture Insurance Scheme: Market based solutions for better risk sharing (2007), Washington DC: World Bank. 11

24 Key among these is the finding that the mobilization of the ultimate beneficiaries at the grassroots level is critical for minimizing the risks of political or government capture, and for ensuring that the desired outcomes are achieved. Accordingly, the project pays particular attention to strengthening the capacity of small and marginal farmers (the PACS members) in project monitoring. 41. The project also incorporates lessons from successful sector-wide approaches (SWAPS), by placing a strong emphasis on strengthening governance and implementation capacity by encouraging strong country ownership, coordinated and open policy dialogue among the various development partners involved in the project, sector-wide accountability and strengthening of fiduciary safeguards, and improvements in client capacity, systems and institutions. 42. Recent reviews by the Bank s Independent Evaluation Group (IEG) and Quality Assurance Group (QAG) of Bank assistance to the financial sector during FY93-05 have found that the Bank s presence contributed to financial sector development in client co~ntries. ~ According to IEG s Review of March 2006, the outcomes of lending for financial sector reforms that were categorized as being under the auspices of the Financial Sector Network (FSE) were significantly better than those of finance components within multi-sector operations. By and large, outcomes of financial sector operations averaged 85 percent satisfactory, while finance components of multi-sector operations averaged 75 percent satisfactory, slightly below the 79 percent average for all adjustment and TA lending, excluding the financial sector. These results are likely to have been driven by the fact that financial sector loans designed by FSE specialists had better technical designs. In its May 2006 synthesis report, IEG concluded that Bank lending and non-lending support, except for lines of credit, helped catalyze positive changes in depth and access to credit. Bank lending contributed positively to changes in governance, regulatory framework, market structure and efficiency, primarily in the banking sector, although non-bank sectors have increased in importance (IEG synthesis, May 2006). Lending accompanied by TA produced better outcomes than without TA. 5. Alternatives considered and reasons for rejection 43. Regarding the choice of lending instrument, a development policy loan (DPL) was not deemed appropriate for the reason that the project s success crucially depends on the deployment of project funds towards investments in the various areas for which they are earmarked. Furthermore, after careful consideration, it was agreed that the project s design and objectives would not be appropriately supported through an Adaptable Program Loan (APL). The project is designed to support a set of CCS reforms to be implemented over a well-defined (three year) time frame in states that are willing to participate. Any state wishing to participate must join by January 2008, at the latest, which means that the outer limit of the project s implementation timeframe is January There are no provisions, at this stage, to implement subsequent phases of reforms in the PS, or to expand the Go1 Package to cover states that do not join by January However, should this change, and depending on the outcomes in the participating states, the Bank could consider supplemental assistance for deepening reforms in CCBs in the participating states or expanding support to cover CCBs in new states through the Additional Financing route. A SIL, with the possibility of Additional Financing, would provide the necessary flexibility to deepen reforms, over time, if needed, and expand coverage to new states that may enter at a later date. This would provide l5 IEG evaluations were presented in the following reports: (i) IEG Review of World Bank Assistance for Financial Sector Reform, March 2006; (ii) World Bank Lending for Lines of Credit: An IEG Evaluation, May 9, 2006 and (iii) Financial Sector Assessment Program: IEG Review of the Joint World Bank and IMF initiative, May 16, IEG compiled the key findings of all three reports into one publication, World Bank Assistance to the Financial Sector: A Synthesis of IEG Evaluations, May 18, QAG assessments consist of: (i) Quality of Country AAA: A QAG Assessment, November 2005; and (ii) Quality Enhancement System for Lines of Credit: A QAG Assessment, December

25 the Borrower with the option to seek additional financial support from the Bank, but with lower financial charges (commitment fees). C. IMPLEMENTATION 1. Partnership arrangements 44. The project will adopt a sector-wide investment approach (SWAP), with Bank funds provided to Go1 through parallel financing. The SWAP will enable the Bank to support GoI s reforms in a comprehensive and coordinated manner across the PS, and leverage Bank resources to scale-up impact. Bank financing to Go1 is complemented by financing from a number of donors, including: the Asian Development Bank (ADB), KfW and DFD. ADB s Board has approved (in December 2006) a policy based programmatic loan of US$1 billion to Go1 for this purpose; the loan supports all aspects of the Go1 Package. A loan of US$175 million (equiv.) from KfW to support the recapitalization component of the Go1 Package is being prepared. The ADB and KfW funds will flow to five states (not including the PS to be supported by Bank funds). DFID has also committed to providing a grant of US$2 million to Go1 to support the technical assistance components of the Go1 Package. In addition, GTZ is supporting Go1 with project preparatory activities, including the development of common accounting, auditing and MIS frameworks for the CCBs. 45. The concerned development partners will meet regularly to facilitate effective coordination and communication. Arrangements for M&E, reporting, financial management, fiduciary oversight, etc., to be used for the implementation of the Go1 Package across states, have been agreed. Not only will this help ensure more effective implementation, but also, it will help reduce duplicative reporting and transactions costs for the Borrower, and a greater focus on results. 2. Institutional and implementation arrangements 46. The Banking Division at the Department of Economic Affairs (DEA), Ministry of Finance (MoF), Go1 has been designated to provide overall policy guidance and monitoring, while NABARD is the main implementing agency. A dedicated Department for Cooperative Reforms and Revival (DCRR), currently staffed by nine officers, has been set up within NABARD to coordinate implementation. A three-tier structure has been established to support implementation and monitoring. This includes: (a) a National-level Implementation and Monitoring Committee (NIMC), which is responsible for the overall policy and strategic direction of the reforms; (b) SLICs; and (c) DLICs. The composition, detailed terms of reference (TORS), and operating guidelines for these committees have been drawn up (Annex 6). Support teamslsecretariats, staffed with NABARD officials, have been established to help the SLICs and DLICs in their day-to-day functions. 47. NABARD will be responsible for project financial management (FM) and reporting. To ensure that these functions are performed efficiently and effectively, NABARD will provide requisite staffing to ensure that these functions are performed adequately. FM capacity, focused on accounting, MIS, internal controls, etc. will be built up in CCBs at all three levels, supported through Components I and I1 of the project (Annex 7). 48. NABARD is fully committed to enhancing transparency under the project. Besides the ondemand disclosure of information, NABARD has initiated proactive (suo moto) disclosures that include the public disclosure of all key documents related to the Go1 Package. NABARD further intends to enhance disclosures to fully comply with provisions of the Right to Information (RTI) Act 2005, including section 4 of the act on proactive disclosures. Below is a summary of actions that NABARD is committed to take to fully comply with the RTI and enhance transparency and accountability: 13

26 e e e e Develop a disclosure strategy with the objective of allowing greater access to information suo moto to reduce the need for requests for information by the public; Develop systems and procedures to implement the disclosure policy including document management system and information management system; Develop organizational arrangements and capacity building plan; Plan reporting and monitoring arrangements to monitor implementation of the disclosure policy. 49. NABARD will conduct a period review of compliance with the disclosure requirements under the RTI and take actions to enhance disclosure on an on-going basis. NABARD has appointed a senior person as the central public information officer responsible for RTI for the organization. Further, at the regional level, NABARD's Public Information Officers will play this role and at the departmental level, the departmental heads would be additional focal points. 50. NABARD will be responsible for the overall coordination of procurement under the project, and will ensure compliance with the agreed procurement procedures. Procurement under the IT component will follow standardized guidelines, issued by NABARD, detailing the technical specifications, tendering process and bid documentation, and benchmark costs for good and services. The SLICs will take responsibility for all operational decisions, including short-listing of vendors, finalizing the tender documents for competitive bidding, bid evaluation, award of contracts, etc., with inputs from the SCBs. The SCBs will sign the final procurement contracts. NABAFW will act as the payment agent and will make direct payments to contractors/ vendors on the basis of written instructions received from SLIC and SCB. NABARD will ensure that sufficient expertise in IT related procurement (for Component 11) is made available to all the SLICs. An Action Plan to mitigate procurement risks, which are related primarily to IT procurement, has also been developed (see the risks matrix below and Annex 8) The Capacity Building TA and Implementation components (Components I and IV) will involve procurement of consultancies and training, and will be carried out by NABARD. In the case of high value training, which can be provided by private sector institutions, procurement will be done following Consultant Selection guidelines. However, most of the modules envisaged under the project's capacity building TA program for CCBs will require NABARD to engage Specialized Cooperative Training Institutes, as there is no comparable expertise available elsewhere. NABARD/SCBs will sign Training MoUs with these Institutes (Annex 8). 52. An Implementation Manual (IM) acceptable to the Bank has been prepared and adopted by MoF, NABARD and other implementing agencies, as applicable. The IM includes, inter alia, the agreed FM and disbursement arrangements; procurement guidelines; guidelines on Preventing and Combating Fraud and Corruption in Projects Financed by IBRD Loans and IDA Credits (dated October 15,2006); and a detailed framework for the continuous measurement and monitoring of outcomes (Annex 3), that will be a key element in ensuring effective implementation. 53. Arrangements have been put in place to ensure intensive project supervision, covering FM and procurement aspects, with three annual supervision missions. The supervision team will draw on expertise from the Bank, as well as external experts. The concerned development partners will meet regularly to facilitate effective coordination and communication. 54. Fundsflow. All project funds will flow from Go1 (as grants) through NABARD. In line with the Go1 Package, once the MoU has been signed, the PS receives funds to carry out the SAs. Funding for the SAs can flow to a state as soon as it signs the MoU; all other funds for implementing activities under Component IV would begin to flow upon project effectiveness. Funds for implementing activities under Components I&II would flow only after the CSA has been revised by the PS. Finally, recapitalization 14

27 funds to implement Component I11 would flow to CCBs, based on the achievement of agreed benchmarks, as specified in the Go1 Package and the MoUs, and summarized above. 55. With respect to Components I, I1 and IV, the expenditure would be directly incurred by NABARD for the purchase o f goods and services to be financed by these components of the project. For the FRS (Component 111), all project funds will flow from Go1 through NABARD to the CCBs. Once the SAs for all the eligible PACS under a given DCCB have been completed, the net payment to the PACS will be calculated after setting-off their overdue liabilities to the DCCB. At that point, the payment to the concerned PACS and DCCB will be credited into their accounts. After the SAs of all DCCBs in a state have been completed, payments due to the DCCBs/SCBs can be calculated on the basis of dues from each DCCB, and the SCB would then receive its payment. It may be noted that all payments in respect of all components/activities under the project will be made by NABARD, so that the expenditures will be captured in NABARD s accounting system (Annex 6, 7). 56. Bank-financed project funds allocated to Components I, I1 and IV will be disbursed on the basis of interim unaudited financial reports (IUFRs) evidencing actual expenditures, on the various components and activities of the project. Funds allocated to Component I11 (FRS) will be disbursed on the basis of actual transfers made to CCBs in accordance with OP/BP 6.0, and reported in the IUFRs under two sub-categories, based on the two sets of benchmarks, as defined above. The first category of FRS funds (75 percent of recapitalization support) will flow to the CCBs once the initial set of benchmarks is met; the second category of FRS funds (25 percent of recapitalization support) will flow to the CCBs after the second set of benchmarks is met (Annex 6, 7). 57. An initial advance of US$ 100 million will be provided to Go1 to meet the expected expenditures in the first four months of the project (with a provision to increase this limit if necessary to US$ 150 million). While IUFRs will be submitted on a quarterly basis, Go1 would have the flexibility to seek reimbursement earlier than the quarterly intervals by submitting reports for shorter periods. The disbursement percentage for all project components will be set at 80 percent of the gross expenditures &e., 80 percent of GoI s share) as reported by NABARD/ Go1 through the IUFRs. This is based on the expected relative contributions of the Bank and Go1 in the states where Bank funds would be deployed. Retroactive financing up to an amount of US$ 50 million will be made available for all categories of eligible expenditures incurred after August 1, Monitoring and evaluation of outcomedresults 58. As noted above, the NIMC will provide overall policy and guidance for overseeing monitoring and implementation. A strong monitoring framework to track inputs, outputs and outcomes in a systematic and timely fashion has been developed and agreed with Go1 and NABARD (Annex 3). Project outcomes and outputs will be monitored via project supervision using administrative data from several sources. This effort will be supported through the project (Component IV). In addition, an independent long-term impact evaluation will be carried out in three states to directly assess the degree to which the project meets its higher level development objective. The design of the evaluation ensures a well-defined treatment and control group. The baseline survey of PACS and households has been initiated. In addition to the baseline survey, the assessment in each state will use two follow up surveys. Examples of indicators that this impact evaluation will track include increased membership of small and marginal farmers in the CCS, improved access to credit across agricultural seasons, and improved livelihoods of small and marginal farmers. 15

28 4. Sustainability 59. GoI s strong commitment and ownership of the reforms to be supported by the project are clear from the efforts that have gone into designing the Package; building the necessary political consensus for implementation, particularly with State Governments; and mobilizing the sizeable resources required to finance the reforms. Over a relatively short time span (since the reforms were announced in January 2006), Go1 has managed to secure the commitment of several states to implement far-reaching reforms that entail ceding control of the CCS. Furthermore, participating states and participating CCBs will make upfront financial contributions to project costs; this strengthens their ownership of the project s objectives. 60. The project has been designed with an eye to ensuring longer term sustainability of outcomes. Indeed, the project addresses the key legal and regulatory constraints that hamper the governance and operations of CCBs; includes measures to strengthen the managerial and technical capabilities of CCBs, along with staff and management rewards and incentives for better perfonnance16; and also includes efforts directed at networking, cost pooling and risk diversification, which are critical to enhancing cost reduction and longer-term commercial viability of CCBs (Annex 9). 61. Furthermore, complementary measures will be introduced to address other factors, such as agricultural failures, which could lead to renewed increases in nonperforming loans of CCBs, and jeopardize the project s sustainability. In this context, it may be noted that Go1 is already implementing reforms of the agricultural insurance system and catastrophic risk mitigatiodmanagement. Demand-side measures, such as marketing support for small and marginal farmers as they diversify their economic activities into new areas, are also being implemented by Go1 and State Governments, with assistance from the Bank in some states. 5. Critical risks and possible controversial aspects 62. The rewards from the successful implementation of this project are substantial, but the risks, too, are high. The following important risks-that need to be addressed to ensure that project objectives are achieved and its impact is sustained-have been identified, along with risk mitigation measures that have been agreed with Go1 and NABARD: Risk Factors 1. I Political economy risk I Description of risk A key risk arises from the fact that many CCBs have long been the victims of capture by local politicians and State Governments. This is manifested in the lending decisions of CCBs, as also, in their use by GoIIState Governments as vehicles to Ratinga of risk H Mitigation measures The project will address these risks through the following mitigation measures: (a) Upfront 1egalIregulatory reforms that will: tighten banking oversight of SCBsIDCCBs by transferring the regulation from State Governments to the Reserve Bank Ratinga of residual risk S l6 To incentivize good performance, NABARD has issued instructions linking its regular refinancing of the CCBs to acceptance of reforms under GoI s package. The Bank is supporting such measures through its rural poverty reduction and livelihoods projects in states such as Andhra Pradesh, Madhya Pradesh, and Rajasthan, and shortly, in Bihar, Orissa and Tamil Nadu. In Gujarat, IFC is providing such support through the Self Employed Women s Association s (SEWA) Trade Facilitation Centre. 16

29 ~ Implementation capacity Financial Management grant temporary relief to distressed farmers (by waiving interest on loans to farmers made by PACS and/or imposing interest rate caps on PACS lending) in the face of catastrophic events, such as floods or drought. This could pose a serious risk to the sustained recovery of PACS, and jeopardize the PDO and longer-term impact. The risk that NABARD may not have adequate capacity to perform its functions as the project main implementing agency. The risk here arises from the limited capacity of the lowest tier entities (PACS) to undertake payment functions, maintain accounting records, and fulfill financial reporting requirements, needs to be recognized. H S of India; minimize State Governments ownership/control of CCBs and help democratize these institutions; specifically, the new law (CSA) (which is a starting point for the reforms) will limit State Government ownership in CCBs; minimize State Governments participation on the Boards of CCBs and limit powers of State Governments to supersede the Boards of CCBs; ensure timely elections; and grant full voting membership rights for all users of financial services; (b) The project builds in covenants that require Go1 to ensure that the Project is carried out in accordance with prudent financial, banking and economic polices, and to ensure that full autonomy is provided to the CCBs in all financial and internal administrative matters, set forth in the Go1 Package and the MOU. (c)any loan waiverdinterest caps will be accompanied by upfront financial compensation to the CCBs through the budget of the responsible government; (d) A strong focus on bottom up monitoring by the project s targeted beneficiaries. This will draw on successful experiments with social mobilization in India (e.g., the Andhra Pradesh rural poverty reduction project) and elsewhere. NABARD has set up a new department (DCRR) to oversee and implement the project. DCRR staff is competent and committed. To fill any capacity gaps, support will be provided to NABARD in selected areas under the project. Furthermore, the project s implementation structure is such that key implementation responsibilities are shared by the SLICs, which will also receive capacity building support, as required. Under the project, the FM function will be largely performed and coordinated by NABARD, and role of the PACS will be limited. NABARD s existing FM system can provide the Bank with reasonable assurance, and accurate and timely information, on the status of the project and use of Bank funds. Nevertheless, there is a clear need to strengthen the FM, accountability and corporate governance arrangements for the PACS. This will be achieved over the project period by implementing an M S 17

30 Procurement Reputational risk for the Bank The key procurement risk under the project arises from its IT component, which will be spread across a large number of institutions at various tiers of CCBs. The SLICs, which will be responsible for key operational and technical decisions related to IT procurement, currently have limited capacity in this area. The key source of reputational risk for the Bank is that the project involves supporting the CCBs, which do not have a good track record. FM capacity building program, included under Component I & 11. A linkage will be built with the MIS at the DCCB-level to compile and report the necessary PACS-level information. Sample ex-post audit checks will be conducted to verify the use of funds. NABARD will be responsible for ensuring compliance with the agreed procurement procedures, and will also ensure that sufficient expertise in IT related procurement is made available to all the SLICs. An action plan to build the capacity of SLICs in IT-related procurement has been agreed. This will include building up SLIC s expertise in preparation of bidding documents, preparation of tender notice, invitation for bids, receipt, opening, and evaluation of bids, finalizing of the contract, and the administration of contract To achieve this, NABARD and the PS will use the services of IT experts. An initial workshop to familiarize the SLIC members in procurement processes will be arranged by the Bank in June 2007; this will be followed up by continuous capacity building support to be provided under the project s Component IV. Implementation of the action plan will be reviewed after six months to assess the need for further capacity building efforts. In addition, an Action Plan to mitigate procurement risks has been developed (Annex 8). The above-noted risk mitigation measures to strengthen the project s design and implementation arrangements should help ensure that the project is a success. The strengthened role of RBI in regulating SCBs and DCCBs, and of NABARD in setting the prudential norms for PACS, will act as a further risk mitigant. The projects design and implementation arrangements have benefited from international best practices. The project incorporates a robust M&E framework, with an emphasis on full information disclosure, and continuous selfmonitoring by beneficiaries, which should further help ensure project success and mitigate reputational risks for the Bank. Strong country ownership for the project at all levels is another important factor worth mentioning. 18

31 Size, complexity, and coordination Risks arising from factors beyond the projects immediate control 111. Overall Risk The size and complexity of the project, and the many players involved, will make implementation and supervision a challenge. Other factors, such as agricultural failures, could lead to renewed increases in nonperforming loans of CCBs, thereby eroding the project s benefits and jeopardizing sustainability. Project implementation arrangements and supervision plans have been carefully worked out to balance simplicity with rigor, and provide the Bank with an adequate role in supervision, while maintaining GoI s strong ownership of the project. Furthermore, the concerned development partners will meet regularly to facilitate effective coordination and communication to take stock of implementation and results. The Implementation Manual, which includes, inter alia, a detailed framework for the continuous measurement and monitoring of outcomes, will be a key element in ensuring effective implementation and supervision. As a result of the proposed project, the CCBs would have stronger balance sheets that would be able to better absorb a sudden increase in nonperforming loans (NPLs). Furthermore, Go1 is already implementing reforms of the agricultural insurance system and catastrophic risk mitigation/ management, with the aim to improve farmers income security. This is being supported by the Bank through nonlending TA. Demand-side measures, such as marketing support for small and marginal farmers, as they diversify their economic activities into new areas, are also being implemented by Go1 and State Governments, with assistance from the Bank (in some states). arating of risks on a four-point scale according to the probability of occurrence and magnitude of adverse impac Substantial (S); Modest (M); Low or Negligible (N). M S S High (H); 6. Loadcredit conditions and covenants 63. Covenants applicable to project implementation are as follows: (a) GOI, NABARD and the PS, as the case may be, shall maintain the DCRR, NIMC, SLICs, DLICs with adequate powers, functions and resources; (b) NABARD shall implement the project in the PS in accordance with the provisions of the MoU entered into between GOI, NABARD, and each such PS, and in accordance with the Implementation Manual (IM) agreed with the Bank; (c) NABARD shall ensure that PS PACS, DCCBs and SCBs issue Letters of Undertaking, satisfactory to the Bank, for carrying out their respective activities under the Project, in accordance with the Go1 Package, the MoU, and the Implementation Manual; (d) Go1 shall, based on the M ou and the Letters of Undertaking, provide funds to CCBs to be utilized for recapitalizatiodloss reduction under arrangements satisfactory to the Bank; (e) NABARD shall monitor progress of the project in accordance with indicators satisfactory to the Bank: 19

32 (f) The mid-term review of the project shall be carried out in July 2009; (g) Disbursement for recapitalization (under Component 111) will be provided in two portions, subject to fulfillment of key benchmarks as set out in the Go1 Package and detailed in the MoUs; (h) The Project Implementing Entity (NABARD) shall, within one month of effectiveness, adopt the design of, and the implementation strategy for, the common accounting, MIS and internal control systems, satisfactory to the Bank, to be implemented by the CCBs pursuant to the respective Letters of Undertaking; (i) The Project Implementing Entity shall implement the action plan to strengthen the procurement capacity required for Component I1 of the Project, and ensure that SLICs have undertaken adequate measures to fully implement such a plan; 0) The Go1 will ensure that the Project is carried out in accordance with prudent financial, banking and economic polices, and will ensure that full autonomy will be provided to the CCBs in all financial and internal administrative matters, set forth in the Go1 Package and the MOU; (k) The Go1 will undertake to suspend or terminate the right of the PS to use Credit/Loan proceeds, or obtain a refund of all or any part of the amount of the CreditILoan withdrawn if the PS or the CCBs fail to perform their obligations under the MOU or the Letters of Undertaking. D. APPRAISAL SUMMARY 1. Economic and financial analyses 64. Economic Analysis. The viability of India s CCS is undermined by a combination of factors, which will be addressed through the project. One key set of problems relate to poor governance and political interference and the absence of an adequate legal and regulatory framework. These will be addressed through the reform program outlined above, which is an integral part of the Go1 Package, to be supported through the project. A second set of problems relate to operational capacity weaknesses in the CCBs, which will also be comprehensively addressed through the project s first two components. Third, there are some fundamental economic reasons that have constrained the viability of CCBs, and these include: (i) their inability to capture economies of scale sufficiently to provide affordable financial services to the poor; and (ii) their inability to diversify risks adequately (as they operate in small geographic areas). These problems are not specific to India; they are faced by financial cooperative around the world. Drawing on cross-country experience, and especially on the Mexican experience, the project will include a strong focus on cost reduction through promoting networking and cost pooling, by providing CCBs (in a centralized manner) with a wide array of services (IT, legal, accounting, regulatory compliance, TA, liquidity management, etc.) that are subject to economies of scale; these initiatives will also be supported through the project s first two components. Efforts will also be made to gradually promote risk diversification; the consolidation that is expected over time should help reduce the geographical concentration of the credit risk exposure of PACS. In the medium to longer run, a market for credit risk swaps could be developed. 65. By transforming the CCBs into more effective, efficient and commercially sustainable providers of financial services, the project will help the poorest households in rural India-the small and marginal farmers-to access formal financial services more readily, increase the amount of financing available from the formal sector, reduce borrowing costs, and reduce dependence on moneylenders, who tend to charge exorbitant rates of interest. Over a five year period, it is expected that the number of small and 20

33 marginal farmers receiving credit from CCB s would increase by over 50 percent (to 22 million). Furthermore, the team s analysis indicates that, by strengthening PACS and their upper tiers, the project would result in a 70 percent increase in the volume of CCBs credit outstanding over a five year period. The reforms, coupled with the proposed investments in institutional capacity building and IT, would help improve PACS efficiency and services, over time. All this should enable small and marginal farmers to substitute borrowing from moneylenders (at rates in the range of 36 to 120 percent per annum) with formal borrowing from PACS (at rates of about 12 to 13 percent). Access to cheaper and more plentiful credit will provide small and marginal farmers not just the immediate resources necessary for consumption spending, but also, over time, financing for productive investments that can contribute to the diversification of their economic activities, thereby increasing incomes and improving livelihoods Beyond credit, support provided under the project s first two components will also help the CCBs provide a wider range of financial services, such as savings, money transfer, insurance, etc. to small and marginal farmers. Better access to these services would help these households protect themselves against periods of low income or unexpected fluctuations in income (for example, caused by drought or crop diseases), and help to maintain consumption standards (through the accumulation of financial saving^).'^ Improved access to finance could thus have significant longer term welfare implications. 67. Finally, while the project involves a substantial stream of expenditures over the next three to five years, creating a sustainable and viable CCS would reduce the future fiscal burden for GoI. First, the Government s insistence on transformation of the legal, regulatory and governance frameworks of the CCS as a precondition for the provision of FRS would help minimize the risk of having to bail out the CCS again in the future, as it has done repeatedly in the past, due to the failure of previous programs to address the fundamental problems constraining the system. Second, postponing the reforms and recapitalization would only add to the final costs of restructuring the CCS (because operating and credit losses would continue to accumulate), with an adverse impact on access to rural finance in the interim. Third, as discussed above, the alternative of liquidating the CCS would involve substantial financial and political costs, as well as social and economic dislocation costs that are deemed to be untenable as compared to the costs of the Go1 Package (Annex 9). 68. Financial Analysis. The impact of the FRS on CCBs will be to restore their solvency, enable them to achieve sustained profitability, and significantly improve their ability to attract additional financial resources for intermediation through the PACS to farmers. The team s analysis from a sample of ten weaker than average DCCBs selected from states that have joined the Go1 Package to date shows that, over a five year period, following receipt of financial assistance in 2007, the DCCBs CRAR should rise from an average of minus 0.88 percent to 9.08 percenta2 In the same timeframe, return on assets (ROA) should show consistent improvement, rising from 0.07 percent to a 1.46 percent by the end of the period, providing a good indication that the DCCBs will be able to achieve sustained profitability. The dramatically improved CRAR and profitability of the DCCBs should enable a substantial increase in their lending (by over 100 percent over five years), leveraging the amount of assistance provided by about 10 times. The FRS is thus expected to have the effect of providing a decisive halt in the present downward l8 The total membership of PACS is currently 127 million people; of these, some 47 million are small and marginal farmers, of whom, around 15 million currently access credit. l9 The role of savings and borrowing in protecting consumption against unexpected shocks, first discussed by Milton Friedman (1 957) in the permanent income hypothesis has since been extensively tested empirically. The analysis uses conservative assumptions: (a) financial performance has been projected on the basis that credit quality will improve less quickly than the improvement seen in the period 2003 to 2005; in reality, the dramatic changes in the governance of DCCBs and PACS which the legal reforms will bring, reinforced by improved management, training, and new and lower cost (due to pooling of facilities) IT systems, should enable the DCCBs to improve credit quality at a faster rate; and (b) the analysis assumes that DCCBs financial spreads will remain about the same. 21

34 spiral of the DCCBs, and restore them to sustainable financial health. On a systemic basis, the analysis indicates that the FRS would result in increased lending by about 11 1 percent, leveraging the amount of assistance provided by about 23 times. The benefits are even higher when the positive impact of assistance provided directly to PACS by the FRS is incorporated (Annex 9). 69. Conducting a standard net present value (NPV) and internal rate of return (IRR) analysis for the project is not straightforward. However, it is possible to estimate both losses and benefits at the level of the DCCBs (where the data is also more recent) which, given their role as the primary source of refinance for the PACS, provides a reasonable proxy for the likely impact of the Go1 Package as a whole. For the sample of 10 weaker than average DCCBs drawn from the eight states that have signed so far, the NPV is estimated at Rs. 870 million and IRR at 3 1 percent. These numbers provide a high degree of confidence that the project as a whole will generate very positive rates of return in purely financial terms (Annex 9). 2. Technical 70. The project s technical design has benefited from an extensive body of analysis, including the GoI s own analysis, and Bank ESW and lending operations. The approach taken has also benefited from international experience with credit cooperative restructuring in countries such as Canada, Mexico, the Netherlands and US, including the lessons learned from similar Bank projects in countries like Mexico. The key principle underlying the project s technical design is that the one-time recapitalization of potentially viable CCBs, while necessary, is not a sufficient condition for their revival on a sustainable basis, and must be accompanied by fundamental improvements in the legal and regulatory framework to address the governance and operational constraints currently experienced by all three tiers of the system, together with improvements in the managerial and technical capabilities of CCBs, and support for more effective networking and cost pooling. The project s design ensures that these various components are implemented as an integrated package, and sequenced in a manner that ensures that any financial infusions are contingent upon the fulfillment of critical legal, regulatory, and institutional reforms. This should help ensure sustainable improvements in the CCS, and minimize the risk of scarce public resources being wasted on entities that are not committed to, or capable of, reforms. 3. Fiduciary 71. NABARD will be responsible for implementing the agreed FM arrangements for the project. The FM assessment carried out by the Bank found that NABARD s existing FM system, with adequate enhancements and linkages with MIS at various tiers, will have the capacity to provide the Bank with accurate and timely information on the status of the project and use of Bank funds. The FM capacity of CCBs in all three tiers will be strengthened through TA provided under the project s Component I (Annex 7) * 72. All expenditures under Components I, I1 and IV will be incurred by NABARD and will, therefore, be captured within NABARD s accounting system. Funds for Component I11 (FRS) will be transferred by NABARD to the CCBs, and the net amounts due to them will be clearly identified. There will be a need to build a linkage with the MIS at the DCCB-level, to provide reconciled statements with information on recapitalization funds received by PACS; this will be supported through TA under Component I. 73. NABARD will report to the Bank the financial progress under the project on a quarterly basis by submitting interim un-audited financial reports (IUFR)--in the agreed format that will provide evidence on the actual end-usage of funds in respect of Components I, I1 and IV, with adequate supporting documentation. Transfers in respect of Component I11 will be tracked by NABARD along with a list of CCBs that have received the (net) recapitalization finds due to them, and will be reconciled with actual 22

35 funds flow. The project will be subject to bi-annual external audits, in the first two years, which will be conducted by statutory auditors who are acceptable to the Bank, based on terms of reference agreed with the Bank. After the first two years, annual financial audits of the project will be undertaken*. Sample audit checks would be conducted (ex-post) to verify the use of funds (Annex 7). 74. The project will require NABARD to undertake significant procurement of goods and services under Components I, I1 and IV. Procurement of Bank-financed goods and services will be undertaken in accordance with the World Bank s Guidelines: Procurement Under IBRD Loans and IDA Credits dated May 2004; and Guidelines: Selection and Employment of Consultants by World Bank Borrowers dated May 2004, and the provisions stipulated in the Legal Agreement (Annex 8). 75. Whenever procurement under a specific tender exceeds US$2 million, it will be subject to International Competitive Bidding (ICB), as per the Bank s ICB procedures and Standard Bidding Document for procurement of goods under ICB. NABARD s tendering process and bid documents for National Competitive Bidding (NCB) have been reviewed by the Bank and found to be in line with the guidelines and requirements of the Central Vigilance Commission of India, and similar to the Bank s guidelines and requirements, the main difference being that NABARD follows a two envelope system. NABARD has confirmed that procurement under the two envelope system will be carried out such that: (a) the technical and financial bids are opened in public; (b) the price bids are kept sealed at a safe place; (c) the date for opening of the technical envelope is indicated in the bid documents; and (d) bidders who qualify, and have a responsive bid, are invited for the public bid opening o f their price bids, while those who do not qualify are given one week to request a review. 76. To ensure consistency in the IT procurement approach followed across states, NABARD has issued detailed guidelines, covering technical specifications, tendering process and bid documentation, benchmark costs for goods and services to be procured, and payment and funds flow arrangements. A revised 18-month procurement plan covering Components I, I1 and IV, and reflecting the states own TA and IT deployment plans and cost estimates, has been agreed with NABARD (Annex 8). 77. A procurement assessment identified the need to enhance the procurement capacity of SLICS, with a particular focus on the procurement of IT equipment under Bank-financed projects. NABARD will ensure that sufficient expertise in IT related procurement (for Component 11) is made available to all the SLICs. This will cover support to SLICs to build up the required expertise in the preparation of bidding documents, preparation of tender notice, invitation for bids, receipt, opening, and evaluation of bids, finalizing of the contract, and the administration of contract which, besides other things, include ensuring compliance with the contract conditions, payment terms, variations, dispute resolution, monitoring etc. To achieve this, NABARD and the PS will use the services of IT experts, for example, from the State IT departments and the National Informatics Center Services Inc. (NICSI), who have the necessary experience in IT procurement. These efforts will be supplemented by training of SLIC members. An initial workshop to familiarize the SLIC members in procurement processes will be arranged by the Bank some time during June 2007; this will be followed up by continuous capacity building support to be provided under the project s Component IV. The support will be reviewed after six months of implementation to assess the need for further capacity building efforts. Additional procurement capacity building support will also be provided through the project (Component IV) (Annex 8). 4. Social 78. No specific social safeguards issues have been identified at present. * The existing NABARD auditors are acceptable to the World Bank. 23

36 5. Environment 79. The activities supported by the project are not likely to cause any significant adverse environmental impacts and none of the safeguards are likely to be triggered. Hence, the project is designated in Category C for environmental screening where the responsibility for (potential future) safeguards review and clearance has been transferred to the Sector Unit. 6. Safeguard policies Safeguard Policies Triggered by the Project Yes No Environmental Assessment (OP/BP 4.0 1) [I [XI Natural Habitats (OP/BP 4.04) [I [XI Pest Management (OP 4.09) [I [XI Physical Cultural Resources (OP/RP ) [I [XI Involuntary Resettlement (OP/RP 4.12) [I [XI Indigenous Peoples (OP/BP 4.10) [I [XI Forests (OP/Bf 4.36) [I [XI Safety of Dams (OP/BP 4.37) [I [XI Projects in Disputed Areas (OP/BP 7.60) [I [XI Projects on International Waterways (OP/RP 7.50) [I [XI * By supporting theproposedproject, the Bank does not intend to prejudice thejinal determination of the parties claims on the disputed areas 7. Policy Exceptions and Readiness 80. The project requires no policy exceptions. Assessments and preparation of fiduciary arrangements, staff and consultant selection, M&E systems, and implementation and procurement plans have been finalized and have been found to meet the regional criteria for readiness of implementation. 24

37 Annex 1: Country and Sector or Program Background INDIA: STRENGTHENING RURAL CREDIT COOPERATIVES PROJECT Financial Sector Reforms over the Past Decade: A Summary A well-functioning financial system is central to meeting the challenge of sustaining India s economic growth at above 8 percent a year, accelerating growth, and reducing poverty. Indian policy makers recognize that continued financial reforms are critical for mobilizing the longer term savings necessary to meet the country s investment needs, including the much-needed longer-term investments to finance the region s vast infrastructure deficit. Moreover, there is a growing appreciation that finance can play a vital role in making growth more inclusive; by extending the range of individuals who can get a foothold in the formal economy, finance can help India s poor to catch up with the economy as it grows, share in the benefits of growth, and climb out of poverty. The role of finance as a growth-accelerator and growth-equalizer is supported by solid cross-country analysis, which shows that well-functioning financial systems are associated with more rapid and inclusive growth. 22 Since the early 1990s, India has introduced impressive financial sector reforms that have proceeded steadily, albeit gradually. Interest rates have been mostly liberalized; capital markets have been substantially deregulated and restrictions on capital inflows eased;23 private entry has been allowed into banking, mutual funds and insurance; banks required holdings of government debt have been reduced, and the burdens of priority sector requirements eased. As a result of the reforms since the early 1990s, India s financial sector has changed, in some respects, beyond recognition. The depth and liquidity of India s capital markets have increased significantly since the 1990s, with equity markets booming (Table 1.1); the share of capital markets now exceeds one-half of financial sector assets. Table 1.1 India: Selected indices of stock market development (Selected years, ) Listings Market Capitalization ( percent of GDP) Turnover ( percent of market capitalization) Source: Standard & Poor s While the banking sector continues to play an important role in the financial system and remains overwhelmingly government-owned, it has seen some fundamental changes: prudential norms have been tightened, bank capital bolstered, the supervisory systems strengthened, and competition has increased. The share of private and foreign commercial banks in total financial sector assets has more than doubled in the past decade (even if state-owned banks continue to dominate, accounting for about 70 percent of total banking sector assets) (Table 1.2). Government domination of the insurance and mutual funds industries is also in decline. 22 See, for example, Beck, Demirguq-Kunt and Levine (2004), op.cit; Honohan (2004), op.cit. 23 Further steps to liberalize capital controls may be on the horizon pursuant to the Tarapore Committee Report on Fuller Capital Account Liberalization, July

38 Table 1.2: India: Structure of the Financial Institutions (Selected years, percent of total assets) Public Public Sect. Private Private Sect. Cooperative Public Private Total Sector Term And Term banks and Sector Sector March Banks Lending Inst. Foreign Banks Lending Inst.* NBFC (dep.) Insurance Insurance (Rs. Billion) , , , , , ,677 Source: RBI Trend and Progress in Banking, various years. Notes: 1. Includes the RRl3s; 2. HDFC and ICICI (in 2002, ICICI was merged with ICICI bank and ceased to exist as a term lending institution). India has managed to achieve an impressive rate of financial savings, significantly higher than in many other large emerging market economies. Despite its much lower per capita income, India s financial assets, at well over US$l trillion, are higher than in countries like Brazil, Indonesia, or Mexico. The share of financial assets in GDP in India is about 173 percent, compared to 104 percent in Mexico, 112 percent in Indonesia, and 157 percent in Brazil, all of which have significantly higher per capita incomes than India. Moreover, India s financial liberalization of the 1990s was not followed by a major financial crisis, unlike in many other countries. India s financial system is in fact more robust today than at the start of the reforms; one indication of this is the speed with which the Indian financial markets were able to recover from the May-June 2006 emerging markets turbulence. The Challenge of Rural Finance Reforms While the reforms of the 1990s have meant that India s growing middleclass has access to a range of increasingly sophisticated financial institutions, products and services, rural dwellers still have very limited access to finance from formal sources, like commercial banks or cooperative banks. According to a recent World Bank survey24, some 59 percent o f rural households do not have a deposit account and 79 percent have no access to credit from a formal source. The problem of access is particularly severe for small and marginal farmers (the poorest group among rural dwellers, who own up to 4 acres of land). Some 87 percent of Figure 1.1 Access to Finance - RFAS 2003 (percentage) Marginal Small Large Commercial Others Total W NO credit account UNO savings account Note: Marginal farming households=landholding<l acres; Small=l to 4 acres; Large farmers=>4acres; Commercial households= with or w/o land but with income from nonfarm sources exceeding half of total household income; Others=mixed households with land and non-farm commercial incomes but the latter being less than half of their total household income. Source; World Bank (2004) marginal farmers and 70 percent of small farm-ers have no access to credit from a formal financial institution; 70 percent of marginal farmers and 451 percent of small farmers have no deposit account in a formal financial institution (Figure 1.1). 24 World Bank (2004), op.cit.; Basu (2006), op.cit. 26

39 In the absence of formal finance, small and marginal farmers have had to rely heavily on moneylenders, who tend to charge exorbitant rates of interest, ranging from 36 percent to 120 percent a year. At such interest rates, the rural poor risk falling into a debt trap from which recovery seems only a very distant prospect. The recent rise in farmer suicides in states like Andhra Pradesh and Maharashtra i s one manifestation of this growing problem of indebtedness in rural India. Government of India s Strategic Thrusts for Rural Finance Reforms Against this background, rural finance reforms designed to improve access to finance for the poorest groups (small and marginal farmers) have emerged as an important priority for the Government of India (GoI). The strategy has three major thrusts: First, increasing competition among the various providers of rural finance (rural branches of commercial banks, RRBs, the cooperative credit institutions, microfinance institutions, etc.). After a slow take-off, policies to promote competition among rural finance providers have gathered pace in the last year or so. Notably, with a lowering of restrictions on branch licensing in rural areas, and a recently announced policy that allows banks to operate through correspondents, private players have begun to expand their rural operations, resulting in greater competition. Many of the restrictive provisions of the service area approach, which limited competition among bank branches in rural areas by allowing banks to operate only in pre-allocated service areas of about villages per bank branch, have been revised. A number of measures to facilitate the expansion of microfinance have also been announced over the past two years. Measures have also been announced that provide market-based incentives for banks to lend to MFIs, and promote partnerships between commercial banks and MFIs. A microfinance law, designed to provide a better policy and regulatory framework for the sector, is being finalized. Second, developing products for the better management and mitigation of risks in rural finance, with a focus on: (i) revamping the agriculture insurance system to provide improved coverage of the risks faced by small and marginal farmers (this is being supported through a Bank technical assistance); (ii) fostering partnerships between government and private sector to pilot weather-index insurance, which can be a good way for farmers to hedge businesses against imponderable weather risks (scaling up weather insurance pilots and improving product design is also being supported through the Bank technical assistance); (iii) developing a negotiable warehouse receipt system, which allows farmers to use their crops as collateral for post-harvest financing, thereby potentially reducing default risk and improving the access of small and marginal farmers to formal financing (a Warehousing Bill has recently been introduced in parliament); and (iv) efforts to develop the commodities futures markets, which would allow better price discovery and make an important contribution to addressing the risk of falling commodity prices, which is among the main sources of farmer default. A model act that has been recently formulated as a template to reform agricultural produce marketing legislation at the state level is a step in the right direction; the act could make an important contribution to fostering a single national market for agricultural commodities. Third, reforming rural financial institutions (RFIs) so that they are better positioned to provide financial services small and marginal farmers. While India s rural finance landscape features a variety of RFIs (see Box l.l), the immediate focus is on reforming the CCBs, which have the largest network among all types of rural financial institutions in India and potentially the deepest outreach. India s CCBs comprise 108,779 PACS, 367 DCCBs and 31 SCBs. Following years of political interference, poor governance, weak regulation and supervision, and inadequate management capacity, a very large number of these institutions are severely impaired, and cannot provide financial services to the poor on a 27

40 commercially sustainable basis. Accumulated losses were estimated at Rs. 9,277 crores (US2.24 billion).25 Box 1.1 India s Rural Finance Landscape India has a range of rural financial service providers, including formal sector financial institutions at one end of the spectrum, informal providers (mostly moneylenders) at the other end of the spectrum, and between these two extremes, a number of semiformal/microfinance providers. In terms of sheer size and spread of operations, the formal rural finance institutions dominate the rural finance landscape. In 1981 the National Bank for Agriculture and Rural Development (NABARD) was established as an apex institution to facilitate agricultural credit, and, in 1991, the Small Industries Development Bank of India (SIDBI) was set up to cater to the needs to small enterprises and provide refinance to state level financial institutions. The formal RFIs include: Cooperative credit banks: India also has a vast network of rural cooperative credit banks (CCBs), with a three tiered structure at the state, district and village level (see below also). There are some 14,000 branches of rural cooperative banks and more that 108,000 grass roots level retail outlets of Primary Agriculture Credit Societies (PACS), which are used by the cooperative system as channels for funds flow. While having the largest and most widespread retail network, the share of these institutions in agriculture credit has been declining steadily particularly over the last 15 years, and now stands at one third, half the level it was 15 years ago; Regional rural banks; Rural branches of commercial banks, mostly public sector banks (but also some private sector banks); The post office system adds to the physical service point network of the country with more than 154,000 post office branches handling more than 110 million money orders and administering over 150 million savings accounts. However, credit transactions are not handled through this network; Insurance companies have a moderate reach in rural areas, though this is gradually increasing. Semi-formal/microfinance sector. While India is home to many microfinance innovations, in terms of people reached and the scale of financing, microfinance in India is still small. It reaches less than 10 percent of the country s rural poor. Dominant among the microfinance models is the SHG bank linkage model, whereby women s SHGs are linked to the rural branches of commercial banks, RRBs or cooperative banks. The other model is specialized MFIs. The total branches of MFIs are estimated to be in the range of a few thousand compared to the vast numbers of bank branches. Recent developments have led to other inter-linkages between the formal, both public and private sector banks, and semiformal sector initiatives, particularly the SHG-bank linkage program (led by NABARD), as well as lending by SIDBI (which has been a pioneer and takes credit for developing this financial institutional space) and commercial banks to MFIs. Informal providers: Informal financiers include a range of actors: landlords, local shopkeepers, traders, professional moneylenders, etc. While there are no definite estimates of the number o f informal sector providers, these are spread very widely across the country. Not surprisingly, informal borrowing is very important for the poorest (marginal and commercial categories), who are the most deprived of formal finance. With a few notable exceptions (such as West Bengal, where land reforms are the most advanced in the country), village moneylenders and other types o f informal financiers have been around for as long as villages have existed. Informal financiers have the advantage of knowing their client better than most formal institutions such as banks, they have a better ability to enforce contracts, and provide flexible products. India s Rural Credit Cooperatives Credit cooperatives in India were established over a century ago, within the contours of traditional principles of self-help, democracy and solidarity, drawing primarily upon the Raiffeisen model that was adapted to the Indian context. The key purpose was to meet the credit needs of rural India and provide a substitute to the dependence on moneylenders. The underlying approach was that cooperatives must remain autonomous associations of persons united voluntarily to meet their common economic needs and aspirations, through jointly owned and democratically controlled enterprises. Over time, and particularly after the 1960s, the state assumed an ever increasing role in the promotion, development, management, financing, rehabilitation and regulation of the CCBs. The central government and state and * These estimates are for March 3 1, 2003 (without including a contingency provision of Rs. 4,000 crores). The breakdown of accumulated losses was as follows: Rs. 4,595 crores for the PACS, Rs. 4,401 crores for the DCCBs, and Rs. 281 crores for the SCBs, based on data from

41 local governments justified their interventions in the CCS for the sake of expediting the institutionalization of rural credit and enlarging its coverage and ability to provide timely and adequate credit to farmers as tool for poverty reduction. However, it was this which ultimately led to the impairment of the governance and management of the CCBs, and, over time, to their current position of financial disrepair. The CCBs have long operated through a three tier structure: the PACS constitute the base at the village level; DCCBs the intermediate tier, and SCBs, the apex. RBI reports that there were 108,779 PACS, 367 DCCBs and 31 SCBs in the country at the end of March 31, 2005 (Figure 1.2). This provides the CCBs with an unmatched network of outlets; one for every six villages in India, far deeper than the commercial bank outreach in rural areas with nearly four times as many outlets. Figure 1.2 hlultl-stare Operating In Slngie State SCAWBs: State Co oplratlve Aprlculture and Rural Development Banks. PCARDBs Prlmary Co-opeiatlve Agriculture and Rural Derelopment Banks. Note : Ffgures in brackf& Indlcare the number of Institutions at end-march 2006 for UCBs and at end-march 2005 for rural cooperative credlt Institutions. Source: RBI, Report on Trend and Progress of Banking in India, According to the latest RBI report on the Trend and Progress of Banking in India, as on March 31, 2005, these CCBs held around Rs280,OOO crores (US$67 billion) in assets, Rs145,OOO crores (US$35 billion) in deposits and Rs160,OOO crores (US$39 billion) in outstanding loans. As a proportion of the total banking system, this share is relatively small percent of total banking assets, 7.1 percent of total banking deposits and percent of total banking outstanding loans. However, the role of the CCBs in formal agricultural financing is still substantial. Data from the Economic Survey , shows that. these accounted for around 22 percent of total institutional credit to agriculture (Table 1.3). Furthermore, they accounted for the bulk of formal credit to small and marginal farmers. 29

42 I Table 1.3 India: Institutional credit ta Adculture Agency OE Rs. Cooperative banks 20,800 23,604 23,716 26,959 31,231 39,402 RRB 4,220 4,854 6,070 7,581 12,597 15,222 Commercial banks 27,807 33,587 39,774 52,441 ai, ,477 Total 52,827 62,045 69,560 86, , ,ioi Share of cooperatives in total 39% 38% 34 31% 25% 22% Source: NABARD data reported in the Economic Survey, and for based on information from Ministry of While the share of the CCBs in agriculture credit has been a declining over time for a variety of reasons, the CCBs still remain important on several counts: (i) the vast network of PACS provides an unparalleled network to provide financial services to rural areas; (ii) the average loan size channeled through the CCBs (Rs. 6,637 or US$160) is much lower than that of the commercial banking system (Rs. 31,585 or USD765), thereby indicating the CCBs role in outreach to smaller farmers; (iii) the CCBs have a very large membership base - the Vaidyanathan Committee estimates this to be over 127 million; (iv) of the total membership of the CCBs, there is a significant degree of participation from deprived sections of society - the scheduled castes and tribes as well as small and marginal farmers; (v) over time the CCBs have also been used as a channel for delivery of a variety of other services, including the Public Distribution System, and while, this has typically led to losses on account of inadequate spreads, the potential to channel a larger variety of non-financial services - agriculture trading and agri-input supply for one - through this network on a profitable basis, remains true today, provided adequate capacity development and freedom to select and price services appropriately is enabled. However, the potential of the CCBs to provide quality services in rural areas, and particularly to poorer groups, is severely constrained by their weak financial position (Annex 9). The Go1 Package Against this backdrop, Go1 announced, in 2006, a comprehensive and well-balanced package to revitalize the CCBs. The Go1 Package is based on the recommendations o f the Vaidyanathan Task Force, which was established in August 2004 to suggest an implementable action plan for reviving the CCS. The Task Force submitted its report to the Central Government on 04 February The Government, after due consideration, accepted the recommendations in principle and placed them before the National Development Council at its meeting on 27 June The Task Force report and its recommendations were discussed in depth at a special meeting of the State Chief Ministers on 9 September, It was agreed that a draft statement of the consensus emerging from the deliberations be prepared and discussed with the Finance and Cooperation Ministers of selected State Governments. This meeting was held on 29 September, 2005, where the consensus was further crystallized into a Statement of Consensus. Based on this Statement of Consensus, the Go1 Package spelling out the financial, legal and institutional measures for restructuring of the CCBs was prepared. The Go1 Package is designed to: (i) minimize State Governments ownership in CCBs; (ii) ensure full voting membership rights for all users of financial services, including depositors in PACS; (iii) minimize State Government interference in all financial and internal administrative matters in CCBs, including by removing the State Government s participation on the Boards of CCBs and limiting the powers of State Governments to supersede the Boards of CCBs; (iv) permit CCBs in all three tiers freedom to take loans from regulated financial institution and not necessarily from only the upper tier and, similarly, placing their deposits with any regulated financial institution of their choice, beyond certain agreed thresholds; (v) ensure timely elections before the expiry of the term of existing Boards; (vi) facilitate the regulatory powers of the RBI over SCBs and DCCBs, and of NABARD, over PACS; and (vii) ensure that all CCBs are required to adhere to prudential norms as per the directions of the I 30

43 supervisorhegulator. These reforms will be accompanied by measures to strengthen the managerial and technical capacity o f CCBs, and to enhance efficiency and cost savings, as well as financial restructuring support (FRS) to bring the potentially viable CCBs to an acceptable level of health. The main elements of the Go1 Package are: (a) the introduction of far reaching legal and regulatory reforms to address the governance and operational constraints currently experienced by all three tiers of the system, so as to ensure the democratic, self-reliant and efficient functioning of CCBs; (b) measures to improve the managerial and technical capabilities of CCBs through extensive training, and support more effective networking and cost pooling, for example, through establishing a common IT platform for back office functions, that will help CCBs achieve scale economies and reduce their service costs, and improve the quality and transparency of reporting; and (c) the provision of one-time financial restructuring support (FRS) to qualifying CCBs, to cover their accumulated losses and bring them to an acceptable level of health (see also Annex 4, 6). Legal and Institutional Reforms The root cause of the poor financial state o f cooperative societies lies in poor management and governance. Unless these are improved, the entire capitalization amount would be wasted. This calls for amendments in the relevant Acts such as the Cooperatives Societies Acts (CSAs) of the States, Banking Regulation (BR) Act, NABARD Act, DICGC Act etc., as detailed in the GoI s Package, and a commitment on the part of states that the laws, as amended, will be implemented strictly. Reforms in the CSA As carrying out legal amendments is a time consuming process, the State Governments may issue Executive Orders under the existing powers to bring in the desired reforms which will relate to: i. Ensuring full voting membership rights on all users of financial services including depositors in cooperatives other than cooperative banks; ii. Removing State intervention in all financial and internal administrative matters in cooperatives iii. Providing a cap of 25 percent on State Government equity in cooperatives and limiting participation in the Boards of cooperative banks to one nominee. Any State Government or a cooperative wishing to reduce the State Government s equity further would be free to do so and the cooperative will not be prevented from doing so; iv. Allowing transition of cooperatives registered under the state CSA to migrate to the Parallel Act (wherever enacted); v. Withdrawing restrictive orders on financial matters; vi. Permitting cooperatives in all the three tiers freedom to take loans from any regulated financial institution and not necessarily from only the upper tier and, similarly, placing their deposits with any regulated financial institution of their choice, beyond certain thresholds. The threshold limits may be determined by the State GovernmentRCS concerned for each entity or class of entities having regard to the funds required by the entity to achieve the basic objectives of the CCS; vii. Permitting cooperatives under the Parallel Act (wherever enacted) to be members of upper tiers under the existing CSAs, and vice versa; viii.limiting powers of State Governments to supersede the Boards; ix. Ensuring timely elections before the expiry of the term of the existing Boards; x. Facilitating regulatory powers for RBI in the case of cooperative banks; xi. Prudential norms including CRAR, for all financial cooperatives including PACS, as per the directions of RBI. 31

44 Reforms in the Banking Regulation Act I949 Approach Amendments to the BR Act would include the following: i. All cooperative banks would be on par with the commercial banks as far as regulatory norms are concerned; ii. RBI will prescribe fit and proper criteria for election to Boards of cooperative banks. Such criteria would however not be at variance with the nature of membership of primary cooperatives which constitute the membership of the DCCBs and SCBs; iii. However, as financial institutions, these Boards would need minimum support at the Board level. Hence, the RBI will prescribe criteria for professionals to be on the Boards of cooperative banks. In case members with such professional qualifications or experience do not get elected in the normal electoral process, then the Board will be required to co-opt such professionals to the Board and they would have full voting rights; iv. The CEOs of the cooperative banks would be appointed by the respective banks themselves and not by the State Government. However, as these are banking institutions, RBI will prescribe the minimum qualifications of the CEO to be appointed and the name proposed by the cooperative bank for the position of CEO would have to be approved by RBI; v. Cooperatives other than cooperative banks as approved by the RBI shall not accept nonvoting member deposits. Such cooperatives would also not use words like bank, banking, banker or any other derivative of the word bank in their registered name. The proposed financial assistance is a one-time measure only. States would have the option to participate or not to participate in the package. To date, 11 states have joined the Go1 Package: Andhra Pradesh (AP), Arunachal Pradesh, Bihar, Gujarat, Haryana, Madhya Pradesh (MP), Maharashtra, Orissa, Rajasthan, Uttar Pradesh (UP) and Uttarakhand. A few more states are likely to join before the cut-off date of January States choosing to participate will be entitled for financial assistance under the package if they agree, through the mechanism of a formal MOU or Exchange of Letters with the Central Government, to implement (in a phased manner and within a period of 3 years), the legal and institutional reforms envisaged. States not ready to make the choice immediately will be given two years to take a decision on this matter. Financial Restructuring Support (FRS)/Recapitalization Financial restructuring support (recapitalization) under the package would cover accumulated losses in the CCBs. This, however, does not mean writing off of the loans which are yet to be repaid by the borrowers. The cooperatives will have to continue to make efforts to recover these loans and thereby improve their financial health. FRS will be conditional and released only on the implementation of the recommendations for legal and institutional reforms. FRS will start with first bringing the PACS to an acceptable level of financial health through cleansing of their balance sheets and strengthening their capital base, and then move on to the upper tiers. This step will enable PACS to clear their dues to the upper tiers and thereby reduce the accumulated losses of DCCBs. The DCCBs will thereafter be provided assistance to clear the balance of accumulated losses, if any, and to reach a minimum norm of capital adequacy. The same process will apply to the SCBs. 32

45 Financial restructuring will include criteria for determining the eligible purposes and institutions, quantum of assistance required, pattern of sharing the liability, conditionalities attached and the time frame. Eligible Purposes. Financial assistance under the package will be available for wiping out accumulated losses, covering invoked but unpaid and un-invoked guarantees given by the State Governments and other dues to the CCS from them, and increasing the capital to a specified minimum level. In order to ensure that CCBs continue on sound financial, managerial and governance norms, technical assistance will also be provided to upgrade institutional and HR development. Accumulated Losses. Accumulated losses in the CCS cover losses on account of the following: (1) non-repayment of loans for agricultural and other businesses given by the cooperatives; (ii) nonrepayment of loans to individuals for other purposes like consumer goods, housing, gold loans etc.; (iii) losses on account of non-credit businesses like public distribution system (PDS), procurement of food grains on behalf of government, sale of fertilizers etc.; (iv) non-repayment of loans issued under government guarantees where the State Government has not yet paid to the cooperatives although guarantees have been invoked un-invoked; (v) non-payment of dues from governments on account of waivers or subsidies announced by them; and (vi) losses due to fraud etc. The magnitude of the accumulated losses will be determined by SAs of all the societies in the CCS using uniform criteria and standards. CRAR. The package will include assistance necessary to bring all cooperatives, including PACS, to a minimum Capital to Risk weighted Assets Ratio (CRAR) o f 7 percent. While this ratio will be raised within three years to 9 percent by PACS, DCCBs and SCBs shall raise their CRAR as prescribed by the RBI. This increase in CRAR shall be met by the CCBs from their own resources. Refund of share capital to State Governments. The share of the State Government in the equity of each institution in the three tiers shall be brought down below 25 percent of the total subscribed share capital within a period of three years, subject to the condition that there will be only one government representative on the Board of a DCCB or SCB to represent the equity of the State Government. The CEO of the DCCB or SCB shall not be regarded as the representative of the State Government for the purpose of this paragraph. However, there would be no State Government nominee on the board of a PACS even if it has received equity contribution from the State Government. Where the State Government s equity is more than 25 percent, the amount in excess of 25 percent shall be converted into a grant by the State Government to the concerned CCB. In other words, there will be no liability devolving on the CCB entity insofar as retirement of State Government equity is concerned, and no funds will flow towards reducing the State Government s equity to a maximum of 25 percent. A State Government or an individual CCB entity which wishes to reduce the State Government equity further will be free to do so. In the interest of cooperatives becoming fully democratic, autonomous and self-reliant institutions, it is desirable that State Government equity participation be progressively reduced further and eliminated within a reasonable period of time. This can also be achieved by the societies in the CCS by moving over their registration to the parallel Acts wherever States have enacted such a law. Cost of Special Audit (SA). The recapitalization will cover accumulated losses as of 31 March For this purpose, a SA of accounts will be carried out for all the PACS, DCCBs and SCBs based on uniform accounting criteria. This SA will ensure that in the event o f insufficient provisioning made by the 33

46 CCS, they do not get under capitalized. The SA will be conducted under the supervision of the Implementing agency, NABARD. A standard format and contents of the SA reports has been developed. The arrangements for conduct of the special audit (including the agencies and personnel) will be worked out by NABARD in consultation with each State as soon as MOU for implementation of the package i s signed by that State Government. Eligible Institutions. In regard to PACS which satisfy the eligibility criteria, the capitalization will be direct; in regard to others, the capitalization will take place in the next upper tier. The capitalization, based on the independent special audit, will be sequential in nature, and each higher tier will be capitalized only after the beneficial impact of the lower tier has been factored in. All PACS with a recovery level of at least 30 percent of the demand as on 30 June 2004 will qualify for being covered under the revival package and to receive financial assistance. State Governments will be under obligation to determine the future set up of PACS with recovery levels of less than 30 percent. State Governments will take appropriate steps to ensure the flow of agricultural credit to farmers in the operational areas of such non-qualifying PACS. The PACS with recovery levels of 50 percent and above will be capitalized to achieve 7 percent CRAR, subject to their meeting the benchmarks set by the Package. The PACS with recovery levels between 30 percent to 50 percent will receive financial assistance in three annual, back-ended installments at the beginning of each succeeding year, subject to their achieving an incremental increase in their recovery rate by at least 10 percentage points on 30 June 2006 against the benchmark recovery achieved on 30 June 2004, and an annual increase o f 10 percentage points thereafter. The Go1 Package notes that the CCBs cannot be financially viable institutions on a sustainable basis unless recovery levels are improved beyond these levels. It will be necessary for them to become stricter on recovery and achieve recovery rates of at least 85 percent over the next 5 years. Technical assistance The Package will also cover the costs of training and capacity building to improve the financial management skills of staff and board members; for installation of uniform accounting and monitoring systems; as well as for computerization. This grant assistance from the Central Government will be phased over a period of two to three years based on necessity and will culminate with the completion of implementation in each State. Costs and Sharing Pattern The total cost of the Go1 Package (at the all-india level) has been estimated by Go1 at Rs. 13,596 crore (a little over US$3 billion). The liability for funding the financial package will be shared by the Central Government, State Governments, and the CCS based on origin of loss and existing commitments. The Central Government will bear 100 percent of the losses arising out of direct credit business of PACS, 100 percent of the losses arising out of the agricultural credit business of DCCBs and SCBs and a portion of their losses out of non agricultural credit business, 50 percent of the losses due to PDS and input distribution undertaken in pursuance o f national policy, the requirement of resources to raise CRAR to 7 percent, and the full cost of technical assistance for human resource development, computerization and improving accounting systems. 34

47 State Governments will bear 50 percent of the losses on account of the Public Distribution System (PDS) and input distribution, all dues pertaining to invoked and un-invoked guarantees and other receivables, and a portion of losses out of non agricultural business of DCCBs and SCBs. The CCS will bear the losses arising out of activities like direct advances taken up on their own and losses due to fiauds etc. The actual magnitude of the share will be determined on the basis of the findings of the special audit. However, a broad picture, based on available aggregate data as on March 2003, is presented below: Total Add Contingencies Grand Total 9,596 4,000 13,596 I needed I needed ** This amount can be estimated only after recapitalized balance sheets for the CCS are available. In broad terms, this works out to a sharing pattern wherein the Central Government will contribute about 68 percent o f total costs, State Governments will contribute about 28 percent, and the CCBs will contribute about percent. The Central Government will provide its share as grants. The States are expected to meet their share from their budget or by open market borrowing. The Centre will also consider assistance on more liberal terms for special category States and for specified scheduled areas and tribal areas to meet their liability under the package. Benchmark Activities Release of financial assistance under the financial package will be back ended and linked to achievement of pre-defined benchmarks in respect of legal, institutional and regulatory reforms and will, therefore, be phased over a period. Following is a summary of benchmark monitorable activities by various agencies and release of financial assistance under the package: 35

48 Benchmark Activities State Govt. accepts the package, issues consent letter, signs the MOUs (or exchange letters) with GoI. PACSIDCCBslSCB sign Letters of Undertaking with their respective implementation committees, the CSA is revised by the State Governments, SAs are completed, and State Govt. releases committed liabilities. Release of financial assistance Assistance is released for conduct of special audits, computerization of CCS and HRD initiatives. 75 percent o f financial assistance for funding accumulated losses would be released. Elections are conducted wherever due, professionals are either elected or co-opted, professional CEO appointed, CSA amended or special chapter incorporated, a sound system of internal checks and controls put in place by SCBsDCCBs and Development Action Plans (DAPs) are signed with NABARD. Balance 25 percent o f financial assistance for funding accumulated losses would be released. Implementation Mechanism NABARD is designated as the implementing agency for the Package. However, for guiding and monitoring the implementation of the scheme at national, state and district levels, Implementing and Monitoring Committees would be constituted. At the national level, this committee would comprise Secretary or Additional Secretary (Financial Sector) and Secretary (Cooperation), and representatives of RBI, NABARD, State Government(s), and two eminent co-operators. At the State level, the committee would comprise the Secretary (Finance), Secretary (Cooperation) and RCS, representatives of NABARD, SCBs and a CA. At the district level, a similar committee would be constituted including the District Collector or an officer of appropriate level. A dedicated team o f officers from NAJ3ARD would support each of these committees to help implement the scheme. Deposit Guarantee Scheme PACS. NABARD is currently examining the need to develop such a scheme for the members of the 36

49 Annex 2: Major Related Projects Financed by the Bank and/or other Agencies INDIA: STRENGTHENING RURAL CREDIT COOPERATIVES PROJECT Sector Issue Bank-financed Projects Providing technical assistance to Savings and Credit Institutions for authorization, training to sector staff, strengthening these entities in marginal areas to widen access to financial services to vulnerable and indigenous groups, putting in place a monitoring and evaluation system, and supporting sector studies (Mexico) Providing technical assistance to Savings and Credit Institutions through capacity building, developing a technology platform, and information dissemination to create financially viable, operationally effective, managerially sound entities that serve vulnerable and indigenous groups (Mexico) Improving access of micro-enterprises throughout the Northeast Region to sustainable, formal financial services by supporting expansion of the program known as "CrediAmigo" in Brazil through expansion of the microfinance loan portfolio, strengthening the institutional capacity, evaluating the impact of CrediAmigo on micro-enterprise dynamics and household welfare. (Brazil) Providing training, implementing an automation project, rolling-out of the banking system at branch level, and financing hardware and networking, and change management initiatives (Pakistan) An example of a Bank-government pooling of funds SWAP in the health sector, where the project helps to strengthen the BFP's ability to achieve poverty and inequality reduction and promoting human capital development by supporting consolidating the cash transfer programs, improving coverage, strengthening of the system for identifying the target population and the basic institutional functioning of the program. (Brazil) Project Name Savings and Credit Sector Strengthening and Rural Microfinance Capacity Building Technical Assistance Project (BANSEFI Phase I) Savings & Rural Finance (BANSEFI) Phase I1 Project (ongoing) Northeast Microfinance Development Project (ongoing) Banking Sector Technical Assistance Project (ongoing) Brazil Bolsa Familia Program (on-going) R Development Objective S S ting Implementation Performance S S S 37

50 Strengthening six commercial banks financially (capital restructuring) and institutionally, and also take concrete steps to reduce the Government s direct involvement in the banking system through opening up the capital to outside shareholders (India) Improving SME access to finance (including term finance) and business development services, thereby fostering SME growth, competitiveness and employment creation through a multipronged approach that addresses key bottlenecks to SME financing and development (India) Financial Sector Development Project: India (P010563, closed) Small & Medium Enterprise Financing and Development project (on-going) 38

51 Annex 3: Results Framework and Monitoring INDIA: STRENGTHENING RURAL CREDIT COOPERATIVES PROJECT PDO The project will assist in providing members o f the CCBs, including small and marginal farmers, with significantly enhanced access to formal finance (credit, savings, etc.), by ensuring that the potentially viable CCBs in the Participating States are transformed into efficient and commercially sustainable institutions. Outputs from each component Component I: Capacity Building Technical Assistance: Managerial, operational, technical, and compliance capacity o f participating CCBs is appropriately strengthened, and training capacity o f cooperative training institutes is adequately built. Component 11: Institutional strengthening of the ccs Computerization and enhanced systems are adequately implemented in participating CCBs in order to promote better networking, cost efficiencies, and immoved tranmarencv Project Outcome Indicators Rapid upward trend in the volume of credit uptake from CCBs (70 percent over the life of the project);26 Rapid upward trend in the number of small and marginal farmers who receive credit from CCBs (50 percent increase by the end of the project, relative to baseline); Upward trend in Recovery rates in the participating CCBs in the PS; Profitability improves in at least 2/3 o f the participating CCBs in the PS by the end of the project period. Participating CCBs publish election schedules and hold elections on regular basis over the project period. Output Indicators Evidence of timely and satisfactory progress toward the delivery of Component I outputs, as planned, including the following specific measures2 : 1. Capacity building for faculty of state-level cooperative training institutes to design and deliver basic training modules for the CCBs is implemented according to the plan; 2. A member education strategy for selected PACS members is developed and implemented according to plan; 3. Training and capacity building for participating CCBs to strengthen their ability to comply with the new regulatory framework, as well as their managerial, operational and technical capabilities is implemented according to the TA nlan. Evidence of timely and satisfactory progress toward the delivery of Component I1 outputs, as planned, including the following specific measures: 1. Computerization and enhanced systems are set-up as planned: (i) new IT Platform is installed in the PS; (ii) participating PACS in all PS migrate to the new Common Accounting System within three years from the date on which the MoU was signed; (iii) participating PACS implement the new MIS within three years from the first flow of funds to the PS. Use of Outcome Information YR 0 (Pre-refodre-project) Data from Special audits and Vaidyanathan Task Force creates baseline YRlto5 Annual outcome information will be used to track progress towards the PDO and to make changes in the project if necessary during implementation. Use of Output Monitoring Component I: Information on outputs from this component will be used to track progress towards institutional strengthening o f CCBs and CCB training institutes and to make changes in the project if necessary during implementation. Component 11: Information on outputs from this component will be used to track progress towards computerization and systems enhancement, and to make changes in the project if necessary during implementation. 26 Credit extended by Cooperative banks expanded by 14 percent for both two successive years ( over and over ) falling short of the government target o f an expansion o f 45 percent in Through reports from NIMC and independent impact assessment, technical and social assessment during missions, review of available data and stakeholder interviews. 39

52 and reporting Component 111: CCS Financial Restructuring Support: Sustained solvency in potentially viable CCBs is achieved Component IV: Project Implementation, monitoring and communication: implementation, monitoring and evaluation, and communication activities professionally and efficiently managed Proposed components for implementation: I. Capacity Building Technical Assistance; I. Information Technology; I. Financial Restructuring Support;. Project Implementation, monitoring and communication. Evidence of timely and satisfactory progress toward the delivery of Component I11 outputs, as planned, including the following specific measures: 1. All CCBs deemed eligible for FRS as per the predetermined criteria receive recapitalization support upon achievement of the pre-agreed benchmarks as planned. 2. Improved capital adequacy as prescribed by RBI: at least 213 of the participating CCBs in the PS achieve higher capital to risk weighted assets ratios (CRARs) (increasing each year, and reaching a minimum of 9 percent for PACS and a minimum rate for DCCBs and SCBs as determined by the regulator) over the life of the project. Evidence of timely and satisfactory progress toward the delivery of project on time and budget, including the following specific measures: 1. Implementation capacity of NABARD, and of the SLICs, DLICs, and RCS in PS is strengthened, as necessary; 2. The agreed M&E framework is developed and implemented; 3. A communications and dissemination strategy is prepared and implemented. Inputs: (Budget for each Component) US$ 20.0 million US$ 80.0 million US$495.0 million US$ 5.0 million Total Project Costs: US$ 600 million Implementing Agency: NABARD Component 111: Information on outputs from this component will be used to track progress in the solvency position of CCBs; insufficient improvement may trigger hrther measures and feed into DLICiSLIC decision-making. Component IV: Information on outputs from this component will be used to make changes in the project if necessary during implementation. 40

53 .- C M E z B m ri 0 v1 v) k e a u m

54

55 m d

56

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58 Annex 4: Detailed Project Description INDIA: STRENGTHENING RURAL CREDIT COOPERATIVES PROJECT This annex provides details of the four components of the project: (a) Capacity building TA; (b) Information technology; (c) CCS financial restructuring support; and (d) implementation. All the components support, and, go hand in hand with the following legal reforms that underpin the Go1 Package : Legal Reforms. Poor management and governance have contributed to the current state of insolvency of the rural CCS. Legal reforms that will contribute to address these shortcomings are thus essential to ensure sustainability of the project. More specifically, these reforms include the following All cooperative banks would be on par with the commercial banks as far as regulatory norms are concerned; Fit and proper criteria will be stipulated by the regulator for election to boards of cooperative banks. Such criteria would, however, not be at variance with the nature of membership of primary cooperatives which constitute the membership o f the DCCBs and SCBs; Appointments to the Boards of CCBs will also follow criteria prescribed by the regulator. In case members with such professional qualifications or experience do not get elected in the normal electoral process, then the Board will be required to co-opt such professionals to the Board and they would have full voting rights; The CEOs of the cooperative banks would be appointed by the respective banks themselves and not by the State Government. However, as these are banking institutions, RBI will prescribe the minimum qualifications of the CEO to be appointed and the name proposed by the cooperative bank for the position of CEO would have to be approved by RBI; and Cooperatives other than cooperative banks as approved by the RBI shall not accept nonvoting member deposits. Such cooperatives would also not use words like bank, banking, banker or any other derivative of the word bank in their registered name. Providing full voting membership rights on all users of financial services including depositors in cooperatives other than cooperative banks; Removing state intervention in all financial and internal administrative matters in cooperatives; Providing a cap of 25 percent on State Government equity in cooperatives and limiting participation in the Boards of cooperative banks to one nominee. Any State Government or a cooperative wishing to reduce the State Government s equity further would be free to do so and the cooperative will not be prevented from doing so; Allowing transition of cooperatives registered under the CSA to migrate to the new Act (in cases where the issuance of a new Act has been chosen); 46

59 Withdrawing restrictive orders on financial matters; Permitting cooperatives in all the three tiers freedom to take loans from any regulated financial institution and not necessarily from only the upper tier and, similarly, placing their deposits with any regulated financial institution of their choice, beyond certain thresholds; Permitting cooperatives under the new Act (wherever enacted) to be members of upper tiers under the existing CSA, and vice versa; Limiting powers of State Governments to supersede the Boards; Ensuring timely elections before the expiry of the term of the existing Boards Facilitating regulatory powers for the RBI in the case of cooperative banks; and Establishing prudential norms, including CAR, for all financial cooperatives including PACS. Component I - Capacity building technical assistance (TA) (Bank financing: US$20 mn) This component (corresponding with the HR initiative under the Go1 package) will aim to build up the capabilities of the CCBs in all three tiers to strengthen their ability to comply with the new legal, regulatory and supervisory framework, and to provide them with the necessary capacity to meet the performance targets set in their DAPs and promote longer term financial sustainability. The focus will be on building the capacity of the Boards and staff of CCBs in all three tiers in the following areas: understanding the new legal and regulatory framework and governance codes; improved performance tracking and reporting; implementation of a new and enhanced common accounting system, MIWnternal controls, and audit mechanisms; enhanced credit appraisal and risk management; business diversification and product development; and HR development. Additionally, PACS will be provided with capacity building assistance to support more effective networking. Finally, the component will also include capacity building assistance to support member education, focused on small and marginal farmers who are members o f PACS; the latter will involve developing and implementing a strategy, focusing on such areas as financial literacy, and better awareness of rights and responsibilities, among PACS members. To begin with, this component would support institutions in five or six states, with the possibility of subsequent scale-up through Additional Financing. Specifically, this component includes a focus on the following broad themes: (a) Developing the capacity of the Boards, management and staff of all CCBs in management and governance, especially in the following areas: understanding the new legal and regulatory framework and governance codes; improved performance tracking and reporting; implementation of a new and enhanced common accounting system, MIS/ internal controls, and audit mechanisms; enhanced credit appraisal and risk management; business diversification and product development; HR development; and management capacity including Financial Management skills. Specifically, training and advisory services for DCCB and SCB staff will be provided on compliance with the new law, regulations, implementation of the new governance codes, regulation and supervision mechanisms, and performance tracking and reporting, internal controls, MIS, PACS appraisal, product diversification and overall improvements of their financial performance. 47

60 The TA at the PACS level seeks to provide them with the tools to operate more effectively as a sustainable cooperative and to give members training on their rights and duties within the context of a democratically functioning cooperative. Training for the PACS Board will focus on the changes introduced by the cooperative reform, their new duties and rights, governance requirements of selfmanaged PACS. Agency roles will also be of importance in the scope of training at the PACS level; and PACS members: Training of members on rights and duties of PACS members and of their Board. The role played by these change agents will be crucial in ensuring that PACS get reoriented. Training for the PACS staff will focus on MIS, loan appraisal, and overall improvements of the financial performance of the PACS. Training of PACS staff and management will also include support for networking, pooling of services, product diversification and service centers for product delivery, business planning and other means of improving viability. The training will include a strong focus on how to achieve cost reduction through promoting networkmg and cost pooling via a wide array of services (IT, legal, accounting, regulatory compliance, TA, liquidity management, etc.) that are subject to economies of scale. In addition, training on risk diversification, credit risk exposure and credit risk swaps will be provided. Thus the reforms will assist in achieving the longer term goal of improving risk management, efficiency, cost structure, and long-term viability and sustainability of CCBs. (b) Capacity building assistance to support member education in selected PACS: The component will also include developing and implementing a member education strategy, involving stakeholder participation (including from PACS members, small and marginal farmers). The focus of the education strategy would to provide CCBs members with the knowledge they require to become aware of their rights, responsibilities and entitlements as members of PACS, as well as understanding and using new financial products the CCBs may offer. The GoI, with support from the German technical assistance development agency (GTZ), has already initiated the design of a financial management strengthening strategy for the rural CCS including developing a uniform accounting framework for the CCBs at all levels (including PACS), enhanced Internal Control system, and guidelines for sound audit mechanism for the CCS. Given that GTZ s current approach only envisages the implementation of these financial management tools on a pilot basis in a few CCS units, the Bank s support would incorporate the financial management tools developed by GTZ consultants into the TA and IT components (the latter to ensure compatibility of the hardware and software to be procured with the financial management computer tools developed). Assistance would be delivered through a combination of tools, including the provision of conventional training programs; training-of-trainers; hands-on, on-the-job training and short-term and medium-term advisory services provided by experts; and study visits/exposure programs. The conventional training programs would be delivered primarily by existing state-level cooperative training institutes identified by NABARD, which would receive capacity building assistance, including training of their faculty to design and deliver basic training modules for the CCBs in accounting, auditing, governance, HR management, MIS, and members duties and rights, etc. At the level of DCCBs and PACS, on-the-job training and advisory services will be provided primarily by a cadre of mobile trainers/consultants/auditors. In addition, on-the-job training at the level of SCBs as needed; the consulting resources would be mainly national, although some presence of international expertise may be required, at least on a short-term basis. Component I1 - Information technology (IT) (Bank financing: US$80 mn) 48

61 This component (corresponding to the computerization initiative under GoI s Package) will support, the computerization of CCBs within each of the five PS, in order to enhance the efficiency and transparency of the CCS through enabling the efficient implementation of the new common accounting system and MIS, and fostering cost efficiencies through facilitating the pooling of costs related to back office transactions. The component would finance: (a) acquisition of applications software and its ongoing maintenance and enhancement; (b) acquisition of hardware; (c) roll-out services, including data entry of the initial database; and (d) users training, provided through conventional training programs as well as on-the-job training and advisory services, which, would be provided by a cadre of mobile trainers/consultants. To begin with, this component would support the development of IT Platforms for the CCS on a limited basis (in selected districts, in about five states), with the possibility of subsequent scale-up through Additional Financing. The IT system to be acquired would have two key characteristics: (a) Common application systems providing the administrative functions required to manage products, customers/members, branches, internal operations, planning and compliance with regulations with a special emphasis on accounting and MIS. This is consistent with the trend within the sector to standardize the approach to the use of appropriate technologies, procedures and processes and is consistent with plans already initiated by NABARD in conjunction with GTZ, the German government development agency, to design and make available standard application systems in these two areas; (b) Office Equipment for stakeholders, branches and integration agencies. These are likely to include personal computers or terminals, printers and ancillary equipment related to security, etc. according to the needs of each stakeholder. The IT component will focus on providing the basic IT infrastructure to the CCBs. As the CCBs in most PS have typically very limited or no IT deployment at present, the focus of the IT component i s to facilitate software based accounting and MIS. This would help contribute to streamlining operations, strengthening internal controls and portfolio management, improving data monitoring and reporting abilities and thereby providing for better supervisory compliance. While the IT infrastructure will be basic and comprise essential IT infrastructure as described above, it will be structured to enable the SCBs and DCCBs to add more sophisticated applications and systems according to their needs using their own resources over time to fund this. Component I11 -CCS Financial Restructuring Support (FRS) (Bank Financing: US$495 mn) This component (corresponding to the recapitalization initiative under the Go1 Package) will support the financial restructuring of potentially viable CCBs by providing recapitalization as a grant (not equity) to wipe out the accumulated losses36 of CCBs, restore the value of members capital in the CCBs, and bring these institutions to a minimum capital to risk weighted assets ratio (CRAR) of 7 percent. While PACS will be required to raise this ratio within three years to 9 percent, DCCBs and SCBs shall raise their CRAR as prescribed by the RBI. This increase in CRAR shall be met by the CCBs from their own resources. 36 This however does not mean writing off loans that are yet to be repaid by borrowers; the CCBs will have to continue to make efforts to recover these loans. Whereas, the initial recapitalization of CCBs will bring their CRAR to 7 percent as of 2004, the subsequent annual CRAR targets will be based on their balance sheets at the time. This means that the CCBs that may have incurred any additional losses since 2004 will not be fully compensated for all current losses, and will be required to redouble efforts to recover losses incurred since 2004, if they are to meet the stipulated CRAR targets, over time. 49

62 The FRS will start by first bringing the PACS to an acceptable level of financial health through cleansing of their balance sheets and strengthening their capital base, and then move on to the upper tiers. This step will enable PACS to clear their dues to the upper tiers and thereby reduce the accumulated losses of DCCBs. The DCCBs will thereafter be provided assistance to clear the balance of accumulated losses, if any, and to reach a minimum norm of capital adequacy. The same process will apply to the SCBs. To ensure prudent use of public resources, only the potentially viable CCBs will be recapitalized. All PACS with a recovery rate of at least 30 percent as on June 30, 2004 will qualify for being covered under the revival package and to receive financial assistance, provided the reform benchmarks (see below) set by the Go1 Package are met. State Governments will be under obligation to determine the future set up/exit strategy for PACS with recovery rates of less than 30 percent. Provision of funds under the FRS will be linked to the implementation of a set of far-reaching and time-bound legal, regulatory and institutional reforms to address the governance and operational weaknesses affecting CCBs. Specifically, prior to any funds from Go1 flowing under this component, the concerned State Governments will be required to achieve the following set of initial benchmarks: (a) Special Audits (SAs) are completed (DCCB-wise); (b) the CSA has been revised; (c) the State Government contributes its share of capitalization funding; and (d) PACS, DCCBs and SCBs sign Letters of Undertaking with their respective DLIC and SLIC. The benchmarks for the release of the remaining recapitalization funds to CCBs are as follows: (a) the CSA is amended or special chapter incorporated; (b) elections to the Boards of CCBs are conducted wherever due; (c) professionals are either elected or coopted to these Boards as per the fit and proper criteria as may be stipulated by the regulator; (d) professional CEOs satisfying the qualifications as may be prescribed by the regulator are appointed; (e) a sound system of internal checks and controls put in place by CCBs; and (0 CCBs sign Development Action Plans (DAPs) signed with NABARD, committing to key performance targets, over a three-year period (Annex 6, 7). The amount required for recapitalization is being calculated on the basis of the Special Audit (SA) results. The states will conduct SAs of all qualifying CCBs to determine the magnitude of accumulated losses, and hence, the amount of FRS for revival to be provided under this ~omponent.~ In line with the Go1 Package agreed with the states, the SAs will be based on audited balance sheets as of March ). The SAs are based on standard formats and methodologies developed by NABARD, and some further improvements in the SA process may be suggested, based on the lessons learned from the first set of SAs that are completed. The SAs are conducted by the audit staff of the State Cooperative Department, trained especially for this job by NABARD. The DLICs, which comprise representatives from NABARD, the DCCB, the State Government and a CA will provide quality assurance over the SAs, by reviewing the SAs and recommending to the SLICs the amount of the accumulated losses of CCBs as calculated by the SAs. The DLIC s CA is mandated by the Committee to conduct a sample check (15 percent) of the SAs. Based on the recommendation of the DLICs, the SLICs have the role of approving the accumulated losses of the CCBs. Special Case: PACS with recovery rates between 30percent and 50percent For these PACS, the same procedures as above will be followed, but they will receive financial assistance in three annual, back-ended installments at the beginning of each succeeding year, subject to 37 It may be noted that these SAs, which are financial reviews (rather than full-blown audits), are designed specifically to recompute the accumulated losses of CCBs, by applying the standard provisioning norms as prescribed by RBI. The SAs will update previous figures used at the time the GoI s package was being formulated. At that time, the accumulated losses in the system were estimated at Rs. 9,277 crores (a little over US$2 billion), with the breakdown as follows: Rs. 4,595 crores for the PACS, Rs. 4,401 crores for the DCCBs, and Rs. 281 crores for the SCBs. 50

63 their achieving an incremental increase in their recovery rate by at least 10 percentage points on 30 June 2006 against the benchmark recovery achieved on 30 June 2004, and an annual increase of 10 percentage points thereafter. In other words, to receive any recapitalization funds under the FRS, these PACS will need to achieve one additional criterion - namely, a recovery rate o f at least 10 percentage points higher than what was reported on 30 June Component IV - Implementation (Bank Financing: US%5 mn) This component will cover support for project implementation, including: (a) Overall implementation capacity, to build the implementation capacity of all key entities that are involved in project implementation. (b) Support for the SAs, will which entail support for undertaking the SAs in the five PS (as described in Component 111). (c) Monitoring and Disclosure, which will focus on ensuring that the agreed M&E framework is implemented according to plan. This will involve providing capacity building to the agencies responsible for data collection and reporting. In particular, it will assist these agencies in strengthening their data gathering and compilation systems, as well as the skills of the staff that undertake this activity. It will aim to ensure that the data collection is undertaken at the required frequency and that the reporting is done according to the set criteria and is consistent over time. Support will also be provided to GoI, NABARD and other entities to help with the disclosure of information on the project s design principles and implementation, throughout the implementation period. Such information could include, for example, (i) the criteria governing the selection of states and CCBs supported, the evidence supporting the decision, and the process through which the selection was made; (ii) the criteria governing the selection of CCBs for closure/merger/or any other form of amalgamation or exit, the basis on which a particular approach was chosen, the evidence supporting the strategic choice, and the process through which it was executed; and (iii) the frameworks underlying procurement decisions. The objective would be to enhance information flows with regard to the project as also mechanisms to promote transparency as benchmarked by the RTI legislation. 51

64 Annex 5: Project Costs INDIA: STRENGTHENING RURAL CREDIT COOPERATIVES PROJECT Local Foreign Total Project Cost By Component and/or Activity US$ million US$ million US$ million Capacity building technical assistance Of which IDNIBRD O Information technology Of which IDNIBRD CCS financial restructuring support Of which IDNIBRD O O Imp1 em en tat ion Of which IDNIBRD O Total Baseline Cost Physical Contingencies Price Contingencies Total Project Costs of which IDNIBRD Notes: 1. Includes: IDA US$300 million, IBRD US300 million, Go1 counterparty contribution US260 million. 2. Identifiable taxes and duties are US$13.0 million, and the total project cost, net of taxes, is US$737.0 million. Therefore, the share of project cost net of taxes is 98.3 percent. Total project costs do not include front-end fees paid for by Government of India. 52

65 Annex 6: Implementation Arrangements INDIA: STRENGTHENING RURAL CREDIT COOPERATIVES PROJECT The Banking Division at the Department of Economic Affairs (DEA), MoF, Go1 have been designated to provide overall policy guidance and monitoring, while NABARD is the main implementing agency. A dedicated Department for Cooperative Reforms and Revival (DCRR), currently staffed by nine officers, has been set up within NABARD to coordinate implementation. A three-tier structure has been established to support implementation and monitoring. This includes: (a) a National-level Implementation and Monitoring Committee (NIMC), which is mandated to provide overall policy guidance and strategic direction of the reforms; (b) State-level Implementation Committees (SLICs); and (c) District-level Implementation Committees (DLICs). The composition and detailed terms of reference (TORS) and operating guidelines for these committees at all three tiers have been drawn up, the latter with inputs from the Bank (Table 6.1). Support teamshecretariats, staffed with NABARD officials, have been established to help the SLICs and DLICs in their day-to-day functions. Committee National Implementation and Monitoring Committee (NIMC) State Level Implementing and Monitoring Committees (SLICs) District Level Implementing and Monitoring Committees (DLICs) Table 6.1: Project Imple Members Chairman: Secretary (Financial Sector), DEA, MoF Secretary, Ministry o f Agriculture Deputy Governor, RBI ChairmaniMD NABARD Secretary in charge o f Cooperation - participating states, two co-operators. Chairman: Secretary, Finance Secretary, Cooperation CGM, NABARD Regional Office Registrar Cooperative Societies MD, State Cooperative Bank ED, NABARD Head Office CA Chairman: District Collector DDM, NABARD (or NABARD representative) CEO, DCCB JRC S/DRC S NABARD Regional office Representative CA ientation Committees Key Objectives Overall guidance over Project implementation Monitoring of achievement of Project objectives Guide and monitor overall Project implementation in the state, including in computerization and capacity building o f staff Facilitate formation of DLICs and signing Letter of Undertaking between SLIC and SCB, and among DLIC, DCCBs and PACS Plan and ensure conduct o f SAs Pursue with State Government legal reforms Recommend appointment o f CAS for DLIC from panel prepared by NABARD Vet and finalize SAs results and financial assistance recommended for PACS, DCCBs and SCBs Report progress to NIMC Guide and monitor overall Project implementation in the district, including in computerization and capacity building of staff Ensure signing Letter of Undertaking by DCCBs and PACS and monitor its compliance Facilitate preparation of time-bound action plan for revitalization and business development by each PAC and DCCB; review its implementation Arrange Special Audit process and ensure sample test by CA Examine, finalize, certify and recommend sanction o f financial assistance to PACS and DCCB to the SLIC Send a monthly report on implementation progress to SLIC and NABARD 53

66 The project will adopt a SWAP approach, with Bank funds provided to Go1 through parallel financing. The SWAP will enable the Bank to support GoI s reforms in a comprehensive and coordinated manner across the PS, and leverage Bank resources to scale-up impact. Bank financing to Go1 is complemented by financing from a number of donors, including: the ADB, KfW and DFID. ADB s Board has approved (in December 2006) a policy based programmatic loan of US$1 billion to Go1 for this purpose; the loan supports all aspects of the Go1 Package. A loan of US$175 million (equiv.) from KfW to support the recapitalization component of the Go1 Package i s being prepared. The ADB and KfW funds will flow to five states (not including the PS to be supported by Bank funds). DFID has also committed to providing a grant of US$2 million to Go1 to support the technical assistance components of the Go1 Package. In addition, GTZ is supporting Go1 with project preparatory activities, including the development of common accounting, auditing and MIS frameworks for the CCS. Harmonized arrangements for M&E, reporting, financial management, fiduciary oversight, etc., to be used for the Go1 Package across states, have been agreed. Not only will this help ensure more effective implementation and improved outcomes, it will also help reduce duplicative reporting and transactions costs for the Borrower, and a greater focus on results. An Implementation Manual (IM) acceptable to the Bank has been prepared and adopted by MoF, NABARD and other implementing agencies as applicable. The IM includes, inter alia, the agreed financial management and disbursement arrangements, procurement guidelines, and a detailed framework for the continuous measurement and monitoring of outcomes (see below), that will be a key element in ensuring effective implementation. Arrangements have been put in place to ensure intensive project supervision, covering FM and procurement aspects, with quarterly supervision missions. The supervision team will draw on expertise from the Bank, as well as external experts. The concerned development partners will meet regularly to facilitate effective coordination and communication to take stock of implementation and results Implementation Arrangements -capacity Building of CCS; Information technology; and Project Implementation (Components I, I1 and IV) NABARD has overall responsibility for all financial management activities, including periodic financial reporting to the Bank as specified in Annex 7. NABARD has set-up a dedicated department staffed by dedicated NABARD and supported by regional office staff to implement the reforms. To ensure that these functions are performed efficiently and effectively, NABARD will provide requisite staffing to ensure that these functions are performed adequately. FM capacity, focused on accounting, MIS, internal controls, etc. will be built up at all levels of the CCS, supported through the project (Component I). NABARD will be responsible for the overall coordination of procurement under these components. Procurement under the IT component will follow standardized guidelines issued by NABARD detailing the technical specifications, tendering process and bid documentation, and benchmark costs for good and services. The SLICs will take responsibility for all technical and operational decisions, including short-listing of vendors, finalizing the tender documents for competitive bidding, bid evaluation, award of contracts, etc., with inputs from the SCBs. The SCBs will sign the final procurement contracts. NABARD will act as the payment agent and will make direct payments to contractors/ vendors on the basis o f written instructions received from SLIC and SCB. NABARD will ensure that sufficient expertise in IT related procurement (for Component 11) is made available to all the SLICs. An Action Plan to mitigate procurement risks, which are related primarily to IT procurement, has also been developed. For procurement under the capacity building TA and implementation components, 54

67 which will involve training and consultancies, NABARD s HQ (DCRR) will take responsibility for technical and operational decisions. In the case of high value training, which can be provided by private sector institutions, procurement will be done following Consultant guidelines. However, most of the modules envisaged under the project s capacity building TA program for CCBs will require NABARD to engage Specialized Cooperative Training Institutes, as there is no comparable expertise available in the private sector. While these Institutes are not strictly government-owned, and are defined as autonomous, they often depend upon the State Governments/cooperative sector for their finances, in part or full. NABARD/SLIC will sign MoUs with these Institutes for imparting training (see Annex 8). Bank loan disbursements for Components I, I1 and TV will be made against expenditures on incurred by NABARD for the purchase of goods and services to be financed by these components of the project. Bank-financed project funds allocated to these components will be disbursed on the basis of interim un-audited financial reports (IUFRs) evidencing actual expenditures, on these components. Implementation Arrangements for CCS Financial Restructuring Support (FRS) (Component 110 SAs and Estimation of Accumulated Losses. The process of financial restructuring will begin by carrying out SAs to identify the amount and source of losses accumulated in the balance sheets of the CCBs and the amount of resources necessary to cover such losses and bring the risk-weighted Capital Adequacy Ratio (CRAR) to 7 percent Upon MoU signature, NABARD would proceed to train a cadre of auditors (Master Trainers) for each state who would, with additional support from NABARD, train the full set of auditors who would carry out the SAs. These auditors would be drawn primarily from each state Audit Department. NABARD will check all SAs. Furthermore, the C A in the DLICs will check a random sample (about 15 percent) of the SAs in the District. Upon completion of this process, the DLIC will certify the SAs and forward them to the SLIC for their final vetting. The SAs will identify the type of losses of each CCB, as the source of funding to cover such losses will vary. The Go1 - and thus funding from the World Bank loadcredit proceeds - cover 100 percent of the losses arising out of direct credit business of PACS; 100 percent of the losses arising out of the agricultural credit business of DCCBs and SCBs, and a portion of their losses out of non agricultural credit business; 50 percent of the losses incurred by the PACS in carrying out noncredit activities, such as the distribution of basic foodstuffs (Public Distribution System, PDS) and agricultural input distribution on behalf of the GoI. The Go1 will also cover any additional funding required for CCBs to reach 7 percent CRAR. State Governments will bear 50 percent of the losses on account of PDS and input distribution, all dues pertaining to invoked and un-invoked guarantees and other receivables, and a portion of losses out of non agricultural business of DCCBs and SCBs. The CCBs will bear the losses arising out of activities like direct advances taken up on their own and losses due to frauds or errors. Table 6.2 summarizes the source of funding that will cover each type of loss. Table 6.2: Loss Type and Source of Funding under the Package Loss Type I Responsibility under theproject PACS credit Go1 PACS Non-credit Shared Go1 and State DCCBs and SCBs PAC and agricultural credit Go1 DCCBs and SCBs lending to non-pac cooperatives State with invoked State guarantees DCCBs and SCBs lending to non-pac cooperatives Shared Go1 and State with un-invoked State guarantees DCCBs and SCBs lending to non-pac cooperatives DCCBs themselves without State guarantees DCCBs and SCBs receivables from the State (State State announced loan waivers) 55

68 On the basis of SAs, each SLIC and NABARD will certify the net payment to be made to each CCB. This process can be carried out as the SAs for each District are finalized and the net payment to PACS and DCCBs can be calculated by taking into account their dues to their respective upper tier bank. At that point, the payment to the concerned PACS and DCCB will be made, with the funds credited to their accounts. Payments due to the SCBs can be calculated on the basis of dues from each DCCB as well as from the SA of the SCB itself and the SCB would then receive its payment. Fundsflow. All project funds will flow from Go1 (as grants) through NABARD. In line with the Go1 Package, once the MoU has been signed, the PS receives funds to carry out the SAs. Funding for the SAs can flow to a state as soon as it signs the MoU (thereby becoming a PS); all other funds for implementing activities under Component IV would begin to flow upon project effectiveness. Funds for implementing activities under Components I&II would flow only after the CSA has been revised by the PS. Finally, recapitalization funds to implement Component I11 would flow to CCBs, based on the achievement of reform benchmarks, as specified in the Go1 Package and the MoUs. With respect to Components I, I1 and N, the expenditure would be directly incurred by NABARD for the purchase of goods and services to be financed by these components of the project. For the FRS (Component 111), all project funds will flow from Go1 through NABARD to the CCBs. Once the SAs for all the eligible PACS under a given DCCB have been completed, the net payment to the PACS will be calculated after setting-off their overdue liabilities to the DCCB. At that point, the payment to the concerned PACS and DCCB will be credited into their accounts. After the SAs of all DCCBs in a state have been completed, payments due to the DCCBdSCBs can be calculated on the basis of dues from each DCCB, and the SCB would then receive its payment. It may be noted that all payments in respect of all components/activities under the project will be made by NABARD s Head office and/or Regional offices, so that the expenditures will be captured in NABARD s accounting system (Annex 7). Bank-financed project funds allocated to Components I, I1 and N will be disbursed on the basis of interim un-audited financial reports (IUFRs) evidencing actual expenditures, on the various components and activities of the project. Funds allocated to Component I11 (FRS) will be disbursed on the basis of actual transfers made to CCS in accordance with OP/BP 6.0, and reported in the IUFRs under two sub-categories, the requirements for which are specified in the Go1 Package and the MoUs: 0 The first category o f FRS funds (75 percent of recapitalization support) will be for CCBs where an initial set of pre-defined benchmarks have been completed, which are (as mentioned earlier): SAs are completed DCCB-wise; the CSA has been revised; State contributes its share of capitalization funding; PACS, DCCBs and SCBs sign Letters of Undertaking with their respective DLIC and SLIC; 0 The second category of FRS funds (25 percent of recapitalization support) will be for CCBs where a further set of pre-defined benchmarks have been completed, which are: CSA amended or special chapter incorporated; elections to the Boards of CCBs conducted wherever due; professionals are either elected or co-opted to these Boards as per the fit and proper criteria as may be stipulated by the regulator; professional CEOs satisfying the qualifications as may be prescribed by the regulator are appointed; a sound system of internal checks and controls put in place by CCBs; and DAPs are signed with NABARD committing them to key performance targets to be achieved over a three year period. An initial advance of US$ 100 million will be provided to Go1 to meet the expected expenditures in the first four months of the project (with a provision to increase this limit if necessary to US$ 150 million). While IUFRs will be submitted on a quarterly basis, Go1 would have the flexibility to seek 56

69 reimbursement earlier than the quarterly intervals by submitting reports for shorter periods. The disbursement percentage for all project components will be set at 80 percent of the gross expenditures (i-e., 80 percent of GoI s share) as reported by NABARD/ Go1 through the IUFRs. This is based on the expected relative contributions of the Bank and Go1 in the states where Bank funds would be deployed. Retroactive financing up to an amount of US$ 50 million will be made available for all categories of eligible expenditures incurred after August 1,

70 Annex 7: Financial Management and Disbursement Arrangements INDIA: STRENGTHENING RURAL CREDIT COOPERATIVES PROJECT NABARD has been designated as the principal Implementing Agency for this project. The Financial Management arrangements will be overseen by NABARD s offices at its corporate headquarters in Mumbai (Department of Cooperative Reform & Revival), at the state headquarters, and their district-level offices. Other entities at national level (NIMC), at state-level (SLICs, SCBs), districtlevel (DLICs, DCCBs) and village-level (PACS) would provide the necessary assistance to NABARD for collating the information, but will not handle project funds. NABARD s existing FM system, with adequate enhancements and linkages with MIS, will have the capacity to provide the Bank with accurate and timely information on the status of the project and use of Bank funds A financial management (FM) assessment of NABARD was carried out during appraisal and its capacity to report on and coordinate all FM aspects of the project was assessed. In addition, an independent consulting firm was engaged to carry out the Financial Management and Accountability Assessment Study for the short term rural credit cooperative sector. This study was carried out as per specific Terms of Reference, across a sample of entities in the CCS (SCBs, DCCBs and PACS) across two states, AP and Rajasthan. The key objectives of the study included an assessment of the: Broader policy, FM, and accountability issues in the CCS at all levels, and accountability arrangements within the GoI s proposed reforms to help design the capacity building component of the Package; Approach and method being used by SAs 38 to verify the quantification of accumulated losses in the CCS, and the reliability of this calculation based on the quality of existing information available at the PACS level. FM Strengths, Weaknesses and Mitigating Arrangements The project has the following strengths in the area of financial management: (i) NABARD s budgeting, accounting and reporting system has been operational for several years, and will be used for accounting and generating the required financial reports under the project; (ii) payment & accounting arrangements for Component I, I1 and IV of the project will be made within NABARD s offices, which will ease accounting and financial reporting under the project (iii) the project is expected to build adequate FM capacity of CCS institutions over the project implementation period. The consultant s review of FM, corporate governance, and accountability arrangements of the CCS has indicated that PACS at the lowest tier of CCS have weak FM capacities; there is, therefore, a clear need to improve & strengthen FM, accountability and corporate governance arrangements of the CCS (especially PACS). Nevertheless, under the project, the FM function will be largely performed and coordinated by NABARD, and PACS will not handle project funds, as such this aspect of FM capacity of the PACS may not directly impact the project in the short run. The PACS capacity i s proposed to be strengthened over the project period by preparing and implementing an FM capacity building program as part of the Technical Assistance program. 38 It may be noted that these Special audits are not fully-fledged audits, but rather, financial reviews which are designed to recompute the accumulated losses of the CCS, using their existing audited financial statements of March 3 1, 2004, and applyng provisioning norms, as prescribed in the GO1 program. 58

71 The FM risk for this project is currently rated as substantiafg (Table 7.1). To address this risk, the capacity building component will need to focus on strengthening the accounting, reporting and overall accountability systems and structures in the CCBs. Although the Country level FM risk for India is rated at Modest4', it does not have specific relevance for this project as major implementation will be done by NABARD which functions outside the core government. The linkage with core government will be only to the extent of budgetary transfers from banking division to NABARD. Risks Remarks(mitigati0n strategies)* Residual risk rating Country level Implementa tion level (Entity/ Project) I The Country level FM risk for India is rated at Modest. M S OVERALL INHERENT RISK S Accounting Internal Controls Funds flow 11 be available on a timely basis and for transfer to CCBs if the States do Financial Reporting Auditing OVERALL C H - High S - Substantial M - Modest L - Low * The mitigation strategy is provided in parenthesis. 39 Periodic supervision missions will review these ratings and revise as needed. 40 While a Country Financial Accountability Assessment has not been conducted in India, several pieces of core ESW and AAAs are available, which provide adequate information about budgetary & financial accountability framework and reasonableness in functioning of the primary institutions of accountability at the central government level. In light of this information, the risk of project funds not being used for intended purposes at country level (India) is rated as moderate. 59

72 NABARD s Accounting Procedures, Policies and Accounting System NABARD s accounts are prepared on the basis of a historical cost convention, in accordance with generally accepted accounting principles. They follow accounting standards as issued by the Institute of Chartered Accounts of India. Additionally in accordance with RBI guidelines for prudential norms and income recognition, adequate provisions are made for loan assets on the basis of their ageing, as on the balance sheet date. Project Financial Statements for the project will be prepared each fiscal year in accordance with consistently applied accounting standards and policies that are acceptable to the World Bank. These will identify the various sources of funds and the actual usage on components and activities out of these funds. A section covering Financial Management and Disbursement arrangements has been included in the Project Implementation Manual, which will provide guidance to project staff during implementation. NABARD has a modem & integrated accounting system which has the capacity to capture all financial transactions from its accounting units (Head Office & Regional Offices). For the Project, NABARD has devised a set of separate account heads and account codes which will capture the expenditures incurred under the four components of the project. This expenditure will be captured at the Head Office and Regional office levels and integrated for the purpose of reporting to the Bank through GOI. It has been confirmed from NABARD that the system would be able to extract information and report on the various project components/activities on an aggregate basis state wise. Expenditures under the project Financial Restructuring Support (Component 111): This component will support the financial restructuring of eligible CCBs by providing recapitalization, aimed at wiping out accumulated losses. The amount required for recapitalization will be calculated on the basis of the results of the SAs. The FRS funds, however, will be made available to CCBs that meet eligibility criteria (threshold recovery rates, as detailed in Annex 4), and a further set of additional sequencing criteria (set by SLICs as per NIMC/GoI guidance). The Go1 (MoF) will transfer funds to NAB- as Grants-in-Aid through its budget and NABARD will transfer these funds to the concerned CCBs on the basis of the figures as verified by the DLIC and approved by the SLIC. The amounts due to the CCBs will be determined after netting all dues. TA/ IT Component (Component I & 11): It has been confirmed in discussions with NABARD and GoI, that all expenditures under the Component I 2% I1 are to be incurred by NABARD s offices and would, therefore, be captured within NABARD s accounting system. For training related expenditures, NABARD has an existing practice of entering into Memorandum of Understanding (MoUs) with national, regional, and state-level cooperative training institutions for reimbursing the training and associated costs on the basis of pre-agreed benchmarks. MoU includes service & expenditure benchmarks in respect of the quality of the training, level of trainers, number of trainees, duration, and payments that would be made to these institutions. No advances will be provided under these MoUs and all payments will be on the basis of invoices raised by the respective institutions, after the training is completed, at agreed rates set out in the MoU. This practice will be continued, with adequate enhancements in internal controls and documentation. National level consultants will also be hired, when necessary, for providing on-the-job training and advisory services at SCBs, DCCBs and PACS. In respect of IT procurement (hardware and software) NABARD would make payments on the basis of operational/technical decisions of the SLICs, but the procurement contracts would be signed by the concerned SCBs and payments as per contractual milestones will be made directly by NABARD after 60

73 SLIC/SCB certifies the invoices and advises NABARD to make payments. NABARD s accounting system will capture this expenditure from individual regional offices, and consolidate them state wise and at a national level for the TA component. NABARD would seek reimbursements only on the basis of actual expenditures booked on the basis of invoices, bills, receipts and other documents evidencing expenditures. Project Implementation support: The project will also support costs incurred by NABARD and other implementing agencies (detailed in Annex 6), in relation to implementing the project and may include operational expenditures such as support for the SA in the PS, project monitoring, communication and hiring of consultants to provide these services. Key findings of a sample survey in 2 states from financial management and accountability study by Independent Consultant (Full report available in project file) Accounting including financial reporting: All the PACS surveyed followed a Cash basis of accounting. However accounting of interest on loans and advances was on accrual basis. Several deficiencies were noted in day to day accounting of transactions and internal control mechanisms were weak. Budgetary controls were inadequate or missing. Staffing was weak - key PACS officials like the paid Secretary/Manager/CEO were on the rolls of two or more PACS and were available only on select days in a month. At the PACS level, there was a strong need for maintaining the loan accounts properly and periodically tallying the same with the books of the DCCB. Normal reconciliations were not being carried out at the PACS level. Audit and Internal Control: All PACS surveyed did not have mandated standards for their audit. Audit reports of PACS did not comment on the adequacy of internal control mechanisms. Comments on proprietary elements namely, securities received against loans and advances, personal expenditures debited, security of assets, etc. were not covered by the audit report. The audit was conducted by the officials of the State Cooperative Department trained for the purpose. Specialized audit tools and audit approaches seemed to be absent. Special Audit and Recar>italization: The basis for special audit was primarily the regular audit report for As the focus of special audit was compilation of accumulated losses, the weaknesses/deficiencies under the existing accounting and audit system (mentioned above) for surveyed PACS continued even after the special audit. Therefore, the recapitalization figures may be impacted. The sample studies in the states of AP and Rajasthan revealed wide variations between the accumulated profits /losses position as per regular audit as on and the initial position as finalized by the Special Auditors. However the overall picture for a state will emerge only after the special audit for the entire state is completed. The above findings reflect the weaknesses of the lowest tier of CCBs and are in line with current understanding on their capacity. However these weaknesses are expected to be addressed by implementing the new common accounting system and MIShnternal controls under Components I & I1 o f the project, Internal Control and Internal Audit NABARD s Inspection Department comprises an Inspection wing (responsible for inspection and assessment of NABARD s internal management systems, controls, and business practices) and a Concurrent audit wing (responsible for pre-checks in respect of all financial transactions before payments 61

74 are made, and NABARD s loaning business). A part of the concurrent audit function is outsourced to private chartered accountancy firms under specific terms of reference and the Inspection wing conducts a sample check of their work. The Inspection Department has confirmed that all financial transactions under the project would be covered under NABARD s internal audit program; this provides some additional assurance for the appropriate usage of Bank funds. The Department of Supervision is responsible for the supervision of the SCBs and DCCBs (as well as Land Development Banks and RRBs), for checking compliance with the relevant provisions of the Banking Regulation Act, through on-site inspections and off-site monitoring. As a part of their regular supervision work, DoS would also supervise the implementation of this project and the recapitalization process. Financial Reporting (IUFRs) NABARD will be responsible for all project financial reporting and regular FM supervision of the project. The DCCR will coordinate with Finance and Accounts Department (FAD) to ensure the timely production of quarterly interim un-audited financial reports (IUFRs). These reports will make use of existing financial reporting information in the NABARD s accounting system and additional information, as necessary, and will consolidate financial information for all components of the project. Information in respect of receipt of funds by PACS will not be available through NABARD s accounting system. However, this information will be generated through the MIS system and will be reconciled with the financial accounts to be sent along with quarterly financial reports (Interim Un-audited Financial Reports, IUFRs). IUFRs would cover (a) Sources and Uses of Funds for the project and separately identifying the components and activities of Bank financed project, cumulative and for the period; (b) Details of funds received at various levels for each of the WB funded states (Component 111, FRS) (c) Payments made against contracts subject to prior review by the Bank, (d) Disbursement category wise break-up for expenditures made under the WB financed component (e) Overall Sources and Uses of funds for assistance for each of the states, cumulative and for the period. In addition a list of CCBs that have received the recapitalization (under the FRS) at the end of the quarterly period, along with any amounts that are held as advances at any o f the three tiers will be maintained by NABARD and be made available during supervision missions. The reporting formats called as Interim Un-audited Financial Reports (IUFRs 1-5) have been agreed with NABARD and are also attached in the implementation manual. These financial reports will present evidence on the actual usage of funds in respect of the Component I, I1 and IV and transfers in respect of the FRS component (Component 111). The financial reports will also include details in respect of amounts transferred to the various levels and those remaining unutilized at the end of the reporting period, as specified in the World Bank loan legal covenants. It has been agreed that NABARD will transfer funds to the three ties of CCBs within reasonable time of the approval o f the Go1 Package by SLICs. FM Staffing The project s Financial Management arrangements and supervision will be managed by NABARD including professionals drawn from the relevant NABARD departments (including DCRR and the Accounts Department). NABARD will act as the Bank s counterpart for all FM issues like financial reporting, disbursement and external audits and it will be responsible to ensure implementation of agreed FM arrangements, including the generation of timely and accurate financial information and the preparation of quarterly Financial Monitoring Reports and their consolidation to be provided to the Bank through GoI. 62

75 Funds flow and Disbursement Budget: The MoF had provided a budget allocation of Rs 1500 crore in the year for the Go1 Package which has been released to NABARD for funding the SAs and the recapitalization of the CCBs in select states. It is understood that while a small part of this amount has been expended in funding the cost of SAs, the balance amount is presently lying with NABARD. The budget allocation for the year has been proposed at Rs 1500 crore. It is understood from the Banking Division that they may ask for a revised allocation as may be required later. It has been agreed that Go1 would maintain adequate budgetary availability of funds for this Package during the implementation of the project. Funds flow: The Bank s funds are expected to flow to such participating states (PS) that have signed MoUs with Go1 and NABARD possibly including: Gujarat, Haryana, Orissa, Uttarakhand and Uttar Pradesh. There will be a provision for adding or deleting states as the implementation of the project proceeds (Figure 7.1). All project funds will flow from Go1 (as grants) through NABARD. Upon effectiveness, funds for all activities under Components IV can flow; with the exception of funding for SA which will flow to a state once it becomes a Participating State (Le. has signed the MoU). Funds under Components I&II can be accessed after the CSA has been revised by the PS. Finally, recapitalization funds under Component I11 will flow to CCBs in a PS after: (i) the SAs are completed on a DCCB-wise basis; (ii) the state has contributed its proportionate share of funding; and (iii) Letters of Undertaking have been signed with relevant CCBs. With respect to Components I, I1 and IV, the expenditure would be directly incurred by NABARD for the purchase o f goods and services to be financed by these components of the project. For the FRS (Component 111), all project funds will flow from Go1 through NABARD to the CCBs. Once the SAs for all the eligible PACS under a given DCCB have been completed, the net payment to the PACS will be calculated after setting-off their overdue liabilities to the DCCB. At that point, the payment to the concerned PACS and DCCB will be credited into their accounts. After the SAs of all DCCBs in a state have been completed, payments due to the DCCBdSCBs can be calculated on the basis of dues from each DCCB, and the SCB would then receive its payment. It may be noted that all payments in respect of all components/activities under the project will be made by NABARD s Head office and/or Regional offices, so that the expenditures will be captured in NABARD s accounting system. With respect to the FRS (Component 111), the figures of the calculation of losses and netting between tiers are certified by the District and State Level Implementation Committees on completion of SAs. On receipt of this certification the respective states will confirm that their part of the contribution has been made available in full and that the payments have been sent to the CCBs. NABARD will credit all PACS, DCCBs and SCBs accounts through cash transferdcheques from the local NABARD regional office to the respective SCB. This transfer maybe made in the form of a payment order from NABARD s RBI account to the respective SCB account in RBI, with instructions for the accounts of DCCBs and PACS to be credited the net amounts calculated above. DCCBs usually hold saving bank accounts with SCB and similarly PACS hold their savings bank accounts with offices of DCCBs. These bank accounts will be used for crediting the FRS package and also for recovering the dues owed to upper tier. It will be ensured that funds given to a CCB would not be available for full usage till the over-dues to upper tier have been squared ofp. Once all eligible PACS in a district have been recapitalized to the required level, the DCCB will receive FRS. The SCB will be the last to receive FRS (Annex 4, 6). 41 A guidance in this respect will be issued by NABARD to the participating CCBs. 63

76 Disbursements: Bank-financed project funds allocated to Components I, I1 and IV will be disbursed on the basis of interim un-audited financial reports (KJFRs) evidencing actual expenditures, on the various components and activities of the project. Funds allocated to Component I11 (FRS) will be disbursed on the basis of actual transfers made to CCS in accordance with OP/BP 6.0, and reported in the IUFRs under two sub-categories, - the requirements for which are specified in the Go1 Package and the MoUs: 0 The first category of FRS funds will be for CCBs where an initial set of pre-defined reforms have been completed, which are (as mentioned earlier): SAs are completed DCCB-wise; CSA is revised; State contributes its share of capitalization funding; PACS, DCCBs and SCBs sign Letters of Undertaking with their respective DLIC and SLIC; 0 The second category of FRS funds will be for CCBs where a further set of pre-defined reforms have been completed, which are: elections to the Board conducted wherever due; professionals are either elected or co-opted to the Board as p& the fit and proper criteria as may be stipulated by the regulator; professional CEOs satisfying the qualifications as may be prescribed by the regulator are appointed; a sound system of internal checks and controls put in place by CCBs; CSA amended or special chapter incorporated. Component 111, actual expenditure is defined as the actual amounts actually transferred to CCBs accounts for recapitalization, and these figures will be consolidated for a districthet of districtshtate and certified by NABARD before including it in the IUFRs. As regards other components, the actual expenditure will be the expenditure actually incurred by NABARD as evidenced by the amounts booked in the monthly accounts of NABARD on the basis o f bills, invoices, receipts and other documents including payment vouchers, and certified by NABARD as the expenditure actually incurred. Any payments to CCBs, which are not in line with the Go1 Package, will not to be eligible expenditure under the project. An initial advance of US$ 100 million will be provided to Go1 to meet the expected expenditures in the first four months of the project (with a provision to increase this limit if necessary to US$ 150 million). While IUFRs will be submitted on a quarterly basis, Go1 would have the flexibility to seek reimbursement earlier than the quarterly intervals by submitting reports for shorter periods. The disbursement percentage for all project components will be set at 80 percent of the gross expenditures (i-e., 80 percent of GoI s share) as reported by NABARD/ Go1 through the ILJFRs and disbursements will be made to two Designated Accounts: one for IDA and the other for IBRD. This is based on the expected relative contributions of the Bank and Go1 in the states where Bank funds would be deployed. Retroactive financing up to an amount of US$ 50 million will be made available for all categories of eligible expenditures incurred after August 1,2006. Table 7.2: Eligible Expenditure Categories under the FRS Component Category 1 : Eligible goods, works, component I and IV Category 2 : Eligible goods, works, services and implementation costs for Component I1 Category 3 :Recapitalization Funding under Component I11 (FRS) Category 3a: First Disbursement Category 3b: Second Disbursement Total I USD 25 mn services and implementation costs for I I USD 80 mn USD mn USD mn USD 600 mn 80% of the gross expenditures 80% of the gross expenditures 80% of the gross expenditures 80% of the gross expenditures 64

77 Designated Accounts: Two Designated Accounts, one for IDA and the other for IBRD would be opened with the RBI by the Banking division, GoI, and an initial advance credited into it. This initial advance has been set at US$ 100 million and may be increased to US$ 150 million to meet the expected expenditures for the initial four months under the project. Replenishments would be provided to the Designated Accounts through the disbursement mechanism (IUFRs) as the expenditures are incurred by GOY NABARD on various components of the project. Statutory (External) Audits Entity Audi: NABARD s statutory auditor is appointed by GoI, usually for a continuous period of two years, and selected from the panel of CA firms that i s maintained by RBI for financial sector audits. Currently the audit is conducted by M/s Sharp & Tannan, CAS. An entity audit of NABARD will be submitted to the Bank within 6 months of the end of the fiscal year. Project audit: During the first two years of the project it is proposed to have a six- monthly statutory audit of the project. For this the financial statements will have to be prepared six-monthly in a format which is similar to the agreed KJFRs. After the first two years, the audit will be annual. The audit will cover the project in the Bank financed states (both for the recapitalization and the other components) and a certification of the aggregate project with Overall sources and uses of funds. This project audit will be conducted as per agreed Terms of Reference (TORS) by a firm of CAS acceptable to the World Bank. The auditors will certify in the project audit report the actual amounts transferred by NABARD to the SCBs and thereon to the DCCBs and PACS for recapitalization purposes, and verify that these amounts were as reflected in the IUFRs. A management letter, commenting on internal control and areas of improvement, will also be produced. The auditors report will be submitted to the Bank no later than three months after the closing of every half year for the first two years of the project and thereafter within 6 months of the end of every fiscal year. In addition, the Bank shall also receive the annual audit report of NABARD within six months from the end of each fiscal year. Table 7.3 lists the audit reports that will be monitored by the Audit Reports Compliance System: Agency Table 7.3: Reports Audit Report I be Monitored by the Audit Audited by Leports Compliance System Due Date DEA Designated Accounts audit report CAG 30 sep of every year NABARD Project audit as per agreed TOR including audit of Designated Accounts The Statutory auditors (An independent firm of CAS acceptable to the Bank) Within 3 months of the end of every 6months for the first two year of the project. Thereafter the audit will be annual and will be submitted after the end of 6 months of the fiscal year NABARD Entity Audit An independent firm of CAS, as appointed by Go1 30th September of every year 65

78 Project Implementation Manual A project Implementation Manual (IM) has been prepared and reflects the overall implementation arrangements & associated FM arrangements, including funds flows, disbursements and reporting, internal control and audit arrangements which have been have been finalized with the Go1 and NABARD during preparation. FM Supervision The project will require intensive supervision in the initial years to review the implementation of the agreed FM arrangements and progress in the implementation of the FM strengthening component financed under the Bank project. This approach will entail: (a) Supervision on a risk based approach with three missions a year and support by consultants for field missions. Thematic supervisions could also be conducted to provide specific focus on certain components of the project, like FRS. (b) Visits to a sample selection of states based on the extent of rollout of the project to supervise the FM arrangements (c) Implementation of the FM strengthening and TA program: Supervision will also include review of the implementation of the Common Accounting System, MIS and Internal Control System as envisaged within the project. (d) In addition the supervision could include a fiduciary oversight of the operations/decisions of the SLIC/ DLIC in so far as it pertains to PS, and do a sample verification of the approval of "accumulated losses calculations" by the SLIC. In addition performance reviews of some recapitalized PACS to assess if they are now working as per prudent business practices and are likely to be sustainable in the future will be undertaken. 66

79 I NABARD I I CCBS via SCB 1 I SCB 1 I CCBs Funds now from SC8 "4. DCCS Io PACS 1 When MoV tranche 2 conditions met NABARD I PACS, DCCBs, SCB Fund. flow from SCS VI. OCCS to PACS 67

80 General Annex 8: Procurement Arrangements INDIA: STRENGTHENING RURAL CREDIT COOPERATIVES PROJECT Procurement for the proposed project will be carried out in accordance with the World Bank s Guidelines: Procurement under IBRD Loans and IDA Credits dated May 2004 revised October 2006; and Guidelines: Selection and Employment of Consultants by World Bank Borrowers dated May 2004 revised October 2006, and the provisions stipulated in the Legal Agreement. The general descriptions of various items under different expenditure categories are described below. For each contract to be financed by the Loadcredit, the different procurement methods or consultant selection methods, the need for prequalification, estimated costs, prior review requirements, and time frame are agreed between the Borrower and the Bank project team in the Procurement Plan. NABARD has prepared a project Implementation Manual (M), which includes detailed procurement guidelines for guidance of the procuring agencies at all levels under the Project. Details on responsibilities with respect to issuance of the tender notices, receipt of the bids, bid evaluation, issuance of the acceptance letter, signing of the contract, etc. are indicated in the Manual. The basic principles are indicated in Attachment 1. NABARD s tendering process for NCB is in line with CVC guidelines and requirements, and is similar to the Bank s guidelines and requirements, the main difference being that NABARD follows a two envelope system. NABARD has confirmed that that the two envelope system will be implemented such that: (a) the technical and financial bids are opened in public; (b) the price bids are kept sealed at a safe place; (c) the date for opening of the technical envelope is indicated in the bid documents; and (d) bidders who qualify and have a responsive bid, are invited for the public bid opening of their price bids, while those who do not qualify are given one week to request a review. These guidelines have been issued to the SLICs in all Participating States to ensure consistency in approach and would be monitored by NABARD. Procurement of Works: Works procured under this project would include construction of small buildings for PACs on selective basis, and some rehabilitation works for cooperative training institutes. The amount would be very limited, costing less than USD 5,000 per contract, and would be procured following Shopping procedures. Procurement of Goods: The major procurement under the project involves purchase of computer hardware and software for the CCBs. The procurement will be done using a bidding document developed by NABARD in consultation with Bank. However, for ICB contracts, the Standard Bidding Documents (SBDs) of the Bank, as maybe revised from time to time, will be adopted. NABARD has prepared (a) new common accounting standards, (b) accounting and MIS data standards for PACS, (c) guidelines for the PS to produce IT strategies, initially for the PACS, and (d) accounting and MIS data standards for aggregation at the district and consequently the state-level and the guidelines for related IT strategy approaches by the PS, which would determine the procurement requirements at the state-level. Most procurement under the project will be at the state-level. The SLIC in each PS will be entrusted with carrying out the procurement in line with NABARD s guidelines as described in the Implementation Manual. The contract will be signed by the SCB in each participating state and NABARD will make the payment and will monitor compliance with the procurement procedures. 68

81 The procurement of a large number of computers for a large number of geographically dispersed PACS renders the procurement complex and risky. Adoption of state-wise procurement as against centralized procurement makes the contracts manageable as also the numbers and logistics. As such, the procurement risk is substantially reduced. There will be three major procurement components in the contracting stage: (a) acquisition of the applications software and its ongoing maintenance and enhancement. Procurement would mostly be done competitively, though there may be cases where single-sourcing can be justified if a State has already progressed sufficiently in implementing. (b) Hardware procurement, competitively throughout, in bulk, in one or a few stages closely coordinated with roll-out (c) Roll-out services, data entry of the initial database, users training which will be procured competitively in parallel with the hardware procurement. The Procurement Plan for the first 18 months has been prepared. Selection of Consultants: This may include hiring of Consultancy Services under Components I, I1 and IV, including consultancy services for procurement, support for management of IT component, advisory consultancy teams to work with NABARD staff on the design and implementation of monitoring framework, etc. Short lists of consultants for services estimated to cost less than USD 500,000 equivalent per contract may be composed entirely of national consultants in accordance with the provisions of paragraph 2.7 of the Consultant Guidelines. Training: In addition to a large IT component, the project supports substantial capacity building of CCBs and others. This will be delivered through training, which will be carried out in accordance with periodic plans and budgets to be prepared by NABARD. The training requirements, training strategy, and training modules, have been finalized by NABARD. The bulk of the training will be provided by specialized training institutes, such as the Bankers Institute for Rural Development (NABARD promoted), College o f Agricultural Banlung (RBI promoted), and various state-level cooperative training institutes. While these institutes are defined as autonomous, they often depend upon the State/Cooperative Sector for their finances in part or full. However, there is no comparable expertise available in the private sector. NABARD/SCBs will sign MoUs with these institutes. The MoUs will indicate the number of batches to be trained, number of persons per batch, fees per person, which will be based on the data available from previous training of similar nature. These MoUs will also include service benchmarks with respect to the quality and level of training. Operational Costs: administrative procedures of NABARD, which were reviewed and found acceptable to the Bank, would be followed for financing these costs. Others: The Project will support recapitalization of eligible CCBs, however, there is no procurement in this component. B. Assessment of the Agency s Capacity to Implement Procurement An assessment of the capacity of NABARD/other State agencies to implement procurement actions for the project has been carried out by Bank procurement staff which involved a review of the organizational structure for implementing the project and interaction with concerned staff responsible for IT procurement, administration, and finance. The IT Unit in NABARD is headed by an offcer of the rank of Chief General Manager. Their main function is to play the role of technology provider with respect to Information System (IS) and IT needs of NABARD so as to enable users to employ state-of-the-art 69

82 technology on a continued basis to achieve their goals, as well as develop and maintain the corporate database. As such, the concerned staff of NABARD is well-versed in the preparation of technical specifications for the IT component. However, except for some consultancies to be procured by NABARD, the bulk of the procurement would be done at the state-level where, as mentioned earlier, SLICs would be in charge of technical and operational decisions on procurement. The SLICs are composed of members having administrative, financial, and audit background. Nevertheless, there is a need to enhance IT-related project procurement capacity at State level. NABARD will ensure that sufficient expertise in IT related procurement is made available to all the SLICs. A procurement assessment identified the need to enhance the procurement capacity of SLICS, with a particular focus on the procurement of IT equipment under Bank-financed projects. This will cover support to SLICs to build up the required expertise in the preparation of bidding documents, preparation of tender notice, invitation for bids, receipt, opening, and evaluation of bids, finalizing of the contract, and the administration of contract which, besides other things, include ensuring compliance with the contract conditions, payment terms, variations, dispute resolution, monitoring etc. To achieve this, NABARD and the PS will use the services of IT experts, including from organizations like NICSI, who have the necessary experience in IT procurement. These efforts will be supplemented by training of SLIC members. An initial workshop to familiarize the SLIC members in procurement processes will be arranged by the Bank some time during June 2007; this will be followed up by continuous capacity building support to be provided under the project s Component IV. The support will be reviewed after six months of implementation to assess the need for further capacity building efforts. Procurement Risks and Mitigation Measures. For the reasons mentioned above, the overall project risk for procurement is high. Nonetheless, this risk is substantially lowered by the decision to undertake state-level procurement and by actions initiated to build IT procurement capacity for SLICs. An Action Plan to mitigate any remaining risks has been developed by NABARD. Apart from the efforts to strengthen the capacity of SLICs mentioned above, the key elements of the action plan are as follows: SLICs will determine the number and locations of PACs requiring IT equipment prior to proceeding with IT procurement; A strong monitoring mechanism i s being established; NABARD/SLICs will publish information of all contracts above Rs 1 million on website to bring about transparency in decision making; SCBs/SLICs will maintain all the records relating to procurement; SCBs/SLICs will also maintain a separate record relating to complaints and their redressal. Prior Review Goods and Equipment: All ICB contracts. Consultancy Services: All contracts above US$ 200,000 equivalent. Post Review All contracts not covered under prior review will be subject to post award review. This review shall be done as follows: 70

83 0 A sample of contracts will be selected on random basis annually for the post award review by the Bank or its representatives. Bank supervision missions will also conduct post award review of selected contracts. 0 NABARD will provide semi-annual information on MOUs signed with the training institutes. NABARD will also provide, on semi-annual basis, information relating to the training provided by such institutes, such as number of batches, duration of training, number of participants, expenditure per participant, etc. 0 Statutory Audits: The statutory audit for the project will be conducted as required under relevant provisions for the specific institution, which will also review the procurement procedures adopted and give a report accordingly. Procurement Plan NABARD has developed a Procurement Plan for the first 18 months of project implementation which provides the basis for the procurement methods. This plan has been agreed between NABARD and the Bank on May 24, 2007 and is available in the Project s database and in the Bank s external website. The Procurement Plan will be updated in agreement with the Project Team annually or as required to reflect the actual project implementation needs. Procurement Thresholds: All contracts of goods above USD 2,000,000 to be procured following ICB procedures. The contracts between USD 2,000,000 and USD 100,000 to be procured following NCB procedures. The contracts below USD 100,000 may be procured following Shopping procedures. During The first 18 months, no ICB contract is anticipated. Proprietary items and software may be purchased following Direct Contracting procedures. D. Frequency of Procurement Supervision The Bank will carry ex-post and supervision missions on Procurement twice a year. 71

84 Attachment 1 NCB Procedures The Process of Procurement will be Transparent, providing equal opportunity and should not place unnecessary restrictions on bidders. Wide publicity should be given to the Notice Inviting Tendedhvitation For bids. The Notice should be published in at least one leading daily Newspaper. Wherever possible, the Notice should also be published on purchaser s website. Bidders should be given sufficient time to purchase documents and prepare the bids. Normally, this should not be less then 30 days. In addition to Tender box, bids submitted by post or courier should also be acceptable. The financial bids should be opened publicly in the presence of bidders or their representatives who chose to remain present. The bids should be evaluated in terms of provisions of bidding documents. There should not be variation between conditions in bidding documents and the Contract Agreement. The evaluation should be fully documented. No bids should be rejected unless there are clear and logical reasons and the same should be fully documented. All important documents (e.g. bill of quantities, technical and commercial conditions, price bid, letter of Intent, Agreement) should be signed by both parties and the records should be properly maintained. Pre dispatch inspection should be ensured whenever required. There should be no negotiations, even with the lowest bidder except in exceptional circumstances. The exceptional circumstances should be defined before the procurement process takes place. NABARD follows a two envelope system which has the following safeguards: (a) technical and financial bids are opened in public; (b) price bids are kept sealed at a safe place; (c) the date for opening of the technical envelope is indicated in the bid documents; and (d) bidders who qualify and have a responsive bid, are invited for the public bid opening of their price bids, while those who do not qualify are given one week to request a review. 72

85 Annex 9: Economic and Financial Analysis INDIA: STRENGTHENING RURAL CREDIT COOPERATIVES PROJECT Economic Analysis The viability of India s CCS is undermined by a combination of factors that can be grouped into four major areas: (a) an inadequate legal and regulatory framework; (b) poor governance; (c) weak operational capacity; and, (d) problems related to size, scope and scale, which undermine cost efficiency (these problems are not unique to India s financial cooperatives). Several key factors have been identified in the literature as critical to the long-term survival and development of Cooperative Financial Institutions (CFIs) and the realization of their full potential to serve low-income clients. 42 These factors include the quality of the management and operations of CFIs, the benefits of networks to ensure efficiency and sustainability, and the role of legal frameworks to encourage this potential; whether the legal and regulatory framework should be uniform for all CFI or whether it should be tiered; and, the effects of different supervisory arrangements on the governance and performance of CFIs. The project addresses these factors and supports the implementation of extensive reforms in all four major areas, with the aim of ensuring the long-term viability of the CCS. Lessons from four case studies in Burkina Faso, Brazil, Kenya and S~i-Lanka~~ point to many cross-cutting issues pertinent to the long-term viability of financial cooperatives. They argue that on the one hand, business models of institutions-that is, the nature of the clientele served, level of integration as a network, governance and staffing, types of operational systems, types of products and services, and so on-are influenced by external factors (such as the level of financial sector development; the legal, regulatory, and supervisory environment; the role of donors, technical assistance agencies, and political factors; and historical and cultural factors). On the other hand, CFIs themselves often have an influence on some of these factors. The four case studies showed that CFIs can successfully provide financial services in rural areas in developing countries, and that they can do so while being profitable. The major advantage of CFIs over typical MFIs is their ability to offer deposit services, which are increasingly recognized as the financial services most demanded by low income communities. Furthermore, because rural CFIs charge interest rates that are significantly lower than those charged by their MFI and informal competitors, an increase in the interest rates they are able to charge to levels closer to the market rate can improve their profitability. Generally, CFIs have operated better in a regulatory environment that has adequate prudential regulations and the supervisory mechanisms necessary to enforce them. Diversification, on a geographic basis and by income levels of clientele, seems to have helped all the financial cooperative networks studied to scale up in a sustainable way. Because the marginal cost of transactions is not closely correlated with the size of transactions, a mixed clientele effectively allows CFIs to serve their lower-income clientele by providing larger loans without having to charge the higher interest rates or fees typically charged by MFIs that exclusively serve low-income clients. The question of how the level of integration of CFIs is related to CFI performance could not be definitively settled from the case studies. An analysis of Mexico s PATMWBANSEFI project points to similar conclusions44., While some trade-off was detected between financial viability and outreach in some institutions, many others managed to balance this trade-off by lowering transaction costs through higher volumes and larger loans. In the aggregate, the project has been able to achieve both its outreach and sustainability goals. This was a result 42 Carlos E. Cuevas and Klaus P. Fischer (2006) Cooperative Financial Institutions: Issues in Governance, Regulation, and Supervision, World Bank Working Paper 82, Washington, DC: World Bank. 43 Ajai Nair and Renate Kloeppinger-Todd (2007), Reaching Rural Areas with Financial Services: Lessons from Financial Cooperatives in Brazil, Burkina Faso, Kenya, and Sri-Lanka, ARD Discussion Paper 35, Washington DC: World Bank. 44 Julia Paxton (2006), An analysis of Mexico s PATMIR Project, Ohio University. 73

86 of the project s emphasis on taking the time to invest in human capital in the institutions operating in a more marginal context; on the project being part of an integrated rural development strategy; on technical assistance to strengthen governance; and, on improved financial transparency through improved MIS and better accounting which helped the cajas perform better and the project to track and report implementation better. In India, institutional reforms, recapitalization, rationalization and legal, regulatory and governance reforms to be supported by the proposed project will address many of the weaknesses of the CCS and help it move towards sustainable financial intermediation through the creation of financially stable and prudently managed CCS institutions. An improved CCS would result in cost savings, efficiency gains, and better intermediation at lower costs for these institutions. In particular, the reforms address all four of these areas as follows: Inadequate regulation and supervision of the CCS The existing legal and regulatory framework for the CCS is inadequate and characterized by weak regulation, inadequate prudential norms, poor supervision and political interference. While the RBI i s responsible for the regulation of the upper two tiers of the CCS (with NABARD as the delegated supervisor), even in these tiers there is a problem of overlapping jurisdictions and dual control exercised by State Governments. Prudential regulations to provide the framework for sound supervision of the CCS have also been lacking. The project will address this problem through far-reaching reforms. Participating States will be required to pass new legislation or amend their existing CSAs to ensure that the regulation and supervision of the CCS is significantly enhanced and put on par with that of commercial banks, while reducing the supervisory powers currently vested in State Governments. In particular, reforms will facilitate the extension of the regulatory powers of the RBI over SCBS and DCCBs, and of NABARD, over PACS; ensure that all CCBs are required to adhere to prudential norms stipulated by the RBI (including CAR); and, ensure that fit and proper criteria are adhered to for election to boards of CCB s and for their management. Poor governance: The CCS is plagued by poor governance and State interference: elections for Boards of Directors of CCS institutions have not taken place for a long time, Boards are frequently superseded, and State Governments regularly interfere in day-to-day operational decisions. Most State Governments combine several roles: dominant shareholder, manager, regulator and supervisor, and auditor. Political influence on the CCS has had a consistently negative impact on the financial performance of the system. The project will address these problems by committing States to implementing the reforms necessary to create a democratic, self-reliant and efficiently functioning CCS by: (i) eliminating State Governments ownership in CCBs; (ii) ensuring full voting membership rights for all users of financial services, including depositors in PACS; (iii) removing State Government interference in all financial and internal administrative matters in CCBs, including removing the State Government s participation on the Boards of CCBs and limiting the powers of State Governments to supersede the Boards of CCBs; (iv) ensuring timely elections before the expiry of the term of existing Boards; (v) removing state intervention in all financial and internal administrative matters in cooperatives; (vi) withdrawing restrictive orders on financial matters; and, (vii) permitting cooperatives in all the three tiers freedom to take loans from, or place deposits with, the regulated financial institution of their choice. In addition, capacity building will be provided under the project to support member education, focused on small and marginal farmers who are members of PACS. This will involve developing and implementing a member education strategy, focusing on such areas as financial literacy, and better awareness of rights and responsibilities, among PACS members. Furthermore, training will be provided 74

87 for the members, management and boards of CCS institutions in governance issues, including agency responsibilities, rights and responsibilities of individuals and institutions, the new governance requirements, the new legal and regulatory framework, and stakeholder participation. The proposed reforms will introduce enhanced governance and a regulatory environment driven by prudential regulation, which would transform the legal, regulatory, and governance frameworks of the CCS and result in strengthened supervision of the system, and in setting-up the pre-conditions to make the cooperatives member-driven and member-focused. This is a crucial first step to bring India s CCS to a governance status akin to that of Mexico s CFIs at the outset of their reform process. Weak operational capacity: Management and staff of CCS institutions are often politically appointed and poorly qualified, internal controls are weak or non-existent, credit appraisal and financial management skills are limited, information technology and MIS is typically antiquated and dysfunctional (and mostly absent in the case of PACS), and the capacity to develop new products and services is lacking. In addition, PACS lending products are not suited to the agricultural cycle, and PACS lack the financial resources to meet credit demand: the majority of PACS lending is short term (less than one year) and aligned with the CCS financial year ending on 31 March, but not with crop cycles. As a result, one driver of the low average on time recovery rate (about 66 percent) on PACS lending is that repayment is required at a point in the crop cycle when farmers have a limited ability to pay because their working capital is tied up in a growing crop. Furthermore, a recent Bank study of the CCS45 found that a lack of crop insurance was one of the two main causes of insolvency in CCS institutions. Only about 15 percent of farmers are now covered by crop insurance. As a result, PACS are exposed to the risks posed by agricultural calamities such as drought and, because of their small size and lack of geographical and sector diversification, the impact of these risks can be catastrophic. The project will address these weaknesses by strengthening the management capacity of CCS institutions and providing the staff, management and Boards of the CCS with capacity building for: performance tracking and reporting; implementation of a new and enhanced common accounting system, MIShternal controls, and audit mechanisms; enhanced credit appraisal and risk management; business diversification and product development; and HR development. The project will also support financial management strengthening by developing a uniform accounting framework for the CCS at all levels (including PACS). It will also support the development of an IT platform that would help computerize and connect all three tiers of the CCS with a view to promoting the enhanced transparency of the CCS, including implementation of a new PACS-level accounting system and MIS. The institutional strengthening aspects o f the project will thus allow PACS and DCCBs to better assess the creditworthiness of their clients (who often lack stable incomes and collateral) at lower transaction costs, and PACS will also be able to diversify their service offerings to respond to the changing demands of rural areas and the growing significance of the rural non-farm sector, particularly the production of higher value crops and increased value addition by small farmers. Taken together with the improved financial condition of the system these factors should allow CCS institutions, including PACs, to borrow more funds in commercial financial markets and thus stem the outflow of rural savings. Finally, there are some fundamental economic factors of scale and scope that have constrained the viability of CFIs, and these include: (i) their inability to capture economies of scale sufficiently to provide affordable financial services to the poor (due to the existence of a large number of small CFIs 45 See the Report on Crop Insurance (2006), Washington, DC: World Bank. This critical problem was also identified as a major problem by a 2005 ADB-financed study of the rural financial sector in Rajasthan, West Bengal, and Andhra Pradesh; see Rural Finance Sector Restructuring and Development (2005), Manila: ADB. 75

88 resulting in high transaction costs); and (ii) their inability to diversify risks adequately (because their operations are restricted to small geographic areas). Various country experiences show that in order to achieve efficiency gains, creating economies of scale by pooling costs is a useful tool; at the same time, in order to achieve higher profitability and reduce the institution-specific impact of NPLs on solvency, pooling of risks should be considered as a risk mitigation tool. While networks of CFI s can go a long way in helping to achieve this, the level of integration desired, the extent to which the apex organization becomes a strategic hub, the right balance between subsidiarity and centralization, the trade-off between reduced volatility of failure risk associated with higher integration and the burden of financing an apex that increases with integration, are all questions that leaders of CFI movements around the world have to grapple with, and policymakers need to understand better. Drawing on cross-country experience, and especially on the Mexican experience, the project will include a strong focus on cost reduction by promoting networking and cost pooling, and by providing CCBs, acting as the apex of their respective State CCS, with a wide array of services (IT, legal, accounting, regulatory compliance, TA, liquidity management, etc.) that are subject to economies of scale. These initiatives will be supported through the project s TA and IT components. Efforts will also be made to gradually promote risk diversification: the consolidation of PACS and DCCBs that i s expected to occur over time should help reduce the geographical concentration of the credit risk exposure of PACS. In the medium to longer run, a market for credit risk swaps could be developed. Thus the reforms will assist in achieving the longer term goal of improving risk management, efficiency, cost structure, and long-term viability and sustainability of CCS institutions In addition, reforms such as: the freedom to set interest rates; the ability to offer deposit services as well as other payment services; the availability of greater financial resources from commercial sources and flexibility for the CCS to serve a mixed clientele; and, mechanisms to provide other products such as crop insurance, will help the CCS to diversify its risks and achieve lower transaction costs as a result of economies of scale. Impact of better access to finance on rural incomes and livelihoods The total membership of PACS is 127 million people, of which 37 percent (some 47 million people) are small and marginal farmers. Despite the extensive rural finance network in India there i s still a significant gap between the supply of, and demand for, reasonably priced rural credit. The distressed condition of the system has meant that a relatively small proportion of members receive credit from these institutions, or place their savings in them. Total formal rural credit comprises only about 26 percent of aggregate bank credit and only about 20 percent of marginalized groups have access to the formal financial sector. These low levels of access are caused in part by the fact that about 60 percent o f DCCBs are in some degree of financial distress and consequently unable to fully perform their intermediation functions in the rural economy. By improving the condition and performance of the CCS institutions it is expected that a better functioning system will be able to mobilize increased financial resources and leverage its capital more efficiently to channel larger volumes of credit to rural areas (Figures 9. 4 and 9.6), thus helping to bridge the supply-demand gap in rural finance. 76

89 lihood of catastrophic inco dequate credit has been of the activities needing, some 59 percent of rural respectively. A significant body of research points to a close link between better access to finance and improved livelihoods. A key finding of economic and sector work is that well developed and inclusive financial systems are generally associated with rapid growth and better income distrib~tion~~, Access to finance helps the poor catch up with the rest of the economy as it grows and also helps extend the range of individuals, households, and firms that can get a foothold in the modem economy while helping to reduce damaging concentrations of economic power. There is now a growing body of theoretical and empirical literature showing that broader access to finance helps an economy produce more, and distribute income more fairly47. Both consumers and producers benefit, as their welfare and productivity are raised48 46 For a summary, see, for example, Patrick Honohan et. al. (2005), A Note on Financial Access Indicators, Washington, DC: World Bank. 47 For a producer, access to credit for fixed or working capital enables an increase in production possibilities which can have farreaching implications not only for the producer but for patterns of employment, occupational choice and even economy-wide productivity and growth. 48 For a good discussion on the microeconomic underpinnings of the welfare implications of improved access to financial intermediation, see Improving Access to Finance in Brazil, World Bank (2003). The study points out that intermediation enables inter-temporal choices in consumption and investment for the individual, allows the determination of the cost of capital and hence helps guide investment to its most productive use, and permits the social reallocation of savings from low to high productivity uses thus raising social welfare. 77

90 Improved access to finance could also have longer term welfare implications, permitting people to borrow when young (for example, for education or for other physical or human capital investments) and then repay and save for retirement when they are older4 as a result of the increased income which such investment creates. In addition, increased access to less expensive financing would also reduce the extortionate interest costs paid by small and marginal farmers to moneylenders, which is often higher than their earning capacity, and can result in bankruptcy and extreme poverty. Improved access to formal credit should enable small and marginal farmers to substitute borrowing from moneylenders (at rates in the range of 35 to 60 percent per annum) with formal borrowing from PACS (at rates o f about 12 to 13 percent). Moreover, by virtue of also supporting non-farm activities, successful institutional reforms of the CCS and the development of new non-agricultural credit products could contribute to increased diversification of household economic activities, improving income security. To summarize, reforms of the CCS will, over time, help increase rural household incomes through: (i) increased access to financial resources and assets; (ii) lower costs of borrowing; (iii) higher returns from farming; (iv) increased diversification of household economic activities; and, (v) possibly increased household participation in economic activity resulting from increases in the number and intensity of both farming and non-farming activities. Impact on broader rural economy By working in parallel with other rural development initiatives, such as the development of crop insurance and agricultural marketing reforms, the project should contribute to better overall economic performance of the rural sector resulting from the more efficient use of financial services and increases in the number of rural borrowers and volume of credit from formal institutions. Through the increased availability of finance from the CCS, better access to productive resources (farm inputs, improved agricultural technologies, and better rural infrastructure) and increased overall economic activity and wealth, the project could thus potentially contribute to the transformation of the rural economy by empowering small and marginal farmers and increasing their participation in economic development, and provide an opportunity for low income households to realize significant social, equity, and poverty reduction gains. In addition, as the major institutional provider of agricultural production credit, a well functioning CCS will positively affect the backward (inputs) and forward (marketing) linkages of the rural economy and their integration with other services used or provided by the rural cooperative system. Lastly, phasing out State Governments interference in the system would restore the autonomy of the CSS institutions as member controlled and owned financial intermediaries. The transformation of PACS into genuinely member controlled entities would mean that they would be increasingly driven by the priorities of their members rather than the States. Individual institutions would be more self reliant and autonomous, and more capable of articulating local issues and mobilizing local resources, and thus enhance the bargaining power of local communities, widen options for income generating activities, and enhance local control over factors of production. Impact on future fiscal burden While the project involves a substantial stream of expenditures over the next three to five years, creating a sustainable and viable CCS would reduce the future fiscal burden for GoI. First, the 49 The life cycle hypothesis as an explanation for savings and borrowing behavior, discussed in Ando, Modigliani and Brumberg in a series of articles in the 1950s and 1960s. 78

91 Government s insistence on transformation of the legal, regulatory and governance frameworks of the CCS as a precondition for the provision of FRS assistance would ensure that it will not have to bail out the CCS again in the future, as it has done repeatedly in the past due to the failure of previous programs to address the fundamental problems of the system. Second, further postponing the reforms and recapitalization would only add to the final costs of restructuring the CCS (because operating and credit losses would continue to accumulate) and would have an adverse impact on access to rural finance in the interim. Third, as discussed above, the alternative of liquidating the CCS would involve substantial financial and political costs, as well as social and economic dislocation costs that are deemed to be untenable as compared to the costs of implementing the Go1 Package. In conclusion, by transforming the CCBs into more effective, efficient and commercially sustainable providers of financial services, the project will help the poorest households in rural India - small and marginal farmers -to access formal financial services more readily, increase the amount of financing available from the formal sector, reduce borrowing costs, and reduce dependence on moneylenders, who charge exorbitant rates of interest. It is expected that the reforms envisaged under the project would help expand the membership of the CCS (including small and marginal farmers). Furthermore, the team s analysis indicates that, by strengthening PACS and their upper tiers, the project would result in a 2.5 times increase in the credit volume outstanding from the CCS over a five year period, to about US$ 40 billion (equivalent). The investments in institutional capacity building and IT proposed under the project would help improve PACS efficiency. Beyond credit, the project is expected to help the CCS provide a wider range of financial services, such as savings, money transfers, insurance, etc. Better access to these services would help the rural poor to protect themselves against periods of low income or unexpected fluctuations in income (for example, caused by drought or crop diseases), and help to maintain consumption levels (through the accumulation of financial saving^).^' Access to cheaper and more plentiful credit (from PACS instead of moneylenders) will provide small and marginal farmers not just with the immediate resources necessary for consumption spending, but also with financing for productive investments that can help improve agricultural productivity and also contribute to the diversification of household economic activities, thereby increasing incomes and improving livelihoods. Financial Analysis Financial condition of the CCS The CCS institutions, RRBs and the rural branches of commercial banks, together account for 28 percent of the deposits and 27 percent of the loans of the Indian banking system (see Table 9.1 for key balance sheet size indicators for the CCS). With its vast branch network, the CCS has about 60 million borrower accounts, accounting for over two thirds of the number of rural borrowers and rural branches, and about a third o f the credit disbursed in rural areas. While the share of the CCS has been declining over time, it still remains a very important Figure 9.1: Condltion of Rural Credit Cooperatives in India 57% I 50% 30% 1 StCBs DCCBs PACS 50 The role of savings and borrowing in protecting consumption against unexpected shocks, first discussed by Milton Friedman (1957) in the permanent income hypothesis has since been extensively tested empirically, as discussed in Bond and Townsend (1996). 79

92 Table 9.1: A Profile of Rural Co-operative Credit Institutions* (As at end-march 2005) SCBs DCCBs PACS. No. of Co-operative Banks ,08,779 Balance Sheet Indicators (Rs crores) i) Deposits 44, ,098 18,976 ii) Borrowings 14,608 22,568 40,250 iii) Loans and Advances Issued 44,452 66,266 39,212 iv) Loans and Advances Outstanding 37,346 73,091 48,785 v) Total LiabilitiedAssets 71,806 1,33,33, 75,407 * Based on reporting institutions ** Working capital Source: RBI, Report on Trend and Progress of Banking in India of mal finance, especially considering the average loan size channeled through the PACS (Rs. 6,637 or US$1505') is much smaller than that of the scheduled commercial banks (Rs. 31,585 or US$713), thereby indicating the CCS' important role in financial outreach to smaller farmers. However, the financial position of the CCS is severely impaired and the accumulated losses of the system have been estimated at approximately US$ 2 billion. Performance indicators are weak, and worsen going down the tiers of institutions (Figure 9.1). The weak Exvected financial imuact The widespreid financial distress of PACS 1 and DCCBs has been driven by the interplay of the Flgure 0.2: Impact of the FRS on the CRAR of 10 DCCBs... that would not merely help build the capacity and systems in all three tiers of the CCS but also -4.w% I -NlhR(S dwtimdfr.5 I 5' Vaidyanathan Committee Report, The problem of crop insurance is being addressed through separate Government initiatives to improve the National Agriculture Insurance Scheme, the main crop insurance program in the country. The National Agricultural Insurance Scheme provides insurance cover for food crops, oilseeds, and selected annual commercial crops. Indebted farmers (Le., borrowers of seasonal agricultural loans) are covered on a compulsory basis, while non-indebted farmers may be covered on a voluntary basis. NAIS has so far only reached about 18 million, mainly small, farms out of a total of about 120 million farms and has experienced recurring losses. The Bank is providing technical support to gradually increase the coverage of agricultural insurance and improve program design and performance. 80

93 The impact of the FRS on CCS institutions will be to restore their solvency, enable them to achieve sustained profitability, and significantly improve their ability to attract additional public and private financial resources for intermediation through Figure 9.3: Impact of the FRS on the ROA of 10 PACS to farmers. These positive financial effects can be DCCBs demonstrated by modeling the impact of the FRS on 2 Wh DCCBs (which are the primary conduit for PACS refinance and thus provide a proxy for the performance I Wh of their member PACS) at both the systemic and micro 0 0% level. Ten DCCBd3 (half of which had negative capital.i Wlt in 2005) from eight states have been analyzed using conservative assumptions and their performance has -2Wh been projected in two scenarios: (a) that they receive -3 Wk financial assistance equal to the amount of retained -4 Mp/I losses as of 31 March from the FRS; and, (b) DCCBs do not receive FRS assistance but still benefit in -5 Wk the form of improved credit quality (i.e. lower provisioning costs) from the legal and governance reforms required by the Go1 Package. This analysis shows that, over a five year period following receipt of financial assistance in 2007, the DCCBs CRAR should rise from an average of minus 0.88 percent to 9.08 percent (Figure 9.2). In the same timeframe, return on assets (ROA) should show consistent improvement, rising from 0.07 percent to a 1.46 percent by the end of the period (Figure 9.3), providing a good indication that the DCCBs will be able to achieve sustained profitability. Lastly, the dramatically improved CRAR and profitability of the DCCBs should enable a substantial increase in their lending because they would achieve the creditworthiness required to increase their borrowing and attract additional deposits (Figure 9.4). The FRS thus has the effect of providing a decisive halt in the present downward spiral of the DCCBs and restores them to sustainable financial health. Systemic analysis (using data consolidating all DCCBs) 453 m Flgure 9.4: Impact of the FRS on Lendlng by 10 DCCBa XC4 2cQ5 2oJ9E Xa7E 2MBE 2W8E 2010E 20flE 2012E INR Lakhi I 1 1 using the same assumptions demonstrate equivalently positive results from DCCBs participation in the FRS (Figures ). Despite benefiting from a reduction of provisioning costs as a result of the legal and governance reforms, the position of the DCCBs if they do not receive assistance fkom the FRS reflects continuing financial weakness, which is driven by the inability to sufficiently improve their ROA without a capital infusion to relieve the burden of their nonperforming loan portfolios. In turn, their financial distress severely limits their ability to increase lending by making them increasingly less creditworthy intermediaries for lenders and depositors, restricting their capacity to increase the amount of funds raised for new lending. 53 DCCBs were selected using stratified random sampling. The DCCBs are: Akola (Maharashtra); Boudh (Orissa); Ganvhal (Uttaranchal); Jabalpur (Madyha Pradesh); Jaisalmer (Ragasthan); Jalna (Maharashtra); Kodinar (Gujarat); Kumool (Andrha Pradesh); Mau (Uttar Pradesh); and, Surendranagar (Gujarat). 54 The results of the analysis indicate that the amount of assistance provided by the FRS using 2004 losses as the basis for calculation will provide a sufficient cushion to absorb any additional losses incurred by the DCCBs since

94 The analysis of the DCCBs has been carried out using conservative assumptions regarding the beneficial impact of non-financial components of the Go1 Package: Figure 9.5 impact of the FRS on DCCB Systemic ROA zap/. :A I 1,m/...,,mi w...,m/... l.ap/ XC6 XC6E m7e ZCC8E mbe 23lOE 23lE First, financial performance has been projected on the basis that credit quality will improve less quickly than the improvement seen in the period 2003 to 2005 (the most recent data available), where provisioning requirements were reduced by about 19 percent on an annual basis, whereas the analysis has assumed that this annual rate of improvement would fall to 10 percent, and the amount of provisions would rise in absolute terms. In reality, the dramatic changes in the governance of DCCBs and PACS which the new CSAs will bring, reinforced by improved management, training, and new and lower cost (due to pooling of facilities) IT systems, should enable the DCCBs to improve credit quality at a faster rate; and, 0 Second, the analysis has assumed that DCCBs financial spreads will remain about the same. Accordingly, the analysis shows a decline (from 5.39 percent in to 4.26 percent five years later) in the DCCBs net interest margin as DCCBs adopt a prudent approach by slightly increasing their liquidity from about 13 percent of total assets in 2007 to about 16 percent of total assets in To summarize, analysis of the impact of the FRS at both the systemic and micro level provides a strong basis for concluding that it will be able to deliver effective financial assistance to the CCS and consequently, to rural credit consumers, by enabling them to access much greater amounts of reasonably priced credit. The analysis also demonstrates that the benefits from the FRS would be heavily leveraged: in the case of the 10 DCCBs analyzed, credit availability is increased by about 101 percent over five years (versus 61 percent without the FRS), leveraging the amount of assistance provided by about 10 times. On a systemic basis, the analysis indicates that the FRS should increase lending by about 112 percent (versus 61 percent without the FRS) leveraging the amount of assistance provided by about 23 times. The leverage impact of the FRS at the systemic level is higher than for the 10 DCCBs because the system as a whole has a higher starting level of statutory capital and reserves. This means that at a systemic level the FRS assistance creates more total capital available for leveraging. Because positive capital is highly concentrated in disproportionately few DCCBs the leverage results shown for the 10 DCCBs are more representative of the expected results from the FRS than the systemic results. 82

95 In considering the benefits of the FRS it should also be borne in mind that this analysis has not incorporated the positive impact of assistance provided directly to PACS by the FRS, whose own financial resources available for lending would be increased by compensation for past operating losses paid in cash, recovery of fully provisioned nonperforming loans, and a new ability (and the creditworthiness needed) to borrow from commercial banks and raise additional funds from member deposits. Figure 0.1: Impact of the FRS on Sytem-Wide DCCB Lending 20,CW.CW 18.CW ,CW.CW 14,CW.CW ,CW.CW 10,030,~ 8.CW.CW 8.CW.CW... /... 2 Q4 2M) E 2WBE 2MXlE 201CE 2011E 2012E Figure 9.7: Impact of the FRS on Systemic CRAR of DCCBs 17m I i/ 11.m m m M7E 2m8E E M12E --C\MthFRS ----)-MthutFRS Net present value and internal rate of return analysis Conducting a standard net present value and internal rate o f return analysis for the project is not straightforward. This is because the Government s cost estimates are of necessity based on relatively old data, and because pending completion of the SAs the true amount o f losses incurred by the PACS cannot be reliably estimated. This in turn makes estimates of the increases in systemic liquidity, credit and the ensuing benefits uncertain. However, as discussed in the financial analysis section, it is possible to estimate both losses and benefits at the level of the DCCBs (where the data is also more recent) which, given their role as the primary source of refinance for the PACS, provides a reasonable proxy for the likely impact of the Go1 Package as a whole. The benefits to the beneficiaries of improvements in the condition of DCCBs arise from the substitution of increased amounts of formal credit for informal, producing a one-for-one increase in borrower incomes equal to the reduction in the interest cost incurred for borrowing. Further benefits, such as the positive impact on rural incomes of the ability to finance new rural economic activities and improvements in the supply and pricing of agricultural inputs could be substantial but have not been estimated. The costs of the FRS for DCCBs are as derived from the audited financial statements of DCCBs for March 31, 2004 (the calculation date for FRS assistance), with the FRS assistance impacting the DCCBs projected 2007 balance sheets (reflecting the moment when FRS assistance will actually be received). In order to calculate the net present value of the project, the cost of funding the project is assumed to be 7.55 percent, the rate on comparable maturity (5 years) Go1 bonds. As noted, the unavailability of accurate PACS data restricts assessment of the net present value and internal rate of return of the program to the proxy provided by the DCCBs. However, the results for a sample of 10 weaker than average DCCBs drawn from eight states that have signed up so far, are sufficiently positive - the NPV is estimated at Rs. 87 crores and IRR at 3 1 percent (Table 9.2) and at the systemic level, these values would be even higher. This provides a high degree of confidence that the project as a whole will have very positive rates of return. 83

96 Item Increase in available DCCB refinance with FRS Moneylender Minimum Interest Rate DCCB refinance rate to Rural Borrowers Substitution Cost Benefit Borrower Cost Savings on Interest Cost of FRS Net Benefit Discount Rate Net Present Value Internal Rate of Return 2008E 2009E 2010E E 2012E ,129 30% 27% 24 % 23% 22 % 14% 14% 14% 14% 14% 16% 13% 10% 9% 8% % % 84

97 Annex 10: Safeguard Policy Issues INDIA: STRENGTHENING RURAL CREDIT COOPERATIVES PROJECT Safeguard Policies Triggered Environmental Assessment (OP/BP 4.01) Natural Habitats (OP/BP 4.04) Forests (OP/BP 4.36) Pest Management (OP 4.09) Yes No TBD X X X X 1 Phvsical Cultural Resources fop/bp 4.11) I 1 x 1 I Indigenous Peoples (OP/BP 4.10) Involuntary Resettlement (OP/BP 4.12) Safety of Dams (OP/BP 4.37) Projects on International Waterways (OP/BP 7.50) Projects in Disputed Areas (OP/BP 7.60) X X X X X Environmental Category: C The project is categorized as a Category C project from the Environmental Assessment point of view and it is unlikely that any of the Environmental or Social safeguards are triggered. However, a detailed Social and Institutional Assessment carried out with a sample number of PACS and DCCBs would help in identifying the specific reasons for the malfunctioning of the Cooperative Credit System in India in terms of lack of governance, accountability, transparency, inclusion etc. towards helping identify measures to address them. An assessment of governance systems in PACS and DCCBs for instance would require looking into their institutional issues, their modes of transparent and inclusive decision making, systems to avoid elite capture etc. and it is important that the focus of the proposed Social and Institutional Assessment is indeed on identifying ways of addressing each of these important areas. The 85