Cofinancing (US$M): c. Policy Areas: The policy areas included into the Program Document of the FIRM DPL were the following:

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1 Public Disclosure Authorized IEG ICR Review Independent Evaluation Group 1. Project Data: Date Posted: 03/25/2015 Report Number: ICRR14675 Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Country: Indonesia Is this Review for a Programmatic Series? Series ID: First Project ID: P Appraisal Actual Project Name: Financial Sector and Project Costs (US$M): Investment Climate Reform and Modernization Development Policy Loan L/C Number: Loan/Credit (US$M): Sector Board: Financial Systems Practice Cofinancing (US$M): Cofinanciers: Board Approval Date: 11/20/2012 Closing Date: 12/31/ /31/2013 Sector(s): General finance sector (50%); Banking (25%); Capital markets (25%) Theme(s): International financial standards and systems (40%); Other Private Sector Development (20%); State-owned enterprise restructuring and privatization (20%); Micro; Small and Medium Enterprise support (20%) Evaluator: Panel Reviewer: ICR Review Coordinator: Group: Lev Freinkman Jorge Garcia-Garcia Lourdes N. Pagaran IEGPS2 2. Project Objectives and Components: a. Objectives: According to the Program Document (PD, page 36), the objective of the Financial Sector and Investment Climate Reform and Modernization (FIRM) Development Policy Loan (DPL) was to promote the development of a sound, efficient and inclusive financial sector and support improvements in the investment climate in Indonesia to help the Government of Indonesia (GOI) achieve its medium-term economic development and poverty reduction goals. The Loan Agreement (LA) does not contain an explicit statement of project objectives. b. If this is a single DPL operation (not part of a series), were the project objectives/ key associated outcome targets revised during implementation? No c. Policy Areas: The policy areas included into the Program Document of the FIRM DPL were the following: (i) Financial sector stability. The focus of the program was to improve financial system stability through effective supervision and regulation. The primary emphasis was on institutional strengthening of key regulatory agencies and improving inter-agency coordination, specifically to provide for (a) establishment of a new powerful independent institution (OJK) responsible for regulation and supervision of all financial services; (b) setting-up a comprehensive financial crisis management framework, based on clearly spelled-out rules for monitoring, prevention, and information sharing; and (c) strengthening a regulatory framework for deposit insurance system. Yes No (ii) Financial sector diversification. The program aimed to accelerate the development of non-bank financial

2 institutions (NBFI), especially within the capital markets and insurance sector. Historically the financial sector of Indonesia has been dominated by commercial banks, which hampered adequate mobilization of savings and financial risk management. To address this structural deficiency and facilitate diversification, the program promoted steps aimed at (a) strengthening governance and transparency requirements for capital market participants; and (b) improving regulation of the insurance sector to advance financial soundness and corporate governance of insurance companies. (iii) Financial inclusion. The program objective was to increase availability of financial services for the poor and underserved. The primary tool for this was the preparation of a National Strategy for Financial Inclusion (NSFI) as a framework document to guide and coordinate actions of various stakeholders across the government. In addition, the program supported several specific interventions to enhance financial inclusion, including: (a) broader usage of TabunganKu low-cost savings accounts; (b) expansion in the small business credit program (KUR); and (c) a pilot scheme for disbursement of government conditional cash transfers (PKH) via bank accounts. (iv) Investment climate. The program also supported government policies intended to improve the overall business environment and strengthen economic competitiveness. It focused in two specific areas: (i) improving policy coordination and regulatory certainty by developing a Government regulatory reform action plan, and (ii) strengthening institutional arrangements for contract enforcement through modification of the judiciary procedure to allow for small claims courts and specialized commercial courts. d. Comments on Project Cost, Financing, Borrower Contribution, and Dates: The program was appraised on October 9, 2012, approved by the Board on November 20, 2012 and became effective on December 14, The original loan amount of US$100 million was disbursed in full upon effectiveness. The original loan closing date, December 31, 2013, remained unchanged. 3. Relevance of Objectives & Design: a. Relevance of Objectives: Relevance of Objectives : High The objectives of the FIRM DPL were fully consistent with the key priorities and expected outcomes of the current World Bank Group Country Partnership Strategy (CPS, Fiscal Years ) for Indonesia. The FIRM DPL was explicitly mentioned in the CPS in the section on financial sector support within the first CPS Pillar. Under the same Pillar, the CPS also underlined a need for investment climate reforms to encourage growth in private investments. Furthermore, the current CPS clearly states that one of the key outcomes of CPS implementation would be the preservation of financial sector stability, deepening of financial markets, and enhanced access. The reforms supported under the FIRM DPL were also well aligned with the objectives of the Government s own longer term development strategy, the Master Plan for Acceleration and Expansion of Indonesia s Economic Development (MP3EI), launched in May The Master Plan also prioritized the role of the private sector as a key driver of economic development and growth. In this context, the Government emphasized strengthening and diversification of the financial sector, in particular on its ability to operate in a sustainable manner in a challenging external environment. According to the ICR, improving economic competitiveness by creating a healthier business climate was one of Indonesia s national priorities for as stated in the Government s earlier development plan (RPJMN). This also reflected a broader concern about impact of administrative barriers on private sector investments (Indonesia was ranked quite poorly by the IFC s Doing Business th in 2011). b. Relevance of Design: Relevance of Design: Modest The causal chain of the operation, as it related to the design of the first three pillars (financial sector reforms), was generally convincing. It was linking fiscal and policy support from the Bank to a) the improvements in capacity of various financial sector regulators, and b) reduced barriers for expansion in up-take of several financial products that mostly bring benefits to the lower-income groups. These regulatory improvements in turn have a direct link with improvements in expectations and perceptions of market participants, which in turn have

3 supported strengthening financial market confidence, enhancements in financial inclusion, and deepening and diversification of the financial system. At the same time, the project design shows a significant weakness related to the weak alignment of the investment climate pillar with the Government s reform momentum. The investment climate prior actions did not directly address the core problems of domestic business environment, such as e.g. high administrative barriers for new entry. Instead, under the Pillar 4, the project intended to reduce those regulatory barriers that were seen as important to facilitate FDI inflows. But the project design underestimated the risks associated with the emerging protectionist and nationalistic pressures in Indonesia, which ultimately undermined the government s interest in the FDI-facilitating reform agenda (ICR, paras. 16 and 30). It is worth noting that originally the Bank did not plan to include the investment climate pillar into the FIRM reform program, being concerned about associated risks, but later it agreed to do this at the Government s request (ICR, para. 43). In hindsight, the inclusion of this pillar seems to be a mistake. The follow-up DPL operation did not contain this pillar and had an exclusive focus on the financial sector, the area where the Government has shown strong reform ownership. 4. Achievement of Objectives (Efficacy): Objective 1: Promote the development of a sound financial sector Substantial The Authorities took further steps to strengthen the regulatory framework in the financial sector. The new regulator of financial services, OJK, fully took over the regulatory and supervisory authority for capital markets and non-bank financial institutions in January 2013, and for the banking sector in January The Financial System Stability Coordination Forum (FKSSK) has been established as a new body responsible for maintaining financial stability. Bank Indonesia has enhanced the regulatory framework for the banking sector through issuance in December 2013 of Regulation No.15/12/PBI/2013 addressing the issue of minimum capital adequacy for commercial banks. The Deposit Insurance Regulator (LPS) has made steps to strengthen its compliance with the International Association of Deposit Insurance core principles. Specifically the new system of differentiated premium rates has been adopted in Several of these reforms were undertaken as part of the preparation of the follow-up Bank operation, Financial Sector Reform and Modernization DPL. This regulatory progress has had a positive effect on market participants confidence and investment practices, which brought broad-based improvements in the indicators that reflect health of the banking sector. Capital adequacy ratio (CAR, capital over risk weighted assets) of the banking sector as a whole has increased from 17.6% in mid-2011 to 18.13% at the end-2013 against the DPL target of %. The share of non-performing loans fell to low 1.77% at the end-2013, against the DPL target of 3.8%. According to the IMF (Art. 4 Report, Dec. 2013, pp ), Indonesia s financial soundness indicators generally improved and compared favorably to its major peers. The banking system appears sound as a whole, with systemic risk remaining low. The FKSSK plays the central role in guiding crisis management responses through the established rules of coordination across various regulators. However, Indonesia s financial sector remains vulnerable to various risks and there are still significant gaps within the crisis management framework (ICR, para. 22). Objective 2: Promote the development of an efficient financial sector Substantial The Government has taken steps to improve efficiency of the financial sector, in particular by advancing diversification of the sector and strengthening the regulatory framework for its non-bank segments. Specifically the new comprehensive regulation (PMK No. 53/2012) for insurance companies was made effective on January 1, The regulation entails an increase in the minimum capital requirements for insurance companies, which would promote consolidation and strengthening of the industry, which historically has been quite fragmented and under-capitalized. In addition, in January 2013 the Government enacted a new law on Micro Finance Institutions (Law No. 1/2013). These regulatory changes helped to improve market perceptions and encourage additional investment leading to the accelerated development of non-bank financial institutions (NBFI): the share of NBFI in total financial assets is estimated to reach 24% as of December 2013 (WB staff estimate reflecting the latest data available) against the baseline of 20% at the end of 2011 and the DPL target of 22%. Still the share of NBFI in Indonesia remains quite low compared to the peers, such as Malaysia. Objective 3: Promote the development of an inclusive financial sector - Modest The authorities have continued their work to finalize the preparation of the National Strategy for financial inclusion and a new Presidential Decree formalizing the Strategy is expected to be issued shortly. Meanwhile, various

4 government stakeholders have rolled out their own plans to implement policies aimed at enhancing financial inclusion in their respective areas of responsibility. Specifically, in July 2013 the Financial Services Authority (OJK) has issued Regulation No.1/POJK.07/2013 on consumer protection in the financial services sector. The dedicated financial consumer care center was established and made operational since On November 19, 2013, the President of Indonesia issued the National Strategy on Financial Literacy, and the financial literacy program has been launched under the OJK s guideline. Furthermore, in December 2013 Bank Indonesia issued the revised guidelines for no frills savings accounts (TabunganKu, introduced in 2010) to promote the uptake. At the end-2013, the number of TabunganKu accounts reached 10.6 million (as reported by the Bank s project team based on data from Bank Indonesia). The performance of small business credit program (KUR) was also solid, with total annual disbursement of IDR41 trillion in 2013 against the DPL target of IDR25 trillion (as more information was available to potential borrowers through a more effective outreach campaign). However, no progress occurred regarding disbursement of government social transfers (PKH transfers) through the recipients accounts in commercial banks. The PKH bank account pilot was completed as planned in , but the expansion beyond the pilot was postponed by the Government. This is because, partly due to a poor pilot design, the pilot did not prove itself successful (ICR, para. 27, with further clarifications provided by the team). So the FIRM target of 1.4 million households obtaining their transfers via PKH bank accounts as of end-2013 was not achieved, as there was no pilot expansion in Objective 4: Support improvements in the investment climate - Negligible The FIRM DPL did not result in any meaningful outcomes on key investment climate policy issues (ICR, para. 30). The DPL supported the preparation of the regulatory reform action plan (MP3EI Plan), but the necessary internal policy consensus about deregulatory agenda was not achieved. Furthermore, there was some backtracking in on regulatory policies in certain sectors, such as mining. Overall, Indonesia s investment climate did not show any broad-based improvement in recent years. Its overall Doing Business ranking has improved from 129th in 2011 (according to DB2012 publication) to 114th in 2014 (per DB2015), but this development was driven by a major change in one single area of business environment - Getting a credit : the country s ranking there has improved by 55 positions from 126th in 2011 to 71th in This advancement is another reflection of broad and rather successful financial sector reforms Indonesia has undertaken since the late 90s, and which were partially discussed under the FIRM Objectives 1-3 above. In most other areas of investment climate, monitored under the DB indicators, including starting a business, registration of property, and enforcing contracts, Indonesia s global rankings remain practically unchanged. The reforms in the area of contract enforcement were specifically supported under the investment climate Pillar of the FIRM, which intended to facilitate the establishment of small claim courts through revisions to the relevant legislation. In the event, implementation of this reform did not go beyond the recommendations stage, and, according to the team, there is no immediate prospect for the recommendations, issued as part of FIRM prior actions, to have a positive effect on actual dispute resolution practices. The respective DPL target was to reduce the average number of days to enforce the contract from 570 in 2011 to 500 in The actual number for 2013, according to the respective DB report, is 498. However, this reduction was entirely due to the change in methodology used in the DB survey, and could not be considered as an indication of improvements in dispute resolution practices due to a reform effort (ICR, para. 31). Moreover, DB data suggest a further deterioration of the situation: the global ranking of Indonesia on the Enforcing contracts indicator has deteriorated from 156th in 2011 to 172th in Efficiency (not applicable to DPLs): 6. Outcome: The outcome rating of the program is moderately satisfactory reflecting high relevance of objectives, modest relevance of design, substantial achievement for the first two development objectives, the modest rating for the third objective, and negligible progress for the fourth objective (investment climate). The program helped the borrower to make substantial progress in the areas of financial sector s stability and diversification, as well as of financial inclusion. Indonesia s financial soundness indicators have improved. The core weakness of the program results relates to the design of 4 th Pillar: the design overestimated the government s commitment to advance reforms in the investment climate, while the prior actions did not provide for sufficient reform momentum in the event of weak reform ownership.

5 a. Outcome Rating: Moderately Satisfactory 7. Rationale for Risk to Development Outcome Rating: The Indonesian authorities have established a solid track record in the area of financial sector reforms and the risk of policy reversal there is considered to be low (ICR, para 39). The performance of the financial sector has improved in recent years, while the authorities regulatory capacity strengthened. According to the IMF, the banking system appears sound as a whole. However, Indonesia s financial sector, like those in other emerging markets, remains vulnerable to external shocks and international financial market volatility. Moreover, important gaps still remain in the crisis management framework, including those related to the bank resolution (ICR, para. 22). According to the IMF, there are also concerns over the existing regulatory framework, in particular with respect to robustness of loan classification and provisioning standards. In this sense, the reform agenda in the financial sector is far from complete, which justified overall Moderate risk rating for development outcomes under project Objectives 1-3. The FIRM DPL did not achieve anything among its investment climate targets, and thus there is no risk of losing any substantial project s achievement under project Objective 4. Therefore, this situation does not influence the overall risk to development outcome. a. Risk to Development Outcome Rating : Moderate 8. Assessment of Bank Performance: a. Quality at entry: The team worked closely with the Government and other partners to put together a comprehensive package aimed at advancing broad financial sector reforms. The operation was built upon a strong reform momentum in this sector and reflected the lessons learned under the earlier DPL series, which historically supported policy packages covering both financial sector and investment climate reforms. The preparation of the FIRM was completed in less than six months after the concept review reflecting both availability of deep sector-specific knowledge and strong Government ownership (ICR, paras. 10 and 43). The policy package was built on strong analytical foundation, including FSAP (2010) and number of more-focused analytical reports and assessments (PD, paras ). Furthermore, the FIRM preparation was supported by technical assistance programs coordinated with the development partners, including Governments of Australia and Switzerland. However, there were two moderate shortcomings in Quality at Entry. First, there was a significant disconnect between prior actions and the agreed PDO indicators (as discussed below in section 10a). Second, as discussed above (Sections 3b and 4), the team underestimated the risks associated with the proposed investment climate reforms, and did not offer adequate prior actions to lock-in the reform momentum in this area. In addition, a minor deficiency of project design relates to insufficient preparation of the pilot to disburse the PKH social transfers through bank accounts, which later resulted in the Government decision to postpone the expansion of this activity beyond the pilot stage. Quality-at-Entry Rating: Moderately Satisfactory b. Quality of supervision: The Bank continued with the intensive program of policy dialogue and technical assistance in both FIRM policy areas after project approval. These activities were directly linked to the preparation of the follow-up, much larger DPL (USD 500 million), approved by the Board in July As explained by the team, the Bank technical and policy support during the supervision stage included, among others, undertaking a gap analysis in NBFI supervision; providing recommendations on integrated supervision models; support for a series of crisis simulation exercises to strengthen crisis prevention and management. This work benefitted from the solid presence of Bank team in the field.

6 Quality of Supervision Rating : Satisfactory Overall Bank Performance Rating : Moderately Satisfactory 9. Assessment of Borrower Performance: a. Government Performance: The Government has shown a high level of commitment and ownership to the preparation and implementation of broad-based reforms in the financial sector. There has been effective policy coordination across the Government (including financial sector regulators that are formally independent from the Government) as well as monitoring of reform progress (ICR, para. 47). This ongoing commitment is further demonstrated by the successful preparation of the follow up DPL in July However, the Government s performance was clearly unsatisfactory with respect to the investment climate objective. First, the Government insisted on inclusion of investment climate reforms into the DPL program against the team s judgment. Second, it failed to deliver any meaningful progress against its original commitments to improve the business environment. When it comes to the investment climate agenda, the Government lacked coordination and discipline in formulating and implementing its policy. Government Performance Rating : Moderately Satisfactory b. Implementing Agency Performance: Two main implementing agencies for the FIRM, Ministries of Economic Affairs and Finance, performed relatively well in coordinating and overseeing activities of various government agencies involved in the implementation of financial sector reforms. The new Financial Services Authorities (OJK) performed especially well in assuming its new regulatory responsibilities (ICR, para. 48). However, the government agencies were unable to fix the problems blocking implementation of investment climate reforms. Implementing Agency Performance Rating : Moderately Satisfactory Overall Borrower Performance Rating : Moderately Satisfactory 10. M&E Design, Implementation, & Utilization: a. M&E Design: The main weakness of the project M&E design relates to the apparent gap between the prior actions and selected monitoring indicators. Most prior actions did not provide for actual policy change, but only for some preparatory steps to lead to particular policy reforms in the future, as they were formulated in terms of preparation of various drafts and recommendations. In this situation, and given that the project was not part of the programmatic series, it would have been desirable to have separate monitoring indicators to track the pace of implementation of respective policy reforms after the project was approved. This would have been an appropriate way to monitor the operation and find out if it brought about any ultimate policy change. In the event, it did (for the financial sector), but this reform success cannot be directly attributed to this loan under the selected project result framework. The six indicators selected for tracking progress with program implementation did not cover policy and regulatory reform developments. Instead their focus was on monitoring changes in the performance of specific segments of the financial sector, as well as changes in the contract enforcement mechanisms. Baseline data were provided in

7 the Policy Matrix in Program Document (Annex 2). In addition, as mentioned in the ICR (para. 54), the development of the M&E indicators could have been done in closer cooperation with key government counterparts. This would have resulted in more ownership and perhaps bring better alignment of the project results framework with the Government s own performance targets. b. M&E Implementation: M&E Implementation was limited. The team did not produce any supervision reports, as those are not required for stand-alone DPLs per the OPCS guidelines. The ICR reports status of selected indicators as of end-2013, the project closing date. The data for Indicator 4 (the number of PKH bank accounts) were not reported, as they were not collected in 2013 (as the PKH pilot was discontinued). c. M&E Utilization: The ICR does not provide any evidence of utilization of M&E data, e.g. either in the decision making or in the design of the follow-up operation. M&E Quality Rating: Modest 11. Other Issues a. Safeguards: No safeguard policies were triggered by this operation. b. Fiduciary Compliance: The ICR does not discuss fiduciary issues related to the project implementation. c. Unintended Impacts (positive or negative): d. Other: 12. Ratings: ICR IEG Review Reason for Disagreement/Comments Outcome: Satisfactory Risk to Development Moderate Outcome: Bank Performance: Satisfactory Borrower Performance: Satisfactory Moderately Satisfactory Moderate Moderately Satisfactory Moderately Satisfactory There were significant weaknesses in project design, including those related to the results chain, prior actions, and the M&E framework. And the project performance, while solid under the set of its policy objectives related to strengthening the financial sector, failed to achieve any traction under its investment climate objective. Shortcomings in the project design pull the rating down. The Government failed to deliver on its commitments under the investment climate portion of reform agenda,

8 supported under the project. Quality of ICR: Satisfactory NOTES: - When insufficient information is provided by the Bank for IEG to arrive at a clear rating, IEG will downgrade the relevant ratings as warranted beginning July 1, The "Reason for Disagreement/Comments" column could cross-reference other sections of the ICR Review, as appropriate. 13. Lessons: The following lessons are taken from the ICR with some adaptation of language: The extensive background analytical work is critical for successful preparation and implementation of DPL. It is not just a key element in identifying the priorities for reform program, but also a tool for consensus building among the government counterparts. In the case of FIRM, this helped to advance the policy dialogue and allowed the DPL to be prepared in six months. The presence of a strong agency capable of serving as a coordinator within the government became an important driver of successful policy reforms in the financial sector. In the case of FIRM and related operations, the Ministry of Economic Affairs has shown a leadership role in guiding and overseeing reform progress across a large number of stakeholders, some of which are formally independent from the Government. The following lesson is drawn by IEG: Weak prior actions, which do not provide for actual policy change, amplify the risk of an inadequate policy reform follow-up. This risk is likely to be further aggravated if the project design does not include special monitoring and supervision arrangements to track actual policy development after the project approval. 14. Assessment Recommended? Yes No 15. Comments on Quality of ICR: The ICR presents the detailed analysis of project results and implementation experiences, but it has two shortcomings. First, it is quite shallow in discussing actual policy reforms carried out after the Board approval. It did not discuss the extent of the Government s follow-up on policy actions that had constituted prior actions for the FIRM. The Bank support to these ongoing reforms at the supervision stage remains unreported by the ICR either. For the purposes of this review, to cover this gap, additional documents had to be consulted, including PD for the follow-up operation, Financial Sector Reform and Modernization DPL, and the implementation report on the Indonesia Financial Sector Strengthening TF (2014). Second, the ratings of project progress towards its development objectives, as presented by the ICR, are inconsistent with the existing ICR guidelines. The ICR assesses project progress by project Policy Area, not by project Policy Objective, as the guidelines recommend. It also uses the incorrect ratings e.g. Satisfactory vs. Substantial for project efficacy. a.quality of ICR Rating : Satisfactory