Document of The World Bank PROJECT APPRAISAL DOCUMENT FOR A PROPOSED LOAN IN THE AMOUNT OF US$14.46 MILLION TO THE FEDERATIVE REPUBLIC OF BRAZIL FOR A

Transcription

1 Public Disclosure Authorized Document of The World Bank Report No BR Public Disclosure Authorized PROJECT APPRAISAL DOCUMENT FOR A PROPOSED LOAN IN THE AMOUNT OF US$14.46 MILLION Public Disclosure Authorized TO THE FEDERATIVE REPUBLIC OF BRAZIL FOR A FINANCIAL SECTOR TECHNICAL ASSISTANCE LOAN August 7, 2001 Public Disclosure Authorized Finance, Private Sector and Infrastructure Brazil Country Management Unit Latin America and the Caribbean Region

2 CURRENCY EQUIVALENTS Currency Unit - Real (Rs$) EXCHANGE RATE 1999 Rs$1.79 = US$1 June 2001 Rs$2.41 = US$1 WEIGHTS AND MEASURES Metric System FISCAL YEAR January I - December 31 ABBREVIATIONS AND ACRONYMS ADR BCB BIS BNDESpar BOVESPA CAS CBTAL CMN CPMF CVM FSTAL GDP IBRD IAS ICB IDB IFC IMF MOF NBF NCB PCU PFSECAL PFRSAL PROER PROES QCBS SIAFI SISBACEN SOE SPC SUSEP TA TOR UNDP American Depository Receipt (Banco Central do Brasil ) Brazil Central Bank Bank for International Settlement (Banco Nacional de Desenvolvimento Econ6mico e Social - participaciones) (Bolsa de Valores de Sao Paulo) Stock Exchange of Brazil (Sao Paulo) Country Assistance Strategy Central Bank Modernization Technical Assistance Project (Consehlo Monetario Nacional) National Monetary Council Contribuicao Provis6ria sobre Movimentacao Financeira Provisional (tax) Contributions on Financial Transactions (Comissao de Valores Mobiliarios do Brasil) Brazil Securities Commission Financial Sector Technical Assistance Loan Gross Domestic Product International Bank for Reconstruction and- Development International Accounting Standards International Competitive Bidding Inter-American Development Bank International Finance Corporation International Monetary Fund Ministry of Finance Not Bank-financed National Competitive Bidding Project Coordinating Unit (First) Programmatic Financial Sector Adjustment Loan Programmatic Fiscal Reform Structural Adjustment Loan Restructuring and Strengthening of the National Financial System. Reduction of State level participation in banking activities Quality-and-Cost-Based Selection Sistema Integrado de Administracao Financeira (government chart of accounts) Information System of the Central Bank Statements of Expenditure (Secretaria de Previdencia Complementar) Secretariat of Complementary Pension Funds (Superintendencia de Seguros Privados) Superintendency of Pension Insurance Technical Assistance Tenns of Reference United Nations Development Program Vice President Brazil Country Director Sector Director Team Leader David de Ferranti Gobind T. Nankani Danny M. Leipziger Anjali Kumar

3 Brazil Financial Sector Technical Assistance Project CONTENTS A Project Development Objective Project development objective Key performance indicators... 3 B Strategic Context Sector-related Country Assistance Strategy (CAS) goal supported by the project Main sector issues and Government strategy Sector issues to be addressed by the project and strategic choices...7 C Project Description Summary Project components Key policy and institutional reforms supported by the project Benefits and target population Institutional and implementation arrangements D Project Rationale Project alternatives considered and reasons for rejection Major related projects financed by the Bank and/or other development agencies Lessons learned and reflected in the project design Indications of borrower commitment and ownership Value added of Bank support in this project E Summary Project Analysis Economic Financial Technical Institutional Social Environmental assessment Participatory approach F Sustainability and Risks Sustainability Critical Risks Possible Controversial Aspects... 17

4 G Main Loan Conditions Effectiveness Conditions Other H Readiness for Implementation... S18 I Compliance with Bank Policies Annexes Annex 1. Project Design Summary Annex 2. Project Description Annex 3. Estimated Project Costs Annex 4. Cost-Benefit Analysis Summary. or Cost-Effectiveness Analysis Summary Not applicable Annex 5. Financial Summary for Revenue-Earning Project Entities, or Financial Summary... Not applicable Annex 6. Procurement and Disbursement Arrangements Table A. Project Costs by Procurement Arrangements Table Al. Consultant Selection Arrangements Table B. Thresholds for Procurement Methods and Prior Review Table C. Allocation of Loan Proceeds Annex 7. Project Processing Budget and Schedule Annex 8. Documents in Project File Annex 9. Statement of Loans and Credits Annex 10. Brazil - Country at a Glance

5 Brazil Financial Sector Technical Assistance Project Project Appraisal Document Latin America and the Caribbean Regional Office Brazil Country Department LCC5C Date: August 7, 2001 Team Leader: Anjali Kumar Country Manager/Director: Gobind T. Nankani Sector Manager/Director: Danny Leipziger Project ID: P Sector: FS - Financial Sector Development Lending Instrument: Technical Assistance Loan (TAL) Theme(s): Poverty Targeted Intervention: [ ] Yes [X] No Project Financing Data [X] Loan (I Credit [3 Grant Li Guarantee [ Other [Specify] For Loans/Credits/Others: Amount (US$m): Proposed terms: LIBOR based variable spread loan (VSL) Grace period (years): 5 Years to maturity: 15 Commitment fee: 0.75% Service charge: n/a Front-end fee on Bank loan: 1.0% Financing plan (US$m): Source Local Foreign Total Government IBRD (incl. front end fee) IDA Other (specify) Total: Borrower: Federative Republic of Brazil Guarantor: Ministry of Finance, Government of Brazil Responsible agenc(ies): Banco Central do Brasil (BCB); Comissao de Valores Mobiliarios do Brasil (CVM) Addresses and Contact persons Banco Central do Brasil, SPS - Quadra 3 - Bloco B - Edificio Sede - 18 andar, Brasilia (DF), Brasil Contact Person: Helio Jose Ferreira. Tel: (61) ; Fax: (61) hjose@bcb.gov.br Comissao de Valores Mobiliarios, Rua Sete de Setembro, 111, Rio de Janeiro RJ CEP , Brasil Contact Person: Jose Alexandre C. Vasco Tel: (21) Fax (21) & vasco(cvm.gov.br Estimated disbursements (Bank FY/US$M): FY IBRD Front end fee 0.14 Annual Cumulative Project implementation period: 3 years Expected effectiveness date: November, 2001 Expected closing date: June 30, 2005 OCS PAD Form: October 9, 1998

6 Page 2 A. Project Development Objective 1. Project development objective. (see Annex I) The central objective of the project is to support the development of institutional capacity to assist the implementation of Brazil's program offinancial sector reforms. Brazil has embarked upon a far-reaching program of financial sector reforms, which are being supported by the Bank through programmatic adjustment lending. The First Programmatic Financial Sector Adjustment Loan (Loan 7053-BR) was presented to the Bank's Board on May 24, The proposed Financial Sector Technical Assistance project has been prepared in parallel to the first phase of programmatic lending, of $404 million, and will facilitate the achievement of the reforms targeted for the next stages of programmatic lending. Subsequent phases of programmatic lending will include two to three loans depending on the pace and depth of future reform implementation, for a total amount ranging between US$800 million and US$1.2 billion. The broad-based and comprehensive financial sector reform program pursued by the government and supported by the Bank's programmatic lending includes: (a) actions to raise efficiency in financial intermediation and broaden access to financial services, by strengthened credit contract enforcement, improved debtor information, and reduction of risks in the payments system; (b) reforms to enhance financial system transparency and the effectiveness of regulation and supervision for both the banking system and securities markets through strengthening prudential norms and their enforcement, rationalizing the division of responsibilities among supervisory agencies, enhancing institutional capacity of the supervisory agencies, upgrading disclosure and accounting standards and improving corporate governance for companies; and (c) steps to bolster defenses against financial crisis through more effective bank failure resolution and deposit insurance systems and improved contingency crisis planning. Not included in the Bank's program but also incorporated in the government's reform agenda are reforms such as constitutional amendments enabling critical changes to central bank/financial system laws, as well as deep restructuring of the federal banks. The proposed project would therefore support both the achievement of these reform objectives and the long term development of institutional capacity, through technical assistance to the two key financial sector regulatory agencies in Brazil entrusted with the design and implementation of the reform program; the Banco Central do Brasil (BCB, Brazil's central bank) and the Comissao de Valores Mobiliarios (CVM, Brazil's securities commission). Technical assistance is targeted at a number of areas which are included in the scope of the reform program and which would support the overall effectiveness of the supervisory agencies. Specifically, assistance to the Central Bank would include: support to the reduction of interest rate spreads and payments system reform, strengthening of banking supervision, regulation, and failure resolution as well as enhanced preparedness for banking sector difficulties, and finally, support to increase the overall efficiency of the Central Bank through a follow up to Bank-assisted diagnostic work on information technology systems. Support to the CVM would focus on: strengthening compliance, supporting greater transparency and better monitoring of corporate financial accounting and disclosure, improving market surveillance, strengthening investor protection and public information, and finally, undertaking diagnostic studies on the present and future roles, resources and responsibilities of capital market regulatory agencies. During the period of project implementation, there could be a restructuring of financial sector regulatory activities. Authorities in Brazil are investigating the restructuring of responsibilities so that issues of systemic importance, and the banking sector, are monitored by the Central Bank, and responsibilities for issues related to financial markets, consumer/investor protection come under the purview of a consolidated securities market regulator. A draft law reflecting these broad principles is under preparation. The present operation broadly supports the adoption of such a program, and its design already reflects provisions for its smooth integration within such a structure.

7 Page 3 2. Key performance indicators: (see Annex 1) Indicators in terms of the achievement of project development objectives would be closely linked to the progress achieved in terms of programmatic goals for financial sector reform, as described in the Brazil First Programmatic Financial Sector Adjustment Loan. They would include the preparation of reform strategies and action plans based upon the policy/diagnostic studies undertaken and the initiation of regulatory reforms ready for approval. In addition, indicators of progress would also include the adoption of key institutional strengthening measures, through training and technology modifications. Specific project output indicators for each of the two agencies' major components are:' Outputs - Central Bank Component Indicators: * Payment System risk reduction and / Studies launched on risk management at clearing houses, measures identified strengthened securities markets for to mange clearing house risk, and actions taken to adopt such measures. government debt. * Strengthened banking supervision / Introduction of examination manuals and bank rating system * Strengthened bank failure resolution / New law on bank failure drafted, contingency plan formulated within Central Bank. * Sectoral Policy to enhance intermediation / Studies undertaken on financial system competition, spreads, bankruptcy efficiency (studies and action plans) procedures, collateralization, and taxation. Action plans formulated. * Reduction of intermediation spreads through V Enhanced Credit Risk Center put into operation. improved Risk Center * IT Diagnostic & Implementation. / Formalization of IT upgrading plan and implementation of proposals on electronic data management and Unified Access interface. Outputs - CVM Component Indicators: * Diagnostic studies including CVM / Special studies launched on CVM's role and resources, administrative organization, role of related agencies procedures. Special diagnostic of Information Technology needs undertaken. Discussions of results with senior officials and Action Plans formulated. * Strengthening Compliance / Draft new CVM regulations prepared on areas including govemance, minority investor protection. Digitalization and public availability of database on regulation, rulings, decisions, etc. * Improved Corporate Financial Analysis / Training programs on corporate financial analysis and accounting completed. capacity * Enhanced Surveillance / Inspection / Enhanced on-site inspection program formulated and launched * Strengthened Investor Protection and v Website strengthened and increased information for investor protection made increased transparency in collective available investment schemes B. Strategic Context 1. Sector-related Country Assistance Strategy (CAS) goal supported by the project: (see Annex 1) Document number: BR of May 1, Date of latest CAS discussion: May 24, 2001 The present technical assistance loan accompanies and supports a series of proposed programmatic adjustment loans for the financial sector. Programmatic adjustment lending to the financial sector is embedded within the Bank's assistance program to Brazil, in its most recent CAS (May 2001). On the basis of its importance for growth and poverty reduction, and given the evidence of reform progress, the Government and the Bank have confirmed the financial sector as a priority area for assistance through programmatic adjustment lending. Specifically, the CAS anticipates continued programmatic lending in the area of the financial sector subject to the continuation of a quality sector dialogue and achievement of reform goals. Detailed further with a time-phased program in minutes to negotiations.

8 Page 4 A quality dialogue is continuing and the govemment's commitment to reform remains strong. The proposed operation follows an existing technical assistance loan to the Central Bank. While the previous technical assistance loan had a major emphasis on banking regulation and supervision (Loan 4245-BR of 1997), it also provided a vehicle to support Bank dialogue in the financial sector, which has expanded and deepened over the past year to encompass a number of jointly selected new areas. Government follow up to the intensive discussions of the past year is the next phase is reflected in the recent adjustment lending program, embodied by the presentation to the Bank's Board on May 24th of the first of a proposed series of programmatic financial sector adjustment loans. The present proposed technical assistance loan would be the vehicle which would assist the government to determine options and modalities for implementation of its policy agenda for second and possible third phase adjustment lending. 2. Main sector issues and Government strategy. 2.1 Shallow and high-costjfinancial intermediation Brazil's financial system is largely bank dominated. While assets of the banking system, at about US$500 billion, or 95 percent of GDP, are high, credit to the private sector accounts for only 35 percent of GDP, or only 33 percent of banking system assets. A large part - about one half - of bank credit to the private sector is provided by state-owned institutions. Stock market capitalization amounts to some US$230 billion or around 40 percent of GDP, while debt securities on issue amount to around US$270 billion or 50 percent of GDP. These shares are high by Latin American standards, although equity markets are illiquid and debt securities largely dominated by government paper. Outside the banking system, the largest holders of financial assets in Brazil are pension funds, either directly or through their mutual funds. Total assets of pension and mutual funds are estimated at about US$120 billion (22 percent of GDP). An increase in the depth offinancial intermediation in Brazil is a key issue, which requires both the channeling of bank deposits towards new loans, and raising the depth and liquidity of financial markets. Reducing the high costs of intermediation in Brazil has been identified as a major challenge for the achievement of greater depth in intermediation. Factors that lead to high spreads have been identified to include indirect taxation (principally the tax on financial transactions, CPMF), forced investments, and unremunerated reserve requirements. Limited competitive pressures and high costs of contract enforcement and debtor monitoring have also been identified by the government as causes, due to prevailing judicial processes for collateral repossession and corporate reorganization and bankruptcy. The authorities are also aware that more efficient sharing of credit information would help reduce informational rents, thereby increasing competition between lenders, and disciplining borrowers. Brazil has made great progress towards improving debtor information, through the BCB's Risk Center, although much still remains to be done, especially to enhance the availability of positive, as opposed to negative, debtor information. 2.2 Banking -access issues and the role of the federal banks On average, Brazilian private banks appear profitable, liquid, and well provisioned and capitalized Risks to systemic stability in the Brazilian banking sector are considered low. This is because of the dominant presence of federal banks (whose creditworthiness is ultimately that of the government), the financial strength of the largest Brazilian-owned private banks, and the growing presence of highly-rated international banks. In addition, the unsound major private banks were already removed in the context of the wave of bank failures. Nevertheless, access to financial services is skewed in Brazil, with some segments of the population under-served or left out of the formal financial system. It is estimated that Brazil has about 45 million checking accounts and 44 million saving accounts, for a population of approximately 170 million people. Probably less than 20 percent of Brazilians households have access to bank deposit instruments, and even less to bank credit. Brazil's banking system (total assets of US$500

9 Page 5 billion or 95 percent of GDP) is concentrated and still dominated by public (mainly federal) banks, although foreign bank presence has risen significantly in recent years. A thorough restructuring of the state-owned bank sector has taken place over the last five years in Brazil. The government-established PROES program in 1996 provided federal funds to states whose banks were either restructured, privatized, converted into a development agency, or liquidated. The government also began, in , to take significant anid unprecedented steps, particularly in terms of diagnosis, public disclosure, and supervision of the federal banks. TIhe Central Bank extended a Global Consolidated Inspection program to the two largest federal banks, Banco do Brasil and Caixa, and commissioned a major study on the financial situation of the entire federal banking group. These efforts have been followed, very recently in June 2001, bv the government's anouncements about significant restructurings of the balance sheets offederal banks. Details, and an assessment of impact, are still under evaluation. 2.3 Upgrading of banking regulation and supervision After somewhat slow progress through 1997, the Central Bank has made significant strides towards strengthening bank supervision, although there are still needs for training a sufficient contingent of qualified staff in implementation of the new regulations and the new supervision techniques. With the recent acceleration of progress, Brazil is now considered to be near full compliance with the Basle Core Principles for Effective Banking Supervision. Most visible has been the qualitative jump in on-site supervision, associated with the introduction of the Global Consolidated Inspection (GCI) program. About a year ago the inspection program was extended to cover also the federal banks. There has also been a substantial upgrading of prudential regulations. The 1997 World Bank technical assistance loan to the Central Bank has been helpful in boosting the sense of reform urgency and its implementation. 2.4 Strengthening the safety net - bankfailure resolution and contingency planning The current bank failure resolution and deposit insurance framework--established in the mid-1990s-has so far served Brazil adequately well. Key components of this framework are Law 9447 and the Fondo Garantidor de Creditos (FGC); a deposit insurance fund. These two institutions, combined transitorily with a government restructuring program, PROER, enabled the authorities to skillfully manage the wave of bank failures that unfolded in , including the orderly resolution of 3 of the 10 largest banks in Brazil. The deposit insurance fund exhibits many of what could be considered "better international practices." However, some estimates suggest that liquid resources available to this fund may not be fully sufficient to confront failures of the largest banks. Reforming the Brazilian bank failure resolution framework, with regard to the process of extra-judicial liquidation, and the role recently entrusted in this context to the Central Bank, also presents a challenge. The government is proposing a review of the entire framework of bank failure resolution and a re-examination, in this context, of the role of the guarantee fund. 2.5 Financial infrastructure - reducing risks and raising efficiency in Payments Systems The Central Bank has devoted considerable resources to redesign the country's payment infrastructure. In the present system, the Central Bank has shouldered the risks of payment failure by providing overdrafts to participants as necessary to ensure finality in settlement. Risks have also arisen due to limited integration between payments and securities settlement procedures. As the economy has stabilized, the government has shifted its attention from speed of payments to problems of risk management, and the need to establish a sound and reliable legal framework for payments. A series of actions underway today aim at eliminating ihe ri.lcs i;.wurr.d b.v the Central Bcnk, and at transferrinig residual risks to relevant private participants in the payments system under new rules and oversight. As part of this structural shift, the role of the Central Bank is being altered, to strengthen and provide a legal underpinning to its oversight of the payments system. Risk management principles for private participants are being enunciated in a new law and accompanying regulations. When the reform is completed, Brazil

10 Page 6 will have a safer and sounder payments system which protects the Central Bank from risk of loss while reducing moral hazard. 2.6 Strengthening Capital Markets Potential for the further development of securities markets in Brazil appears substantial, especially in view of the huge size and rapid pace of growth of institutional investor funds. Total assets of institutional investors are estimated at about US$120 billion or 22 percent of GDP-the highest among Latin countries excepting Chile. However, Brazil has a number of challenges to face in terms of expanding the use of capital markets for corporate finance. The bulk of debt securities outstanding (over 80 percent) are comprised of government bonds. A significant part of debt securities moreover mobilizes bank finance - i.e., they are funded by bank deposits. Liquidity in equity markets-although higher than in many Latin countries is low, especially for voting shares. Like many other countries in the region, a large proportion of trade takes place in non-voting shares, while trading in many larger companies is meanwhile moving offshore, to international capital markets. Development of securities markets is constrained by a number of factors. Apart from the sizeable government refinancing needs, there have been major deficiencies in corporate governance, with minority shareholders unduly exposed to risks of expropriation by controlling shareholders, especially during major transfers of corporate control, e.g., when companies go public or go private. These arise due to the large proportion of shares with no voting rights, poor representation on boards, the lack of "tag along" rights (which allow minority shareholders to "tag along" and obtain the same price as the controller shareholder in the event of a company sale) and low "public float" (the set of shares traded). Transactions costs in securities trading are high. Regulatory responsibilities are scattered across a number of agencies, creating some overlaps or gaps in functional coverage. While the CVM has been striving for strengthened disclosure and investor protection, improved market surveillance and securities regulation, it has been constrained in terms of its own resources. Human resources of CVM are stretched and its enforcement powers limited, undermining its capacity to investigate and punish violations. The government is addressing key issues in capital markets through radical changes in the present corporate law and securities law, as well as through an agenda of reinforcing regulations and changes in operating procedures at the CVM. A series of proposed changes are embedded in the revised corporate law and securities law, which have recently been approved (end-march 2001) by the lower House of Congress. Final passage is now awaited. 2.7 Institutional structure of financial system regulation Regulatory policy for the financial system as a whole is mainly the responsibility of the Consehlo Monetario Nacional (CMN). The Central Bank of Brazil (BCB), a relatively strong and mature supervisory agency, is responsible for monetary policy and inflation targeting, in addition to the regulation and supervision of large segments of the financial system - banks, a multitude of non-bank financial institutions, debt mutual funds, broker dealer registrations, money and foreign exchange markets, interest and exchange rate futures, and the payments system. The Comissao de Valores Mobiliarios (CVM), is a newer, less powerful regulatory agency, with greater resource constraints. The CVM is responsible for the regulation of listed companies, broker dealer activities, and equities trading. Pension fund regulation is under the purview of the Secretaria de Previdencia Complementar (SPC) in the case of closed-end corporate pension funds, and of the Superintendencia de Seguros Privados (SUSEP) in the case of open-ended funds. SUSEP is also in charge of regulating and supervising insurance companies. The government is aware that the organization of regulation and supervision of the financial system is segmented, with some variance in the quality of prudential oversight across supervisory agencies together with overlaps in function or gaps in coverage. Authorities in Brazil are investigating the restructuring of financial sector responsibilities, with responsibility for issues of systemic importance, and for the banking sector, to the Central Bank, and responsibilities for issues related to financial markets, consumer / investor protection to a consolidated securities market regulator. A draft law

11 Page 7 reflecting these broad principles is under preparation. The present operation reflects support for the adoption of such a program and is designed to be smoothly integrated within such a structure. 3. Sector issues to be addressed by the project and strategic choices: The proposed project encompasses a broad-based agenda of knowledge and policy formulation support for virtually the entire range of issues discussed in the previous section, to Brazil's key financial sector regulatory agencies in the implementation of the government's financial sector reform agenda. It also aims at the long term enhancement of institutional capacity in the regulatory agencies themselves. The present Financial Sector Technical Assistance Loan (FSTAL) builds upon the accomplishments of the previous Central Bank technical assistance project (CBTAL) of 1997, which focused more specifically on banking supervision and regulation, and diagnostic work in a number of other central bank modernization areas. Three principal channels of effort are envisaged for the support to the government's overall financial sector reform program, which will provide the underpinning for the Bank's proposed phased programmatic lending to the financial sector, and anchor future milestones of achievements in programmatic lending to an agenda of specific reform actions. First and foremost among these is technical assistance, both under the present as well as the previous project, under which the government will initiate and manage specific activities which contribute to the reform program, making use of the Bank's financing. Second, in parallel to technical assistance, the government is engaged in a dialogue of analytical and advisory activities with the Bank (AAA), through which certain issues will be explored and policy options analyzed directly by Bank staff and consultants. Third, the government is undertaking selected studies on its own initiative, independent of Bank funding, on sensitive priority areas. Compared to the principal policy areas of the PFSECAL, areas of assistance supported under the present operation include, in 'Intermediation Efficiency and Access to Financial Services', policy-oriented studies on the impact of actions to reduce spreads, on collateralization, bankruptcy procedures, and on financial sector competition, in addition to support for the redrafting of the bankruptcy law. With regard to the Banking System Soundness and Safety Net, support for the strengthening of banking supervision is being provided by the CBTAL, while support for the formulation of revised bank failure resolution rules, improved bank intervention processes, and the development and maintenance of a contingency plan is under the present proposed FSTAL. With regard to Payment Systems and Securities Clearance and Settlement, the FSTAL would finance consultancy services to help strengthen the Central Bank's ability to evaluate risk control management of clearing houses, as well as the upgrading of operational desks at the Central Bank for the introduction of the new payments system. In the area of Securities Markets, the technical assistance would include a number of measures to strengthen the regulatory and enforcement framework, which include support for the preparation or revision of regulations on minority shareholder protection, strengthened corporate financial analysis, improved off-site supervision, increased web-based disclosure and better investor protection through enhanced public information. Apart from the technical assistance agenda, the Bank has tentatively discussed an agenda for analytical and advisory activities (AAA) with Brazilian authorities, which would include issues of access to financial services, especially for the underserved population, and financial sector taxation. The authorities' own agenda for analytic work includes investigations of sensitive areas such as rural and housing finance, which will play an important role in the reform agenda for the largest federal banks. In terms of strategic choices, the technical assistance loan, in parallel to the PFSECAL, does not explicitly address issues concerning Federal banks, as debate continues in this area, and the likelihood of major reform actions is probably beyond the time horizon of the Bank's programmatic reform. Federal banks,

12 Page 8 together with the rest of the banking system, will nevertheless benefit from support in the other project areas, such as strengthened banking supervision. 2 C: Project Description Summary 1. Project components: (see Annex 2 for a detailed description and Annex 3 for a detailed cost breakdown) The first component comprises support to address systemic financial sector issues, and reinforce banking supervision, through the Central Bank. Issues covered include (I.1) support for payments system reform, (through policy advice on risk control management at clearing houses, the upgrading of operations desks for the implementation of the new payments system), and for the development of a more efficient market in government securities. The next subset of activities addresses the banking system ( ) and encompasses strengthened banking supervision (through a combination of studies, information technology upgrade, the formalization of written policies and procedures, training for supervision staff and the initiation of off-site supervision); and improvements to the banking system safety net (through a revision of bank failure resolution rules, the initiation of contingency planning, and improved monitoring of bank interventions). Project Description Summary Projet Components Category 'Costs Inic % of Bank- % of Contingencies totlo finamcing Bank- (US$ 000) t (USS 000) financing 1. Support to address systemic financial sector issues, and reinforce 11, , banking supervision, through the Central Bank (Total) Pre-identified Activities 1.1. Payment System Reform Policy / Institution building Improve Banking Supervision, Policy / Institution building 2, , Regulations; Bank Failure Resolution and Preparedness Reduction of interest rate/spreads and Policy Other studies on Sectoral Policy 1.7. Implementation of IT Diagnostic Policy/ Institution building 2, , Proposals 1.8. Project Management Project management 3, Second Phase/Supplementary Activities 2, , Support for the strengthening regulation and compliance, and 6, , increasing transparency and investor protection, in the area of securities markets, through support to the CVM (Total) Pre-identified Activities 11.1 Diagnostic Studies Policy I Institution building 1, , Strengthening Compliance, Corporate Cons/Trg & Equip 1, , Finance; Surveillance and Inspection Investor Protection and Public Cons/Equip Information; Collective Investments 11.7 Institutional Support and Project Cons/Trg & Equip 1, Management Second Phase/Supplementary Activities 1, , Total 17, , Front End Fee (1% ofibrd) Total incl. Front End Fee 18, , Support in this area is expected to be undertaken through Bank Analytic and Advisory Activities (AAA).

13 Page 9 A third tier of activities ( ) addresses issues related to overall financial intermediation (through studies on interest rate spreads, financial sector competition, financial sector taxation, bankruptcy and collateralization). A final component (1.7) on informnation technology supports the overall strengthening of the Central bank, building upon the recommendations of a diagnostic study undertaken in the previous technical assistance loan. The second component is focused upon support for strengthening regulation and compliance, and increasing transparency and investor protection. in the area of securities markets. through support to the CVM, Brazil's securities markets regulator. Specifically, the project supports diagnostic work (11.1) on the role, responsibilities and resources of the CVM, an investigation of measures to strengthen enforcement, and the overall allocation of regulatory responsibilities between capital market entities. The project also supports (11.2) the upgrading of the regulatory framework to help CVM achieve its agenda in terms of strengthened governance, (II.3) support to new accounting techniques expected under the revised Corporate and Securities laws, (11.4) improved market surveillance, and ( ) strengthened disclosure and investor protection. The project also fortifies the overall capacity of both the Central Bank and the CVM through training, information technology support, and in the case of CVM, support to the project administration unit. Both components include a number of pre-identified activities, and also include additional funds for supplementary / second phase activities amounting to around a quarter to a third of total project value. These include both activities which are foreseen as necessary, but where the scope and design, and hence cost allocation, is not possible without a prior phase of diagnostic work, as well as potential activities which emerge as institutional priorities in the second and third years of project implementation. Given the rapid evolution of the financial system, and indeed the likelihood of structural changes in the organization of financial oversight, some degree of flexibility would be vital to maintain the overall momentum of reform in the evolving environment. 2. Key policy and institutional reforms supported by the project: Policy reforms supported by the project are described in Part 2 above, and are also detailed in the documentation of the first programmatic lending operation for the financial sector (PFSECAL) which this loan accompanies. The project also has an important institution building role to play with both the Central Bank and the Comissao de Valores MobiliArios. The project strengthens human capacity in both institutions especially in the areas of banking supervision both through onsite inspection (at both institutions) and off-site monitoring (BCB) and market surveillance (CVM). The project also fortifies the analytic capacity, and access to key sectoral information and the sharing of this information with key players, through information technology design and development. This will promote, for example, the disclosure and analysis of material information by listed companies at the CVM, analysis of information on mutual funds and pension funds, and the maintenance of public information on a website, for better investor protection. In the case of the Central Bank, information technology design and development will critically support the installation of the new payments system, the enhanced functioning of a Credit Risk information system, and the linking of a series of data bases required for the purposes of monitoring and regulating the financial system. 3. Benefits and targetpopulation: A strengthened financial system benefits all segments of the population. The reforms supported by the technical assistance loan would have a bearing on poverty reduction by increasing long-term growth; improving the capacity to deal with volatility and mitigate cycles; enhancing preparedness for, and reducing the probability of, financial crises; and broadening access to financial services.

14 Page 10 Evidence from empirical studies has firmly established a causal link running from financial system depth and soundness to economic growth. The financial sector reforms supported by this loan would help increase long-term growth through their impact on real interest rates and productivity, through measures to enhance efficiency of intermediation and reduce risk of bank failures. Improvements sought in the program for supervision, credit contract enforcement, debtor information systems, minority shareholder protection, etc. will enhance the financial sector's capacity to perform its basic functions of mobilizing savings, allocating capital, monitoring corporate managers, and transforming risk. Availability of financial services would enable the poor better to confront sharp economic fluctuations. And strong financial systems play a primary role as absorbers of shocks, as they shelter and diversify savings. 4. Institutional and implementation arrangements: Institutional and implementation arrangements at the Central Bank are well defined and already in place, as there is an inherited structure which was set in place for the previous technical assistance loan. It is expected that the same office will continue oversight functions for the new technical assistance loan. The project implementation unit, commended in a recent mid-term review of the project for its "very competent and committed staff', has an appropriate resource endowment to discharge its responsibilities. The head of the unit is a senior Central Bank staff, and is supported by three additional senior persons plus three junior advisors. Some areas for further strengthening project monitoring have been recently discussed, and should further enhance the unit's high overall competence. Procurement functions for the Central Bank (and for the CVM) are likely to be undertaken by the UNDP. Institutional arrangements at the CVM, an agency relatively new to the bank, are affected by the considerably more severe resource constraints suffered by CVM. Project coordination responsibilities will be handled by CVM's headquarters in Rio de Janeiro, and the project manager appointed is the institution's chief financial officer, who has recently also been appointed as a superintendent of CVM. He will be supported in this function by a steering committee which includes department heads of all functional departments participating in the project, as well as a technical working group of persons operating below the steering committee, in the respective departments. The project coordinator will be supported by CVM staff for procurement and financial management, and additionally, 4 persons, financed by the Bank's loan, for planning and procurement, financial monitoring, operational monitoring and overall office support, who will be supervised by the office of the financial superintendent. The project provides assistance for the funding of these persons, due to CVM's extreme resource constraints, although it is envisaged that there will be a gradual and parallel transfer of knowledge and capacity to in-house staff. Currently the CVM has a staff of only 290, as against a staff authorization of 397. Due to national budgetary constraints, the CVM has not been permitted to fill its existing vacancies and, in fact, since 1996 its staff size has actually declined. However, some lifting of the hiring freeze is expected in late 2001, and ten to twenty new staff may be expected on board by year end. CVM will also be assisted by its informal contacts with the Central Bank's Brasilia office, whose prior experience with Bank-financed technical assistance is very valuable. CVM's contacts with Brasilia could also be facilitated by its own Brasilia office.

15 Page 1 1 Financial Sector Technical Assistance Project - Implementation Arrangements CVM PTO9Ie Coordin*Xr i~ n D: Project CtrRatiionoa Saperkaft"00) t Sedn (:mmtt Senior Advsor Pr1cu rem ant naed Senior Alviior Finacnnd Scuior Advisor Operations planoin Teuiral CommalcXFf Junior Advisor Junior AdvisorI Aals Team Assistant D: Project Rationale 1. Project alternatives considered and reasons for rejection. More than one alternative vehicle for the delivery of technical assistance to the financial sector was considered, but rejected in favor of the present loan design. First of all, the possibility of lending support to the entire financial sector programmatic adjustment package through the existing TA loan (CBTAL) was explored. However, the Mid-term review of the CBTAL clearly revealed that residual funds in the present loan were far from adequate to cover needs envisaged. Second, the present CBTAL would be closed before the proposed programmatic series of loans, so that support for the entire period of the reform program would not be available. Third, the CBTAL encompasses only a single regulatory agency. Despite the pivotal and powerful role of the Central Bank, this would imply that only a part of the spectrum of financial sector issues would have been covered. Given the positive expansion of our dialogue with the authorities to encompass capital markets issues, and in view of the greater needs of the CVM, it was considered important to use a vehicle which would permit the extension of support to the CVM as well as the Central Bank. It was therefore determined that a new technical assistance loan would be essential. However, it was also decided that to the extent that there are residual funds in the existing TA loan which could be allocated towards meeting programmatic reform objectives, residual funds in the ongoing technical assistance project (CBTAL) could also be tapped, especially where there is urgent need to expedite the launching of the reform program (details are in Section C below). This is facilitated by the design of the present TA loan, where funds for future years were not predetermined. Another alternative considered in terms of project design was an even wider technical assistance loan, spanning a larger number of regulatory agencies. Thus in addition to the Central Bank and the CVM. agencies such as SUSEP, the regulator of insurance and open-ended pension funds, or the SPC, which is responsible for the oversight of closed end pension funds, could also have been included in the scope of the technical assistance. This alternative too was not adopted, for a number of reasons, including especially, the resulting complexity of the project and likely implementation difficulties, the differences in juristic nature of the entities (as SPC does not enjoy the independent legal status of the other agencies),

16 Page 12 and finally, the likelihood of their ultimate merger anyway, under a single umbrella, over the course of the next few years. 2. Major related projects financed by the Bank and/or other development agencies: Implementation Development Progress (IP) Objective (DO) Bank-financed Central Bank Modernization Financial sector Technical Assistance; Technical Assistance Project S S Banking supervision and institutional (Loan 4245-BR; Project ID development No: P048357) Overall financial sector reform First Programmatic Financial Sector Adjustment Loan (Loan 7053-BR; Project ID No: P070640) Other development agencies IP/DO Ratings: HS (Highly Satisfactory), S (Satisfactory), U (Unsatisfactory), H-U (Highly Unsatisfactory) The present project is closely associated, first of all, with the first Programmatic Financial Sector Adjustment Loan to Brazil, (Loan 7053-BR; Project ID No:P070640), recently submitted to the Bank's Board on May 24, As discussed above, the aim of the present operation is to support the government's overall reform program in the financial sector, as described in Section 2 above, and in particular, to facilitate the achievement of the reform targets, which would contribute to future programmatic adjustment loans in the sector. Major indicators of satisfactory progress, pointed out in the recent CAS, which would be directly supported by the present Technical Assistance operation, include improvements in the monitoring system for banking sector risk, new legislation for bank closure and deposit insurance, and issuance of corporate governance regulations. A series of two or possibly three programmatic loans to the sector are envisaged over the CAS cycle. The proposed project is also associated with a previous Bank operation in Brazil; the Central Bank Modernization Technical Assistance Loan (Loan 4245-BR; Project ID number: P048357), of November The previous operation focused on complementing the Central Bank's modernization efforts, especially in terms of professionalizing banking supervision. It also aimed to assist diagnostic work on the financial sector's structure, and on continuous strengthening of Central Bank management systems. Despite delays in startup, primarily due to macroeconomic constraints and changes in personnel at the Central Bank, implementation has now accelerated remarkably, under the leadership of present strongly supportive Central Bank management. The project was rated fully satisfactory in the most recent Project Status Report, of March 14, 2001, following an extensive mid-term review in December 2000.The CBTAL project proved to be an important vehicle for a meaningful financial sector dialogue with the government, on a wide spectrum of issues, and provided support for the launching of the proposed programmatic financial sector adjustment operation. It has also laid the foundations for the institutional capacity which will serve to implement the present proposed loan. The implementation team is also providing advice and guidance to the new, additional agency in the present project, the CVM, and would thus be able to help the CVM in its startup phase of implementation. While cumulative disbursements of the CBTAL end-december amounted to some US$12.7 million, a number of additional activities are under way and funds up to US$6.5 million are already committed to a

17 Page 13 pipeline of ongoing activities. Additional activities will be launched as budgetary allocations of funds from the government become available; however a number of competing proposals and plans for such activities exist, and funds will be allocated in order of institutional priority. A part of the residual funds in the present CBTAL will be used in support of the proposed programmatic adjustment lending, in the case of activities where swift startup (prior to the next round of budgetary approvals) is sought. Funds earmarked for such activities amount to at least some US$756,000, and are directed primarily to the programs of strengthened banking supervision and enhanced credit risk management, as well as towards the implementation of information technology diagnostic proposals (see table below for details). These estimates are preliminary only and further increases in these allocations, out of the residual US$3.5 million, may be considered appropriate depending on bids received for current tenders. As such, implementation of the extended program of support to the Central Bank under the proposed financial sector adjustment loan would not be possible on the basis of residual funds in the present project. The Central Bank has strong ownership of and commitment to the present project, recognizing its role in institutional modernization. As such, institutional support for its successor is enthusiastic. Proposed Expenditures from the CBTAL for Support to the Financial Sector Reform Pro ram under the PFSECAL Component Category Contingenc;e A. Improve Banking and Supervision Regulations 179,000 - Formalization of written policies and procedures of off-site Consultancy/ Training 99,600 surveillance process. (DIFIS) - Formalization of training plan. (DIFIS/DEPES) Consultancy/ Training 79,400 B. Credit Risk Information Center. 345,200 - Adjustments in the current system to satisfy supervisory needs Consultancy/ Training/ 345,200 during the period of development of the new system. Equip. C. Enhance Preparedness for Future Banking Sector Difficulties 8,300 - Initiate Contingency Plan Directives (DIFIS) Consultancy 8,300 D. Implementation of IT Diagnostic Proposals 224,000 - Formalization of a Implementation Plan, based on the Gartner Consultancy/ Training 224,000 Diagnostic. (DEINF) Total: 756, Lessons learned and reflected in the project design: A first lesson is the importance of a flexible design which is adapted to the borrower's needs and priorities as they evolve over the period of implementation. The strong support for the CBTAL owed much to this design feature, which has permitted the project to sustain and indeed enhance its relevance despite changes in senior Central Bank management, and changing macroeconomic circumstances. The lesson is reflected in the present project to the extent that (i) certain activities for both agencies will be specified later, based on preliminary diagnostic needs assessments to be undertaken in the initial stages of implementation. Additional funds have been allocated for such needs, as well as other unspecified needs which may arise as implementation proceeds. Such additional funds amount to a quarter to a third of total borrowing per agency. A second lesson to emerge from the CBTAL is the vulnerability of project implementation to disbursement of funds from the government, which can lead to delays in implementation. In Brazil,

18 Page 14 government agencies which are project beneficiaries of IBRD loans are nevertheless required to request a release of project funds annually from the government together with the rest of their budget allocation. In years where compelling fiscal reasons have forced the government to restrain its spending, there have been difficulties in securing the release of project funds. The present project will attempt to incorporate prompt release of funds to the beneficiary in loan documentation. 4. Indications of borrower commitment and ownership: Commitment of the Central Bank to the present project is a continuation of the support extended to the first (CBTAL) project. The mid-term review of the CBTAL particularly commended the 'very competent and committed' project coordination unit established by the Central Bank. Efforts made by the Central Bank to follow up on suggestions and recommendations made in course of supervision of the CBTAL and the preparation of the FSTAL are further indicators (e.g., suggestions with regard to project monitoring and procurement monitoring). In the case of the CVM, support for the project was evident in the several detailed discussions held with all CVM departments, which would be the implementing units for various project elements, as well as from the Chairman and the Superintendent General. Many units contributed their own proposals for project design and keenly debated alternative conceptual approaches towards implementation. Both agencies have been very cooperative during the process of preparation, in terms of the preparation by Bank staff of procurement readiness assessments and financial management capacity assessments. Both agencies have already prepared procurement plans. Project coordinators of each agency have been invited to a week-long Bank procurement seminar, and have agreed to attend. Finally, both agencies financial contributions to the project and its execution also reflect their commitment. These contributions in the case of CVM and BCB include substantial local taxes, on some expenditure categories amounting to as much as 20 percent of the value of purchases, payments to the procurement agents at a total of 4 percent of purchases, and additionally, in the case of BCB, payments for all expenses in the project coordination unit. S. Value added of Bank support in this project. As detailed in Sections B and C above, there are close ties between the PFSECAL program and the present project, and therefore Bank support to this project is a key element in the achievement of the overall support of Brazil's program of financial sector reforms. Apart from facilitating the achievement of specific reform objectives through targeted institutional support, the project also provides for overall capacity enhancement of key regulatory agencies, which would promote sound supervision of the financial system. Additionally, the project provides a vehicle to the Bank for sustained dialogue over issues identified with the government over the period of programmatic adjustment lending. Finally, the Bank's presence helps Brazil's government to stay abreast of and achieve international best practice with regard to the its financial system reforms, while the Bank's supervision machinery acts as an aid to the government's own project monitoring mechanisms in keeping up the momentum of reform and finetuning its implementation over time to achieve the desired objectives. E: Summary Project Analysis: (detailed assessments are in the project file, see Annex 8) 1. Economic: (supported by Annex 4) [ ]Cost-Benefit Analysis: NPV=US$ million; ERR= % Not applicable [ Cost Effectiveness Analysis. Not applicable

19 Page 15 Note: The technical assistance character of the present operation imply that quantitative economic and financial analysis are not possible or appropriate. However, if successfully carried out, the proposed project will bring benefits at two levels; support to overall financial sector reform in Brazil and second, enhanced capacity, credibility and effectiveness of the key policy making, regulatory and supervisory bodies in the financial sector; the Central Bank and the CVM. [ ] Other (specify) 2. Financial: (see Annex 5) NPV=US$ million; FRR= % Fiscal impact: Not applicable No direct fiscal impact. However, the support given to improved crisis and contingency planning should protect the government against potential future contingent liabilities which could arise in the eventuality of any future financial crises. 3. Technical: Technical merits of project design at the CVM have been examined by high-level Bank consultants, over the course of project preparation. Project design for BCB elements related to diagnostic studies have been discussed in detail with Bank staff, as part of the preparation of programmatic financial sector adjustment lending. Details of other elements, especially with regard to banking supervision, the credit risk center, and support for the reinforcement of information technology needs, is grounded in detailed diagnostic work prepared by prominent firms of international consultants, financed under the CBTAL. There is thus a high level of confidence in the design of these project elements. 4. Institutional: a. Executing agencies: Banco Central do Brasil and Comissao de Valores Mobiliarios. The BCB now has a proven track record as an executing agency and CVM has participated fully in the sound planning of project implementation. Capacity assessments, particularly with regard to procurement and financial management responsibilities, in both agencies, have been found to be satisfactory. b. Project management: Project coordination units established by the Banco Central do Brasil and Comissao de Valores Mobiliarios. The unit at BCB is already operational and effective; plans for the organization of the project management unit at CVM have been discussed in detail and are clearly identified. The structure envisaged should be adequate for project support purposes. 5. Social: Not applicable 6. Environmental assessment: Environmental Category [ ] A [ ] B [X] C

20 Page Participatory approach. [key stakeholders, how involved, and what they have influenced; ij participatory approach not used, describe why not applicable] a. Primary beneficiaries and other affected groups: Primary beneficiaries of the proposed technical assistance are the government, in terms of overall support to its financial sector reform program, and the two institutions concerned, the Central Bank and the Securities Commission, who would be more effectively able to monitor, regulate and supervise the financial system through the support of the project b. Other key stakeholders: The larger group of stakeholders includes the populace as a whole, as the program of support to financial sector reform would benefit all members of society, including the poor and vulnerable (see Memorandum to the President of the proposed Programmatic Financial Sector Adjustment Loan). F: Sustainability and Risks 1. Sustainability. There has been a demonstration of sustainability of reforms at the Central Bank. Commitment to the project was sustained despite many changes in management, and the project has also achieved its core development objectives. Staff trained are now making effective use of training, as witnessed by the huge increase in the scope and rigor of supervision of the banking system, credit risk monitoring has been enhanced, and a large volume of thorough analytical work has preceded the design of current reform efforts. Concems about sustainability at CVM are somewhat greater due to the severe staff constraints that CVM has suffered from. Many of the project elements proposed however are designed to make irreversible and permanent improvements to CVM's capacity - e.g. the enhancing of its capacity for corporate financial analysis, the digitizing of its legal opinions to enable easier and more widespread access, and the enhancing of its public website. Moreover, CVM's staff remain committed to the institution and staff turnover is low. This should enable the retention of trained staff and extension of training to other inhouse persons.

21 Page Critical Risks: (reflecting assumptions in the fourth column of Annex 1) Risk Risk Rat4 Risk Minimization Measure From Objective to CAS Goal * Institutional strengthening objectives and support to M Sustained reform momentum built up with reform program at Central Bank and CVM is executive agencies in government through the sustained even if there are changes in political PFSECAL program, robust in face of changes leadership. in political leadership. From Outputs to Objective * The coordination unit at the Central Bank will not be N Frequent contact with Central Bank project ably coordinate the initiation and execution of tasks management unit as well as operational units with the several concerned departments. to ensure coordination. * In the event or a change in the institutional structure M Discussions of possible changes in of CVM and other capital market regulatory bodies institutional structure which show that the during the duration of the project, there will not be a project would remain relevant in the new smooth continuation of the project by the new frameworks under consideration. Close entity, (if created), or by CVM itself, in the event of consultations with authorities on new an expansion in its mandate. structure. * CVM is not able to allocate adequate human M Project monitoring during supervision to resources to project as it proceeds to ensure lasting encourage local capacity building building of capacity * Maintenance of stable project coordination unit in M Considerable preparation time was spent with CVM's Rio office, which also maintains adequate CVM project coordination office to ensure coordination with procurement agents, who may be smooth supervision and the loan provides for located elsewhere, eg., Brasilia. additional support to the project office. Provisions have been made in project design to help consultant travels between Rio and := Brasilia. From Components to Outputs * The Central Bank and CVM do not receive adequate M Propose specific annual transfers to be agreed budgetary allocations from the government in advance * Timely drawdown of residual funds in CBTAL, to N Detailed discussions and reviews of pipeline of ensure initiation of disbursements of funds in FSTAL projects in CBTAL does not occur. * Implementation / startup difficulties of CVM, as a M Intensive preparation/ supervision, advance relatively new and resource constrained agency training seminars to key personnel, and peer support from Central Bank Overall Risk Rating M I Risk Rating - H (High Risk), S (Substantial Risk), M (Modest Risk), N (Negligible or Low Risk) Overall it should be noted that the combination of two agencies with two project agreements in a single project, together with the high supervision requirements described above, also suggest that on the Bank's side, a commensurate supervision budget will be necessary. 3. Possible Controversial Aspects: G: Main Loan Conditions 1. Effectiveness Conditions: 2. Other.: (classify according to covenant types used in the Legal Agreements)

22 Page 18 Requirements at negotiation (to be agreed upon and recorded as minutes of negotiations): CVM and BCB will submit to the Bank the format of the financial, procurement and monitoring reports, and establish the flow of funds to disburse the funds from the loan account. This condition was met. Requirements before disbursement of loan proceeds to CVM: CVM will establish the project management unit at its office in Brasilia Key staff including a procurement advisor and financial manager will be identified and contracted. CVM will furnish the Bank with evidence that it has assistance satisfactory to the Bank to carry out the procurement activity. H: Readiness for Implementation [ I 1. a) The engineering design documents for the first year's activities are complete and ready for the start of project implementation. [X] 1. b) Not applicable. [XI 2. The procurement documents for the first year's activities are complete and ready for the start of project implementation. [X] 3. The Project Implementation Plan has been appraised and found to be realistic and of satisfactory quality. Project implementation plans focussing on procurement and financial reporting have been prepared by both agencies. Many elements such as the audits of performance expost, monitoring., etc., have been discussed in detail with Bank staff and Bank suggestions have been incorporated. Periodic updates to reflect revised timetable of final approval are also being undertaken. [ I 4. The following items are lacking and are discussed under loan conditions (Section G): 1: Compliance with Bank Policies [ X] 1. This project complies with all applicable Bank policies. [ ] 2. The following exceptions to Bank policies are recommended for approval. The project complies with all other applicable Bank policies. Team Leade'r: Anjali Kumar Acting SeRor Director: Jyoti Shukla (for Danny Leipziger) Cou y rector: Gobind T. Nankani

23 Page 1 9 Annex 1: Project Design Summary Brazil: Financial Sector Technical Assistance Project avf''ki1y L*00Ino u? Sector-related CAS Goal: Sector Indicators: Sector t Country Reports: (from Goal to Bank Mission) (see PFSECAL MOP) Supportfinancial sector > Increased depth and efficiency Evaluation of sectoral indicators tovfincia sector reforn in res reforms on the baszs of their ad widened accs inoerl will be integrated with the toefinancial sheco Preogramatincra importance for growth and financial intermediation;dendbytepormai poverty redution, through programmatic adjustmnent >' risks ned iat Reduction of rik nfnnil monitoring of programmatic adjustment lending to the Financial Sector Loan is sustained at present levels even if there are lending and subject to the > infrastructure; Soundness operation of financial sector under PFSECAL changes in political leadership. continuation of a quality sector private and public banks; dialogue and agreement on > More efficient bank exit and reform priorities. better capacity to respond to crises > Effective surveillance, disclosure and investor protection in securities markets Project Development Outcome I Impact Indicators: Project Reports: (from Objective to Goal) Objective: t> Policy studies/ diagnostics to Task supervision Team and Institutional strengthening formulate appropriate reform Project coordination units will objectives and support to reform nstituponat capacith to assist strategies launched and action monitor implementation of program at Central Bank and tnstitutiona the rmpoflementation capity to orazil asis s > plans Regulatory drawn reforms up; ready for targets coordination of FSTAL with in monitoring close of CVM are changes is sustained in political even if there preogramso. icilsco reforms. '> approval;pfealedrhp Institutional strengthening through training / IT modifications launched Output from each Output Indicators: Project Reports: (from Outputs to Objective) component: I. Central Bank Output indicators will be The coordination unit at the V Studies launched on risk monitored by Periodic Progress Central Bank will ably coordinate * Payment System risk management at clearing Reports generated by the Project the initiation and execution of reduction and strengthened houses, measures identified to Coordination Units presented to tasks with the several concemed securities markets for mange cleaming house risk, the Bank. Regular contact will departments. govemment debt. and actions taken to adopt such be maintained with the Bank * Strengthened banking measures. supervision team. supervision V Introduction of examination manuals and bank rating * Strengthened bank failure system resolution V New law on bank failure * Sectoral Policy to enhance drafted, contingency plan intermediation efficiency formulated within Central (studies and action plans) Bank. * Reduction of intermediation V Studies undertaken on financial spreads through improved Risk system competition, spreads, Center bankruptcy procedures, * IT Diagnostic & collateralization, and taxation. Implementation Action plans formulated. V Enhanced Credit Risk Center put into operation. V Formalization of IT upgrading plan and implementation of proposals on electronic data management and Unified Access interface.

24 Page 20 Output from each Output Indicators: Project Reports: (from Outputs to Objective) component: II CVM / Special studies launched on * Diagnostic studies CVM's role and resources, ingtning CVM administrative procedures. Output indicators will be including ~ ~ ~ In the event or a change in pcil ianstc finstitutional the structure of CVM and organization, role of monitored by Periodic Progress other capital market regulatory related agencies Information Technology needs and by Projeca * is pubnfraeion Reports gnrosj bodies during the duration of the undertaken. Discussions of Coordination Units presented to project, there will be a smooth results with senior officials and the Bank. Regular contact willpcty Strengthening Compliance Action Plans formulated, be maintained with the Banke Draft new CVM regulations andnew entity, (if created), or by prepared on areas including tcvm itsef, in the event of an govemnance, minority investor expansion in its mandate. protection. Digitalization and a CVM is able to allocate public availability of database adequate human resources to on regulation, rulings, project as it proceeds to ensure Improved Corporate decisions. etc. lasting building of capacity Financial Analysis capacity ve Training programs on corporate financial analysis and Maintenance of stable project coordination unit in CVM's Rio * Enhanced Surveillance / accounting completed. Enhanced on-site inspection office, which also maintains adequate coordination with Inspection program formulated and procurement agents, who may be launched located elsewhere, eg., Brasilia. * Strengthened Investor V Website strengthened and Protection and increased increased information for transparency in collective investor protection made investment schemes available. Project Components/Sub- Inputs: (budget for each Project Reports: (from Components to Components: component) in US$m Outputs) 1. Central Bank 11.2 Both agencies will maintain * The Central Bank and CVM * Payment System Reform, > 3.8 reports of allocations of funds according to standard and agreed will receive adequate budgetary allocations from the govemment Banking Supervision, Bank reporting formats * Timely drawdown of residual Failure Resolution and Banking funds in CBTAL to ensure Sector Difficulties; Interest initiation of disbursements of rate/spreads and Studies on funds in FSTAL Sectoral Policy * Implementation / startup * IT Diagnostic & Implement- > 7.4 difficulties of CVM, as a ation, Project Management; relatively new and resource Supplementary Activities constrained agency are successfully overcome 11. CVM 6.7 * Diagnostic Studies, > 3.6 Compliance, Corporate Finance, Surveillance I Inspection and Investor Protection and Collective investments * Inst. Support/ Proj. Mgmt > 3.1 and Supplementary Activities

25 Page 21 Annex 2: Project Description Brazil: Financial Sector Technical Assistance Project (Note also Annex Table 2B: Links between Ongoing Central Bank Modernization Technical Assistance Loan and Proposed Financial Sector Technical Assistance Loan) Proiect Component I - US$11.2 million: Support to Address Systemic Financial Sector Issues, and Reinforce Banking Supervision through the Central Bank. The thrust of this component is to ensure that areas related to systemic issues, and areas related to the banking sector, incorporated in the government's financial sector reform program, have the necessary support to facilitate implementation. In summary, topics covered include (I.1) support for payments system reform, (through policy advice on risk control management at clearing houses, the upgrading of operations desks for the implementation of the new payments system), and for the development of a more efficient market in government securities (this supports both securities market development and the reinforcement of public sector debt management, at the secondary market level). The next subset of activities addresses the banking system ( ) and encompasses strengthened banking supervision (through a combination of studies, information technology upgrade, the formalization of written policies and procedures, training for supervision staff and the initiation of off-site supervision); and improvements to the banking system safety net (through a revision of bank failure resolution rules, the initiation of contingency planning, and improved monitoring of bank interventions). A third tier of activities ( ) addressespolicy issues related to overall financial intermediation (through studies on interest rate spreads, financial sector competition, financial sector taxation, bankruptcy and collateralization). A final component (1.7) on information technology supports the overall strengthening of the Central bank, building upon the recommendations of a diagnostic study undertaken in the previous technical assistance loan. Additional details on the specific activities to be initiated are given below, and further information may be obtained from preparatory work in project files. 1.1 Payment System Reform and Bond Market Development' Strengthening BCB 's ability to evaluate risk control management of clearing houses. The new Brazilian payment system will be characterized by the co-existence of several clearinghouses. Many of them will start operations or will re-structure their operations as a result of the reform process now underway. Under the new regulatory framework, each clearinghouse will assume the counterpart risk vis-avis its participants. The central bank is required to evaluate the risk control procedures being proposed by each clearing house as an integral component of the clearing house approval and authorization process. Senior central bank representatives involved in the reform process expressed concern as to their lack of experience and technical skills to carry out this important activity. This is especially critical as most central bank resources are absorbed by the development of the new central bank owned and operated RTGS system. The activities could be envisaged to include consulting support in the area of risk management, pre-training at central bank headquarters of involved personnel, and short visits to meet key people in other central banks 1 Government bond market development issues and payments system reform issues are linked, in Brazil, in part due to the proposal that the new payments system will provide for the smooth integration of government bond trading with the payments system. Additionally, oversight for debt securities in Brazil is under the Central Bank and not under the Securities Commission. Administratively, both departments are under the same directorate in the Central Bank.

26 Page 22 recently involved in this activity (e.g. Federal Reserve, European Central Bank, Bank of Japan). Upgrading of the Operation Desks for the Implementation of new Payment System A parallel activity, associated with the implementation of the new payments system, is the need to upgrade the operation desks of the International Reserves Operations Department (DEPIN), the Open Market Operations Department (DEMAB), and the Banking Operations Department (DEBAN), for monitoring arrangements, to enable the implementation of the new payment system. Improvement of the market infrastructureforfixed income securities (government bonds). The emphasis of this exercise is to identify the type of the market microstructure needed to ensure liquid and efficient government debt markets. This will imply evaluating the "optimal" design of trading, reporting, transparency and settlement regimes that the country needs given the size of the market and the sophistication of the market participants. The focus of this effort would be on those areas where there is a role for public policy. Building of institutional and retail demandfor government bonds In Brazil, the government has been relying largely on financial markets for the distribution of government paper and its institutional investors vehicles are in many cases sophisticated. One untapped potential market is the active engagement of retail segments in the purchase of bonds, directly and through mutual funds. For the government to be able to identify the major impediments to this process, this task envisages a detailed assessment of the most common problems limiting the development of voluntary demand, focusing on the retail dimension of the demand for securities, exploring ways to make better use of the existing retail networks, and evaluating the incidence of the new technology (internet, etc), issues of investor education and market transparency. Expansion of Benchmarks The recent development of a more liquid fixed-rate debt market provides a unique opportunity to shift away from the current reference rate for floating instruments and lessen the widespread indexation to the SELIC rate. As of today, roughly 60% of federal domestic debt are floating-rate (LFT) securities, indexed to the overnight SELIC rate. However, as liquidity increases in some of the large short- term LTN issues, the government could have the opportunity to shift away from SELIC and start using a more conventional 3, 6 month or I year interest rate Tbills to index the floating LFTs. The Indice de Renda Fixa de Mercado (IRF- M) recently developed by ANDIMA (a private broker's association) may be able to play an important role by becoming a more conventional risk-free benchmark for the market, and increasing transparency and investor awareness about true market interest rates. The proposed activity would explore with the help of consultants who offer experience in relevant developed countries which underwent a similar process, ideas on what the government of Brazil could do to gradually move to a longer duration reference rate for the market. 1.2 Improve Banking Supervision and Regulation: Formalization of information technology upgrading plan The component would build upon and expand the considerable work initiated in this area in the CBTAL. Special attention would be focused on information technology needs of off-site examination and system supervision. The overall objective is the development of a medium and long term plan in order to improve the effectiveness of supervision through information technology platforms. Mainfain best practices in money laundering prevention/supervision. Brazil has initiated a series of activities, notably regulatory reforms, to increase transparency in financial practices and prevent money laundering. The present proposal would promote training events for the staff of

27 Page 23 the Department of Surveillance of Illegal Activities (DECIF), enabling them to compare working routines with those of similar agencies in developed countries, and propose actions to be developed within the Brazilian context. Upgrading of the Supervision Unit's Unified Information System (SISUP) The off-site surveillance function in BCB is relatively weak; a situation recognized by BCB's management who is making a considerable effort to improve this area and is aware that information systems should be developed in order to capture, compile and present relevant information on a timely basis for easy analysis and review by the on-site examiners. The expertise of the analysts in this area needs to be increased substantially and the staff should be well trained in order to develop an early waming system which will permit a continuous analysis of banks that will enable not only the detection of existing weakness, but also the projection of potential weakness based on analysis of key financial indicators. The focus of the present activity would be the development of a blueprint for the modernization of SISUP, the Central Bank's unified information system, in order to make information such as balance sheets, periodic reports of financial institutions, or institutional performance with regard to regulatory limits, etc., more accessible and user friendly, aiming for a reliable and functional system. This is expected to require a change in the technological environment of the system. Improvement would explore, but not be limited to, the SENTINELA (warning system) and INDICOM (economic-financial indicators) transactions. Other transactions identified as needed may be included. The activities suggested follow upon the recommendations of information technology diagnostic work undertaken by the Central Bank technical assistance loan. Upgrading and improvement of analytical reports generated in the supervisory process Associated with the previous component, the current system does not permit the customizing of the reports produced by inspectors, or the possibility of inserting comments in the paper on-line. Upgrading the system would aim to enable the insertions of comments and qualifications, and also reports to be accessible on-line. Study on the regulation of competitiveness within the financial system Over the last few years, there has been a trend towards concentration in Brazil's banking system, with the merger of several banks with larger banks, and the closure of some smaller banks. While on the one hand this may have occurred in the context of stricter prudential regulations on issues such as capital adequacy, and may thus have contributed towards the overall soundness of the sector, there may also be an impact upon sectoral competition. The study would aim to evaluate the overall status of competition in the financial system and make recommendations for the strengthening of contestability while maintaining safety and soundness of financial institutions (see also, 1.5 and 1.6 below). Licensing offinancial institutions The proposed task aids the strengthening of the regulatory framework of the Central Bank, through the formalization of written policies and procedures of authorizations for the licensing of financial institutions. 1.3 Bank Failure Resolution:. Revise Bank Failure Resolution Rules and prepare new draft law. An important drawback of the Brazilian bank failure resolution framework relates to the process of extra-judicial liquidations of failed banks which have proven to be cumbersome, saddled with heavy bureaucratic procedures and protracted. As a result, unnecessary and significant asset value destruction has become the norm. The Central Bank has initiated a program to amend the relevant legislation for bank failure resolution, as well as the statutes of the deposit insurance agency. It involves several technical and policy studies. This review process would assess central issues. These include: (i) the reduction of the Central Bank role in the extra-judicial liquidation process and the increase of the role of the private sector; (ii) the balance of rules and discretion in the corrective phases of

28 Page 24 dealing with troubled banks; (iii) the introduction of more efficient resolution techniques for closed bankssuch as "purchase and assumption" operations; (iv) the potential role of FGC in a reformed liquidation process; (v) the strengthening of FGC financial position, particularly via access to contingent lines; and (vi) possible changes to the design of the deposit insurance (e.g., the introduction of risk-based premiums and other complementary monitoring powers). Strengthen effectiveness in the administration of bank failures. An extension of the above topic, this component would improve the supervision process during intervention: off site (effective accompaniment, introducing new computerized methods; settle standard accompaniment to each stage of intervention process) and on-site (schedule of supervision; focus on management). 1.4 Enhance Preparedness for any Future Banking Sector Difficulties: The Central Bank has initiated work to develop a blueprint contingency plan to ensure adequate preparedness to deal with early stages of a financial crisis, should one unexpectedly arise. In developing a contingency blueprint, the work program would find solutions to ensure: (i) minimization and adequate management of risks of contagion and systemic illiquidity; (ii) inter-institutional coordination and effective decision making processes; (iii) adequacy of existing legal powers and protection for supervisory actions; and (iv) suitable exante special legal powers. The plan would seek to protect the interests of depositors (especially small depositors), avoid incurring unnecessary large costs in the process, minimizing any future burden on taxpayers; and promptly restoring the solvency, liquidity and profitability of the banking system. Develop contingency banking crisis plan. The first step in this process would be to develop a basic plan, in order to help identify the types of actions that may have to be taken during a crisis, taking into consideration the skills, policies and processes that would be required. It could be envisaged to include measures for determining the conditions of banks; strengthening undercapitalized banks as appropriate, resolving insolvent banks, managing and re-privatizing banks under temporary state ownership, and establishing a crisis management unit. Revision of Contingency Plan, as necessary. Once a blueprint is in place, dry runs would be practiced from time to time to test the system and correct any shortfalls. Revisions to the plan would aim at keeping up to date the measures proposed during the development of the plan, as well as strengthening identified aspects of the plan, in order to maintain crisis preparedness. 1.5 Reduction of Interest Rate/Spreads; and 1.6 Studies on Economic Policy It is recognized by the BCB that Brazil exhibits one of the highest interest rate spreads in the world. A recent internal study shows that inefficiency and cost-based reasons for high intermediation margins relate mainly to overheads and government-imposed costs such as indirect taxation (principally the CPMF), forced investments, and unremunerated reserve requirements. High overhead costs may be attributed to limited competitive pressures and the high costs of contract enforcement and debtor monitoring. The costs of credit contract enforcement is in turn related to inefficient judicial processes for collateral repossession, corporate reorganization and bankruptcy. Debtor screening and monitoring costs also feed into overhead costs. More efficient sharing of credit information would help reduce informational rents. As part of a broad-based set of actions to foster the reduction in spreads the Central Biank is initiating a series of actions, which include follow up studies on the rationalization of financial sector taxation, enhanced transparency, and debtor information. The actions proposed in this context in the present technical assistance loan include: (i) draft reformulation of bankruptcy law to allow for prioritizing of secured creditors,

29 Page 25 replacement of management and increased flexibility in restructuring; (ii) a study (model) of the impact of actions to reduce spread, through measures such as improved creditor rights (better contract enforceability, repossession of collateral), more efficient judicial processes, and bankruptcy reform. It would include the development of credit and default risk indicators through the use of the credit risk information center and other data resources, as well as facilities for modeling the spread through macroeconomic, microeconomic and financial structure variables. The tasks also include (iii) a study to propose measures to increase productivity and/or competition in the financial sector which would identify regulatory objectives and make recommendations on measures to achieve objectives; (iv) a study on bankruptcy procedures, and (v) a study on taxation. The latter study would examine both the implication of financial sector taxation for spreads, as well as broader issues of neutrality of tax treatment across different financial sector instruments, and between foreign and domestic investors. Finally, a study is also proposed on the subject of (vi) collateralization, which is intended to explore the enhanced use and repossession of collateral as a means towards broadening the availability of basic financial services to the under-served segments of the population, in addition to lowering credit risk (and hence spreads). 1.7 Implementation of Information Technology Diagnostic Proposals: This component will be based on the recommendations of the Gartner Group report, and the work plan to implement the approved measures, developed within the first Central Bank Modernization TA Loan diagnostics study. An interrelated series of follow up actions have been identified which are proposed to be taken within this proposed TA Loan are: (i) an Electronic Document Management System study, on the procedures of generation, flow, safekeeping, control and retrieval of documents within the BCB; the acquisition of associated software and hardware, and training as necessary; (ii) training of IT for new managerialfunctions, especially, project managers for the implementation of information technology needs for the various end use areas of the BCB. This also involves training in the implementation and use of a new technological platform; and (iii) development of an Unified Interface for the access of the various systems of the BCB, such as SISBACEN, internet, intranet, news agencies, message services, as well as management reports. 1.8 Supplementary / Additional Fund Allocations To the extent that some items can only be defined following the detailed studies and works proposed for the project, additional funds have been put in reserve for these needs, which will be better defined in Years 2 and 3. If BCB considers that further needs may arise, other than in the areas defined above, it may be possible to increase the envelope of funds in this category to encompass additional unforeseen needs. Proiect Component II - US$ 6.7 million Support to Brazil's securities markets for Strengthening Regulation and Compliance and Increasing Transparency and Investor Protection Through support to the Comissao de Valores Mobiliirios General Introduction The CVM is in the difficult position of regulating increasingly sophisticated markets with severe constraints on available resources. Complex corporate business transactions requiring CVM review are becoming more prevalent. The Internet, automated securities trading and increased access to foreign markets is making market oversight more difficult and time-constrained. The CVM has identified several areas of responsibility where it believes it must increase its efforts, provided

30 Page 26 sufficient resources become available. Of particular note is its need to increase periodic direct inspections of market participants, including brokerage firms and mutual funds. Currently, firms are inspected on-site only if a problem has been identified. The CVM also would like to increase its direct monitoring of daily trading practices on the exchanges. In addition, there is little direct inspection by the CVM of the exchanges themselves and their fulfillment of their self-regulatory responsibilities. Although there is dual regulatory responsibility, the Central Bank has been primarily responsible for direct oversight of clearance and settlement facilities and financial institution capital adequacy. At the same time, a number of legislative initiatives are likely to further increase the workload of the CVM. Changes in corporate governance could affect the recent spate of going private transactions. The recent changes to the nation's bank secrecy laws is likely to facilitate easier CVM access to private banking and trading records, increasing the number of investigations the CVM will be able to undertake. A number-of other structural changes are also under consideration that could affect the CVM, for example the establishment of a quasi-private entity to oversee accounting standards and the CBLC implementation of a T+3 clearance and settlement system. There are also ongoing discussions of possibly regulatory consolidation within the government. Internally, staff of the CVM identified a number of other initiatives that have been delayed due to lack of funding. For example, public corporations are currently required to submit financial statements electronically, via physical delivery of a diskette. The CVM would prefer to have companies file the entire document, not just the financial statement, electronically. This would facilitate implementation of a selective review process, improving CVM efficiency and enable the CVM to make the documents available publicly over the Internet. Also, the CVM would like to undertake a comprehensive updating of its regulations and then digitize them, along with all current CVM interpretive opinions, so that they would be readily available to the industry and the public. Easy public access would increase ease of compliance and reduce requests for CVM interpretations in areas that have been previously addressed. As noted, there is an expressed need for more robust market surveillance software. While a number of commercially available packages exist, funding has not been available. Automation plays a substantial part in a number of other desired CVM initiatives. A project currently under development, through private funding from the Brazilian Bankers Association, will create a system for mutual funds electronically to file periodic reports on a fund's securities positions as well as its financial statements. The CVM Internet website has been highly successful. It would be the primary vehicle for disseminating publicly the information generated from these other initiatives. This would increase the system demands for storage, indexing and transmission. The current CVM computer infrastructure could not accommodate these initiatives. While the existing local area network links all CVM staff personal computers, there are insufficient funds for the purchase of pc's for new staff or for the purchase of the additional file servers necessary to support these applications. In addition to limiting system performance, the lack of adequate file servers creates security risks. For example, the use of a single file server for both internal storage and storage of information for external use on the Internet website is recognized by the CVM as a security issue. While the need for computer capacity is vital to operations, budgetary limitations have resulted in spending for information technology to be reduced from $2.9 million (US) in 1996 to $1.2 million (US) in During our visit in December, we learned that a number of maintenance contracts for the system had to be cancelled for the remainder of the year due to lack of available funds. The issue of adequate resources is not merely a matter of money. Under the Brazilian civil service system, all hiring must be through competitive exams. These are conducted yearly for each government agency with the authority to hire new staff. Vacancies arising during the year remain unfilled until the next year's exam cycle. If authority for an exam is not obtained, no one may be hired. Another recent change in the Brazilian

31 Page 27 personnel system is the consolidation of all attorney positions within the Ministry of Justice. The CVM must request an assignment of lawyers from the Ministry, which has final discretion over the request. Once assigned, attorneys must be supervised by other attorneys within the CVM legal office. While attorneys may apply through the exam process for non-attorney positions, if hired, they may not provide formal legal opinions. Specific tasks described below have been determined against the background of an overall review of CVM, its present and future responsibilities in the context of changing regulatory and market conditions, and its role in proposed financial sector reforms. Details on individual components are described below Diagnostic Studies: These would span CVM's institutional needs (and the needs of a new restructured securities market regulator); the regulatory authority of CVM, its overall information technology requirements; and complementary studies on the future role of CVM in the context of the internationalization of Brazil's financial markets Comprehensive Internal Assessment of CVM's resources and responsibilities. The study would undertake an assessment of CVM's resources and requirements in the context of the changing capital market environment; a comparison of CVM resources, in terms of fees, budgetary outlays, etc., to other securities regulators in developed and emerging markets; projections of the likely impact of proposed statutory reforms and Brazilian market expansion / contraction on CVM's duties and resource needs; an examination of staffing numbers and skills available relative to requirements; CVM's links to SROs; and recommendations on more appropriate alignment of responsibilities and resources. Study and Recommendations for Strengthening Enforcement Study of the extent and consequences of the CVM's limitations in enforcement due to its limited administrative remedies, lack of access to civil litigation and / or criminal sanctions; structural delays due to need for commissioners to sit as adjudicators at the hearing stage, and delays arising from appellate review of disciplinary sanctions by the CRSFN, a body which reviews financial sector legal judgments. Recommendations for legal and non-legal remedies. Examination of the overall Brazilian regulatory structure and the role of the CVM. Identification of emerging issues for which regulatory responsibility/structure is not established; such as investment advisers, information vendors, individual firm clearance and settlement responsibilities, oversight of individual employees of regulated broker dealers, firms and individuals in the futures markets. Identification of areas of overlap in responsibility / gaps in responsibility between government agencies, including areas in which multiple agencies have parallel regulatory programs for discrete segments of the overall industry, such as the variety of collective investment vehicles (closed pension funds, mutual funds, foreign fixed income and variable income funds). Comparisons with regulatory structures in other markets, especially in terms of degree of consolidation of supervisory responsibilities between securities markets regulators and relative to banking supervision. Development of a plan to eliminate gaps and harmonize the approaches of the relevant agencies, providing guidance on specific changes to supervision issues. Study on Internationalization of Brazilian Securities markets Role and likely impact of listing / trading of Brazilian firms overseas; Entry of foreign investors in the domestic market; impact of the internet on cross border transactions, especially in terms of applicability and enforcement of domestic regulations.

32 Page 28 Information Technology capacity assessment and identification of needed enhancements. This foundational study would pay special attention to infrastructure capacity and security, market surveillance and Internet website needs, including improved public access to corporate and mutual fund data. Where appropriate in terms of the degree of integration of diagnostic and design work, writing of specific softwares / protocols would be undertaken as part of this overall package. This study is likely to serve as an input into a part of the work program of Years 2 and Strengthening Compliance and Regulations Digitizing and indexing of all official CVM statements, legal and accounting interpretations and disciplinary actions, and making them available on the CVM website. (Market participants, as well as their legal and accounting advisors, need ready access to ensure that they are in compliance. Ready access to policy statements also facilitates compliance and should reduce the workload of CVM staff by eliminating requests for advice or interpretation on previously considered topics) by updating and expanding the body of policy statements and improving their public availability Updating a select number of CVM's existing regulations to reflect the government's financial sector reform agenda, and changes in the marketplace. CVM's staff have identified a number of existing instructions requiring updating and revision, including instructions 5 (listing standards), 13 (tender offers) and 31 (material event disclosure). Many of these are designed to emphasize governance issues, in accordance with the new Corporate Law and other initiatives. It is envisaged that further such regulations would be identified in subsequent years Supporting Corporate Finance and Disclosure The CVM staff review the typical array of corporate disclosure documents, including securities registration filings, periodic disclosure documents and special event or special transactions filings. Information technology support could improve CVM operations in several ways, as discussed below. The particulars of these systems would need to be defined first, and this could be undertaken as part of the overall information technology study in A.5 above. Activities anticipated in this area include (i) the installation of a system for tracking all documents filed to enable closer monitoring of staff productivity and timeliness of staff review, improving management of the process. This would require the design of software to customize the tracking system to CVM's organizational processes. (ii) Installation of software enabling implementation of a selective review system to improve the quality of CVM review and increase the efficiency of its reduced staff; and (iii) on-line availability of the full text of all corporate disclosure documents to enhance public access to all filed documents. Support to the Corporate Finance department would also include training in select areas of Corporate Financial Analysis and Accounting Standards, especially in emerging areas such as valuation of assets and companies for purposes of determining whether corporate reorganizations, mergers or going private transactions are fair to minority shareholders (this is a requisite under the new Corporate Law). CVM's Corporate Finance department has also identified training needs in areas relating to accounting standards such as comparing Brazilian accounting standards with foreign standards. The program would include: specialized in-country training programs with a combination of foreign / local trainers Market Surveillance And On Site Inspection A fundamental responsibility of a securities regulator is monitoring activities of securities markets and participants to ensure fair dealing for investors and financial integrity of system. The CVM currently

33 Page 29 performs ongoing surveillance of trading on the securities exchanges. Less extensive is its use of on-site inspections of market participants to assess compliance with the law and on-site monitoring of SRO regulatory functions to ensure they are performing at an acceptable level. Assistance would be provided to CVM to strengthen existing surveillance and inspection programs, including: Study to assess existing CVM market surveillance capacity, identify regulatory objectives and make recommendations on system upgrade, expansion or enhancement to achieve objectives. (combined with the overall Information Technology study in A.5 above). Institutional capacity would also be strengthened by the provision of portable computer equipment to on-site inspectors, and the acquisition of resources recommended by consultancy, which would establish data processing capacity to identify, analyze and recreate aberrant trading patterns. Consultancy to assist in updating existing CVM operations manuals and protocols for inspections of broker-dealers and mutual funds. This would include, inter alia: Identifying appropriate areas for inspection (e.g. - customer sales practices, regulatory compliance program, books and records maintenance, customer funds segregation, and for broker dealers, capital adequacy); drafting formal inspection protocols; establishing firm inspection methods and review cycles; establishing procedures for determining when to conduct special cause inspections and protocol for inspection; and providing basic training on the use of manuals and in on-site inspection methods. To the extent that inspection protocols for mutual funds have already been established by the Central Bank, full use would be made of these materials. Consultancy to assist in establishment of CVM program for surveillance and inspection of commodity! stock index futures markets and participants; including: licensing standards for member firms and regulatory requirements and procedures for fair trading practices and for recording and disclosing transactions (trading priority rules and audit trail systems). Consultant study to prepare comprehensive analysis of Brazilian electronic trading systems and identify potential systemic or regulatory issues that CVM may determine to address, such as (a) capacity of existing exchange and member firm trading systems; (b) accuracy and integrity of trade information disclosure; (c) Suitability issues; (d) internalization of order flow and best execution Investor Protection and Public Information The central focus of this component would be on increased disclosure, and information to investors to enable them to make informed decisions. Securities markets function best with a well-educated fully informed investor population. The internet is an extremely effective vehicle for reaching investors. CVM currently has a fully functioning website that has capacity limitations. An upgraded website could relieve some of this problem. CVM also proposes to use its website to provide investor education materials. The components would be: (i) consultancy to redesign and upgrade CVM website, including the identification of all categories of public information to be made available on website. (The particulars of such a system would need to be defined; this would be undertaken as part of the overall information technology study in A.5 above); (ii) procurement of equipment and software required for upgraded website; and (iii) consultancies to assist with designing online information sheets, including, e.g.; understanding a corporate balance sheet, calculation of mutual fund or pension plan fees and expenses; guidelines for on-online trading for the individual investor. Around 3-5 topics are expected to be addressed in each year for the next three years Mutual Fund Investor Protection In view of the rapid growth of mutual funds in Brazil in recent years and their importance as collective investment vehicles, the provision of investor protection in this area takes on a special significance. The

34 Page 30 extent to which the CVM should make available information on individual mutual funds through its own website, or whether it should be set up with appropriate linkages to data maintained on individual funds' websites, or on the site of an industry association, is debatable, and the evaluation of alternative models would be considered as a part of the overall assessment of information technology capacity and requirements. Components included would be: (i) Consultancy on use of CVM website to make publicly available statements of mutualfunds' data including monthly holdings, and possible inclusion within the system data to calculate fund net asset value, expenses and administrative fees, and methods to compare positions held with the investment policies stated in a fund's prospectus. (This could be undertaken as part of the overall information technology study in A.5 above, which could also examine as an option / alternative the possibilities of creating links on the CVM website to each mutual fund's individual web page). Training in the use of the mutual funds data system would be included. (ii) CVM would undertake to engage consultancy services of a survey design firm to assist in design and preparation of a survey on investor protection, including design of the sample and distribution system and tabulation and analysis of the responses. The goal of CVM's proposed survey is to obtain a clear understanding of the level of sophistication of the public to better focus the investor protection program and identify areas requiring future action by CVM, both educational and regulatory. Providing survey design assistance for CVM's proposed survey on public knowledge of investing, including differences in types of investments and associated risks Overall Institutional Support. Project coordination unit. Recognizing the extreme resource constraints of the CVM at present, the project would finance the use of long term local consultants to work with staff in the project coordination unit, to aid with the implementation of the project, including the local travel of some consultants to ensure coordination between the Rio and Brasilia offices. Limited additional equipment requirements of such staff, such as desk top computers, copiers, and ancillary office equipment, would also be financed. It is understood that over the period of the project, interchanges with staff in CVM and the project unit would allow a transfer of skills to CVM staff. The project would also support on a limited basis, institutional capacity building initiatives which would serve all departments. These would include: (i) provisions for continued Training. It is envisaged that the CVM would continue to benefit from external advisory services in select areas, which could be arranged in an ad hoc basis, or through the organization of seminars. Provisions for such advisors over the period of project implementation are built in to the project. (ii) Foreign Tours / studies CVM staff in a number of departments indicated the usefulness of foreign tours to study particular issues. Given that there was demand for this facility across all areas of the institution, it was considered advisable to centralize the availability for the use of all departments. (iii) Library and Reference Materials. This would comprise not only the purchase of books and reference materials, but also the subscriptions to journals and CD ROM's, and the availability of online services ( e.g., legal, accounting, etc.) Additional Fund Allocations for Years 2 and 3 To the extent that some items can only be defined following the detailed diagnostic work in the first year of the project, additional funds have been put in reserve for these needs, which will be better defined in Years 2 and 3. It appears that the largest share of these funds is likely to be in the area of consultancy for the design requirements of information technology systems, where optimal design selection will be determined in the first phase of the diagnostic work.

35 Page 31 Annex 3: Estimated Project Costs Brazil: Financial Sector Technical Assistance Project Pr2 joct ConeDou.nts l,ocel F=treIg TOOl % Foreignp % Totl.C Coow) EIehanAg. Base Costs L. Support to address systemic financial sector issues, and 3,928,032 7,071,968 11,000, reinforce banking supervision, through the Central Bank (Total) Pre-identified Activities 1.1 Payment System Reform 33, , , Improved Banking Supervision, Regulations, Bank Failure 399,032 1,946,368 2,345, Resolution and Preparedness I.5-I.6 Reduction of interest rate/spreads and Studies on Sectoral 408, , , Policy 1.7 Implementation of IT Diagnostic Proposals 88,000 2,152,000 2,240, Project Management 3,000,000-3,000, Second Phase/Supplementarv Activities 2,107,200 2,107, Support for the strengthening regulation and 1,848,910 4,730,450 6,579, compliance, and increasing transparency and investor protection, in the area of securities markets, through support to the CVM (Total) Pre-identified Activities 11.1 Diagnostic Studies 224,000 1,005,900 1,229, Strengthening Compliance, Corporate Finance, Surveillance 419,000 1,444,200 1,863, and Site Inspection IL.5-II.6 Investor Protection, Public Infornation and Collective 350,000 13, , Investments 11.7 Institutional Support and Project Management 855, ,950 1,322, Second Phase/Suvplementarv Activities 1,800,000 1,800, Total Base Costs 5,776,942 11,802,418 17,579, Price Contingencies 118, , , Total Project Costs 5,895,739 12,018,239 17,913, : Price contingencies for local costs are based on domestic price escalation rates of 4% and international price escalation rates of 2% based on the index of unit value of manufactured imports.

36 Page 32 Annex 4: Cost Effectiveness Analysis Summary Brazil: Financial Sector Technical Assistance Project (Not Applicable) Main Assumptions: Cost-effectiveness indicators 1 ' These indicators should compare the project with a suitable comparator, e.g., unit project costs of alternative project designs or international standards.

37 Page 33 Annex 5: Financial Summary for Revenue Earning Project Entities (Not Applicable)

38 Page 34 Annex 6: Procurement and Disbursement Arrangements Brazil: Financial Sector Technical Assistance Project 1. Procurement Responsibility. Project implementation will require procurement of a limited quantity of goods but significant technical assistance services for studies and other consultant assignments. For the CVM component, the office of the Financial Superintendent in the Rio headquarters will be responsible for the overall project procurement activity, including compliance with procedures and timetables agreed with the Bank. The project management office SEPRO (Secretaria de Projetos) of the Central Bank will carry out same functions for the Central Bank component. The Central Bank will continue to hire UNDP as procurement agent, as under the ongoing CBTAL currently under implementation, and CVM will also hire UNDP as procurement agent, to carry out the procurement under the Project. The Superintendent in Rio is a qualified manager, knowledgeable about procurement issues. Although recently appointed to the position of project manager, he has made every effort to familiarize himself with all aspects of the project. The project management office within the Central Bank (SEPRO) is a well established unit that has experience in Bankfinanced projects. 2. The CVM Financial Superintendent and project coordinator in Rio will organize a procurement team consisting of at least one experienced staff and an administrative assistant who may be selected with UNDP assistance, or through open competition. The team will be formed as soon as possible. The team, who should be already familiar with the Bank's procurement guidelines, will provide UNDP staff with clear working instructions closely reflecting the Bank's procedures and outlining all procedural aspects of procurement under the project. The working instructions should be an integral part of the project's procurement reference documentation or Black Book, which was under compilation by the appraisal mission. In addition, a procurement workshop, involving the procurement team, UNDP staff and the implementing staff of the Central Bank would be organized prior to the Loan's effectiveness. The workshop would focus on the Bank's procurement policy and procedures and their application to the procurement arrangements planned for project implementation. 3. Procurement Plan. CVM and Central Bank prepared procurement plans during the project appraisal. The plans cover the first and part of the second year of the project implementation. Many of the initial studies consist of diagnostics and action plans that would require additional consultants services and hardware and software for further implementation. The procurement methods envisioned for the second and third year of implementation include NCB for Goods and QCBS and Individual services for consultants. The plans for the first and second year which include clearly identified items and services were approved by the RPA's office and are in the project files. The procurement plans consist of: (i) procurement plan for the project's goods, including contract packaging, applicable procedures and process scheduling; (ii) a consultant selection process plan for the project's consultant services, including contract packaging, applicable procedures, shortlists, and selection criteria. The procurement plan and consultant selection process plan will be updated periodically, every 6 months. The plans include the (i) list of contracts completed, under execution, under procurement, to be procured in the upcoming calendar semester and, tentatively, in the subsequent semester; (ii) costs of completed and under execution contracts, and estimated costs for upcoming contracts; (iii) schedule of bidding; and (iv) particular methods of procurement of goods or selection of consultants. 4. Methods for Bank-Financed Procurement. Bank-financed procurement will be carried out in accordance with provisions stipulated in the Loan Agreement and the Bank's Guidelines for Procurement (published in January 1995, revised in January and August 1996, September 1997 and January 1999) for supply of goods and the Bank's Guidelines for Selection and Employment of Consultants (published in January 1997, revised in September 1997 and January 1999) for technical assistance and other consultant assignments. The Bank's Standard Bidding Documents and Standard Request for Proposals will be used for the Bankfinanced ICB goods and consultant services, respectively. For NCB procurement of goods, CVM and the Central Bank will use the model standard bidding document issued by SEAIN in November The

39 Page 35 project's procurement arrangements for each component are summarized in Table A. Annex 6, Table A: Project Costs by Procurement Arrangements (in US$ thousand equivalent) PROCUREMENT METHODS CATEGORIES ICB NC Other - 7' CVM BC cvm BC (VM -JC j T i 1. Goods 3, ' ,308 4, Consultants 5, , , , ,577.8 and Training 3. Front Fee Total 3, , , ,000 6, ,296.8 Notes: ICB: International Competitive Bidding; NCB: National Competitive Bidding; Other: includes National and Intermational Shopping; NBF: Not Bank-financed Shopping: US$190,000; Direct Contracting of journals, magazines US$200,000; and US$200,000 through administrative/operational procedures for paying travel, airfare, per-diem, etc. against an annual plan approved by the Bank 2 Taxes at 20% 3Taxes at 20% 4Taxes for consultants at 5%; UNDP fee at 3% and ABC fee at 1% 5 Project implementation unit costs; taxes for consultants at 5%; UNDP fee at 3% and ABC fee at 1% 5. Bank- Financed Goods and Associated Procedures. The proposed project would finance goods consisting of (i) books and professional journals; (ii) software and on-line services subscription; and (iii) computer hardware and software. The characteristics and specifications of part of the latter items will be defined upon completion of the various diagnostics and studies in each of the components of the Project. In the case of the Central Bank, procurement of software and IT hardware in an amount of US$3,000,000 was identified in the procurement plan; similar items, in individual packages estimated to cost less than US$250,000, in an aggregate amount not to exceed US$950,000 are likely to be identified during the diagnostics studies and will be procured through NCB procedures. In the case of CVM, the procurement plan identified items in individual packages estimated to cost less than US$100,000, in an aggregate amount not to exceed US$200,000, will be procured through shopping procedures. The procurement method pregdo (Dutch shopping) can be used as an alternative to shopping'. Journals, magazines and on-line services subscriptions, obtainable only from one source, will be procured directly, in an aggregate amount not to exceed US$200,000. Other operational expenses, including travel expenses of staff participating in training activities, will be paid using administrative procedures of UNDP and CVM, reviewed and found acceptable to the Bank, in an amount not to exceed US$200,000, in accordance with annual plans approved by the Bank. Upon completion of the diagnostics studies in CVM, it is likely that similar items, in individual packages estimated to cost less than US$250,000, in an aggregate amount not to exceed US$500,000 will be procured through NCB procedures acceptable to the Bank. 6. Bank-Financed Consultant Services and Associated Procedures. The proposed project would finance consultant services and training for an estimated total cost of about US$9.3 million and consisting of (i) technical strengthening; (ii) institutional strengthening; (iii) public information; and (iv) coordination and monitoring; and (v) specific project related training and advisory support. ' The pregdo is a simplified procurement method established by law for the procurement of small off-the-shelf items, in which the lowest priced bidders are given the opportunity to improve their offers in a public ceremony.

40 Page 36 Annex 6, Table Al: Consultant Selection and Training Arrangements (in US$ million equivalent) Consultanid07 t-t; and ;f;; i; ;; ;fg0x00;:;;:g ; MEht QSEJ;ECTION : S, A. Firms B. Individuals Total This table does not include training expenses paid when using administrative procedures: travel, per-diem, and rental of space, for training. QCBS: Quality-and Cost-Based Selection QBS: Quality-Based Selection: under the CVM component, QBS will be used for hiring High Level Advisory Services under the Diagnostics Studies component. Under the BC component QBS will be used in four contracts: (1) hiring of the IT upgrading services (2) hiring the Best practices in money laundering services, both under the Improvement Banking and Supervision Regulations component; (3) hiring the studies on collateralization and (4) services for training of IT staff. Both under the Economic Policy Studies component. SFB: Selection under a Fixed Budget: under the CVM component SFB will be used for three contracts: (I) for hiring the Manual preparation services under the Investor Protection and Public Information Component; (2) for hiring the Software Design services under the Collective Investments component; and (3) for hiring the Training on Updating services under the Strengthening Compliance component LCS: Least-Cost Selection; CQ: Selection Based on Consultants Qualifications will not be used in the Project Other: Selection of individual consultants (per Section V of Consultants Guidelines), NBF: Not Bank-financed. 7. The project's selection and employment of consultants will be carried out under arrangements acceptable to the Bank (Table Al), using the Bank's Standard Forms and Contracts. Most of the project's studies, implementation supervision, financial and procurement audits would be carried out following Quality and Cost-Based Selection (QCBS) methods, individual consultants, and other exceptional methods as detailed in Table Al. 8. Procurement Review and Methods. The Bank's procurement review will be in accordance with Appendix 1 of the Guidelines for Procurement and the provisions stipulated in the Loan Agreement. Procurement documents for all ICB will be subject to Bank's prior review, irrespective of the estimated amount of contract. For CVM, the Bank will review all NCB and the first three shopping procedures irrespective of the estimated amount of contract. For the Central Bank, the Bank will review only the first NCB and the first shopping procedure, if any, irrespective of the estimated amount of contract. 9. With regard to consultant services, prior to issuance of any requests for proposal, a complete plan for selection of consultants under the project should be prepared by CVM and Central Bank. The Bank's review of selection of consultants will be in accordance with Appendix I of the Guidelines for Selection and Employment of Consultants and the provisions stipulated in the Loan Agreement. Consultant firm contracts estimated to cost the equivalent of US$100,000 or more per contract will be subject to the Bank's prior review. All consultant firms contracts estimated to cost less than the equivalent of US$100,000 per contract will be subject to post review. For employment of individual consultants estimated to cost the equivalent of US$50,000 or more per contract, in the case of the Central Bank, and US$35,000 or more per contract, in the case of CVM, the qualifications, experience, terms of reference and terms of employment of the consultants will be provided to the Bank for its prior review and the contracts will be awarded only after the Bank's concurrence. Contracts for individual consultants estimated to cost less than the equivalent of US$50,000 for Central bank and US$35,000 for CVM, will be subject to post review. Consultant contract documents to be reviewed will include TORs, shortlists, evaluation reports, and contract forms. A review process similar to individual consultants, will apply to training and workshops. Under the CVM component, in addition to QCBS, QBS and SFB will be used for the assignments listed in the bottom of Table Al, and individual 2 The Loan Agreement will round up the aggregate amounts

41 Page 37 consultants will also be used in an aggregate amount not to exceed US$1.3 million. Under the Central Bank component, in addition to QCBS, QBS will be used for the assignments listed in the bottom of Table Al, and individual consultants will be used in an aggregate amount not to exceed US$1 million. Annex 6, Table B: Thresholds for Procurement Methods and Prior Review Expe ture Contiact Value. i uent lulsc : -C C f tt Caftory (nreshold) Metbod - i US $ thousands US $ thousands 1. Goods > 250 ICB Prior review of any ICB and NCB contracts for 250 < NCB CVM irrespective of amount; for Central Bank all ICB and first NCB irrespective of the amount 100 < IS / NS Prior review of first three shopping procedures for CVM and first shopping, if any, for Central Bank irrespective of amount Post review, random sample, on shopping below threshold. Aggregate Prior Review(Goods): S3,750, Consultant Prior review of consultant selection. Services and Training > 100 QCBS and Subsequently, prior review for all contracts > (Expected to be Firms) other methods Prior Review: $3,500,000 > 50 Individuals Prior review for all Individual Consultant (Expected to be Individual contracts > $35,000 equivalent for CVM and > Consultants. Trainine and US$50,000 equivalent for Central Bank Workshops) Aggregate Prior Review: $1,000,000 Post review, random sample, on all contract service below threshold. Total value of contracts subject to prior review: $8,250,000 (60% of Loan Amount) 10. In addition to the regular tasks of prior and ex-post reviews, the Bank may also carry out spot checks of the quality and consistency of its financed procurement work, with the objective of strengthening the fiduciary responsibilities. 11. Advertising. A General Procurement Notice for hiring of consultant services in the CVM component, and the ICB goods and consultants services under the Banco Central component, should be published in the United Nations Development Business, no later than May The Notice will be updated annually for outstanding consultant services and ICB goods. In addition, detailed consultant services and assignments will be advertised by CVM and Banco Central, as they become available, in at least one national newspaper of a large circulation. Furthermore, the implementing agencies may also advertise some of the project's studies in an intemational newspaper or a technical magazine. The agencies may also seek "expressions of interest" by contacting embassies, professional organizations, or firms that they know or that are registered in DACON (paragraph 1.15 of the Guidelines for Selection and Employment of Consultants). In this case, the information required would be minimum, limited to make a judgement on the firm's suitability. Sufficient time (not less than 30 days) will be provided for responses, before preparing the short lists. 12. Methods for Non-Bank Financed Procurement. The Central Bank will continue to hire UJNDP and ABC, as under the ongoing CBTAL currently under implementation, and CVM will also hire the same agencies, for procurement administration activities under PRODOC documents based on the Cost Sharing

42 Page 38 Agreement and Checklist approved by the Bank. 13. Procurement Records. Detailed procurement records, reflecting the project's supply of goods and consultant services, including records of time taken to complete key steps in the process and procurement activities related to supervision, review and audits, will be maintained by CVM in Brasilia and in SEPRO, at the Central Bank, respectively. These records will be maintained for at least two years after the project's closing date. The records for goods will include public notices, bidding documents and addenda, bid opening information, bid evaluation reports, formal appeals by bidders and outcomes, signed contracts with related addenda and amendments, records on claims and dispute resolution, and any other useful information. The records for consultant services will include public notices for expression of interest, request for proposals and addenda, technical and financial reports, formal appeals by consultants and outcomes, signed contracts, addenda and amendments, records on claims and dispute resolution and any other useful informnation. 14. Procurement Risk Assessment. There is no Country Procurement Assessment (CPAR) for Brazil. A key aspect for defining the level of prior review has been the procurement capacity assessment of CVM and the Central Bank. The assessment involved officials from CVM and Central Bank to complete data collection questionnaires about laws, regulations and procedures. With regard to CVM, since the unit's staffing is yet to be completed and its procurement team yet to be organized, the Bank mission worked with the project manager and his team in Rio de Janeiro, collecting data, analyzing procurement performance and reviewing how CVM's procurement under the project will be organized. Based on this assessment, a capacity assessment for each implementing agency was prepared. CVM was rated high risk and the Central Bank was rated average risk. The Central Bank has an established and experienced project management office that is very familiar with the procurement procedures financed by the Bank and knows well the relationship with UNDP/ABC. Overall Procurement Risk Assessment High Average Low CVM X Central Bank X 15. Frequency of procurement supervision missions proposed: For CVM: one every 6 months, including special procurement supervision for post-review/audits; for Central Bank: one every year. 16. Procurement Audits. CVM and the Central Bank will provide the Bank, no later than six months after the end of each year, procurement records audited by independent procurement experts, acceptable to the Bank. These procurement audits could be performed concurrently with the financial audits. The term of reference for the procurement reviews will be in accordance with internationally accepted standards. Financial Management and Disbursement Accountability Environment at Banco Central do Brasil and Comissao de Valores Mobiliarios - CVM 17. The financial management systems of the project management office at the Banco Central do Brasil

43 Page 39 and Comissao de Valores Mobiliarios - CVM were reviewed by a Bank Financial Management Specialist, for compliance with OPIBP and the Loan Administration Change Initiative (LACI) Implementation Handbook. Based on this review, the project was certified as a "B", indicating that Banco Central do Brasil and CVM financial management capacity satisfies the Bank's minimum financial management requirements. The financial management assessment report for Banco Central do Brasil and CVM is in the project files. 18. Previous experience in financial management with Banco Central do Brasil indicates that generally acceptable systems are in place. However, the project management unit at the Banco Central do Brasil is undertaking adjustments of its financial management system in order to generate PMRs to better monitor its administrative and financial functions and to disburse and certify expenditures, which at the moment are certified by SOEs. The financial management system is in the process of being tested after the adjustments proposed, and exercises in the system are being carried out to allow project staff to become more familiar with project management reports. This system integrates financial, and physical/financial monitoring modules and it will be able to generate PMRs as agreed with the Central Bank's project management office. On the other hand, CVM will adopt the financial management system in place at Banco Central to comply with the Bank's requirements. This implies to disburse and account for the use of the funds. 19. Action plans to strengthen Central Bank's and CVM's financial management systems in order to enable them to produce PMRs acceptable to the Bank were agreed with both Banco Central do Brasil and CVM, and the recommendations to improve the financial management reporting system, including primarily, the management reports, and accounting balance sheets have been almost accomplished and it will facilitate timely preparation of the PMRs and submission of audit reports. Action plans will be finalized within 6 months of the date of the Loan Agreement. Disbursements Procedures 20. Disbursement will be made under traditional procedures for purposes of justification of expenditures until both the Central Bank and CVM complete action plans to enable them to produce PMRs satisfactory to the Bank, and the Government decides to withdraw funds on the basis of PMRs. Disbursement on the basis of SOEs will be required for all items that are not subject to the Bank's prior review, which are: (a) contracts for goods costing less than US$250,000 equivalent for the Central Bank, other than the first contract to be awarded under NCB and shopping procedures; (b) contracts for goods costing less than US$100,000 equivalent for the CVM, other than the first three contracts to be awarded under shopping procedures; (c) contracts for consulting firms' services costing less than US$100,000 equivalent; (d) contracts for individual consultants'services costing less than US$50,000 for the Central Bank, and less than US$35,000 for the CVM; and (e) training activities. Once the Bank (TTL, FMS and PS) has approved the Central Bank or CVM financial management system's capacity to generate PMRs, disbursements may be made from the Loan Account in respect of the Central Bank or the CVM, as the case may be, on the basis of PMRs. PMRs on the use of the funds would be submitted to the Bank on a quarterly basis. All applications would be supported by a cash forecast of projected expenditures corresponding to the period of the application of the funds, as established by the Borrower and agreed with the Bank. All supporting documentation authenticating the expenditures reported in the PMRs will be maintained by the project implementation unit and made available for review by auditors and Bank missions as requested. Because UNDP will be effecting all payments under the Project, there will not be a Special Account for the Project. Disbursements will be made directly to the UNDP accounts for the Central Bank and CVM components of the Project.