Completion Report. Project Number: Loan Number: 1946 December Lao People s Democratic Republic: Banking Sector Reform Program

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1 Completion Report Project Number: Loan Number: 1946 December 2010 Lao People s Democratic Republic: Banking Sector Reform Program

2 CURRENCY EQUIVALENTS Currency Unit Kip (KN) At Appraisal At Program Completion (27 July 2002) (31 March 2009) KN1.00 = $ $ $1.00 = KN10,070 KN8,573 ABBREVIATIONS ADB Asian Development Bank AML anti money laundering (regime) APB Agriculture Promotion Bank BCEL Banque pour le Commerce Extérieur Lao BOL Bank of the Lao PDR BRIC bank restructuring implementation committee BSRP Banking Sector Reform Program CAR capital adequacy ratio CIB Credit Information Bureau FIU financial intelligence unit GDP gross domestic product IMF International Monetary Fund JFICT Japan Fund for Information and Communication Technology Lao PDR Lao People s Democratic Republic LDB Lao Development Bank NPL nonperforming loan OEDR Office of Economic Dispute Resolution SDR special drawing right SOCB state-owned commercial bank SOE state-owned enterprise TA technical assistance NOTES (i) (ii) The fiscal year (FY) of the government and its agencies ends on 30 September. FY before a calendar year denotes the year in which the fiscal year ends, e.g., FY2009 ends on September In this report, $ refers to US dollars.

3 Vice-President C. Lawrence Greenwood, Jr., Operations 2 Director General K. Senga, Southeast Asia Department (SERD) Director J. Ahmed, Financial Sector, Public Management, and Trade Division, SERD Team leader Team member T. Hla, Economist, SERD M. L. Ventura, Associate Operations Analyst, SERD In preparing any country program or strategy, financing any project, or by making any designation of or reference to a particular territory or geographic area in this document, the Asian Development Bank does not intend to make any judgments as to the legal or other status of any territory or area.

4 CONTENTS Page BASIC DATA i I. PROGRAM DESCRIPTION 1 II. EVALUATION OF DESIGN AND IMPLEMENTATION 2 A. Relevance of Design and Formulation 2 B. Program Output 3 C. Disbursements 10 D. Program Schedule 10 E. Implementation Arrangements 10 F. Conditions and Covenants 11 G. Related Technical Assistance 11 H. Consultant Recruitment and Procurement 12 I. Performance of Consultants, Contractors, and Suppliers 12 J. Performance of the Borrower and the Executing Agency 12 K. Performance of the Asian Development Bank 12 III. EVALUATION OF PERFORMANCE 13 A. Relevance 13 B. Effectiveness in Achieving Outcome 13 C. Efficiency in Achieving Outcome and Output 14 D. Preliminary Assessment of Sustainability 14 E. Impact 14 IV. OVERALL ASSESSMENT AND RECOMMENDATIONS 14 A. Overall Assessment 14 B. Lessons 15 C. Recommendations 16 APPENDIXES 1. Program Framework Status of Compliance with Loan Covenants 24

5 i BASIC DATA A. Loan Identification 1. Country 2. Loan Number 3. Program Title 4. Borrower 5. Executing Agency 6. Amount of Loan 7. Program Completion Report Number B. Loan Data 1. Appraisal Date Started Date Completed 2. Loan Negotiations Date Started Date Completed 3. Date of Board Approval 4. Date of Loan Agreement 5. Date of Loan Effectiveness In Loan Agreement Actual Number of Extensions 6. Closing Date In Loan Agreement Actual Number of Extensions 7. Terms of Loan Interest Rate Maturity (number of years) Grace Period (number of years) Lao People s Democratic Republic (Lao PDR) 1946 Banking Sector Reform Program Lao People s Democratic Republic Bank of the Lao People s Democratic Republic SDR11,341,000 ($15 million equivalent) as the original loan amount and SDR11,341,000 ($17,042,978.29) as the net loan amount PCR: LAO July August October October November February May March 2003 None 31 December March % during grace period; 1.5% thereafter Disbursements a. Dates Initial Disbursement 24 March 2003 Effective Date 07 March 2003 Final Disbursement 31 March 2009 Original Closing Date 31 December 2006 Time Interval 72 months Time Interval 45 months

6 ii b. Amount (SDR) Cat. Category or Original Partial Revised Amount Undisbursed No. Subloan Allocation Cancellations Allocation Disbursed Balance (1) (1) (2) (3 = 2 4) (4) (5) (6 = 4 5) First Tranche 3,781, ,781,000 3,781,000 0 Second Tranche 3,781, ,781,000 3,781,000 0 Third Tranche 3,779, ,779,000 3,779,000 0 Total (SDR) 11,341, ,341,000 11,341,000 0 Total ($) 17,042,978 17,042,978 17,042,978 0 C. Program Data Program Performance Report Ratings Ratings Implementation Period Development Objectives Implementation Progress 30 Nov May 2006 Satisfactory Satisfactory 30 Jun Dec 2009 Satisfactory Partly Satisfactory D. Data on Asian Development Bank Missions Name of Mission Date No. of Persons No. of Person-Days Specialization of Members a Country Contact/ 3 12 Oct a, b Consultation Fact Finding 1 24 May 5 Jun a, b, c, d, e, f, g, h, i, j Fact Finding Jun a, b, c, d, e, f, g, h, i, j, k Appraisal 27 Jul 12 Aug a, b, c, d, e, f, j, l Pre-implementation Review 1 Review 2 Review Jan May Jul 8 Aug Nov a, b a a, d a, d, f Review Feb a, d, m Review May d, m, n Review 6 14 Jan 1 Feb c, d, f, m, o Review May c, m Review Jul c, f, m, o Review Dec c, m, o, p Review Oct c Review Dec b, c, j, m Review Feb b, m Review Feb b, q Review Oct b Program Completion Review Feb b, j a a = financial economist, b = economist, c = financial sector specialist, d = counsel, e = project economist, f = director, g = poverty reduction specialist, h = investment officer, i = deputy director general, j = project/operations analyst, k = procurement/consulting services specialist, l = consultant, m = financial management specialist, n = young professional, o = microfinance specialist, p = administrative assistant, q = national officer

7 I. PROGRAM DESCRIPTION 1. A banking crisis closely followed and in part was a consequence of the macroeconomic and fiscal crisis that begin in in the Lao People s Democratic Republic (Lao PDR), during which prices rose by 200% and the kip depreciated by a similar percentage. National government revenues plunged during this period and the fiscal deficit reached 5.6% of gross domestic product (GDP) in The fiscal crisis, combined with the prevalent practice of directed bank lending to state-owned enterprises (SOEs) served to deepen and prolong the banking crisis as arrears in government payments to SOE suppliers mounted, inflating the already large volume of nonperforming loans (NPLs) at the state-owned commercial banks (SOCBs). The SOCBs held some 70% of banking sector assets at the time. By 2004, NPLs in the three largest SOCBs had reached 60% 80% while capital adequacy ratios (CARs) ranged between 40% and 80%. The significant and growing cost of the needed restructuring threatened to undermine further the government s fragile fiscal position and adversely affect macroeconomic stability if measures were not immediately taken to stem losses and address fundamental issues confronting the sector. 2. The Banking Sector Reform Program (BSRP) provided the policy-based element in a package of policy and technical assistance (TA) aimed at restructuring the banking sector and restoring it to financial health. Other integral elements of the package were a TA loan project, two grant-based TA projects, and a Japan Fund for Information and Communication Technology (JFICT) project, all in support of the implementation of reforms under the BSRP (see section G for details). 1 At the time the program was formulated, the sector was facing crisis with a large and growing stock of NPLs in SOCBs (composing more than 70% of total loans) leading to the insolvency of the three largest SOCBs. 3. The reforms under the BSRP and its associated TA projects were closely coordinated with complementary funding from the International Monetary Fund (IMF) and the World Bank. The IMF supported close monitoring of the fiscal and monetary framework to help minimize macroeconomic risk, and the strengthening of supervision by the central bank. The World Bank funded reforms in SOEs, many of which were insolvent and accounted for a large share of the stock of NPLs at the SOCBs. 4. While the restructuring of the banking sector was its core, the BSRP also had broader objectives. It sought to build the foundations for a sounder and more efficient financial sector and improve access to finance. To these ends, program extended support across the following range of areas: (i) Restructuring the banking sector. This component involved (i) strengthening the legal framework for commercial banking and creating a level playing field for SOCBs and private banks, (ii) improving governance in the main SOCBs through governance agreements, and (iii) resolving NPLs in the main SOCBs and assisting in their recapitalization. 1 (i) ADB Report and Recommendation of the President to the Board of Directors on a Proposed Technical Assistance Loan to the Lao People s Democratic Republic for the Banking Sector Reform Project. Manila (TA Loan 1931-LAO); (ii) ADB Grant Assistance to the Lao People s Democratic Republic for Banking Automation to Support Outreach, Efficiency, and Governance. Manila (JFICT project 9050); (iii) ADB Technical Assistance to the Lao People s Democratic Republic for Strengthening Governance for Banking Sector Reform. Manila (TA 4002-LAO); and (iv) ADB Technical Assistance to the Lao People s Democratic Republic for Promoting Governance in Financial Transactions. Manila (TA 4770-LAO).

8 2 (ii) (iii) (iv) Strengthening of enabling legal environment and judicial oversight. The measures under this component were intended to strengthen the commercial legal environment by establishing a commercial chamber in the People s Supreme Court, building the capacity of commercial judges, and establishing an anti money laundering regime. Facilitating private sector access to finance. The measures under this component sought to develop the regulatory and institutional framework for secured transactions and lease financing to improve access to finance, especially for small and medium-sized enterprises (SMEs). Promoting rural finance and microfinance. This component supported the restructuring of the Agriculture Promotion Bank (APB) and its policy environment, including the removal of policy loans from the bank s mandate and the lifting of interest rate ceilings on loans. 5. The BSRP built on reforms under earlier Asian Development Bank (ADB) programs in the financial sector that sought to support the sector s transition from a monobank-based system of directed credit to a structure that accommodated a wider range and number of financial institutions, competition, and market-based financial intermediation A loan of $15 million (SDR11.34 million) for the BSRP was approved by ADB on 28 November It was to be disbursed in three tranches of $5 million each (SDR3.78 million) upon compliance with (i) specified first-tranche release conditions, upon loan effectiveness; (ii) specified core second-tranche release conditions, about 18 months after loan effectiveness; and (iii) specified core third-tranche release conditions, about 36 months after loan effectiveness. 7. The loan agreement was signed on 3 February 2003 and became effective on 7 March The first tranche was disbursed on 24 March 2003, and the second tranche on 2 July The third tranche, originally scheduled for release by January 2006, was disbursed on 31 March II. EVALUATION OF DESIGN AND IMPLEMENTATION A. Relevance of Design and Formulation 8. The program s objectives were grounded in the poverty reduction partnership agreement between the government and ADB, 3 which includes a joint commitment to give priority to (i) macroeconomic stability, (ii) faster economic growth based on a strengthened commercial environment, and (iii) the development of a financial system that is conducive to private sector development and achieves considerable rural outreach. 9. At the time of program formulation and during implementation, the BSRP s core objective of restructuring the banking sector and restoring it to financial health was highly relevant to dealing with the immediate exigencies of the crisis, as well as some of its underlying causes. As noted below, this objective was not only consistent with the priorities of the government and ADB but also critical to broader progress in development. 2 ADB Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the Lao People s Democratic Republic for the Financial Sector Reform Project. Manila; and ADB Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the Lao People s Democratic Republic for the Second Financial Sector Reform Project. Manila. 3 ADB Poverty Reduction Partnership Agreement between the Lao People s Democratic Republic and the Asian Development Bank. Vientiane. 28 September.

9 3 10. The banking sector in the Lao PDR accounts for some 98% of total financial sector assets and is dominated by a small number of SOCBs, which together account for some twothirds of sector assets. At the time of program formulation, much of the lending by these institutions was policy-based, directed lending: decisions to allocate credit based not on commercial criteria but rather on political or social considerations. These practices were a holdover from the earlier monobank system, where the state used the banking system to allocate credit. More than 60% of the loans made by the Banque pour le Commerce Extérieur Lao (BCEL) 4, for example, were to state enterprises. 11. The dominant role of the SOCBs in the financial sector and their directed credit lending largely undermined the sector s essential function of promoting economic growth by allocating resources to their most productive uses. Lending by SOCBs for political and social purposes and to SOEs also served to crowd out private sector access to credit, impeding job creation among other things These practices, combined with weaknesses in general management, credit assessment, and risk management capacity, contributed to the accumulation of a large and growing stock of NPLs. The weak governance structure at the Bank of the Lao PDR (BOL) made matters worse. The BOL lacked independence and adequate supervisory capacity, and further faced issues in effectively conducting prudential supervision due to the conflict of interest inherent in its role as both owner and regulator of SOCBs. The fiscal burden imposed by large and recurring losses in the SOCBs threatened to undermine macroeconomic stability as well as investment in other sectors vital to the country s development, such as health and education. 13. To allow the economy to achieve its growth potential and help meet the government poverty reduction goals anchored in its National Socio-Economic Development Plan ( ), a sound and stable financial sector had to be established and resource allocation improved. To this end, it was imperative that the SOCBs be restructured and recapitalized, and their lending put on a commercial basis. 14. The BSRP s full scope, however, covered a wide range of reforms, some of which extended beyond the immediate exigencies of the crisis and took a significantly longer time to implement than anticipated under the program. In all, the BSRP entailed 42 policy actions distributed over three tranches and eight implementing agencies. This mix of core objectives with longer-term goals that were important but less integral to addressing the crisis, in retrospect, appear to have diluted the focus and priorities of the program, and overstretched the resources available for what was an already complex, urgent, and resource-intensive crisis operation. B. Program Output 1. Restructuring the Banking Sector and State-Owned Commercial Banks a. Sector Restructuring 15. The measures under this component were intended to (i) reduce the number of SOCBs, (ii) establish a legal framework for the banking sector that fostered competition and sound 4 The largest SOCB. 5 (SOEs notably account for only 1% of employment)

10 4 banking practices, and (iii) develop a forward-looking strategy that would promote a more diverse, competitive, and commercially oriented financial sector. 16. To help focus restructuring efforts and resources, two smaller SOCBs, Lao May Bank and Lane Xang Bank, were merged into a newly created Lao Development Bank (LDB), thereby reducing the number of operational SOCBs from three to two. Apart from helping to concentrate limited managerial resources, the consolidation aimed to allow for the new entities to streamline operations, reduce costs, and improve profitability over the medium term. 17. Banking laws and regulations were strengthened through amendments to the commercial banking decree aimed at (i) improving corporate governance in commercial banks, (ii) strengthening prudential requirements, and (iii) providing for more equal treatment of participants in the sector. The revised decree was later upgraded to the Law on Commercial Banks (announced in January 2007), with provisions that (i) strengthen corporate governance in banks by requiring them to create governance committees and directors to have relevant banking experience, (ii) strengthen prudential requirements, and (iii) allow majority foreign ownership of banks. The law also encourages competition in the sector by allowing all commercial banks to operate branches nationwide. 18. The government has adopted a financial sector strategy that outlines a broad vision and road map for the development of the financial sector. The strategy presents a systematic approach to developing the sector and to identifying and resolving issues that impede development. It covers the modernization and strengthening of central bank operations, as well as the development of (i) the banking sector, (ii) the capital market, (iii) money markets, (iv) nonbank financial institutions, (v) microfinance, and (vii) financial sector infrastructure. The strategy, however, took much longer to formulate and adopt than anticipated under the BSRP, in part due to the government s consultative and consensus-building approach, the novelty of many of the financial concepts, and the wide range of stakeholders involved. b. Operational Restructuring of State-Owned Commercial Banks 19. The key instrument underpinning the operational restructuring and recapitalization of the remaining SOCBs (BCEL and LDB) was a set of governance agreements between the MOF, the BOL, and the SOCBs. 6 The agreements established a systematic framework for the restructuring process based on: (i) (ii) (iii) (iv) (v) a road map with defined financial and operating targets, a business plan for achieving the targets, a performance measurement system, objective reviews of progress by external auditors, and a commitment by the BOL and the MOF to undertake corrective action where needed. 20. A fundamental aim of the agreements was to establish an effective credit culture within the SOCBs (with approvals based on rigorous scrutiny of customers ability to repay) that would lay the foundation for their sound operation after restructuring and recapitalization. 6 The agreements were signed by the Minister of Finance, the BOL governor of the Bank of the Lao PDR, and the chair of each SOCB board.

11 5 21. As a basis for this, the agreements gave the SOCBs the necessary independence in extending credit and setting interest rates, with advisory and capacity building assistance from a team of resident international banking advisers funded under a parallel TA loan (Banking Sector Reform Project; see footnote 1). To induce the SOCBs to meet the operational restructuring targets under the agreements, progress was linked to support for their financial restructuring through the phased issue of recapitalization bonds by the MOF The first set of governance agreements, reached in 2003, had to do with putting in place the key elements of an institutional framework (e.g., credit committees) along with the procedures, and the measures needed to reduce the losses and bring about more prudent, commercially based lending. The targets and timelines under the agreements, however, proved ambitious, given the fundamental nature of many of the measures and the need to build related capacity. Parties to the agreements also found them overly complex and sought clearer guidance on steps needed to implement key measures, including the performance evaluation of SOCBs and the issue of recapitalization bonds Initial progress in implementing the agreements was problematic as a result. Reviews by external auditors noted only partial compliance by both SOCBs, delaying the targeted issue of the first tranche of the recapitalization bonds. Also, as economic conditions improved, the agreements seemed overly restrictive to the SOCBs. Growth in new lending (capped at 18%) could not match the growth in deposits. The government therefore requested a revision of the governance agreements 9 in 2005 to clarify and simplify procedures and redirect performance targets to better reflect institutional capacity. The revised agreements were signed in July 2006, and subsequent reviews by external auditors recorded substantial compliance by both SOCBs with marked improvements in implementation and achievement of targets. c. Financial Restructuring of State-Owned Commercial Banks 24. As outlined above, the BSRP backed a phased and conditional buildup of capital in the SOCBs to lay the foundation for their long-term safety and soundness. The buildup was to be achieved through (i) an aggressive program of case-by-case resolution of NPLs, with emphasis on cash collection; (ii) the phased issue of government securities; and (iii) better operating efficiency and retention of profits to increase equity, combined with measures under the governance agreements that would place bank operations on a commercial basis and curtail new NPLs. These measures were the core elements of a capital buildup plan for each SOCB to meet the BOL s capital adequacy ratio target of 8% over the medium term from close to 60% in the case of LDB and close to 100% in the case of BCEL at the start of the BSRP. 25. Notable progress has been made on all three fronts. Since 2004, BCEL has collected some KN33.8 billion on NPLs, while LDB has collected some KN246 billion. Collection has been less successful in the case of BCEL, perhaps because a major share of its loans (some 43%) were made to SOEs, where repayment issues have proved to be more intractable than in the private sector. 10 New lending to SOEs has since been sharply scaled back under the new regime put in place by the governance agreements, which requires lending to be based on commercial criteria and rules out new lending to borrowers in default. 7 Recapitalization bonds were bonds issued by MOF to increase the chartered capital of the SOCBs. The bonds were nontransferable and had a term of 5 years, with interest supposed to be set at 1% above consumer inflation. 8 The agreements and many of the key actions stipulated under them were clearly new to the country s institutions. 9 The need for revision was anticipated and provided for in the program design. 10 LDB, on the other hand, had a much more limited exposure to SOEs, amounting to less than 2% of its portfolio.

12 6 26. The phased issuance of government securities principally of tranches of recapitalization bonds linked to progress in achieving the targets set in the governance agreements has also significantly helped to strengthen the financial position of the SOCBs, though not at the pace originally foreseen. 27. Difficulties in implementing the first set of governance agreements and meeting the performance targets of SOCBs, along with the continued fiscal weakness of the government through 2005 and lack of clarity in procedures, delayed the issue of recapitalization bonds by the MOF. Issues in March 2003, October 2003, and May 2004 had originally been scheduled under the BSRP. 28. Subsequent progress in meeting the targets under the revised governance agreements and the government s stronger fiscal position allowed the issue of bonds starting in The first issue of KN200 billion took place in February 2006 and the actual placement in June The second issue of KN150 billion was made in February 2007 with placement in September In February 2009 the MOF issued instructions for the placement of the remaining KN150 billion worth of bonds. Interest on the bonds was often paid about 3 months late to the SOCBs, in part due to weak cash management of the Treasury at the MOF. 29. The profitability of the SOCBs has improved since 2007 as the economy has grown more rapidly, spurring growth in lending under the new, commercially oriented, regime. Strengthening economic conditions and, more directly, better credit risk assessments by the SOCBs (due to measures instituted under the governance agreements) as well as stronger capacity have helped to dramatically reduce NPLs. NPL ratios have fallen below 3% on loans provided by BCEL and LDB after March 2003, while overall NPL ratios for BCEL (1.48% 11 ) and LDB (5%) reached historic lows in It should be noted, however, that NPLs measured under BOL criteria differ somewhat from those measured under international accounting standards (see Figure 1 and Table 1). 30. As a consequence of the impact of these measures, CARs markedly improved over the course of the program, with the CAR for BCEL increasing from almost 100% in 2003 to 5.65% in 2008 and the CAR for LDB improving from close to 60% in 2003 to 3.75% in Figure 1: Nonperforming Loan and Capital Adequacy Ratios of State-Owned Commercial Banks A. Nonperforming Loan Ratio B. Capital Adequacy Ratio % NPL BCEL APB LDB CAR % LDB BCEL APB APB = Agriculture Promotion Bank, BCEL = Banque pour le Commerce Extérieur Lao, BOL = Bank of the Lao PDR, LDB = Lao Development Bank, NPL = nonperforming loan. Source: Bank of Lao PDR. 11 BCEL reported an (unaudited) NPL ratio of 0.7% for 2009.

13 7 Table 1: Nonperforming Loans of State-Owned Commercial Banks, as of 31 December 2007 (% of total loans, unless otherwise indicated) Loan Quality (IAS Classification) APB BCEL LDB 1. Current loans Special mention Substandard Doubtful Loss Memo items: NPL (IAS provisioning for categories 3 5) NPL (based on BOL rules) Outstanding loans (KN billion) Shareholders equity (KN billion) (175.0) 88.0 (109.0) ( ) = negative, APB = Agriculture Promotion Bank, BCEL = Banque pour le Commerce Extérieur Lao, BOL = Bank of the Lao PDR, IAS = international accounting standards, LDB = Lao Development Bank, KN = kip, NPL = nonperforming loan. Note: The IAS lists five categories of loan quality, as shown in the table. Nonperforming loans are estimated from the provisioning for loans in categories 3 5. The BOL, on the other hand, uses a four-category system for rating loan performance and estimating NPLs. Source: Asian Development Bank. d. Program Monitoring and Prudential Supervision 31. The BSRP also required the BOL to ensure that (i) its Bank and Financial Institutions Supervision Department visits each SOCB at least twice yearly to increase the reliability of financial reports and confirm compliance with interim performance measures, and (ii) there is adequate off-site monitoring for timely and accurate financial reporting. 32. BOL carries out on-site inspections of each bank every 6 months, in addition to the quarterly performance evaluation visits made to each SOCB under the program. Measures established with respect to off-site monitoring include regularly assessing the financial statements of the SOCBs, reviewing the findings of external auditors, and requiring banks to regularly provide additional key data including loan portfolio data. 2. Strengthening the Enabling Legal Environment and Judicial Oversight a. Commercial Division of Court Enforcement 33. At the time of program formulation, judges had very limited training and experience in commercial transactions and associated areas such as debt enforcement arising from loan transactions, enforcement of securities, and bankruptcy. To strengthen the incentives to repay loans, the BSRP sought to develop a court system that could effectively adjudicate commercial cases and provide a credible threat of enforcement to borrowers. 34. In line with program measures, a commercial chamber was established in the People s Supreme Court and judges were trained under attached TA. The training, originally intended to be focused on commercial law, had to be reoriented toward building a more fundamental understanding of the law instead. A follow-on TA was later provided to further develop capacity in this area, but progress was slower than anticipated because of the need to develop basic

14 8 capacity first, as well as subsequent transfers of trained judicial personnel to jobs in unrelated areas. 35. Measures are beginning to have an impact, however. More NPL cases are being filed in the commercial courts (30 in 2007) and more timely and better quality decisions noted by SOCBs. The strongly communal structure of Lao society nonetheless means that asset foreclosure remains a time-consuming process involving many parties and requiring a village committee to oversee foreclosure and asset disposal. The auctioning of foreclosed assets is still uncommon. But officials from the joint venture ANZ Vientiane Commercial Bank reported the bank s successful foreclosure of five properties in 2008, adding that the process, while time consuming, was transparent. 36. To improve the efficiency of asset resolution and alternative dispute resolution, the BSRP also called for measures to initiate a structured voluntary system for resolving disputes related to loan defaults. The Office of Economic Dispute and Resolution (OEDR), under the Ministry of Justice, oversees this process. Under attached TA (footnote 1) and in line with measures under the program, the OEDR has set up a mediation service, strengthened its capacity, and worked to codify procedures, notably preparing a manual for mediation, application forms for arbitration and mediation, and templates for arbitration awards. In 2008, 38 cases were submitted for mediation and arbitration through the OEDR. b. Anti Money Laundering Regime 37. To strengthen governance and integrity in the banking sector, the BSRP included measures aimed at development of an effective anti money laundering (AML) regime. Among its key elements were AML laws and regulations and a financial intelligence unit (FIU). 38. Accordingly, the government issued a decree in March 2006 creating the basic legal framework for an AML regime and providing for the formation of an FIU. A committee of senior staff from BOL s Bank and Financial Institutions Supervision department was the nucleus of the FIU. In May 2007 this committee was upgraded to a separate unit equivalent to a department with its own staff and budget. The FIU now has three divisions for (i) regulation and supervision, (ii) information technology, and (iii) analysis. It is active in developing and issuing guidelines to banks to implement the AML decree, and in analyzing suspicious transaction reports. In practice, however, its operations have been limited by its staff and budgetary resources. 39. Mechanisms for interagency cooperation were established in March 2008 with the formation of a high-level interagency AML working group under the FIU director general and including representatives from law enforcement, customs, and supervisory authorities. The government has also taken an increasingly active role in strengthening international cooperation in this area, joining regional AML bodies, notably the Asia/Pacific Group on Money Laundering (APGML) in July Lao PDR is scheduled to undergo the first APGML mutual evaluation of its AML regime toward the end of Facilitating Private Sector Access to Credit a. Secured Transactions System 40. To strengthen the enforcement of security over land and other collateral and to give the private sector better access to finance by allowing security to be taken over a wider range of

15 9 property, measures aimed at introducing amendments to the Law on Secured Transactions and related laws were also made part of the BSRP. 41. The Law on Secured Transactions was amended in May 2005 to clarify the rights and obligations of the parties with respect to collateral and strengthen enforcement. A draft decree on lease financing was also developed to establish a legal framework for leasing that specifies the rights and obligations of the parties and provides for conditional self-help repossession. 42. Beyond the strengthening of the legal framework, the program also called for the development of a fully computerized secured transactions registry and its linkage to records in the motor vehicle registry. This condition was later waived, partly because of unforeseen institutional complications. Under the BSRP, the MOF had been identified as the logical home for the secured transactions registry, as it registered security over state assets (Department of State Asset Management) and was also home to the land registry (land being the main form of collateral used by banks). However, the transfer of the land registry to the Prime Minister s Office in 2005 significantly weakened the rationale for the MOF to be the base for the registry. 43. These changes and the range of parties involved have led to protracted discussions on where the registry might be housed and what the roles and responsibilities of the parties might be. The matter still has to be decided. 12 The aim of linking the secured transactions registry to records in the motor vehicle registry also proved somewhat misplaced, as records in the motor vehicle registry were, at the time of program formulation, and still are paper based and fragmented. A World Bank project has recently begun pilot-testing a computerized database system, but its operationalization and rollout to all the provinces is likely to take some time. 44. As an interim measure to strengthen security over collateral and improve private sector access to finance, ADB and the BOL worked to upgrade the system at BOL s Credit Information Bureau (CIB) from one that was manual and paper based to a secure web-based system. The system allows banks to efficiently perform collateral checks on property and movables and register pledged assets a function similar to the secured transactions notification from a registry. Banks can also track customer credit histories, thereby giving customers a strong incentive to maintain good repayment records to have better access to credit, on easier terms. The CIB is now fully operational and its real-time online coverage is about 70% of all accounts. The balance is largely attributable to accounts in rural branch offices that need to use off-line manual processing for lack of computer connectivity. 4. Developing Rural Finance a. Agriculture Promotion Bank 45. The BSRP also included measures aimed at transforming APB from a policy bank into a commercial bank. The restructuring of APB began in Policy lending was separated from commercial lending, and policy loans were transferred in 2007 to a new policy bank (Nayoby Bank). A restructuring and recapitalization framework based on governance agreements, similar to that used for BCEL and LDB, was constituted in Focused support for implementation was provided under a separate TA cluster for rural finance development The International Finance Corporation is also supporting planning for a secured transactions registry. 13 ADB Proposed Grant Assistance to the Lao People s Democratic Republic for Upgrading of ICT and MIS at the Agriculture Promotion Bank. Manila (JFICT 9096-LAO).

16 Restructuring is still ongoing, but there has been significant progress. The governance agreements grant autonomy to APB management in setting interest rates a major change in policy and approach to a sector where subsidized credit was long the norm. The start of restructuring, however, took longer than anticipated, partly because of the need for a feasibility study and the work involved in separating the operations and assets (18 branches) of the old APB into a new, commercially oriented APB and a policy bank. b. Microfinance 47. The program required the BOL to prepare, adopt, and implement regulations for microfinance credit unions allowing a variety of microfinance models, interest rate autonomy, and private ownership. The BOL has issued improved regulations for savings and credit unions that allow interest rate autonomy and private ownership, among other things. C. Disbursements 48. The loan comprised three tranches of $5 million each (about SDR3.78 million per tranche, or a total of SDR11,341,000 at the time of loan effectiveness). The first tranche was scheduled to be released upon loan effectiveness, the second about 18 months after that, and the third after another 18 months. Disbursements were contingent on compliance with tranche release conditions. The amounts actually disbursed were $5,178, for the first tranche, $6,162, for the second, and $5,701, for the third. Therefore, actual disbursements by the closing date of 31 March 2009 totaled $17,042, (SDR11,341,000). D. Program Schedule 49. The first tranche was disbursed on 24 March 2003, 17 days after the loan was declared effective. The second tranche, originally scheduled for release by October 2004, was disbursed 44 months later, on 2 July 2008, because of delays in meeting a number of tranche release conditions. The third tranche, originally scheduled for release by January 2006, was disbursed on 31 March 2009, 9 months after the second tranche was disbursed. E. Implementation Arrangements 50. The executing agency for the program was the BOL. The implementing agencies were the MOF, the Ministry of Justice, the Ministry of Security, the People s Supreme Court, and three SOCBs BCEL, LDB, and APB. 51. To support the implementation of the bank restructuring measures and to monitor and help coordinate other BSRP reforms, the BOL created a bank restructuring implementation committee (BRIC) under a deputy governor and including the chairs of key BOL committees involved in the design of the program (bank restructuring, NPL, human resource committee, and information technology committees) and senior representatives from the Bank and Financial Institutions Supervision Department and other relevant departments. 52. At the recommendation of ADB, the BRIC s composition was expanded to include representatives from the MOF and the chairs of the BCEL and LDB boards. The BRIC met regularly throughout program implementation to review progress and address issues. Its composition helped ensure appropriate attention to issues from senior officials where needed.

17 A project implementation unit was established in BOL to serve as the secretariat of the BRIC and support the day-to-day monitoring and coordination of program implementation. F. Conditions and Covenants 54. The disbursement of the second and third tranches of the BSRP was significantly delayed by slow progress on a range of actions, including difficulties with the original set of governance agreements and delays in the issue of recapitalization bonds by the MOF (see Appendix 2 for details of the status of compliance). From 2007, however, progress markedly speeded up, the most significant factors perhaps being the revisions made in the governance agreements in 2006 that strengthened ownership and freed progress toward targets. The achievement of targets, combined with the improved economy and the stronger fiscal position of the government, in turn, facilitated the issue of recapitalization bonds by the MOF. Delays in the issue of bonds may also be attributed in part to the weak cash management capacity of the MOF, indicating the need to strengthen public financial management. 55. The condition requiring the MOF to establish a secured transactions registry linked to the motor vehicle registry was waived, but the waiver should not materially affect the core objectives of the program. The condition could not realistically be met within the program period, given the unanticipated institutional changes and the need to coordinate and achieve consensus across a wide and disparate range of parties (as well as the fact that basic preconditions were not in place in the case of the motor vehicle registry). The web-based system established at the CIB as an interim measure has allowed key functional aspects of a secured transactions registry to be provided, while also giving the private sector better access to finance by allowing borrowers, notably SMEs, to supplement collateral with established credit histories. G. Related Technical Assistance 56. The implementation of reforms under the BSRP was supported by a TA loan (Banking Sector Reform Project) processed in parallel with the program, as well as an attached TA grant (Strengthening Governance for Banking Sector Reform) (footnote 1). Additional support also came later from a JFICT-funded project (Banking Automation to Support Outreach, Efficiency, and Governance) in 2004 and a follow-on TA grant (Promoting Governance in Financial Transactions) in Completion reports are available for the two grant-based TA projects The Banking Sector Reform Project supported the implementation of core BSRP reforms that were aimed at restructuring the SOCBs by (i) providing advisory and capacity development services, including those of resident international banking advisers, for restructuring BCEL and LDB and strengthening their governance, and (ii) upgrading computer systems and building related capacity in SOCBs to complement the restructuring efforts. 58. The project was critical to the implementation of the BSRP, particularly the restructuring under the governance agreements. Close and sustained guidance and capacity building support from the resident international banking advisers hired under the TA loan helped make the fundamental restructuring of the SOCBs possible. The modern core banking systems established in the SOCBs, with assistance from the TA loan project, allowed the banks to 14 ADB Technical Assistance Completion Report: Strengthening Governance for Banking Sector Reform. Manila; and ADB Technical Assistance Completion Report: Promoting Governance in Financial Transactions. Manila.

18 12 manage their operations more effectively and efficiently and meet the stricter reporting requirements of the BOL. The JFICT project also extended complementary support. 59. The attached TA-based grant was primarily focused on the resolution of NPLs through the commercial courts. The difficulties involved were greater than expected, partly because the courts first needed help in building basic capacity. But the TA generally achieved the majority of its expected output and was rated successful. A later TA provided follow-on support in this area as well as in alternative dispute resolution and the establishment of a secured transactions registry. While the output under the TA was satisfactory, some key outcomes are still pending (e.g., the establishment of a secured transactions registry); for that reason the TA was rated only partly successful. A key lesson noted in the completion report was that judicial reform is a major undertaking requiring considerable, committed support over the long term rather than intermittent TA if the results are to be significant and sustainable. H. Consultant Recruitment and Procurement 60. The recruitment of consultants under the BSRP s associated loan and grant-based TA packages was generally satisfactory. The procurement of a core banking system for LDB under the TA loan was significantly delayed at the start by procedural issues and related changes made by the BOL in the project management team. The new system was eventually procured and implemented successfully, but the process took longer than anticipated and required close ADB support, partly because the new team lacked familiarity with procurement procedures and the tasks involved in migrating the bank s data and operations from largely ad hoc arrangements to a modern integrated core banking system were inherently complex. I. Performance of Consultants, Contractors, and Suppliers 61. The performance of consultants and contractors under the associated TA packages was generally satisfactory. J. Performance of the Borrower and the Executing Agency 62. The performance of the borrower and the executing agency is rated satisfactory. The BOL, in its role as executing agency, generally provided able and responsive counterpart support and adequate facilities throughout program implementation. Coordination with respect to reforms that were considerably outside its direct jurisdiction, such as the establishment of a secured transactions registry and the development of the commercial court system, was problematic, but such issues are arguably attributable for the most part to program design. Key departments in the BOL that took part in program implementation strengthened their capacity over the course of the program, and staff gained deeper familiarity with ADB procedures and processes. However, the lack of independence and weak supervisory capacity of the BOL, and the conflict of interest inherent in its dual role as owner and regulator of SOCBs, undermined its prudential supervision and therefore its effectiveness as executing agency. Frequent staff rotations within the BOL also made it less effective. K. Performance of the Asian Development Bank 63. The performance of ADB is rated satisfactory. Regular review missions were fielded throughout the implementation of the program. The fact that implementation took significantly longer than anticipated, however, reflected the various changes in mission leadership during implementation. Given the program s scope and complexity, these changes, along with

19 13 differences in approach and understanding with counterparts, probably delayed implementation further. Progress in implementation depended on flexibility and a pragmatic approach to revising the first set of governance agreements. III. EVALUATION OF PERFORMANCE A. Relevance 64. The program s design is rated as less relevant to achieving the targeted outcome. While a main focus of the BSRP was the restructuring and recapitalization of the SOCBs, its scope also, however, included a wide range of other measures that complicated implementation without having a significant direct impact on the program s main objective. Some of these actions (establishment of a secured transaction registry) ultimately had to be waived, while others (e.g., the development of the commercial court system) will require significant dedicated resources over the medium to long term if fundamental issues are to be effectively addressed and significant and sustainable progress achieved. B. Effectiveness in Achieving Outcome 65. The program is rated effective in achieving its main targeted outcomes, but less effective in other respects. While the financial sector in the Lao PDR remains shallow compared with that of other countries in the region, the ratio of broad money to GDP (M2/GDP) underwent a modest but significant increase, from 19% to 25%, over the course of program implementation. This levels are similar to those in appropriate regional comparators such as Cambodia, and it should be noted that the relative shallowness of the financial sector is in part a function of the predominantly rural nature of the economy (some 80% of the population lives and works in the rural areas) and the country s stage of economic development (annual per capita income is about $500). 66. The restructuring and recapitalization process largely achieved its objective, as is evident when performance after the program is compared with the benchmark at its start (see Figure 1). The governance agreements under the BSRP had a key role in this process and helped to improve corporate governance in the SOCBs. They established organizational structures and incentives supportive of prudent lending on a commercial basis while giving managements the requisite autonomy to achieve performance targets. Capacity in key areas such as credit assessment was built and strengthened, and these changes are reflected in the dramatic reduction in NPL ratios for new loans. The quality of assets is also reflected in the substantial change in the loan portfolio away from a predominance of state enterprise loans toward increased lending to private sector enterprises. By the end of 2007, for example, 75% of BCEL s lending was to non-state enterprises, compared with 41% in While SOCBs still account for the majority of financial sector assets (around 59%), their share is declining with the entry and expansion of new private and joint venture banks (five new commercial banks started operating in 2009). The entry of private banks will exert fresh competitive pressures on the SOCBs, strengthening their incentives to improve performance, while the new Law on Commercial Banks strengthens prudential requirements and provides for more equal treatment for all banks. 68. However, while the program was effective in achieving the core objective of restoring the health of the banking sector, primarily the SOCBs, it was less effective in other elements of the program, such as the development of commercial courts and related legal and judicial reforms.