Program and Project Administration Memorandum. Proposed Loans and Technical Assistance Grant Kingdom of Bhutan: Financial Sector Development Program

Program and Project Administration Memorandum Program Number: 37164 Loan Number: 2279/2280 October 2007 Proposed Loans and Technical Assistance Grant Kingdom of Bhutan: Financial Sector Development Program The program and project administration memorandum is an active document, progressively updated and revised as necessary, particularly following any change in project or program costs, scope, or implementation arrangements. This document, however, may no reflect the latest project or program changes.

CURRENCY EQUIVALENTS (as of 27 August 2007) Currency Unit ngultrum (Nu) Nu1.00 = $0.0243 $1.00 = Nu41.088 ABBREVIATIONS AASB accounting and auditing standards board ADB Asian Development Bank AML anti-money laundering BOBL Bank of Bhutan Limited CFT combating the financing of terrorism CIB credit information bureau EA executing agency FIA Financial Institutions Act FISD Financial Institutions Supervision Division FIU financial intelligence unit FSA Financial Services Act FSDP Financial Sector Development Program GAAP generally accepted accounting principles GAAS generally accepted auditing standards IA implementing agency IAS International accounting standards MOF Ministry of Finance PMU program/project management unit PSC program steering committee RAA Royal Audit Authority RICBL Royal Insurance Corporation of Bhutan Limited RMA Royal Monetary Authority RSEBL Royal Securities Exchange of Bhutan Limited TA technical assistance NOTES (i) (ii) The fiscal year (FY) of the Government and its agencies ends on 30 June. FY before a calendar year denotes the year in which the fiscal year ends. In this report, "$" refers to US dollars.

CONTENTS Page LOAN PROCESSING HISTORY ii DESIGN AND MONITORING FRAMEWORK iii I. PROJECT DESCRIPTION 1 A. Project Area and Location 1 B. Impact and Outcome 1 C. Components and Outputs 1 D. Special Features 6 II. COST ESTIMATES AND FINANCING PLAN 7 A. Detailed Adjustment Cost Estimates 7 B. Financing Plan 8 C. Allocation of Loan Proceeds 9 III. IMPLEMENTATION ARRANGEMENTS 10 A. Executing and Implementing Agencies 10 B. Program and Project Management Organization 10 IV. IMPLEMENTATION SCHEDULE 12 V. FINANCIAL MANAGEMENT DURING IMPLEMENTATION 12 VI. CONSULTANT RECRUITMENT 13 VII. PROCUREMENT 13 VIII. DISBURSEMENT PROCEDURES 14 IX. PROGRAM AND PROJECT MONITORING AND EVALUATION 15 X. REPORTING REQUIREMENTS 15 XI. AUDITING REQUIREMENTS 16 XII. MAJOR LOAN COVENANTS 17 XIII. IMPLEMENTATION OF THE ACCOMPANYING TA 18 XIV. KEY PERSONS INVOLVED IN THE PROJECT 18 XV. ANTICORRUPTION 19 APPENDIXES 1. Policy Matrix for Financial Sector Development Program 20 2. Detailed Cost Estimates and Financing Plan 25 3. Program/Project Organization Chart 27 4. Implementation Schedule 28 5. Summary of Financial Management Assessment 30 6. Project Loan: Outline Terms of Reference for Consultants, Cost Estimates, and Financing Plan 33 7. Procurement Plan 38 8. List of Ineligible Items (or Negative List) 40 9. Sample Withdrawal Application for Direct Payment and Reimbursement 41 10. Sample Withdrawal Application Form for Imprest Fund 42 11. Sample Progress Report 43 12. Sample Audit Letter 48 13. Technical Assistance for Institutionalizing Skills and Capacity Development: Outline Terms of Reference for Consultants, Cost Estimates, and Financing Plan 50

ii LOAN PROCESSING HISTORY Milestones Dates Approval of Project Preparatory Technical Assistance 17 July 2005 Fact-Finding Mission 26 June 8 July 2006 1 st Management Review Meeting 11 September 2006 Appraisal Mission 18 27 September 2006 2 nd Management Review Meeting 13 October 2006 Loan Negotiations 30 31 October 2006 Board Circulation 14 November 2006 Board Consideration and Approval 7 December 2006 Loan Agreement Signing 8 March 2007 Loan Effectiveness 4 June 2007

iii DESIGN AND MONITORING FRAMEWORK Design Summary Impact Improved depth, soundness, and stability of the financial system for supporting private sector development and economic growth Performance Targets/Indicators Compliance with the capitalto-risk asset ratio of 10% Reduced nonperforming loans (NPLs) in the financial sector (e.g., NPLs in the nonbank sector decreased from 20% in 2005) Decreased interest rate spread a from about 8% in 2005 Data Sources/ Reporting Mechanisms RMA annual report Annual reports from other government agencies Program reports ADB review missions Assumptions and Risks Assumptions Political stability and commitment to carry out the reform process Sustained current economic growth Risk Economy affected by significant negative external shocks Outcome Improved governance of the whole financial sector and more efficient financial intermediation Improved autonomy of RMA under revised RMA Act Strengthened regulatory and supervisory framework under FSA covering all subsectors Introduction of private sector representatives to the boards of financial institutions Adoption and mainstreaming of AML/CFT and best practices in financial services Increased number of professionals in the financial sector (e.g., accountants, auditors, insurance underwriters, actuaries, etc.) b to be benchmarked RMA annual reports Financial institutions chartered annual reports ADB review missions Assumptions Political will to undertake reform in the financial sector Continued political dialogue between ADB, the Government, and other key stakeholders Risks Policy reforms not implemented or reversed Laws and regulations not properly implemented or enforced Outputs 1. Improved regulation and supervision of the financial sector Draft revised RMA Act and FSA finalized and submitted to the National Assembly for passage Banking, insurance, and securities markets regulations completed and issued conforming to international standards Improved compliance and enforcement of financial sector supervision Official copies of laws, regulations, and codes National Assembly s official announcement of revised RMA Act and FSA adoption RMA official announcement of new rules and regulations adopted Certificates of training completion and professional qualification RMA annual reports Assumptions Adequate laws and regulations are prepared on time National assembly accepts final draft revised RMA Act and FSA Risks Significant delay in passing the draft revised RMA Act and FSA Expected results and objectives of legal

iv Design Summary Performance Targets/Indicators Data Sources/ Reporting Mechanisms ADB review missions Assumptions and Risks and regulatory reform not fully met due to lack of understanding or political will 2. Strengthened corporate governance structure and operations of financial institutions Guidelines for corporate governance issued and enforced BOBL s corporate structure improved and business plan adopted BOBL s improved performance targets based on the business plan (e.g., reduced cost/income ratio from current 77.7% as of December 2005) RICBL s structure rationalized, insurance businesses segregated, and business plan approved by BOD RMA s official announcement of new rules and regulations adopted Financial institutions chartered annual accounts BOBL s board resolution to adopt a rolling business plan that will provide performance indicators of BOBL by way of signing a MOU with the Government RICBL s board resolution to adopt the business plan and segregate insurance businesses Assumptions Revised RMA Act gives RMA the autonomy to apply fit-and-proper tests of board members Financial institutions willingness and commitment to improve efficiency and to reform corporate governance Institutional capacity to undertake reforms Risks Loss and/or lack of qualified staff Delays or watered down reform process due to political interference in financial institutions internal affairs 3. Effective AML/CFT regime established AML provisions included in the FSA AML and CFT regulations adopted FIU established with adequate mandate and budget for qualified staff and information technology management information system Scope for money laundering through the financial sector reduced Copies of FSA and AML/CFT regulations Copy of FIU s charter RMA s annual report and specific AML and CFT reports Copies of AML and CFT procedure manuals in the financial institutions and evidence of know-yourcustomers reporting to RMA Assumptions Effective coordination among relevant government agencies, especially RMA, police, and judiciary Financial institutions adoption of effective management information system and staff resources to carry out AML and CFT procedures and reporting Risks Weak enforceability of AML and CFT legal and regulatory framework FIU established within RMA not granted sufficient powers to carry out its mandate

v Design Summary Performance Targets/Indicators Data Sources/ Reporting Mechanisms Assumptions and Risks Insufficient resources allocated and/or low capacity in FIU 4. Developed national accounting and auditing policies and standards Accounting standards committee and subsequently Bhutanese AASB established Bhutanese GAAP and GAAS approved by AASB Bhutanese GAAP and GAAS implemented in financial institutions Plans to establish the Bhutanese AASB approved Plans to develop the Bhutanese GAAP and GAAS GAAP and GAAS manuals and workshops provided by the AASB Assumptions Institutional capacity to undertake reform Qualified consultants promptly engaged Effective monitoring by AASB Risks Development of an unduly onerous system that discourages reporting Insufficient resources allocated and/or low capacity in AASB 5. Strengthened information sharing CIB established and regularly updated Legal, regulatory, and institutional framework established Copy of CIB charter Copy of CIB rules and regulations CIB reports Assumption Financial institutions use CIB to improve credit risk assessment Risk Misuse of information in CIB Activities with Milestones 1. Improve regulation and supervision of the financial sector 1.1. RMA finalizes draft revised RMA Act and FSA by December 2006 and submits it to the National Assembly for passage by June 2008. 1.2. RMA conducts stakeholder consultations on the draft regulations and education workshops for financial institutions by June 2008. 1.3. RMA issues implementing regulations under the FSA by December 2009. 1.4. Implement the secondment program so that experienced officers of the Financial Institution Supervision Division at RMA receive on-the-job training in countries with strong financial supervision and obtain skills and practical experience in onsite supervision of banks, development finance, insurance, and capital markets by December 2009. 1.5. Conduct the training program for enhancing RMA staffers accounting and auditing skills by December 2009. 1.6. The securities market expert conducts on-the-job training for strengthening professional knowledge of securities markets and related regulations by June 2008. 2. Strengthen corporate governance structure, and operations of financial institutions 2.1. RMA completes prudential regulations for corporate governance by June 2008 and issues them by December 2009. Inputs Program loan of $11 million to the Government to support policy reforms Project loan of $2 million TA 4615-BHU: Preparing for the Financial Sector/Nonbank Financial Institutions Reform Program (TA of $500,000, providing 13 person-months of international consultancy and 9

vi Activities and Milestones 2.2. RMA conducts stakeholder consultations on the draft regulations and educational workshops for financial institutions by June 2008. 2.3. BOBL prepares a business plan by June 2008, to be approved by its BOD, for expanding its lending operations and determining how best to deal with its existing excess liquidity, linking management remuneration to performance, improving recruitment and performance evaluations, and developing a human resources strategy by December 2009. 2.4. The Government drafts an MOU by June 2008, for signing by the Government and BOD, to provide time-based institutional performance targets for BOBL and so commercialize its operations by December 2009. 2.5. RICBL prepares and approves a rationalization plan by June 2008 that details the necessary steps to separate its business operations. Rationalization plan is implemented by December 2009. 2.6. RICBL prepares a business plan by June 2008 for post-rationalization to ensure the phased-in segregation of business units, adequate solvency provisioning, and capital adequacy by December 2009. 2.7. Implement the training program for strengthening insurance underwriting skills by December 2009. 3. Establish effective AML/CFT regime 3.1. The Government drafts the FSA to provide RMA with the authority as the AML/CFT regulator and supervisor in the financial sector by December 2006. 3.2. RMA develops and issues regulations by June 2008 requiring financial institutions to establish procedures for know-your-customer processes, generating reports on suspicious transactions, and reporting them to RMA by June 2008. 3.3. RMA establishes FIU in conformity with the FSA by June 2008. 3.4. FIU takes charge of financial reporting requirements and procedures for AML/CFT supervision by June 2008 and commences operations by December 2009. 4. Develop national accounting and auditing policies and standards 4.1. Ministry of Finance establishes an accounting standards committee with representation of involved government agencies to take charge of accounting and auditing reform by December 2006. 4.2. The committee creates the Bhutanese AASB by November 2006. 4.3. AASB develops the Bhutanese GAAP and GAAS by June 2008 4.4. AASB discusses with stakeholders the newly developed Bhutanese GAAP and GAAS and approve them for implementation by December 2009. 4.5. RMA establishes a training program to develop the accounting and auditing profession and to obtain accountancy training in a relevant member country by December 2009. 5. Strengthen information sharing 5.1. RMA establishes a CIB unit for developing a plant to establish CIB by December 2006. 5.2. RMA establishes CIB with corresponding rules and regulations by June 2008. 5.3. RSEBL develops a website for disseminating mandatory market information by December 2009. 5.4. RSEBL develops a database and system to improve depository and settlement processes by December 2009. Inputs person-months of national) Attached TA for institutionalizing skills and capacity development on a sustainable basis in the financial sector (TA of $250,000, providing 6 person months of international consultants and 3 person-months of various resources persons) AASB = accounting and auditing standards board, ADB = Asian Development Bank, AML = anti-money laundering, BOBL = Bank of Bhutan Limited, BOD = board of directors, CFT = combating the financing of terrorism, CIB = credit information bureau, FIU = financial intelligence unit, FSA = Financial Services Act, GAAP = generally accepted accounting principles, GAAS = generally accepted auditing standards, MOU = memorandum of understanding, RICBL = Royal Insurance Corporation of Bhutan Limited, RMA = Royal Monetary Authority, RSEBL = Royal Securities Exchange of Bhutan Limited, TA = technical assistance. a Difference between lending rates to manufacturing or services industries and 1-year term deposit rates. b Government ministries currently employ10 chartered accountants and outsource most of their financial service needs, including accounting, auditing, and insurance underwriting.

A. Project Area and Location I. PROJECT DESCRIPTION 1. The Financial Sector Development Program (FSDP) is designed to strengthen the legal, regulatory and supervisory framework, and the governance structure, operational efficiency, and institutional capacity of the financial sector in Bhutan. It aimed at improving the soundness, stability, and depth of the financial system to support private sector activity and sustained economic growth. B. Impact and Outcome 2. The FSDP consists of a program loan and a project loan. The program loan includes crucial policy reforms, and the project loan will provide direct assistance to facilitate FSDP implementation and ensure the smooth implementation and sustainability of the policy reforms under the program. It is envisaged that the FSDP will have a positive impact on establishing an environment more conducive to business investment and stimulating the development of a more active private sector. The outcome of the FSDP is improved depth, soundness, and stability of the financial system by strengthening the governance of the whole financial system and improving the efficiency of financial intermediation. C. Components and Outputs 1. The Program Loan 3. The Program consists of five components. The outputs and major activities are spelled out as follows, as well as detailed in the design and monitoring framework (page iii) and policy matrix (Appendix 1). a. Improve the Regulation and Supervision of the Financial Sector 4. As a first step to ensure a strong reform regime, a revised Royal Monetary Authority (RMA) Act will need to be drafted and finalized to give RMA autonomy to act with independence on monetary matters and vest it with enhanced powers to oversee the operations of the entire financial system. In the absence of an International Monetary Fund (IMF) program to support it, the FSDP should continue its support toward ensuring the finalization and passage of the revised RMA Act, which has been finalized with Asian Development Bank (ADB) assistance 1 and is currently undergoing translation for submission to the National Assembly. The program will therefore ensure that the revised RMA Act is submitted and enacted. Under the revised RMA Act, a cap will be placed on the amount that the Government can borrow from RMA on a non-revolving basis for a term not exceeding 3 months. Further, the corporate governance structure will be converted into a two-tier structure, giving RMA management greater control over RMA policy and operations. It will be composed of a restructured board and an executive committee. The current board, comprising the minister of finance (acting as chairman), secretary of finance, managing director of RMA, and two other appointed directors (one from Ministry of Finance (MOF) and one from the Ministry of Trade and Industry) all from the public sector is being replaced with one comprising, firstly, the governor, two deputy governors, and 1 ADB. 2002. Technical Assistance to the Kingdom of Bhutan for Strengthening the Capacity of the Royal Monetary Authority and Royal Securities Exchange of Bhutan (Financed by the Japan Special Fund). Manila (TA 3905-BHU approved on 23 August 2002).

2 four directors appointed by the Government from outside RMA. The executive committee will comprise the governor (heretofore called the managing director) and two deputy governors. Moreover, the governor and members of the board are now barred from serving as employees, shareholders, or board members of financial service providers during their tenure of office, and from being associated with them in any way. These steps are in line with the Government s preference to proceed in measured steps towards the institution of a fully independent central bank. 5. Secondly, the need is pressing for the draft FSA to be finalized and enacted to address gaps in the regulation and supervision of the whole financial sector of Bhutan. The small size of Bhutan s economy makes it appropriate to have RMA as the single regulator. Therefore, under the Financial Services Act (FSA), RMA is to be vested with powers to license, regulate, and supervise all financial service providers throughout the country. The draft FSA is currently under review under ADB assistance, 2 and the remaining gaps in legislation and regulation for such sectors as insurance and securities exchange are to be amended in the final FSA to ensure that the FSA is comprehensive and coherent. In particular, RMA will be provided with powers to (i) conduct on-site inspections in the whole financial sector; (ii) license, regulate, and supervise the insurance sector as a separate entity; (iii) act as the securities regulator to investigate and prosecute securities violations for both licensed and non-licensed companies; (iv) issue rules and guidelines on corporate governance matters (see point [b] below); and (v) deal with antimoney laundering (AML)/combating the financing of terrorism (CFT) issues (see point [c] below). Prudential regulations on banking supervision, insurance regulations, and securities exchange will be revised, updated, and further strengthened to ensure adequate regulation and supervision in the relevant sectors. Furthermore, the FSDP will support setting up a standard chart of accounts to be followed by all financial institutions and their external auditors. It will also help draft appropriate licensing requirements and procedures for new entrants in the banking and insurance sectors to ensure and encourage fair competition in all financial subsectors. b. Improve the Corporate Governance Structure and Operations of Financial Institutions 6. The FSDP will consider all-pervasive issues of corporate governance in the financial sector by strengthening the legal framework to include matters relating to corporate governance, improving the operations of Bank of Bhutan Limited (BOBL) and clarifying the organizational structure of Royal Insurance Corporation of Bhutan Limited (RICBL). The FSA will provide RMA with comprehensive powers to regulate and enforce corporate governance for the whole financial sector. The provisions on corporate governance will include, among other stipulations, (i) an appropriate fit-and-proper test for boards of directors; (ii) private sector representation in the structure and composition of the boards of directors, (iii) conflict-of-interest rules, and (iv) restrictions on cross shareholdings. 7. The corporate governance legal framework will provide autonomy for public sector financial institutions and ensure the commercial orientation of their operations. A memorandum of understanding will be prepared and signed between MOF and the board of directors of BOBL to provide time-bound institutional performance targets and autonomy for its operations. In turn, management of BOBL will prepare a rolling business plan that will define the parameters and performance indicators that management of BOBL will deliver to allow the board of directors to meet their commitment under the memorandum of understanding with MOF. The business plan 2 ADB. 2005. Technical Assistance to the Kingdom of Bhutan for Preparing the Financial Sector/Non-bank Financial Institutions Reforms Program. Manila (TA 4615-BHU approved on 17 July 2005).

3 will provide for expanding its lending operations and determining how best to deal with its existing excess liquidity, linking remuneration for management and the board of directors to performance, improving recruitment and performance evaluations, and developing a strategy for human resources. Management of BOBL will be recruited under clear, objective, and fair recruitment guidelines and procedures to ensure improvement in operational efficiency and financial performance. RMA, as regulator, will be informed of all discussions and agreements between the Government and BOBL. 8. It is important to improve the organizational structure of RICBL according to insurance core principles of International Association of Insurance Supervisors, which require complete separation of life insurance, other insurance, and any other financial services. RICBL will prepare a rationalization plan detailing the necessary steps to separate its business operations. RICBL will also prepare a business plan post-rationalization to ensure the phased-in segregation of business units, adequate solvency provisioning, and capital adequacy. A successful segregation of financial assets according to different operations can improve the matching and reserving system for assets and liabilities to ensure the provision of adequate solvency margins. c. Establish an Effective AML and CFT Regime 9. The program loan will support the Government s initiatives to establish an effective AML/CFT regime. The AML/CFT component of the program aims to strengthen the AML/CFT policies and procedures currently employed in Bhutan. This will include (i) updating legislation (i.e., the proposed FSA) to establish RMA as the AML/CFT regulator and supervisor for all financial institutions; (ii) RMA drafting and issuing regulations requiring financial institutions to establish procedures for know-your-customer processes, generating reports on suspicious transactions, and reporting them to RMA; and (iii) RMA establishing a financial intelligence unit (FIU) whose function will be to gather information on suspected money laundering or financing of terrorism and liaise with law enforcement agencies. The enhanced AML/CFT framework is in line with the Government s Good Governance Plus Strategy (2005). d. Develop National Accounting and Auditing Policies and Standards 10. The program loan will address the high degree of opacity and incomparability of reports and performance records of financial institutions by developing and applying uniform and consistent national accounting and auditing standards. It will support the development of the national accounting and auditing standards to form the Bhutanese generally accepted accounting principles (GAAP), in line with international accounting standards (IAS) where applicable, and the generally accepted auditing standards (GAAS) in line with international auditing standards. The FSDP envisages creating the Bhutanese accounting and auditing standards board (AASB), which will be tasked with developing the Bhutanese GAAP and GAAS. MOF will form an accounting and auditing standards committee, which will develop the plan to establish accounting and auditing standards board (AASB). Comprising the accounting and auditing standards committee will be representatives of the private sector, MOF, Royal Audit Authority (RAA), RMA, and Ministry of Trade and Industry. AASB will also have the authority to regulate and supervise the accounting and auditing profession. Of paramount importance is that the Government initiates a training program to develop the accounting and auditing profession in Bhutan.

4 e. Strengthen Credit Information Disclosure 11. A reliable system for sharing credit information among lending institutions can expedite loan applications and improve credit risk assessment. It would potentially lower the cost of borrowing and facilitate financial transactions. The program loan will support establishing a credit information bureau (CIB) with the aim of improving the quality of financial institutions credit risk assessment. It will help the Government set up a CIB unit at RMA, which will prepare an implementation plan in consultation with major stakeholders. The CIB unit will be responsible for the institutional set-up and legal and regulatory framework for its full operation. CIB establishment will be based on the findings of the feasibility study 3 on appropriate arrangements for data collection, system maintenance, and information sharing. 2. The Project Loan a. Building Sector Capacity 12. The project loan will support filling in gaps in present capacity in the financial sector, providing practical on-the-job training for the regulator and supervisor and selected key financial institutions with a view toward assuring smooth implementation of the new regime. The capacity-building schemes will be reinforced by employee incentives and retention measures to ensure the dissemination and maintenance of the training knowledge as well as to compensate for the training cost by providing a certain period of post-training service time. The retention measures will combine reward and prevention, as staff will be (i) rewarded by incorporating training in their performance evaluation for possible career advancement and greater supervisory or management responsibility; and (ii) discouraged from leaving RMA or financial institutions after completing training by a lock-in clause in their employment contracts requiring that early leavers compensate the Government for the cost of training on a pro-rata basis. i. Secondment Program for Strengthening Financial Supervision 13. To obtain skills and practical experience in the on-site supervision of banks and NBFIs, the project loan will support a program for Financial Institutions Supervision Division (FISD) staff of RMA to be seconded to a member country with strong financial regulatory and supervisory bodies. The secondment program for improving the performance of FISD s staff is intended to last, on an intermittent basis, for the whole FSDP implementation period. Four senior FISD staff for each supervision area (i.e., banks, development finance, insurance, and possibly the securities market) will go on secondment for a minimum of 3 months each year. After returning from secondment, the trained staff will share their practical experience with colleagues by (i) giving short training sessions, (ii) creating a supervision materials library to be regularly updated, and (iii) helping the chief of FISD to update the supervision manuals with lessons learned during secondment. ii. Training Program for Enhancing Accounting and Auditing 14. The project loan will support a training program for two RMA staff to obtain professional qualifications in accounting and auditing (e.g., chartered accountancy from the Institute of 3 RMA has prepared a feasibility study for establishing a CIB with assistance from Dun & Bradstreet SAME Ltd. The draft report was furnished to ADB. The study recommends the required software, operational model, and legal framework to establish and govern the CIB.

5 Chartered Accountants in England and Wales). The staff will train in a country within the region so that, at the end of the 3-year accountancy training program, RMA should have in-house accountants to enhance its supervisory role. iii. Training Program for Enhancing Insurance Underwriting Skills 15. The project loan will support a staff training program with insurance companies in member countries with a more advanced and well-regulated insurance sector to develop inhouse skills in insurance underwriting and claims adjustment. This will reduce RICBL s reliance on foreign consultants in key areas of the insurance business. Experienced RICBL officers will join the regular staff of the host company to carry out day-to-day tasks and so receive valuable on-the-job training in underwriting for general insurance (fire, motor, engineering and marine, and aviation transport), life insurance, and claims processing. In each year, six different and relevant employees will go on secondment for a minimum of 6 months each year during the 3 years of program implementation. In addition, in view of the newly identified need of technical assistance for preparing the RICB rationalization plan, a short-term international insurance expert will be recruited, iv. Capacity Building for Securities Exchange 16. The project loan will provide on-the-job training to increase securities-trained personnel in FISD and Royal Securities Exchange of Bhutan Limited (RSEBL). The capacity-building program will cover (i) supervision processes; (ii) listings and delistings; (iii) trading modalities; (iv) settlements, payments, and depository operations; (v) governance, covering disclosure and conflicts of interest, etc.; and (vi) the new regulatory framework. The specialized training will enhance the monitoring, surveillance, and supervision of the securities market and brokers as well as strengthen the operations of the securities exchange. An international capital markets specialist will be recruited to provide the training. v. Improving Corporate Governance 17. The project loan will help draft regulations to provide for and internalize good corporate governance measures. It will also assist institutions to carry out these proposed measures and effect appropriate organizational changes, such as fit-and-proper tests for boards of directors, enhancing the structure and composition of boards, conflict-of-interest rules, restrictions on cross shareholding, and others measures as appropriate. An international legal expert will be recruited to undertake the improvements in corporate governance, assisted by a national legal expert. b. Developing AML/CFT Framework 18. The project loan will support the institutional development of an FIU in RMA. This support will include (i) FIU s organizational design, (ii) operating procedures including off- and on-site supervision for AML/CFT issues, (iii) management of FIU during initial stages prior to handover to FIU staff, and (iv) the establishment of the FIU including procurement of basic IT infrastructure. Assistance will also cover associated on-the-job training for RMA, police, prosecutors, and judges regarding (i) the effects of AML on economic development and international standards, (ii) the legal requirements to meet international standards, (iii) the regulatory and institutional requirements, (iv) the compliance requirements for financial institutions, (v) building an effective FIU, (vi) domestic (interagency) and international

6 cooperation, (vii) CFT, and (viii) investigating money laundering and terror financing. In addition, this component will promote compliance with the new AML/CFT regulations and reporting requirements by providing informational seminars for financial intermediaries. This will be provided by an international AML/CFT expert, assisted by a national legal specialist. c. Improving Accounting and Auditing Practices 19. The project loan will support the recruitment of an international financial sector accounting and auditing firm to (i) help the accounting and auditing reform committee (to be established by the Government) develop a roadmap for starting up and developing AASB, (ii) help AASB develop the Bhutanese GAAP and GAAS in line with IAS, and (iii) update financial reporting formats. In addition, this component will promote compliance with the new GAAP and GAAS by providing progress seminars for financial intermediaries, practitioners and professionals, affected parties, and the private sector. d. Supporting CIB Establishment 20. To help the Government establish a CIB and ensure the selection and start-up of an operational model suitable to the country, the project was initially planned to recruit a CIB expert to (i) design and plan the establishment of CIB in line with the CIB feasibility study, 4 (ii) carry out procurement activities for establishing CIB including determination of appropriate powers to be vested in RMA and/or CIB for carrying out its functions, and (iii) help operationalize CIB and do pilot testing. However, due to the significant progress made by RMA in finalizing the CIB establishment plan and relevant procurement documents of Request for Financial Proposals, the TOR of the CIB expert will be revised with a focus on drafting necessary legal and regulatory framework (the TOR will be posted separately). e. Improving Securities Information Disclosure 21. The bedrock of securities regulation is the timely disclosure of material information. To improve it, RSEBL needs to upgrade its equipment and software so it can retain copies of reports published by listed companies and upgrade the inventory of securities ownership for market disclosure. The project loan will support (i) developing a well-designed website to ensure proper information disclosure for RSEBL and (ii) upgrading and automating the database for RSEBL to improve depository information. The developed website will serve to (i) collect and disseminate information about the market, listed companies, and brokers; and (ii) help raise awareness of and interest in the securities market. The upgraded and automated database will help RSEBL enhance internal controls and inspections for the depository. Assistance will cover associated training for RSEBL and brokers on the use and maintenance of the website. D. Special Features 22. There are two special features of the FSDP. First, it provides a comprehensive and integrated approach to financial sector development, applying lessons from earlier TA to move away from an uncoordinated and compartmentalized approach. Second, the design of the FSDP supports training schemes to ensure the successful implementation of program components as well to create a pool of Bhutanese professionals in accounting, auditing, and insurance underwriting and thereby improving self-reliance in these areas. 4 RMA has prepared a feasibility study for establishing a CIB with assistance from Dun & Bradsheet SAME LTd. The draft report was furnished to ADB. The study recommends the required software, operational model, and legal framework to establish and govern the CIB.

7 23. The program loan will support strengthening the overall governance of the financial system through an improved legal, regulatory, and supervisory framework for all financial services and institutions. The FSDP comprehensively addresses the governance issue. The close coordination and integration of proposed recommendations is the important feature of the program, which is highly consistent with the Government-approved Good Governance Plus Strategy (2005) for achieving transparency, accountability, and efficiency in the whole financial system and so advance private sector and economic development. 24. The project loan will focus on strengthening key institutions for delivering the key facets of the FSDP, leading to more effective regulation and supervision and improved governance. In particular, the features of this project loan are (i) continuous development of supervisory skills that will ensure proper implementation of the regulations and up-to-date knowledge for dealing with new market situations; (ii) the creation of a pool of Bhutanese professionals in accounting, auditing, and insurance underwriting, thereby reducing reliance on foreign consultants; (iii) improved job skills for financial institutions staff; and (iv) improved financial information disclosure. II. COST ESTIMATES AND FINANCING PLAN A. Detailed Cost Estimates 1. The Program Loan 25. The estimated adjustment costs of policy reforms under the FSDP are based on medium-term adjustment costs. The tentative estimated adjustment cost is approximately $16.5 million, which includes the following: (i) (ii) (iii) (iv) (v) Financial regulation and supervision. The estimated cost is $6 million, of which $4 million will be borne by the financial institutions, arising from adjustments for implementing the new regulations and adjustments to the NPL provision following a new schedule of loan classification that follows more stringent international standards, and $2 million will support RMA s implementation of laws and regulations and, among others, for additional staffing, stakeholder consultations, downstream training, administration, supervision costs, etc. Corporate governance. The cost is $3 million. The additional costs will arise from implementing corporate governance rules such as introducing private sector representatives on boards, preparing and implementing business plans for BOBL and RICBL, preparing human resources strategies, strengthening performance evaluation, and conducting stakeholder workshops. AML/CFT. The estimated cost of establishing and maintaining an FIU in RMA is $2 million. AASB. The cost of establishing and operating AASB and developing Bhutanese GAAP and GAAS, including market consultations, amending local legislation, drafting accounting and auditing provisions, and implementation, is about $4 million. CIB. The cost of establishing a CIB and relevant legislation for its functioning and governance is $1.5 million, as estimated under the study commissioned by RMA.

8 2. The Project Loan 26. The total project cost is estimated at $2.5 million, including contingencies and financial charges. A summary of cost estimates based on components is provided in Table 1. A detailed cost estimate is in Appendix 2. Table 1: Cost Estimates ($ 000) Item Total Cost A. Baseline Costs 1. Component 1: Building Sector Capacity a 1,259.0 2. Component 2: Developing AML/CFT Framework 258.0 3. Component 3: Improving Accounting and Auditing Practices 500.0 4. Component 4: Supporting CIB Establishment 121.0 5. Component 5: Improving Securities Information Disclosure 120.0 Subtotal A 2,258.0 B. Contingencies 1. Physical Contingencies b 68.0 2. Price Contingencies c 113.0 Subtotal B 181.0 Total Project Costs (A+B) 2,439.0 C. Interest Charges d 60.0 Total Project Costs to be Financed 2,500.0 AML = anti-money laundering, CFT = combating the financing of terrorism, CIB = credit information bureau. a Including secondment and training programs. b Estimated at 3% for equipment, training, consulting services, maintenance, and project administration. c Estimated at an annual inflation rate of 5%. d Interest charges during implementation on loans from the Asian Development Fund are at 1% during the grace period. Source: Asian Development Bank estimates. B. Financing Plan 1. The Program Loan 27. To support the Government s the policy reform program, ADB provided a program loan of Special Drawing Rights (SDR)7,472,000 ($11 million equivalent) from ADB s Special Funds resources. The borrower is the Government. The program loan will have a fixed term of 24 years, including a grace period of 8 years. The interest charge will be 1.0% per annum during the grace period and 1.5% per annum thereafter. Program loan proceeds are expected to be utilized over a period of 36 months from the date of loan effectiveness. 2. The Project Loan 28. It is proposed that ADB support the project with a loan of SDR1,359,000 ($2 million equivalent) from its Special Funds resources. A financing plan for the project is provided in Table 2. The project loan will have a fixed 32-year maturity, including a grace period of 8 years. The interest rate charge will be 1.0% per annum during the grace period and 1.5% per annum thereafter. Table 2: Financing Plan ($ 000) Source Total % Asian Development Bank 2,000.0 80.0 Government a 500.0 20.0 Total 2,500.0 100.0 a includes office space, counterpart staff, communications, administration support and contingencies. Source: Asian Development Bank estimates.

9 C. Allocation of Loan Proceeds 1. The Program 29. The proceeds of the loan shall be applied to the financing of expenditures on the Program in accordance with the provisions of the Program Loan Agreement (Reference to Article III of the Program Loan Agreement). In addition, it shall be used to finance the foreign exchange costs of Eligible Items in accordance with the provisions of Schedule 3 to the Program Loan Agreement. 2. The Project Loan 30. The loan proceeds will be applied to the financing of expenditures on the Project in accordance with the provisions of the Project Loan Agreement. The allocation of loan proceeds to the items of Categories in percentage of ADB financing is set forth in the following table (Reference to the Schedule 3 of the Project Loan Agreement). Table 3: Allocation and Withdrawal of Loan Proceeds* (Financial Sector Development Project) CATEGORY Amount Allocated [SDR] Number Item Category Subcategory 1 Equipment 75,000 ADB FINANCING Percentage and Basis for Withdrawal from the Loan Account 1A Designing the website for RSEBL 4,000 100 percent of total expenditure 1B Upgrading and automating the depository 46,000 100 percent of total expenditure database 1C Developing AML/CFT framework and basic infrastructure 25,000 100 percent of total expenditure 2 Consulting Services 524,000 2A Capacity Building of Capital Market Development 67,000 100 percent of total expenditure 2B Capacity Building for Corporate 44,000 84 percent of total expenditure Governance 2C Developing AML/CFT 105,000 100 percent of total expenditure 2D Improving Accounting and Auditing 241,000 100 percent of total expenditure Practice 2E Supporting CIB Development 61,000 100 percent of total expenditure 2F Developing Securities IT Infrastructure 6,000 100 percent of total expenditure 3 Training 593,000 3A Regulatory and Supervisory Secondment 166,000 96 percent of total expenditure Program 3B Accountancy Program 40,000 56 percent of total expenditure 3C Insurance Program 387,000 100 percent of total expenditure 4 Interest Charge 41,000 100 percent of amount due 5 Unallocated 126,000 100 percent of total expenditure Total 1,359,000 ADB = Asian Development Bank, AML = anti-money laundering, CFT = combating the financing of terrorism, CIB = credit information bureau, IT = information technology, RSEBL = Royal Securities Exchange of Bhutan Limited, SDR = Special Drawing Rights. * Exclusive of Taxes and Duties

10 III. IMPLEMENTATION ARRANGEMENTS A. Executing and Implementing Agencies 1. The Program Loan 31. MOF will be the executing agency (EA) for the program loan and will be responsible for coordinating with the ministries and agencies concerned on the policy reforms. 32. MOF will be the implementing agency (IA) for two components: (i) improving corporate governance and (ii) developing accounting and auditing standards. RMA will be the IA for three components: (i) improving financial regulation and supervision, (ii) establishing an AML/CFT framework, and (iii) a CIB. 2. The Project Loan 33. MOF will be the EA and responsible for coordinating support for project implementation. MOF will also be the IA for improving accounting and auditing practices. RMA will be the IA for the four components of (i) building sector capacity, (ii) establishing an AML/CFT framework, (iii) supporting CIB establishment, and (iv) improving securities information disclosure. The IAs will provide information and analyses to the program/project management unit (PMU) and coordinate the fielding and work of consultants. The PMU will be responsible for coordinating project implementation and ensuring the submission of project reports. Sound accounting and internal control systems will be adopted by the PMU. B. Program and Project Management Organization 34. MOF will set up an inter-agency program steering committee (PSC) headed by the secretary of MOF and comprising, among others, representatives of RMA, BOBL, RICBL, and RSEBL to monitor progress, coordinate implementation, and ensure effective fulfillment of the proposed policy reforms. The PSC will meet every quarter or as often as needed. It will provide ADB, for reference, all reports and minutes of PSC meetings, and ADB may attend these meetings as an observer. A program and project organization chart is in Appendix 3. 35. MOF will establish a program and PMU headed by a program director, who shall be a senior staff of RMA, responsible for program and project administration, loan disbursement, accounts maintenance, and reporting to the PSC. The program director will be assisted by representatives of respective divisions at RMA and MOF s Division of Debt Management at the Public Accounts Department. One of the representatives will be designated as an alternate program director. Table 4: Key Functions of the Executing and Implementing Agencies Agency Component Key Functions MOF EA Open accounts (one deposit account for the Program, one imprest account for the Project) at RMA to receive the loan proceeds. Management and replenishment of accounts. Organize audits of the accounts by chartered accountants annually. Establish, organize, and chair the quarterly inter-agency PSC to monitor progress, coordinate implementation, and ensure effective fulfillment of the proposed policy reforms. Establish a.pmu headed by a program director, who will be a senior staff of RMA for

11 Agency Component Key Functions program administration, loan disbursement, accounts maintenance, and reporting to ADB. The program director will be assisted by representatives of respective divisions at RMA and MOF s Debt Management Division at the Department of Public Accounts. Carry out procurement and consultant service recruitment, in coordination with the PMU. Liaise with PMU, IAs, and ADB to address any implementation issues. Prepare the 6 monthly and annual progress reports based on the information submitted by PMU and IAs. Ensure that selection criteria is adopted in connection with identifying staff members of RMA, MOF, RICBL, and RSEBL for training provided under the Project and the recipients of such training continue their services for no less than 2 years upon completion of the training. MOF IA Ensure that RMA drafts and issues regulations and guidelines on corporate governance for financial institutions. Ensure that MOUs are signed between BOBL and Government regarding commercialization of BOBL s operations. Ensure that a formal commitment is reached between MOF, RMA, and RICBL regarding a rationalization plan for RICBL that conforms to best practice. Establish a committee, with representation of involved government offices and technical persons from the private sector, to take charge of accounting and auditing reform (by December 2006). Ensure that the committee creates the Bhutanese AASB that will be tasked with the development of the Bhutanese GAAP and GAAS (by June 2008). Ensure that the AASB develops the Bhutanese GAAP and GAAS (by June 2008). Ensure that AASB discusses with stakeholders on the newly developed Bhutanese GAAP and GAAS and approved for implementation (by December 2009). RMA IA Finalize draft FSA (by December 2006) and submit to the national assembly for passage (by June 2008). Conduct stakeholder consultations on the draft regulations and education workshops for financial institutions (by June 2008). Issue implementing regulations under the new FSA (by December 2009). Implement the secondment program for experienced officers of the FISD at RMA to receive on-the-job training in relevant countries with a strong financial supervisor, to obtain skills and practical experiences on on-site supervision for banks, insurance, capital markets, and pensions (3 person-months each supervisor) (by December 2009). Ensure that a traineeship program is established to develop the accounting and auditing profession in Bhutan by supporting two RMA staff to obtain accountancy training (3 years) in a relevant foreign country (by December 2009). Ensure that the securities market expert conducts on-the-job training for strengthening professional knowledge of securities markets and related regulations (by June 2007). Complete prudential regulations for corporate governance by June 2008 and issues them by December 2009. Conduct stakeholder consultations on the draft regulations and educational workshops for financial institutions by June 2008. Supervise agreed actions of RICBL to separate accounts and business operations for general insurance, life insurance, and the credit and investment department and regarding reporting requirements (by June 2008). Implement the training program for strengthening insurance underwriting skills by December 2009. Revise the draft FSA to ensure the authority given to itself as the AML/CFT regulator and supervisor in the financial sector (by December 2006). Develop (by June 2008) and issue regulations requiring financial institutions to establish procedures for customer identification ( Know your Customer ) processes, and generating reports on suspicious transactions and reporting such transactions to the RMA (by December 2009).