Document of

The World Bank

Report No. 13176-EE

STAFF APPRAISAL REPORT

ESTONIA

FINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

SEPTEMBER 15, 1994

Privatization and Enterprise Development DivisionCountry Department IVEurope and Central Asia Region

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Currency Equivalents(August 31, 1994)

Currency Unit = Estonian Kroon (EEK)US$1 = EEK 12.65

EEK I = US$0.079DM I = EEK 8

EEK I = DM 0.125

Fiscal Year

January 1 - December 31

Abbreviations and Acronyms

BITS Sweden Board for Investment and Technical SupportBOE Bank of EstoniaCAG Core Advisory GroupCAS Country Assistance StrategyDAGTl Danish Agency for Development of Trade and IndustryEBRD European Bank for Reconstruction and DevelopmentEC PHARE European Commission Assistance Program for Eastern EuropeEEK Estonian KroonEFB External Financing BoardEU European UnionFSUB Former Soviet Union (12) and BalticsGDP Gross Domestic ProductGOE Government of EstoniaG24 Group of 24ICB International Competitive BiddingIMF International Monetary FundLIB Limited International BiddingMIS Management Information SystemsMOF Ministry of FinanceNEB North Estonian BankPFI Participating Financial InstitutionPIU Project Implementation UnitSA Special AccountSKr Swedish KronerSOE Statement of ExpenditureSTF Systemic Transformation FacilitySWIFT Society for Worldwide Interbank Financial TelecommunicationsTA Technical AssistanceTCB Tartu Commercial BankTOB Treuhand Osteuropa BeratungsgesellschaftTOR Terms of ReferenceUBB Union Baltic BankUSAID United States Agency for International Development

STAFF APPRAISAL REPORT

ESTONIA

FINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

Table of Contents

Loan and Project Summary ............................................ i

I. BACKGROUND .. 1......................... A. Country Context ............................................ IB. Privatization and Private Sector Development ........................ IC. Financial Sector Background ................................... 2D. Strategy and Issues in the Financial Sector .......................... 6

II. THE PROJECT ............................................... 8A. Project Development and Objectives, and Rationale for Bank Involvement ... . 8B. Project Components and Description .............................. 9C. Project Cost and Financing Plan ................................ 13

III. PROJECT IMPLEMENTATION ARRANGEMENTS ...... .. ............ 16A. Implementation Arrangements .................................. 16B. Procurement .............................................. 18C. Disbursements ............................................ 20D. Project Accounting, Financial Reporting, Auditing and Supervision .... .... 21

IV. BENEFITS AND RISKS .. 23A. Project Benefits ........................................... 23B. Project Risks ............................................. 23

V. AGREEMENTS AND RECOMMENDATIONS .......................... 24

ANNEXES

Annex I Estonian Commercial BanksAnnex II The Government of Sweden Capital FundAnnex III General Structure of the Credit LineAnnex IV Eligibility Requirements for the Banks, Sub-Borrowers and the Sub-ProjectsAnnex V Documentation and Reporting Requirements for the Financial Institutions

Development ProjectAnnex VI Draft Terms of Reference for the Audits of the Commercial BanksAnnex VII Draft Terms of Reference for Advisors for Participating BanksAnnex VIII Draft Terms of Reference for the Institutional Development Program for the North

Estonian BankAnnex IX Terms of Reference for the Project Implementation UnitAnnex X Draft Terms of Reference for the Core Advisory GroupAnnex XI Draft Terms of Reference for Environmental TrainingAnnex XII Disbursement TablesAnnex XIII Supervision Plan

MAP

This report is based on the findings of an appraisal mission in May 1994. Members of theappraisal team included Messrs./Mmes. Lily Chu (mission leader), Stan Bereza (FSD), SamuelTalley (FSD), John Nellis (PSD), and Esen Ulgenerk (Consultant). Messrs. Andrew Ewing (PSD)and Vince Polizatto (FSD) are the peer reviewers. Mme. Tracy McTernan provided invaluablesecretarial support. Messrs. Paul Siegelbaum and Basil Kavalsky are the managing DivisionChief and Department Director, respectively, for the operation.

ESTONIA

FINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

Loan and Project Summary

Borrower: Republic of Estonia

Executing Agency: Project Implementation Unit (PIU) within the Ministry of Finance(MOF).

Beneficiaries: Participating commercial banks, and recipient enterprises.

Amount: US$10 million

Terms: Fifteen years, including five years of grace, at standard IBRD rates.

Onlending Terms: The World Bank funds will be onlent by the Ministry of Finance to thecommercial banks. The rate to the commercial banks will be WorldBank lending rate plus I percent. Rates to final borrowers will bemarket rates determined by negotiation between the commercial banksand the final borrowers.

Objective: The principal objective of the project is to strengthen the bankingsector, and increase the availability of investment financing to theenterprise sector.

Description: The Project will consist of: (i) a commercial bank developmentcomponent, including long-term funding and technical assistance;(ii) assistance to the North Estonian Bank (NEB), the last 100 percentstate-owned bank; and (iii) technical assistance to assist in projectimplementation. The commercial bank component will provideresources to the financial sector to make medium and long-term loansto private and privatized enterprises. This will be supplemented by aSKr 100 million (approximately US$12 million) Capital Fund providedby the Government of Sweden that would be dedicated to thecapitalization of the banking sector and to the restructuring of the NEB.In addition, cofinancing will be provided by the Swedish Board forInvestment and Technical Support (BITS), EC PHARE, the DanishAgency for the Development of Trade and Industry (DAGTI), theGovernment of Norway, and the Government of the Netherlands fortechnical assistance for: (i) audits conducted according to internationalaccounting standards; (ii) training in environmental screening;(iii) individualized technical assistance to participating banks;(iv) restructuring assistance for the NEB; and (v) the establishment of

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a Project Implementation Unit and Core Advisors Group to ensuresuccessful implementation of the project.

Project Benefits: The project will: (i) improve efficient allocation of resources byimproving the intermediation capabilities of the banking sector;(ii) increase the stability of the banking sector, which will lead togreater mobilization of funds; (iii) increase long-term investment byproviding critically needed long-term funds to the enterprise sectorwhich will in turn improve the productivity of private enterprises byproviding technology and capital goods; and (iv) provide an incentivefor privatization by targeting investment funding toward privatecompanies.

Project Risks: Among the possible risks are changes in the political environmentwhich might make it difficult for the Government to sustain theprogram of macroeconomic stabilization and which might slow downthe progress towards a fully-fledged market-based economy. Inparticular, as a result of inappropriate financial policies, high inflationcould lead to a deterioration in the investment climate with adverseeffects for growth, output and employment; this could cause theperformance of sub-borrowers under the line of credit to deteriorate,which could then increase defaults. Finally, the ability of the banks toabsorb the long-term funds is limited, unless supported by necessarytechnical assistance.

Estimated Costs: Local Foreign Total- (US$ million equivalent) -

Commercial Bank Development 0.20 21.30 21.50North Estonian Bank Restructuring 6.00 2.50 8.50Project Implementation 0.40 1.35 1.75

Total 6.60 25.15 31.75

Financing Plan: Local Foreign Total------- (US$ million equivalent) -------

IBRD - 10.00 10.00Govt. of Estonia/

Bank of Estonia 6.30 - 6.30Govt. of Sweden - 12.00 12.00Other Cofinancing 0.10 3.15 3.25Participating Banks 0.20 - 0.20

Total 6.60 25.15 31.75

Estimated Disbursements:Bank Fiscal Year FY 95 FY 96 FY 97 FY 98

-------------- (US$ million equivalent) -------------

Annual 2 3 3 2Cumulative 2 5 8 10

Economic Rateof Return: NA

Closing Date: June 30, 1998

Map: IBRD No. 26135

ESTONIA

STAFF APPRAISAL REPORT

FINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

I. BACKGROUND

A. Country Context

1.1 Since re-establishing its independence in August 1991, Estonia has achievedconsiderable progress in transforming its economy into a market oriented system. Its economyhad been severely distorted by a half century of central planning and constrained by heavy tradedependence on the former Soviet Union and the Baltics (FSUB). Driven in large part by thedecline in its trade and severe terms of trade shock, real GDP declined by over 40 percent since1990; GDP per capita is estimated to have been US$2,700 in 1993. However, early 1994 figuresindicate GNP to be growing at about 5 percent on an annual basis. Unemployment has increasedas uncompetitive enterprises have been forced to close in the face of falling sales, hard budgetconstraints, and increasing or unsustainable levels of inter-enterprise arrears. Those openlyunemployed and receiving unemployment benefits still account for less than 4 percent of the laborforce, although surveys indicate the true unemployment number may be closer to 6 or 7 percent.

1.2 Estonia began its price liberalization program and related economic reforms in1989 and the pace of reform has accelerated in the last 2 years. Tight fiscal discipline helpedassure the success of the currency board scheme under which Estonia' s own currency, the kroon,was introduced in June 1992. Inflation averaged only 2-3 percent per month during 1993.Inflation then rose to an average monthly inflation rate of about 6.5 percent during the firstquarter of 1994, but had fallen to an average of 1.6 percent per month in the second quarter of1994. The external current account has stayed broadly in balance, substantial foreign exchangereserves have been accumulated, and significant progress has also been made in other structuralreforms, particularly in the trade and legislation areas. Additional information on themacroeconomic situation can be found in the Country Assistance Strategy for Estonia (September1994).

B. Privatization and Private Sector Development

1.3 One important element in economic growth is the development of the privatesector. Small-scale privatization (defined as enterprises with a book value under 600,000 Estoniankroons) has been progressing well, with more than 80 percent of the small-scale enterprisesprivatized, primarily through public auction. Privatization of medium and large scale enterpriseshas been moving at a slower pace, but is greatly improving. Initially, the Estonian PrivatizationAgency had been relying on an evaluated bid approach to privatization. This case-by-caseapproach is labor intensive and has resulted in 157 purchase contracts as of August 1994, ofwhich about half were for whole companies. However, since the Estonian Government has

introduced genuine hard-budget constraints for state-owned enterprises, and since banks have beenreluctant to lend to state-owned enterprises until the issue of responsibility for debts held by thoseenterprises is resolved, one result of the slow pace of privatization has been to drive cash-starvedenterprises into bankruptcy.' As a result, the Governrment has recognized that the slow pace ofprivatization is a serious problem, and has begun taking steps to speed it up. The World Bankhas encouraged the Government to continue with the current privatization processes, but tosupplement these with additional methods. The Government is now pursuing a multi-trackprivatization program including: (i) the current method of international tender followed bynegotiation (assisted by Treuhand Osteuropa Beratungsgesellschaft (TOB) and USAID);(ii) expanded auctions, with no size limitation; (iii) a pilot of five initial public offerings (ECPHARE technical assistance); (iv) direct trade sales (EBRD technical assistance); (v) turn aroundmanagement (EBRD technical assistance), and (vi) joint ventures. The progress made towardsimplementing these multiple tasks has been impressive. If all these tracks proceed as realisticallyplanned, it is highly likely that within I or 2 years, almost all the enterprises held by the Ministryof Economy will have been partially or completely privatized. This will still leave many largeinfrastructure companies (such as telecommunications, railroads, energy, etc.) to be privatized,but these will likely be done on a case-by-case basis.

1.4 A critical part of these different privatization tracks will be the use of vouchers,which will allow the general population to participate in the ownership of these larger enterprises.The Government has already distributed voucher cards to all eligible residents (Estonian residentswho worked in Estonia prior to Independence), and has begun setting up voucher accounts. Thevouchers are freely tradeable, and the Government hopes to have these voucher accounts readyfor use in time to participate in the planned EC-assisted initial public offerings, which arescheduled for issuance by the end of the year.

1.5 The private sector is also growing through new investment, both foreign anddomestic. By the beginning of 1994, over 50,000 new private companies had been established,including 4,000 with foreign investment participation. Foreign direct investment for 1994 wascalculated at EEK 2.2 billion, including an estimated EEK 1.2 billion in capital stock.

C. Financial Sector Background

1.6 Before Independence, Estonia's financial sector consisted of the North EstonianShare Bank (formerly the Estonian Branch of the Vnesheconombank), the Savings Bank, theSocial Bank, the Industry and Construction Bank, and 16 regional banks financing the agriculturalsector. The Bank of Estonia (BOE) was founded in January 1990, and in the following 2 years,most of the state-owned banks were privatized or had state ownership diluted through share salesto the public. With the entry of new private banks, the Estonian financial system had 42operating banks as of mid- 1992.

1. As of May 1994, it was estimated that more than 300 companies have been placed in bankruptcy, includingsome large companies deemed inviable by the Ministry of Economy.

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1.7 In late 1992, several banks developed liquidity problems. The Tartu CommercialBank (TCB) began having serious loan portfolio problems. Two other banks, the Union BalticBank (UBB) and the North Estonian Share Bank had many assets held with theVnesheconombank in Moscow. In January 1992, the Moscow Vnesheconombank froze theMoscow-held accounts of banks based in other republics. The amount of Russian assets held inEstonia was much smaller than the Estonian assets held in Moscow. The resulting shortfall inassets left the UBB and the North Estonian Share Bank with large gaps in their balance sheets.In November 1992, these three banks, representing 40 percent of the total assets in the bankingsystem, were placed in moratorium.

1.8 Since the Government and the BOE viewed the problems of the TCB to be dueto poor loan decisions, they proceeded with the liquidation of TCB. The shareholders lost theirinvestments, and the depositors received partial refunds as the liquidation proceeded. In contrast,the illiquidity of UBB and the North Estonian Share Bank were perceived to be due to theproblem of frozen assets. The authorities decided to merge the twobanks into a new bank, NorthEstonian Bank (NEB). The former shareholders of the UBB and the North Estonian Share Bankreceived bonds which are payable only from the proceeds of the frozen assets held in Moscow(i.e., the former shareholders would receive nothing unless those assets are eventually recovered).The Government replaced the NEB's frozen assets with EEK 300 million of Government bonds,and in return took over the ownership of the bank. The NEB is now the only bank that is100 percent state-owned.2

1.9 After the banking crisis, the BOE conducted a relicensing survey of the banks andincreased the minimum banking capital requirement to EEK 6 million.3 This screening resultedin several mergers, liquidations and voluntary closings during 1993. As of August 1994, thebanking sector consisted of the BOE, 20 commercial banks4, a savings bank, and a developmentbank (the Estonian Investment Bank). Summary information on the commercial banks can befound in Annex I.

2. The Estonian Savings Bank is 67 percent owned by the Bank of Estonia, and 33 percent owned by Hansapank,a private commercial bank. The Bank of Estonia has been seeking to sell another 33 percent to an outside investorwho could also bring banking expertise.

The Government also owns a share, ranging from 2 to 35 percent, in several of the other former state banks,including the Industry and Construction bank and the former agriculture banks. These banks issued shares to thepublic, and the state share was gradually diluted. It is expected that the state share will continue to be diluted asnew shares are issued. Eventually, the Government plans on liquidating all its holdings in commercial banks.

The BOE is also the majority shareholder (67 percent) of the Estonian Investment Bank, a development bank setup with assistance from the EBRD and the Nordic Investment Bank. The EBRD owns the other 33 percent of theEstonian Investment Bank.

3. The minimum capital has since been raised to EEK 8 million, and is scheduled to increase to EEK 15 millionin 1995, EEK 25 million in 1996, and EEK 35 million in 1997.

4. The Social Bank was placed into moratorium in August 1994.

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1.10 The firm reaction of the Government to the banking crisis has had a positiveinfluence on the sector. Banks adopted much more careful lending policies, since the Governmentdemonstrated that it was willing to allow both shareholders and depositors to suffer losses if abank ran into trouble. On the other hand, the rapid and unsupported restructuring in the sector,together with the introduction of the kroon, initially weakened public confidence in the newlyemerging banking sector. Deposit accumulation was slow, and most of the funds placed with thebanks were of 3-months maturity or less.

1.11 Although now the public's confidence in the banking sector is beginning to return,the banks still have extremely short-term funding sources; for some banks, more than 90 percentof their deposits are demand deposits5 . Given the maturity of these funds, it is not surprising thatthe banks are continuing to lend almost exclusively short-term. Therefore, very little investmentfinancing has been available; instead the banks are primarily providing trade or working capitalfinance. Even in the cases where the banks feel relatively secure about the longer-term credit riskof loans, the loans are structured as short-term loans which are rolled over, with a renegotiatedinterest rate. Some of the "longer term" loans (i.e., 1 year or more) also have rates renegotiatedat regular intervals. The borrowers have not yet objected to this practice of renegotiating loanrates, since rates have been falling in Estonia (it remains to be seen what borrower reaction willbe during periods of rate increases).

1.12 Interest rates are freely set between lender and borrower. With few exceptions,the Government plays no role in the direction of loans or the setting of interest rates.6 Interestrates and lending spreads are falling. Deposit rates range anywhere from 3 to 15 percent(depending on term of deposits). Lending rates for prime customers are now as low as16 percent, while trade finance still can command rates of upwards of 50 percent.

1.13 Despite the high rates of return being earned on trade finance, the better banks areinterested in developing traditional long-term lending skills. They recognize that the profitabilityof trade finance is based on the resale of Russian commodities and metals which are still pricedbelow international levels, and that this profitability will gradually disappear as East-West pricinggaps diminish. The banks are becoming aware of the need to assume project-finance risk for loansto carefully selected clients in order to maintain market share and profitability. A number of themhave started financing small projects (EEK 200,000-500,000) for up to I year; some banks have

5. As of December 1993, 85.2 percent of all commercial banks' deposits were demand deposits, 13.2 percentwere time deposits with maturities of I year or less, and only 1.6 percent of deposits were of maturities of overI year.

6. The exceptions include a Rural Fund, providing loans to rural areas, under which banks borrow at 5 percentand relend at a maximum of 15 percent. The amount of the fund was EEK 124 million in 1993 and is budgeted atEEK 64 million in 1994. In 1993, Rural Fund loans were 100 percent guaranteed by the Government; now, theyare 50 percent guaranteed.

Other exceptions are tied to specific aid programs. These include a I million ECU credit line from the EU for smalland medium size enterprises, with a maximum interest rate of 12 percent per year, and a USAID sponsored farmprogram with maximum interest rate of 15 percent.

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set up 2- to 3-year lease finance projects. Some have also started compiling pipelines of mediumto long-term investment projects which they plan to finance if longer-term resources becomeavailable.

1.14 Financial Infrastructure. Legislation. The banking system has been operatingunder a Banking Law passed in December 1989. A new Central Bank Law of the Republic ofEstonia was approved in 1993. The Law requires the BOE to authorize and supervise theactivities of the commercial banks and the credit institutions. A draft Credit Institutions Law hasbeen prepared and presented to the Parliament.

1.15 Other supporting legislation such as laws on mortgages and bankruptcy have alsobeen passed. The Bankruptcy Law is used and enforced actively. The Law on Mortgages stillneeds a supporting administrative framework. Although mortgages are now legal, a land registryis only now being developed, and only a handful of properties have been registered. Technicalassistance on land registration is being provided by the World Bank. The development of thisland registry is essential to the development of an active mortgage market, and will lead toincreased lending to homebuilders, farmers, and enterprises which have a large part of their assetvalue in fixed property.

1.16 The Government is also working on a draft accounting law. This law will bringenterprise accounting in line with international practices. EC PHARE is also working with theBOE to bring bank accounting and reporting in line with internationally accepted standards.

1.17 Banking supervision. The Government of Estonia is working with the EU andthe IMF to improve banking supervision. The supervision department is heavily dependent ondata supplied by the banks. Since not all the banks are being audited by independent auditorsaccording to international standards, and since the supervision department still has limitedcapabilities in on-site inspection, it is difficult to verify the validity of bank information. Inaddition, the supervision department needs to develop the capability to handle problem banks,both in pre-identifying and in managing them through various damage control and rehabilitationmeasures.

1.18 Payment system. The bank payment system has improved considerably. In late1992, payments would take as long as several weeks to clear. Since then, a clearing system atthe BOE which is connected to the banks by computer was set up and heavy fines for settlementsof more than 2 days were implemented. The result is that most payments in the country now clearin less than 1 day.

1.19 Capital Markets. Capital markets are underdeveloped in Estonia. The BOEbegan issuing 30-day CD's in 1993. The only Government bonds issued to date have been thoseused to recapitalize the NEB. A short-term interbank market is developing.' A few privateplacements of bonds and equities have taken place, but there is no active secondary market for

7. This market has increased from EEK 104 million in October 1993 to EEK 1260 million in August 1994.Weighted average interest rates have fallen from 6.72 percent in October 1993 to 5.56 percent in August 1994.

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securities. Given the extreme limitations of the capital markets, the banking sector is usually theonly channel for most enterprises to obtain funds.

D. Strategy and Issues in the Financial Sector

1.20 The financial sector is still in a very early stage of development. Theinfrastructure is only now falling into place. At this stage of development, with no functioningcapital markets, no venture capital, and no long-term institutions such as private pension' orinsurance providers,9 the banks will be the primary channel for medium and long-term funding.

1.21 Although the banks are the logical channel, the banking sector itself is still in arudimentary phase of development. The sector has already gone through a great deal ofconsolidation, decreasing from 42 banks to 22 banks in less than 2 years. However, in a countryof 1.5 million people, with a total land mass of 45,215 square kilometers (the country can becrossed by car in 4 hours), it is possible that the market could be well-served by a much smallernumber of banks. Furthermore, Estonia has no restrictions on the entry of foreign banks; as thecountry's macro-economic situation has improved, the BOE has begun receiving inquiries fromforeign banks on the procedures for opening branches in Estonia. Two Finnish banks have alreadyannounced plans to open branches by the end of 1994. It is quite probable that as foreign banksenter the market, and as bank competition sharpens, further consolidation of the banking sectorwill occur.

1.22 Another issue is the size of the banking sector. Even though future consolidationof the banks may decrease the number of banks, it will not alter the fact that the absolute sizeof the entire sector is still very small. Total capitalization of all the commercial banks was onlyEEK 566.7 million as of June 1994.'° Even though large amounts of longer term funding willbe made available through this project and other donor projects, the banks may not have asufficient capital base to intermediate the funds, particularly since the number of banks that willqualify to act as credit line channels will be quite small.

1.23 Demand for Credit. Measuring demand for long-term credit is difficult, sincebanks have not encouraged long-term loans. However, many of the banks visited by the WorldBank mission have a pipeline of medium and long-term projects that they would like to financeif and when they obtain long-term funding resources. The Estonian Investment Bank hasapproved approximately EEK 110 million in loans since starting operations in 1993, and has a

8. The Estonian Innovation Bank is now launching an initiative to start a private pension fund. The Bank'sintention is to place funds received with Estonian commercial banks or overseas investments, not make long-termdomestic investments.

9. There are a number of insurance companies in Estonia, but except for the state insurance company, they areprimarily providers of various forms of term insurance.

10. This excludes the Estonian Investment Bank, which is capitalized at 4.5 million ECU, and the Social Bank,which was placed in moratorium in August 1994.

project pipeline of EEK 270 million (approximately US$20 million). They view their bottleneckas one of human capital rather than one of limited project availability. So far, they have onlyfive trained credit officers, and can only process about two projects per month.

1.24 Skills Development. A review of project documentation prepared by thecommercial banks showed varying degrees of skill and understanding of credit analysis andproject finance. These banks will need to develop skills in project finance structuring andanalysis, risk analysis, credit initiation, credit appraisal and loan monitoring to successfully on-lend the World Bank credit line.

1.25 The skills development needs of the banks are not only in credit and projectfinance, however. To successfully operate as sound commercial banks in accordance withinternational standards, the commercial banks need skills building and on-the-job assistance indiverse areas such as (i) operations, (ii) treasury management, (iii) trade finance products andservices, (iv) bank strategic management, (v) developing MIS systems, and (vi) human resourcesdevelopment.

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II. THE PROJECT

A. Project Development and Objectives, and Rationale for Bank Involvement

2.1 A Bank identification mission took place in September 1993. At that time, themission felt that although long-term investment funds were urgently needed by the enterprisesector, a World Bank credit line could not be justified, since the IMF and G-24 (through the EU)were planning on providing funds which would be channeled through the banking sector."

2.2 However, in subsequent discussions with the Government of Estonia, theauthorities expressed concern that the banks might not have a sufficient capital base to absorb theIMF and G-24 funds and that there was also a need for increasing technical capacity to evaluateand process these funds.

2.3 The World Bank, along with the Government of Sweden, began to work to developan integrated approach to financial sector strengthening in Estonia. The following needs wereidentified:

(i) Long-term credit resources to meet enterprise investment needs. (Partiallymet through the IMF, EU/G-24 money.)

(ii) Technical assistance to deliver long-term resources.(iii) An increase in the capital base of banks, which would allow them to make

full use of available funding.

In addition to credit delivery, sharpening competition in the banking sector dictates that:(a) commercial banks need to develop all skills, not just credit skills; (b) the Government mustmove out of the commercial banking sector; and (c) the BOE must continue to upgrade its banksupervision capabilities, particularly since the consequences of further banking sector competitioncould lead to troubled banks.

2.4 With these needs in mind, an overall program was developed. To meet long-termcredit needs, a package of credit resources (IBRD), capital injections (Government of Sweden),and technical assistance (BITS, EC PHARE, DAGTI, the Government of Norway, and theGovernment of the Netherlands) was structured. The technical assistance was designed to helpwith credit assessment and project finance, as well as with bank operations, treasury functions,MIS needs, etc. The project would also help the Government recapitalize and restructure theNEB, so as to stabilize the NEB sufficiently to facilitate its privatization. In parallel, EC PHAREand the IMF will be working to provide technical assistance to improve overall supervisioncapabilities, including the capability to deal with troubled banks and to improve bank accountingand reporting.

I. The IMF has approved an STF of approximately US$32 million, and started initial allocation of funds tocommercial banks in July 1994. The EU/G-24 has allocated approximately ECU 20 million for assistance to Estonia.Part or all of these funds may also be channelled through the banking system.

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2.5 The World Bank is a strong supporter of the reform process undertaken by theRepublic of Estonia. It views a strong financial sector and new investment in the private sectorto be critical to the long-term development of Estonia. Notwithstanding the recent policy andinstitutional advances and the availability of capital, investment is not taking place at the desiredpace. In 1993, fixed capital formation represented about 10 percent of GDP compared to 15-25 percent in other comparable countries. Only 4.7 percent of government expenditures wereallocated to investment and net domestic credit accounted for 30 percent of the overall assets ofthe banking system. The project will help the country overcome these difficulties by:(i) facilitating intermediation through improving credit analysis capabilities, the lendingenvironment and the stability of financial institutions; (ii) providing some of the funding requiredby enterprises for investments to restructure operations and increase production; and(iii) providing an incentive to privatize by making much sought after investment funds availableto the private sector. The World Bank's role in this project has been to serve as a catalyst andcoordinator of multinational and bilateral support programs that address pivotal needs in thesesectors. In addition to mobilizing the resources for the program described in this document, partof the structure of the World Bank program will be integrated with the IMF STF program andthe EU/G-24 assistance program.

B. Project Components and Description

2.6 The project would consist of three components:

(i) Commercial Bank Development. A line of credit will be channelledthrough the commercial banking system to provide long-term funds forprivate enterprises. These funds will be supplemented by cofinancing bythe Government of Sweden (the Swedish Capital Fund), which would beused to provide additional capital to private banks. In addition, technicalassistance will be provided to (a) conduct audits at international standards,and (b) develop skills in credit analysis, project finance, and generaloperations.

(ii) Restructuring of the North Estonian Bank The Bank would assist in thecoordination of financial resources and technical assistance to restructureand eventually privatize the NEB.

(iii) Project Implementation. Technical Assistance would be provided to assistin strengthening project implementation. This would include the projectimplementation unit, financial advisors, and environmental training.

2.7 Commercial Bank Development. This component will include an IBRD-financedcredit line of US$10 million. The funds will be channelled through a Project ImplementationUnit (PIU) at the Ministry of Finance and then onlent through participating banks. A spreadwould be added to the IBRD lending rate to reflect administrative and guarantee costs. Theinterest rate on the sub-loans will be negotiated freely between each participating bank and its

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client. Cofinancing from the Swedish Capital Fund (see Annex II for more details on the SwedishCapital Fund) would be made available to the participating banks on a fixed ratio to World Bankfunds. Hence, under a 1:1 ratio, a qualified bank which was making a qualified subloan and, i h:_'ad also reached an agreement with the Swedish Capital Fund on investment conditions,

would receive 50 percent of the funds in the form of a loan from the World Bank Credit line(through the PIU), and 50 percent of the funds in the form of a capital injection. The on-lendingbanks will bear the foreign exchange and credit risks of the sub-loans. More implementationdetails are in the section on project implementation (Section III) and Annexes III-V.

2.8 To ensure that banks develop the skills necessary to use these funds wisely,technical assistance will also be provided. This would include:

(i) Audits. The better Estonian banks are already being audited byinternationally recognized accounting firms. However, although the BOEis working to align Estonian bank accounting with internationally acceptedaccounting standards, there are still some important differences in bankaccounting, most notably in loan loss provisioning. Estonian banks areonly allowed to deduct for tax purposes loan-loss provisions up to5 percent of their loan portfolio. Not surprisingly, almost every Estonianbank has loan-loss provisions equal to 5 percent of their loan portfolio.One of the criteria for becoming a participating bank in this proposedproject is to meet minimum financial standards--including adequate loanloss provisioning--based on audits conducted according to internationallyaccepted accounting practices. Since such audits can easily cost upwardsof US$100,000 equivalent, and some of the applicant banks may havecapital of only US$1-2 million, EC PHARE and the Government of theNetherlands have offered to help finance audits. Some of this work isbeing initiated under project preparation. Draft terms of reference forthese audits can be found in Annex VI.

(ii) Individual Technical Assistance to Participating Banks. Each of the banksqualifying for the World Bank Credit Line/Swedish Government CapitalFund, will receive additional technical assistance. If an equity investmentis negotiated, the Swedish Capital Fund, as a shareholder, would place adirector on each bank's Board of Directors. Each director would be anexperienced banker, who would provide advice and assistance to the bank.In addition, the director would be responsible for identifying and definingan individualized package of technical assistance for the bank. It isexpected that this technical assistance will include: (i) credit analysis;(ii) project finance; (iii) bank operations; (iv) treasury management; and(v) management information systems. Draft terms of reference can befound in Annex VII.

2.9 Restructuring of the North Estonian Bank. As described in paragraphs 1.7-1.8,the NEB was formed in early 1993 by the merger of two banks that had developed liquidity

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problems due to the freezing of claims on the Moscow Vnesheconombank. At that time, theGovernment of Estonia provided new assets in the form of EEK 300 million in Governmentbonds.

2.10 Unfortunately, although this EEK 300 million was sufficient to fill the gap createdby the frozen claims, it was not sufficient to cover losses from the loan portfolios of the twoformer banks. A recently completed audit identified over EEK 124 million in loan losses,representing 36 percent of the total NEB loan portfolio.

2.11 In addition to financial assistance, the NEB needs a great deal of technicalassistance. The current management is facing an extremely difficult task in developing newbanking skills and repositioning itself in a constantly changing and increasingly competitivemarket for financial services. At the same time it is trying to conduct a thorough workout ofproblem loans in its portfolio, particularly those loans granted under previous management andmuch looser credit policies. Although the management has been aggressively pursuing collectionthrough, among other steps, the filing of bankruptcy petitions to seize and liquidate borrowers'assets, the value of the assets awarded in bankruptcy court has in general fallen short of theamount of the loan. Given the difficulty of developing new skills, staff and procedures whileattempting to recover a large amount of bad and overdue loans, the NEB can not continue muchlonger without clear changes in its structure.

2.12 The Estonian authorities have already begun taking steps to financially restructurethe NEB. As a one time contribution, the BOE has written off EEK 40 million of its loans tothe NEB, which represents part of the assistance provided by the BOE at the time of the bankingcrisis.

2.13 This step has removed a large amount of the bad loans from the NEB's balancesheet. However, once the remaining bad loans are written off, the remaining capital, at3.4 percent of outstanding loans, will be insufficient to support the current loan base of the NEB,let alone provide for future loan growth. The Government of Estonia, with assistance from theGovernment of Sweden's Capital Fund, plans to inject new capital into the NEB, which wouldhelp to stabilize the NEB. The Government of Sweden's contribution will be conditional on:

(i) An agreement on a privatization program.

(ii) An agreement on an institutional development program, including anassessment of and the appointment of management committed to its rapidimplementation.

(iii) A capitalization program for the bank which brings the bank up to a levelwhich satisfies the prudential norms established by the BOE with theSwedish component of the capital base representing a minority share of thecapital.

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The recapitalization of the NEB would be contingent on the signing of an agreement between themanagement of the NEB and the Estonian authorities which would incorporate sanctions for non-compliance with the program as well as incentives for successful completion. To help themanagement implement such a program, technical assistance will be provided, including:(i) financial restructuring; (ii) development of a privatization plan; and (iii) institutionaldevelopment. A more detailed description of the institutional development needs can be foundin Annex VIII. EC PHARE has offered to finance such assistance.

2.14 Project Implementation. Proper project implementation will be critical to thesuccess of the project. A PIU will be set up in the Ministry of Finance, and will be responsiblefor overseeing and coordinating overall project implementation. Section III, Annexes III-V andAnnex IX include more details on the role and responsibilities of the PIU. Technical assistancewill also be provided to assist in project implementation. Such assistance would include:(i) establishment of a Core Advisers Group (CAG); and (ii) training in environmental screening.

2.15 The Core Advisers Group. The CAG will be a key element in the implementationof the credit line. The primary purposes of the CAG will be to assist the PIU and the WorldBank in: (i) evaluating the eligibility of the banks under criteria defined by the World Bank;(ii) monitoring the on-going performance of the participating banks and their loan portfoliosunder the credit line; and (iii) reviewing sub-loan projects to be financed through the credit line.

2.16 In addition, the advisors will provide on-going technical assistance to commercialbanks. Such assistance would include: (i) developing credit policies and procedures/creditmanuals; (ii) developing internal operational manuals applicable under internationally acceptableaccounting standards and applications; (iii) structuring and evaluating term-lending;(iv) developing operational and investment budgets in line with bank strategy; and (v) developingproper internal management information systems for effective asset and liability management.The CAG will also serve to support the implementation of the IMF STF program, and theEU/G24 program. More details can be found in the Terms of Reference for the CAG (Annex X).The CAG will be financed by EC PHARE, BITS, and DAGTI.

2.17 Training in Environmental Screening. One of the conditions of the World Bankloan is that the financial institutions processing the loan take into account the environmentallegislation of Estonia and the policy of the World Bank on environmental assessment (OperationalDirective 4.01). Screening of individual sub-projects by the commercial banks (projectimplementing institutions) will be required and those projects which require environmental impactassessment under Estonian law must receive project approval prior to finalization of lending.These approvals are issued by either the Environmental Impact Assessment Board of Estonia'sMinistry of Environment or by the Environmental Protection Boards of County Government,depending on the classification of the proposed project under Estonia's environmental assessmentguidelines.

2.18 World Bank environmental staff have already reviewed current environmental lawsand regulations, and found them to be satisfactory. The main emphasis of this project will beto build up the institutional capacity to ensure that the World Bank environmental policies and

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Estonian environmental laws and regulations are being properly applied. The primary goal ofthis technical assistance would be to train the loan departments of the participating commercialbanks to screen proposed sub-projects according to environmental standards. Further institutionalbuilding activities will be carried out in future World Bank projects, including a plannedEnvironment project. Terms of reference were prepared by the environmental staff and can befound in Annex XI. Some of this work has already been initiated as project preparation, and hasbeen funded by the Government of Norway.

C. Project Cost and Financing Plan

2.19 Project costs are estimated at US$31.75 million equivalent. The IBRD loan wouldbe US$10 million. The Government of Sweden is proposing to establish a Capital Fund ofSKr 100 million (approximately US$12 million). The Government of Estonia and the BOE willprovide approximately US$6 million for the restructuring of the NEB, and will also beresponsible for the cost of the Project Implementation Unit (approximately US$0.3 million).Participating banks are expected to contribute US$0.2 million toward technical assistance.Technical assistance is expected to be covered by financing from BITS, EC PHARE, DAGTI,the Government of Norway, and the Government of Netherlands. Table I shows estimatedproject costs and Table 2 shows planned project financing.

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Table 1Detailed Project CostsUS$ million equivalent

Foreign Cost as a Component CostProject Component Local Costs Foreign Costs TOTAL .% of Total Cost as a % of Project

Costs

Commercial BankDevelopment

Credit Funds 10.00 10.00 100.0 31.5

Equity Funds -- 10.00 10.00 100.0 31.5

Initial Audits 0.10 0.30 0.40 75.0 1.3

Development TA 0.10 1.00 1.10 90.9 3.5

North Estonian BankRestructuring ___ __ ___ _ __ __

Recapitalization 6.00 2.00 8.00 25.0 25.2

Restructuring TA -- .50 .50 100.00 1.6

ProjectImplementation

Project 0.30 -- 0.30 0.0 0.9Implementation Unit

Core Advisor Group 0.10 1.20 1.30 93.3 4.1

Environmental -- 0.15 0.15 100.0 0.5Training

Total Project Cost 6.60 25.15 31.75 79.2 100.0

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Table 2Planned Project Financing

US$ million equivalent

Project Component Local Foreign Total TOTAL % IBRDFinancing

MOF/ Participating Cofinancing IBRD Govt. of Other IBRD MOF/ Parficipating Govt. of OtherBOE Banks Sweden Coftnancing BOE Banks Sweden Cofmancing

Commercial BankDevelpment

Credit Funds 10.00 10.00 10.00 100.0

Equity Funds 10.00 10.00 10.00 0.0

Initial Audits 0.10 0.30 0.10 0.30 0.40 0.0

Development TA 0.10 1.00 0.10 1.00 1.10 0.0

North Estonian Bank

Recapitalization 6.00' 2.00 2.00 .00 0.06.00

Restructuring TA 0.50 0.50 0.50 0.0

Project Implemenation

Project Implementation Unit 0 30 0 30 0.30 0.0

Core Advisor Group 0.10 1.20 1.30 1.30 0.0

Environmental Training 0.15 0.15 0.15 0.0

Total Project Costs 6.30 0.20 0.10 10.00 12.00 3.15 10.00 6.30 0.20 12.00 3.25 31.75 31.5

1 The Bank of Estonia's contribution will be limited to the assumton of bad loans removed from the portfolio of the North Estonia Bank.

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III. PROJECT IMPLEMENTATION ARRANGEMENTS

A. Implementation Arrangements

3.1 A Project Implementation Unit will be set up within the Ministry of Finance, andwill be responsible for overseeing and coordinating overall project implementation. Besideskeeping records and administering the Bank loan, the PIU would monitor the operations of theparticipating agencies and facilitate coordination and problem-solving for all the components ofthe Bank loan. Also, the PIU would be the liaison office of the Government with the WorldBank. Draft terms of reference for the PIU can be found in Annex IX. Staffing needs werediscussed with the Government during appraisal. It is expected that the PIU will draw upon thestaffing and skills of the PIU established for the Estonia Rehabilitation Loan. As such, the PIUwill have familiarity with Bank procurement, disbursement, and reporting procedures. TheGovernment has appointed the head of the Project Implementation Unit and this was confirmedduring negotiations. The Government will complete local staffing of the PIU prior to Boardpresenation.

3.2 Credit Line. The credit line administration will be managed through the ProjectImplementation Unit. In conjunction with the World Bank, it will (i) select banks based oneligibility criteria defined by the World Bank, (ii) make decisions on accepting new banks intothe program or disqualifying banks which fall out of compliance, (iii) review the firsttwo projects submitted by each participating bank and each project over US$2 million,(iv) review other projects on an ex-post basis. In addition, the PIU will be responsible for theproper accounting, reporting and procedural implementation of the disbursements and repaymentsunder the credit line. The PIU will also be responsible for ensuring that the procurement ofequipment and services are handled according to World Bank guidelines, and that all subprojectsare in compliance with World Bank environmental guidelines.

3.3 The PIU will be assisted by a Core Advisors Group, consisting of three qualifiedand experienced bankers. This CAG will be responsible for: (i) preparing recommendations forthe PIU on the eligibility of the interested banks under the defined criteria; (ii) monitoring theon-going performance of the banks and their loan portfolios under the credit line; and(iii) assisting the PIU in reviewing the sub-loan projects. In addition, they would be availableto provide technical assistance to all the commercial banks during their stay in Estonia. Suchassistance would include assisting banks in: (i) developing credit policies and procedures withproper controls; (ii) adopting internationally acceptable accounting standards and applications withproper operational procedures matching their automation strategies; and (iii) structuring andevaluating term-lending, including pre- and post-lending risk assessment and project financeanalysis methodologies and preparing project-finance loan packages.

3.4 Although the official borrower of the credit line will be the Republic of Estonia,the on-lending commercial banks will assume full responsibility for the credit and exchange rate

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risks of projects financed under the proposed credit line. Qualifying banks will sign separatesubsidiary loan arrangements with the Ministry of Finance.

3.5 The subsidiary loan agreements will include provisions to ensure that allsubprojects meet World Bank requirements including World Bank procurement and environmentalpolicies (para. 3.8). No eligible bank will be allowed to borrow more than its net worth asdefined under internationally acceptable accounting rules and standards after deducting properloan loss provisions. Any bank that has increased its net worth can apply up to once each yearto increase the maximum loan amount it can borrow under the credit line.

3.6 Commercial Bank Eligibility. Any commercial bank that would like to apply forthe World Bank Credit Line can ask to be reviewed by the CAG. The CAG will evaluate thebank, and prepare a recommendation for the PIU/World Bank as to whether the bank meets thedefined eligibility criteria for project participation. In cases of non-eligibility, the banks may askfor technical assistance and/or a restructuring plan with assistance from the CAG. The CAG mayrecommend the eligibility of a bank depending on the progress to the documentedstructuring/technical assistance plan. Final approval for eligibility will be made by the PIU inconsultation with the World Bank. Annex IV contains eligibility criteria for the commercialbanks.

3.7 Eligible Sub-borrowers and Subprojects. The proposed credit line is geared tooffer medium and long-term credit support for the widest range possible of private investmentactivities in the country. Specifically, any newly privatized and emerging private sectorenterprises would be able to get subloans to finance projects. Each sub-borrower enterprise willsign a credit agreement with the on-lending banks. These credit agreements will have a standardand common framework with a legal opinion as to their acceptability under Estonian law. Thesubloan agreements may differ in the amount, interest rate, disbursement and repayment, etc.However, they will all contain the eligibility criteria for the enterprises and sub-projects as theminimum representations and warranties for the loans (Annex IV).

3.8 Environmental Requirements. As a category "B" project involving intermediarylending, an environmental screening mechanism is being set up for projects financed by the creditline. Since Bank environmental staff have reviewed environmental legislation and regulationsin Estonia, and found them to be adequate, the primary environmental emphasis of this projectwill be to ensure that these laws and regulations are properly followed. Environmental staff havebeen involved in preparing technical assistance to train commercial bank staff in properenvironmental screening processes, and to strengthen the Ministry of Environment'sEnvironmental Assistance Board.

3.9 Documentation Requirements. The Republic of Estonia will sign a LoanAgreement with the World Bank. The on-lender banks will sign separate Subsidiary LoanAgreements with the Ministry of Finance. The sub-borrowers will sign standard borrowingagreements with the commercial banks suitable to the terms and conditions of the credit line. Thedocumentation and compliance follow-up will be monitored by the PIU based on a series of

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reporting requirements as defined under the terms and conditions of the line of credit. Thereporting requirements are listed in Annex V.

3.10 Swedish Capital Fund. The Government of Sweden is now in the process oflegally establishing the Swedish Capital Fund. The exact mechanism for delivery of cofinancingfrom the Swedish Capital Fund is being finalized. Currently, it is envisaged that the Capital Fundwill negotiate umbrella investment agreements with each of the participating banks. After aparticipating bank has received approval for a subproject under the World Bank line of credit,the PIU will notify the Swedish Capital Fund. In cases where the bank is eligible for cofinancingfrom the Swedish Capital Fund, the World Bank will agree to disburse up to 50 percent of theexternally financed subproject amount according to World Bank disbursement procedures. TheSwedish Capital Fund will make an investment in the participating bank of an amount coveringthe remaining 50 percent of the externally-financed subproject amount. The exact form of theinvestment is still under discussion, but will in any event qualify as capital under the BOE'sprudential regulations.

3.11 Technical Assistance. Technical Assistance would be financed by multilateral andbilateral donors. Terms of Reference would be designed in consultation with the Governmentof Estonia, the funding donor, and the World Bank. Draft terms of reference can be found inAnnexes VI-XI.

B. Procurement

3.12 Procurement of goods and works would be done in accordance with World Bankguidelines. For subprojects financed under the World Bank's credit line and executed by sub-borrowers, procurement of goods and works would comply with those customary for operationsthrough financial intermediaries. The PIU would assure that all contracts financed under the loanare procured in accordance with Bank guidelines according to the following thresholds:(i) contracts valued up to US$50,000 equivalent for goods and up to US$100,000 equivalent forminor works would be procured by local shopping on the basis of three quotations from qualifiedsuppliers; (ii) contracts valued at between US$50,000 and US$1 million equivalent for goodswould be procured through International Shopping on the basis of at least three quotations fromthree different countries; (iii) contracts between US$100,000 and US$1 million equivalent forworks would be procured through local competitive procedures acceptable to the Bank; (iv) allcontracts above US$1 million equivalent would be procured through International CompetitiveBidding (ICB); however, specialized items available from only a few suppliers may be procuredthrough Limited International Bidding (LIB). Direct contracting may be used for proprietaryitems and those available from a single supplier. For all ICB projects, the Bank's StandardBidding Documents for Goods would be used. Prior review by the Bank of procurementdocumentation would be carried out for: (i) all contracts above US$500,000 equivalent and(ii) the first two contracts for goods procured under international shopping or for works procuredunder local competitive procedures submitted by each qualified bank. Procurement proceduresand documents under other contracts would be subject to random review by the Bank duringproject supervision. Expected aggregate amounts for procurement of goods and works are

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US$2 million for local shopping; US$6 million for international shopping; US$500,000 for directcontracting and US$500,000 for LIB.

3.13 When ICB procedures are used, qualified domestic manufacturers may be alloweda preferential margin of 15 percent or the existing rate of import duties, whichever is lower, inthe evaluation of bids, in accordance with the Bank's Procurement Guidelines. A summary ofproposed procurement arrangements is given in Table 3.

Table 3Summary of Proposed Procurement Arrangements

(US$ million)

Procurement MethodNot Bank Total

Project Element ICB Other Financed Costs

1. Equipment 2.00 9.00 9.00 20.00and Materials (1.00)1 (9.00)2 (10.00)

2. Consultant Services/Technical Assistance 3.75 3.75

3. Other3 8.00 8.00

TOTALS 2.00 9.00 20.75 31.25a(1.0-0) (92 .0-0)1000

Figures in parentheses are the respective amounts financed by the Bank loan.

2 "Other" procurement arrangements are expected to include goods and minor works procured under localshopping (US$2 million), International Shopping (US$6 million), direct contracting (US$500,000) and LimitedInternational Bidding (US$500,000).

3 Includes recapitalization of NEB.

3.14 All subproject appraisals approved for a subloan would include a discussion ofprocurement procedures to be used and criteria for selection of suppliers of goods and servicesto ensure that these conform with the Bank's Guidelines. Qualifying banks and sub-borrowersare expected to keep records on quotations requested. Evidence of these quotations would berequired for ex-post review during project supervision. Although all technical assistance underthis project will be financed by other donors, it is expected that agreements on the hiring of

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consultants under this project will be carried out in consultation with the World Bank, and wouldbe confirmed by signed Memoranda of Understanding.

3.15 Like many other Eastern European and FSUB countries, Estonia does not have atradition of competitive bidding for the procurement of public goods and services. TheGovernment, however, recognizes the importance of establishing public procurement regulationsas part of its comprehensive program to transform its economy from a centrally planned to amarket-oriented system based on the development of a competitive private sector. A commissionin the Ministry of Economic Affairs has been established to prepare a draft law on publicprocurement. The Bank is providing technical assistance in this area. Work is progressing welland a draft law could be ready in early 1995. A World Bank seminar on procurement trainingwas conducted in August 1994.

3.16 Support to build up the capacity of participating banks will be provided intwo ways. First, as part of the project launch, a procurement expert will be included in theProject Launch Mission, and would conduct workshops for the participating banks inprocurement. Second, the banks would receive ongoing procurement support from theprocurement expert located in the PIU. The PIU will monitor adherence to the ProcurementGuidelines and furnish appropriate reports to the Bank.

C. Disbursements

3.17 Disbursements by the Government under the credit line would be made againstspecific approved project finance requests of the qualifying banks. The banks would be allowedto borrow on a first-come, first-serve basis. All the banks would submit their first two projectfinance/subloan requests to the World Bank through the PIU with its approval. In addition,subloan requests over US$2 million equivalent would also need prior World Bank approval. Allother subloans would be subject to ex-post reviews by the World Bank.

3.18 To facilitate the disbursements of the Loan proceeds, a Special Account (SA) maybe established. The SA would be maintained in a commercial bank selected by the Governmentand acceptable to the World Bank. The bank would be selected from a number of acceptablebanks, on the basis of competitive bidding. Selection criteria for participation in the bids are:(i) the bank should be financially sound as demonstrated by its most recent financial statements,as audited by an internationally recognized firm; (ii) the bank would have a significant foreigncorrespondence network covering all major currencies; (iii) the bank would have a reasonablecapacity and experience for issuing letters of credit, for making direct foreign payments and otherinternational transactions, with appropriate arrangements for the training and development of itsstaff; (iv) the bank should be capable of performing a wide range of local banking services,including cash payments, transfers to other domestic banks, issuance of debit notes, applicationof conversion rates from foreign currencies and maintenance of adequate records for the SA;(v) the bank should be preferably a member of SWIFT and should routinely use or plan to usethis facility to expedite payment transfers; (vi) the bank should be willing to issue a Comfort

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Letter to assure that amounts deposited in the Special Account will not be set off or otherwiseseized or attached to satisfy amounts due to the bank by the borrower; (vii) the bank would bewilling to maintain adequate accounts as required by the World Bank, provide monthly bankstatements to the World Bank and the PIU, and any other information considered necessary(copies of all transactions would be routinely submitted to the PIU); and (viii) the bank wouldbe willing to charge reasonable rates for its services and provide reasonable interest on balancesheld from time to time.

3.19 The initial deposit to the SA would be based on project expenditures expected tobe paid through the SA in the short run, with a maximum amount equal to US$1 million. TheAccount will be opened in the name of the Borrower and would be administered by the PIUwhich will send requests to the World Bank for replenishment of the SA. These requests wouldbe accompanied by detailed monthly bank statements of the SA and with all other requireddocumentation.

3.20 Disbursements will be made against standard Bank documentation. Expendituresfor individual subloans valued at under US$500,000 equivalent for goods and works financedunder this loan would be disbursed against Statements of Expenditures (SOEs) certified by thePIU. The PIU would ensure that all supporting documentation is adequately maintained and thatit is available for review at the bank's request. Disbursements for all subloans valued at or aboveUS$500,000 equivalent for goods and works, would be made against fully documentedwithdrawal applications. Under the credit line, the Bank would finance up to 100 percent of theamounts disbursed by qualified banks for subloans. In cases where the qualified bank is alsoqualified for cofinancing under the Swedish Capital Fund, the Bank would finance up to50 percent of the amounts of the subloans.

3.21 The loan is expected to take 4 years to disburse and the closing date for the loanwould be June 30, 1998. Disbursement tables can be found in Annex XII.

D. Project Accounting, Financial Reporting, Auditing and Supervision

3.22 Accounting. The Borrower will have the responsibility for the appropriateaccounting of the funds provided by the Bank under the Loan, for reporting on the use of thesefunds, and for ensuring that audits of the financial statements or reports are submitted to theBank. The PIU, on behalf of the Borrower, will establish an appropriate accounting system toprovide information on the proper receipt and use of funds in accordance with the LoanAgreement. The system should ensure timely and accrued accounting of all transactions underthe Loan and clear presentation of the financial information.

3.23 Financial Reporting. Financial reporting, to be carried out by the PIU, wouldclosely reflect the specific requirements of the Loan. It would comprise a statement of receiptsand payments for the reporting period since the beginning of the program. The reporting wouldbe in accordance with the disbursements classified and reported by the expenditure categories

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agreed with the Borrower and spelled out in the legal documents. Quarterly progress reportswould be submitted, including a separate report with respect to the Special Account. A ProjectCompletion Report will be submitted to the Bank by the PIU promptly after the completion ofthe program, not later than 6 months after the loan closing date.

3.24 Auditing. Financial statements and reports on the Loan (including the SpecialAccount) would be audited by auditors acceptable to the Bank and the audit reports would besubmitted to the Bank within 6 months after the end of the fiscal year. Selected auditors mustbe: (i) impartial and independent from the entity to be audited; (ii) well-established and reputable;(iii) experienced in type of assignment to be undertaken; and (iv) able to fulfill the terms ofreference required within the specific timetable. In addition, participating commercial banks willbe expected to be audited each year by an auditor acceptable to the Bank, and to make these auditreports available to the Bank.

3.25 Project Supervision. Due to limited human resources in the public sector inEstonia and the complexities arising from the participation of many donor organizations, therewill need to be a strong emphasis on supervision. The establishment of a PIU will help facilitatesmooth project implementation and supervision. In order to ensure continued understanding ofthe project objectives and implementation arrangements as well as effective monitoring of projectimplementation by both the participating institutions and Bank staff, detailed supervision will beneeded. A Project Supervision Plan can be found in Annex XIII and was confirmed atnegotiations. An important feature of project supervision will be a mid-term review, which willinclude a review of the rate of commitment of funds. If the actual commitment rate of fundsseriously lags planned commitments, the World Bank and the Government of Estonia willconsider the advisability of partial loan cancellation. In addition, the Bank will review progressin the areas of (i) training activities in the Bank Supervision Department of the Bank of Estonia,including on- and off-site examinations, identification of problem banks and steps taken toremedy such problems; (ii) on-site bank supervision being conducted by the Bank SupervisionDepartment; (iii) restructuring and privatization of the NEB; (iv) establishment of a timetable forthe participating financial institutions to comply with accounting and reporting formats withinguidelines of the Bank for International Settlements; and (v) increasing aggregate loans withmaturities over one year to account for at least 20 percent of total loans held by participatingfinancial institutions, provided that such lending is consistent with prudential regulations.

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IV. BENEFITS AND RISKS

A. Project Benefits

4.1 The project will: (i) improve efficient allocation of resources by improving theintermediation capabilities of the banking sector; (ii) increase the stability of the banking sector,which will lead to greater mobilization of funds; (iii) increase long-term investment by providingcritically needed long-term funds to the enterprise sector which will in turn improve theproductivity of private enterprises by providing technology and capital goods; and (iv) providean incentive for privatization by targeting investment funding toward private companies.

B. Project Risks

4.2 The primary risk is that there may be changes in the political environment whichwould make it difficult for the Government to sustain its progress in moving to a market-basedsystem, particularly in the areas of privatization and tight monetary and fiscal policies. Anotherrisk is that the rate of inflation, which increased slightly in early 1994, could continue to increase,which would reverse the current trend toward lower interest rates. This, coupled with the riskof decreasing output, could cause the performance of the sub-borrowers under the line of creditto deteriorate, which would then increase defaults. Finally, the ability of the banks to absorb thelong-term funds is limited, unless supported by necessary technical assistance.

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V. AGREEMENTS AND RECOMMENDATIONS

5.1 Discussions were held at negotiation on all aspects of the proposed loan including:

- Commercial bank, sub-borrower, and subproject eligibility requirements(paras. 3.6-3.7).

- Reporting requirements (para. 3.9).

- Procurement arrangements (para. 3.12-3.16).

- Disbursement arrangements (para. 3.12-3.21).

- Project supervision arrangements (para. 3.25).

- Adequate staffing of the PIU during the lifetime of the project.

5.2 Condition for Loan Effectiveness.

The establishment and staffing of the CAG.

5.3 Recommendation. With the agreements reached above, the proposed FinancialInstitutions Development Project is suitable for a Bank loan of US$10 million equivalent to theRepublic of Estonia at the standard variable rate for a term of 15 years, including a grace periodof 5 years.

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ESTONIA: FINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

Commercial Banksa, Ranked by 1994 Assets(EEK millions)

Name of Bank Assets Capital Comments

Jan June Jan June1993 1994 1993 1994

Hansapank 415.8 1389.5 24.1 88.7 Private bank - target market: mediumand large enterprises

Uhispank (Union Bank) 495.5 1253.3 80.2 109.5 Formed from 10 land banks (formerbranches of the former Sovietagriculture bank); 25 percentGovemment and municipal owned;diversifying from agriculture.

Eesti Hoiupank (Savings 497.9 1112.8 4.4 10.0k 67 percent state owned; 33 percentBank) owned by Hansabank.

Pohja-Eesti Pank (North 1041.0 1038.5 39.9 9 .0 b 100 percent state owned; formed fromEstonian Bank) two banks placed in moratorium.

Tallinna Bank 67.7 414.4 10.2 27.9 Private bank; purchased large amountof portfolios of Tartu CommercialBank (liquidated in 1993).

Eesti Toostuspank ja Ehituse 191.6 393.7 18.5 35.5 Former state bank, minority state-Kommertspanka (Industry and owned; focusses on industry.Construction Bank)

Eesti Maapank (Land Bank) 111.4 279.0 7.3 26.6 Formed by merger of 5 land banks(former branches of former Sovietagriculture bank); 33 percent ownedby Govemment; 64 percent owned byfarmers' unions, and 3 percent ownedby private individuals.

Virumaa Kommertspank 43.9 234.9 11.7 21.9 Private bank.(Virumaa Commercial Bank)

ERA Bank 77.5 155.7 10.7 18.8 Private bank; focusses on loans toprivate enterprises.

RAEpank - 150.3 -- 11.7 Private bank; current focus foreignexchange, trade finance and retail;have pioneered use of debit cards inEstonia operations commenced inApril 1993.

-26- ANNEX IPage 2 of 2

Name of Bank Assets Capital Comments

Jan June Jan June1993 1994 1993 - 1994

Esstex Toostuse Arengupank 40.8 134.4 9.5 5.6 Owned by 29 light manufacturing(Estonian Investment enterprises.Development Bank)

Evea Bank 42.4 128.5 9.5 24.9 Private; small business bank.

Nowe 33.8 109.4 7.7 47.0 Private bank; wants to be major tradefinance and transit trade bank.

Eesti Forekspank 8.1 107.1 6.2 31.0 50 percent owned by Estonian Stock(Estonia Forex Bank) Exchange; initially established as

clearing and settlement house,converted to bank; manages weeklyforex auctions among Estonian Banks.

Rahvapank 36.9 92.9 8.2 14.0 Land bank.

Eesti Kredidipank (Estonian 45.1 91.9 10.2 30.1 Private bank; specializes inCredit Bank) import/export transactions.

Keila Bank 20.2 81.1 6.6 13.9 Private bank.

Eesti Innovatsioonipank 23.2 58.7 6.4 16.7 Private bank; specializes in(Innovation Bank) intermcdiating transactions between

the FSUB and the West,

Tallinn Business Bank 10.4 35.2 6.2 16.2 Private bank; focusses on localRussian community.

Ameerika Balti Pank (Baltic 10.6 24.8 5.9 7.7 Private bank; has some foreignAmerican Bank) ownership.

TOTALb 3,213.8 7286.1 283.4 566.7

'Totals do not include the Estonian Investment Bank, a development bank which has capital of approximately EEK72 million. It is one-third owned by the EBRD, two-thirds owned by the Bank of Estonia. It has received technicalassistance from the EBRD, Nordic Investment Bank, EC PHARE, Kreditanstalt fur Wiederaufbau, and others.

Totals also exclude Eesti Sotsiaalpank (Social Bank), which was placed into moratorium in August 1994.

b19 9 4 capital figures are not directly comparable across banks. Only the Savings Bank and North Estonian Bankhave had their financial statements audited according to International Standards. This has resulted in extensive loanloss provisioning. Hence, capital figures for these two banks are much lower than if calculated under EstonianStandards. 1994 capital figures for the Savings Bank and North Estonian Bank are as of Dec. 1993.

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ANNEX IIPage 1 of 3

ESTONIAFINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

The Government of Sweden Capital Fund

1. The proposal outlined below has been developed in response to a number of factorsaffecting the financial sectors of the three Baltic countries. First, there are new banks with smallcapital bases in all three countries, implying a strong need for additional bank capital, as well astechnical assistance to bolster local banking skills. Second, there is a critical shortage of lendingto enterprises--particularly medium- and long-term lending (i.e., longer than 1 year)--because ofa lack of domestic term funding and the fact that commercial banks perceive the credit risks ofsuch lending to be too high. Third, the G-24 financing operations have made significant volumesof medium- and long-term funds potentially available to the banking system; the volume of thisfunding is far in excess of lending volumes which can be supported by existing bank capital andbanking skills. While these G-24 funds are potentially an extremely valuable resource for boththe financial and enterprise sectors, the governments are concerned that these funds might not beused in a prudent way. They are particularly concerned that they be used in a manner which doesnot expose the Government to excessive risk of nonpayment when the funds are channeledthrough the banking system for onlending to the industrial and agricultural sectors.

2. The Government of Sweden has indicated that it would, in principle, be willingto make available as much as SKr 300 million (approximately US$35 million) to restructure andrecapitalize the banking sectors in the Baltics. The proposed Government of Sweden project hastherefore been structured to use these funds to create a set of incentives which will encourage thelocal banks to undertake institutional strengthening measures, including grant-financed technicalassistance, in exchange for an injection of capital which will expand their lending capacity andthus their profit opportunities. It assumes the Swedish grant funds are part of a comprehensivepackage comprising Swedish capital funding, a World Bank line of credit, and a package oftechnical assistance. Although the Capital Fund would be managed under a separate structure tothe World Bank credit line, selected banks eligible to receive additional capital from the Fundwould have to also be eligible at all times for participation in the World Bank credit line. Thequalification criteria and conditions designed for the World Bank credit line would be applied todisbursements under the Capital Fund, which would cofinance investment projects utilizing theWorld Bank credit line. This will ensure that the banks undertake the technical assistancenecessary to develop proper lending practices, and will simplify bank and project screening. Thusprocedures will be in place to ensure that banks will not receive additional capital until their ownbanking operations, procedures and skills are developed enough to support the risk of theadditional lending that the new capital will permit.

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ANNEX IIPage 2 of 3

3. Two primary uses of the Swedish capital funds are envisaged. The first would beto expand the capital base of commercial banks that undergo institutional strengthening (throughtechnical assistance), and that provide long-term credit for qualified projects. The second wouldbe to provide equity injections into state-owned banks as part of an overall restructuring plan thatwould culminate in the privatization of those banks.

4. Commercial Banks. The expansion of the capital of private commercial banks:

(a) The World Bank would establish a Line of Credit (US$10 million in the case ofEstonia) in each of the Baltic countries, which would incorporate the standardconditions of eligibility for participating financial institutions (e.g., financialaudits, financial ratios, loan loss experience, credit appraisal capacity, adequateaccounting and financial controls, etc.). Those banks that also participate in theCapitalization Program of the Capital Fund would also be subject to specializedconditions reflecting the need to protect the interests of the capital provider.

(b) Technical assistance would be made available in conjunction with the World Bankproject to assist banks which desired to participate in the Line of Credit/CapitalFund, to meet the eligibility conditions. This technical assistance will be financedprimarily with bilateral or multilateral grants.

(c) When a commercial bank presents a project that qualifies for financing under theWorld Bank's Line of Credit, that bank would also receive a contribution to itscapital from the Capital Fund, in a loan-to-capital ratio of 1:1. The capital wouldbe provided on strictly commercial terms to avoid any subsidy element in pricing.This additional capital would increase the ability of the commercial bank to makeloans, from the Line of Credit, from G-24 sources or from other sources, underthe Bank of Estonia's risk capital regulations. This ability to increase its lending--and thus its revenues--would be the main economic incentive for the commercialbank to participate in the program.

5. The Swedish Government is currently working to define the final legal structurefor the fund, and the exact form of capital to be provided to the commercial banks. Since theSwedish Government is interested in providing financing and technical support to the bankingsector, but does not wish to take managerial control away from the Estonians, selecting the formand amount of capital is difficult. In any event, the capital will be in a form that will qualify asTier I capital. While not becoming actively involved in operational matters, the Swedish CapitalFund would be represented on the Board of Directors of the bank. The Swedish Capital Fundwould also expect the participating bank to sign an investment agreement, detailing the rightsof the Swedish Capital Fund, and the obligations of management.

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ANNEX IIPage 3 of 3

6. The North Estonian Bank. The North Estonian Bank (NEB) is the onlyremaining 100 percent state-owned bank in Estonia. The NEB has had financial problems,sparked first by the freezing of many of its assets that were held in the MoscowVnesheconombank, and now due to bad loans inherited from previous management. TheEstonian Government would like to stabilize the NEB, and subsequently privatize it. Estonianauthorities have already begun taking steps to financially restructure the NEB. The Bank ofEstonia has already assumed EEK 40 million in doubtful loans.

7. This step has removed some of the bad loans, once the remaining bad loans arewritten off, the remaining capital will be insufficient to support the current loan base of the NEB,let alone provide for future loan growth. The Government of Estonia, with assistance from theGovernment of Sweden's Capital Fund, plans to place a new injection of capital into the NEB,which will stabilize the NEB. The Government of Sweden's contribution will be conditional on:

(i) An agreement on a privatization program

(ii) An agreement on an institutional development program, and the appointment ofmanagement committed to its rapid implementation.

(iii) A capitalization program for the bank brings the bank up to a level which satisfiesthe prudential norms established by the central bank with the Swedish componentof the capital base representing a minority share of the capital.

The recapitalization of the NEB would be contingent on the signing of an agreement between themanagement of the NEB and the Estonian Authorities which would incorporate sanctions for non-compliance with the program as well as incentives for successful completion.

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ANNEX IIIPage I of 5

ESTONIAFINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

The Structure of the Credit Line

1. It is proposed that a loan of US$10 million be made to the Republic of Estonia(borrower). The funds would be on-lent to qualifying commercial banks after proper screeningand authorizations, to finance medium to long-term productive private sector projects. The loanto the Government would have final maturity of 15 years with 5 years of grace.

2. The interest cost to the borrower would be the World Bank onlending rate on avariable basis. The rate to the commercial banks would be World Bank on-lending rate plusI percent to cover the administrative costs and guarantee risk for the management of the creditline by the Government.

3. The on-lending commercial banks will take the credit and exchange risks of theprojects financed. Qualifying banks would sign separate Subsidiary Financing Agreements withthe Ministry of Finance. The qualifying sub-borrowers would also need to sign sub-loanagreements with the on-lending banks integrating specific standard terms and conditions.

4. Credit Line. The credit line administration will be managed through the ProjectImplementation Unit (PIU). In conjunction with the World Bank, it will: (i) select banks basedon eligibility criteria defined by the World Bank; (ii) make decisions on accepting new banks intothe program or disqualifying banks which fall out of compliance; (iii) review the firsttwo projects submitted by each participating bank and each project over US$2 million;(iv) review other projects on an ex-post basis. In addition, the PIU will be responsible for theproper accounting, reporting and procedural implementation of the disbursements and repaymentsunder the credit line. The PIU will also be responsible for ensuring that the procurement ofequipment and services are handled according to World Bank guidelines, and that all subprojectsare in compliance with World Bank environmental guidelines. Terms of Reference for the PIUcan be found in Annex IX.

5. The PIU will be assisted by a Core Advisors Group (CAG), consisting of threequalified and experienced bankers. This CAG will be responsible for: (i) preparingrecommendations for the PIU on the eligibility of the interested banks under the defined criteria;(ii) monitoring the on-going performance of the banks and their loan portfolios under the creditline; and (iii) assisting the PIU in reviewing the sub-loan projects. In addition, they would beavailable to provide technical assistance to all interested commercial banks during their stay inEstonia. Such assistance would include: (i) developing credit policies and procedures with propercontrols; (ii) adopting internationally acceptable accounting standards and applications with proper

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ANNEX IIIPage 2 of 5

operational procedures matching their automation strategies; and (iii) structuring and evaluatingterm-lending, including pre- and post-lending risk assessment and project finance analysismethodologies and preparing project-finance loan packages. (Terms of Reference for the CAGcan be found in Annex VI.)

6. Subsidiary Loans to Qualifying Commercial Banks. Each eligible commercialbank will enter into a general subsidiary loan agreement with the Government. These loanagreements will govern on-lending conditions. It is expected that no eligible bank can borrowmore that its net worth as defined under internationally acceptable accounting rules and standardsafter deducting proper loan loss provisions. Any bank that has increased its net worth can applyonce-a-year for an addendum to the maximum loan amount they can borrow under the credit line.

7. Any commercial bank that would like to apply for the World Bank Credit Linewill ask to be reviewed under the eligibility criteria specified in Annex IV. In cases of non-eligibility immediately, the banks may ask for technical assistance and/or a restructuring planthrough the guidance and/or approval of the CAG. Any restructuring plan will need the approvalof the World Bank with a 1-year trial period. Through this time, the CAG will assess andappraise progress on a quarterly basis. The CAG may recommend the eligibility of a bankdepending on the progress to the documented structuring/technical assistance plan. Final approvalfor eligibility will be made by the PIU, in consultation with the World Bank.

8. Terms and Conditions for the Loans to Banks

Loan Amount: Not to exceed the net worth of the bank at any period oftime; any loan $US2 million equivalent or more shall beapproved by the Bank.

Terms of the Loan: Minimum loan maturity of two years, maximum loanmaturity of ten years, including grace period.

Currency: Loans will be made in the same currencies borrowed by theGovernment of Estonia from the World Bank.

Interest Rate: World Bank interest rate plus I percent to cover theGovernment's administrative costs and fees.

Interest Period: Six months

Commitment Fee: Equal to commitment fee paid by the Government ofEstonia to the World Bank.

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ANNEX IIIPage 3 of 5

Prepayment: Negotiable with the PIU

Agreements and Commitments:

The PIU will be responsible for ensuring that a representative sample of theoutstanding loans will be subject to an ex-post review of appraisal. The ex-postreview will verify that the subloan criteria has been satisfied. In cases where thesubloan criteria have not been met, the subloan will be deemed to have been madeentirely from the participating bank's own resources where the PIU/CAG has theright to call the loan to the bank in default together with accrued interest andprincipal outstanding.

In cases where a commercial bank fails to adhere to sublending criteria, the PIUhas the right to disqualify the bank from further commitments under the credit lineprogram.

The on-lender banks agree to continue to be audited under international accountingstandards and applications throughout their borrowing from the credit line. If on-lender banks no longer meet criteria for qualifications for the program, the bank'sright to further commitments under the project may be suspended.

The on-lender banks agree to provide periodic or on-demand reports as requestedto the CAG, PIU or the World Bank.

The on-lender banks will use their best efforts to ensure that the sub-borrowersfollow procurement and environmental rules acceptable to the World Bank.

9. The on-lender banks will be monitored for eligibility throughout the time of theirparticipating under the credit line. The qualification for on-going eligibility will be monitoredby the CAG with the concurrence of the PIU and the World Bank.

10. Loans to Subborrowers. The projects to be financed under the credit line wouldbe appraised and approved by the on-lender eligible banks. The onlending banks would thensubmit these sub-projects to the PIU for financing under the World Bank/Government of SwedenCredit Line/Capital Fund. The first two sub-projects from each bank and all projects overUS$2 million will be reviewed by the CAG who will prepare a recommendation for the PIU andthe World Bank. Final approval will be made by the PIU in consultation with the World Bank.All other projects will be subject to ex-post review.

11. Each sub-borrower enterprise would sign a credit agreement with the on-lendingbanks. These credit agreements would have a standard and common framework with a legal

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ANNEX IIIPage 4 of 5

opinion as to their acceptability under Estonian laws. These subloan agreements may differ inthe amount, interest rate, disbursement and repayment, etc'. However, they would all contain theterms and conditions with regard to eligibility criteria for the enterprises and sub-projects as theminimum representations and warranties for the loans.

12. Disbursements. Disbursements by the Government under the credit line will bemade against specific approved project finance requests of the qualifying banks. The banks willbe allowed to borrow on a first-come, first-serve basis.

13. To facilitate the disbursements of the portion of the Loan proceeds, a SpecialAccount (SA) will be established. The SA would be maintained in a commercial bank selectedby the Government and acceptable to the World Bank. The bank would be selected from anumber of acceptable banks, on the basis of competitive bidding. Selection criteria forparticipation in the bids are: (i) the bank should be financially sound as to demonstrate by theirlast accounts, as audited by an internationally recognized firm; (ii) the bank would have asignificant foreign correspondence network covering all major currencies; (iii) the bank wouldhave a reasonable capacity and experience for issuing letters of credit, for making direct foreignpayments and other international transactions, with appropriate arrangements for the training anddevelopment of its staff; (iv) the bank should be capable of performing a wide range of localbanking services, including cash payments, transfers to other domestic banks, issuance of debitnotes, application of conversion rates from foreign currencies and maintenance of adequaterecords for the SA; (v) the bank should be preferably a member of SWIFT and should routinelyuse or plan to use this facility to expedite payment transfers; (vi) the bank should be willing toissue a Comfort Letter to assure that amounts deposited in the Special Account will not be setoff or otherwise seized or attached to satisfy amounts due to the commercial bank by theborrower; (vii) the bank would be willing to maintain adequate accounts as required by the WorldBank, provide monthly bank statements to the World Bank and the PIU, and any otherinformation considered necessary. Copies of all transactions would be routinely submitted to thePIU; and (viii) the bank should be willing to charge reasonable rates for their services andprovide reasonable interest on balances held from time to time.

14. The initial deposit to the SA would be based on project expenditures expected tobe paid through the SA in the short run, with a maximum amount equal to US$ I million. TheAccount will be opened in the name of the Borrower and would be administered by the PIUwhich will send requests to the World

1. As banks in Estonia are free to set market interest rates without Government interference, and there arefree flows of capital, subloans can be made in either foreign or domestic currency, as negotiated between theonlending bank and the borrower.

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ANNEX IIIPage 5 of 5

Bank for replenishment of the SA. These requests would be accompanied by detailed monthlybank statements of the SA and with all other required documentation.

15. Disbursements will be made against standard Bank documentation. Expendituresfor individual subloans valued at under US$ 100,000 equivalent for goods and works financedunder this project would be disbursed against Statements of Expenditures (SOEs) certified by thePIU. The PIU would ensure that all supporting documentation is adequately maintained and thatit is available for review at the bank's request. Disbursements for all subloans valued at or aboveUS$ 500,000 equivalent for goods and works, would be made against fully documentedwithdrawal applications. Under the credit line, the Bank would finance up to 100 percent of theamounts disbursed by qualified banks for subloans. In cases where the qualified bank is alsoqualified for cofinancing under the Swedish Capital Fund, the Bank would finance up to50 percent of the amounts disbursed for subloans.

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ANNEX IVPage 1 of 3

ESTONIAFINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

Eligibility Criteria for the Qualifying Banks,Subborrowers and the Sub-Projects

Eligibility Criteria for the Banks

Compliance with the prudential rules and regulations of the Bank of Estonia.

Complete audit of most recent fiscal year financial statements conducted underinternationally acceptable accounting standards and applications. The wouldinclude a portfolio review and loan-loss provisioning done to internationalstandards.

- Minimum EEK 20 million equity and 8 percent capital adequacy, after full loan-loss provisioning under internationally accepted accounting standards.

- Minimum I year of operations with a defined corporate strategy.

- Audit discipline in place under internationally acceptable accounting standards andapplications.

- The bank's earnings (after proper provisioning for loan losses) are adequate toallow the bank to meet its future obligations.

- Defined and documented credit policies and procedures with acceptable controls,risk asset classification standards and loan loss provisioning practices in place. Ifnot yet in place, a time-bound action plan approved by the PIU/CAG to implementthe above.

Existence of a unit specialized in structuring and appraising medium and long-termlending.

Sound internal financial policies and limits/controls in place with regard to creditadministration and asset and liability management.

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ANNEX IVPage 2 of 3

In order to maintain eligibility, the bank would need to:

Continue to demonstrate its sound financial condition evidenced by the submissionof annual financial statements audited to international standards by independentauditors satisfactory to the World Bank.

Continue to be in material compliance with the prudential regulations of the Bankof Estonia.

Maintenance, during each fiscal year, of a minimum collection ratio of principaland interest of 90 percent, as confirmed by the external auditors of the bank.

II. Eligibility Criteria for the Sub-Borrowers

TLegal entities that are majority privately-owned and privately managed.

Proven management and at least I year of profitable operations or, in cases of de-novo enterprises/projects, proven management with extensive experience inrelevant areas and positive credit history verified through proper channels.

An independent audit discipline under Estonian accounting standards andapplications within 6 months of the financing of the project, if not already inplace.

Proven positive value added in total operations based on international marketprices.

III. Eligibility Criteria for the Sub-projects

- Loans cannot be given to finance:

refinancing existing obligations of the enterprises (refinancing of bridgeloans will be acceptable)equity investmentsshort-term trade finance loans

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ANNEX IVPage 3 of 3

The onlending rates for loans will be no less than 200 basis points above theprevailing yield on the corresponding Government bonds of the same currency andof similar maturity, with 6-month variable interest rates. The minimum 200 basispoints premium would be required to cover the following: (a) credit risk; (b)cross-currency risk; (c) interest rate risk; and (d) administrative costs.

Minimum maturity 2 years, maximum maturity 10 years.

The minimum equity contribution by the subborrower would be 30 percent.

The debt service coverage ratio for the life of the project must be a minimum of1.5 for the project alone and for the project incorporated into the cash flow of theon-going concern.

The project must on a stand-alone basis generate a positive net present value at thediscounted rate of return that is equivalent to the cost of the loan including theinterest, fees, and other charges.

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ANNEX VPage I of 3

ESTONIAFINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

Documentation and Reporting Requirements

Documentation Requirements

For the Government of Estonia:

- The General Loan Agreement with the World Bank

For the On-Lender Banks:

- Subsidiary Financing Agreement with the Ministry of Finance

- Annually audited financial reports under internationally acceptable accountingstandards and applications

- Disbursement documentation listed below for the disbursement requests under thecredit line

- Maintenance of the proper credit files

- Periodic Reporting to the PIU/IBRD

For the Sub-Borrower Enterprises:

- Project Technical Feasibility Study prepared by an independent technical expert

- Business Strategic Plan including the integration of the project into the ongoingoperations of the enterprise

- Audited financials

- If applicable: license, management, buy-back agreements

For the Banks to submit to the PIU/CAG/World Bank for Loan Request:

- Disbursement and Repayment Schedule for the loan matching with the project

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ANNEX VPage 2 of 3

- An analysis by the bank covering:

- The application package of the enterprise

- The technical, economic and financial feasibility of the project to be financedincorporating the projected cash flows, balance sheet projections and otherfinancial sensitivities as prepared by the medium/long-term project financedepartment of the bank

- An analysis of the marketing/selling capability of the proposed end-product ofthe project

- An analysis of the risks associated with the project and the enterpriseperformance with minimum two sensitivity cash flow projections of itsoperations integrating the project

- An evaluation of the borrower's credit worthiness, ownership structure, overallmanagement and financial position

- Any additional contracts, leases, long-term export agreements, etc. that supportsthe economic and financial viability of the project

- Official Request of the bank management accompanied by the decision of thecredit committee of the bank with full supporting details

II. Reporting Requirements

By the PIU to the World Bank under a reporting agreement:

- Applications of the first two loan requests of the banks

Applications of the subsequent loan requests of the banks over US$2 millionequivalent

On a semi-annual basis: sub-loan portfolio performance/progress reports and thepost-lending review of the compliance of the sub-loans to the terms and conditions

By the CAG to the World Bank, on a semi-annual basis:

- Reports on the qualifications of the banks

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ANNEX VPage 3 of 3

Reports on the financial performance of the eligible and borrowing banks

- Reports on the progress of the restructuring plan/technical assistance programapplications for the banks involved

By the banks to the PIU:

- Subsidiary loan and subloan portfolio performance reports on a semi-annual basis,covering:

- interest and principal repayment performance- principal not yet due- documentation verifying compliance with World Bank procurement rules- progress report on the projects and sub-loans including the performance of

the enterprises

- Annual audited financials of the borrowing enterprises

By the banks to the CAG:

- On a semi-annual basis; a comprehensive report on the financial and businessperformance of the bank including a detailed analysis of the loan portfolio of thebank.

By the enterprises to the on-lender banks:

- Entitlement to access to sub-borrowers' accounting and management informationby commercial banks/CAG and/or PIU and other designated/appointed agents atthe discretion of the commercial banks will be a mandatory requirement of thesub-loan agreement.

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ANNEX VIPage 1 of 8

ESTONIAFINANCIAL INSTITUTIONS DEVELOPMENT PROJECTDraft Terms of Reference for Audits of Commercial Banks

I. Introduction

1. Since independence, Estonia has made impressive progress towards establishing amarket economy. The banking sector has adjusted to these changes after some restructuring. Thebanks have a familiarity with operating under international standards but would still need furtherskills building to become fully institutionalized under international standards.

2. The World Bank is planning to provide long-term credit resources to be channelledthrough the commercial banking system. In addition, the Government of Sweden may establisha capital fund that will be used in conjunction with the World Bank line of credit. These fundswill be provided within the framework of an overall program of financial sector reform andtechnical assistance.

3. In order to qualify for this credit line/ capital fund, commercial banks will need tomeet a number of quality standards which will be set by the different institutions, in conjunctionwith the Government of Estonia. One basic qualification will be the financial stability of thecommercial banks. In order to assess the financial state of the commercial banks, an externalaudit conducted according to international standards by an established auditing firm will berequired for each bank which wishes to participate.

4. Activities and outputs. A comprehensive financial audit of the bank as detailed inthe following paragraphs will need to be conducted. For efficiency and speediness, it would beexpected that, when an international auditing firm has - at the request of the management, theshareholders or any other party - already carried out an analysis of a bank, the same firm, uponrequest by the participating bank, may prepare a proposal for expanding upon that work toinclude the additional work required under these terms of reference. Conduct of this expandedwork will, of course, depend upon successful negotiations with the audit firm and reasonablenessof cost. Otherwise, the audit will be put out for bid according to World Bank standards.

5. A comprehensive financial and portfolio audit will be performed in accordance withinternational auditing guidelines issued by the International Federation of Accountants (IFAC)and will be in accordance with International Accounting Standards. The financial statements tobe audited will be the balance sheet and the income statements. In cases where there aredifference between International Accounting Standards and Estonian Accounting Standards, thefinancial statements will be restated according to International Accounting Standards.

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ANNEX VIPage 2 of 8

6. Scope and detail of the diagnostic study. The required audit services will placeparticular emphasis on the assessment of the quality of the Bank's portfolio, and proper loan lossprovisioning according to risk classifications under internationally accepted criteria.

7. The financial audit shall include a detailed examination of the financial statements ofeach bank in order to assess the accuracy and reliability of the accounting data and systems.

8. In the course of undertaking the audits, items deserving particular attention include:

a. A complete description of the work carried out and of the methodologies applied. Forthe portfolio review any discrepancy and/or interpretation of the methodologydescribed in the international auditing guidelines should be explained in details andjustified.

b. The portfolio review will be undertaken to determine the overall quality of the bank'sloan portfolio, broken down by performance, with categories such as satisfactory, sub-standard, non performing, etc. An assessment of risky loans irrespective of whetheror not they are overdue, should be performed together with discussions with themanagement based on the proper classification of the loans and contingentsoutstanding. Rescheduled or rollover loans should be clearly identified and amountindicated. The review will emphasize loans which were originally made under theguidance of the former state banking system. For each of these loans/credits,disclosure should be made on amount that represents a risk exposure for individualbanks.

c. An assessment of the adequacy of the existing level of provisions, and as appropriate,recommendations for adjustments thereto based on the above requested evaluation ofthe riskiness of the loan portfolio, irrespective of the applied classification of the bankmanagement.

d. An itemization and assessment of the adequacy of various reserves.

e. Analysis of the concentration of credit and other bank exposure risks to determine theextent to which a few companies or a group of companies account for a largeproportion of the total outstanding loans and/or loans and equity of the bank.

f. Assessment of equity portfolio of the bank and the reasonableness of the valuesreported on the balance sheet. In assessing the equity portfolio, particular attentionshould be given to the bank's objectives and policies in making equity investments.The realization of the objective/policy should be assessed, particularly with regard toinvestments in non-financial institutions. The relationship (ratio) between total

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ANNEX VIPage 3 of 8

equity investments and the bank's own net worth and the reasonableness thereof, mustbe assessed. Are the equity investments short or long term? Are they related toloans? For equity obtained through loan collateral, does the bank have an internaltime limit to sell off such equity? What is the effect one borrower and/or industryconcentration? What screening criteria are used to invest? What exit strategy will thebank use?

g. Assessment of the reliability and composition of reported earnings of the bank, withspecial emphasis on the extent to which the accrued but uncollected interest on nonperforming loans is taken into income, and the relative shares of operating and non-operating income.

h. Breakdown and analysis of operating costs of the bank.

i. Solvency assessment. Attention should be given to interest rate and maturitymismatches.

j. Capital structure: A description of the shareholders' structure should be given and thefollowing questions been answered: Is capital growth funded by internal cashgeneration or capital contribution? In case of capital contribution is it cash or realassets? In case of real assets, has a reliable third party valuation been provided?

k. Composition and structure of the bank's assets, deposits and other direct and indirectliabilities, both in local and foreign currencies. Fixed assets are to be separately listedalong with their recorded values. Any hidden or recorded reserves from over- and/orundervaluation of the fixed assets and equity investments should be specificallyindicated and adjustment made as appropriate. Particular attention should be paid tothe foreign exchange direct and indirect assets and liabilities of the banks and theirprofit recording especially with regard to off-balance sheet foreign exchangetransactions. All assets should be classified between income and non-incomegenerating. All outstanding term borrowing should be identified and broken down ona loan by loan basis.

Interbank borrowings and placements in local and foreign currency should be listedwhile particular attention be given to any maturity and foreign exchange mismatchestogether with risks of large dependence or overexposure concentrations to particularbanks or groups of banks.

1. Notes on each item of the balance sheet and income statement, explaining its natureand any clarifications considered as useful.

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ANNEX VIPage 4 of 8

9. Accounting policies and valuation criteria used in the preparation of the FinancialStatements and which are departing from International Accounting Standards.

m. Itemization of each adjustment and reclassification considered necessary by theauditors. All adjustments and reclassifications found by the auditors, even ifimmaterial, should be noted.

n. Itemized exposure to the Members of the Board and other parties connected with thebank including the parties that are involved in the supervision of the banks.

o. Any significant event affecting the financial statements occurred between the accountdate and the date of the audit report.

p. An assessment of the overall collateral provided for loans comprising over 5 percentof the paid-in capital of the bank, with respect to whether the collateral providessufficient coverage for the amount of the direct and /or indirect obligation of theborrower.

q. Guarantees:

1. Recipient bank: What is the process on other bank's financial statements(do they have annual or quarterly financial statements with contingentliabilities of guaranteeing banks?). What proportion is authorized by thecentral bank? What significance does authorization have?

2. Issuing bank: this should be incorporated in the analysis on leverage.Who is monitoring this in the bank?

In addition to the above the capacity of the bank to comply with thefollowing criteria should be assessed:

Capital adequacy

r. Maintaining a total capital risk-adjusted assets ratio of 8 percent.

s. Maintaining minimum equity capital of 20 million EEK equivalent.

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ANNEX VIPage 5 of 8

Profitability

t. Demonstrating financial solvency and profitability as measured by net income (afterproper loan loss provisions) providing a positive return on assets.

Quality of the lending process and loan portfolio (recommended)

u. Limiting maximum exposure to a single borrower and its connected parties to50 percent or equity capital in 1994; and subsequently to 35 percent in 1995 and25 percent in 1996.

v. Limiting maximum aggregate large exposures (defined as any credit and off-balance-sheet exposures to a single party exceeding 10 percent of bank's equity capital) to12 times equity capital in 1994; and subsequently to 10 times in 1995 and 8 times in1996.

w. Maintaining a loan portfolio of which no more than 20 percent has been rescheduledduring the last 6 months of operation of the bank.

x. Maintaining a total collection rate (total amount of current and overdue principal andinterest collected as a percentage of current and overdue amounts due in the year,calculated before loans reschedulings) greater than 85 percent.

y. Maintaining a minimum 1:1 ratio between loan loss provisions and the sum ofdoubtful and loss assets, where "doubtful assets" are defined as those where collectionor liquidation in full is highly improbable and "loss assets" are defined as uncollectibleand lacking any value as financial assets.

z. Demonstrating a satisfactory set of credit policies and procedures with propermonitoring structures and loan classification criteria

aa. Demonstrating a capability and properly trained personnel for assessing the risksand returns of projects it finances for the long term.

ab. Demonstrating a satisfactory set of policies and practices for assessing theenvironmental effects of projects it finances.

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ANNEX VIPage 6 of 8

Managerial Autonomy

ac. Demonstrating substantial managerial autonomy through:

1. source of funds.2. legal and ownership structure.3. composition of and locus of authority for appointment of Board of Directors.4. management and staff selection and promotion policies and practices.5. loan approval procedures (equal treatment of shareholders and non-shareholders

and the absence of shareholders on the credit committee).Management Effectiveness

ad. Demonstrating adequate policies, procedures and performance in the followingareas:

1. market strategy.2. organizational structure.3. credit.4. financial management ( foreign exchange, accounting).5. planning and budgeting.6. internal audit.7. management information systems.8. training.

9. Reports to be provided by the auditor(s)

a. The total package of financial statements.

b. The evaluation of the quality of the assets.

c. A statement of loans. An opinion on the adequacy of the provision for loans andon any valuation reserve.

d. A statement of the overall asset and liability structure of the bank including thebank's exposure and maturity risks with regard to its foreign exchange balancesheet.

e. An enumeration and quantification of all adjustments necessary to fairly presentthe financial statements.

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ANNEX VIPage 7 of 8

f. The identification and quantification of the risk concentration for the bank'slending, contingent and treasury activities.

g. The identification of credit extended to bank managers, members of the board,shareholders, and other related parties.

h. As part of the audit of the income statement suggestions on areas and manner inwhich efficiencies in costs and expenditures may be improved.

i. An assessment on internal controls and procedures and specific recommendationsto improve them.

j. An evaluation of liquidity, assets and liability management risks.

k. An evaluation on the adequacy of capital.

10. In addition to the above, the financial report should be prepared in long form andshall discuss the following:

a. Summary of efforts made by the auditors to verify the reliability of the accountinginformation processed in the computers centers or through manual procedures.The auditors should mention any inability to obtain sufficient information or verifyany part of work and enter a relevant reservation in judgement.

b. Summary of steps taken to verify the extent of compliance with legal standardsand regulations of the Bank of Estonia, and with International AccountingStandards, with details concerning any observed violations as well as actions takenin relation.

c. Copies of technical reports by outside consultants (or other auditors), if theauditors use them to support their opinion.

11. Confidentiality. This exercise is being carried out exclusively for the purpose ofdeveloping a basis for strengthening the concerned viable banks. Accordingly, the auditors willneither discuss with, nor distribute to parties outside the Bank of Estonia, the World Bank/donororganization and the management of the commercial bank, without their explicit authorization,any aspects or details relating to their findings.

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ANNEX VIPage 8 of 8

12. Independence and impartiality. The auditors must be independent of anymember of the board of directors, executive officer or senior manager of the bank. Independenceimplies that the senior managing partner, other partner, or staff member who would be involvedin the diagnostic study, is neither serving as a director of the bank nor has any personal financial,or close business relationship except as an independent professional advisor during the courseof the diagnosis.

13. Auditor qualification. It is essential that the work be carried out by auditorswith extensive international experience in auditing in the banking sector. In some cases, whichare encouraged, the team may include the auditor of the bank even if it is a local firm notrepresenting a "big international audit firm." In this latter case, the auditor would be under theresponsibility of the international firm, be a full member of the team and be supervised by theinternational audit firm. Given the importance and the complexity of the task to be undertaken,it is anticipated that the studies would be carried out by a reputable international audit firmdrawing on their best staff worldwide to propose a team with the suitable skill mix.

14. Curriculum vitae (CVs) of the principals of the firms who would be responsiblefor providing the conclusions and reports should be provided, together with the CVs of otherpersonnel proposed for the project, including detailed experiences with banking activities intransitional economies and language qualifications. CVs for personnel should include details onaudits carried out by these staff, including ongoing assignments. The staff proposed for thesediagnostics will have to be made available and to participate directly in the investigations and theformulation of opinions and recommendations. They shall not be replaced, during the course ofthe studies, without prior agreement of the participating bank and of the World Bank.

15. Timetable. The auditor would be expected to begin the work as soon as thecontract is signed. No later than __, the auditor should prepare a draft report (in English),detailing its preliminary findings in particular regarding the portfolio analysis and the itemsmentioned in paragraph 9 of these terms of reference. This report will be submitted no later than

, 1994. After review by the concerned parties, the auditors should be prepared to makea presentation to these parties which highlights major findings and recommendations.

16. Inputs, budgets and funding. The auditors will prepare their proposals on an all-costs-included basis, the local banks providing secretarial support, furnished office space withtelephones, and car transportation. Those arrangements will be finalized during the negotiationsof the contracts.

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ANNEX VIIPage I of 4

ESTONIAFINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

Draft Terms of Reference for Advisors toQualifying Commercial Banks

I. Background

1. Since Independence, Estonia has made significant progress toward establishing acompetitive banking sector operating in a free market environment. The banking sector hasadjusted to the evolving market conditions after some restructuring. The banks have a familiaritywith operating under internationally competitive standards but would still need further skillsbuilding to become fully institutionalized under international standards.

2. The World Bank, in conjunction with the Government of Sweden, is preparing ajoint credit line/capital fund that will be used to provide long term credit resources and capitalto qualifying banks. The Government of Sweden will provide capital to the banking sector,permitting banks to increase their long-term loan volume. The World Bank Credit Line of theproject is intended to encourage the further development of the capability for credit analysis andproject finance in the banking sector, and to provide needed long-term funds to the enterprisesector. To that end, participating banks would undertake a program of technical assistance indiverse areas from bank strategy development to setting-up a treasury unit with full back-officesupport. Three key areas that all the participating banks will need for successful performanceunder the credit line project are: (i) development and implementation of Credit Policies andProcedures; (ii) adoption of internationally acceptable accounting standards and applications withproper operating guidelines and procedure; and (iii) medium to long-term project financestructuring and management. Additional technical assistance to meet the individual needs of eachbank will be determined.

3. The technical assistance can either be provided by placing banking experts asadvisors with these banks, or through subcontracting an international bank or bank consultancycompany to provide these services.

II. Functions and Activities of the Advisors

4. The banking experts are expected to assist the management in redesigning theirbanking operations specific to their area of expertise. They will also actively participate in the

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ANNEX VIIPage 2 of 4

decision making and application process of their areas of responsibility, together with the bankmanagement. The experts working in the three key areas of credit, accounting and projectfinance will be expected to carry out the following functions:

A. Credit:

a. Assist the management developing a comprehensive credit manual, including butnot limited to: (i) lending strategy; (ii) portfolio objectives; (iii) credit assessmentprocedures; (iv) risk ratings pre- and post- lending; (v) credit limits; (vi) creditmonitoring procedures; and (vii) debt recovery procedures.

b. Participate in several branch credit monitoring audits with the audit and/or creditcontrol departments.

c. Prepare periodic reports on the progress and recommendations for furtherstrengthening of the credit/lending skills and procedures/controls of the bank.

d. Participate and contribute actively in the identification and management of theproblem loans of the bank while providing on-the-job training to the staffinvolved.

B. Operations/Accounting:

a. Assist and work closely with the management in the transformation of theaccounting records/applications and standards of the bank into internationallyacceptable norms.

b. Develop procedures for internal control and audit functions in the bank, includingthe activities of the branches.

c. Develop a management information system for monitoring operations of the bankincluding treasury and loan activities.

d. Participate actively in the decision making of Committee meetings related toaccounting/automation and operational applications,

e. Deliver on-the-job training to key managers designated to be in charge ofaccounting, control, audit, systems and operations and financial controldepartments of the bank.

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ANNEX VIIPage 3 of 4

f. Assist the management in the preparation of annual operational and investmentbudgets/plans.

C. Project Finance:

a. Assist the management in developing banking related products and services andin drafting internal implementation guidelines.

b. Provide on-the-job training to the Department for Medium and Long Term Credits(or Project Finance Department) including short seminars.

c. Assist the designated credit staff in restructuring and/or work-out of problematicloans. Together with the advisor for credit policies and procedures, develop theproblem loan management guidelines for the bank.

d. Deliver 2- to 5-day case-oriented seminars to designated staff of all levels on:(i) different loan products; (ii) project finance-analysis and structuring;(iii) syndications; (iv) mergers and acquisitions; (v) target marketing; (vi) capitalmarket products and related banking products.

e. Assist and train the credit officers in developing sector and industry analysisstudies.

f. Assist the designated staff in structuring, selling and managing syndications.

g. Assist the bank management in developing target/niche market definitions suitableto their growth strategy and develop criteria for acceptability for enterprises.

III. Qualifications for the Advisors

5. The advisors to be placed should have minimum 5-7 years of on-the-job experiencein their areas of expertise at the Head Offices within a multibranch bank preferably one that hasinternational operations. If a bank consultancy company is selected to provide the technicalassistance, it must have a proven track record in delivering similar types of technical assistancein developing country environments.

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ANNEX VIIPage 4 of 4

IV. Reporting Requirements

6. The advisors will, on a quarterly basis, provide progress reports on their activitieswith an action plan for the next 3 months. These reports will be available to the CAG, the PIU,the World Bank and other supervisory/donor bodies as specified.

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ANNEX VIIIPage 1 of 10

ESTONIAFINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

Draft Terms of Reference forInstitutional Development Assistance for the North Estonian Bank

1. Background. In late 1992, two banks, the Union Baltic Bank (UBB) and theNorth Estonian Share Bank (formerly the Estonian branch of the Soviet Vnesheconombank) hadmany assets held with the Vnesheconombank in Moscow. In January, 1992 the MoscowVnesheconombank froze the Moscow-held accounts of banks based in other republics. Theamount of Russian assets held in Estonia was much smaller than the Estonian assets held inMoscow. The resulting shortfall in assets left the UBB and the North Estonian Share Bank withlarge gaps in their balance sheets. In November 1992, these three banks, representing 40 percentof the total assets in the banking system, were placed in a moratorium.

2. The authorities decided to merge the two banks into a new bank, North EstonianBank (NEB). The former shareholders of the UBB and the North Estonian Share Bank receivedbonds representing claims against the frozen assets held in Moscow (i.e., the former shareholderswould receive nothing unless those assets are eventually recovered). The Government replacedthe NEB's frozen assets with EEK 300 million of Government bonds, and in return took over theownership of the bank. The North Estonian Bank is now the only bank that is 100 percent state-owned.

3. Unfortunately, although this EEK 300 million was sufficient to fill the gap createdby the frozen assets, it was not sufficient to cover losses from the loan portfolios of the twoformer banks. An audit conducted on international standards has revealed more than EEK120 million in loan losses.

4. In addition to financial assistance, the NEB needs a great deal of technicalassistance. The current management is facing an extremely difficult and daunting task. Themanagement is trying to develop new banking skills and reposition itself in a constantly changingand increasingly competitive market for financial services. At the same time it is trying toconduct a thorough workout of problem loans in its portfolio, particularly those loans grantedunder previous management and under much laxer credit policies. Although the management hasbeen aggressively pursuing collection through, among other steps, the filing of bankruptcypetitions to seize and liquidate borrowers' assets, the value of the assets awarded in bankruptcycourt has in general fallen extremely short of the amount of the loan. Given the difficulty ofdeveloping new skills, staff and procedures while attempting to recover a large amount of badloans, the NEB can not much longer continue without clear changes in its structure.

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ANNEX VIIIPage 2 of 10

5. The Estonian authorities have already begun taking steps to financially restructurethe NEB. The Bank of Estonia has already assumed EEK 40 million in doubtful loans. TheGovernment of Estonia has written off more than EEK 80 million of remaining bad loans againstits equity.

6. These steps have removed the bad loans and have resulted in a positive net worth,but the remaining capital will be insufficient to support the current loan base of the NEB, letalone provide for future loan growth. The Government of Estonia, with assistance from theGovernment of Sweden's Capital Fund, plans to place a new injection of capital into the NEB,which will stabilize the NEB. The Government of Sweden's contribution will be conditional on:

(i) An agreement on a privatization program

(ii) An agreement on an institutional development program, and the appointment ofmanagement committed to its rapid implementation

(iii) A capitalization program for the bank brings the bank up to a level which satisfiesthe prudential norms established by the central bank with the Swedish componentof the capital base representing a minority share of the capital

The recapitalization of the NEB should be contingent on the signing of an agreement betweenthe management of the NEB and the Estonian Authorities which would incorporate sanctions fornon-compliance with the program as well as incentives for successful completion.

7. The Institutional Development Program. The following issues are of particularimportance:

(i) Improvements in operational and Management structures

- There is an urgent need to strengthen the management team at the top ofthe bank

- An operational manual should be established

- A system of controls should be put in place for credit (see below ), foreignexchange risk, interest rate risk as well as a system for the monitoring andcontrol of liquidity

- Credit and Treasury Committees should be established (It is essential thatboth a supported with an effective secretariat charged with the timelyprovision of the necessary management information)

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ANNEX VIIIPage 3 of 10

- Training programs must be set up for all levels of staff

(ii) Development of a Business Strategy for the Bank

The management of the bank must develop a clear strategy for the futuredevelopment of the bank and translate this into a formal strategy document

Action Plans and Budgets must be constructed to map out a route forachieving the strategic objectives of the bank

A monitoring and control system must be in place for ensuring thatnecessary corrections and adjustments are made

(iii) Development of Effective Credit Risk Management

- The management of the bank should develop a formal credit policy andtranslate this into a formal document. The document should pay particularattention to limits on lending to related parties, concentration of lending toindividual counterparties (in relation to own funds), and to the lendinglimits and discretions applied by the branches

- The organization of the credit department must be reviewed andrestructured and the number of credit specialists considerably increasedfrom the current level (8)

- Review and automation of the method of interest accruals to ensurecompliance with international accounting standards

- A standard credit file should be introduced which gives completeinformation about all stages of the development and repayment of a loan

- A standard method of evaluation of credits must be introduced

- A method of loan classification, loan provisioning and suspension ofinterest should be established in line with the international standards beingintroduced by the Bank of Estonia

- A pricing policy should be established for loans to provide an adequatereturn on capital, to cover funding and administrative costs, the costs ofliquidity and the provisions required to cover expected losses on loans ofdifferent type and maturity

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ANNEX VIIIPage 4 of 10

- A debt recovery procedure should be elaborated and implemented

(iv) Management Information, Computer and Reporting Systems

- The reports received by senior management should be enhanced to providetimely and concise information regarding all the banks main risk positionsand sources of profitability

- A minimum package of management information to enable the soundmanagement of the bank should be prepared

- The BANKMASTER system, currently in use in the bank should be used,and if necessary upgraded to produce the necessary reports

- A manager should be appointed to deal with the improvement in reportingand information systems

- A professional evaluation should be undertaken to determine whether theBANKMASTER system can satisfy the management information needsimplicit in the strategy of the bank. In particular, an assessment should bemade of the capability of the system, if enhanced, to provide real timeinformation for the branch network as a whole

In the event of a positive evaluation system enhancement should beintroduced as soon as possible. If this is not the case an evaluation ofalternative systems should be undertaken by a suitably qualified expert anda program of rapid implementation put in place

The systems team of the bank should be strengthened

(v) Accounting Systems

- As a priority the bank must have operational accounting systems whichsatisfy international accounting standards and the requirements of theEstonian Authorities, particularly the central bank and the TaxationAuthorities

In view of the difficulties of a transitional economy particular attentionshould be given to ensuring that correct practices of interest accrual andsuspension are followed throughout the bank

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ANNEX VIIIPage 5 of 10

A system of management accounts should be introduced in the bank toassess the profitability of branches' to correctly allocate the costs ofbalance sheet management and to begin the process of measuring productprofitability

(vi) Development of a Marketing and Marketing Analysis Team

A small team should be established to undertake a continuous analysis ofthe Estonian banking market and to undertake the monitoring ofcompetitors. The work of the team will be a vital input into the planningprocess of the bank

The team should also assist in the development with senior managementof marketing and product development plans for new products

(vii) Setting up of a Problem Loan Work-Out Unit

In view of the large amount of non-performing loans in balance sheet of the bankit is essential that the bank develop a capacity to deal with problem debtors toenhance its capacity to improve repayments from the current "problem portfolio"and to ensure that such problems to do not recur in the future. The unit's objectiveis to safeguard the interests of the bank through the following strategy:

Identifying the precise problems of the borrowers

-Find a workable solution to the problem borrower (This will focus initiallyon the potential for the financial rather than the physical restructuring ofenterprises)

The financial restructuring in term and rate of the borrowers obligationsshould be done according to regulations established by the central bank(e.g., no restructuring allowed in the absence of a further import of capitalby borrowers or commitment to a privatization program)

The work-out unit is responsible for the implementation and monitoring ofthe work-out plan

If the recovery of the borrower is not feasible the unit is responsible forcollection of the problem loan through voluntary or forced liquidation

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ANNEX VIIIPage 6 of 10

Given the emphasis on developing the specialized skills of this unit and thescarcity of such skills elsewhere in Estonia, serious consideration shouldbe given to provide the bank with an incentive fee for collecting those"bad" loans carved out of the balance sheet. Targets should be set up forthe collection program as well as an annual audit of the collection process.Longer term the unit would also develop expertise for more comprehensiverestructuring processes for enterprises involving restructuring,reorganization and recapitalization.

(viii) Development of an effective Treasury function

- A set of policies for the control of interest rate, foreign exchange rate andliquidity should be developed by management and translated into a formaldocument

An information base should be constructed for the monitoring and controlof liquidity, interest rate and foreign exchange risk

A risk manager should be appointed to implement the above risk policiesworking within the Treasury of the bank

The risk manager should develop the agenda for the Treasury Committeewhich would involve the most senior management of the bank

(ix) Internal Audit

A stronger internal audit team of at least four people should be constructed

A set of internal audit procedures should be prepared

(x) Development of a Privatization Plan for the Bank

A clear timetable moving the bank towards privatization should beestablished, including mileposts for completing the financial reconstructionand rehabilitation measures indicated above.

Major strategic initiatives (e.g., development of investment bankingactivities) should be postponed prior to privatization given the need to finda merger partner/strategic investor.

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ANNEX VIIIPage 7 of 10

Qualifications of the Advisors. The program of institutional development forthe North Estonian Bank will require the support of extensive technical assistanceand the involvement of a strengthened senior management team. If the EstonianAuthorities accept the preconditions the following elements must be put in placeas soon as possible:

(i) A General Management Advisor will need to work for a period of at least a yearto develop a business plan for the bank and to develop action plans for itsimplementation, as well as advising management on general management issues(see TOR below)

(ii) An experienced bank accountant will be required for perhaps 6 months to developthe accounting systems of the bank and assist in the strengthening of the internalaudit function (see TOR below)

(iii) An experienced credit professional will be required for a period of up to a yearto develop the credit function with particular attention to the problem loans, loanpolicies and the formation of the work-out unit (see TOR below)

(iv) A systems expert (or consulting company) will be contract to conducting aninvestigation of the flexibility of the BANKMASTER system or to seek analternative. Assistance will then be provided over a period of perhaps 3 monthsto achieve a systems upgrade.

(v) A Treasury specialist will be contracted to:

Develop a liquidity management system

Develop a foreign exchange risk and interest rate risk management system

Assist the bank in setting up daily money management meetings andmonthly T reasury (or Asset-Liability management meetings)

It is envisaged this attachment might last 3 months.

(vi) A comprehensive training program will be developed for the bank preferablythrough a contract signed with commercial bank from a developed market.

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ANNEX VIIIPage 8 of 10

8. Terms of Reference. General Management Advisor. The requirement will be fora commercial banker with a proven track record of bank "turnaround" situations to support thesenior management of the North Estonian bank in all aspects of institution building and to be theleading member of the team of international advisors. The banker will need to have crediblemanagement experience in the following areas:

(i) Strategic and operational planning

(ii) Human resources management

(iii) Financial control

(iv) Management of the credit function

If possible, the candidate should also have experience in:

(v) Marketing management

(vi) Treasury

(vii) Systems

The advisor will be responsible for the following key tasks in the institution building program:

(i) Development of the organizational and management structure of the NorthEstonian bank

(ii) Development of a system of management controls for the day-to-day running ofthe bank. This will include the implementation, in conjunction with the creditadvisor, of appropriate branch procedures covering all operational areas

(iii) Development of a Human Resources Management strategy as well as a trainingand recruitment program for the bank

(iv) Development, in conjunction with the other advisors and the management of thebank, a strategic plan. This will define the overall structure of development for thebank to the point of privatization

(v) Development, in conjunction with the other advisors and the management of thebank, realistic operational plans designed to achieve the key strategic objectives.The areas of particular importance will be:

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ANNEX VIIIPage 9 of 10

a) Accounting and systems development

b) Human Resources development

c) Product development

d) Financial targets

e) Risk Management Objectives

(vi) The general management advisor will also play a key role in coordinating theefforts of all the donors( multi-lateral and bi-lateral) involved in the institutionaldevelopment program for the "core" bank. He will be required to prepare quarterlyprogress reports on all the targeted areas of development.

9. Accounting Advisor. The requirement is for an individual with extensiveexperience of the bank financial management function. While accounting qualifications are a pre-requisite this is not a job for an auditor but for someone with extensive operational financialmanagement experience which could have been gained in the role of a senior managementaccountant or a finance director in a commercial bank.

The key tasks for the jobholder would be:

(i) Implementation of the a Plan of Accounts to international standards which isconsistent with the requirements of the BOE as the consolidated reporting formatfor the bank

(ii) Development of a regulatory reporting system in line with the requirements of theBank of Estonia

(iii) Development of a profitability measurement system (including a transfer pricingsystem to allow branch profitability measurement)

(iv) Development of a budgeting system as an integral component of the bank'splanning system

(v) Development of accounting and financial analysis training in the bank

The accounting advisor will also have a key role to play in the specification of the MIS to bedeveloped for the bank. A knowledge of English would be essential to the jobholder. Estonianspeaking candidates will be looked upon with particular favor.

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ANNEX VillPage 10 of 10

10. Credit Advisor. The requirement is for an individual with extensive (at least10 years) management experience the credit function of a major bank capacity. Experience indeveloping markets working for a major international bank will be considered with particularfavor.

The principle responsibilities will be:

(i) Develop and implement a credit policy for the bank

(ii) Develop procedures for the analysis of new loans

(iii) Develop Terms of reference and procedures for the activities of the bank'sproblem loan work out unit(including treatment of collateral, restructuring of debt(in line with BOE regulations) and liquidation of enterprises

(iv) Assist in the development of credit training in the bank including the developmentof a credit manual

(v) Develop a loan portfolio review procedure within the bank

(vi) Assist in the formation of the bank's credit committee.

A very good knowledge of English would be essential to the candidate. Estonian speakers whoare suitably qualified will be looked upon particularly favorably.

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ANNEX IXPage I of 3

ESTONIAFINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

Draft Terms of Reference for the Project Implementation Unit

1. The Project Implementation Unit (PIU) will have primary responsibility forchanneling the World Bank Credit Line to the Government of Estonia, which will be used tofinance qualifying Estonian private sector projects through eligible on-lender Estonian commercialbanks.

2. Overall activities of the PIU will include, in consultation with the World Bank:

(i) Selection of qualified commercial banks(ii) Ongoing monitoring of qualified banks, and, if necessary, disqualification

of banks which fall out of compliance with conditions of the program(iii) Prior review of first two projects from each participating bank and each

project over US$2 million equivalent.(iv) Ex-post review of other projects

In addition, the PIU will be responsible for:

(i) On-lending/disbursement of the World Bank funds to eligible banks(ii) Compliance review of the World Bank Procurement Rules and

Environmental Guidelines(iii) Monitoring, accounting and reporting on overall project implementation of

the World Bank credit line, under the terms and conditions specified by thedocumentation

(iv) Maintaining the accounting records of the "Special Account" incorporatingthe disbursements and repayments of the revolving World Bank credit line

(v) Conducting post-lending reviews of the project lending applications of theborrowing banks with proper reporting of the results.

(vi) Ensuring on behalf of the Government and the World Bank that allcompliance requirements under the terms and the conditions of the creditline are met.

3. Legal Structure. The PIU will be unit in the Ministry of Finance. This unit must beempowered to act as an agent of the Republic of Estonia, i.e., able to disburse and collect WorldBank loan funds, sign contracts and manage donor special accounts. The unit must also beempowered to hold and conduct transactions in Estonian Kroon and foreign exchange accounts.

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ANNEX IXPage 2 of 3

4. Organizational structure. The PIU will be staffed by a competent team with theauthority and stature to deal directly and effectively with the Core Advisors Group, qualifyingbanks, the World Bank, and other providers of assistance to this project.

5. It is proposed that the PIU will have four Estonian staff, composed of:(i) Department Head; (ii) Credit Line Manager; (iii) Accounting Manager; and(iv) Secretary/Support Staff. In addition, a foreign procurement advisor will be needed.

6. The Department Head will be responsible for:

Selection of qualified commercial banks, with the assistance of the CreditLine Manager and the Core Advisors GroupOngoing review of bank qualifications, and decisions on qualifying newbanks, or disqualifying banks which fall out of compliance

7. The Credit Line Manager will be responsible for:

- Prior review of first two projects from each participating bank and eachproject over US$2 million equivalent

- Ex-post subloan eligibility reviews and reporting- Review of the standard subloan agreements of the banks with the

enterprises- Analysis and consolidation of the subloan portfolio performance reporting- Referral to the World Bank of the loan applications of the banks for

approval for lending- Referral to the Accounting department for disbursement of the loans after

proper verification of the documents and the necessary approvals.

8. The Accounting Manager will be responsible for:

- Establishing the Special Account- Setting up the project accounts, accounting system and related

documentation controls- Authorizing disbursements to/from the "special account" based on loan

payments/re-payments/replenishment needs, etc.- Arranging for the audit under international accounting standards and

applications for the PIU and all related project accounts by an acceptableindependent audit firm

- Collecting repayments of the credit line- Monitoring final payment of the credit line to the World Bank

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ANNEX IXPage 3 of 3

Reporting, as required, on project disbursement and collection performance underthe credit line.

9. The Procurement Advisor will be responsible for:

- Providing information and guidance to qualifying banks and subborrowerson procurement processes

- Organizing training seminars for qualifying bank and subborrower staff onprocurement procedures

- Checking compliance with World Bank Procurement rules- Providing assistance in procurement conducted by the PIU, including the

hiring of consultants for technical assistance.

10. Qualifications of the staff of the PIU. The credit line manager needs to beexperienced and/or trained in the project finance and credit structuring/evaluation methodologies.Prior experience in credit administration department (and/or a strong training in this area) of acommercial bank would be helpful.

11. The accounting manager need to have an accounting background with strongfamiliarity and/or training in bank accounting under international standards and applications.

12. The procurement advisor will be a professional with experience in World Bankprocurement procedures, and familiarity with potential contractors and suppliers.

13. Cost of the PIU. It is estimated that the PIU will need to be fully operational forthe first 3 years of the operation of the credit line. Afterwards, the PIU will have mainlymonitoring activities that may be integrated with other responsibilities. The PIU can also be usedfor the monitoring and reporting of the other donor funds for project finance. It is expected thatthe administrative costs of the PIU will be covered through a margin over the cost of funds tothe government to be charged to the on-lender banks.

14. Reporting requirements of the PIU Semi-annually: Subloan portfolioperformance/progress and the post-lending review of the compliance of the sub-loans forprocurement and other terms and conditions as specified in the loan documentation.

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ANNEX XPage I of 9

ESTONIAFINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

Draft Terms of Reference for the Core Advisors Group

I. Introduction

1. Several bilateral donors and multilateral institutions are providing or are developingplans to provide credit resources to the Government of Estonia in support of the stabilization andadjustment process. A sizeable part of these funds is intended to be channeled through thebanking system.

2. Although Estonia, since gaining its independence, has made impressive progresstowards establishing a market economy, further restructuring of the banking sector is needed toimprove the efficiency with which further bank lending including on-lending of externalresources, is undertaken. External bilateral donors and multilateral institutions providing fundshave therefore been assisting the Estonian authorities in designing an institutional framework tosupport the on-lending of these resources through the commercial banks.

A. The External Financing Board (EFB)

3. To facilitate the channeling through the Estonian banking system of external fundsreceived under the remaining of EU/G-24 assistance and part of the purchases from theInternational Monetary Fund, the External Financing Board (EFB) within the Ministry of Financewas established in October 1993. Unless otherwise provided for or agreed in the context ofbilateral agreements relating to the use of EU/G-24 assistance packages, these funds willchanneled to the banks in the form of credit lines established by the Government for thequalifying banks. Banks will be pre-qualified on the basis of whether they meet basic prudentialcriteria and their capacity to evaluate medium- and long-term credit risks.

4. As a first step, the Banking Supervision Department of the Bank of Estonia (BOE)will announce a set of objective prudential criteria and inform the EFB of the list of commercialbanks meeting those criteria. A separate Core Advisors Group (CAG), composed of foreignexperts, will assess the capacity of these banks to evaluate credits, in particular medium-termcredits related to investment. The CAG would recommend to the EFB for pre-qualification thosebanks demonstrating an adequate capacity for credit evaluation. The EFB would then decidewhich banks to pre-qualify based on these recommendations. There would be a clearunderstanding that banks which do not meet the prudential banking criteria set by the Bank ofEstonia, or are not recommended by the CAG would not be pre-qualified.

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ANNEX XPage 2 of 9

5. The Banking Supervision Department of the Bank of Estonia will announce amaximum limit for the credit lines to be made available, based on a set of objective criteria. Onthis basis, the CAG would ascertain the size of the credit line available to each bank and informthe EFB, which would then instruct the Bank of Estonia (which manages the foreign accountsof the Government) to release credit lines from the Government for these amounts to each bank.In addition, the EFB would set a uniform guideline for the banks regarding a minimumproportion of the credit line which should be used by the banks for lending for investmentpurposes. The EFB will monitor loans made under the credit line and if the performance of agiven bank is found to be unsatisfactory (e.g., it is unable to service the credit line, or it is foundnot to meet the prudential standards of the Bank of Estonia), the EFB would suspend or cancelthe credit line.

6. The credit line provided to banks will be tranched. The EFB will set guidelinesincreasing, for each additional tranche, the proportion of minimum investment lending. Theexperience of the banking system with the previous tranche would guide the setting of limits andguidelines for the next tranche. The on-lender commercial banks can request a credit line in anyof six currencies (USD, JPY, DEM, FRF, GBP, ECU) and are expected to take the credit andexchange risks of the projects financed under the proposed credit line.

7. The provisions above are without prejudice to any specific arrangements or rulesapplying to the use of EU/G-24 assistance packages.

B. The World Bank Financial Institutions Development Loan

8. The World Bank, in conjunction with the Government of Sweden, is preparing ajoint credit line/capital fund that will be used to provide long term credit resources and capitalto qualifying banks. The Government of Sweden will provide capital to the banking sector,permitting banks to increase their long-term loan volume. The World Bank Credit Line of theproject is intended to encourage the further development of the capability for credit analysis andproject finance in the banking sector, and to provide needed long-term funds to the enterprisesector.

9. The World Bank loan will be made to the Government of Estonia. The funds willbe on-lent to qualifying commercial banks after proper screening and authorizations, to financemedium- and long-term productive investments of the private sector. Although this credit linewill be formally the responsibility of the Government of Estonia, the on-lender commercial banksare expected to take credit and exchange risks of the projects financed under the credit line.

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ANNEX XPage 3 of 9

10. The credit line administrations will be managed through a Project ImplementationUnit (PIU) in the Ministry of Finance. This unit will be responsible for the proper accounting,reporting and procedural implementation of the disbursements and repayments under the creditline. The PIU will also be responsible for ensuring that the procurement of all equipment andservices are done in accordance with the World Bank guidelines, and that all sub-projects are incompliance with World Bank environmental guidelines.

11. Disbursements by the Government under the credit line will be made againstspecific approved project finance requests of the qualifying banks. The banks will be allowedto borrow on a first-come, first-serve basis. The CAG will review and provide recommendationson the first two projects of each bank as well as projects over US$2 million; these projects andrecommendations will be sen to the PIU and World Bank for approval. Other projects will besubject to verification of eligibility criteria (such as environmental screening and compliance withnegative list), as well as ex-post review.

12. Disbursements will be made against standard World Bank documentation. Underthe credit line, the World Bank would finance up to 100 percent of the amounts disbursed byqualifying banks for sub-loans. In cases where the bank is also qualified for co-financing underthe Swedish Capital Fund, the World Bank would finance part of the amounts disbursed for sub-loans.

13. The CAG will provide recommendations to the PIU on the eligibility of banks andwill assist in monitoring the banks for their ongoing eligibility.

14. Under both the EFB arrangement and the World Bank project, the CAG willprovide technical assistance to all interested commercial banks in Estonia. One important areaof technical assistance would be to strengthen banks' own credit evaluation units, including bothparticipating banks, and banks not immediately eligible for a credit line, but which would liketo qualify. In addition, assistance would be provided to all banks, regardless of theirparticipation in the credit line programs, in a wide range of areas, including: (i) developing creditpolicies and procedures/credit manuals with proper controls; (ii) developing internal operationalmanuals applicable under internationally acceptable accounting standards and applications;(iii) structuring and evaluating term-lending, including pre- and post-lending risk assessment andproject finance methodologies; (iv) developing operational and investment budgets in line withbank strategy; and (v) developing proper internal management information systems for effectiveasset and liability management.

15. The operation of the EFB as envisaged above and the World Bank project wouldbe conditional on the hiring of three experienced bankers to serve as a Core Advisors Group fora period of 2 to 3 years, the anticipated period of disbursement of initial funds. At the end ofthis period, the need for the CAG will be re-evaluated. These advisors would be placed in the

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ANNEX XPage 4 of 9

Ministry of Finance. To promote the transfer of knowledge, local assistants will be hired and/orcounterpart staff from the Bank of Estonia, Ministry of Finance and/or Bankers' Association willwork with the CAG to receive on-the-job training.

16. The CAG would not bear any financial liabilities for default of loans extended bythe qualifying commercial banks. However, the CAG will provide its assessments, guidance andadvice according to ethical and professional standards of the international banking community.

II. Functions and the Activities of the Core Advisors Group

A. The Core Advisors Group will jointly:

1. Evaluate the eligibility of the banks for the EFB and World Bank Credit Lines

2. Review progress of the implementation of the restructuring and/or technicalassistance programs of the banks applying for the qualification under the creditline,

3. Monitor and report periodically to the EFB and to the World Bank, respectively,on the financial performance of the on-lending banks,

4. For the World Bank Financial Institutions Development Loan only: Review andprovide recommendations on the eligibility and acceptability of the first two sub-projects for each banks, as well as subprojects over US$2 million equivalent,which will then be reviewed by the PIU and the World Bank,

5. For the World Bank Financial Institutions Development Loan only, verifyeligibility of other subprojects (environmental screening, compliance with negativelist, etc.), and refer the subproject to the PIU for further processing.

6. For the EFB only: Assess the credit evaluation capacity of the banks applying fora credit line and report the findings to the EFB,

7. For the EFB only: Ascertain the size of the credit lines announced by the BOEand report to the EFB.

8. Coordinate its activities with the EC/PHARE project for bank training in Estonia,and, if requested, assist banks in writing terms of reference for financing under theproject.

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ANNEX XPage 5 of 9

B. The functions and the activities of the individual advisors will be:

1. Advisor for Credit Policy/Procedures will be expected to perform the followingfunctions:

a. Assist the management of qualifying banks to develop proper credit policy andprocedures according to different types of products and customers the bank isplanning to specialize in.

b. Assist the management in developing internal methods and policies with regardto risk asset classifications, proper monitoring of the loan portfolio, inidentifying problem loans/watch list clients and also in developing proceduresand policies in dealing with problem loans.

c. Provide guidance to the credit committees of the banks which are planning toon-lend funds from the credit line.

d. Coordinate and assist the interested banks' internal training programs relatedto credit.

e. Provide guidance and assistance in international training/study-tours for thepersonnel related to credits. This personnel would range from central liabilityclerks to loan officers.

f. For the EFB only: Monitor the financial performance of on-lending banks andreport developments to the EFB.

Specific activities to be carried out by the advisor include:

a. Deliver a series of case-oriented seminars of 3-5 days to different levels ofmanagements of banks in the following areas: (i) financial analysis fordifferent types of companies; (ii) defining risks related to lending; (iii) creditpolicy development; (iv) credit management(from initiation to repayment);(v) Risk asset evaluation; (vi) credit process and monitoring; (vii) problemloan management; and (viii) work-outs and liquidation.

b. Attend the Credit Committee Meetings of the banks interested in developingtheir lending skills.

c. Work with the Credit Department Heads of interested banks

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ANNEX XPage 6 of 9

d. Prepare periodic reports on recommendations for improving the lendingenvironment, needs for skill building in lending as well as own activities to therelated counterparties.

2. Advisor for Accounting/Operations will be expected to perform the followingfunctions:

a. Assist the banks in developing proper operations manuals for their standardservices and products.

b. Assist the banks in adopting and understanding the International AccountingStandards and Applications.

c. Assist the banks in setting up internal control and internal audit departments.

d. Assist the banks in converting to an automated operations mode with propercontrols.

e. Assist the banks in developing correct and meaningful ManagementInformation Systems.

f. Assist the banks in unit cost analysis, improvements in productivity andefficiency thus rationalizing their products and services suitable to theircapabilities.

Specific activities to be carried out by the advisor include:

a. Deliver 3-5 days applied seminars to the different levels of management of thebanks in areas like; bank technology management, MIS, accountingapplications and standards with their implications, risks and controls of runninga bank operation, fraud in an automated environment, unit costing of bankproducts and services, bank efficiency analysis, measuring customerprofitability and bank profitability, objectives of operational guidelines.

b. Prepare recommendation reports to interested banks in ways of improvingoperational efficiency with proper controls.

c. Assist and coordinate with internal training departments of the banks indeveloping proper on-the-job training programs for different levels of

operating and accounting personnel.

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ANNEX XPage 7 of 9

d. Arrange and coordinate for foreign study tours/training for selected staff.

e. Submit periodic report on sector recommendations as well as own activities tothe related counterparties.

3. The Corporate Banking/Project Finance Advisor will be expected to perform thefollowing functions:

a. Assist the banks in developing capability to assess long term lending/projectfinance.

b. Assist the banks in developing skills in structuring credits (pricing, collateral,different types of products, etc.). Assist the banks in developing credit andservice products.

c. Assist the banks in developing technical skills to provide trade finance relatedproducts and services.

d. Assist the banks in developing sector analysis and enterprise restructuringcapabilities.

e. Assist the banks in developing marketing skills to borrow from internationalfinancial markets/correspondents and in selling and managing syndications.

f. For the EFB only: Monitor the financial performance of the on-lender banksand report to EFB.

g. Assist the banks in introducing new loan products like financial leasing,factoring, bankers acceptances, etc.

h. Assist the banks in developing target market definitions and criteria foracceptability for enterprises.

i. Assist the banks in appraising equity investments for future involvement instock markets and privatization process.

Specific activities to be carried out by the advisor include:

a. Work closely with the loan officers/credit marketing departments of thequalifying and other banks.

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ANNEX XPage 8 of 9

b. Give 3-5 days seminars on: (i) loan products; (ii) project finance analysis andstructuring; (iii) syndications; (iv) mergers and acquisitions; (v) credit

marketing; (vi) target marketing; (vii) methods of developing and introducingnew products and services; (viii) total service quality.

c. Confirm approval on project finance structuring capability on the banks thatwant to qualify under the World Bank Credit Line.

d. Prepare periodic reports on developing corporate/wholesale banking for thesector as well as own activities to the related counterparts.

III. Qualifications of the Advisors

A. Advisor for Credit Policy/Procedures:

Minimum 10-15 years of experience in an international bank particularly indeveloping country environments as a senior credit related line-officer. Thefunctions held can be: (i) head of a credit or credit administration department ofa large multinational bank; (ii) member of a credit committee or credit policycommittee of a multibranch and/or multinational bank; (iii) risk asset reviewer ofa bank; and/or (iv) member of a bank regulatory body with particular emphasis onloan portfolio assessment and monitoring capabilities of the banks. Several yearsof experience in direct managing and/or monitoring/administering of a loanportfolio in order to understand the psychology of lending is preferred.

Having worked only as a supervisor in a regulatory body is not sufficient. Furtherexperience in developing credit policy and procedures as well as creditperformance criterion would be helpful. The advisor should also be aware of thenew methods being developed for risk evaluation as well as risks involved in thefinancial engineering products developed during the last 5 years. Estonianlanguage skills are desirable; fluent English language skills will be required.

B. Accounting/Operations Advisor:

Minimum 10 years of experience as Head of Operations, or Head of Accountingand Control Department of a bank that has been or is operating under theEuropean Accounting Standards and Applications. Background in accountancy ishelpful provided the experience and application was in banking. Experience in anaudit company, etc., is not necessary. Hands-on management of bank

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ANNEX XPage 9 of 9

operations, especially in a developing financial market, is much preferred.Familiarity with bank technology, automated bank-MIS software is important.Estonian language skills are desirable; fluent English language skills will berequired.

C. Corporate Banking/Project Finance Advisor:

Minimum 10 years of experience as: (i) corporate banker; (ii) investment/merchantbanker; (iii) head of credit and marketing department; and/or (iv) head of a bankinvolved in wholesale banking. Knowledge and hands-on experience in structuringdifferent types of loans in different sectors, evaluating projects, syndications, tradefinance and asset based finance is essential. Should be familiar with andpreferably involved in several large project finance term-lending projects,preferably from international capital markets or through international investmentand development banks. Knowledge on monitoring a credit portfolio and hand-onresponsibility for administrative management of the loan portfolio would also behelpful. Estonian language skills are desirable; fluent English language skills willbe required.

IV. Reporting Requirements

A. The Core Advisors Group will jointly report:

I. On a quarterly basis, eligibility status and overall performance evaluation of thequalifying banks.

2. On a quarterly basis, progress reports on the restructuring plan and/or technicalassistance programs of the banks under the qualification program.

3. On a semi-annual basis, financial evaluation reports on the eligible banks includingand overall assessment of the loan quality of the banks, supported by auditedfinancials when available.

B. The advisors will individually also report on an annual basis on their activities under thetechnical assistance program with necessary recommendations relevant to their areas of expertise.

C. These reports will be sent to the EFB and the PIU, as well as to the participatingmultilateral and bilateral groups.

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ANNEX XIPage I of 5

ESTONIAFINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

Draft Terms of Reference for Environmental Training

1. Introduction. The country of Estonia is developing a program of FinancialInstitutions Development for which it anticipates receiving financial support from the WorldBank. An aspect of this loan is to be a small Credit Line (US$10 million) which will incorporatethe standard conditions of eligibility for participating financial institutions (e.g., financial audits,financial ratios, loan loss experience, credit appraisal capacity, adequate accounting and financialcontrols, etc.), as well as specialized conditions reflecting the need to protect the interests of thecapital provider.

2. One of the conditions of the World Bank loan is that the financial institutionsprocessing the loans take into account the environmental legislation of Estonia and the policy ofthe World Bank on environmental assessment (Operational Directive 4.01). Screening ofindividual sub-projects by the commercial banks (project implementing institutions) will berequired and those projects which require environmental impact assessment under Estonian lawmust receive project approval prior to finalization of lending. These approvals are issued byeither the Environmental Impact Assessment Board of Estonia's Ministry of Environment or bythe Environmental Protection Boards of the appropriate County Government, depending on theclassification of the proposed project under Estonia's environmental assessment guidelines.

3. Scope of Work. World Bank environmental staff have already reviewed currentenvironmental laws and regulations, and found them to be satisfactory. The main emphasis ofthis project will be to build up the institutional capacity to ensure that these laws and regulationsare being properly implemented. Further institutional building activities will be carried out infuture World Bank projects.

4. Consultants would undertake a program to develop the ability of the projectimplementing institutions to screen the individual sub-projects, provide management training tohigher level personnel in the Estonian Environmental Impact Assessment Board, and improve theoverall capabilities of the governmental institutions responsible for environmental assessment.The goal of the program would be to train the loan departments of the participating commercialbanks to screen proposed sub-projects for those which require environmental impact assessmentapproval from the Environmental Impact Assessment Board or the County Environmental Boards.The institutional capacity of the Environmental Impact Assessment Board will be augmentedthrough management training, computerization of the Board, computer training,

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ANNEX XIPage 2 of 5

development of an environmental assessment data base, overseas internships and training for keyemployees, assistance with the development of environmental standards, English languagetraining, and the publication of EA guidelines in Estonian and English. The consultant groupundertaking this work should be composed of a mix of local and foreign consultants to utilize thecomparative skill advantages presented by both. Local Estonian consultants have a high capacityto do most of the assignments detailed here and would be complemented by specialized foreignconsultants. Thereby skill transfer would also be enhanced.

5. Support for the Banking Sector. The following major tasks would be conductedunder the element of the activity oriented to the needs of the banking sector:

(a) Consultation. The local consultants would consult with both the EnvironmentalImpact Assessment Board and the Core Adviser Group (CAG) in order tounderstand their views and concerns in regard to the substance of the trainingprogram for commercial bank personnel. The consultants would familiarizethemselves with the loan evaluation process carried out by the commercial banks.The consultants would take into account the current loan evaluation process aswell as the technical assistance on loan evaluation which will be offered by theCAG when developing the TA on environmental assessment. The EstonianChamber of Commerce and the Estonian Privatization Agency would also becontacted and their views solicited.

(b) Review of Current Environmental Assessment Procedures. The localconsultants would review the current legislation and regulations that are in forcein the Republic of Estonia concentrating on "The Order on the Procedure ofEnvironmental Impact Assessment," and the Environmental Assessment Guidelinesprepared by the Environmental Impact Assessment Board with the assistance ofthe Stockholm Environmental Institute - Tallinn.

(c) Translation of the Environmental Assessment Guidelines. The localconsultants would translate the previously mentioned Environmental AssessmentGuidelines from Estonian into English.

(d) Publication of the Environmental Assessment Guidelines. The Guidelineswould be published in a bilingual (Estonian/English) volume in the quantity of2,000 copies.

(e) Preparation of Environmental Assessment Manual. The local consultantswould prepare for publication a 10-20 page manual on environmental assessmentprocedures in Estonia directed to the needs of the banking community in

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ANNEX XIPage 3 of 5

reviewing potential loans. The manual would be prepared in both the Estonianand English languages. The manual would be suitable for use both during thetraining process and in everyday banking business. The manual would provide areview of the applicable environmental procedures and include concise overviewof the types of environmental issues commonly encountered in commercial banklending operations in Estonia. It would include, but not be limited to, thefollowing items:

(i) An annotated list of Estonian environmental laws, regulations andprocedures which are related to the development of economic activities(such as those on environmental assessment, natural resource charges,coastal zones, emissions limits for pollution, and endangered species, forexample);

(ii) A list and short descriptions of environmental permits necessary to initiateeconomic activities;

(iii) More detailed summaries of the regulations most directly concerninginvestment activities (such as the Order on Environmental ImpactAssessment and the Guidelines); and

(iv) A list of contact institutions in the Estonian government for inquiriesregarding specific environmental and permitting issues.

(f) Training Program. The local consultants,in consultation with the CAG, woulddesign and implement a training program directed chiefly at the employees ofcommercial banks dealing with loan evaluation. The program would include"training of trainers." Participants in the training program should also includerepresentatives of the following:

- the Environmental Impact Assessment Board;- the County Environmental Boards;- the Estonian Privatization Agency; and- the Estonian Chamber of Commerce.

The training session would be conducted by the local consultants in Tallinnprimarily in the Estonian language. The course would introduce the key writtenmaterials including the Environmental Assessment Guidelines and EnvironmentalAssessment Manual to the participants. A case-study approach, utilizing case-studies of environmental assessments prepared in Estonia, would be used tofamiliarize the participants with the practical application of environmental

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ANNEX XIPage 4 of 5

assessment requirements. The training sessions be scheduled to take place on ahalf-day basis (mornings or afternoons) for one working week.

Support for Environmental Management Institutions. The following major taskswould be conducted under the element of activity directed towards strengthening thegovernment institutions responsible for supervision and management of theenvironmental assessment process - the Environmental Impact Assessment Board and theCounty Environment Boards:

(a) Management Training. The Director of the Environmental Impact AssessmentBoard would receive management training from the foreign consultants to increasethe efficiency and capacity of the Board. This training would concentrate onincreasing the capacity of the EIA Board in program planning and personnelmanagement;

(b) Computerization and Computer Training. The Environmental ImpactAssessment Board would be provided with three computer/printer sets and the staffmembers would receive training in their use. A telefax would also be providedfor the Board.

(c) Development of an Environmental Assessment Data Base. The foreignconsultants would assist the Board in the establishment of a computerized database that can be utilized for the evaluation and analysis of environmentalassessments and related documents.

(d) Overseas Internships and Training. The Director of the Board would placed ina 1-month internship at the World Bank, where he would also have an opportunityto consult with environmental assessment experts at the World Bank, InternationalFinance Corporation and the United States Environmental Protection Agency.Two professional level staff members the Board would attend 1-2 month coursesin environmental impact assessment. This training would be followed by aninternship in a national environmental institutions dealing with environmentalassessment for one employee and an internship'in a private consulting firm whichregularly prepared environmental assessments for the other employee.

(e) Environmental Audits. The foreign consultants would provide assistance for thedevelopment of proposed procedures for the use of environmental audits as analternative to the preparation of environmental assessments. Efforts would focus

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ANNEX XIPage 5 of 5

on the use of environmental audits in the evaluation of proposed investments forthe rehabilitation and/or upgrading of industrial and energy facilities. Board staffwould be provided with a short-course in environmental audits which wouldinclude a practical exercise to be conducted at an industrial facility in Estonia.This work would be coordinated with the program for industrial auditing andwaste-minimization being conducted in Estonia by the World Environment Centerwith support for the United States Agency for International Development.

(f) Assistance with Development of Environmental Standards. The foreignconsultants would assist the Board, whose competence also includes environmentalstandards, in preparation of proposed emissions standards for industrial enterprises,and in developing a practical process for the phased implementation of thesestandards which should be compatible with those of the European Union.

(g) Translation of the World Bank Environmental Assessment Sourcebook. Thelocal consultants would translate relevant sections of the World Bank'sEnvironmental Assessment Sourcebook into Estonian for the use of the Board.

6. Inception Report. The consultants would submit an inception report within30 days of start-up. The inception report should include a training plan for the conduction of thepreviously mentioned activities.

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ANNEX XIIPage I of I

ESTONIAFINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

IBRD Disbursements

CATEGORY AMOUNT % OF EXPENDITURES(US$ million) TO BE FINANCED

Participating financial 8.01 50 percentinstitutions eligible to receivefunds from the Swedish Capitalfund.

Other PFIs 2.0' 100 percent of foreign expenditures100 percent of local expenditures(ex-factory cost)80 percent of other itemsprocured locally

Total 10.0

Estimated allocations

Estimated IBRD Disbursements(US$ million)

FY 95 FY 96 FY 97 FY 98

Annual 2 3 3 2

Cumulative 2 5 8 10

- 81 -

ANNEX XIIIPage 1 of 1

ESTONIAFINANCIAL INSTITUTIONS DEVELOPMENT PROJECT

Supervision Plan

APPROXIMATE ACTIVITIES STAFF COMPOSITION STAFFDATES WEEKS

10/94-12/94 Project Launch Task Manager 10Bank SpecialistEnterprise/PSD SpecialistProcurementDisbursementAccountingEnvironment

2/95 Supervision Task Manager 5Bank SpecialistEnterprise/PSD SpecialistProcurement

5/95 Supervision Task Manager 5Bank SpecialistEnterprise/PSD SpecialistDisbursement

8/95 Supervision Task Manager 4Bank SpecialistEnterprise/PSD SpecialistDisbursement

12/95 Supervision Task Manager 4Bank SpecialistEnterprise/PSD SpecialistProcurement

3/96 Supervision Task Manager 4Bank SpecialistEnterprise/PSD SpecialistDisbursement

6/96 Mid-term Review Task Manager 10Bank SpecialistEnterprise/PSD SpecialistProcurementDisbursementCountry Lawyer

- 82 -

APPROXIMATE ACTIVITIES STAFF COMPOSITION STAFFDATES WEEKS

9/96 Supervision Task Manager 4Bank SpecialistEnterprise/PSD SpecialistDisbursement

12/96 Supervision Task Manager 5Bank SpecialistEnterprise/PSD SpecialistProcurementDisbursement

3/97 Supervision Task Manager 4Bank SpecialistEnterprise/PSD SpecialistDisbursement

6/97 Supervision Task Manager 4Bank SpecialistEnterprise/PSD SpecialistDisbursement

9/97 Supervision Task Manager 4Bank SpecialistEnterprise/PSD SpecialistDisbursement

12/97 Supervision Task Manager 4Bank SpecialistEnterprise/PSD SpecialistDisbursement

3/98 Supervision Task Manager 4Bank SpecialistEnterprise/PSD SpecialistDisbursement

6/98 Final Supervision Task Manager 4DisbursementCountry Lawyer

IBRD 26135

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.7/29/1994E~~i. n, 3T