Document of The World Bank Report No: 17165-IND PROJECT APPRAISAL DOCUMENT ONA PROPOSED LOAN IN THE AMOUNT OF US$20 MILLION TO THE REPUBLIC OF INDONESIA FOR A BANKING REFORM ASSISTANCE PROJECT November 20, 1997 Indonesia Country Management Unit East Asia and Pacific Region Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized
Transcript
Document ofThe World Bank
Report No: 17165-IND
PROJECT APPRAISAL DOCUMENT
ONA
PROPOSED LOAN
IN THE AMOUNT OF US$20 MILLION
TO THE
REPUBLIC OF INDONESIA
FOR A
BANKING REFORM ASSISTANCE PROJECT
November 20, 1997
Indonesia Country Management UnitEast Asia and Pacific Region
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CURRENCY EQUIVALENTS
Currency Unit = Rupiah1 Rupiah = US$0.000303
US$1 = 3300
FISCAL YEAR: April 1 to March 31
ABBREVIATIONS AND ACRONYMS
ADB Asian Development Bank
BI Bank Indonesia
BRAP Banking Reform Assistance Project
GOI Government of Indonesia
3BRD International Bank for the Reconstruction andDevelopment
IMF International Monetary Fund
MOF Ministry of Finance
SAL Structural Adjustment Loan
SOE Statement of Expenditures
TOR Terms of Reference
WB World Bank
Vice President: Mr. Jean-Michel SeverinoCountry Director: Mr. Dennis de TraySector Director: Mr. Jonathan FiechterTask Team Leader: Mr. Vikram Nehru
Indonesia: Banking Reform Assistance Project
Contents
PageA. Project Development Objective
1. Project development objective ...................................................... 2
B. Strategic Context
1. Sector-related CAS goal supported by the project ..............................................22. Main sector issues and Government strategy ......................................................23. Sector issues to be addressed by the project and strategic choices .....................4
C. Project Description Summary
1. Project components ...................................................... 52. Key policy and institutional reforms supported by the project ...........................63. Benefits and target population ...................................................... 64. Institutional and implementation arrangements ..................................................6
D. Project Rationale
1. Project alternatives considered and reasons for rejection ...................................82. Major related projects financed by the Bank and/or other development
agencies ...................................................... 93. Lessons learned and reflected in proposed project design ..................................94. Indications of borrower commitment and ownership .........................................95. Value added of Bank support in this project ..................................................... 10
Table a. Project costs by procurement arrangements .25Table b. Thresholds for procurement methods and prior review .26Table c. Allocation of loan proceeds .27
Annex 8. Project processing budget and schedule .28Annex 9. Documents in project file .29Annex 10. Status of Bank group operations in Indonesia .30Annex 11. Indonesia at a glance .31
East Asia and Pacific Region
Indonesia: Banking Reform Assistance Project
Project Appraisal Document
Date: November 20, 1997 Task Team Leader: Vikram NehruCountry Director: Mr. Dennis de Tray Sector Director: Jonathan FiechterProject ID: 17165-IND Sector: Financial Sector Program Objective Category: Financial Sector
Management ManagementLending Instrument: Technical Assistance Loan Program of Targeted [I Yes [XI No
Intervention:
Project Financing Data [xI Loan [I Credit [ I Guarantee [] Other[Specify]
For Loans/Credits/Others:
Amount: US$20 millionProposed terms: [I Multi-currency [x] Single currencyGrace period (years): 3 years [xI Standard [x] Fixed [I LIBOR-based
VariableYears to maturity: 15Commitment fee: 0.75 %
Project implementation period: December 4, 1997 to March 31, 2000
Expected effectiveness date: December 4, 1997 Expected closing date: September 30, 2000
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A: Project Development Objective1. Project development objective (see Annex 2for key performance indicators):
The project is designed to assist the Indonesian Government in improving the structure,resilience, soundness, and efficiency of the banking system. It is one element in a larger packageof external financial assistance to help the Government implement a comprehensive policypackage comprising three parts: first a strong macroeconomic framework designed to achieve anorderly adjustment to the substantial depreciation in the exchange rate; second, a strategy toreform the financial sector with special emphasis on the banking system; and third, a broad rangeof structural measures to sharpen competitiveness and improve governance. Together withforthcoming loans and grants from other bilateral and multilateral sources, the proposed technicalassistance project is designed to complement the 36 month stand-by arrangement approved by theIMF on November 5, 1997. The project is the initial component of the Bank's contribution tothis effort which proposes an expanded lending program centered on two parallel adjustmentloans, the first of which would focus on the financial sector, and the second on broader structuralmeasures designed to sharpen the competitiveness of the Indonesian economy.
B: Strategic Context
1. Sector-related Country Assistance Strategy (CAS) goal supported by the project:
CAS Report Number. 16691-IND Date of latest CAS discussion: July 10, 1997
The last CAS prepared for Indonesia was discussed by the Board on July 10, 1997. The CASidentified the financial sector as a new focal area for Bank Group operations, arguing that astrong financial sector was essential to increasing economic efficiency and maintainingmacroeconomic stability. The focus on financial sector issues stemmed from a concern about themisallocation of financial resources, weaknesses in the portfolios of several banks, and thebanking system's ability to withstand large negative shocks to the economy.' Nevertheless, theCAS did not foresee the currency crisis that has gripped the Indonesian economy over the pastthree months and the immediate and profound implications it holds for the financial sector andfor the future growth of the economy. This has forced a reassessment of the Bank's assistancestrategy, especially in light of the need for technical assistance in the financial sector as well asimmediate, fast-disbursing adjustment lending to support financial sector and structural reforms.The proposed project is an integral part of this revised strategy which itself is part of a broaderpackage of assistance that includes the IMF and the Asian Development Bank.
2. Main sector issues and Government strategy:
The main sector issue is the need to improve the structure, resilience, soundness, and efficiencyof the banking system, and thus to help Indonesia resume rapid, sustainable growth as quickly aspossible. This requires: (i) strengthening the financial sector, especially through the resolution ofclosed banks; (ii) intensive supervision of state and private banks with doubtful portfolio quality;(iii) improved efficiency in the operations of state banks through systemic and structural changeswith the eventual goal of privatization; (iv) strengthened capacity in the Central Bank to designand implement prudential regulations and provide supervisory oversight; and (v) theestablishment of a regulatory and legal environment supportive of a modern, efficient, and securebanking system.
World Bank. 1997a. Indonesia Country Assistance Strategy, Report No. 16691-IND, Page 12, para. 40,line 6.
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Well before the currency crisis, several Bank reports had raised serious concerns about theefficiency and soundness of Indonesia's financial sector, the financial condition of the banks, and
2the sector's vulnerability to large macroeconomic disturbances. Weak supervision of thebanking system, rapid growth in loan portfolios, liberal intra-group lending practices, politicalinterference in lending decisions, excessive exposure to the property sector, and large and risingnon-performing assets as a share of the total portfolio-all made the banking system particularlyvulnerable to external shocks.
Financially troubled private banks. The Government has since taken several bold measures toremedy the problem. At the outset of the financial reform program announced on November 1,1997, Bank Indonesia closed 16 insolvent private banks. Caretaker managements were installedwhich will be replaced by liquidation teams. Within two weeks of their closure, the banks werecompensating small depositors with deposits of less than Rp. 20 million and liquiAtionproceedings were being initiated.
Other private banks with weak portfolios and insufficient capital adequacy levels are beingrequired to present rehabilitation plans describing their approach to achieve full capital adequacy,changes in ownership structure, management, board of directors, and introduction of appropriateprovisioning systems. These plans would be subjected to intensive oversight and monitoring byBank Indonesia staff. Since the portfolios of banks are likely to worsen as the currency crisisaffects the financial position of their borrowers, Bank Indonesia will be required to conduct aprogram of heightened supervision of the remaining banks that would emphasize implementationof a new loan classification system, more stringent provisioning requirements, intensive efforts tocollect bad debts, and new internal systems for risk management, credit appraisal, and portfoliodiversification.
State-owned banks. Among Indonesia's seven state banks, the Government will initiate arestructuring program with the eventual aim of selling at least 49 percent of the equity to theprivate sector or more in accordance with prevailing law. The program will require that all statebanks conduct portfolio and systems reviews as well as special financial audits. Those with largeamounts of bad loans will be required to merge and the resulting financial institution will focusexclusively on the collection of bad debts; "good" debts of these institutions will be sold to otherfinancial institutions for normal processing. Arrangements will also be made to meet theliabilities of these merged banks through a process of bad debt collection, downsizing, sale offixed assets, and compensation for the transfer of good loans to other financial institutions. Asfor other state banks, the infonnation contained in the portfolio and systems reviews and specialfinancial audits will provide the basis for action plans to make them more efficient, improve theircapital adequacy, and strengthen their credit appraisal, risk management, and provisioningprocesses. These plans would use a combination of three strategic tools: regulatory and/orperformance contracts between the banks' management and the Ministry of Finance,3 mergersbetween banks, and sale of at least 49 percent of the shares to the private sector or more inaccordance with prevailing law.
2 See World Bank. 1997b. Indonesia: Sustaining High Growth with Equity, Report No. 16433-IND, Page126, par. 5.44; World Bank. 1996. Dimensions of Growth, Report No. 15383-IND; and World Bank.1995. Indonesia: Improving Efficiency and Equity. Changes in the Public Sector's Role, Report No.14006-IND,
3 Performance contracts between the Ministry of Finance and a state bank will be used when the bank inquestion is essentially solvent, sound, and in compliance with Bank Indonesia's prudential standards. Aregulatory contract, on the other hand, will be imposed by Bank Indonesia on the bank in question when thebank is determined to be insolvent or seriously undercapitalized, or in violation of other prudentialrequirements.
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Bank Indonesia. To strengthen supervision and examination capabilities, the project willfinance international experts to assist Bank Indonesia on improving enforcement of loanclassification, provisioning rules, liquidity management and foreign exchange positions control.Bank Indonesia will also need new skill-sets and enhanced enforcement capabilities to prepareand implement regulatory contracts with state banks, which will be required if the financial orsystems reviews detect major deficiencies. To this end, the project will finance full-timetechnical experts experienced in drafting, implementing and monitoring "cease and desist" ordersand other rehabilitation programs usually imposed by regulatory contracts. Finally, theorganizational structure of Bank Indonesia will be reviewed and recommendations made on howto improve the quality and effectiveness of its supervision and examination of state and privatebanks.
Policy, regulatory and legal environment. Finally, the policy, regulatory, and legalenvironment for banking will be strengthened with the intention of incorporating internationalbest practice. Likely areas of focus would include bankruptcy, banking disclosure, taking andrealizing collateral security interests, company law implementation including shareholder rightsand governance, and laws and regulations on financial instruments, fair banking practices, andinsurance. Laws and regulations covering foreign ownership will be similarly assessed with theintention of facilitating entry of international banks and investors into Indonesia. Prudentialregulations and enforcement procedures will be strengthened in line with the Basle Committee'sCore Principles of banking supervision. Cross ownership will be limited and the Central Bank'sshareholdings in private banks will be divested. Loan loss provisions are to become fully taxdeductible and Bank Indonesia supervision will be overhauled to effectively implement risk-based oversight of the banking system.
3. Sector issues to be addressed by the project and strategic choices:
The project will support implementation of the Government's financial sector reform program asdiscussed with the IMF and the Bank and supported by the IMF's three-year Stand-ByArrangement and the Bank's proposed financial sector adjustment loan. The objectives of thereform program-to improve the structure, resilience, soundness, and efficiency of the bankingsystem-will require a broad-based and technically demanding agenda of actions and enactmentsthat will require the best possible expertise available. The project will help mobilize thatexpertise and apply it in the most judicious and effective manner, supplementing andcomplementing the capacities of the Central Bank and the Ministry of Finance.
Given the comprehensive and wide-ranging reforms planned for the banking sector, the WorldBank, International Monetary Fund, and Asian Development Bank will share responsibility forproviding the Indonesian Government with technical assistance. The respective responsibilitiesof the three institutions is given in Annex 1 and is based on an understanding reached betweenthe three agencies and the Government during a joint financial sector technical assistance missionunder the leadership of the Fund.
On the basis of this arrangement, the Bank's proposed Banking Reform Assistance Project willfocus on providing assistance in four areas: (i) restoring the financial health of undercapitalizedprivate banks through better credit practices, stringent supervision, improved loan classificationsystems and loan provisioning, greater accounts transparency, better client information,appropriate portfolio diversification, and changed management; (ii) preparing state banks foreventual privatization by developing a good information database on their finances, systems, andasset portfolio, changing their management, improving incentives and capacity to recover pastdue loans, ensuring that banks are protected from undue outside influence in making r-editdecisions or collecting loans, and improving their information disclosure; (iii) increasing theinstitutional capacity of Bank Indonesia by strengthening its examination capabilities, its capacity
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to initiate and monitor regulatory contracts, and its overall organization structure; and (iv)conducting a review of laws and institutions in the financial sector with the aim of implementingthe necessary legislative, regulatory, and institutional changes to facilitate banking reforms.
At the same time, the International Monetary Fund will provide help with the resolution processin private banks and assist in strengthening Bank Indonesia's institutional capacity, while theAsian Development Bank will assist in the evaluation and implementation of private bankrehabilitation plans, restructuring regional development banks, and in the infrastructuredevelopment for the capital market, including institutional investors such as insurance companiesand pension funds.
C: Project Description Summary1. Project components (see Annex 3 for a detailed description and Annex 4 for a detailed costbreakdown):
Component Cateworv Cost % of Bank- % of(US$m) total (nancingJ Bank-
__________________ _____ ~~~~~~~(US$m) financing
Portfolio, financial and Technical assistance 10.0 48.8% 10.0 100%systems audits
Evaluation of Technical assistance 0.5 2.4% 0.5 100%rehabilitation plans
State banks financial Technical assistance 3.0 14.6% 3.0 100%restructuring
Bank Indonesia Technical assistance 3.0 14.6% 3.0 100%supervision
Diagnostic review of the Technical assistance 0.5 2.4% 0.5 100%legal environment
Equipment Physical 0.1 0.5% 0.1 100%
Project management unit Technical assistance 0.5 2.4% 0.5 100%
Contingencies 2.9 14.1% 2.4 82.8%
Total 20.5 100% 20.0 97.6%
NOTE: Rounding affects totals
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2. Key policy and institutional reforms supported by the project:
Given the urgent need to provide assistance in the implementation of banking system reforms,this project would focus only on the two high priority areas of policy reform and institutionbuilding. Specifically, policy reforms assisted by the project will include: (i) evaluation of therehabilitation plans of financially troubled private banks and installment of systems to assist intheir implementation and monitoring; (ii) evaluation of state banks' portfolios by internationallyrecognized audit firms to provide a benchmark of portfolio quality and to identify emergingproblems; (iii) preparation and implementation of plans to merge insolvent state banks (into asingle institution which would focus its efforts on debt recovery) and transfer their good assets toother financial institutions; (iv) implementation of special financial audits for all state banks byinternationally recognized auditors; (v) preparation and implementation of plans to prepare otherstate banks for privatization; (vi) the review and revision of laws and institutions in the financialsector that could help ease the implementation of banking reforms and a study of the desirabilityand feasibility of a system of deposit insurance suitable to Indonesia's institutional environment;and (vii) improvements in information disclosure of the financial situation of state banks thatwould underpin market valuation of their equity.
Institution building will focus on strengthening Bank Indonesia, including its overallorganizational structure and its capacity to (i) evaluate and monitor rehabilitation plans; (ii)reorganize, restructure, and downsize state banks in preparation for their eventual privatization;(iii) carry out on-site and off-site bank examinations; and (iv) initiate and then monitor regulatorycontracts imposing requirements and prohibitions on problem institutions.
3. Benefits and target population:
The project is aimed at reducing the fiscal costs of the banking system restructuring programthrough design of policies and institutional arrangements to accelerate the restructuring of stateand private banks and limit the extent of contagion to the rest of the banking system. Thebenefits will include much stronger state banks, an accelerated program for their privatization,improved market discipline, and more effective procedures for corporate bankruptcy andforeclosure on collateral. Finally, the project supports development of policies that will place thefinancial system on a sounder footing, bring more transparency to the financial system, increaseconfidence, and gradually facilitate the smooth flow of credit to the real sectors of the economy.
In a narrow sense, the target population includes depositors and borrowers. With successfulbanking system reforms, they could look forward to dealing with safer banks, a broader variety offinancial products to meet their growing financial needs, and higher returns on their savings. In abroader sense, however, the target population includes all Indonesians; an efficient and stablebanking system is central to broad-based economic growth and development.
4. Institutional and implementation arrangements:
The implementation period of the loan would cover approximately two years, to complement theproposed banking system adjustment loan (expected to be presented to the Board in January1998). The executing agencies under the project would be Bank Indonesia (Bi) and the Ministryof Finance with the Secretariat of the Monetary Board as the main coordination agency. Otheragencies, including the Ministry of Justice, and the Office of the Coordinating Minister forFinance, Economy, and Development Supervision, would be called upon as necessary to providecounterparts to consultants and cooperate in some of the activities of the project. The Secretariatof the Monetary Board would establish a project management unit headed by a ProjectCoordinator that would be responsible for the day-to-day management of the project, engagelocal and international consultants, and procure equipment. The Project Coordinator would be a
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qualified senior manager with experience in financial and banking matters and drawn from thecorporate sector. The Secretariat of the Monetary Board, consisting of representatives from MOF,BI, and Office of the Coordinating Ministry of Economics, Finance and DevelopmentSupervision, would convene regularly to monitor progress in project implementation. A ProjectManager with the Directorate General of Financial Institutions in the Ministry of Finance wouldbe responsible for managing the finances of the project. On the Bank's side, supervision wouldbe carried out by the Economics Unit under the Country Director based in Jakarta in coordinationwith specialized staff in units at headquarters. Coordination of technical assistance provided bythe Bank, IMF, the Asian Development Bank, and bilateral donors will be coordinated through aspecial coordinating committee convened for that purpose (with the Bank's initiative) in Jakarta.
Prior review would be required for all contracts for: (i) consulting firms above US$100,000equivalent; (ii) all individual consultants above US$50,000 equivalent, and (iii) the first twocontracts for goods. Contracts below these limits would be subject to ex-post reviews duringsupervision.
Disbursements based on Statement of Expenditures (SOEs) would be used for all contracts for (i)consulting firms below US$100,000 equivalent; (ii) all individual consultants below US$50,000and (iii) all goods. Supporting documentation for these SOEs would be maintained by the ProjectManagement Unit for review by the Bank and independent auditors. Contracts above these limitswould be fully documented. Retroactive financing of up to US$1,000,000 for expenditures afterNovember 13, 1997 will be permitted.
In order to facilitate disbursements, the GOI would establish a Special Account at BankIndonesia on terms and conditions satisfactory to the Bank. The authorized allocation of thespecial account of US$3,750,000, representing approximately four months expenditures, wouldbe limited to US$1,750,000 until the aggregate amount of withdrawals reaches US$7,000,000.
Project records and accounts would be maintained by the Project Manager to reflect theoperations, resources and expenditures for each project activity, in accordance with soundaccounting practices. The accounts will be consolidated annually into financial statements forthe project as a whole. Appropriate project accounting and reporting systems and procedureswould be put in place as part of project preparation and the relevant implementing agency'scontrol environment would be reviewed by the Bank. Supporting documentation will be madeavailable to the Bank's Country Management Unit and independent auditors as requested. Forexpenditures incurred on the basis of Statements of Expenditures (SOEs), all records providingevidence for such expenditures will be retained by the project management unit until at least oneyear after the Bank has received the audit report for the fiscal year in which the last withdrawalfrom the Loan Account or payment out of the Special Account is made, whichever is later.Project records and accounts, including the Special Account and SOEs, will be audited annuallyin accordance with appropriate auditing principles that are consistently applied by auditorsacceptable to the Bank, with terms of reference for auditors and reports approved by the Bank.The Bank's Financial Accounting, Reporting, and Auditing Handbook (FARAH) published inJanuary 1995 would be used by the auditors in accordance with Bank's auditing guidelines.Audit reports will be furnished to the Bank within six months after the close of the Government'sfiscal year.
Monitoring of project execution will be undertaken by the Secretariat of the Monetary Boardwhich, together with the Project Coordinator, will provide the Bank, for its review and approval,an annual working plan not later than December 31 of each year, starting 1997. Quarterlyprogress reviews of the project will be presented to the Bank by the Secretariat of the MonetaryBoard not later than February 15, May 15, August 15 and November 15 of each year, starting in1998. A mid-term review will be conducted jointly by the Secretariat of the Monetary Board and
