Document of The World Bank FOR OFFICIAL USE ONLY Report No: 60062-XK PROJECT PAPER ON A PROPOSED ADDITIONAL CREDIT IN THE AMOUNT OF SDR 4.30 MILLION (US$6.85 MILLION EQUIVALENT) TO THE REPUBLIC OF KOSOVO AND RESTRUCTURING FOR FINANCIAL SECTOR STRENGTHENING AND MARKET INFRASTRUCTURE PROJECT (FORMERLY TITLED FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT) May 16, 2011 This document is being made publicly available prior to Board consideration. This does not imply a presumed outcome. This document may be updated following Board consideration and the updated document will be made publicly available in accordance with the Bank’s Policy on Access to Information. i CURRENCY EQUIVALENTS (Exchange Rate Effective April 30, 2011) Currency Unit = Euro Euro 0.68 = US$1 US$1.62 = SDR 1 FISCAL YEAR January 1 – December 31 ABBREVIATIONS AND ACRONYMS AF Additional Financing AMIK Association of Microfinance Institutions in Kosovo BDs Bidding Documents BCC Business Continuity Center BIS Bank of International Settlements CA Credit Agreement CBK Central Bank of Kosovo CMU Country Management Unit CPSS Committee on Payment and Settlement Systems CSD Central Securities Depository DIFK Deposit Insurance Fund of Kosovo DvP Delivery versus Payment EICS Electronic Interbank Clearing System EU European Union FIRST Financial Sector Reform and Strengthening Initiative FSSMIP Financial Sector Strengthening and Market Infrastructure Project FSTA Financial Sector Technical Assistance Project GoK Government of Kosovo HR Human Resources IADI International Association of Deposit Insurers IBRD International Bank for Reconstruction and Development IDA International Development Association IMF International Monetary Fund ISN Interim Strategy Note ISR Implementation Status and Results Report KBA Kosovo Bankers’ Association KfW Kreditanstalt für Wiederaufbau / German Development Bank MoF Ministry of Finance MFIs Microfinance Institutions NBFIs Non Banking Financial Institutions NPLs Non-performing loans NPS National Payment System PDO Project Development Objective P-RAMS Procurement Risk Assessment Management System PMT Project Management Team RTGS Real Time Gross Settlement SDR Special Drawing Rights ToRs Terms of Reference TPL Third Party Liability USAID United States Agency for International Development Vice President: Philippe H. Le Houerou Country Director: Jane Armitage Country Manger: Ranjit Nayak Sector Director: Gerardo M. Corrochano Sector Manager: Lalit Raina Task Team Leader: Isfandyar Z. Khan i KOSOVO FINANCIAL SECTOR STRENGTHENING AND MARKET INFRASTRUCTURE PROJECT Contents  I. Introduction ............................................................................................................................................. 1  II. Background and Rationale for Additional Financing ............................................................................ 1  III. Proposed Changes ................................................................................................................................. 3  IV. Appraisal Summary .............................................................................................................................. 6  A.  Technical ...................................................................................................................................... 6  B.  Partnerships .................................................................................................................................. 8  C.  Procurement ................................................................................................................................. 8  D.  Financial Management ............................................................................................................... 10  E.  Post Project Safeguards for Component 6 (Provision of Seed Funding to the DIFK) ............... 13  F.  Environment and Social ................................................................................................................. 13  G.  Implementation Arrangements ................................................................................................... 14  Annex 1: Results Framework and Monitoring......................................................................................... 15  Annex 2. Revised Project Results Framework ......................................................................................... 19  Annex 3: Kosovo Financial Sector Snapshot............................................................................................ 23  Annex 4: Detailed Description of Components 4, 5 and 6 ....................................................................... 26  Annex 5: Summary Procurement Plan ...................................................................................................... 31  Annex 6. Operational Risk Assessment Framework (ORAF) .................................................................. 33  ii   KOSOVO FINANCIAL SECTOR STRENGTHENING AND MARKET INFRASTRUCTURE PROJECT (FORMERLY TITLED FINANCIAL SECTOR TECHNICAL ASSISTANCE PROJECT) PROJECT PAPER EUROPE AND CENTRAL ASIA ECSPF Basic Information (Original Project) Project ID: P108080 Project Name: Kosovo, Financial Sector Technical Assistance Team Leader: Isfandyar Zaman Khan Expected Closing Date: June 30, 2011 Environmental category: C Lending Instrument: Technical Assistance Loan Joint IFC: Joint Level: Basic Information (Additional Financing) Date: March 30, 2011 Team Leader: Isfandyar Zaman Khan Country Director: Jane Armitage Sectors: General finance sector (45%); Country Manger: Ranjit Nayak Payment systems, securities clearance and Sector Director: Gerardo M. Corrochano settlement (30%); Banking (25%) Sector Manager: Lalit Raina Themes: Standards and financial reporting (40%); Regulation and competition policy (40%); Other financial and private sector development (20%) Project ID: P122084 Environmental category: C Lending Instrument: Technical Assistance Additional Financing Type: Scale Up and new Loan activities Joint IFC: Joint Level: Project Financing Data [ ] Loan [X ] Credit [ ] Grant [ ] Guarantee [ ] Other: For Loans/Credits/Others: Total Bank financing (US$m): 6.85 Proposed terms: IDA credit with a final maturity of 20 years including a grace period of 10 years Financing Plan (US$m) Source Local Foreign Total RECIPIENT 0.00 0.00 0.00 IDA Credit 6.85 0.00 6.85 Total: 6.85 0.00 6.85 Recipient: Republic of Kosovo Responsible/Implementing Agency: Central Bank of Kosovo (CBK) iii Pristina Kosovo Contact Person: Mr. Gani Gerguri (Governor) Telephone No.: 038 243 767, 038 222 055 ext. 229 Email: executiveasst@bqk-kos.org; Estimated disbursements (Bank FY/US$m) FY 2011 2012 2013 2014 Annual 1,013,331 5,270,000 1,186,669 1,380,000 The disbursement schedule is for both the original Cumulative 1,013,331 6,283,331 7,470,000 8,850,000 project and the proposed additional credit Project implementation period: Start September 1, 2011 End: June 30, 2014 Expected effectiveness date: September 1, 2011 Expected closing date: June 30, 2014 Does the project require any exceptions from Bank policies? [ ]Yes [X] No Have these been approved by Bank management? [ ]Yes [X] No Does the project include any critical risks rated “substantial” or “high”? [X]Yes [ ] No Project development objective Original project development objective: The objective of the Project is to enhance the stability and development of Kosovo’s financial system by supporting stronger prudential regulation and supervision by the Central Bank of Kosovo (CBK) for banks and non bank financial institutions, supporting the institutional strengthening of the CBK, and strengthening the banking and microfinance industry through capacity building. Revised project development objective: The objectives of the Project are to (i) enhance the stability and development of the financial sector; and (ii) strengthen the financial sector’s underlying market infrastructure. Project description Component 1: Assistance to the CBK Component 4: Establishment of a Real Time Gross Settlement System (RTGS) Component 5: Establishment of a Business Continuity Center (BCC) Component 6: Provision of seed funding to the DIFK Components 2 and 3 exist in the original project Which safeguard policies are triggered, if any? None iv I. INTRODUCTION 1. This Project Paper seeks the approval of the Board of Executive Directors to: (a) provide additional financing (AF) in the form of an additional credit of US$6.85 million to the Kosovo Financial Sector Technical Assistance Project (P108080); and (b) restructure the Project to make the accompanying amendments to the Original Project’s legal documents. 2. The proposed additional financing would both help to scale up activities under the Original Project and support new activities as part of the project restructuring due to the enhanced scope of the Project. The changes to the Project as part of the additional financing and restructuring include: (i) expanding the project development objective (PDO) and title of the Project to reflect the broadened scope of the Project; (ii) adding three new components that build on the technical capacity that was developed as part of the Original Project; and (iii) modernizing the results matrix to reflect the revised scope. 3. The additional financing would enhance the financial sector market infrastructure and make the financial sector more efficient and resilient by: (a) scaling up the technical assistance provided under the Original Project to support the Central Bank of Kosovo (CBK); (b) financing the costs associated with the implementation of the CBK’s Strategy for the Development of a National Payments System (NPS) and establishing a Real Time Gross Settlement (RTGS); (c) establishing a Business Continuity Center (BCC) for the CBK; and (d) providing seed funding to the Deposit Insurance Fund of Kosovo (DIFK). The restructuring is necessary to make changes to the Original Project that reflect the impact of the additional financing. II. BACKGROUND AND RATIONALE FOR ADDITIONAL FINANCING 4. The Original Project, supported by an IDA grant of SDR 1.3 million (US$2 million equivalent), was a technical assistance grant and was approved by the Board of Executive Directors on December 13, 2007 and became effective on January 3, 2008. It consisted of three components: Component 1 - Assistance to the CBK aimed at strengthening its institutional framework and sustainability and improving the regulatory and supervisory framework for the banking and non-banking financial institutions (NBFI) sectors; Component 2 - Assistance to the Association of Microfinance Institutions of Kosovo (AMIK) aimed at strengthening the microfinance industry; and Component 3 - Assistance to Kosovo’s Bankers’ Association (KBA) aimed at building capacity within banks. 5. The Original Project has achieved impressive results to date, especially when considering the nascent stage of development of the legal and regulatory framework for the financial sector in Kosovo, the overall weak capacity, and challenges of dealing with a relatively new Central Bank. The CBK’s institutional capacity has substantially been strengthened thanks to the preparation and implementation of a medium-term development strategy. This has led to the recruitment and retention of high quality staff. The Original Project has also enhanced the legal and regulatory framework under which the Kosovo financial sector operates. Specifically, it has helped to create conditions for a viable insurance sector by assisting the Government of Kosovo (GoK) to establish the legal framework for third part liability and for compulsory insurance. In 1 addition, a detailed actuarial assessment of life insurance activities and products was carried out and the sector adopted the recommendations made there under. 6. As of March 2011, the Original Project had disbursed the equivalent of US$735,033 (36 percent of the total grant amount), with commitments of US$894,000 (45 percent of total amount). By May 2011 it is expected that further contracts for US$460,000 will be signed, bringing the committed amount to 67.7 percent of the total project cost. The Original Project Closing Date was extended by one year to June 30, 2011, to provide sufficient time to implement the planned activities. Disbursement delays were initially encountered due to weak capacity and unfamiliarity with Bank procedures. This was compounded by departure of the CBK governor and the Project Management Team (PMT) head last summer, which further slowed down disbursement. This led to a downgrade of the Original Project from Satisfactory to Moderately Satisfactory in the last Implementation Status and Results Report (ISR) in January 2011. However, quickly a well-qualified acting CBK Governor and a new PMT head were appointed and the Original Project has proceeded at a satisfactory pace since then. The acting Governor has now been confirmed as the new Governor by the Parliament in April 2011. The initial lack of familiarity with Bank procedures has been largely overcome as PMT staff gained implementation experience. Components 2 and 3 of the Original Project are expected to be fully completed by June 2011 and component 1 is expected to be 47 percent disbursed. The Original Project is in full compliance with the loan covenants and has no outstanding Financial Management Reporting (FMR) or procurement issues. Table 1: ISR Ratings in the last 12 months ISR Ratings ISR #3 ISR #4 ISR #5 12/8/2009 6/29/2010 1/13/2011 Progress towards PDO MS S MS Overall Implementation Progress S S MS Financial Management S MS S Procurement S S S Counterpart Funding S S S M&E S S S Note: MS is for Moderately Satisfactory, S is for Satisfactory 7. Since the Original Project was approved by the Board of IDA, Kosovo declared its independence and subsequently became a member of the World Bank Group and the International Monetary Fund (IMF) in June 2009. As an independent country, Kosovo needs a basic infrastructure to support its financial sector, such as a real time payment system. Under United Nations’ Interim Administration Mission in Kosovo, the Central Bank operated an electronic interbank clearing system. While the system is effective in clearing payments, settlements do not occur in real time. Considering increasing volume and value of transactions this is not in line with international best practices as it gives rise to settlement risk. Under RTGS the payee banks and their customers have certainty regarding receipt of funds during the day, thus enabling them to use the funds immediately without exposing themselves to this risk. Finally, as a fully fledged central bank, the CBK needs to have a back-up system to ensure that it can continue to perform its functions in case of a disaster. 2 8. Although the banking sector has come out of the crisis relatively unaffected (see Annex 3 for a brief analysis of the financial sector), the crisis has highlighted the importance of deposit insurance schemes in ensuring orderly bank resolution and maintaining public confidence in the sector. Furthermore, the crisis has brought to the fore the importance of having well functioning bank resolution frameworks that ensure transparent, cheap and fast resolution. Against this backdrop Kosovo has introduced a deposit insurance scheme and is reforming the existing bank resolution framework. The existence of a deposit insurance scheme is also a requirement for EU accession. 9. The additional financing is seen as the most appropriate way to scale up the Original Project’s impact and development effectiveness and support Kosovo in introducing a real time settlement system, a business continuity center for its Central Bank and a deposit insurance scheme. The Financial Sector Strengthening and Market Infrastructure Project (FSSMIP) will build upon: (i) the technical capacity of the CBK built under the Original Project; (ii) the Bank’s other technical assistance work with the CBK; and (iii) the fact that the CBK will remain the main implementation partner. The fiduciary capacity of the CBK will also be enhanced since the scaled up activities require more sophisticated procurement processes. 10. The proposed additional financing and restructuring of the Original Project is consistent with the Kosovo Interim Strategy Note (ISN) for FY10 and FY11. The additional financing for the Original Project was specifically mentioned in the ISN as part of the first pillar that aimed to improve macroeconomic stability. In particular, strengthening the capacity of the CBK to supervise financial institutions and modernizing the payment systems were identified as key priorities. 11. In addition to the FSSMIP, the Bank is supporting the development of the banking and insurance sectors via two FIRST grants focusing on the legal and regulatory framework of the sectors and the capacity of the regulator. Moreover, the Bank has supported the CBK through the Western Balkans Technical Assistance Facility, which has financed development of the payment system and Business Continuity strategy and supported a crisis management preparedness assessment. Further technical assistance to the Deposit Insurance Fund will be provided under the Western Balkans Technical Assistance Facility to develop an institution building plan to reach compliance with the Core Principles for Effective Deposit Insurance System adopted by the Basel committee and the International Association of Deposit Insurers (IADI). III. PROPOSED CHANGES 12. The Additional Financing involves: a. Broadening the project development objectives; b. Updating the title of the Project; c. Expanding activities that scale up the original Project’s impact and development effectiveness and adding three new components; d. Extending the project timeline; e. Updating the results matrix to reflect the enhanced scope of the Project that now includes financial infrastructure in addition to technical assistance; f. Updated implementation arrangements for the additional financing. 3 13. A level one restructuring is required because the Project’s Development Objectives (PDOs) are being broadened for the AF. As a consequence of the AF, the proposed restructuring involves: a. Broadening the project development objectives; b. updating the title of the Project; c. updating the results matrix to reflect the enhanced scope of the Project that now includes financial infrastructure in addition to technical assistance; d. updating references to the Central Bank of Kosovo from “CBAK” as it was formerly known to “CBK”; e. Modifying the Procurement and Consultant guidelines to be used for the Original Project from the Procurement and Consultant Guidelines published by the World Bank in May 2004 and revised in October 2006 to the Procurement and Consultant published by the World Bank in May 2004 and revised in October 2006 and May 2010; and f. Extending the closing date of the Project. 14. PDO. The development objective is being changed to recognize the inclusion of components to improve the financial market infrastructure. The original development objective was to enhance the stability and development of Kosovo’s financial system by supporting stronger prudential regulation and supervision by the CBK for banks and non bank financial institutions, supporting the institutional strengthening of the CBK, and strengthening the banking and microfinance industry through capacity building. The new development objectives will be to (i) enhance the stability and development of the financial sector; and (ii) strengthen the financial sector’s underlying market infrastructure. 15. Project Name. The name of the Project is revised to “Financial Sector Strengthening and Market Infrastructure Project (FSSMIP)” because of the additional focus on financial infrastructure following the additional financing and restructuring. 16. Results Matrix. The results matrix has been strengthened from the Original Project (Annex 1) and the additional activities that focus on strengthening the financial sector market infrastructure have been incorporated. 17. Scaling up of components from the Original Project. The Original Project had three components that focused on technical assistance to the CBK, AMIK and KBA. No additional financing is planned for the AMIK and KBA. For component 1, additional financing for technical assistance will be provided for: a. Supporting the implementation of the CBK’s training as identified in the training needs analysis that CBK conducts regularly. 18. Three new components. Building on the success of the Original Project, and the engagement of the World Bank through other activities, three new components will be added as part of the project restructuring and additional financing: 4 a. Component 4 - Establishment of a Real Time Gross Settlement System. An effective financial sector infrastructure contributes to the provision of affordable financial services to underserved populations. The NPS of a country encompasses everything that is concerned with the movement of money from payer to payee, covering all phases of payment from initial offer of a payment instrument to final settlement. The payment system in Kosovo is relatively underdeveloped. Weaknesses include: the lack of interoperability between commercial banks' card networks leading to inefficiency and cost increase for users and delayed settlement of payments. This also results in a high percentage of payment transactions in cash. In September 2009, the CBK approved a strategy document and an action plan for implementation of NPS. Component 4 will enable implementation of the action plan by establishing an RTGS. This will reduce operating costs for banks, increase the speed, and shorten execution times for the high value payments. Above all, the system will minimize the payment risk and increase confidence in the banking sector. b. Component 5 – Establishment of a Business Continuity Center: In 2007, the Bank provided the CBK with technical assistance for the development of its Business Continuity Strategy in line with the Bank of International Settlements (BIS) Core principle VII. The Strategy identifies the business processes supporting the key operational functions within the CBK in the event of a disaster, establishes a Business Continuity Management Team, develops and documents an IT disaster recovery plan to facilitate the proper and timely recovery of IT operations, and establishes recovery locations to be used based on the disaster classification. The Strategy recommends establishing a Business Continuity Center outside Pristina, which will be a 'hot' stand-by site and will contain continuously-updated live data from all the CBK's critical systems. Such a back up site for the CBK would ensure stability of the financial sector in the event of a disaster. The additional financing will assist in establishing such a center and will include the renovation of a building site. The site has already been chosen and is located in the city of Prizren and owned by the CBK. c. Component 6 - Provision of seed funding to the DIFK. An efficient deposit insurance scheme is essential to ensure orderly bank resolution. Moreover, the existence of such a scheme is critical to maintaining public confidence in the banking sector, as the financial crisis has illustrated. The presence of such a fund is also a requirement for the EU accession. Introduction of a Deposit Insurance scheme in Kosovo was initiated by the CBK in 2007 with technical assistance from KfW. The Law on Deposit Insurance was approved by the Parliament in October 2010 and is now in force after being made effective in December 2010. Through the additional financing IDA will provide seed funding to the DIFK. The KfW and IMF are key partners in this component. The DIFK is expected to build reserves of approximately €15 million over time. The DIFK funding will include premiums from financial institutions, GoK contribution, and grant capital of €4.5 million from KfW. 5 Table 2: Project costs by component (in USD) Original (f) (g) Total (h) Project Additional undisbursed Total (a) Original (b) Disbursed (c) Committed (d) Undisbursed Financing (d)+ (f) (a)+(f) (03/2011) (03/2010) (a)-(b) Component 1: 1,540,000 493,723 684,623 1,046,277 130,000 1,176,,277 1,670,000 Assistance to CBK Component 2: 240,000 121,722 80,000 118,278 - 118,278 240,000 Assistance to AMIK Component 3: 220,000 170,800 32,000 51,000 - 51,000 220,000 Assistance to KBA Component 4: -- -- -- -- 1,870,000 1,870,000 1,870,000 Establishment of a RTGS Component 5: -- -- -- -- 850,000 850,000 850,000 Establishment of a BCC Component 6: -- -- -- -- 4,000,000 4,00,000 4,000,000 Provision of seed funding to the DIFK Total 2,000,000 786,245 796,623 1,213,755 6,850,000 8,063,755 8,850,000 19. Implementation and Procurement Schedule. The revised plan for all activities under the additional financing to be implemented in three years and the accompanying procurement plan are included in Annex 5. 20. Project Timeline and Disbursements: The estimated disbursement schedule for the Grant and Credit would be as follows: Table 3: Revised disbursement estimates for the Project (including the Grant and Credit) FY 08-11 FY12 FY13 FY14 Total Component 1: Assistance to CBK 724,000 430,000 286,000 230,000 1,670,000 Component 2: Assistance to AMIK 240,000 - - - 240,000 Component 3: Assistance to KBA 220,000 - - - 220,000 Component 4: Establishment of a RTGS - 520,000 500,000 850,000 1,870,000 Component 5: Establishment of a BCC - 150,000 400,000 300,000 850,000 Component 6: Provision of seed funding to the - 4,000,000 - - 4,000,000 DIFK Total 1,013,331 5,270,000 1,186,669 1,380,000 8,850,000 21. The large disbursement foreseen in FY12 is attributable to the disbursement of seed funding for the DIFK in that year. IV. APPRAISAL SUMMARY A. TECHNICAL 22. For Component 1 (Assistance to the CBK), initial delays occurred because of the minimal experience of the PMT with World Bank procurement and financial management procedures. 6 This was compounded by the departure of the CBK Governor and the PMT head in July 2010. A new acting Governor and PMT head were quickly appointed and the Original Project has proceeded at a reasonable pace since then. Two fiduciary reviews of the CBK were conducted in recent months. The World Bank has done a review of the project arrangements and found the CBK procurement and financial management capacity to be adequate. The IMF conducted a safeguard assessment and found the legal structure and independence, financial reporting framework, internal audit mechanism, system of internal controls and external audit by independent auditors to be adequate. Over the course of the Original Project, the capacity of the PMT was also enhanced; the financial management system is fully operational and the staff well trained and project staff have gained experience, albeit relatively modest, with procurement requirements as well. The procurement plan for this component has been revised in light of the fast development of the financial sector that has taken place in the past three years. In April 2011, the acting Governor was appointed as the new Governor and thus there is continuity in the top management of the CBK. 23. For component 4 (Establishment of an RTGS), the RTGS working group has been established within the CBK, and it is responsible for drafting bidding documents to procure and implement the RTGS. Consultations have been carried out with other regional central banks, and draft bidding documents to procure and implement RTGS have been prepared. 24. For component 5 (Establishment of a business continuity center), a team within the CBK has been established to support the implementation. The establishment of the BCC will require the procurement of a contractor for refurbishment work of an identified CBK-owned building in Prizren followed by installment of backup servers. Terms of Reference (ToRs) will be developed by the CBK with assistance from IDA and will be advertised shortly after approval. In addition, procurement will be required for hardware, networking connections and software to equip the BCC to support the business-critical systems, which will be established in the BCC, with the exception of the RTGS system. Procurement for back-up software will also be required. 25. For Component 6 (Provision of seed funding to the DIFK), the Law on “Establishment of Deposit Insurance System for Financial Institutions in Kosovo” has been adopted and came into force in December 2010. Furthermore, the process of creation of the DIFK as an independent legal entity has been completed on May 3rd, 2011 with the: (i) appointment of the Management Board through a decision of the CBK; (ii) approval by the Management Board of the TORs and selection process for the recruitment of the DIFK director; (iii) opening of two accounts for the DIFK in the CBK (one account will be used for the DIFK operational expenditures and one for the DIFK’s funds); and (iv) appointment of an interim Director. 26. Finally, to make the DIFK effective, the following needs to be achieved: (i) Approval by the Management Board of a directive on governance (Management Board decisions making process and structure of the DIFK); (ii) Approval by the Management Board of a directive adopting the human resources, financial management and procurement procedures of the CBK; (iii) Signing of a binding agreement between the DIFK and CBK on outsourcing of human resources, financial management and procurement functions to the CBK; (iv) Approval by the Management Board of a directive on payout form; (v) Approval by the Management Board of a directive on criteria for payee banks; and (vi) A decision by the Management Board that an amount equivalent to the IDA contribution (US$4 million) will be sufficient to initiate coverage 7 of depositors. In addition, material explaining coverage will need to be developed prior to the DIFK being effective. These will be included as disbursement conditions in the Financing Agreement. 27. Under operational policy 6.00 (Bank Financing), the World Bank may finance expenditures that are productive from loan proceeds. IDA contribution to the DIFK in the amount of US$4 million will enable the DIFK to commence provision of deposit insurance services. Like any insurance business, a deposit insurance fund does not hold resources equivalent to the insured amounts. However, for a deposit insurance fund to be credible and inspire confidence in the population, it is crucial that the DIFK has some capital reserves to demonstrate ability to pay-out. Against this backdrop, up-front disbursement of IDA resources is a critical component of the support to the DIFK as it will strengthen its balance sheet and these reserves will provide a buffer in the event of a crisis. The provision of seed capital to the DIFK will raise confidence in the banking system. Heightened confidence in the banking sector backed by a deposit insurance scheme will in turn increase the mobilization of domestic savings, thus increasing on-lending resources for banks operating in Kosovo. Domestic savings mobilization is crucial for growth in Kosovo in light of reduced capital inflows to Eastern Europe after the crisis. Therefore, the provision of capital to the DIFK constitutes a clear productive purpose and hence meets the requirements of operational policy 6.00. 28. The DIFK is expected to build reserves of approximately €15 million over time. DIFK funding will include premiums from financial institutions, GoK contribution, and grant capital of €4.5 million from KfW. B. PARTNERSHIPS 29. The development of the financial sector in Kosovo is supported by a number of donors. Specifically, with respect to the said Project, the World Bank is working with the US Treasury to ensure that the RTGS platform funded under this Project is fully integrated by the Central Securities Depository (CSD) system being supported by the US treasury. In addition, The World Bank under the Western Balkans Technical Assistance Facility will, together with the IMF and KfW, provide technical assistance to the DIFK to support preparation of, annual updates to and implementation of an institutional building plan to ensure compliance with Basel/IADI principles. KfW will also provide seed funding to the DIFK and the IMF is supporting the introduction of a new bank resolution framework. While the funding and partnership support provided by the US Treasury, KfW, IMF and the GoK is useful, the FSSMIP is not dependent on the same and may proceed independently of such funding and support. C. PROCUREMENT 30. A procurement capacity assessment of the CBK to undertake necessary procurement actions under the AF was conducted using the web-based Procurement Risk Assessment Management System (P-RAMS). At the project level, the CBK has acquired some procurement experience under the Original Project thus far. However, procurement under the additional financing is of a more complex nature involving International Competitive Bidding (ICB), which requires a relatively high degree of technical capacity, particularly with respect to procurement 8 of the IT inputs. Given that the Project coordinator is relatively new, and the procurement officer’s experience on Bank procurement requirements is still modest, the CBK was found to have only limited experience and knowledge for the preparation of the technical requirements and Bidding Documents (BDs) for the RTGS IT package under the AF. This in turn could lead to delays in bidding process/contracting. Moreover, there is some concern that potential interference by officials in the procurement process, including selection and contract award, may negatively impact project implementation. 31. In view of the above assessment, and to avoid procurement delays and potential political interference in the tendering process, the following mitigation measures have been agreed upon: (a) an international IT expert will be hired to support the CBK in the procurement of RTGS main IT system; in particular, the consultant will help with BDs preparation (including technical specifications/functionality) in the evaluation process, and also during delivery and acceptance of the IT system. The process of preparation of ToRs will commence prior to effectiveness of the Project however the IT expert only needs to be on hired prior to evaluating the technical requirements and preparing the bidding documents for procurement under the RTGS component; (b) IDA will continue to conduct prior reviews of all contracts (as is the case under the current Original Project); (c) the World Bank's procurement specialists will conduct regular and need based training in World Bank's procurement policies and procedures; (d) regular support, guidance, and supervision by the World Bank's procurement specialist during project supervision; and (e) a procurement plan covering the first 18 months of the project implementation has been prepared and will be discussed and approved by IDA. 32. Procurement Risk and Mitigation Measures: The overall project risk for procurement is high before mitigation measures, and with the agreed mitigation measures described above, the residual risk for procurement is judged to be substantial. The table below summarizes the project procurement risks, the mitigation measures proposed and the oversight and monitoring arrangements for procurement. Table 4: Procurement Risk and Mitigation Measures Procurement Risks Mitigation Measures Mitigation Measures Mitigation Measures during Preparation by Effectiveness during Implementation Modest procurement The CBK procurement Prepare ToRs for an Hiring of IT expert to be capacity within the officer will continue to information technology done prior to evaluating CBK and inadequate increase his expert, to assist the the technical knowledge of Bank’s procurement knowledge CBK in evaluating the requirements and procurement and in current FSSMIP technical requirements preparing the bidding consultant guidelines. Project. and preparing the documents for Lack of capacity on bidding documents for procurement under the IT/technical side of the RTGS IT system. RTGS component respective IT (component 4) of the department for Project. Regular and ad- preparation of technical hoc training in the specifications/ Bank’ procurement functionalities for policies and procedures RTGS main IT package. by the Bank’s Procurement Specialist 9 (PS). Project coordinator and procurement officer to attend procurement training offered. The CBK does not have Prepare draft Update the detailed Implementation of the a procurement planning procurement plan. procurement plan for procurement plan will process. the first 18 months of be closely monitored by the Project. the Bank’s task team. Regular support, guidance, supervision by the Bank’s procurement specialists during the project implementation. Potential interference by Assurance that no Follow up closely and Follow closely through officials in the interference in discuss anticorruption prior and post review of procurement process, procurement and guidelines and include contracts to be alerted of including selection and agreement on who will provisions related to any red flags. contract award. sign the contract. disclosure of conflict of interests, code of ethics for evaluation committee. 33. Applicable Guidelines: Procurement for the proposed Project will be carried out in accordance with the World Bank’s "Guidelines: Procurement under IBRD Loans and IDA Credits" published in May 2004 and revised in October 2006 and May 2010 (Procurement Guidelines); and "Guidelines: Selection and Employment of Consultants by World Bank Borrowers" published in May 2004 and revised in October 2006 and May 2010 (Consultant Guidelines); and the provisions stipulated in the Financing Agreement (FA). D. FINANCIAL MANAGEMENT 34. Financial Management Arrangements. The ongoing Original Project is implemented by the CBK. The project implementation team comprises of staff of the CBK supported by a local financial management consultant located at the Grant Unit within the Ministry of Finance. There are no outstanding interim financial reports or audit reports under the ongoing Original Project. Although the existing financial management arrangements for the implementation of the Original Project are considered adequate, the scaled up FSSMIP comprises more complex components including establishment of a payment system, business continuity center, and seed funding to the DIFK. These components will be subject to the World Bank financial management requirements, including satisfactory financial control mechanism and independent financial audit1. To mitigate fiduciary risk that credit proceeds will not be used for purposes intended, and to further strengthen existing financial management arrangements, disbursement conditions as outlined in paragraph 26 have been established. 1 OP/BP 10.02 – Financial Management 10 35. Overall financial management risk has been assessed as substantial before mitigation measures and moderate after mitigation measures. Specifically for component 6, in addition, there is a fiduciary risk related to the short implementation period that may not be sufficient to allow for the FM arrangements to be tested and therefore provide assurance that funds will not be diverted from their intended purpose after the closing date. In addition, US$4 million allocated to the DIFK component will be disbursed up-front, therefore, even during the term of the Project, conventional remedies such as suspension (of future disbursements) will have little value in case of a breach by the Recipient. It is likely that the funds disbursed from the IDA credit will not be "used" by project Closing Date, unless there is a financial crisis, and depositors’ payout takes place. This risk is mitigated by ensuring the DIFK has a strong and effective governance structure and oversight mechanisms in place by effectiveness, in addition to the annual audit and public disclosure of its financial statements beyond closing date. Additionally there are a number of post project closing measures including right to audit after project closing which are detailed in section E below (paragraphs 42-45). 36. The CBK’s legal framework as defined in the “Law on the Central Bank of the Republic of Kosovo”, July 2010, provides a high degree of autonomy to the CBK, with principal objective to foster and maintain a stable market based financial system, including a safe, sound and efficient payment system and management of official international reserve. Based on the IMF Safeguard Assessment of CBK dated November 4th, 2010, the legal structure and independence, financial reporting framework, internal audit mechanism, system of internal controls, external audit by independent auditors are considered adequate, and place reliance on use of the CBK’s systems and controls for implementation of the proposed scaled-up Project. 37. As far as fiduciary arrangements in the DIFK are concerned, the DIFK will de-facto rely on the CBK for fiduciary arrangements. All DIFK’s back office functions will be outsourced to the CBK upon payment of a reasonable fee. Moreover, the DIFK will adopt HR, financial management and procurement procedures of the CBK (see disbursement conditions in paragraph 26). Finally, the DIFK will have two accounts established with the CBK (one account for the operational expenses of the DIFK and one for the deposit insurance fund). 38. Disbursements and Auditing Arrangements. The World Bank Group disbursement procedures for loan/credit proceeds will be followed. The additional financing Credit proceeds for the establishment of the Business Continuity Center and the establishment of RTGS system components will be disbursed under existing arrangements for the Original Project whereby the GoK pre-finances all project expenditures and requests reimbursements from IDA. Direct method of disbursement for large contracts will also be available. Regarding disbursements into the DIFK, a one-time up-front deposit will be made from the Credit Account through the Ministry of Finance to a segregated Deposit Account maintained at the CBK. Such disbursement will not be supported by invoices on expenditures incurred. Both the project financial statements and the DIFK will be audited annually by independent auditors. 39. Under the World Bank’s operational policies 12.00 and 6.00, the World Bank may advance loan proceeds into an account that is held in a financial institution acceptable to the World Bank and operated on terms and conditions acceptable to the World Bank to finance eligible expenditures as they are incurred. Since the capitalization of the DIFK is an eligible expenditure, up-front disbursement for the DIFK is financing an expenditure as it is actually 11 incurred and meets the requirements under the World Bank’s policies. The funds will pass through the Ministry of Finance and credited to the DIFK account at the CBK. Therefore, the financing for this component can be advanced accordingly. 40. Financial covenants for the FSSMIP will include:  Maintenance of a financial management system and preparation of project financial statements in accordance with consistently applied accounting standards acceptable IDA, adequate to reflect the operations, resources and expenditures related to the Project.  Annual audit of the project financial statements and of the DIFK carried out by an independent auditor, and under terms of reference acceptable to IDA. The audit reports will be submitted to IDA no later than six months after the end of period audited.  The Recipient will make the annual audited financial statements of the Project publically available in a timely fashion.  The Recipient shall prepare and furnish to IDA not later than forty five (45) days after the end of each calendar quarter, interim unaudited financial reports for the Project covering the quarter, in form and substance satisfactory to IDA. 41. Financial covenants specifically for component 6 (Provision of seed funding to the DIFK) are as follows:  The Recipient shall, at all times, ensure that the DIFK maintains governance arrangements and a financial management system adequate to reflect the operations, resources and expenditures of the DIFK, both acceptable to IDA.  The Recipient shall, at all times, ensure that the DIFK: (i) prepares and maintains annual financial statements in accordance with consistently applied accounting standards acceptable to IDA; (ii) has such financial statements annually audited by independent auditors in accordance with consistently applied auditing standards; (iii) prior to the Project Closing Date, makes such audited financial statements publicly available and furnishes to IDA copies of such audited financial statements not later than six months after the end of the financial year; (iv) after the Project Closing Date, makes such audited financial statements publicly available within one month of such reports becoming available and furnishes to IDA, upon its request, copies of such audited financial statements, as IDA may require; (v) performs a special audit upon IDA’s request, and makes the reports and findings of such special audit available to IDA; and (vi) if a payment under the Deposit Insurance Scheme is made out of the DIFK Fund to an entity, provides to IDA, at IDA’s request, evidence that the payment was made on account of an Insured Event. 12 E. POST PROJECT SAFEGUARDS FOR COMPONENT 6 (PROVISION OF SEED FUNDING TO THE DIFK) Closing Assessment 42. The Recipient shall review and assess with IDA no later than March 30th, 2014, the operations of the DIFK and the Deposit Insurance Scheme (the “Closing Assessment”). In making the Closing Assessment, the following factors will be considered: (i) the governance arrangements for the DIFK are satisfactory to IDA; (ii) the financial management system of the DIFK is satisfactory to IDA; (iii) the DIFK and the Deposit Insurance Scheme are operating in accordance with the provisions of the DIFK Legislation and the Financing Agreement; (iv) the DIFK, in the opinion of IDA, has sufficient resources for the continued operation of the Deposit Insurance Scheme and the GoK transferred a minimum of €3.3 million resources to the DIFK (other than the IDA contribution under component 6); (v) the DIFK’s audit reports are unqualified; (vi) the DIFK has adopted by-laws and an operating manual satisfactory to IDA; and (vi) any other factors considered relevant by IDA. The goal will be to ensure that Kosovo is complying with international best practices as identified in the Basel/IADI Core Principles for Effective Deposit Insurance and that the DIFK has robust fiduciary management and governance systems that make it sustainable in the long run. 43. As part of the Closing Assessment, IDA may require the Recipient, in consultation with the CBK and the DIFK, to:  no later than April 30th, 2014, prepare a plan (the “Plan”) designed to ensure the continued achievement of the DIFK’s objectives, and the continued operation of the DIFK and the Deposit Insurance Scheme; and  afford IDA a reasonable opportunity to exchange views with the Recipient on the Plan. The Recipient shall immediately repay into the Credit Account for cancellation an amount equal to the proceeds of the Credit provided by IDA under component 6 of the Project, if the Closing Assessment or the Plan is, in the opinion of IDA, unsatisfactory. After Project closing and until the IDA credit is paid in full, the Recipient would maintain a strong and effective governance structure, strong oversight arrangements and fiduciary arrangements. 44. The Recipient will, after closing date, continue to make the annual audited financial statements of DIFK publically available through publishing or posting on its website within one month of receipt of such reports from the auditors. 45. IDA reserves the right to conduct a special review/audit of the DIFK in the event that IDA becomes aware of any irregularities subsequent to the closing date. F. ENVIRONMENT AND SOCIAL 46. Project Components 1, 2, 3, 4 and 6 will have no impact on the environment. Project component 5 (and in particular the renovation of the building that will host the business 13 continuity center) is likely to have minimal or no adverse environmental impacts. No World Bank environment or social safeguards policies are triggered. Therefore, the Project has been assigned a Category ‘C’ in accordance with the World Bank safeguard policy OP/BP/GP 4.01 (Environment Assessment). Even though there are no requirements to produce an EMP or an Environmental Assessment for the small-scale renovation of select areas of the Central bank of Kosovo building, a simple Environmental checklist has been prepared and will be included in the bidding documents for the renovation works and the contractor would need to fill that out. The checklist will also be disclosed on the renovation. Beyond initial screening and completing the checklist, no further environmental due diligence is required. G. IMPLEMENTATION ARRANGEMENTS 47. Under the Original Project the PMT was established within the CBK. The team is responsible for overall project management, coordination and procurement. Under the Original Project the PMT included representatives from the CBK, KBA and AMIK. The implementation arrangements remain the same under the additional financing. However, reflecting the design of the additional financing, the PMT will now comprise only two members from the CBK (Head of the Payment Systems, and the current PMT head), and the Director of the DIFK. 48. The PMT will continue to interact closely with the Grant Unit of the Ministry of Finance, which will remain responsible for financial accounts and management of the FSSMIP. In collaboration with the Grant Unit the PMT will be responsible for ensuring that the Project establishes and maintains: (i) adequate accounting systems and procedures; (ii) flow-of-funds mechanisms facilitating timely disbursement of funds and timely payments for goods, works and services; (iii) regular reporting on the use of funds; and (iv) appropriate arrangements for regular financial audits. Same as under the Original Project, all activities will be coordinated by the PMT and the PMT will be responsible for implementing planned technical assistance activities and collecting and reporting progress to IDA. In addition for component 6 (Provision of seed funding to the DIFK), there are special arrangements for implementation and they are referred in detail in section D above. For Component 4, the RTGS working group will assist the PMT in preparing the bidding documentation for procurement and implementation under the component. The PMT and the Grant Unit have experience with financial management under Bank-financed projects and have established sound internal control mechanisms on the application and use of funds. As an additional condition for effectiveness of the Financing Agreement, an inter-agency agreement between the Ministry of Finance and the CBK will be signed for the implementation of the Project which will set out the roles and responsibilities of the respective entities and their obligations vis-a-vis each other in relation to the Project. 14 ANNEX 1: RESULTS FRAMEWORK AND MONITORING KOSOVO: FINANCIAL SECTOR STRENGTHENING AND MARKET INFRASTRUCTURE PROJECT Results Framework Revisions to the Results Framework Comments/ Rationale for Change PDO Current (PAD) Proposed The objective of the Project is to To enhance the stability and Revised to reflect the outcomes of enhance the stability and development of development of the financial sector; the new activities added under the Kosovo’s financial system by supporting and strengthen the financial sector’s additional financing including stronger prudential regulation and underlying market infrastructure. establishment of the RTGS for supervision by CBK for banks and non delivery of financial services, bank financial institutions, supporting establishment of a BCC to reduce the institutional strengthening of CBK, the impact on the financial sector in and strengthening the banking and the event of a disaster, and microfinance industry through capacity establishment of the DIFK to building. increase confidence in and stability of the financial sector. PDO indicators Current (PAD) Proposed change* Component 1 Revised Status of updated legal and regulatory The two original indicators will be (i) Development by the CBK of a framework for banks and NBFIs and merged into one to better monitor supervision plan for each of Kosovo’s capacity building in the financial progress towards revised PDO. main banks and the implementation of sector. such plans; (ii) Development by the CBK of an ongoing supervision plan for insurance companies and for pension funds and the implementation of such plans. Component 4 Status of operationalization of RTGS. Additional indicators to reflect the new activities added under the additional financing including Component 5 Status of establishment of a fully strengthening the national payment operational BCC. systems, establishing the BCC and operationalization of the DIFK to increase confidence in and stability Component 6 Status of establishment of the DIFK. of the financial sector. Intermediate Results indicators Current (PAD) Proposed change* Banking Preparation of a Revised: Sector development strategy The formulation of these indicators for the CBK including Number of missing and/or outdated has been modified to reflect the options to ensure regulations and directives drafted for restructuring of the original Project. access by the CBK to banks and NBFIs, which have been long term resources passed recently or to be passed over 15 Revisions to the Results Framework Comments/ Rationale for Change and including the life of the Project. incentives to limit staff attrition. Automated tool for offsite supervision Establishment and use acquired and implemented. by the CBK of a regulatory reporting Number of the CBK staff trained in data base for banks using analytical tool and regarding and insurance new regulations. companies. Improved regulatory reporting by banks and non banks to the CBK. Production of improved stability reports and bank analyses by the CBK. Preparation and execution of supervisory strategies for key banks. Insurance In-going supervision Sector and claims management strategy prepared. Detailed assessment of the TPL tariff liberalization carried out. Actuarial assessment of life insurance carried out. Insurance market report publication covering quantitative and qualitative information on each insurance company and the market. On-site and off-site manuals finalized and in use. Pension Review and Funds and preparation of other NBFI necessary draft amendments to regulations and rules for the licensing and risk-based supervision of private pension funds (Pillar II and Pillar III). Microfinance Provision of at least Revised: Number of training sessions The formulation of this indicator Sector one training session to to MFIs in transforming into deposit- has been refined. 16 Revisions to the Results Framework Comments/ Rationale for Change each MFIs taking institutions and to other MFIs transforming into deposit-taking institutions and to other MFIs. Preparation of a MFI impact assessment. Provision of training Revised and modified: Number of The formulation of this indicator KBA sessions to bank training sessions to bank officers and has been refined and simplified. officers on training KBA staff on banking sector topics assessment need methodologies focusing on small banks and to the KBA’s trainers on advanced banking sector topics based on bank training need assessment. Payment New Additional indicator reflecting a Systems new activity added under the Status of operational integration of additional financing. There is a the RTGS system with the existing critical need to develop a modern Electronic Interbank Clearing System and low cost payment infrastructure (EICS). in Kosovo by establishing the RTGS in line with EU standards Status of operational integration of and BIS/CPSS and IOSCO the RTGS system with the Central Principles and Recommendations. Securities Depository (CSD). Percentage of transactions in GoK and CBK securities settled in the RTGS system in conformity with the principles of Delivery versus Payment (DvP). Percentage of payments settled immediately or with a short delay(< 15 minutes). Business New Additional indicators reflecting a Continuity new activity added under the Center Status of completion of refurbishment additional financing. There is a of the BCC facility. critical need to establish a BCC which will protect the data of the Percent failover from the CBK’s CBK in the event of a disaster and primary processing site to the BCC, align Kosovo with EU standards. and restoration back to the primary site, successfully demonstrated for all . the CBK’s critical systems. Number of regular failover exercises 17 Revisions to the Results Framework Comments/ Rationale for Change conducted on a quarterly basis per year Deposit New Additional indicators reflecting a Insurance new activity added under the Fund Amount contributed from the additional financing. There is a Government to the DIFK critical and urgent need to establish the DIFK, which will insure payout Premiums from the member banks of insured depositors in the event of received a bank failure. The creation of the fund is also a requirement for EU accession. * Indicate if the indicator is Dropped, Continued, New, Revised, or if there is a change in the end of project target value. 18 ANNEX 2. REVISED PROJECT RESULTS FRAMEWORK Project Development Objective (PDO): To enhance the stability and development of the financial sector; and strengthen the financial sector’s underlying market infrastructure.   Baseline Cumulative Target Values5 Original Progress Responsibility 2012 2013 2014 Data Source/ PDO Level Results Indicators2 UOM3 Project To Date Frequency for Data Comments Core Methodology Start (2011)4 Collection (2008) 1. Status of updated legal and regulatory framework for banks Non Partially Partially Partially Text Achieved 6 monthly CBK PMT and NBFIs and capacity building existent Achieved Achieved Achieved in the financial sector Payments 2. Status of operationalization of Non Achieved Text NA In progress In progress 6 monthly CBK Group/ PMT RTGS existent (CBK) Business 3. Status of establishment of a fully Non Achieved continuity Text NA In progress In progress 6 monthly CBK operational BCC existent Mgmt. team (CBK) 4. Status of establishment of the Non DIFK text existent NA Operational Operational Operational One time CBK DIFK/PMT 2 Please indicate whether the indicator is a Core Sector Indicator (for additional guidance – please see http://coreindicators). 3 UOM = Unit of Measurement. 4 For new indicators introduced as part of the additional financing, the progress to date column is used to reflect the baseline value. 5 Target values should be entered for the years data will be available, not necessarily annually. Target values should normally be cumulative. If targets refer to annual values, please indicate this in the indicator name and in the “Comments” column. 19 Intermediate Results and Indicators Baseline Target Values Unit of Original Progress To Responsibility 2012 2013 2014 Data Source/ Intermediate Results Indicators Measur Project Date Frequency for Data Comments Core Methodology ement Start (2011) Collection (2008) Intermediate Result 1: Number of activities completed related to improvement of banks and NBFIs’ legal and regulatory framework and training held 1. Number of missing and/or outdated regulations and directives Framework Work plan 1st set of 2nd set of drafted for banks and NBFIs new developed to for key key Project Bi- laws, which have been passed # None lay base for upgrading regulation regulations annually Progress PMT/CBK recently or to be passed over the legal regulations s to be to be Reports modernization adopted adopted adopted life of the Project Off-site Off-site Staff 2. Automated database for offsite database for supervision trained Project TORs Software monitoring Bi- supervision acquired and Text database is developed acquired and and analysis annually Progress PMT/CBK implemented non database Reports used in day existent gone live to day work 3. Number of the CBK staff trained 10% of 50% of 100% of Project Bi- in using analytical tool and # NA NA supervisors supervisor supervisors annually Progress PMT/CBK regarding new regulations trained s trained trained Reports 4. Number of training sessions to Project MFIs in transforming into deposit- Bi- # 0 6 0 0 0 Progress AMIK Target achieved taking institutions and to other annually Reports MFIs 5. Number of training sessions to Project Target achieved Bi- bank officers and KBA staff on # 0 7 0 0 0 annually Progress KBA banking sector topics Reports Intermediate Result 2: Operationalization of RTGS 6. Status of operational integration of the RTGS system with the Payments Non In Bi- existing Electronic Interbank Text existent NA In progress progress Achieved annually CBK Group/ PMT Clearing System (EICS) (CBK) 20 Intermediate Results and Indicators Baseline Target Values Unit of Original Progress To Responsibility 2012 2013 2014 Data Source/ Intermediate Results Indicators Measur Project Date Frequency for Data Comments Core Methodology ement Start (2011) Collection (2008) 7. Status of operational integration Payments of the RTGS system with the Non In Bi- Text NA In progress Achieved CBK Group/ PMT Central Securities Depository existent progress annually (CBK) (CSD) 8. Percentage of transactions in GoK and CBK securities settled in RTGS system Payments the RTGS system in conformity Should always be % 0 0 0 0 100 Daily operating Group/ PMT with the principles of Delivery 100%. statistics (CBK) versus Payment (DvP) 95% of payments 9. Percent of payments settled should be settled Daily, RTGS system Payments immediately or immediately or with a short delay % 0 0 0 0 95 monthly, operating Group/ PMT with a very short (< 15 minutes) annually statistics (CBK) delay (< 15 minutes) Intermediate Result 3: Establishment of a fully operational BCC Business Bi- 10. Status of completion of Non continuity Text NA In progress Achieved Achieved annually CBK refurbishment of the BCC facility existent Mgmt. team (CBK) 11. Percent failover from the CBK’s primary processing site to the BCC, and restoration back to Non Bi- the primary site, successfully % existent NA NA NA 0 annually CBK CBK/PMT demonstrated for all CBK’s critical systems 12. Number of regular failover CBK As required under Non responsible exercises conducted on a quarterly # existent NA NA NA 4 Quarterly operating CBK/PMT operating policy basis per year of CBK units 21 Intermediate Results and Indicators Baseline Target Values Unit of Original Progress To Responsibility 2012 2013 2014 Data Source/ Intermediate Results Indicators Measur Project Date Frequency for Data Comments Core Methodology ement Start (2011) Collection (2008) Intermediate Result 4: Establishment of the DIFK € 3.3 13. Contributed amount from GoK (m) 0 0 0 0 3.3 One time DIFK PMT/CBK 14. Premiums received from Bi- text NA NA Yes Yes Yes DIFK PMT/CBK member banks annually 22 ANNEX 3: KOSOVO FINANCIAL SECTOR SNAPSHOT THE BANKING SECTOR 1. As of December 2010, Kosovo’s financial sector is composed of 8 private commercial banks, 11 insurance companies, 2 pension funds, 17 microfinance institutions and 29 financial auxiliaries. Banking sector assets represent by far the bulk of the financial system, representing 76.5 percent of the total assets of the financial sector as of December 2010. The banking sector is dominated by foreign banks both in terms of number (six out of eight) and in terms of assets (89.8 percent). The sector is highly concentrated within the three largest banks (foreign) holding about 78.9 percent of total banking sector assets as of June 2010 (down from 82.8 percent in June 2009). Pension funds have a market share of about 16 percent while insurance companies and microfinance institutions represent a mere 3.2 percent and 4.1 percent respectively of the total financial sector assets (Table 1). Table 1: Basic Indicators of the Banking System 2008 2009 2010 Number of Banks 8 8 8 Number of Foreign Banks 6 6 6 % of total Financial Sector Assets 79.9% 78.1% 76.5% Number of Insurance companies 12 11 11 % of total Financial Sector Assets 3.6% 3.2% 3.2% Number of Pension Funds 2 2 2 % of total Financial Sector Assets 11.9% 14.2% 16.2% Number of Microfinance Institutions 16 19 17 % of total Financial Sector Assets 4.5% 4.6% 4.1% Bank Asset/GDP 46.3% 55.3% 56.7% Assets Growth y/y 26.9% 21.5% 11.2% Deposit Growth y/y 27.9% 21.4% 10.2% Credit Growth y/y 32.7% 8.9% 13.2% Source: CBK 2. The international financial crisis has had only a modest impact on Kosovo’s financial sector and has been limited to a slowdown in credit growth and a deterioration of the quality of the credit portfolio. In 2009, loans grew by 8.9 percent, compared to a 33 percent increase in 2008. Credit growth started picking up again in 2010 (13.2 percent increase). The Non- performing loan (NPL) ratio has almost doubled from 4.7 percent in 2008, to 8.0 percent at end 2010 (Table 2). In particular, NPLs for foreign banks rose sharply from 4.5 percent to 8.0 percent whilst for local banks the ratio increased from 7.0 percent to 8.0 percent during the same period. As a result, profitability of the banking system has declined in 2010 with a ROA of 1.7 percent and a ROE of 16.5 percent compared to 2.4 percent and 20.2 percent respectively in 23 2008. Furthermore, net interest margins decreased to 6.4 percent in 2010 (from 8.9 percent in 2008) due to increasing competition. Although the quality of the loan portfolio has deteriorated and profits have decreased, capital adequacy for the system remains above the required 12 percent level. Table 2: Key Prudential Indicators of the Banking System 2008 2009 2010 Liquidity Liquid assets to short term liabilities 56.9% 54.1% 63.6% Liquid assets to total assets 30.0% 39.4% 37.3% Capital Adequacy Regulatory capital to risk-weighted assets 16.7% 17.9% 18.9% Capital to Assets 11.7% 9.8% 10.1% Asset Quality NPLs (above 60 days)/ loans 4.7% 6.6% 8.0% Past due loans (above 30 days)/ loans 1.9% 3.5% 2.1% Provisions/ NPLs 97.0% 92.1% 81.4% Earnings and Profitability ROA 2.4% 1.4% 1.7% ROE 20.2% 12.8% 16.5% Source: CBK THE INSURANCE SECTOR 3. As of December 2010, the number of insurance companies operating in Kosovo is 11, including eight foreign-owned representing almost 80 percent of the total assets of the insurance industry. The insurance sector has been expanding its activities since 2007 and now stands at €90 million representing an annual growth of 20.1 percent. The number of policies sold by insurance companies has been increasing on average by eight percent on annual growth in the past two years. The amount of premiums received by insurance companies has also grown by almost five percent annually. 4. The main business of insurance companies continues to be Third Party Liability Insurance (TPL), whose premiums represent roughly 2/3 of the total premiums received. The largest part of claims paid by insurance companies consist of claims paid on TPL policies (74 percent of total claims paid). The ratio of premiums received to claims paid has increased from 24.2 percent to 38 percent between June 2009 and June 2010. 24 Table 3: Selected Insurance Sector Indicators 2007 2008 2009 2010 Number of policies (contracts) sold by Insurance Companies 406,343 476,457 511,351 542,097 Growth of policies sold by insurance companies - 17% 7% 6% MTPL Gross written premium/Total Gross written premium 69% 63% 53% 56% Claims paid to MTPL/Total paid claims by insurance companies 83% 83% 64% 61% 25 ANNEX 4: DETAILED DESCRIPTION OF COMPONENTS 4, 5 AND 6 A. Establishment of an RTGS 1. For some time the CBK has operated an electronic interbank clearing system (EICS), to which all commercial banks are connected for the submission of interbank electronic payments. These payments include so-called priority payments, which are typically of high value and thus qualify as systemically important payments as defined by CPSS/BIS6. Priority payments are settled on an individual basis through the CBK’s general ledger, but on a deferred basis (i.e. not immediately). EICS clears all other incoming payments on a regular daily cycle (four times daily) and passes the resulting net figures to the CBK’s general ledger system for settlement. While EICS is efficient and effective in clearing payments, the deferred settlement arrangements are contrary to international best practice and BIS recommendations, and give rise to an element of systemic risk. 2. At present cash dominates as the medium of payment outside the government environment. This is partly due to a continuing distrust of banks, but also to high costs of using banks, and a lack of interoperability between banks’ electronic card networks (which support ATMs and EFTPOS terminals). Main non-cash instrument used by citizens are paper-based. Although they are cleared electronically by EICS, they require the payer physically to present the paper document and make the payment at a bank branch. International experience shows that the most effective ways to reduce payment costs are: (i) to move as far as possible to the use of electronic instruments and clearing and settlement systems; and (ii) to foster competition among banks. At present the lack of interoperability between card networks not only favors larger banks at the expense of smaller banks (thus promoting monopolistic behavior), but also discourages citizens from acquiring and using cards. 3. The introduction of the RTGS system will provide safe and efficient settlement of all systemically important payments including: (i) priority payments; (ii) net interbank positions arising from EICS clearing operations, and potentially other payment circuits as they emerge (e.g. national card switch); (iii) transactions in government securities; and (iv) interbank money market transactions. 4. The GoK is planning to commence the sale of securities to support its fiscal management and to stimulate the development of local capital markets. Under the Law on Public Debt, the CBK is the Government’s designated fiscal agent with responsibility for managing the issuance and custody of all government securities in dematerialised (non-paper) form. This will require the CBK to install and operate an electronic Central Securities Depository system to record all ownership details and transactions in the capital markets. The CSD system should be linked with the RTGS system to enable sales and changes of ownership of securities to be effected following the principles of Delivery versus Payment (DvP7). A close linkage between the RTGS and CSD systems will also facilitate the use of securities as collateral for the provision of intraday credit by CBK to RTGS participants, thus assisting in the smooth operation of the RTGS system. 6 See Core Principles for Systemically Important Payment Systems, available at http://bis.org/publ/cpss43.htm 7 DvP ensures that change of ownership occurs at the same time as transfer of funds, thus eliminating a number of risks associated with such transactions. 26 Development of the RTGS system, however, is not dependant on the pre existence of a CSD system. 5. The Kosovo Bankers’ Association is currently running a simple informational system for the interbank money market, under which banks with surplus liquidity can offer funds for sale and banks with a need for funds can gain information on what is available. The CBK is planning to examine and possibly extend the functionality of this system to include a trading platform on which deals can be struck. This Money Market System (MMS) would also be coupled with the RTGS system so that MMS deals can be settled following the principles of Payment versus Payment (PvP), which is analogous to DvP for dealing in funds. B. Establishment of a Business Continuity Center 6. The CBK already operates at least two mission-critical systems, the EICS and the core banking system, which maintains the CBK’s general ledger (including the settlement accounts of the commercial banks). If the main IT processing centre housing these systems were to become unavailable, for that time period, the CBK would be unable to process any interbank payments or to maintain its records of commercial banks. If the outage is a relatively minor one (24 hours) then the missed work could be caught up by working overtime. However, in the event of a serious disaster lasting several days, the only option available at present would be to revert to completely paper-based operations. This would be extremely risky, as it is unlikely that anyone in the banking community can remember how to operate without the electronic systems. It would also slow down business and government activities, and cause reputational damage to Kosovo in the international community. Needless to say, the foregoing will only be exacerbated once the planned CSD and RTGS systems are in operation. 7. The introduction of the above mentioned systems, coupled with the existing EICS, will provide Kosovo with a modern and world-class electronic payments infrastructure. The economy and the country as a whole will rapidly become dependent on the continuous availability of these systems. In order to assure continuous availability, the CBK will establish a stand-by computer processing site or Business Continuity Centre, which will contain a complete copy of the hardware, software and data for all critical systems, including the CBK’s general ledger system. In the event of any incident at the main site in the CBK’s head office, processing can be rapidly switched to the BCC to enable the systems to continue operating without loss of data while the incident is resolved. C. Provision of seed funding to the Deposit Insurance System for Kosovo 8. The objective of a deposit insurance system is to protect small depositors in the event of bank failure, i.e. when a bank’s license is revoked by the regulator. The existence of a credible deposit insurance system inspires confidence in a nascent financial sector and contributes to its growth. The recent financial crisis has also shown that credible deposit insurance schemes are critical to maintain public confidence in the banking sector during crisis. In recognition of its importance, the EU requires that candidate countries develop a deposit insurance scheme. 27 9. As a newly independent country, Kosovo did not have a deposit insurance scheme until late 2010. In October 2010 the Parliament of Kosovo passed the Law on “Establishment of a Deposit Insurance System for Financial Institutions in Kosovo” (# 03/L – 216) the “Law”; the Law became effective in December 2010. 10. The Law stipulates that the deposit insurance funds are administered by the DIFK. The latter is an independent legal entity with a management board composed of: the Governor of CBK, one representative of the Ministry of Finance, the director of the DIFK, an expert in the field of deposit insurance, and a certified auditor. Given the limited functions that the DIFK will perform, the entity will have only one employee, namely the director of the DIFK. All DIFK back office functions will be outsourced to the CBK for a nominal fee. Moreover, the DIFK will adopt all existing CBK regulations on human resources, procurement and financial management and will be subject to an annual audit by the same auditor of the CBK. 11. The DIFK has been established as an entity with the appointment of the Management Board, the approval of the TORs and selection process for the recruitment of the DIFK director, the opening of two accounts for the DIFK in the CBK (one account will be used for the DIFK operational expenditures and one for the DIFKs funds), and the appointment of an interim Director. 12. For the DIFK to become effective, the following needs to be achieved: (i) Approval by the Management Board of a directive on governance (management board decisions making process and structure of the DIFK); (ii) Approval by the Management Board of a directive adopting the human resources, financial management and procurement procedures of the CBK; (iii) Signing of a binding agreement between the DIFK and CBK on outsourcing of human resources, financial management and procurement functions to the CBK; (iv) Approval by the Management Board of a directive on payout form; (v) Approval by the Management Board of a directive on criteria for payee banks; and (vi) A decision by the Management Board that an amount equivalent to the IDA contribution (US$4 million) will be sufficient to initiate coverage of depositors. In addition material explaining coverage will need to be developed prior to the DIFK being effective. These will be included as disbursement conditions in the Financing Agreement. 13. Like any insurance business, a deposit insurance fund does not hold resources equivalent to the insured amounts. However, for a deposit insurance fund to be credible and inspire confidence in the population, it is crucial that a deposit insurance fund has some capital reserves to demonstrate ability to pay-out while banks pay regular premium in the deposit insurance funds, and then eventually become the main regular contributors, seed funding is required to begin with. The DIFK is expected to build reserves of approximately €15 million over time. DIFK funding will include premium from financial institutions, GoK contribution, and KfW grant capital of Euro 4.5 million. The GoK has allocated €3.30 million in the 2011 budget as seed funding for the DIFK. The budget passed the first parliamentary reading on March 25, 2011 and the second on March 31, 2011, the budget law was published in the official gazette on April 4, 2011 and is thus in force. There is also a proposed allocation for an additional €3.30 million in 2012 and €3.30 million in 2013. 28 14. As outlined in the Law, the resources of the deposit insurance fund are to be invested in highly liquid and safe securities. These include only securities of EU governments dominated in Euros. Additionally short term investments maybe in fixed income securities or debt instruments denominated in Euros issued by banks or companies with the highest ratings, defined as a minimum quality rating of “A1”, “P1”, “AA”, or “Aa”, as relevant. 15. The Law sets the amount of insured deposits to €2,000, an adequate amount for an incipient financial system. The deposit insurance scheme will become effective six months after the promulgation of the Law (i.e. in June 2011), unless the DIFK Management Board is not constituted or if the same determines that the resources in the DIFK are not sufficient. In light of the GoK appropriation in the 2011 budget and the IDA contribution it is very likely that the deposit insurance scheme in Kosovo will become effective in mid June 2011. Closing Assessment 16. The Recipient shall review and assess with IDA no later than March 30th, 2014, the operations of the DIFK and the Deposit Insurance Scheme (the “Closing Assessment”). In making the Closing Assessment, the following factors will be considered: (i) the governance arrangements for the DIFK are satisfactory to IDA; (ii) the financial management system of the DIFK is satisfactory to IDA; (iii) the DIFK and the Deposit Insurance Scheme are operating in accordance with the provisions of the DIFK Legislation and the Financing Agreement; (iv) the DIFK, in the opinion of IDA, has sufficient resources for the continued operation of the Deposit Insurance Scheme and the GoK transferred a minimum of €3.3 million resources in the DIFK (other than the IDA contribution under Component 6); (v) the DIFK’s audit reports are unqualified; (vi) the DIFK has adopted by-laws and an operating manual satisfactory to IDA; and (vi) any other factors considered relevant by IDA. The goal will be to ensure that Kosovo is complying with international best practices as identified in the Basel/IADI Core Principles for Effective Deposit Insurance and that the DIFK has robust fiduciary management and governance systems that make it sustainable in the long run. 17. As part of the Closing Assessment, IDA may require the Recipient, in consultation with the CBK and the DIFK, to:  no later than April 30th, 2014, prepare a plan (the “Plan”) designed to ensure the continued achievement of the DIFK’s objectives, and the continued operation of the DIFK and the Deposit Insurance Scheme; and  afford IDA a reasonable opportunity to exchange views with the Recipient on the Plan. 18. The Recipient shall immediately repay into the Credit Account for cancellation an amount equal to the proceeds of the Credit provided by IDA under component 6 of the Project, if the Closing Assessment or the Plan is, in the opinion of IDA, unsatisfactory. After Project closing and until the IDA credit is paid in full, the Recipient would maintain a strong and effective governance structure, strong oversight arrangements and fiduciary arrangements. 29 19. The Recipient will, after closing date, continue to make the annual audited financial statements of DIFK publically available through publishing or posting on its website within one month of receipt of such reports from the auditors. 20. IDA reserves the right to conduct a special review/audit of the DIFK in the event that IDA becomes aware of any irregularities subsequent to the closing date. 21. If it is determined that the funds are not utilized in the manner envisaged then IDA will ask the Government of Kosovo to return the funds disbursed to the DIFK under the overall Project, and the part of the Credit refunded to IDA will be cancelled. 22. Based on the above, the financing of this component of the Project is in accordance with World Bank policies and therefore no policy waivers are required for financing this component8. 8 A similar rationale was followed for Sri Lanka (P121328) – Crisis Response Small and Medium Enterprise Development Facility Project, India (P086518) – Small and Medium Financing and Development Project, Europe and Central Asia (P110910) - South East Europe and Caucasus Catastrophe Risk Insurance Facility. 30 ANNEX 5: SUMMARY PROCUREMENT PLAN 1. A tentative procurement plan for project implementation is prepared. The Bank will review and approve the plan by negotiations. This plan will be updated annually to reflect the latest circumstances. The procurement plan does not include the seed funding for the DIFK (in an amount of US$4.0 million), as there is no procurement. 2. Goods/Works Description Procurement Domestic Review Comments Method Preference by Bank (yes/no) (Prior/Post) Main IT package for RTGS software, Money Market software, ICB No Prior S&I of IT hardware, implementation and system services, Hardware for Business continuity center, Equipment (vault, security system, etc) Upgrade existing interbank clearing system, upgrade of SH/DC No Prior general ledger (*) Refurbishment of CBK owned building NCB No Prior Legend: International Competitive Bidding (in accordance with section 2 of the Guidelines) ICB = For works contracts valued at or more than > US$500,000 For goods contracts valued at or more than > US$100,000 National Competitive Bidding (in accordance with section 3.3 of the Guidelines) NCB = For works contracts valued less than < US$500,000 For goods : N/A LIB= Limited International Bidding (in accordance with section 3.2 of the Guidelines) Direct Contracting (in accordance with section 3.6 of the Guidelines) Note:*) In regard to the two contracts above for upgrade of existing interbank clearing system and for upgrading the DC= general ledger, the CBK will provide by negotiations (before project effectiveness) justification in regard to the direct contracting method they propose for these two contracts. If such justification will not be provided (or if the justification would not substantiate the direct contracting method), then the CBD should use shopping procedures. Shopping (in accordance with section 3.5 of the Guidelines) SH = For works and goods contracts valued at or less than < US$100,000. No Domestic Preference will apply. Prior review For Works contracts: All ICB contracts. First two contracts for NCB s regardless of value of contract. For Goods contracts: All ICB contracts. First two contracts for NCB s regardless of value of contract. Shopping: First two contracts Direct Contracting: All 31 3. Consultancy Services Description of Assignment Selection Review Comments Method by Bank (Prior/Post) Summary of number of contracts that will be let under IC method: IC Prior (i) Financial Management Expert, and (ii) IT expert to assist CBK for tendering process, delivery and take over and component management Training for PMT and CBK staff - Annual Plan Legend QCBS = Quality and Cost-based Selection (in accordance with sections 2.1 - 2.28 of the Consultant’s Guidelines) QBS= Quality Based Selection (in accordance with section 3.2 the Consultant’s Guidelines) FBS= Fixed Budget Selection (in accordance with section 3.5 the Consultant’s Guidelines) CQ= Consultants Qualifications (in accordance with section 3.7-8 of the Consultant’s Guidelines) contracts valued at or less than < US$200,000 LCS = Least-Cost Selection (in accordance with section 3.6 of the Consultant’s Guidelines) SSS= Single source Selection (in accordance with section 3.9-13 of the Consultant’s Guidelines) IC = Individual Consultant (in accordance with section V of the Consultant’s Guidelines) Prior Review For firms: All contracts equal to USD 50,000 or more. All SSS contracts. For individual consultants: All contracts equal to USD 25,000 equivalent or more. All SSS contracts and all TORs. 4. Post review and Frequency of Procurement Supervision: In addition to the prior review, implementation support mission to be carried out by the Bank team, the capacity assessment of the CBK recommends post reviews on at least one in five (20 percent) of the contracts subject to post review during the review period. Implementation support reports will include the findings of the Bank’s team in its post review. It is expected that an implementation support mission in the field will be conducted once a year during which post reviews will be conducted. 32 ANNEX 6. OPERATIONAL RISK ASSESSMENT FRAMEWORK (ORAF) Project Development Objectives    The objective of the project is to enhance the stability and development of the financial sector; and strengthen the financial sector’s underlying  market infrastructure.    PDO Level Results Indicators:      1. Status of  updated legal and regulatory framework for banks and NBFIs and capacity building in the financial sector  2. Status of  operationalization of RTGS  3. Status of establishment of a fully operational BCC  4. Status of establishment of the DIFK    Risk    Risk Category  Risk Description  Rating  Proposed Mitigation Measure  Project Stakeholder  Medium L  Delays in approval of project by the  The CMU and the task team will work closely with the  Risks   Parliament.  Parliament to inform on the importance of the project.  Medium I   The CBK’s limited capacity in project  Based on the procurement team’s discussions with CBK and  implementation, and especially in the  their recommendations, CBK will hire an international expert  preparation of technical and bidding  to assist CBK on specs and bidding documents preparation.  documents for complex procurement  The task team will continue an active dialogue.   packages, constitutes a risk for    implementation.   The Task team has already provided assistance to CBK for the    preparation of vision documents and assistance is ongoing for  Implementing Agency    a legal infrastructure for payment systems. In addition, there  Risks  has been a wide range of capacity building initiatives with the  help of the existing project, through FIRST grant, IMF support  and the Balkan TA facility.    The newly appointed Governor of CKB (in April 2011) and his  team are committed to a successful implementation of the  project.  Project Risks      Medium I  The project design is simple, but includes  Work has been already initiated on the major component  Design  activities (Payment System) with large  (Payment Systems) and CBK team is learning how to put    contracts to be awarded on an international  together: (i) bidding documents, (ii) ICB procurement method  33 competitive bidding. Thus, cumbersome  including evaluation, and contract award process.  procurement processes for this component  For the DIFK a number of safeguard both before during and  could constitute a risk for project  after implementation have been proposed and covered in the  implementation.  An additional project risk  legal documents to ensure proper use of IDA funds  is upfront disbursement for the DIF K  component.   Low  There are no social or environmental  The team will undertake consultations and review procedures  Social & Environmental  impact risks.  as necessary.      Low  The risk for lack of coordination among  Continued dialogue among donors and regular consultations  donors is low as there is wide ownership of  especially with the US Treasury, as they are helping Kosovo in  this project in the donor community.  issuing Government Paper by financing a depository system.   Program & Donor      KFW is providing Eur. 4.5 million in seed capital for the  Deposit Insurance Fund (DIF), and the IMF is also reviewing  the DIF law and institutional set up. Both donors are actively  engaging with the Bank.  Low  The improved project designed for  As additional financing is processed, current project  Additional Financing, including focused  indicators will be streamlined.  results indicators, should ensure an    adequate delivery quality. However, since  The original FSTA project is one piece of Bank’s spectrum of  Delivery Quality  this is an additional financing (rather than  a  support to the financial sector. Through the Balkan TA facility    new operation), it does not get the same  and 2 FIRST grants, the Bank has worked with the CBK on  all  level of preparation budget, which could  the proposed components and thus has had adequate  impact quality.  resources to prepare.    Overall Risk Rating at  Overall Risk Rating During  Comments  Preparation  Implementation    The preparation and implementation risk ratings are    high. This is based on the assessment that: the existing    project is much smaller than the proposed AF ($2    million versus proposed $6.85 million);  poor  High  High  disbursement rates under existing project; weak  capacity to implement complex IT procurement;   political instability; and corruption and governance  risks. 34