CASE STUDIES IN DONOR GOOD PRACTICES No. 13 June 2004 Collaboration for Post-Conflict Rebuilding and Financial System Development: European Donors with KfW Leadership in Southeastern Europe by Ann Duval with Ruth Goodwin-Groen This case study describes how European donors' strategy for post-conflict rebuilding helped develop the financial system in Southeastern Europe, through funds managed by Kreditanstalt für Wiederaufbau (KfW). Overview donor representative in the region to tap significant Since the late 1990s, several European donors have sources of lending capital and technical assistance, worked together to provide long-term lending capital and instead of individually approaching up to eight different technical assistance to financial intermediaries in donors. Southeastern Europe as part of their post-conflict recon- struction efforts. By 2003, these donors--which grew to Setting the stage include the European Union (via the European Commis- By the end of the war in BiH in late 1995, the economy sion and the European Agency for Reconstruction was failing, most of the infrastructure had been [EAR]), the Netherlands Development Finance Company destroyed, and over two million people had become (FMO), and the Austrian, Swiss, and German refugees abroad or were displaced internally. In early governments--had collectively committed over 110 1996, the international community launched a US $5.1 million euros to the banking sector in the region. Under billion, five-year rebuilding plan for the country--the the leadership of KfW, they forged a common vision for largest reconstruction effort in Europe since the end of developing strong financial intermediaries, delegated World War II. EU member states agreed that one of the fund management to KfW, and harmonized lending terms most pressing needs was for housing to support the return and reporting requirements. of refugees and displaced persons. However, many believed grants were the best instrument for housing KfW's technical know-how as a development bank, projects to spur housing development. including its experience in product design and commer- cial partner selection, made it a suitable technical partner "There were so many organizations--bilateral donors, to manage the lending programs. Individual donors multilateral donors and NGOs --working in an isolated way signed management agreements with KfW, giving it the with no coordination. Also, we felt that many donor programs were eroding the financial sector through subsidies and authority to administer all donor funds. KfW was also grants. We . . . thought it must be possible to create a responsible for selecting local lending institutions, program that would coordinate donor financing in order to monitoring their performance, and (via separate funding bridge the housing gap and to strengthen the banks." arrangements) contracting technical assistance. Klaus Glaubitt, Chief, Private and Financial Sector Development Division, KfW. The collaborative effort, often referred to as the European Funds, has had far greater impact than any one donor Concerned about the negative impact that subsidies and could have achieved alone, in terms of strengthened local grants could have on the viability of the financial system, lending institutions, increased outreach, and market KfW designed a program to offer housing loans through development. The accomplishments in Bosnia and local partner banks at near-market conditions. It then Herzegovina (BiH), Montenegro, Kosovo, and Serbia sought donors to finance the program. In 1998, the EU have been significant: At the end of 2003, 26 local provided the first 15 million euros for the Housing Loan lending institutions had been strengthened with more than Program (HLP) as a "revolving grant," with a clear 14,000 loans outstanding to micro, small, and medium mandate to KfW to administer the program on their entrepreneurs. Local banks and MFIs now work with one behalf. The Dutch FMO became a donor to the program Page 2 A DIRECT Case Study in 2001, and the German government followed in 2002. In 2001, the Swiss government provided initial financing Under the HLP, KfW selected and signed loan agree- to launch a credit line for yet another sector, rural ments with local banks to provide them long-term loans development. KfW established the Rural Lending at near-market rates. The banks used the capital to on- Program (RLP) in BiH, to which the EU began to lend to clients at their own risk. Long-term funding contribute in 2002. coupled with technical assistance to the banks in designing appropriate housing loan products ensured that Moving into new areas. Building on the experience in low-income clients had access to much-needed, sustain- BiH, in 2000, KfW began creating similar programs to able sources of credit. promote financial intermediaries in other post-conflict areas in the region. Widening Donor Collaboration--New Sectors, · Montenegro: KfW launched an SME fund with New Countries Austrian government financing. Within two years, it Expanding into new sectors . In addition to meeting the was managing 15 million euros (on behalf of the urgent reconstruction needs, BiH faced many other EAR and the German, Austrian, and Swiss challenges to ensure its economic recovery and develop- governments) for both SME and rural lending. ment. In response, KfW began to design a program to · Kosovo: KfW initially channeled funds from EBRD, support small and medium enterprises (SMEs) through FMO, and Germany into a new microfinance bank, the banking sector. The Austrian government, which had and later launched an SME lending program (with also been preparing to set up a SME program, quickly EAR, German, and Swiss funding) and a housing joined KfW when it heard of its plans and previous loan program (with EAR and German funds). experience with the EU on the housing loan program. By mid-1998, an SME credit line (SMELP) for BiH was in · Serbia: As in Kosovo, KfW channeled EBRD, FMO, place, with a 2.55 million euro grant from Austria. The and German funds to a new microfinance bank, and financing arrangement between the two agencies was also provided refinancing for SME loans (with EAR, substantially the same as that between the EC and KfW German, and Swiss funds) to four existing commer- for the HLP program. cial banks. By December 1998, the Swiss and German governments The graph below gives a snapshot of how much major had also signed contracts with KfW, providing another donors have contributed to the different programs 1.11 million euros for SMELP. They were joined by the currently managed by KfW in Southeastern Europe. (It EU in 1999, which initially contributed 5 million euros. does not, however, show all the different partner banks and MFIs that are borrowing these funds.) A DIRECT Case Study Page 3 Challenges of Donor Collaboration they be able to ensure that their funds continued to be Need for visibility of individual donor funds reduces allocated as originally intended within a regional fund? effectiveness and adds costs. Donors usually want to Donors also needed to ensure adequate governance for maintain the visibility and accountability of their respec- the long term. What would their role be in a new tive funds to track results. For this reason, each donor had structure? What would be the role of relevant national discrete contracts with KfW. This arrangement meant the actors and how could they be included in the decision- financial institutions were not able to mix donor funds making process? The donors are continuing to discuss and money remained idle because re-flows into options for pooling their funds on a regional and/or individual donor accounts were often insufficient to country basis to ensure maximum use of their funds. finance new loans. Furthermore, each donor required (Although, in 2003, the EC decided against placing its separate reports from the banks and KfW on each BiH investments in a regional fund.) In Montenegro, individual credit line, adding administrative costs. Kosovo, and Serbia, KfW and the donors agreed in principle to pool funds within sectors in November 2003, Insufficient policy coordination between field, but formal agreement is still pending from some donors administrative, and legal staff slows implementation. and they have now held off implementation until they Typically, donor operational field staff spearhead explore the alternative possibility of a regional fund. collaboration, with headquarters eventually following "One of the lessons we have learned si that it would have their lead. Operational staff understand the efficiencies to saved a lot of time if the [program] had been set up as a fund be gained for both their own and local institutions. in the first place." Especially when programs are innovative and charting Mark Priestley, Task Manager for Economic Develop- new ground, changing procedures and designing new ment, EC Delegation, Sarajevo types of legal arrangements can take a long time. For example, in BiH, it took the donors' headquarters a year Successes of Donor Collaboration to approve their field staff's initiative to pool SME funds, and then another year for the policy to be operationalized Forging a common vision of financial sector due to new contracting mechanisms and other procedures. development. European donors were initially focused on disbursing funds quickly in the post-conflict situation. Complex administration reduces efficiency. For KfW, However, through a process of regular exchange and the principal challenge has been the legal and consultation, they quickly recognized the advantages of a administrative management of donor funds in multiple adopting a common longer-term approach. Their shared countries. By 2003, KfW was managing eight funds for vision of helping to develop a dynamic and stable different donors, providing lending capital to 26 partners financial sector allowed them to leverage one another's in four countries. Each new funding tranche, donor, strengths. As a result, they contributed to building strong, program, and local partner added administrative com- sustainable financial institutions that could provide plexity for KfW. financial services on a large scale--the backbone of all financial systems. This vision allowed the donors to Lack of precedent for translating grants into loans, achieve a high degree of harmonization on near-market confuses donors' procedures. One operational challenge lending policies, and a common reporting format. --transforming the donor grant instrument into an ongoing credit line--results from the excellent repayment "KfW had an idea and were very proactive in getting support. rates of the financial institutions. The "revolving grants" The EC was very receptive because this mechanism allowed us to move very quickly, which was especially important in the are never actually "spent" because the money is lent out post conflict situation." and repaid by local financial partners, thus keeping the Mark Priestley, Task Manager for Economic Develop- funds on the donors' books. This confuses donor agency ment, EC Delegation, Sarajevo procedures, since their instruments are designed to spend money on short-term projects. Delegating management to a suitable technical partner. The donors agreed that KfW had the technical Uncertainty over regional fund reduces impact. KfW expertise to select and maintain professional relationships has been interested in creating a regional institution (or with commercial lending institutions, coordinate effective fund) to which donors could easily donate grants. But that technical assistance, and manage donor funds. For a fee, option raised many questions. Donors earmarked their KfW eagerly fulfills this role, thus also leveraging the funds for particular programs and countries. How would impact of its work. The other donors benefit from the Page 4 A DIRECT Case Study arrangement because it is less labor-intensive and more less than 2 percent. Local banks in Serbia had disbursed cost-effective to delegate program management to KfW. 163 loans totaling 5.6 million euros. Local banks benefit from the financing arrangement The increased impact of collaborative action is because they only have one direct partner. All financial particularly important for smaller donors, who do not intermediaries also receive valuable technical assistance have the resources to manage complex projects. Even in in credit line management, risk management, etc. the absence of pooled funds, the fact that the donors have agreed to similar lending terms has provided local "KfW has expertise in fund management and a proven track financial institutions with a unified source of long-term record in the region. It makes no sense going it alone when a proven mechanism is in place." financing at near-market conditions. Michael Kilcommons, Programme Manager, Enterprise Development, EAR Operational Center, Belgrade The Way Forward European donors have collaborated at progressively Creating a robust vehicle for coordination. In 1999, deeper levels in the six years since they began supporting KfW and the donors established a steering committee to local financial intermediaries in Southeastern Europe. ensure coordination among their programs. Sustained They are now discussing ways to institutionalize the so- discussions among steering committee members as well called "European Funds" to create a legal entity in which as local staff at the regional level have allowed the donor donors could pool their funds. Such an approach would agencies to tackle difficult policy issues, such as interest increase their impact by reducing transaction costs for the rates and client targeting, and achieve a high degree of financial institutions, increasing KfW's efficiency, and harmonization of near-market lending policies. Today, providing an effective exit strategy for all donors. the committee is the forum for discussions on trans- forming the programs into a long-term legal entity. Their successful collaboration offers one model for donors in other areas of the world. "We knew that KfW would be around for 12 years because of their agreement with the EU, and we knew they were a committed and efficient organization. It made sense to References develop the SME program together with a long-term partner." KfW, Ingrid Matthaüs-Maier and J.D. von Pischke, eds. The Michael Ingrid Sager, Head, Department for Development Development of the Financial Sector in Southeast Europe: Cooperation with Eastern Europe, Austrian Foreign Ministry Innovative Approaches in Volatile Environments. Berlin, Heidelberg, New York: Springer Press, 2004. Agreeing to pool funds. In 2001, the donors to the SME EFBH. European Fund for Bosnia and Herzegovina: The First program in BiH agreed in principle to pool their funds Five Years. Sarajevo: EFBH, 2003. into a single credit line. Legal and contract revision for the SME funds was completed in 2002, and a single Contacts and Websites credit line became operational in BiH in 2003. This decision greatly reduces the inefficiencies of individual EFBH: www.efbh.ba donor credit lines. Building on the success of the SME KfW: www.kfw.de pooled fund, a multi-sector fund for Bosnia has been proposed to pool multiple donor funds across sectors. Ann Duval is an independent microfinance consultant. This case study is based on a review of the documents cited above, as well as input received from Klaus Glaubitt, Ingrid Sager, Mark Priestley, Michael Achieving greater impact. The common approach Kilcommons, Aida Soko (Head, EFBH), Dominik Ziller (Head, adopted has permitted European donors to have European Division, German Ministry of Economic Cooperation significant impact in the region in terms of the number of BMZ]), Haje Schütte (Vice President, Financial and Private Sector local financial institutions strengthened and the number Development Division, KfW), Roland Siller (Vice President, Financial and Private Sector Development, KfW), and Johannes Feist (Director, of low-income clients reached. As of December 2003, KfW office, Belgrade). local banks and MFIs in Bosnia and Herzegovina had 60 million euros available for lending and 9,900 loans Ruth Goodwin-Groen is a microfinance consultant and is currently the outstanding. In Montenegro they had disbursed 2,400 managing editor of the CGAP DIRECT Donor Good Practice Case loans totaling 10 million euros, while maintaining a Studies. portfolio at risk (PAR) below 1 percent. Local lending institutions in Kosovo had disbursed 1,900 loans and were managing a 9.5 million euro portfolio with a PAR