SMALL FARMERS DEVELOPMENT BANK A. Background 1.

The Agricultural Development Bank Limited (ADBL) started the Small Farmers Development Program (SFDP) in 1975 to extend credit to small and marginal farmers. Under SFDP, small and marginal farmers were organized into groups of 57 individuals to borrow from ADBL based on the group guarantee. SFDP was carried out through its subproject office (SPO), which promoted village level committees and was facilitated by a group organizer. Groups were formed based on the community members common socioeconomic status, such as having income below the poverty threshold, being from a common locality, and having citizenship certificates. Separate male and female groups were organized. Loans under SFDP were subject to the ceiling of NRs30,000 per individual group member. Loans generally started at lower levels, with members graduating to larger loans based on experience and satisfactory repayment performance. In addition to the financial operations to support SFDP, ADBL has assumed responsibility for group mobilization and group training. 2. Following resounding success in the pilot sites of SFDP, the number of groups has multiplied rapidly since 1980. Some aid agencies, including the International Fund for Agriculture Development and the Asian Development Bank, funded SFDP 1 on a large scale. However, as the number of SPOs increased rapidly in all the districts of the country reaching 452 by 1990the performance of SFDP progressively deteriorated due to (i)

mounting political interference, (ii) soaring overhead costs, (iii) ineffective loan appraisal and portfolio management, (iv) deliberate default, and (v) rapid and alarming decline in recovery rates. The supply of aid agency funds encouraged ADBL to pass down inflated loan disbursement targets to SPOs. As a result, lending accelerated and became more indiscriminate, leading to even more widespread defaults. In the early 1990s, with the emergence of many microfinance nongovernment organizations, the aid agencies stopped funding SFDP due to its worsening performance, and started channeling funds to nongovernment organizations. 3. This declining performance led to the restructuring of SFDP. In 1987, the Institutional Development Program (IDP) was initiated with the assistance of German development cooperation through Gesellschaft fr Technische Zusammenarbeit (or the German Technology Corporation). IDP was a 5-year program to transform SPOs into Small Farmers Cooperative Limited (SFCL), registered under the Cooperative Act. Under IDP, SPOs were federated into inter-groups, which were federated further into the main committee. A SFCL is composed of 915 inter-groups. The conversion of SPOs to SFCL was preceded by institutional development to improve their performance to make them eligible for conversion. Each SPO was required to improve the loan repayment rate to more than 70%, overdue loans against the total loans to below 10%, and interest arrears to less than 15%. As of July 2005, 200 SFCL had been established. 4. For SFDP restructuring, ADBL established a separate and independent Small

Farmers Development Bank (SFDB) owned jointly by ADBL, the Government, two private banksNepal Bank Limited and Nabil Bankand SFCL. The function of SFDB is to provide wholesale lending to SFCL. SFDB, which was registered under the Company Act of 1991, conducts its business under the Development Bank Act 1996. In connection with the 1 ADB. 1970. Report and Recommendation of the President to the Board of Directors on a Proposed Loan to the Kingdom of Nepal for the Agricultural Credit Project. Manila. ADB. 1974. Report and Recommendation of the President to the Board of Directors on a Proposed Loan and Technical Assistance to the Kingdom of Nepal for the Second Agricultural Credit Project. Manila. ADB.1990. Report and Recommendation of the President to the Board of Directors on a Proposed Loan and Technical Assistance Grants to the Kingdom of Nepal for the Third Small Farmers Development Project. Manila. 2 Supplementary Appendix D enactment of the Banks and Financial Institutions Ordinance, 2 the umbrella act for financial institutions, SFDB also will be licensed as a financial intermediary. B. Performance of SFDB 5. SFDB, which started operations as an independent bank in 2002, makes loans for agriculture and livestock investments through SFCL. Its outstanding loans totaled NRs476.5 million in 2005, comprising loans for (i) crop and crop services, (ii) forestry and fishing, (iii) livestock and livestock services, (iv) agricultural machinery, (v) other agricultural and agroservices, and (vi) tea production. SFDBs performance, outreach, and impact on the rural

finance sector have been limited relative to its resources and market potential. Concerns about SFDB focus on its scale of operations, loan portfolio management, and weak institutional capacity. SFDBs viability is also weak. The return on assets and on equity in the audited accounts is very low, and falls into deficit when the financial statements are restated to take suspense interest into account. Interest expense has grown much faster thanand now exceedsinterest income. Nonperforming loans are not written off the balance sheet regularly. Thus, new arrears are added to unrecovered arrears of the previous year. Unpaid interest is not moved to suspense as required by the central bank. The financial performance of SFDB is summarized in Tables D.1 and D.2. Table D.1: Small Farmers Development Bank, Profit and Loss (NRs million) Item FY2003 FY2004 FY2005 Income Interest Income 27.01 73.44 74.44 Less: Interest Expenses 17.31 56.79 67.95 Net Interest Income 9.71 16.65 6.49 Fees, Commissions, and Brokerage 3.92 9.63 6.69 Other Operating Income 0.00 0.04 0.06 Total Operating Income 13.60 26.30 13.20 Expenses Staff Cost 2.75 4.64 6.26 Other Administrative Expenses 2.01 3.35 4.19 Provisions Against Nonperforming Advances 7.28 16.37 0.98 Total Operating Expenses 12.04 24.35 11.43 Net Operating Profit 1.58 1.96 1.81 Other Income Depreciation, Other Charges, and Other Provisions (0.84) (1.20) (1.11) Profit Before Tax 0.75 0.76 0.70

Tax Provision (0.24) (0.24) (0.22) Profit After Tax 0.51 0.53 0.48 = not available, ( ) = negative. Note. Unaudited financial statements. The profit and loss statement does not include suspense interest as required by the central bank. Source: Small Farmers Development Bank, Nepal. 2 Enacted in February 2004 to support of the Poverty Reduction and Growth Facility of the International Monetary Fund. It unifies five banking laws, and strengthens Nepal Rastra Banks supervisory powers over the financial sector. Supplementary Appendix D 3 Table D.2: Small Farmers Development Bank, Key Ratios Item FY2003 FY2004 FY2005 Profitability (%) Return on Assets 0.15 0.22 0.29 Return on Equity 0.44 0.55 0.51 Operating Efficiency (%) Net Interest Margin 1.69 1.89 1.08 Net Operating Profit to Total Assets 0.15 0.22 0.29 Productivity Return on Staff Costs (%) 57.45 42.24 28.91 Return per Staff Member (NRs 000) 14.60 Intermediation Costs (% of Assets) Staff Costs 0.27 0.53 1.01 Other Administrative Costs 0.20 0.38 0.68 Loan Loss Provisions 0.71 1.86 0.16 Total 1.17 2.77 1.84 = not available. Source: Small Farmers Development Bank. 6. The portfolio quality raises concern about the viability of SFDB. The repayment of loan principal by SFCL has been poor, as a substantial number of loans have been

rescheduled and nonperforming loan amounts are increasing. The collection of loan interest is equally poor, and continues to decline. In FY2003, only NRs27 million of the NRs66 million in interest due for payment, including NRs22 million charged for the year, was collected. Similarly, only NRs74 million of the NRs124 million in interest due in FY2004, including NRs81 million charged for the year, was collected. 7. At SFDB, loans totaling NRs97.8 million were rescheduled until FY2004. The main reason for such a high level of rescheduling was the difficulty SFCLs had in meeting interest payments. SFDB grants the extension of repayment schedule without examining the need foror the viability ofthe SFCL making the requests. Much of the rescheduling has been done in the eastern and central regions of Nepal. The collection details of SFCL indicate that it has been making repayments on the SFDB loans from its own loan and interest collections, not from capital and deposits of members. This suggests growing concern for future repayments. With nearly 90% of SFCL loans to members concentrating on livestock and agro-services, which have poor repayment histories, SFDB is susceptible to serious damage if the subsector performance deteriorates further. The level of nonperforming loans for livestock and agro-services is high, and crop services represent 39% of nonperforming loans (Table D.3). Table D.3: Small Farmers Development Bank, Classification of Subsector Loans (NRs million) Subsector a Pass Substandard Doubtful Loss Total % of

NPL a Crop and Crop Services 7.03 0.66 0.16 3.73 11.92 38.67 Forestry, Fishing, Animal Slaughter 0.99 0.12 0.02 0.21 1.34 26.12 Livestock and Livestock Services 36.88 3.16 1.07 14.05 55.15 33.15 Agricultural Machinery 0.77 0.02 0.16 0.95 18.95 Other Agricultural and AgroServices 62.23 5.44 1.52 16.18 85.37 27.11 Tea 3.16 0.04 0.02 0.10 3.32 4.82 Total 111.06 9.44 2.79 34.43 158.05 = not available. a The percentage of nonperforming loan out of the total loans in the subsector. Note. For FY2004 under the Nepal Rastra Bank subsector category. Source: Small Farmers Development Bank. 4 Supplementary Appendix D 8. The organizational and administrative structure of SFDB is not consistent with ones for a financial intermediary. SFDBs operational approach which recover loans through rebates rather than filed pursuit, and select clients by existing SFCLs discretion rather than proactive effort from SFDBis an indication of weak operational capacity. The current staff incentive system does not distinguish between good and poor performance. SFDB does not have the policies needed to ensure that basic risks in areas such as credit portfolio management and cash management do not harm the banks liquidity. The portfolio audit suggests passivity in servicing loans risk. SFDB does not have a reliable management information system, which is required for timely and accurate information for portfolio

management. C. SFDB Institutional Reform and Strengthening 9. SFDP generally has contributed positively to enhancing income-generating activities and employment opportunities through expanded rural finance outreach to poor small farmers, who otherwise would have been outside the reach of institutional financial services. As of July 2005, SFDP had 65,589 members, including 23,830 women. In addition to receiving tangible economic benefits, SFDP members have benefited from leadership development, group solidarity, empowerment, financial literacy, and skills development. Some of the SFCL members are emerging as viable credit cooperatives and replicating institutional development processes on their own. SFCL and SFDB are likely to play a significant role in reducing rural poverty. Thus, broad-based institutional reform is crucial to transform them into autonomous and viable financial institutions that can continue to provide affordable financial services to small and marginal farmers. 10. The operational and portfolio review of SFDB, conducted under technical assistance provided by the Asian Development Bank, 3 identified several key operational issues and outlined strategies for SFDB reform. The Government and SFDB agreed to initiate the reform process based on (i) expanding and strengthening systems and controls for greater transparency; (ii) building a structure with greater business autonomy, and ensuring functional relationships of departments; (iii) improving the credit culture in SFDB and SFCL by re-emphasizing viability and the borrowers sustainable capacity to generate income

sufficient to maintain the society and service debt; (vi) building a viable and balanced portfolio in which nonperforming loans are minimized; (v) upgrading the management information system to cover all aspects of the banks operations; and (vi) adopting practices that ensure accounting records and financial statements give an accurate picture of the financial health of SFDB and SFCL.