PROJECT INFORMATION DOCUMENT (PID)

APPRAISAL STAGE

Report No.:AB780

Project Name

/ Kenya Financial and Legal Sector Technical Assistance Credit
Region / AFRICA
Sector / Finance and Legal
Project ID / P083250
Borrower(s) / GOVERNMENT OF KENYA
Implementing Agency
Government of Kenya
Kenya
Ministry Finance
P O Box 30007
Treasury Building
Kenya
Tel: (254) 20 338111
Environment Category / [ ] A [ ] B [X] C [ ] FI [ ] TBD (to be determined)
Safeguard Classification / [ ] S1 [ ] S2 [X] S3 [ ] SF [ ] TBD (to be determined)
Date PID Prepared / March 9, 2004
Date of Appraisal Authorization / March 24, 2004
Date of Board Approval / May 27, 2004, 2004
  1. Country and Sector Background

A key priority of the new Kenyan Government is the reduction of poverty through economic recovery and promotion of sustainable growth. The Government recognizes that in order to achieve this objective, it will have to address the structural weaknesses that have contributed to the decline in productivity and competitiveness of the economy in the last two decades. During this period, almost all sectors of the economy experienced a slowdown in growth and levels of poverty increased (from about 48 percent of the population in 1990 to about 56 percent in 2003). Agricultural GDP grew by just one percent per year, the manufacturing sector faced stagnating investment and negative productivity, and there was poor delivery of infrastructure and telecommunication services. At the same time, access to financial services was limited and interest rates were high reflecting the rising levels of government borrowing and non-performing loans. In addition, poor economic governance with weak enforcement of accountability led to an increase in the costs of doing business.

With the right investments and policy and institutional reforms, Kenya does have significant growth potential. The Government has prepared an Economic Recovery Strategy for Wealth and Employment Creation (ERS) through a broad consultative process. Its first priority is to restore the economy on a path of high growth. The strategy also calls for redefining the role of the state as a facilitator for private sector growth and investment. Within this framework, the government commits to maintaining a stable macroeconomic framework, reforming the financial sector and strengthening its regulation to increase savings and investment, implementing mechanisms for private sector participation in provision of infrastructure services, and establishing a competitive environment able to attract increased private investment in productive sectors such as tourism, trade and industry.

The Kenyan banking sector is well developed and comprises 43 commercial banks, with the six largest accounting for about two-thirds of all assets, loans and deposits of the banking system. However, there are high lending rates and interest rate spreads which are a reflection of structural problems in the financial sector. Competition in the system is hampered by the presence of many weak banks which are not able to exert competitive pressure on the few strong banks and by deficiencies in the legal infrastructure. Non-performing loans (NPLs) amounted to about 28 percent of the total loan portfolio in July 2003. The Banking Supervision Department of the Central Bank of Kenya (CBK) has a well-founded off-site and on-site supervision program but it does not always lead to decisive corrective action. On several occasions, failing banks have been allowed to stay open for too long.

The performance of the payments system is hindered by the inadequate legal framework, lack of efficient payment instruments and long cycles of clearing and settlement. The system is largely based on manual and paper-based arrangements.

The non-bank financial institutions are diversified but also have some structural problems. The insurance sector comprises 41 licensed companies, two reinsurers, about 200 brokers and 400 active agents, all supervised by the Commission of Insurance. The commission is not operationally independent and does not have adequate resources to carry out effective supervision of the sector. The supervisory process focuses on ensuring compliance with regulations rather than focusing on risk. In addition, the Insurance Act has critical shortcomings that lead to engagement in excessive risk. The Kenya pension system has very limited coverage and does not provide adequate pension benefits. There are high levels of unfunded liabilities among many of the existing schemes. The Capital Markets Authority has limited capacity and does not have operational independence. Although the legal framework for capital markets has been largely put in place, the enforcement of market rules and supervision of market participants are still weak.

In view of the above constraints, the Government has, in the short term, proposed a financial sector reform program to address policy, institutional and legal issues affecting the efficient operation of the sector. In the long term, the Government is going to draw up a financial sector development strategy that will provide the framework for sectoral measures necessary for achievement of policy objectives. The Government has asked the Bank for a Technical Assistance Credit to assist in the implementation of its financial sector reform program.

  1. Objectives

The overall development objective of the project is to create a sound financial system and a strengthened legal framework and judicial capacity that will ensure broad access to financial and related legal services and optimal allocation of resources for sustained economic growth. This objective will be achieved through provision of technical expertise and building capacity to implement the Government’s financial sector reform program which the Bank will also support through the proposed Financial Sector Adjustment Credit (FSAC), and through supporting activities in the judiciary and the Ministry of Justice and Constitutional affairs (MOJCA) in the context of the Government’s Medium Term Governance, Justice, Law and Order Sector Reforms Strategy.

The project will help the authorities to address the weaknesses identified in the financial sector by the recent joint Bank/Fund FSAP and those in the legal sector. Particular focus will be put on legal issues that affect the efficient performance of the financial sector.

  1. Rationale for Bank Involvement

With the commitment of the new Government to improve public sector management, eliminate corruption and restore the rule of law, the environment for stimulating growth with equity and reducing poverty in Kenya through Bank programs has become considerably better. The last Country Assistance Strategy (CAS) for Kenya was prepared in September 1998 and was focused on supporting the Government’s efforts of improving the existing poor economic governance. A new CAS was presented to the Bank’s Board on May __ 2004 and provides the foundation for a strategy for reengagement with the Authorities, aligned with the Government’s ERS. The Government has already agreed with the IMF on a new Poverty Reduction and Growth Facility (PRGF) program and has moved decisively on improving relationships with development partners. There is renewed interest in Kenya by the international community as exemplified by the spectacular response at the Consultative Group Meeting held in Nairobi in November 2003 where the donors pledged a total of US$4.1 billion over the next three years.

The Bank has acquired extensive knowledge of the Kenya financial sector from the recently concluded FSAP and is currently taking the lead and coordinating all the development partners in the financial sector dialogue. On the legal sector, the Bank has concluded a legal and judicial sector assessment. The Bank has been the dominant donor in the legal sector and is currently co-chairing the efforts of the donors who are collaborating in this sector.

4. Description

The project will have seven components:

Component 1: Financial Sector Development Strategy. The Kenyan authorities recognize that sustainable economic recovery and broad based growth depend on a vibrant and integrated financial sector that supports the mobilization of resources to finance investment across the economy. Sustainable access to appropriate and secure financial services provides a critical tool for poorer households to improve their livelihoods.

The Project will support the formulation of a financial sector strategy necessary to achieve these policy objectives as identified in the ERS. The process will involve broad consultations among stakeholders and will be informed by various recent studies on the financial sector, including the FSAP, the banking sector reform strategy (undertaken for the Government by a joint team of Kenyan and international specialists and funded by DfID) and the study on development finance institutions (DFIs) and rural finance being financed by FIRST. The support will include: (i) Technical Advisors; (ii) Consultants to carry out studies on specific identified issues; and (iii) Workshops for stakeholders to build broad consensus and ownership of the reform process. For example, one of the areas already identified where further study is required is the pension system where there are high unfunded Government liabilities and coverage is limited to people in formal employment.

In support of the sectoral strategy, a framework for monitoring and evaluating progress in financial sector development in Kenya will be required. This framework will need to provide a basis for assessing performance against the higher level policy objectives, which will include measures of improved access, stability and efficiency. The approach taken will need to be consistent with and supportive of monitoring and evaluation efforts under the ERS. It should also provide the basis on which this Project's progress against its overall development objectives will be monitored. The Project will support the beneficiaries in developing and tracking appropriate indicators. Inputs will include: (i) specialist advice on enhancing existing statistical instruments; (ii) specific pilot and baseline studies; and (iii) consultants to support the development and implementation of the framework.

Component 2: Restructuring and Privatization of Financial Institutions. The banking system has a high level of non performing loans concentrated in four commercial banks with state interests. Divesting the Government’s stake in these institutions will help strengthen the banking system through mobilizing the resources of the private sector to build the operational capacity of the institutions, eliminate direct and indirect subsidies and remove political involvement in credit allocation. The result will be to significantly strengthen competition and improve stability which will result in downward pressure on the currently high interest rate margins and increase the incentives to reach underserved markets. It will also demonstrate the Government’s commitment to improving governance and fiscal responsibility.

The Project will support the establishment of a specialist Bank Restructuring and Privatization Project (BRPP) within the Ministry of Finance which will provide the specialist technical resources required to implement the Government’s policy. The core BRPP team, comprising international and Kenyan specialists, will guide the privatization process from the identification of strategic options for divestiture, through short-term preparatory restructuring to preparation and completion of the transactions. This work will be supported by specialist short-term legal and audit consultancy inputs.

Other financial institutions where the Government has a particular interest/responsibility include Co-operative Bank, Kenya Post Office Savings Bank (KPOSB) and the development finance institutions (DFIs). These institutions are afflicted with severe performance problems, including (in all cases except for KPOSB) sizeable non-performing loans. The Project will support the restructuring of these institutions consistent with the Government’s market-based policy for financial sector development.

Component 3: Strengthening Financial Sector Regulators and the Deposit Protection Fund Board. The primary role of the Government in the financial sector is to provide a legal, regulatory, and supervisory framework that promotes soundness and competition in the sector. Currently, the laws governing financial sector regulators (CBK, CMA, RBA and Insurance Commission) and the DPF show several weaknesses that hamper the effective execution of their duties. The authorities agree on the need to review these laws. The authorities have also identified the need to strengthen supervisory capacity within the regulators as well as information sharing and coordination of activities between regulators.

Given the absence of a regulatory and supervisory framework for the microfinance and cooperative segments of the financial sector, the authorities are preparing legislation which aims to stimulate the sustainable development of these sectors.

The Project will provide support for the review, amendment and/or drafting of financial sector laws that govern all the regulators and the DPF. It will also support capacity building initiatives for these institutions, including training needs assessment, training of staff, resident advisors, and establishment of capacity to regulate and supervise the microfinance and SACCOs sectors under the proposed new legislation. In addition, improvements will be made to the Management Information Services (MIS) of these institutions, including software upgrades and purchase of hardware.

Component 4: Improving the Lending Environment. One of the major impediments to growth in Kenya is insufficient access to financial services by large segments of the population and enterprises, especially micro, small and medium sized ones. While there are a large number of providers of micro and SME credit, the market is segmented and disconnected. In the formal banking sector, deficient property registration systems, weaknesses in the creditor rights framework and institutional infrastructure, the overly debtor-friendly enforcement mechanisms and the pervasive lack of credit information have contributed to high lending risks as well as costly and inaccessible credit.

The Project will support: (i) improvements in the operation of the Companies Register to allow for speedy and accurate information sharing of corporate information and data; (ii) combining of the Charges Register and the Chattel Mortgage Register into one and moving the combined separate register (notification system) for charges/pledges over movable assets out of the Companies Register; (iii) establishment of a legal and regulatory framework for the operation of a credit reference bureau that would facilitate the much needed information flow among the credit granting institutions; and (iv) introduction of a summary court procedure for uncontested debt enforcement that would eliminate the frequent frustration of enforcement procedures through the discretionary granting of injunctions. In addition, the project will support the review of impediments to the growth of the leasing industry, including tax laws on leasing.

Component 5: Strengthening Debt Management and Debt Markets. The updating of Government debt databases is handled by the individual entities in Ministry of Finance and CBK responsible for parts of debt management and there is no coordination or consolidation of data. There is also no debt management strategy function within Ministry of Finance and therefore there is need for creating capacity to carry out risk analysis in order to produce periodic strategy documents. Previous efforts to establish improved debt management practices in Kenya have floundered due to weaknesses in the supporting institutional infrastructure.