Financial Sector Policy

1. Introduction

2. Promoting the Financial Sector: an effective way to foster economic development

3. ECO Trade and Development Bank’s role and priorities

3.1 Partners

3.2 Vehicles

3.3 Clients

4. Scope of Operations in the Financial Sector

4.1 Promotion of Selected Sectors or Activities

4.2 Creation/Strengthening of Specific Types of Financial Intermediaries

1. Introduction

ECO Trade and Development Bank (the Bank) sets up its Financial Sector Policy in accordance with the provisions of the Articles of Agreement (the Agreement). Article 1 of the Agreement states the purpose of the Bank as: “The Bank shall mobilize resources for the purposes of initiating, promoting and providing financial facilities to expand intra-regional trade and accelerate economic development of ECO Member Countries.” In order to successfully fulfill its purpose, Article 2 of the Agreement details a number of functions that the Bank has, among which:

• to finance development projects and intra-regional trade in the ECO countries,

• to cooperate with national and international financial institutions and use such institutions as financing channels for its operations,

• to establish special funds for specific purposes and to operate in accordance with the regulations approved by the Board of Governors,

• to undertake any kind of banking activities to mobilize resources and provide other banking services as may be necessary or incidental to the advancement of its purposes.

The Financial Sector Policy defines the role of the Bank in dealing with financial institutions in three dimensions:

(i) partners (co-financiers);

(ii) vehicles (intermediaries); and

(iii) clients (borrowers and investees)

in order to foster cooperation with firms, promote development of financial markets, and improve and expand financial services and products available. It elucidates where the Bank provides assistance and the products to be employed.

The main aim of Bank involvement in the financial sector is, in conformity with its mandate, to promote regional cooperation and social and economic development. At the same time the Bank will pay careful attention to the most cost-effective ways to improve delivery of financing to entrepreneurs and firms, while duly taking into account the necessity for the financial institutions to adequately evaluate and protect against risks.

2. Promoting the Financial Sector: An effective way to foster economic development

In order to promote economic development, it is of particular importance to Member States to foster the development of their market institutions and provide a level playing field to all market participants. The financial sector plays a pivotal role in economic development. But for the financial sector to play its role good regulation and supervision need to be in place, property rights need to be well defined, and institutions need to be b and able to enforce needed legislation (banking law, bankruptcy law, company law, secured transactions, contractual discipline, etc).

In light of the above, it becomes even more important for Member States to create the legal framework and business environment conducive to the development of local financial institutions (irrespective whether domestically or foreign owned). In order to increase savings a solid financial sector needs to evolve, in some countries from a very rudimentary starting point.

Provision of medium term finance by the Bank and additional mobilization of domestic and foreign capital represent a significant contribution towards reducing the difficulties enterprises, in particular SMEs, face in accessing medium to long-term finance. Thus the Bank will help selected financial institutions strengthen their balance sheet, match better assets with liabilities, diversify client base, improve portfolio quality. Consequently, the confidence of the general public in the respective financial institutions may increase with positive implications in many areas of activity.

3. The Bank’s Role and Priorities

The Bank can address many of the issues mentioned above through selective cooperation with financial intermediaries. Bank funding may improve the liability structure of partner financial institutions, help them diversify their portfolio and improve risk management, thus helping them to better serve the needs of the emerging private sector.

Careful monitoring by the Bank of the use of funds offered for intermediation would ensure the access to finance of well managed local companies, contributing to the establishment of good working relations between the intermediaries and the enterprise sector and ensuring their access on a more permanent basis to credit.

The Bank hopes to play a central role in the promotion of the SME sector in Member States, higher trade volumes, and economic integration through increased flows of intra-regional investments. This role may be effectively expressed through adequate association with locally incorporated financial intermediaries.

3.1 Partners (Co-financiers)

The Bank works with two types of partner financial institutions:

• International Financial Institutions (IFIs) and Official Development Agencies; and

• Financial sector institutions (e.g. commercial banks, leasing companies)

3.2 Vehicles (Intermediaries)

As vehicles, domestic financial institutions are used to help channel funds to productive enterprises involved in trade activities and to the SME sector. It represents the preferred relationship that the Bank desires to establish with financial intermediaries in Member States.

As intermediaries financial institutions in Member States receive funds from the Bank and on-lend them to final beneficiaries.

• Agreed Financial Intermediaries

Financial intermediaries must meet minimum eligibility criteria. Normally, the intermediary should not use Bank funds in a capacity of fiscal agent; if this were to happen for clearly documented developmental reasons, then a sovereign guarantee should be required.

Intermediaries are assessed and selected in conformity with the Bank’s approved “Selection of Financial Intermediaries Policy”.

The Bank, as a rule, should not be involved in the details of the approval process of sub-loans, reserving oversight for large sub-loans/investments above a certain level, and concentrating attention on the overall operation of the intermediary itself. However, the Bank reserves the right to request intermediaries to submit sub-loan applications, or a subset thereof, to the Bank for no objection. The intermediary is responsible to the Bank for providing acceptable evidence that the funds extended by the Bank are used according to the pre-agreed destination purpose.

As a rule, the Bank will only take the risk of the financial intermediary, and not that of the recipient of the sub-loan. Notwithstanding this general principle, the Bank may require security in a variety of forms, including pledge of the security obtained for the sub-loans financed with Bank’s money, insurance policy, mortgage, receivables and other assets of the sub-borrowers, in lieu or in addition to the security required from the intermediary borrower.

• Interest Rate and Exchange Rate Policies

It is an established practice that the interest rate is market determined. As in direct operations, a detailed risk analysis – in conformity with the approved methodology – determines a risk margin range that combines project and country risk. The final contractual interest rate is negotiated and agreed with the financial intermediary fully taking into account the provisions of the Bank’s pricing policy. The interest rate may be fixed or variable.

The Bank should not be prescriptive about the terms and conditions on which the intermediary provides financing to final beneficiaries. However, in such cases where Bank financing behaves as an implicit subsidy for the intermediary or the end-user, a pre-established on-lending margin that takes into account the estimated rate of return on investment may be agreed, if the Bank deems appropriate. As there is a trade-off between systemic and institutional concerns, any problem must be treated on a case-by-case basis depending on the specific conditions prevailing at the time of the operation.

From the Bank’s perspective the foreign exchange risk is born by the primary beneficiary of the financing - the financial intermediary itself. There is no justified argument in favor of the Bank’s involvement in the setting of the on-lending interest rate or the share of burden of the foreign exchange risk between the financial intermediary and the final beneficiary of the funding. These issues are left at the discretion of the intermediary. The arrangement between the intermediary and the end-user/final beneficiary is of no concern to the Bank, as the intermediary must be given the freedom and authority to make the best decision on the basis of all available information.

• Project Evaluation, Supervision and Monitoring

Project evaluation would be difficult and costly where it to be performed by the financial intermediary according to the Bank’s requirements for each individual sub-project. It is therefore advisable that such evaluation be performed only for large sub-projects1 that need the Bank’s no objection, or in cases where significant distortions exist and make simple and straightforward financial calculations unreliable. For the majority of sub-loans supervision and monitoring will be conducted by the intermediary according to its own internal procedures, provided that these are acceptable to the Bank, or according to a standard pre-agreed procedure reflected in the legal agreements.

The Bank will perform project evaluation on the overall purpose and scope of the operation to be implemented through the respective financial intermediary. The intermediary in turn will perform according to its own internal methodologies the evaluation of sub-projects. However, it would be beneficial if the Bank would be provided with such methodologies and would have the chance to assess their adequacy and acceptability.

Monitoring the performance of the operation may include aspects of the relations between the intermediary and final beneficiaries, and therefore has a greater scope than supervision. Moreover, it includes an assessment of the degree of compliance with covenants and of performance against monitoring indicators. Project evaluation includes a more detailed look at the performance of final beneficiaries in their relation with the intermediary, as well as a post factum assessment of the adequacy and quality of the initial objectives and a qualitative assessment of their degree of realization.

Ultimately it is important that the Bank be reimbursed and that the funds entrusted to the intermediary are used for the intended purposes while the anticipated results are achieved.

3.3 Clients (Investees)

As clients, financial intermediaries may benefit from financing in the form of debt, or guarantee. In exceptional circumstances, the Bank may consider providing also equity. These operations are directed towards the development and strengthening of financial institutions, increasing the liquidity of the market, supplying credit to specific sectors or activities (manufacturing, agro-processing, tourism, export), and diversification of financial products.

As clients, financial institutions benefiting from Bank funding should be involved in any, or a combination thereof, of the following activities:

• Commercial banking

• Microfinance institutions

• SME finance institutions

• Leasing companies

• Credit guarantee funds

• Export promotion/credit agencies

• Equity Capital Funds

4. Scope of Operations in the Financial Sector

The Bank financing of the financial sector must reflect the priorities of the Bank and conform to relevant Bank policies and strategies. The role of the Bank must be prominent and its contribution identifiable and visible qualitatively, or measurable quantitatively.

Bank operations in the financial sectors of Member States encompass two different approaches, each with its specific set of objectives:

• Promotion of selected sectors or activities;

• Creation/Strengthening of specific types of financial institutions.

4.1 Promotion of selected sectors or activities

This activity concentrates on the end-uses of funds. Bank funds may be provided on a stand-alone basis or may be added to a pre-existing fund or credit line. Where the Bank may mobilize additional resources from the intermediary itself this approach should be pursued as it provides a number of benefits: (i) mobilizes additional domestic capital; (ii) given the inherent fungibility of money, the Bank must ensure that its resources do not merely replace existing availability of funding, but that it is additional; and (iii) increases the risk awareness of the intermediary, as it has something significant at stake.

This type of intervention by the Bank is justified on grounds that:

• In member countries, savers and intermediaries have greater aversion to risk than usually in developed countries;

• Improper information, inadequate enforcement of contracts, incomplete property rights, scarce reliable financial information, unstable macroeconomic environment, make provision of financing to specific sectors of the economy and more generally long-term financing too risky for the preference of savers and financial institutions;

• The financial sector disposes of limited financial resources, that lead to a significant financing gap;

• The operation entails important externalities from the promoted activity that results in higher social benefits than the private (financial) benefits which influence the decisions of lenders and investors.

Specific sectors and activities that qualify for support through financial intermediaries are, in particular, SMEs in: manufacturing, foreign trade, agribusiness, market and social services.

4.2 Creation/Strengthening of specific types of financial institutions

The ultimate purpose of this activity is to support the development of the real sector. Examples include, but are not limited to, support for development finance, microfinance banks, mortgage banks, leasing companies, credit risk funds, equity funds, dedicated credit lines, with the purpose of providing increased amounts of term finance. Such institutions should play a catalytic role, and provide a clear demonstration effect, to be eligible for Bank financing.

However, care must be exercised to avoid support of institutions that are adversely affected by a policy environment that prevented in the first place the genuine development of similar market based institutions.