Docmmt of

The World E?&

This document has a restricted distribution and may be used by recipients only in the performance o f their official duties. Its contents may not otherwise be disclosed without

FOR OFFICIAL USE ONLY

Report No.: 30022

PROJECT APPftAISAL DOC”

ON A

PROPOSED CREDIT

IN THE AMOUNT OF SDR 12.2 MILLION (US$18 MILLION EQUIVALENT)

TO “E

REPUBLIC OF KENYA

FOR A

FI”CL4L AND LEGAL SECTOR T E C m C A L ASSISTANCE PROJECT

September 17,2004

Financial Sector Unit Africa Region

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CURRENCY EQUIVALENTS (Exchange Rate Effective March 1 2004)

Currency Unit = Kenya Shillings (KShs) US$1 = KShs76.45003 US$1 = SDR1.41

AFD ATM BWP BSD CAG CAS CDS CFAA CLE ClMA COMIESA CPAR CS-DRMS DFI DFID DMO DPF EAC EFTPOS ERSWEC FARAH FIRST FLSTAC FMR. FSAC FSAP GDF GJLOS GOK GFN I A S IC ICB IDA D3 D F IMF P

FISCAL YEAR July 1 - June30

Agence Francaise de Developpement Automated Teller Machine Bank Restructuring and Privatization Project 3ank Supervision Department Controller and Auditor General Country Assistance Strategy Central Depository System Country Financial Accountability Assessment Council o f Legal Education Capital Markets Authority Common Market for Eastern and Southern Afiica Country Procurement Assessment Report Commonwealth Secretariat Debt Recording and Management System Development Finance Institution Department €or International Development Debt Management Office Deposit Protection Fund East African Community Electronic Funds Transfer at Point o f Sale Economic Recovery Strategy for Wealth and Employment Creation Financial Reporting and Auditing Handbook Financial Sector Reform and Stxenghening Initiative Financial and Legal Sector Technical Assistance Credit Financial Monitoring Reports Financial Sector Adjustment Credit Financial Sector Assessment Program Gross Domestic Product Governance, Justice, and Law and Order Sector Govement o f Kenya General Procurement Notice International Accounting Standards Insurance Commission International Competitive Bidding International Development Association Industrial Development Bank Institutional Development Fund International Monetary Fund Implementation Plan

IT JSAP KCB KPOSB KRA LCS LRC M&E M I S MOF MOJCA NARC NBK NCB NDO NSE OAG OTC PCU PIU PPF PRGF PRSP PS PSM-TAP PSR QCBS RBA RFP ROSC RTGS SACCOs SDR SIC SME SOE SWlFT TAC TOR UNDB U S A I D

FOR OFFICIAL USE OryLY Information Technology Judicial Strategy Action Plan Kenya Commercial Bank Kenya Post Office Savings Bank Kenya Revenue Authority Least Cost Selection Law Reform Commission Monitoring and Evaluation Management Information System Ministry o f Finance Ministry o f Justice and Constitutional Affairs National Rainbow Coalition National Bank o f Kenya National Competitive Bidding National Debt Office Nairobi Stock Exchange Office o f the Attomey General Over-the-counter Project Coordination Unit (ofthe GJLOS) Project Implementation Unit Project Preparation Facility Poverty Reduction and Growth Facility Poverty Reduction Strategy Paper Permanent Secretary Public Sector Management Technical Assistance Project Project Status Report Quality and Cost Based Selection Retirement Benefits Authority Request for Proposals Reports on the Observance o f Standards and Codes Real Time Gross Settlement Savings and Credit Cooperatives Special Drawing Rights Selection o f Individual Consultants Small and Medium Enterprise, Statement o f Expenses Society for Worldwide InterBank Financial Telecommunications Technical Assistance Credit Terms o f Reference United Nations Development Business United States Agency for Intemational Development

Vice President: Callisto E. Madavo Country ManagerlDirector: Makhtar Diop

Acting Sector Manager: Antony Thompson Task Team Leader: Michael Fuchs

This document has a restricted distribution and may be used b y recipients only in the performance of their official duties. I t s contents may not be otherwise disclosed without Wor ld Bank authorization.

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FINANCIAL AND LEGAL SECTOR TECHNICAL ASSISTANCE PROJECT

CONTENTS

STRATEGIC CONTEXT ANTI WTIONAL,E ......................................................... 1 1 . Country and Sector Issues ....................................................................................... 1 2 . Rationale for Bank Involvement ............................................................................. 2 3 . Higher Objectives to Which the Project Contributes .............................................. 3

PROECT DESCRIPTION ..................................................................................... 3 1 . Lending Instrument ................................................................................................. 3 2 . Project Development Objective and Key Indicators ............................................... 3

4 . Lessons Learned and Reflected h the Project Design ............................................ 7 5 . Alternatives Considered and Reasons €or Rejection., ............................................. 8 ~ L E ~ E N T A T I O N ................................................................................................. 8 1 . Partnership Arrangements ....................................................................................... 8 2 . Institutional and Implementation Arrangements .................................................... 8 3 . Monitoring and Evaluation o f ~ t c o ~ e ~ e s u l t s ................................................... 9 4 . Sustamability ........................................................................................................... 9 5 . Critical Risks and Possible Controversial Aspects .............................................. 10 6 . Credit Conditions and Covenants ......................................................................... 11 APPRAISLQF, S ~ Y ....................................................................................... 11 1 . Economic and Fhancial Analyses ........................................................................ 11 2 . Technical ............................................................................................................... 11 3 . Fiduciary ............................................................................................................... 12 4 . Social ..................................................................................................................... 12 5 . E n v i r o ~ e n t .......................................................................................................... 12 6 . Safeguard Policies ................................................................................................. 13 7. Policy Exceptions and Readiness .......................................................................... 13 Technical Annex 1 : Country and Sector or Program Background .......................... 15 Technical Annex 2: Major Related Projects Financed by the Bank andor Other Agencies .................................................................................................................... 20

3 . Project Components ................................................................................................ 4

1 . .

. .

Technical h e x 3 : Results Framework and Monitoring ........................................ 21 Technical h e x 4: Detailed Project Description ................................................... 25

Technical Annex 6: Implementation Arrangements ................................................ 44 Technical h e x 5: Project Costs ............................................................................ 42

Technical Annex 7: Financial Management and Disbursement Arrangements ....... 47 Technical Annex 8: Procurement ............................................................................. 57 Technical Annex 9: Economic and Financial Analysis ........................................... 62

Technical Annex 1 1 : Project Preparation and Supervision .................................... 63 Technical h e x 12: Documents in the Project File ............................................... 64 h e x 13: Statement o f Loans and Credits .............................................................. 65 h e x 14: Country at a Glance ................................................................................. 67

Technical Annex 10: Safeguard Policies ................................................................. 62

KENYA FINMCIAL AND LEGAL, SECTOR TECHNICAL A S S I S T M C E PROJECT

PROJECT APPRAISGL DOCUMENT

Financial Sector Unit - AFTFS

Date: September 17,2004 Country Director: Makhtar Diop Sector Managermirector: Antony ~ o m p s o ~ i c ~ e l Womer

Project ID: PO83250

Lending Instrument: Technical Assistance

Team Leader: Michael J. Fuchs Sectors: General finance sector (100%) Theme@): State enterprisehank restructuring and privatization @);Other financial and private sector development (S) Environmental screening category: N o t Required Safeguard screening category: No impact

[ f Laan [XI Credit [ ]Grant [ ]Guarantee [ 7 Other:

For L o a n ~ / C r e d i ~ / ~ t h e r ~ : Total Bank financhg (US$m.): 18.0

ASSOCIATION DEFARTMENT FOR 0.00 10.00 10.00 I N T E ~ A T I O ~ ~ ~ E V E L O F ~ ~ Total: 2.00 28.00 30.00

Borrower: REPUBLIC OF KENYA

Responsible Agency: MINISTRY OF FINMCE

Address: The Treasury, P.O. Box 30007 Nairobi, Kenya

Contact Person: Mi. Joseph IC. Kinpa, Permanent S e c r e t ~ / T r ~ ~ ~ Tel: 254 20 3381 11 Fax: 254 20 330426

!Cumulative1 1.00 I 5.00 1 11.00 1 15.00 1 17.00 1 18.00 1 Project implementation period: 5 years; Start: December 15,2004 End: September 30,2009 Expected eflectiveness date: December 15,2004 Expected closing date: March 31,2010 Does the project depart from the CAS in content or other significant respects? ReK PAD A.3 []Yes [ X ] N o

Does the project require any exceptions f iom Bank policies? Re$ PAD D. 7 Have these been approved by Bank management? I s approval for any policy exception sought from the Board? Does the project include any critical risks rated “substantial” or “high? Re! PAD c.5 Does the project meet the Regional criteria €or readiness for implementation? Ref PAD D. 7

[ ]Yes [ X j N o E ]Yes E 3 N o [ ]Yes [XJNo

[X ]Yes [ J No

[ XjYes [] No - - - . - . __ -

Project development objective ReJ PAD B.2, Technical Annex 3

The overall development objective of the project is to create a sound financial system and a strengthened legal fiamework and judicial capacity that wi l l “ r e broad access to financial and related legal services.

This objective will be achieved through provision o f technical expertise and building capacity to implement the Government’s financial sector reform program and to supporting implementation o f the relevant key results areas of the GJLOS Reform Strategy. As part o f a congruent sectoral approach, the Bank, in partnership with other donors, will support the adoption of financial sector reform policies through the proposed Financial Sector Adjustment Credit (FSAC) and capacity building within the financial system through the MSME Project; both projects are currently under preparation.

C o ~ ~ ~ n e ~ ~ 1: in^^^^^ and ~ ~ d ~ c ~ ~ Sector Strategy D ~ e l ~ ~ ~ e ~ ~ * The Project will support the formulation o f a financial sector strategy involving broad consultations among stakeholders and will be informed by various recent studies on the financial sector. The project will also support the development o f a Strategy for the Judiciary as provided in the GJLOS, which will include the introduction o f performance and service standards, a comprehensive training program, and the introduction of a credible system for the selection, appointment, and r e m o ~ a ~ d i s c i p l i ~ e of judges and other judicial staff, and the strengthening o f the Judicial Service Commission. The Project will support relevant agencies in developing a fiamework for monitoring and evaluating progress in financial sector development and judicial and legal reforms.

has a high level of non performing loans concentrated in four commercial banks with state interests. Divesting the Govement 's stake in these institutions will help 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. The Project will support the

Cum~onent 3: S t ren~hen~ng ~ ~ n a n c ~ ~ Z Sector 3eguZator~ and the Deposit ~ o t e ~ ' o n Fund Board The primary role o f the Governmmt in the financial sector is to provide a legal, regulatory, and supervisory framework that promotes soundness and competition in the sector. The Project will provide support for the review, amendment andor drafting o f financial sector laws and regulations that govem all the regulators and the DPF, with the objective of strengthening their effectiveness. It will also support capacity building initiatives for these institutions, including training needs assessment, training o f staff, resident advisors, and establishment of capacity to regulate and supervise the microfmance and SACCOs sectors under the proposed new legislation. In addition, improvements will be made to the Management Information Systems (MIS) of these institutions, including software upgrades and purchase of hardware.

C ~ m ~ ~ n ~ n t 4: ~ t r e n ~ h e ~ ~ n ~ Debt ~unugement and Debt ~ u r ~ e t s * The updating of Government debt databases i s handled by individual entities in the Ministry o f Finance and CBK responsible for parts of debt management and there is no coordination or consolidation o f data. The Project will provide technical support €or setting up a unified and sustainable Debt Management Office, including review o f relevant legislation. The Project will also support a number o f technical improvements with a view to enhancing the operation o f the primary and secondary debt markets. These include: (i) designing a benchmark issuance strategy; (ii) taking measures to improve transparency in fimding operations; (iii) facilitating over-the-counter (OTC) trading in Government securities; and (iv) establishing a Repurchase Market in Government securities

Co~ponent 5: ~ o ~ e r n ~ z ~ n g the ~ u t ~ u ~ u ~ Puyments System. The Kenyan authorities already recognize the existing deficiencies in the clearing and settlement mechanisms and a task force has produced a framework and strategy paper for the modernization o f the national p a p e n t t system which has recommended, among other things, introduction o f Real Time Grost Settlement (RTGS). The Central Bank has already earmarked funds for the acquisition o f a stant alone RTGS. The Project will provide appropriate technical assistance and funding to acquire E Scripless Securities Settlement SystemKentral Depository System (CDS) to facilitate the safe, secure and efficient clearance and settlement of funds and securities transfers b o t h ~rimary ant

I secondary market transfers) in a manner consistent with best international practice. In addition, the project will support the establishment o f an appropriate legal and oversight fiamework, and provision o f expert technical advice and training for staff o f the Department o f Payments System in the CBK. The Project will also h d a diagnostic study to identify the needs for improvements in the mechanisms for low value payments transfers.

C u ~ ~ u ~ e ~ t 6: ~ ~ ~ ~ u ~ i p t g the Lending ~ n ~ i r u ~ ~ e n t . h e o f the major impediments to growth in Kenya i s insufficient access to credit for large segments o f the population and enterprises, especially micro, small and medium sized ones. The Project will support: (i) improvements in the operation of the Department o f the Registrar General which includes: a) assistance to the Companies Register to enable the Registry clear the backlog in filing and allow for speedy and accurate information sharing o f corporate information and data; and b) combining o f the Charges Register and the Chattel Mortgage Register into one; moving the combined separate register (notification system) for chargeslpledges over movable assets out o f the Companies Register and developing a new Personal Property Securities Act (is., secured transactions €famework) in line with international best practices; (ii) improvements in the land registration system through digitizing land records; (iii) establishment o f a legal and regulatory fiamework for the operation of a credit reference bureau that would facilitate the much needed information flow among the credit granting institutions; and (iv) the review o f impediments to the growth o f the leasing industry, including tax laws on leasing.

C u ~ ~ u p t ~ ~ t 7: Legal uptd ~ ~ d ~ ~ i a l ~ e ~ u r ~ * The legal system in Kenya currently faces major challenges in supporting effective financial intermediation. Furthermore, the drafting, implementation and application of the legislative and regulatory reforms, as described in Components 3 and 6 will require strong capacity in the judiciary and in the legislative and executive offices charged with legislative drafting and law revision. An effective legal education will ensure that the legal and judicial professions are well placed to implement these reforms. This Component focuses on these three areas.

~ ~ d i ~ i a ~ reform: Activities in this subcomponent will focus on establishing the court and case management and records management systems and improving court registries. Activities aimed at reducing the backlog o f cases will include supporting alternative dispute resolution (ADR) mechanisms for commercial law cases and introducing small claims court procedures, S m q court procedures for uncontested debt enforcement will be introduced to eliminate the fiequent frustration o f enforcement procedures. Support for a staff training program and more effective human resource administration and management will also be provided.

Law reform: The Project wil l provide technical assistance to finalize the institutional review and capacity building of law reform bodies, including the Law Reform Commission, the Office of the Attomey General and the Parliamentary Service Commission. These institutions will also be supported in carrying out the review, harmonization and drafiing of priority laws in the financial and commercial sectors in Kenya, having regard to the development o f regional trade institutions and initiatives such as the East Africa Customs Union.

Legal ~ d ~ ~ ~ ~ i ~ ~ : In order to strengthen the capacity o f the legal profession and the judiciary in the commercial and financial areas. i t wil l be necessarv to enhance education o f iudges and

lawyers. Following a review o f the institutional arrangements for basic and continuing legal education, key legal education institutions will be provided with support to strengthen facilities, review and develop teaching cunricula and educational materials, update libraries and research capabilities, and create new training and development opportunities for both students and faculty.

Which safeguard policies are triggered, if any? Re$ PALl D.4 ~ ~ c ~ n ~ c ~ 2 Annex 10

NONE

Significant, non-standard conditions, if any, for: Re$ PAD C. 7

NONE

Board presentation: October 14,2004

Credit esectiveness: December 15,12004

Covenants applicable to project implementation:

Preparation and review o f quarterly and annual project implementation progress reports, and updating of the PIP on an annual basis.

A. STRATEGIC CONTEXT AND RATIONALE

1. Country and Sector lssues

A key priority o f the new Kenyan Government is the reduction o f poverty through economic recovery and promotion o f sustainable growth. The Govement recognizes that in order to achieve this objective, it will have to address the s t rucbal weaknesses that have contributed to the decline in productivity and competitiveness o f the economy in the last two decades. With the right investments and policy and institutional refoms, Kenya does have significant growth potential,

The G o v e m e n t has prepared an Economic Recovery Strategy for Wealth and Employment Creation (ERSWEC) through a broad consultative process, Its fxst priority is to restore the economy on a path o f high growth. Within this fiamework, 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 the provision of iafrastructure 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 i s well developed and comprises 43 commercial banks, with the six largest accounting for about two-thirds o f all assets, loans and deposits o f the banking system. A defining weakness, however, i s the severely constrained access to financial services by Kenyan households, notably in the m a l areas, and by private enterprises, especially micro, small and medium enterprises ( M S m s ) . Sustained high interest spreads and transaction costs reflect structural problems.

Competition in the system is hampered by the presence o f 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 (NFLs) amounted to about 25.7 percent o f the total loan portfolio in December 2003. The Banking Supervision Department o f the Central Bank o f Kenya (CBK) has a well-founded of€-site and on-site supervision program but this has not always resulted in decisive corrective action. The performance o f the payments system is hindered by the inadequate legal fiamework, lack o f efficient payment instnunents and long cycles o f clearing and settlement.

Financial institutions outside the banking sector are diversified but also have some structural problems. The insurance sector comprises 41 licensed companies, ttwo reinsurers, about 200 brokers and 400 active agents, all supervised by the Commission o f Insurance. The commission is not operationally independent and does not have adequate resources to carry out effective supervision o f the sector. The Kenya pension system has very limited coverage and does not provide adequate pension benefits. There are high levels o f unfbnded liabilities among many o f the existing schemes. The Capital Markets Authority has limited capacity and does not have operational independence. Although the

1

legal framework for capital markets has been largely put in place, the enforcement o f market d e s and supervision o f market participants are both s t i l l we&.

In view o f the above constraints, the Government is developing a program o f financial sector reform program to address policy, institutional and legal issues impeding the efficient operation o f the sector. In the medium term, the Government has indicated its intention to draw up a financial sector development strategy that will provide the frsunework for 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 firrancid and legal sector reform program.

Good clear laws backed by a strong and credible judiciary are an essential element in creating an environment that i s conducive to business and financial activity. The Govmment has developed a Governance Justice, and Law and Order Sector (GJLOS) R e f o m Program aimed at addressing key weaknesses in the sector, The activities to be supported in this Project fall within the key result areas o f the GJLOS that will most support the strengthening of the financial sector.

2, Rationale for Bank Invoivement

With the comi tmen t o f the new Government to improve public sector management, eliminate compt ion and restore the rule o f 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 focused on supporting the Govement ’s efforts at improving the existing poor economic governance. A new CAS was presented to the Bank’s Board on June 17, 2004 and provides the foundation for a strategy for re-engagement with the Authorities, aligned with the Govement ’s ERS. The Government has already agreed with the IMF on a new Poverty Reduction and Growth Facility (PRGF) program and has moved decisive1 y on improving relationships with development pastners. There is renewed interest in Kenya by the international c o m m i t y as exemplified by the positive response at the Consultative Group Meeting held in Nairobi in November 2003 where the donors pledged a total of US$4.1 bil l ion over the next three years.

Following the change o f govemment, the Bank has reengaged in supporting financial and legal sector reforms in Kenya. The recently concluded Financial Sector Assessment Program (FSAP) and extensive dialogue with the Government and other stakeholders has allowed the Bank to deepen its knowledge o f the issues facing the financial sector. This has been complemented by the Govement ’s efforts in developing a banking sector strategy (undertaken in late 2003) and ongoing work on strategy for devr;lopment finance institutions (DFIs) and m a l finance. Kenya is also taking part in a joint B a M u n d Program on central government debt management and domestic debt market development. Thus the Bank is now well positioned to play a leading role in coordinating Kenya’s development partners in the fmancial sector dialogue.

2

In the legal sector, the Bank has been a leading donor and i s currently co-chairing the legal sector donor coordinating group. In 1999 the Bank provided assistance to Government to develop a legal sector strategy. This strategy was subsequently transfomed and expanded to become the current Government’s medium term Governance, Justice, and Law and Order Sector (GJLOS) reform strategy. The Bank and the other members o f the legal sector coordinating group have worked closely with the Govement on the development o f the GJLOS reform strategy.

3. Higher Objectives to Which the Project Contributes

The Government’s ERSWEC has three pillars o f growth, equity and poverty reduction, and govemmce. The new CAS prepared by the Bank is directly aligned with these objectives. In order to achieve sustained growth, an accessible, efficient and reliable financial sector and justice system are essential for the mobilization and allocation o f resources. ‘The proposed r e f o m o f the financial system will form an important part o f the Government’s effort to move towards a market based economy which will contribute to a sustainable fiscal position and improved allocation o f resources. Broad-based financial and legal sector reforms will directly contribute to improving equity and reducing poverty through expanding access to financial services and the justice system. Strengthening transparency and accountability in these key sectors represents a major contribution in itself to improved governance. Thus, the Financial and Legal Sector Technical Assistance Credit (FLSTAC) supports the achievements o f these core ERSWEC objectives.

B. PROJECT DESCRIPTION

1. Lending Instrument

The total project costs will amount to US$3O million. Funding will be provided by the World Bank, other donors and the Government. The Bank funding o f the FLSTAC project will be in the form o f a US$18 mi l l ion five-year technical assistance credit. DFTD (UK) will provide a grant o f Pound Sterling 6 mill ion (equivalent o f US$lO million) and Govement counterpart funding will be US$2 million. Consultant services, training, and goods wil l be financed under the project.

The International Development Association (IDA) agreed to the Government’s request for a Project Preparation Facility (PPF) in the m o u n t o f US$725,OOO. The PPF funds are being used to finance the activities o f the Bank Restructuring and Privatization Project (under Component 2 below) during project preparation.

2. Project Development Objective and Key Indicators

The overall development objective o f the project is to create a sound financial system and strengthened legal fiamework and judicial capacity that will ensure broad access to financial and related legal services. This objective will be achieved tllrough provision o f technical expertise and building capacity to implement the Government’s fmancial sector r e f o m program and to supporting implementation o f the relevant key results areas o f the

3

GJLOS Reform Strategy. As part o f a congruent sectoral approach, the Bank, in partnership with other donors, wil l support the adoption o f fmancial sector reform policies through the proposed Financial Sector Adjustment Credit @SAC) and capacity building within the financial system through the MSME Project; both projects are currently under preparation.

Key Performance Indicators as o f the end o f the project implementation period include:

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~ercentage o f population with access to appropriate financial services increases

Increase in private credit provision relative to GDP by 30%.

The ratio o f non-performing loans to the total loan portfolio o f the banking system is reduced to less than 10 percent.

Spread between average deposit rate and lending rate for prime customers decrease by 30%.

Reduction o f backlog in commercial cases by 25%.

Appropriate adoption o f key commercial sector laws

Increase in measured satisfaction of the business community with the judiciary by 25%.

by 20%.

Project Components

The project will consist o f seven components:

C o ~ ~ ~ n e ~ t I: ~jnancjaZ and ~ u d ~ ~ ~ a Z Sector Strategy ~ e ~ e Z o ~ ~ e n t ($0.8 ~jZZjun: IDA: $a35 ~ j Z Z j u ~ ~ - The Project wil l support the formulation o f a financial sector strategy involving broad consultations among st&eholders,and will be informed by various recent studies on the financial sector. The project will also support the development o f a Strategy for the Judiciary as provided in the GJLOS, which will include the introduction o f perfiormance and service standards, a comprehensive training program, and the introduction of a credible system for the selection, appointment, and r ~ o v ~ d i s c i p l i n e of judges and other judicial staff, and the strengthening the Judicial Service Commission. The Project will support relevant agencies in developing a framework for monitoring and evaluating progress in financial sector development and judicial and legal reforms.

C u ~ ~ o n e n ~ 2: ~ ~ ~ ~ r ~ ~ ~ ~ r j n g and ~ ~ ~ a ~ z a ~ ~ n ~ ~ ~ j ~ a ~ c j a Z ~ n ~ t ~ t u ~ u ~ ~ @3,3 ~ ~ Z Z ~ u ~ ~ IDA: $1.8 ~ ~ Z ~ ~ O ~ ~ . The banking system has a high level o f non performing loans concentrated in four commercial banks with state interests. Divesting the Government’s stake in these institutions will help 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. The Project will support the establishment of a specialist Bank Restructuring and Privatization Project @WP) within the Ministry of Finance which will guide the privatization process from the identification o f strategic

4

options for divestiture, through short-term preparatory restructuring to preparation and completion o f the transactions. Once the Privatization Bill has been enacted and the Privatization Commission is functional, the intention i s that the BWF will refer to the Commission, k e a s o f possible further support include the restructuring of: (i) the Development Finance Institutions (DFIs), in line with the DFI strategy currently being developed, and (ii) Kenya Post Office Savings Bafllr (KPOSB) and Co-operative Bank, two key institutions for improving access to financial services.

C ~ ~ ~ ~ n e n i 3: S t r e n ~ h e n i ~ g ~ j n a ~ ~ ~ a Z Sector Reg~~utors und the Deposit P ~ o i e ~ j ~ ~ Fund Bourd ($39 m ~ ~ j o n ; IDA: $2.2 m ~ Z Z j ~ n ~ ~ The primary role o f the Government in the financial sector i s to provide a legal, regulatory, and supervisory framework that promotes soundness and competition in the sector. The Project will provide support for the review, amendment andor drafting o f financial sector laws and regulations that govern all the regulators and the DPF, with the objective o f strengthening their effectiveness. It will also support capacity building initiatives for these institutions, including training needs assessment, training o f staff9 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 Systems (MIS) o f these institutions, including software upgrades and purchase of hardware.

C o ~ ~ ~ n e n i 4: S ~ e ~ ~ h e n i n g Debt ~ a n u ~ e m e ~ t und Debt ~ u r ~ ~ s ($1.5 m ~ ~ j ~ n ; IDA: $0.9 m ~ ~ i o n ~ . The updating o f G o v e m e n t debt databases is handled by individual entities in the Ministry o f Finance and CBK responsible for parts o f debt management and there is no coordination or consdlidation o f data. The Froject will provide technical support for setting up a Unified and sustainable Debt Management Office, including review o f relevant legislation. The Project will also support a number o f technical improvements with a view to d a n c i n g the operation of the primary and secondary debt markets. These include: (i) designing a benchmark issuance strategy; (ii) taking measures to improve transparency in bd ing operations; (iii) facilitating over-the-counter (OTC) trading in Government securities; and (iv) establishing a Repurchase Market in Government securities

Cu~ponent 5: ~ o d e r n i ~ j n g the ~ u t j o ~ u Z Pr;rymenis System ($3.1 ~jZZj~n; IDA: $1.8 ~ ~ Z j ~ n ~ . The Kenyan authorities already recognize the existing deficiencies in the clearing and settlement mechanisms and a task force has produced a framework and strategy paper for the modemization o f the national payments system which has recommended, among other things, introduction o f Real Time Gross Settlement (RTGS). The Central Bank has already earmarked hnds for the acquisition o f a stand alone RTGS. The Project will provide appropriate technical assistance and funding to acquire a Scripless Securities Settlement SystedCentral Depository System (CDS) to facilitate the safe, secure and efficient clearance and settlement o f funds and securities transfers (both primary and secondary market transfers) in a manner consistent with best international practice. In addition, the project will support the establishment of an appropriate legal and oversight framework, and provision of expert technical advice and training for staff of the Department o f Payments System in the CBK. The Project wil l also h d a

5

diagnostic study to identify the needs for improvements in the mechanisms for low value payments transfers.

C u m ~ ~ n e n ~ 6: ~ m ~ r u ~ ~ ~ g the L e ~ ~ ~ ~ g ~ ~ ~ ~ r u ~ m e ~ t ($2.3 m ~ l Z ~ o ~ ; IDA: $1-4 million). One ofthe major impediments to growth in Kenya is insufficient access to credit for large segments o f the population and enterprises, especially micro, small and medium sized ones. The Project will support: (i) improvements in the operation o f the Department o f the Registrar General which includes: a) assistance to the Companies Register to enable the Registry clear the backlog in filing and allow for speedy and accurate information sharing o f corporate information and data; and b) combining o f the Charges Register and the Chattel Mortgage Register into one; moving the combined separate register (notification system) for chargeslpledges over movable assets out o f the Companies Register and developing a new Personal Property Securities Act secured transactions framework) in line with international best practices; (ii) improvements in the land registration system through digitizing land records; (iii) establishment o f a legal and regulatory framework for the operation o f a credit reference bureau that would facilitate the much needed information flow among the credit granting institutions; and (iv) the review of impediments to the growth o f the leasing industry, including tax laws on leasing.

C o ~ ~ o ~ e ~ t 7: Legal and ~ u d ~ ~ ~ ~ Reform ($8.1 m ~ ~ ~ n ~ IDA: $4.5 million). The legal system in Kenya currently faces major challenges in supporting effective financial intermediation. Furthermore, the drafting, implementation and application o f the legislative and regulatory reforms, as described in Components 3 and 6 will require strong capacity in the judiciary and in the legislative and executive offices charged with legislative drafting and law revision. An effective legal education will ensure that the legal and judicial professions are well placed to implement these reforms. This Component focuses on these three areas.

~~~~~~~~ refom: Activities in this subcomponent will focus on establishing the court and case management and records management systems and improving court registries. Activities aimed at reducing the backlog o f cases will include supporting altemative dispute resolution (ADR) mechanisms for commercial law cases and introducing small claims court procedures. S u m q court procedures for uncontested debt enforcement will be introduced to eliminate the frequent frustration o f enforcement procedures. Support for a staff training program and more effective h m a n resource administration and management wil l also be provided.

Law reform: The Project will provide technical assistance to finalize the institutional review and capacity building of law reform bodies, including the Law Reform Commission, the Office of the Attorney General and the Parliamentary Service Commission. These institutions will also be supported in canying out the review, harmonization and drafting o f priority laws in the financial and commercial sectors in Kenya, having regard to the development o f regional trade institutions and initiatives such as the East Africa Customs Union.

Legd ~~~~u~~~~~ In order to strengthen the capacity o f the legal profession and the judiciary in the commercial and financial areas, it will be necessary to enhance education o f judges and lawyers. Following a review of the institutional mangements for basic and continuing legal education, key legal education institutions will be provided with support to strengthen facilities, review and develop teaching curricula and educational materials, update libraries and research capabilities, and create new training and development opportunities for both students and faculty.

4. Lessons Learned and Reflected in the Project Design

Based on experiences from similar projects in other countries, one important lesson is the need for a flexible design to be able to respond to the needs o f the client and to address priorities or unforeseen developments that can emerge during implementation. "he description o f the components has therefore been broadly defined instead o f being specific. Another lesson is that for the reforms to be sustainable, the G o v m e n t has to have ownership o f the process and not view it as Bank driven, To this extent, extensive dialogue with the Government was conducted during the early stages o f project preparation to better understand the priorities o f the Government.

The project team recognizes that for the project to meet its objectives and the reforms to be sustainable, there is need to have adequate implementation capacity and skills to maintain momentum in the beneficiary organizations. The project therefore ernphasizes the creation of technical expertise in both the financial and legal sectors and the need to create an environment in which these skills can be retained in the various agencies. Particular emphasis will be placed on organizational development issues, fmancial sustainability and retention o f key staff across all components o f the project.

In both the fmancial and judicial sectors, one common lesson is that coherence o f the reform program requires that a comprehensive, holistic approach be taken so as to ensure that the process o f developing hanc ia l and legal systems is harmonized. Thus, the f irst component o f the project supports developing comprehensive strategies for both the financial and judicial sectors. The work in the financial sector entails bringing together the various threads o f strategy work already undertaken. In the legal area this work will entail setting the context for judicial reform, law reform and legal education before applying these reforms specifically to the financial and commercial sector.

Secondly, there was recognition that all aspects o f financial, legal and judicial reform are part o f a longer-term process involving institutional capacity building and best implemented in stages. The prioritization and sequencing o f reform, based on absorptive capacity and available resources, will be critical. For example, before significant progress can be made in improving access to financial services, the problem o f soundness o f the banking system must be addressed. Similarly, in the legal sector revision o f relevant laws is a prerequisite for successful development and operation o f improved registries.

7

5. Alternatives Considered and Reasons €or Rejection

A freestanding legal and judicial reform project was considered first but it was later considered more prudent to combine it with the financial sector operation in order to streamline the Kenya project pipeline. Experience with financial sector refoms in other African countrks - and also in other regions - demonstrates conclusively how closely the development of the fuzancial sector depends on concomitant legal refoms.

1. Partnership Arrangements

Under this Project, the Bank is working jointly with DFID who will provide co-financing which will be coordinated by the Bank under the implementation arrangements mentioned below. Disbursement o f funds and procurement o f goods and consultants’ services under the Project will follow the Bank’s guidelines. The Bank and RFID will sign a co-fmanciers agreement that will spell out the detailed procedures to be followed by the Government for procurement and disbursement activities.

Within the framework o f overall financial and legal sector reform, the Bank team will support donor coordination in the respective sectors. Currentlyp the Bank and Swedish htemational Development Agency (SIDA) are the joint chairs o f the Legal Sector Coordinating Group. There is substantial involvement o f a wide range o f donors in the rural and microfinance sector but significantly less involvement in the wider fmancial sector.

2. Institutional and Implementation Arrangements

The Project will be implemented over five years. The Implementing Agency for the Project will be the Ministry o f Finance. A high-level official in the Ministry will chair a Project Steering Committee, which will provide strategic guidance for the Project. The Project Steering Committee will be comprised o f three representatives from the Ministry o f Finance, the CBK, and the Ministry o f Justice and Constitutional Affairs. Representatives o f XDA and RFD will sit on the Steering Committee as observers so as to facilitate information exchange and improve the decision making process in the framework o f project implementation.

The administrative responsibility for day-to-day operations o f the Project will l ie with a Project Implementing Unit (PIU), which will report to the Chaiman o f the Project Steering Committee. This Unit will be headed by a full time Project Manager who will have an excellent understanding o f financial and legal sector r e f o m issues, possesses drive for results and an ability to bring stakeholders together in a collaborative manner. The Project Manager will be supported by technical financial sector and legal sector advisors, an accountant and a procurement specialist. Further details are discussed in Annex 6.

8

Financial Management

Project accounts wil l be integrated in the Ministry o f Finance accounting system and the PTU will coordinate project accounting, maintain overall records, and manage disbursements. The PIU will produce quarterly financial monitoring reports and annual financial statements, and ensure their timely audit in accordance with International Public Sector Accounting Standards. The Government, through the Ministry o f Finance will open a separate Project Account where counterpart f inds are deposited in agreed amounts and which will be managed by the PIU in fulfillment o f implementing agencies’ financing requirements. Annex 7 sets out the proposed banking and funds flow arrangements,

3. Monitoring and Evaluation of OutcomesResults

The project design has been guided by a results framework (see Annex 3) intended to be used for both project management and supervision. The primary monitoring mechanism will be quarterly and annual reports prepared by the Project Manager and presented to the Steering C o h t t e e . These reports will assess achievements agahst the Project Implementation Plan (PIP) and overall project progress using the indicators defined in the results fiamework, As pari o f the assessment, financial results will be included and discussed. The PIU will be responsible for updating the PIP on an annual basis, taking into account experiences and the strategic focus o f the Project. It will also assist the implementing agencies in the collection o f relevant data to measure the project’s progress. Consultants will be hired to collect base line data and to cany out impact studies during the course o f the project. All reports will be submitted to the Bank and other finding donors. A mid-term review will be carried out at the hal f way point o f the Project. An Implementation Completion Report (ICR) will be undertaken after the completion o f the project. This will be coordinated with the monitor& o f the GJLOS.

4. Sustainability

The starting point for this Project i s the call for broad-based reforms in the financial and legal sectors as set out in the EWWEC. The Minister o f Finance and the Central Bank specifically requested support for financial sector reform. The Judiciary and the State Law Office asked for support in implementing Key Results h e a s 3 and 6 of the GJLOS. Components have been developed in close cooperation and detailed discussions with each o f the implementing agencies and there is clear commitment and ownership. This project responds therefore to specific demands by Government, a sine qua non for sustainability.

Capacity to develop and implement is crucial to the success o f the reform programs. Recognizing the weaknesses in base capacity across the implementing agencies, the Project will explicitly focus on building capacity in all i t s components. The problems o f organizational development, financial sustainability and retaining the capacity developed under the project will be key elements in ongoing policy dialogue.

9

5. Cri t ical R i s k s and Possible Controversial Aspects

Risks

To project development objectives The Government fails to maintain a stable macroeconomic environment

Appropriate revisions to key financial sector laws are not adopted or are undermined by Parliamentq amendments

Lack o f Govemment commitment and capacity to define and implement necessary policy reforms

To component results Lack o f political commitment to implement broad financial and legal sector reforms, including bank and DFI restructuring and granting autonomy to regulatory agencies.

Limited technical and absorptive capacity o f the various implementing agencies to implement agreed upon activities.

3eneficiaries are not able to retain the staff trained under the project.

Lack of collaboration and coordination among govemrnent agencies undermines the implementation ofrefonns.

Overall Risk Rating

Risk Mitigation. Measures Risks Rating with

Mitigation

An ongoing IMF program and continuous dialogue with the Authorities on necessary policy r e f m .

8road stakeholder participation, including Parliament, to ensure consensus building for law reforms

Policy reforms in the financial and legal sectors to be supported by broad-based strategy formulation and ongoing policy dialogue, engaging wide ranges o f stakeholders.

Continued dialogue with the Govemment on the reform o f the financial sector and engagement of a broader stakeholder group.

Capacity building activities supported by the project components. Pace o f implementation will be adapted to the absorptive capacity o f the beneficiary agencies.

Engage the Government in developing a strategy for retaining qualified individuals in the public sector within the context of the Public Expenditure Review (PER) process.

The broad-based structure o f the project encourages inter-agency collaboration. Project activities include inter-agency discussions on collaboration and cooperation.

s

H

M

s Risk Ratings: H (High Risk); S (Substantial Risk); M (Modest Riskj; N (Negligible or Low Risk)

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6. Credit Conditions and Covenants

Effectiveness conditions

1. Establishment o f a Project Steering Committee.

2. Establishment o f the PTU at the MoF.

3. Preparation o f a Project Implementation Plan (PIP) acceptable to IDA. 4. Opening o f the Project Account and the m o u n t o f the initial advance

(counterpart funds) deposited therein.

5. The DFII) Grant Agreement (with the Govement) has been executed and delivered and all conditions precedent to its effectiveness have been fulfilled.

1. Economic and Financial Analyses Given the character o f this operation, a quantitative economic and financial analysis would not be the appropriate tool to assess the significance o f this project. The pace and depth o f the refoms envisioned in this operation will determine the ultimate economic and financial benefits o f this loan.

2. Technical The technical merits o f the project design have been examined by Bank staff over the course o f project preparation and are considered to be sound and in line with international standards. The design is grounded in a series o f analytical work in the two sectors over the past 15 months, including the analysis and r e c o ~ e n d a t ~ o ~ s from the joint B M u n d FSAP, preparatory work undertaken in conjunction with the Bank’s proposed Financial Sector Adjustment Credit (FSAC), the Banking Sector Strategy paper developed by the Government with fanding from DFII), on-going work on DFIs and rural finance being funded by the FIRST trust h d , the report on Refoming Commercial Justice in Kenya, the Kenya Legal Framework for Investment Report and the legal and judicial sector assessment undertaken by the World Bank, amongst other reports. T e c h c a l assessments will continue throughout the period o f project preparation and implementation.

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3. Fiduciary

The overall conclusion o f the financial management assessment is that the current financial management arrangements in various implementing agencies do not satis@ the World Bank's minimum financial management requirements. It is the intention that the financial management o f this Project will therefore be based on the systems established by the Mill istry o f Finance in order to mitigate financial risks. fn addition, so as to establish an acceptable control environment and to reduce financial management risks, it is envisioned that the Action Plan outlined in h e x 7 should be implemented.

4. Social

Access to appropriate and affordable financial services is a critical tool for poor households to reduce vulnerability to l i fe cycle events, crises and consumption needs, together with increasing income through development of enterprises and employment. Furthemore, reducing the fiscal drain from state involvement in the fmancial sector and the risk o f a financial sector crisis will fiee resources for U_portant social sector expenditure in health, education, water and sanitation. Improving the judicial system will benefit small investors by reducing barriers to access to justice such as cost, culture, language and geographical location. This will empower them to enforce their rights,

Extensive consultations have been held with a broad range o f stakeholders. They have participated in project preparation and will be consulted during project monitoring and evaluation.

5. Environment

a. Are any of t h e ~ o ~ ~ o ~ i n g e n v i r o n ~ ~ n t ~ Z issues i~por tant in the project?

i. ~sta~€ishing policy, ~ e ~ ~ a t o ~ and i ~ s t i t u t i o n a l ~ a m ~ o r ~ for en~ironmenta€ly sustaina~~e growth and resource ~anagement, ~ a r t i c u € a r € ~ in sectors that potenti~€Zy affect the en~ironment~

ii. enhancing €i~e€ihoods of the poor t h r o u g ~ ~ (9 i ~ ~ r o v e d and transparent m ~ ~ ~ g e m ~ n t of n ~ t ~ r a € resources or (io reduced ~ ~ ~ e r ~ ~ i ~ i ~ to e n v i r o n ~ e n t ~ ~ change (e.g., natura€ d i ~ ~ s t e r ~ such a s ~ o o d s ~ ;

iii, ~ r o t e c t i n ~ ~ e o ~ € e 's h e ~ ~ t ~ ~ o ~ e n ~ i r o n ~ ~ ~ t ~ ~ risks a n ~ p o ~ ~ u t i o ~ ~

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5. Safeguard Policies

Which safeguard policies are triggered by this project? Safeguard Policies Triggered by the Project Yes N o Environmental Assessment (OPIBPIGP 4.01) E l Natural Habitats (OPIBP 4.04) Pest Management (OP 4.09) Cultural Property (OPN 1 1.03, being revised as OP 4.1 1) Involuntary Resettlement (OPIBP 4.12) Indigenous Feoples (OD 4.20, being revised as OF 4.10) Forests (OPBP 4.36) Safety o f Dams (OPlf3P 4.37) Projects in Disputed Areas @PBP/GP 7.60)* Projects on International ~ a t e ~ a ~ s (OPBPIGP 7SO)

E 3 E l [I [I [l E1 E l E l El

b. c.

d. e.

f.

g*

h. 1.

7.

what is the safeguard screening category o f the project? (SI, 52, S3, SF) 53 What i s the environmental screening category o f the project? (A, B, C, FI) C If applicable, what are the key safeguard pol icy issues raised by the project? N.A. If applicable, what are the main results o f any safeguard pol icy related studies, and how have they been incorporated into the project? N.A.

What i s the borrower's capacity to implement the safeguard policies r e c o ~ e n d ~ t i o ~ , and, if the capacity is insufficient, how will th is capacity be brought to the required level? N.A. What type of consultations have been conducted related to safeguard issues? H o w did these consultations influence project design? N.A. M e n were the safeguard studies made available at the Infoshop? N.A.

M e n and where were safeguard studies made available in the cooperating country? N.A.

Policy Exceptions and Readiness

(a) Readiness [xl 1, Financial Management and Procurement arrangements are in place.

[I 2. Project Management staff and consultants have been mobilized

[I 3. The procurements documents for the first year's activities are complete and ready for the start o f project implementation.

[] 4. The Project Implementation Plan has been appraised and found to be realistic and o f

E] 5. Results assessment arrangements completed: M&E institutional obligations spelled

[XI 6. The following items are lacking and are discussed under loan conditions.

satisfactory quality.

out; M&E capacity in place; indicators specified; base line data collected

(i) Set up o f a PIU before effectiveness

(ii) Preparation o f a PIP before effectiveness

(b) CompUance [XI 1 ~ This project complies with al l applicable Bank policies.

[I 2. The following exceptions to Bank policies are recommended for approval. The project complies with all other Bank policies.

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Technical Annex 1 : Country and Sector or Program Background Kenya: Financial and Legal Sector Technical Assistance Project

1, Macroeconomic Background

Kenya’s growth performance in the 1990s was dismal, with an average GDP growth o f just over 2% per mum, compared to an annual average o f 7% in the 1970s. This substantial deterioration in economic performance could be traced to a number o f factors, including: i) sharply reduced public spending on social services and infrastructure; ii) the loss o f economic competitiveness; iii) soaring costs o f doing business; iv) deteriorating security conditions; and v) the loss o f donor funding due to governance problems.

Aside from the poor growth performance, trends in other macroeconomic indicators were also discouraging and were consistent with the growth picture.

Saving and ~ n v e s ~ e n t rates declined, with gross domestic investment falling from 20% o f GDP in the early 1990s to 13% by 2001. Most o f this decline was due to the fall in public sector investment although gross capital formation in the private sector also declined from an average o f 11% o f GDP in the 1990s to about 9% by 2001. Gross national savings showed a similar trend, falling from an average o f 14% o f GDP in the first half o f the 1990s to about 4% in 2001

Govern~en€ ~ n a ~ ~ e ~ also came under pressure, with revenues (excluding grants) declining from nearly 30% o f GDP in 1996 to 22% in 2002, due to a mixture o f an increase in tax evasion, decline in tax rates and the general slowdown in economic activity. Unfortunately, government funds were spent inefficiently, with spending on public sector wages and interest payments accounting for ha l f o f total expenditures, and leaving few resources for capital expenditures and the delivery o f essential services.

The deterioration in govement revenue mobilization and the poor expenditure controls led to ~ n c r e ~ ~ e ~ ~ ~ ~ e ~ t i ~ b ~ ~ o ~ i n ~ by the ~ ~ b ~ i c sector and the accumulation o f domestic arrears. The stock of gross domestic debt rose rapidly, peaking at 44% o f GDP in 1994, subsequently declining to 30% by end-2003. External debt however remains relatively low at around $5.6 bil l ion in 2001 (50% o f GDP), largely due to Kenya’s loss of access to international financing for most o f the 1990s.

Despite the negative trends in other indicators, ~ n ~ a € ~ o n in Kenya has remained under control, standing at 2% in 2002.

The IMF has been closely following macroeconomic developments in Kenya. A three- year Poverty Reduction and Growth Facility (PRGF) was approved for Kenya in November 2003 to replace an earlier one which expired in July 2003. The PRGF will enable the Kenyan authorities to implement a coherent program of economic and

structural reforms to address sluggish economic growth, the weak fiscal position, the large domestic debt and the fiagilities in the banking sector.

2. Financial Sector Program Background

After years of non-engagement by the Bank in the Kenyan financial sector, a Bank Financial Sector Mission visited Kenya in January 2003 to initiate discussions with the authorities on the much-needed reform o f the financial system. The discussions focused on possible Bank assistance in three key areas: i) the resolution and privatization o f the remaining state-influenced or owned banks; ii) implementation o f short t m measures to improve the ability o f banks and other institutions to liquidate the large stock o f non- performing assets (NFAs) in the b&g system; and iii) medim term reforms o f the legal and judicial Erameworks needed to significantly improve the mobilization o f fmancial resources through the banking system in support o f the authorities’ high growth economic strategy. I t was proposed that these reforms be addressed by two separate Bank operations: i) a Financial Sector Adjustment Credit (FSAC), covering key policy and institutional reforms; and ii) a Financial Sector Technical Assistance Credit (FLSTAC), providing support for the implementation o f required reforms as well as other medium- term changes in financial infkastructure. At the same time, preparations also began for a joint Bank-Fund Financial Sector Assessment Program (FSAP) to conduct a comprehensive review o f the financial system and identify additional medium term reforms needed to support the development o f the financial sector.

The jo int Bank-Fund Financial Sector Assessment Program (FSAF) was completed for Kenya in late-2003. It provided a broad overview o f potential financial sector vulnerabilities and developmental needs, and also conducted an assessment o f relevant standards and codes, including the Bask Core Principles for Effective Banking Supervision, the TOSCO Assessment for Securities Regulation and the assessment o f the framework for Anti-Money Laundering and Combating the Financing o f Terrorism.

Overall, the FSAP indicated that although the major elements o f a well-developed financial system are in place in Kenya, the financial sector has been unable to reach its full potential in supporting the allocation o f scarce economic resources and promoting strong economic growth* The fmancial system was weak and not in a position to deliver adequate credit to the private sector, especially for investment purposes, and to small- and medium-sized enterprises (SMEs) in particular. In addition, the banking system is vulnerable to a number o f r isks that could endanger financial stability and impose a large burden on the fiscal budget.

Key weaknesses in financial sector infrastructure have posed serious obstacles to developing the financial system and improving access to financial services. The legal ~ a ~ e ~ ~ ~ ~ for property rights, insolvency, and creditor rights i s fragmented, outmoded, and incomplete. The lack o f accurate and reliable information about the borrowers’ ability to pay reduces competition, increases credit risk, and lending rates, and makes i t difficult to reduce the dependence o f banks’ lending decisions on collateral. Inefficiencies and cormption in the system o f land and movable asset registration and in the court system delay court decisions and undermine property and creditor rights; these make

16

lenders reluctant to lend and increase r i sk premiums. The FSAP noted that some o f these problems are being addressed by the authorities, most notably the dismissal of cormpt judges and expanded activity o f the Commercial Court. In addition, these systemic issues will be addressed in the legal reform and improving the lending environment components o f this Project. The Commercial Court will be further strengthened by training judges, introducing modern administration and case management practices, reducing the granting of injunctions that interfere with creditor rights, and accelerating court decisions. Finally, there is an urgent need to strengthen the Companies and Land Registries to enable the collection o f timely and accurate financial data on companies, disseminate th is information to investors and provide creditors with a reliable system for creation and edorcement o f security interests over land and movable assets.

Kenya’s financial system also remains fraagile with non-performing loans in the banking system at around 26% of gross loans and advances. This situation is especially acute in the state-influenced banks. I t was therefore recommended that the highest priority be given to restructuring insolvent banks and divesting government stakes in the banking sector.

The fragility o f institutions is compounded by weaknesses in financial supervision. Major regulators suffer from a lack o f independence from government influence and are often handicapped in enforcing prudential regulations. To reduce overall financial sector vulnerabilities, it i s critical to ensure the independence o f financial supervisors and strengthen their powers to intervene more rapidly to deal with identified problem banks which are currently beneficiaries o f regulatory forbearance. Revisions to both the Banking Act and the associated prudential regulations are also necessary to address deficiencies in the legal framework for banking supervision.

Overall, the FSAP team found that direct government participation in the financial system was a source of distortions and an indirect source o f vulnerabilities. It was therefore recommended that the Government’s role in financial development be focused on providing a robust legal and judicial framework, and strong supervision and regulation of financial institutions and markets, thereby promoting soundness and competition m o n g all providers o f financial services.

Following the FSAP, a series o f follow-up analytical work has been initiated to move the reform process closer to implementation. First, a task force comprising o f Kenyan and international experts was assembled to produce a Strategy Paper for the reform o f the banking sector. The work of the Task Force was overseen by a high-level Steering Committee, chaired by the Ministry of Finance. A final report was submitted to the authorities in late 2003 and i s presently under consideration. Second, due to the chronic lack o f access to financial services identified by the FSAP, the Financial Sector R e f o m and Strengthening Initiative (FIRST) has provided funding for further work in the areas o f rural and development finance. This work is currently being carried out by a team o f international and Kenyan consultants and i s expected to produce a road-map for improving rural and development finance in Kenya.

The sorry state o f the pensions industry has also attracted attention and in February 2004, the Bank hosted a seminar on pension reform for a broad forum o f public sector officers involved in the administration, regulation and reform o f the Kenyan pension system as well as representatives from the private sector. The discussions and interactions revealed a high degree o f concern about a number o f issues, including: i) problems with the current Kenyan pension system, such as inadequacy o f benefits, low coverage (especially of the informal sector), inadequacy o f incentives to contribute, fragmentation and lack o f information; ii) the need o f public information campaigns to sensitizeleducate policy makers and legislators as well as members ofthe public in general; and iii) the need to find mechanisms to generate consensus for reform.

Participants at the seminar proposed a two-stage process for following up on the pension reform seminar:

(a) Using modeling techniques that have been applied in other countries, the Bank should conduct a basic review o f the pension system covering evaluation o f the income and poverty status o f the elderly population, projections o f the l ikely level and distributions o f benefits o f the current pension systems. This would essentially define the nature and scope of the pension issues by presenting a baseline analysis for the current system,

@) Subsequently, building on recent, similar experience supported by donors (in the areas of policy-formation for banking reform and reform o f DFIs and rural finance, see above) one way forward would be to support the authorities by developing a strategy for policy reform using a joint Keny~ in temat iona l team o f professionals. Funding for such strategy development has already been ear-marked under the proposed FLSTAC. The purpose o f such a study would be to undertake a comprehensive review o f the basic problems and limitations o f the current system and to provide a fiamework for considering alternative approaches to reform, thereby initiating the process o f framing a broader pension reform debate. This could then serve as a catalyst for the establishment o f a pension reform commission or other venue for the leadership o f the reform process.

3. Legal Sector Program Background

There are numerous weaknesses in Kenya’s legal and judicial framework which impede both financial intermediation as well as general commercial activity in the country. As mentioned above, the legal framework for property rights, insolvency, and creditor rights is fragmented, outmoded, and incomplete. This situation points to the need for a comprehensive review o f laws to make them more relevant to the needs o f the Kenyan economy at this critical point in i ts evolution.

In recognition o f the importance o f the legal sector, the government has developed a strategy for comprehensive reform in the governance, justice, law and order sector (GJLOS), building on several reports and reform programs developed under the previous regime, including the 1998 Kwach Report on the ~ d ~ i ~ ~ ~ t r a t i o n of Justice, the 2000 Legal Sector ~ e ~ o r ~ Strategy Program and the ~ ~ ~ a ~ d e d Legal Sector ~ e f o ~ Strategy ~ r o g ~ a ~ (200.2). In commercial justice, a report was prepared by DFIP) in 2000 which

18

identifies key issues in this area. Also, efforts are currently underway to improve the credibility o f the judiciary through an anti-corruption campaign.

The existing fiamework for law reform poses a serious challenge for Kenya, particularly in light o f the envisaged adoption o f a new Constitution which would require the prioritization, harmonization, revision and introduction o f a large number o f laws, generally, and in the financial and commercial sectors, specifically. There is therefore a need to develop a cohesive approach to collaboration among the various institutions working in the area of law reform, including the Law Reform Commission and the Office o f the Attorney General, specifically the Parliamentary Service Commission in Parliament.

In addition, the judiciary is confronted by various institutional issues including weak capacity, corruption, and poor enforcement o f laws. The court system operates ineficiently, with most o f its operations handled manually. Dockets are clogged for months on end and most cases take an inordinately long time to be resolved. Improving the efficiency and effectiveness o f the court system is central to improving the hnctioning o f the legal and judicial framework in general. It is therefore critical to pursue the automation o f the courts and the case management systems as well as streamline processes and procedures for handling cases.

In. order to achieve sustainable improvements in the operations o f the legal and judicial €kamework, upgrading skills in the sector is p a m " t . Consequently, improving legal education is mother pr io i ty area for Kenya. The current system for legal education has suffered from neglect and has become largely inadequate for the rapidly growing needs of the Kenyan economy. Ailments o f the legal educational system include unclear institutional mandates, low university admission and graduation standards, a lack o f basic training materials in key commercial and financial sector fields, poor physical infrastructures, limited advanced educational opportunities for teaching professionals in commercial law, outdated libraries, an absence o f basic IT infrastructure and computer research facilities, and a lack o f standard procedures. Needless to say, there are serious concems in various quarters about the competence o f professionals in the Kenyan legal and judicial sector.

There is therefore an urgent need to upgrade the quality of the legal education program, including the development o f a comprehensive judicial training program that can enhance the efficiency, accountability and competence o f judicial staff. Strengthening of relevant curricula and upgrading o f libraries will also be essential.

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Technical Annex 2: Major Related Projects Financed by the Bank andlor Other Agencies

Kenya: Financial and Legal Sector Technical Assistance Project

World Bank Group

The last CAS for Kenya was in 1998 and there have been no lending projects in the financial sector since then. The last financial sector operation was a technical assistance credit that closed in 1994. There are about ten diffment donors in Kenya who are involved in the provision and development o f m a 1 and microfinance.

In partnership with the IMF, the Bank completed a Financial Sector Assessment Program (FSAP) in the second hal f o f 2003 which identified potential vulnerabilities and developmental needs for the sector as well as the risks to macroeconomic stability ftom weaknesses and shortcomings in the financial sector.

The ongoing Public Sector ~ a n a g e ~ e ~ ~ ~ e c ~ n ~ c a ~ Assistance Project (P066490) i s providing technical advisory services, training and equipment to support the computerization o f court registries, and registries in the office o f the Attomey General. It i s also supporting automation o f court case management, and o f recording o f court proceedings. Since the creation o f a Ministry o f Justice, the project was mended to provide capacity building support to this new Ministry. Whi le these steps taken by the Government under the PSM-TAF help to establish the foundation for reform in the Judiciary and parts ofthe Ministry o f Justice, the focus was on addressing the technical problems in the judiciary. The FLSTAC will build on this work being financed under the PSM-TAP (which closes at the end o f CY 2004) working within a coherent strategy for the judiciary so as to confront institutional issues such as weak capacity, cormption, and poor enforcement and to attain the Government’s objective o f “Creating Fair, Accessible, Timely and Responsible Legal and Judicial Systems.”

The Bank also supports legal sector reforms though Institutional Development Fund (DF) grants, gender-sensitive legal reform and capacity building o f the legal profession.

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Technical Annex 3: Results Framework and Monitoring

KENYA: Financial and Legal Sector Technical Assistance Project

PDO

The overall development objective oftfie priject i s to create a sound financial system and strengthened legal W e w o r k and judicial capacity that wi l l ensure broad access to financial and related legal services.

Outcome Indicators

Percentage o f population with access to appropriate financial services increases by 20%.

Increase in private credit provision relative to GDP by 30%

The ratio o f non-perfoming loans to tfie total loan portfolio o f the banking system i s reduced to less than 10 percent.

Spread between average deposit rate and lending rate for prime customers decrease by 30%.

Reduction o f backlog in commercial cases by 25%.

Use of Results Information

YR 1-5 Communicate outcome indicators to wide range o f stakeholders as basis for maintaining dialogue and conhued d e m d for effective r e f o m .

YR3 Strategic review of constraints to improvements in access, stability and efficiency and re- prioritization among components.

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Intermediate Results (One per Component)

Component One:

Financial and judicial sector stratFgies necessary to achieve the Government’s policy objectives have been adopted.

Component Two:

Government-owned financial institutions restructured and privatized.

Results Indicators for Each Component

Component One:

Components o f financial sector strategy have been completed

DFI and Rural finance strategies have been completed

Strategy for the judiciary has been designed

Pilot and baseline studies have been carried out

Component Two:

State-influenced shares in banks have been substantially reduced.

DFI strategy has been implemented,

Co-op Bank in full compliance with regulatory requirements

Strategic and operational audit o f KFOSB and implementation o f its recommendations.

Use of Outcome Monitoring

Component One:

m1 Develophevise sector specific lime-based targets drawing on results of baseline studies

m2 If strategies are not produced, review stakeholder perspectives and focus dialogue on binding constraints, Intensity dialogue with GOK, refining focused capacity building across key GOK policy makers

YR3 If strategy st i l l absent assess need for mjor redesign of remaining project to refocus on components with capacity to independently deliver significant benefits in relation to PDO within remaining project period.

Component Two:

Y R I E no progress, analyze political constraints to restructuring and divestiture and intensify stakeholder debate.

Y R 2 Where clear DFI strategy not in progress assess fiscal and other costs of inaction as basis for focused dialogue with authorities

YR3 If no progress on privatization undertake in-depth review of p e r f o m n c e o f state banks and identify fiscal and other costs as basis for re-invigorating evidence based debate Support CBK to develop resolution strategy for Co-op Bank ifnon-compliant

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Increased soundness of the fmancial system though greater effectiveness of financialsector regulators,

Well developed primaxy market and secondary market for government securities and the money market.

Reduced transaction costs for fmancial transfers as result o f the increased stability and soundness o f money transmission systems.

improved performance along the dimensions o f CAMEL.

Autonomy o f financial regulators has been established

DPF relevant legislation has been passed

MFI and SACCO regulatory framework has been established

Component Four:

Larger auction sizes o f Govement securities,

Reduced Government borrowing Costs.

Sustainable lengthening o f maturities.

Increased secondary market activity across the yield curve

Debt Management Office i s operational

Government securities traded OTC

Component Five:

Substantial reduction in the use of paper based payment instruments.

Same day availability o f a l l large value and time critical transfers.

E l h i m t i o n o f settlement r isk (payments and p r i m a ~ / s e c o n d a ~ market securities transfers)

m2 Where autonomy o f regulators and DPF not achieved initiate and support intensified policy debate.

m 3 If no improvements analyze causes o f fragility in financial system and refocus component (explicitly link to industry capacity budding program). Assess stability and performance ofMFIandSACC0 sectoras basis for accelerating andor re- defining implementation o f regulatory framework.

Component Four:

YR3 Review progress on key activities under component as basis for dialogue with authorities on implementation seeking c o d m e n t to resolve constraints.

Component Five:

YR 3: If no progress, analyze contributors to transaction costs o f money transmission systems and prioritise resolution o f major binding constraints in conjunction with key stakeholders..

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Intermediate Results (One per Component)

Component Six:

improved access to credit as a result o f a better lending environment.

Component Seven:

Strengthened capacity in the law and justice sector that supports financial and commercial sector development.

Results Indicators for Each Component

Component Six:

Increase in private credit provision by 30%

30% ofMSME’s surveyed report improved access to credit

Volume o f leasing fmnce increased by 30%

Private credit registries operational

3acklog in registration o f companies eliminated

Unified notification system for charges on movable assets (collateral registry) set up

Component Seven:

Reduction o f average processing time for all commercial cases by 25%.

Appropriate revisions o f key commercial laws adopted

Increased satisfaction among users o f the commercial justice system

Increased satisfaction o f legal profession in the judiciary

Increased satisfaction o f judiciary in the legal profession

Reduction o f substantiated complaints regarding legal profession and judiciary

Use of Outcome Monitoring

Component Six:

m2 Assess evidence o f early successes and ensure broad communication to widest range o f stakeholders as means to build greater support for r e f o m

m3 If no progress, analyze distribution o f credit provision and identify constraints to expanding access by market segment and link to industry capacity building programs. Communicate evidence of success to stakeholders to ensure continued support

yI14 Continued promulgation of results o f component activities to broad stakeholder group

Component Seven:

5 x 2 Assess evidence o f emerging successes and communicate across stakeholders to build support for reform.

yI13 Present detailed survey findings to stakeholders and engage in dialogue to refocus emphasis on sub-components according to evidence-based prioritization.

m 4 Continue communication o f results indicators to commercial justice users to maintain broad based dialogue and engagement with reform program.

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Technical Annex 4: Detailed Project Description

Kenya: Financial and Legal Sector Technical Assistance Project

Project Component 1 (US$O.8 million)

Financial and Judicial 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 o f 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 o f a financial sector strategy necessary to achieve these policy objectives as identified in the ERSWC. 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 o f Kenyan and international specialists and f h d e d by DFD) and the study on development finance institutions @FIs) and m a l finance being financed by the FIRST Initiative. The support wil l 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 o f the reform process. For example, one o f the areas already identified where fhrther study is required is the pension system where there are high unfunded Government liabilities and coverage i s limited to people in formal employment.

The Project will also support the development o f the Judicial Strategy Action Plan (JSAP) which will include the introduction o f performance and service standards, a comprehensive training program, and the introduction o f a credible system for the selection, appointment, and remova~discipline o f judges and their staff, including strengthening the Judicial Service Commission. The Project will support the implementation of priorities identified by the Government and key stakeholders, and parts o f the plan that will improve the judiciary’s responsiveness to the demands o f the legal and regulatory framework for the fmancial and commercial sectors, inchding alternative dispute resolution mechanisms.

The Project will support implementing agencies in designing a f imework for monitoring and evaluating progress in financial and legaYjudicia1 sector development in Kenya. T h i s fiamework will provide a basis for assessing performance against the higher level policy objectives, including measures such as improved access, stability and efficiency o f the financial system and improvements in case management and judicial procedures. The approach taken will need to be consistent with and supportive o f monitoring and

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evaluation efforts under the ERS. This f imework will also provide the basis on which this Projectb progress against i ts overall development objectives will be monitored. The Project will support the implementing agencies 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 o f the fiamework.

Project Component 2 (US$3.3 million)

Restructuring and Privatization of Financial Institutions

The banking system has a high level o f non-pedonning loans concentrated in four commercial banks with state ownership. Divesting the Government’s stake in these institutions will help s t r e n a e n the banking system through mobilizing the resources o f the private sector to build the operational capacity o f these institutions, eliminating direct and indirect subsidies and removing political involvement in credit allocation. This will help significantly strengthen competition and improve stability, which in turn 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 govemance and fiscal responsibility.

The Project will support the establishment o f a specialist Bank Restructuring and Privatization Project @WP) within the Ministry o f 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 fiom the identification o f strategic options for divestiture, through short-term preparatory restructuring to preparation and completion o f the transactions. This work will be supported by specialist short-term legal and audit consultancy inputs.

Other fmancial institutions where the G o v m e n t has a particular interestlresponsibility include Co-operative Bank, Kenya Post Office Savings Bank (KPOSB) and the development finance institutions (DFIs). These institutions are aMicted with severe performance problems, including (in all cases except for KFOSB) sizeable non- performing loans. The Project will support the restructuring o f these institutions consistent with the G o v m e n t ’ s market-based policy for financial sector development. The restructuring o f the DFIs will be undertaken according to the DFI strategy cunently developed with support from FRST. The Project will support strengthening the role and effectiveness of ISPOSB in serving as a safe depositary for small savers and in providing payment services. Finally, the Project will support strengthening Co-op Bank’s role as key institution for improving access to financial services.

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Project Component 3 (US$3.9 million)

Strengthening Financial Sector Regulators and the Deposit Protection Fund Board

Bank supervision and lender o f last resort facilities are housed in the Central Bank (CBK). The Deposit Protection Fund Board (DPF), formally an independent institution but also housed in CBK, is responsible for deposit insurance and liquidation of failed banks. Both institutions lack independence in their activities because of weaknesses in their enabling legislation. The Bank Supervision Department @SD) o f the CBK has a well-founded off-site and on-site supervision program, but can benefit from additional capacity building.

The other regulatory and supervisory authorities in the financial sector also s e e r from lack o f autonomy. The Insurance Commission (IC) is not operationally independent and does not have adequate resources to carry out effective supervision o f the fnsurance sector. The Capital Markets Authority (CMA) was recently brought within the ambit o f the State Corporations Act, which requires C M A to consult with the Minister o f Finance in exercising its regulation marking power, The Retirement Benefits Authority (mA) does not have adequate skills to develop a &mework for risk based supervision and the capacity to implement the framework. There is cwrently no regulatory authority for SACCOs and M F I s .

The Project will support a substantial overhaul o f the legislative fiamework for banking supervision with the purpose o f enhancing the autonomy o f the C B K in undertaking this fhction. The most notable areas where action will be taken include: (i) vesting o f key powers to deal with problem banks, including removal o f officers or directors, appointment o f a statutory manager, or revocation o f banking licenses with the C B K instead o f the Minister o f Finance, thus ensuring that the C B K will be held fully accountable for any future failure to deal promptly with identified problem banks; (ii) repealing legal provisions o f the Central Bank Amendment Act 2000 and Section 44 o f the Banking Act in order to remove uncertainty in the market place about the Government’s commitment to market-based financial intermediation; and (iii) revisions in current regulations on loan loss provisioning to adequately reflect the impairment o f assets (currently, no specific provisions are required against NPLs classified as substandard, i.e. 91-180 days in arrears, which leads to overstatement of earnings and capital). The Project will support the legislative drafting and subsequent implementation and necessary capacity building.

The Project will also support the amendment and drafting o f new legislation defining the activities o f the DPF so as to (i) make i t an autonomous institution, (ii) strengthen i ts role and effectiveness as a provider o f the financial safety net and (iii) make the liquidation process more effective. Special emphasis will be put on the review o f the Banking Act and the Companies Act and a possible drafting o f DPF-specific legislation. The Project will support legislative drafting and subsequent implementation and necessary capacity building.

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Support wi l l also be provided to other financial sector regulators. The Project will support amendment o f the relevant laws to make the activities o f IC, CMA and RBA autonomous and provide technical assistance in implementation and capacity building. The Project will also assist in the establishment o f an effective regulatory and supervisory framework for SACCOs and M F I s that balances the benefits o f more transparent and sound intermediation in these sectors with the costs it imposes on the institutions and taxpayers. Specifically, the Project will support necessary legislative and regulatory drafting and provide technical assistance in building the institutional framework to implement the legislation and build capacity in the authorities charged with supervising SACCOs and M F I S .

Additional to the activities related to specific legislative changes, technical advisors will be provided where necessary, staff capacity building activities (training, twinning, attachments) carried out and MIS improvements implemented to increase the effectiveness o f all financial sector regulators and supervisors. Finally, the Project will also support the setting up o f a mechanism for information sharing and coordination o f activities among the financial sector regulators.

Project Component 4 (1JS% 1.5 million)

Strengthening Debt Management and Debt Markets

Kenya is participating in the joint World BanMIMF Program on Central Govenunent Debt Management and Domestic Debt Market Development. Under the Program, a diagnostic o f Kenya's central govenunent debt management and debt securities market was carried out and the authorities agreed to the need to design a program of refoms and capacity building.

Central government borrowing is divided between the MoF and the CBK. The MoF, through its External Resources Department, borrows from foreign sources and the CBK borrows on behalf o f govemment in the domestic market but there i s little coordination or consolidation o f these functions. There are no formal debt management objectives and no written procedures for formulation and approval o f a debt management strategy. To the extent that there has been an explicit strategy for debt management, this seems to have developed gradually out o f existing practices, rather than being founded on costlrisk considerations, h order to strengthen central government debt management, the decision has been taken to set up a Debt Management Office @MO) within the MoF.

The Project wil l provide technical support for setting up a unified and sustainable DMO, including review o f relevant legislation. The DMO, among other things, will be responsible for a consolidated debt database and the basic cosv'risk analyses o f the total debt. Th is will involve training the relevant staff in the use o f the Commonwealth debt recording system (the CS-DRMS), a new version o f which is under installation (version

28

2000+), and in the use o f risk models. Upgrading o f the debt recording system will be the f i s t order o f priority.

Activities under strengthening o f debt management will include:

(i) Setting up a Co~pre~ens iv~ debt d a t ~ b a s ~ and debt recording system, including: a) assistance with the reconciliation process o f present data; b) recommendations on new hardware and providing assistance with i ts installation; c) the installation o f CS-DMS 2000+ and providing training o f staff in its use; d) assisting in linking the CS-DMS 200W with the CBK’s database for the domestic debt; and e) preparation o f a procedures manual, and recommendations on how to set up an organization for €uture front office debt data enters and back office controls.

@,I Preparing a report on the r ~ ~ ~ i r e d s t a ~ C a p a c i ~ , including: a) needed skill and staffing levels; b) possible meam to attract and retain skilled staff, both in short and medium terms; and c) alternative training programs.

(iii) Drafting a new ~ ~ b € i c Debt Management Law, including: a) debt management objectives; b) requirement to determine a debt management strategy, with yearly revisions; and c) reporting and evaluation procedures.

fiv) Creating the DMQ and d ~ e ~ ~ ~ i n ~ int~~a€processes, including: a) establishment o f a separate back office to be responsible for the CS-DMS 200W; b) drafiing o f an agreement between the MoF and the CBK clarifying the role o f the CBK as fiscal and paying agent for the central government, and regulating the warranted coordination between these two institutions; c) evaluation o f needed support €unctions to the DMO, e.g., legal, human resources management and IT; d) establishment o f a middle office to analyze the risks in the debt portfolio, prepare proposals for debt management strategies, control that the debt is within prescribed cost and risk limits, and to give inputs in debt sustainability analyses; e) drafting o f organizational guidelines clarif j ing the responsibilities o f the separate units o f the DMO and determining the decision making power within the DMO; r> institutionali~ation o f the process for formulating debt management strategies, and the approval and evaluation o f these strategies; and g) development of a procedure for coordination o f debt management policy with fiscal policy.

Previous efforts to establish improved debt management practices in Kenya have floundered due to weaknesses in the supporting institutional infrastructure. The Project will therefore not only support increased capacity in € o m o f training, but also build up institutions by providing an appropriate legal and organizational framework. The ability o f the MoF to attract and retain skilled staff is crucial for the sustainability o f the DMO.

Development of debt markets is crucial to the development o f long-term securities and capital markets in general. The Project will support a number o f technical improvements with a view to enhancing the operations o f the primary and secondary govemen t securities markets. In order for these technical improvements to be effective, it will be necessary for the CMA to revise current rules so as to allow an OTC market for professional wholesale investors outside the Nairobi Stock Exchange (NSE). Without this policy change, the benefits o f pursuing the following domestic debt market reforms would be severely compromised.

Activities for strengthening debt markets wil l focus on:

6) ~ e ~ ~ c t ~ r i n ~ the ~ r i ~ a r y market for ~ o v e r n ~ e n t securities by (a) preparing an. institutional survey o f demand for government securities and analysis o f government cash flows to serve as a basis for formulating a revised domestic borrowing program o f benchmark bonds; and (b) recommendations on how to phase in the new benchmark bond program.

(ii) ~ e ~ t ~ c t ~ ~ n ~ the secondary murket~or ~ o v e ~ m e n t securities by (a) drafting and implementing rules and regulations to facilitate OTC trading in government securities; (b) drafting a proposal for a primary dealer system which includes a securities lending facility as well as oversight and prudential issues; and (c) conducting a workshop on primary dealer operations, regulatory compliance and other issues related to the primary dealership, provide training for central bank staff and an intemal operations manual for the primary dealership.

eii) ~ ~ ~ ~ o r t for money m a r ~ t ~ ~ e l o ~ m e n t by providing assistance on how to establish a money market index which includes contribution parameters and dissemination procedures.

Project Component 5 (US$3.1 million)

Modernizing the National Payments System

Payments in Kenya are largely paper-based and manually processed. Cash is the most common form o f payment. Checks have traditionally dominated non-cash payments, accounting for about 95 percent o f non-cash payments as o f June 2003. In the absence of an electronic large value transfer system, large payments are made by check, correspondent account transactions pursuant to Society for Worldwide InterBank Financial T e l e c o ~ ~ i c a t i o n s (SWIFT) messages, or through direct transactions in the settlement accounts maintained by commercial banks at the CBK. Retail payments systems comprising proprietary and shared ATM networks, and electronic hnds transfer at point o f sale (EFTPOS), are in place but growing relatively slowly.

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A growing number o f interbank payments in Kenya are conducted through correspondent account transactions on the basis o f instructions transmitted through SWIFT. While banks chose this option because it i s fast and secure, the use o f correspondent accounts in a commercial bank network can contribute to systemic risk. The nine Kenya banks that are not SWIFT members use messenger and courier services to deliver payment instructions to the CBK. The CBK is encouraghg broader participation by banks in the SWIFT system or use of secured SWIFT-derivative (bureau) facilities by connecting through the African Exchange Bureau domiciled in South Af i ica or Kenya Commerce Exchange Service Bureau, which is locally owned.

category o f institutions No. of deposit3 No. of branches No. of deposit AIC

Central bank 1 4 1,758

Payments System Institutional Framework as of June, 2003

Value of AlC (Ksh m)

57,856 Conunaciaf bank NBFIs

Mortgage finance Total

3uiIding society

The risk and efficiency weaknesses stemming from the current arrangements can be addressed through implementing a modem RTGS system.

43 442 1,554,812 354,663,577 2 2 66,330 13,473,63 1 4 34 276,33 1 10,205,421 2 18 63,063 11,865

378,412950

The National Debt Off ice (NDO) in the CBK i s the registrar o f Govenunent securities and operates an in-house developed electronic registry. The settlement rules for Treasury bonds are laid out in the NSE Trading and Settlement Rules as T+3. For transactions o f K s h 5 mil l ion or less, the buyer has the option to make p a p e n t by either interbank transfer, or by check. Interbank transfers are required for a l l transactions over K s h 5 million. The buyer in these larger transactions must supply evidence o f payment to the NSE by 3.0Upm on T+3, in the form o f an interbank money transfer slip or a letter giving instructions for the interbank payment. The seller must f irst deliver the sale and transfer confirmation to the NSE for approval and then send i t to the NDO by 12.00 pm on T+1 for registration. Cash payment and ownership transfer should be completed by close o f business on T4-3.

The main weakness in the current system i s that there i s no coordination within the Banking ~ e p ~ e n t , . w h i c h transfers interbank hds , in the case o f settlement banks. As a result, there is no link between the transfer o f h d s , and the transfer o f title greatly increases settlement risks. Market participants reduce settlement risk by settling directly with each other, rather than through a broker and require the name o f the counterparty before delivering securities. If the counterparty does not have an interbank limit, he wil l be required to complete h is leg o f the transaction first.

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Due to recent securities fiaud, added security measures have been established and the seller may be required to appear in person to confirm payment or Settlement instructions. This creates delays and the transfer o f securities leg o f the transaction can take anywhere between 5 and 14 days to complete. Therefore settlement is not T+3 but closer to 7'3.5. The buyer will first transfer funds on T+5, hoping to receive his securities on the same day. However, this i s not always the case as each transaction requires the CBK to process the settlement instructions which must include broker confinnation, trade confinnation and settlement instruction fiom both buyer and seller. The uncertainty of the settlement period adds to costs by increasing settlement r isk and therefore discourages secondary market trading and prevents the use o f Treasury bonds for liquidity management purposes.

The current weaknesses in the g o v e m e n t securities clearing and settlement systems can be addressed by acquiring a modern Scripless Securities Settlement System and an associated Central Depository System with appropriate W a g e s to a suitable RTGS system.

~~~.~~~~ ~~~~~~~~~~

Kenya i s a member o f the East AfXcan Payments Systems Committee (EAPSCH), charged with the development and h m o n i z a t i o n o f payment systems in the three member countries (Kenya, Uganda and Tanzania). The following developments have been achieved though the work o f the committee:

Automation o f the three countries' clearing houses; I) Development o f guidelines for licensing and regulating E-money schemes and

products; Harmonization o f definition o f payment systems and terminology;

a Development o f guidelines on r isk management measures.

Uganda and Tanzania have already taken steps to acquire a modern Real Time Gross Settlement (RTGS) system. The Kenyan system will be designed to support the required future linkages. Despite the use o f different currencies in the three countries a linkage solution based on a Payment versus Payment (PvF) approach could be implemented using a forex confirmation matching system similar in concept to that used by the wel l known CLS system. The key underlying requirement i s that a l l three domestic RTGS systems use SWIFT as the message carrier. Implementation o f such a system would only b e feasible when a l l RTGS systems are successfully operational; thus this requirement i s not included in this initiative.

The Kenyan authorities already recognize the existing deficiencies in the clearing and settlement mechanisms and a task force has produced a fiamework and strategy paper for the modemization o f the national payments system which has recommended, among other things, introduction o f RTGS. The CBK has already earmarked funds for the setting up o f a stand alone RTGS.

The Froject will provide appropriate technical assistance and knding to acquire a Scripless Securities Settlement System I Central Depository System (CDS) to facilitate

32

the safe, secure and efficient clearance and settlement o f funds and securities transfers (both primary and secondary market transfers) in a manner consistent with best international practice as outlined in the Bank for International Settlements (BE) issued Core Principles for Systemically Important Payment Systems (January 200 1) and Recommendations for Securities Settlement Systems issued by the BIS and the Technical Committee o f IOSCO (November 2001). This will t ie in with the already initiated comprehensive reform o f the national payments system, including the review and development of an appropriate policy, legal and regulatory framework by which the CBK will effectively fulfill its oversight role. In addition, the Project will provide fbnding for training o f CBK staff and the necessary technical and legal expertise to assist and mentor CBK staff in the complex technical, organizational and operational issues involved in payments and securities system reform.

Reforms to low value payments mechanisms are underway but the solutions adopted could be improved upon using new technology. The Froject will fbnd a diagnostic study to identify the needs for improvements in the mechanisms for low value payments transfers.

Specifically, the FLSTAC will support the following:

(g New S c ~ ~ € e s s S e ~ r i t i e ~ ~e t t€emen~ and Centra€ Depositary System ~ ~ ~ ~ ~ ~ C D ~ ~ The proposed loan will build upon the work already accomplished in this area and assist CBK and other appropriate institutions acquire a modern SSSICDS system to provide a safe, secure and efficient repository o f records o f ownership o f all g o v e m e n t securities as well as an efficient mechanism for supporting al l facets o f the primary and secondary markets. This system will be linked with the RTGS system to remove risks v ia a suitable Delivery versus Payment mechanism (DvP) and a Payment versus Payment (PvP) mechanism for foreign exchange trading.

(io Esta~€ishment of an Appr~priate Legal ~ r ~ ~ e w o r ~ and Oversight ~ ~ ~ c t ~ o ~

Modern safe and efficient payments and securities systems requires not only implementation o f new operational systems but also requires two additional essential elements; an adequate legal and regulatory framework and establishment o f a payments system oversight h c t i o n within the Central Bank. The FLSTAC will provide appropriate opporhulities to review and develop an appropriate policy, legal and regulatory framework included as well as a set o f mechanisms by which the CBK will effectively fulfill i t s oversight rote. A diagnostic study to identify the needs for improvements in the mechanisms for low value payments transfers will also be carried out.

fiii) pay^^^^^ System Expert Advice for the Project Team

Payments and securities system reforms are quite complex and involve policy, technical, organizational and operational issues. Successful initiatives have benefited from the support o f well qualified, experienced and motivated experts. Payments system experts are likely to be needed to advise CBK in regard to several pre-procurement design,

33

procurement phase activities, and possibly as well during the installation phase. The FLSTAC will provide fimding for such advisors.

(iv) ~ r ~ j n ~ n g for ~ ~ ~ ~ o ~ ~ h e ~ ~ t ~ o n u ~ ~ u y ~ e n t ~ System ~ ~ v ~ ~ i ~ n (C3K) The Project will provide funding for training o f about 15 staff o f the Division on relevant critical and highly technical matters o f the payments system such as oversight, and securities trading and settlement.

At the end o f the Project, large value and time critical payment transactions will be processed electronically in a Real Time Gross Settlement System (RTGS) environment that has the required legal and regulatory underpinning, efficient linkages with other systems including a scripless securities settlement system I central depository system, central bank general ledger system, and low value retail funds transfer systems operaiing on a deferred net settlement basis, appropriate central bank oversight, and with furictionality to be linked with counterpart RTGS systems in Uganda and Tanzania.

Project Component 6 (uS%2.3 million)

Improving the Lending Environment

ol le of the major impediments to growth in Kenya i s insufficient access to financial services by large segments o f the Kenyan population and enterprises, especially the small and medium sized ones. While there are many reasons for lack o f access to credit, weaknesses in the creditor rights f imework and institutional infkastructure (notably the Companies and Land Registries), the overly debtor-friendly &orcement mechanisms and the pervasive lack o f credit infomation on potential borrowers are among major contributing factors. The resulting adverse lending environment increases the cost o f lending and contributes to the lack o f competition in the provision o f credit.

The Project will support improvements in the legal and institutional framework required to improve the environment in which banks, other fmancial institutions and supply and trade creditors extend credit. The activities supported by the Project will include:

Assistance to the Department (which includes the Companies Register) will include: (a) assistanck to the Companies Register to enable the Registry clear the backlog in filing and allow for speedy and accurate information sharing o f corporate infomation and data; and the development o f amenhents to the necessary laws, such as the Companies Act; assistance will also be extended to other registers in the Department, such as the business names and receivers registers; and (b) combining o f the Charges Register and the Chattel Transfer Register into one and moving the combined separate register (notification system) for chargedpledges over movable assets out of the Companies Register; and developing a new Personal Property Securities Act (Le. secured transactions framework) in line with international best practices.

34

This assistance to the Ministry o f Lands wil l allow the transformation o f the current manual system o f land records into a digital format which will enable much speedier searches as well as establishment and enforcement o f security interests over land and other real estate.

Private credit registry will facilitate the much needed information flow among the credit granting institutions. This assistance will concentrate on the laws and regulations necessary for the optimal functioning o f such an information system, including issues o f data and consumer protection.

The Project will support necessary changes to the taxation o f leasing activities. The current tax regime is internally inconsistent and does measure up to international best practice. This impedes the growth o f leasing, especially financial leases. The Project will support consultations o f Kenya Revenue Authority (KRA) with all major stakeholders, assistance in drafting o f new taxation rules and implementation o f the new rules.

Under (i), a thorough functional review and assessment o f the various existing registers and their business processes will be conducted. Areas already identified as in need o f urgent upgrading are internal processes and procedures, simplification o f the registration requirements, automation, human resource development and appropriate skills mix in the Department, and training. The functional review will also take into account the plans for the decentralization o f the registration process and the creation o f a “one-stop-shop” for companies, support for which is envisioned under the MSME project. On the basis ofthe functional review (audit), recommendations setting out the content and sequencing o f institutional changes and reforms that will be required to upgrade and modernize the various registers in the Department o f the Registrar General will be adopted. This will require well qualified organizational management consultants with expertise in reforming s imi lar institutions. The consulting team needs to have personnel qualified in change management, management hfiormation systems (MIS), IT and law. The first phase o f the reform, the functional audit is envisioned to be fmanced by FIRST. Assistance to the Department o f the Registrar General will build on earlier assistance provided by IRJDP.

The Companies Register will be transformed into an institution capable o f providing accurate and reliable information and service on companies to the credit and capital markets and the interested public. The Project will also support the development o f any legislation necessary for the reform o f the Department and simplification o f various registration procedures (including amendments to the Companies Act).

35

The registration o f chargeslpledges i s particularly fragmented and ineffective under the current system. Individuals, sole proprietorships, partnerships and other non-incorporated entrepreneurs register their charges in the Chattel Transfer Register. Companies, on the other hand, register their charges in the Companies Register. In addition, mortgages and charges on land have to be registered in the various Land Registers (there are several registration systems in Kenya) where they are noted on the title documentation. Such a fi-agmented system leads to inefficiencies and impedes access to credit, as it does not provide a clear and predictable framework in which creditors are able to easily and accurately ascertain the validity and priority o f charges taken over their debtor’s property.

The Project will provide support for combining the Charges Registry and the Chattel Transfer Register into one register and the establishment of a single unified notification system (register) of all security interests (charges, pledges, debentures, etc.) over a l l movable assets and given by a l l legal and natural persons. The first phase o f this assistance, namely the preparation o f detailed recommendations for the reform (its legislative and institutional aspects) i s envisioned to be financed by FIRST. The intention i s eventually to move this single notification system out o f the Companies Register and establish the combined register on a commercial basis. Support will be given for the drafting o f a new legislation (Personal Property Securities Act) to allow for a unified system o f security interests based on international best practices (including Article Tx in the U S or similar legislation in Canada and N e w Zealand).

Under (ii), the Project will support the digitizing o f the land records. There are currently over 3.5 million land records in Kenya and al l o f these are manual records. It i s very difficult to effectively establish and enforce security over land, as searches in the various registries are difficult to undertake, with files often misplaced or missing. The Ministry o f Lands has agreed on a reform program which will include the development o f a Land Policy; review of illegally obtained titles; simplification o f the registers; and necessary changes in the legislation to make the various registration systems consistent with each other. The development o f a comprehensive Land Policy i s supported by several donor agencies. This Project will assist in a discrete part o f the Ministry’s reform program, namely the transfer o f land records from a manual to a digital system by financing consultants and IT equipment.

-

Under (iii), the Project will assist the CBK, MOJCA and the Off ice o f the Attorney General in the development o f any necessary laws and regulations for the operation o f a private credit registry through which financial and non-financial institutions grantink credit will be able to ascertain the credit history o f individuals and small firms. It is the intention that th is system will cover both positive and negative information. Assistance will encompass such issues as appropriate consumer and data protection.

36

Project Component 7 (US% 8.1 million)

Legal and Judicial Reform

The Government has commenced an ambitious reform strategy for the Judiciary, including the removal o f cormpt and incompetent judicial staK The Project will build on the measures taken by the Govement through the Bank’s previous assistance which initiated the computerization o f the Judiciary and the MOJCA and support them in carrying out their respective mandates and to move to the next stage o f reform. The Project addresses the need for a coherent strategy for the judiciary to confiont institutional issues such as weak capacity, corruption, and poor enforcement.

The Judicial Reform sub-component will support the implementation o f the following activities in Key Results k e a No. 3 o f the GJLOS:

fi) Court Case ~ a n a g e ~ e n ~ and Records ~ a n a g e ~ ~ n t System

The objective is to ent.lance the efficiency, transparency and effectiveness o f the court system. The Project will support the automation o f court case management and the review, analysis, and introduction o f procedures such as small claims procedures, summary procedures for uncontested debt, and alternative dispute resolution procedures, and the relevant training and application. Data entry for court case management systems will commence with the commercial courts. Activities to support th is result area include electronically integrating the various processes o f the courts initially in selected pilot areas, including receipt, recording, and tracking o f cases, and generating statistics to enable analysis o f cases and case management performance o f courts. The proposed system will make possible the inter-court tracking o f cases (transfer and appeals) and the generation o f micro and macro statistical reports useful in evaluating perfbrmance at various levels and in formulating policies and introducing systems for continuing case management systems.

The objective is to reduce the incidence o f lost files, increase the speed o f retrieval o f files and reduce opportunities for graft. The Project will support the review o f existing data in the regktries and the installation o f computer hardware and software to adequately capture, store and manage th is data.

The objective is to develop the capacity o f the judiciary to adequately support commercial activity and dispute resolution mechanisms. The Project will support the review o f the policy and institutional f imework for judicial education, md the design o f a comprehensive judicial education program that can enhance the efficiency,

37

accountability and competence o f judicial staff, and improve capacity in subject areas consistent with the scope o f the FLSTAC, and priority needs determined by the Government. The Project will also support the implementation o f the judicial education program on financial and commercial law subjects.

(iv) ~ e f o r ~ e d Civil Procedure Rules

Civ i l cases in the High Court and Magistrates’ Courts are governed by the Civ i l Procedure Rules, which determine the progress o f a case from filing to enforcement o f judgment. The rules date substantially from 1953 (although there have been some useful recent reforms which have streamlined the system) and are outdated. The c iv i l procedure rules will be updated to make civil litigation faster, cheaper, and more efficient and accessible.

(v) Promote the Use of ~ l ~ e ~ ~ ~ i v e Dispute R e ~ o l u t i o ~

Alternative dispute resolution (ADR) refers to informal processes o f resolving disputes. Foms o f ADR include mediation, negotiation, early neutral evaluation, conciliation, adjudication, and expert determination. In addition, there is a well-established f o m a l statute-based system for arbitration in Kenya. The interventions in this area are aimed at raising awareness amongst the Judiciary, litigants and the legal profession about the advantages that ADR can bring to all three, and to integrate ADR within the judicial system. At the local level, ADR will be implemented by adoption ofmediation initially in selected pilot areas through a strengthened paralegal network and training o f local community leaders.

(vg Use o ~ ~ m a l l Claims procedure^

The intention is to investigate and develop initially on a pilot basis the use o f Small Claims Procedures in Magistrates’ Courts in Kenya. The intention is not to set up a new system o f Small Claims Courts, but to build on the existing system o f Magistrates’ Courts, and to introduce small claims procedures into this existing and well-developed system.

Enforcement is the final part o f the Court process. It is the means by which a judgment creditor realizes the effect of judgment in h is Eavor. Enforcement o f judgment differs significantly between countries. In the richest quartile o f countries it takes on average 64 days to enforce a judgment on a small debt collection once the judge has produced an opinion. The countries in the poorest quartile fare worse. On average it takes 192 days - a long time, particularly for small businesses with l i t t le access to credit - to collect debts once judgment is rendered

The most c o m o n modes o f enforcement or execution are: attachment o f assets (e.g. money or movable property); statutory sale o f property; and detention in jai l of judgment debtors. It i s clear that there are a number o f problems with the way the system of enforcement i s currently operating. The commercial sector in particular has felt the

38

burdens o f the current mode of enforcement. Execution proceedings have in certain cases taken years to accomplish, hstrating calculations and projections o f business enterprises. These problems will be tackled by measures including strengthening the Civ i l Procedure Rules; considering the regulation o f auctioneers who are often responsible for the execution o f judgment debts; and considering the whole en€orcement regime, including the efficacy of the system of jailing civil debtors.

Tfie objective of this sub-component i s to strengthen the law reform process and increase accessibility to legal information.

Tfie Law Re€orm sub-component will support the following activities in Key Results k e a No. 6 o f the GJLOS:

Capacity ~#ilding of the Law ~ e f o r ~ C o ~ ~ i ~ ~ i o ~ , W c e of the P a r ~ i a ~ e ~ t a ~ C o # ~ ~ e ~ at the OAG, and the ~ a r l i a ~ e ~ t a ~ Service C o ~ ~ i s s i o n

A coordinating mechanism for law reform i s needed to facilitate a more rational approach to the review, hamonkation and amendment o f the laws o f Kenya. The Project will support a workshop bringing together the three organizations and the Law Society o f Kenya and professional development o f staff in all thee institutions will be undertaken, including a core in-house training program in legal drafting and legal research.

The Project will support technical assistance for the drafting o f priority bills, and the development of a sustainable, participatory approach to law reform. The Project will support the drafting of amendments to laws, including the Companies Act; Insolvency Act; Bankruptcy Act; Business Names Registration Act; Banking Act; Central Bank of Kenya ; Insurance Act; Capital Markets Authority Act; Kenya Postal Office Savings Bank Act; and Retirement Benefits Authority Act. The Project will also support the preparation o f new legislation, including bil ls on the Deposit Protection Fund, Personal Property Securities (secured transactions), and Data and Consumer Protection. Further, i t will support the implementation o f laws currently under preparation, including the SACCOs Bill and Microfinance Institutions Bill.

The Project will finance the assessments o f law library needs o f the Law Reform Commission, M O X A and the Office o f the Attorney General, and the Parliamentary Service Commission. It wil l also finance revision and updates o f the Laws o f Kenya, National Law Reports and development o f publicly accessible legal information. The other activities under this intervention will aim at collection, processing and keeping information in a manner that facilitates access and use. The f i rs t activity will be the automation o f recording o f court proceedings. The second activity will be to streamline court registries to eliminate cases o f “lost files” as well as to decongest the registries for

39

ease o f reference. The third activity is to improve access to legal information by completing pending law reports and putting in place a mechanism for continuous law reporting.

fiv) Legal Sector to Become ~ ~ ~ l o ~ ~ r of Choice for a C r i t ~ c ~ ~ Mas of Smart Lawyers

In the 60s and 70s, the public sector legal institutions used to be the preferred choice for lawyers beginning their careers. This is not the case today. The working environment hardly allows individual lawyers to give their best, and compensation compared to alternative employment is meagre, Consequently, those who jo in the institutions only do so as a last alternative and the services offered by these institutions have deteriorated significantly, The proposed interventions include improving the terms and conditions o f the officers and their work environment. Efforts, which are crucial to the success o f the reforms, are under way to h m o n i s e t m s and conditions o f service so that they are at par with those o f officers serving in the Judiciary.

The objective is to enhance the capacity o f the School o f Law to provide quality legal education. The Kenya School o f law intends to develop a curriculum for the digerent levels o f legal professionals to ensure they have the skills and knowledge to cope with their profession in a fast changing environment. Though generally professionals can update their knowledge in informal ways, there is need to have a formalised and systematic method through which the required skills and knowledge are impacted. The management o f the school also intents to expand the market for the school to target the East Afr-ican Region in the drive to make the school choice number one for post university legal training.

Although there is clearly scope for strengthening the provision o f legal education across the board, the decision has been taken to focus in the first instance on commercial law education. This is both because o f the priority that the G o v e m e n t has put on private sector development, and also because this is a curriculum area that needs particular attention. The aim is to involve the private sector in developing these activities so that the new curriculum reflects real business issues.

The Kenya Law Reform Commission was formed in 1982. However, its impact in leading the agenda in law r e f o m has been negligible. With the coming o f the new Government, the need for an active law reform commission has been revived. In. the short run the Commission proposes to build capacity to lead in law reform. To this end, a workshop bringing together the office o f the Attorney General and the Law Society o f Kenya, as well as the professional development o f staff is planned to support a specialised capacity building program on legal drafting and legal research.

40

Tfie most urgent pending bills will be identified and priority legal drafting needs will be met, by contracting-out if necessary. Legal drafting capacity in the OAG and ministries will be developed b o u g h recruitment and training.

Tfie sustainability o f the reforms supported under the judicial and law reform subcomponents will depend heavily on building adequate capacity in the legal profession and the judiciq. A comprehensive approach and plan o f action i s required to repair a legal and judicial educational system which currently suffers from unclear institutional mandates, low university admission and graduation standards, a lack o f basic training materials in key commercial and financial sector fields, poor physical infrastructures, limited advanced educational opportunities for teaching professionals, outdated libraries and an absence ofbasic IT in&astructure and computer research facilities.

The Legal Education sub-component would support:

fi) Improved Legal P r o f e ~ ~ i o ~

Tfie Project Will support the strengthening of legal education programs including continuing legal education for lawyers, judges and magistrates. It will also support the revision o f admission, graduation and bar membership standards.

Technical assistance will be provided to the Council o f Legal Education to review the curricula o f national institutions to facilitate standardization in key subject areas. The Project will also support the development o f specialized courses in financial and commercial law and legal drafting and the professional development o f law faculties o f all three legal teaching institutions.

All law school libraries will be stocked with basic texts and periodicals in law particularly in financial and commercial law subjects. The Project will also finance the publication o f teaching materials.

41

Technical Annex 5: Project Costs

KENYA: Financial and Legal Sector Technical Assistance Project

Project Cost by Component

1. Financial and Judicial Sector Development Strategies

2. Restructuring and Privatization’ o f State-influenced Financial Institutions

3 Strengthening Financial Sector Regulators and the DPF

4. Strengthening Debt Management and Debt Markets

5. Modernizing the National f a p a t s System

6. Improving the Lending Environment

7. Legal and Judiciary Re€orm

8. Project nilanageme&

Total Base Cost

Physical Contingencies Price Contingencies

I Total Project Cost

Local Financing

US$ Million

0.2

0.3

0.2

0.6

0.7

2.0

2.0

Foreign Financing

US$ Million

0.6

3.0

3.7

1.5

3.1

2,3

7.5

3.3

25-0

3 .0

28.0

Total

US$ Million

0-8

3-3

3.9

1.5

3.1

2.3

8-1

4.0

27.0

3.0

30.0

Includes expenditure under the PPF and government contribution (office space for the BRPP) Includes Government contribution for PIU office space 3

42

0 e3

h P

0

0 d

0 W

N

2

0

8

\o

N '?

\o

2

00 .B .a r; E

Technical Annex 6: Implementation ~ r r a n ~ e ~ e n t s

KENYA: Financial and Legal Sector Technical Assistance Project

The Implementing Agency for the Project will be the Ministry o f Finance. A high level official in the Ministry will chair a Project Steering Committee that will provide strategic guidance for the Project. The Project Steering Committee will be comprised o f three representatives from the Ministry o f Finance, the CBK and the MOJCA. Representatives o f IDA and DFID will s i t on the Project Steering Committee as observers so as to facilitate information exchange and improve the decision making process in the framework o f proj ect implementation.

The Committee may from time to time co-opt other members from the implementing agencies or other Government agencies depending on the issue being discussed. While decision making in the Project Steering Committee will be by consensus, the Ministry o f Finance as chair will have the deciding vote where agreement cannot be reached.

The administrative responsibility for day to day operations of the Project will l ie with a Project Implementing Unit (pnr> which will report to the Chairman o f the Project Steering Co”ittee. The Economic Secretary, Ministry o f Finance, will assist in the coordination o f the activities o f the Unit at the technical level. The PItf will be headed by a fill time Project Manager who will have an excellent understanding o f financial and legal sector reform issues, possesses a drive for results and an ability to bring stakeholders together in a collaborative manner. HelShe should also have a good knowledge of procurement matters. The Project Manager will be supported by two technical advisors (one for the financial sector and one for the legal sector) who will be capable o f assessing project priorities and needs, and guiding project preparation and implementation to a successhl conclusion in a timely manner. In addition, project implementation support will be provided by an accountant who will be trained to be proficient in financial management, and a procurement specialist.

The PTU will be responsible for: (a) assessing and prioritizing project proposals prepared by beneficiary institutions and, for the legal sector, in close coordination with the Project Coordination Unit (PCU) o f the GJLOS; (b) undertaking quality control for terms of reference once a project proposal has been approved by the Steering Committee; (c) overseeing project implementation activities; (d) administering project funding and procurement processing (including the employment o f consultants) and managing the Project Accounts and the Special Account; (e) following up on the agreed financial covenants and disbursement conditions; (0 proposing any necessary adjustments and amendments to implementation methods; (8) providing periodic project progress reports; and (h) acting as the focal point o f contacts between the Government o f Kenya and IDA and other funding donors during the project implementation period.

Once a project proposal has been approved by the Project Steering Committee, each Beneficiary organization will be responsible €or preparing the tenns o f reference and

44

requests for proposals (W) andlor equipment specifications for procurement o f consultant services and goods, respectively. The PIU will provide procurement support and advice on procedural matters to each o f the Beneficiaries in the preparation o f these documents. The documents will be submitted to the PIU where the procurement specialist will be responsible for ensuring that all the World Bank Guidelines for procurement o f goods and consultant services are followed. The PIU will assist Beneficiaries in the evaluation o f RFPs as well as c o r r m ~ c a t i n g the results o f the evaluations to the World Bank. Consultants, contractors and suppliers will be selected in accordance with Bank guidelines, on the basis o f proven experience.

Project Steering Committee

t Director

2 Advisors (Financial & Legal) AccountanUFM

Procurement Officer

I Implementing Agencies

Ministry o f Finance, CBK, M O X A and OAG, RBA, CMA, IC, DPF, Judiciary, Ministry o f Lands, Kenya School o f Law, Kenya Revenue Authority.

45

The PIlJ will liaise closely with the various implementing agencies within the Ministry o f Finance, CBK, MOJCA and OAG, DPF, B A , CMA, Insurance Commission, the Judiciary, and Ministry o f Lands to ensure that project activities will be handled in a way that meets project development objectives effectively, in a timely fashion and in accordance with World Bank requirements. I t wil l also ensure that adequate information is provided for reporting purposes. The proposed project will provide fimding to cover incremental operating costs required for the establishent o f the financial management system and training for PTU staf f in procurement, project and financial management under World Bank financed projects, and the costs o f audits. All other operating costs, including office space, utilities, office supplies and communication costs will be covered by Government counterpart h d s .

The PIU will be set up as soon as possible so that it can start preparing the Project Implementation Plan and review the Procurement Plan for the f irst 18 months o f project activities. Preparation o f a Procurement Plan acceptable to IDA was a condition o f negotiations and has been met while preparation o f a PIP acceptable to IDA i s a condition of project effectiveness. The h d h g for the activities o f the PIU before project effectiveness will be reimbursed to the Government under the retroactive financing clause in the Development Credit Agreement. Activities that will require retroactive financing have been estimated at US$1 million.

46

Technical Annex 7: Financial Management and Disbursement Arrangements KEX%"Y: Financial and Legal Sector Technical Assistance Project

Country Issues

The results o f the latest Kenya Country Financial Accountability Assessment (CFAA) dated April, 2001 indicated that ~ ~ , ~ . ~ d u c i a ~ risk in p u ~ l i c spend in^ is assessed as high. While a lack o ~ c o ~ p ~ i a n c e with esta~lished~nancial and p r o ~ r e ~ e n t r e ~ l a t ~ o n ~ have complete^ rendered many initiati~es aimed at s t r e n ~ t h e n ~ n ~ the control environment i ~ e ~ e c t i ~ e ~ issues of limi~ed ~ e ~ ~ i ~ n , inade~uate moni~orin~, i n s ~ ~ ~ i e n ~ capacity and lack o~en~orcement also need to be resolved. ''

The report further observed that there were high financial management risks due to a weak. control and low capacity environment. Government accounts were regularly late and incomplete. Inter-agency reporting was slow and sometimes difficult to achieve, where hierarchical lines were blurred or foreign to the day-to-day structures and management o f the institution. Accountability chains were weak, and penalties extremely light or nonexistent.

Mitigating Measures

A new G o v e m e n t is now in place with a commitment to ensuring compliance with legislation, strengthening regulatory institutions and fighting corruption.

With the support o f a number o f donor assisted initiatives, including the IDA-funded Public Sector Management Technical Assistance Project (PSMTAP), Government i s seeking to rapidly tfie financial accountability firmework in order to:

mitigate fiduciary r isk in public expenditure management; achieve economy9 efficiency and effectiveness in the use ofpublic funds; enhance transpxency and accountability; and enhance staff capacity in public financial management

A number o f project-specific risk mitigation mangements have been proposed in order to address noted country concerns:

(a) A Project Implementation Unit (Pnr) will be established chaired by a high level officer of the Ministry of Finance. The PIIJ will be responsible for overall project implementation, supervision, monitoring and reporting.

(b) The independent annual audit o f the Project will be subcontracted to a private fim o f auditors on t e m s o f reference (TORS) approved by TDA. The auditors will report to the Government's Controller and Auditor General (CAG). This arrangement

47

i s intended to ensure effectiveness and efficiency o f the audit process. The external audit will cover all World Bank funds and Counterpart l n d s at all levels o f Project execution.

(c) The project will be subject to regular IDA supervision missions aimed at closely monitoring perfomance and the timely resolution o f issues.

Financial Management System

The principal objective of the Project’s financial management system will be to support management in their deployment o f limited resources with the purpose o f ensuring economy, efficiency and effectiveness in the delivery o f outputs required to achieve desired outcomes. Specifically, the system must be capable o f producing timely, understandable, relevant and reliable hanc ia l infomation that will enable management to plan, implement, monitor and appraise the Project’s overall progress towards the achievement of i t s objectives.

The PIU financial officer shall provide technical oversight capacity building, monitoring and coordination hc t i ons . H e shall also be responsible for quarterly Financial Monitoring Reports and Project financial statements. Financial and accounting manuals shall be prepared to guide reporting at respective levels.

The m u a l project financial statements will be audited in accordance with International Standards o f Auditing or other standards as promulgated by the International Organization of Supreme Audit Institutions. The audit will be carried out by an independent auditing firm whose qualifications and experience as well as terms o f reference are acceptable to IDA. The B&s Financial Reporting and Auditing Handbook (FARAf-f) would be used by the auditors in accordance with the Bank’s auditing guidelines. Audit reports will be fbmished to the Bank within six months after the close o f the Project’s financial year.

h assessment of the financial management arrangements o f the project will include a review o f the systems o f accounting, reporting, auditing, f low o f funds and internal controls. The project’s financial management arrangements will be acceptable if they are considered capable o f recording correctly all transactions and balances, supporting the preparation o f regular and reliable financial statements, safeguarding assets, and are subject to auditing arrangements acceptable to the Bank.

The Project is at high r isk until the financial management and other operational systems are well defined and documented, and personnel are trained. However, the Project financial management r i sk in implementation is assessed as moderate once this critical setup phase is passed. The PIU will be tasked with producing a financial management timeline to effectiveness that includes realistic timing for the procurement of, (i) PIU personnel, (ii) accounting systems, (iii) external auditors, (iv) transaction agent (who will design operations and produce procedures manuals), as wel l as the preparation o f manuals and staff training.

48

A World Bank Financial Management Specialist will undertake a review once the systems are more developed and the PIU has been established.

The objectives o f the project’s financial management system are:

0 to ensure that h d s are used only for their intended purposes in an efficient and economical manner;

0 to ensure that funds are properly managed and flow smoothly, adequately? regularly and predictably in order to meet the objectives o f the project;

0 to enable the preparation o f accurate and timely financial reports; 0 to enable project management to monitor the efficient implementation. o f the project;

and 0 to safeguard the project assets and resources.

Furthermore, the following are necessary features o f a strong financial management system:

0 the Project should have an adequate number and mix o f skilled and experienced financial management stafe

8 the internal control system should ensure the conduct o f an orderly and efficient procurement and payment process, and proper recording and safeguarding o f assets and resources; the accounting system should support the project’s requests for h d i n g and meet its reporting obligations to the GOK and IDA;

8 the system should be capable o f providing fmancial data to measure perifomance when linked to the output o f the project; and

0 an independent, qualified auditor should be appointed to periodically review the Project’s financial statements and internal controls.

Weaknesses and Mitigating Measures

Weaknesses in financial management have been identified in the following areas:-

49

Adequate counterpart funds may not be allocated in a timely fashion. Mitigation measures comprise advance assurance fiom GOK o f i t s commitment to ensuring hd ing obligation compliance. In addition, arrangements for quarterly joint reviews with MOF, hplementing agencies and IDA are proposed. GOK continues to suffer major financial reporting weaknesses, notably delays in submission o f audited accounts. It is proposed that the Project’s annual financial statements be subject to independent private auditor on behalf o f the Government CAG.

The PT[_T will be a new establishment without experience in Bank- financed projects. This will be mitigated by the Bank conducting training and capacity building workshops €or the project’s key management and accounting personnel. It is further proposed that close involvement o f the Bank project management and Country team members will center on regularly supervising performance.

Institution a1 and Implementation Arrangements

The PIU will be responsible for the overall financial management o f the project, in accordance with sound and standard guidelines acceptable to DA. It will oversee the management o f Special and Project Accounts, the preparation o f financial monitoring reports (FMR) and annual financial statements, withdrawal applications and other financial requirements o f DA .

The PIU will oversee the statutory audit o f project’s financial statements, ensuring that the process is carried out efficiently and in line with the terms of funding agreement. It will also be responsible for ensuring that matters af.ising f iom audits are dealt with expeditiously.

The Project’s accounting and budgeting systems will be based on existing MOF systems that are f i l ly compatible with Government systems.

Flow of Funds

~~~c~~~ Account - The GOK will establish a U S dollar special account that will receive dollar deposi ts/~ansfe~ from the main credit account.

Project Account - A local currency project account will be opened to form the primary source o f finance for project activities and will be managed directly by the Project.

Respective bank accounts shall be opened by the credit effectiveness date. Initial. cash fiow forecasts upon which the advance disbursement will be made &om the IDA Credit will also be prepared by the same date.

Funds flow arrangements for the project shall be as follows:

IDA will make an initial advance disbursement from the proceeds o f the Credit by depositing into the Borrower-operated Special Account,

* Actual expenditure wil l be reimbursed though submission o f Withdrawal Applications and against Financial Monitoring Reports.

GOK counterpart funds and transfers from the Special Accounts (for payment o f transactions in local currency) will be deposited in the project account in accordance with GOK exchequer control and funding arrangements. Counterpart funds will be allocated through the noma1 central government budgetary process.

Staffing

The Project will have a Finance O€~cer/~ccountant to be responsible for project financial management as detailed in a Project Financial Operations Manual. Ifhe project’s Finance Officer will be expected to attend procurement, financial management and disbursement training sessions conducted by the Bank Country Office.

Description of Financial Management Arrangements

~ n i ~ r ~ u l C o ~ ~ r ~ l ~ and ~ ~ ~ a ~ ~ ~ u ~ ~ u ~ u g e ~ ~ ~ # ~ u ~ ~ u ~ The project’s internal controls wil l be based on the established MOF accounting and internal control systems and documented in. the Project Financial Operations Manual. The manual will be subject to review by the Bank Financial Management Specialist.

The procedures to be used by the project to maintain i ts records will include the requirement for cross references to supporting documentation in the SOE supporting schedules in order to facilitate the inspection of these schedules and improve the maintenance of the project’s records.

Project ~ ~ n a ~ ~ ~ u ~ ~ p e r u ~ ~ ~ ~ ~ ~ a ~ ~ a l The Manual will describe the accounting system: the major transaction cycles o f the project; funds flow processes; the accounting records, supporting documents, computer files and specific accounts in the fmancial statements involved in the processing o f transactions; the l i s t of accounting codes used to group transactions (chart o f accounts); the accounting processes &om the initiation of a transaction to its inclusion in the financial statements; authorization procedures for transactions; the financial reporting process used to prepxe the financial statements, including significant accounting estimates and disclosures; financial and accounting policies for the Project; budgeting procedures; financial forecasting procedures; procurement and contract administration monitoring procedures; procedures undertaken for the replenishment o f the Special Account; and auditing arrangements.

~ ~ a n n ~ n g sad ~ ~ d g ~ t i n g Budgeting for the project will be undertaken in line with existing Government arrangements, including consultation and extensive detailed input by respective

51

implementing agencies. IDA reporting guidelines provide for periodic activity, cash flow and procurement projection analysis and review on an ongoing basis by way o f Financial Monitoring Reports.

Books o ~ A c c ~ ~ ~ t s and List o ~ A ~ ~ o ~ n ~ i ~ ~ Codes The project’s accounting records will be maintained on computerized accounting systems. A list of accounts codes (Chart o f Accounts) for the project will be integrated. This will match the classification o f expenditures and sources and application o f fimds to be set out in the Credit Agreement. The Chart o f Accounts will be developed in a way that allows project costs to be directly related to specific work activities and outputs o f the project. This process is required to be in place by Credit Effectiveness.

Audit Arrangements

~ n t ~ r n u ~ Audit The Project will develop an internal audit h c t i o n to carry out periodic reviews o f activities, compliance with accounting and internal control procedures and carry out ad hoc investigations and reviews under the direction o f the Project Steering Committee to whom they will report. The Committee will be responsible for ensuring that audit recommendations are followed up and implemented.

Eternal Audit The Office of the Controller & Auditor General (CAG) is primarily responsible for the auditing o f a l l government projects. There is an option for the audit to be subcontracted to a firm of private auditors, with the final report being issued by the CAG, based on the tests carried out by the subcontracted firm. It is recommended that the project audit be subcontracted to a private auditor for the following reasons:

e IDA has continued to experience delays in receipt o f audited financial statements, largely owing to lack of technical capacity in the office of the CAG; and

e The project entails multiple implementing agencies, requiring multiple audit locations. The existing setup and audit process o f the office o f the CAG is considered unsuitable for such an arrangement.

The firm o f auditors subcontracted to carry out the audit should meet IDA’S requirements in terms of independence, qualifications and experience. Annual Audited Financial Statements covering the activities o f the Project, taking into consideration the new Audit Policy Guidelines o f the World Bank should be submitted to IDA within six months after end o f each financial year.

Reporting and Monitoring

~i~~~~~~~ ~ ~ ~ i t ~ r i ~ g Reports Formats o f the various periodic financial monitoring reports to be generated from the fmancial management system will be developed. There will be clear linkages between the information in these reports and the Chart of Accounts. The financial reports will be

52

designed to provide quality and timely information to project management, implementing agencies, and various stakeholders on project performance.

The following contents o f quarterly FMRs will be produced by the PIU:-

Financial Reports:

o o

Sources and Uses of Funds by Funding Source Uses o f Funds by Project Act iv i~/Component

m

m Procurement Report Physical Progress (Output Monitoring) Report

The formats will be defined and agreed by Credit Effectiveness and the project must be capable o f producing FMRS by that t h e .

Annual Financial Statements should be prepared in accordance with htemational Public Sector Accounting Standards (which inter alia includes the application o f the cash basis o f recognition o f transactions). The IDA Credit Agreement will require the submission o f audited financial statements to the Bank within six months after the year-end.

Project Financial Statements will comprise:

1. A Statement of Sources and Uses of Funds I Cash Receipts and Payments for each fhnded phase which recognizes all cash receipts, cash payments and cash balances controlled by the entity; and separately identifies payments by third parties on behalf o f the entity,

2. The Accounting Policies Adopted and Explanatory Notes. The explanatory notes should be presented in a systematic manner with items on the Statement of Cash Receipts and Payments being cross referenced to any related information in the notes for each funded phase. Examples o f th is information include a summary o f fixed assets by category o f assets, and a summary o f SOE Withdrawal Schedule, listing individual withdrawal applications; and

3. A Management Assertion that Bank funds have been expended in accordance with the intended purposes as specified in the relevant World Bank legal agreement for each funded phase.

Indicative formats of these statements will be developed in accordance with IDA requirements by Credit Effectiveness.

53

Supervision Plan

A Financial Management supervision mission will be conducted at least every six months. The mission’s objectives will include ensuring that strong fmancial management systems are maintained for the project throughout i ts life. Reviews will be carried out regularly, upon receipt o f quarterly FMRs to ensure that expenditures incurred by the project remain eligible for IDA funding. The Project Status Report (FSR) will include a financial management rating for each component. This rating will be determined by the Country Off ice Financial Management Specialist after an appropriate review,

Project R isks

Specific Project risks here include:

1. Shortage o f liquidity at the central treaswy delaying project implementation through lack o f counterpart funds and/or inability to access counterpart funds because the project is not “inscribed” in the national budget;

2. Weak financial management and procurement capacity delaying implementation;

Country and Project risks can be summarized as follows:

* Tfiis will be mitigated by adoption of a comprehensive Project Financial Operations Mmual

54

** These items are considered non significant as long as mitigating factors, as described in the FM Act ion Plan, are put in place.

The Project is addressing capacity building in the Judiciary and the new Government is currently implementing major reforms in comption, governance and the judiciary, with the expectation that these r isks will be mitigated.

***

Overall R i s k Assessment

The project financial management risk is assessed as being moderate provided that the fmancial management arrangements are properly implemented and the following financial management action plan is satisfactorily addressed in practice:

Financial Management Action Plan

3

Action Financial Monitoring Report formats and input by implementing agencies agreed.

Recruitment o f appropriately qualified and experienced f m c i a l officer.

Training for the Project’s financial managers and accountants on World Bank FM and Procurement procedures,

Financial management system installed. This includes:

1 Procedures Manuals 1 Information System 1 Training

Special and project accounts opened and initial deposits of counterpart funds made.

Relevantly qualified external auditor for the entire project appointed on approved terms o f reference.

Ability o f the PIlJ to prepare FlMRs

Due Date Negotiations Wet)

Effectiveness

Effectiveness

Effectiveness

Effectiveness

Six months after Effectiveness

Effectiveness

Conditionalitv Condition o f Negotiations

Condition o f Effectiveness

Condition o f Effectiveness

Condition o f Effectiveness

Condition o f Effectiveness

Condition o f Disbursement

Condition of Effectiveness

55

Disbursements from IDA and DFD would be initially made on the basis of appropriately approved project work plans, including detailed procurement plans. Subsequent disbursements would be on the basis o f incurred eligible expenditures included in periodic Financial Management Reports (report-based disbursements). Financing o f project activities will be made on the basis o f a 60 percent IDA credit, 33 percent DFID grant and 7 percent Government contribution. The co-fmanciers agreement between IDA and DFID will require that IDA first reviews any withdrawal applications submitted to DFID for adherence to IDA guidelines before DFID can make any disbursements. IDA would make disbursements from the proceeds o f the Credit by depositing into Borrower- operated Special Account to expedite Program implementation. Advances to the Special Account would be used by the Borrower to fmance IDA’S share o f program expenditures under the proposed Credit. Another acceptable method o f withdrawing funds from the Credit i s the direct payment method, involving direct payments from the Credit to a third party €or works, goods and services upon the Borrower’s request. Payments may also b e made to commercial banks €or expenditures against IDA special commitments covering commercial banks’ Letters o f Credit. IDA’S Disbursement Letter stipulates a minimum application value for direct payment and special commitment procedures.

The flow o f funds from the Special Account to project accounts and project activities will be as detailed under the preceding Flow of Funds section. IDA will have the right, as reflected in the Development Credit Agreement, to suspend disbursement o f the Funds if reporting requirements are not complied with.

Technical Annex. 8: Procurement ]KENYA: Financial and Legal Sector Technical Assistance Project

A. Procurement Arrangements

The last Kenya Country Procurement Assessment Review (CPAR) was conducted in 1997. Following the findings and recomendations o f the C P W the C “ e n t o f Kenya (GCTK) applied for the Bank’s support to implement the. recommendations o f the CPAR, and subsequently received from the Bank an IDF grant which was approved in 1998. Using the proceeds o f the grant, GOK started a procurement reform program. One o f the main outcomes o f the reform program was the establishent and gazetting in March 2001 o f National Public Procurement Regulations, which govern all public procuring entities, and production o f standard bidding documents for works and goods. The Public Procurement Regulations allow the Bank procedures to take precedence over any contrary provisions in the national regulations. Therefore there i s no need to specify exceptions in Credit agreements.

Procurement for the proposed project would be carried out in. accordance with the World Bank’s “Guidelines: Procurement Under BFU3 Loans and IDA Credits” dated May 2004; and “Guidelines: Selection and Employment o f Consultants by World 3 d Borrowers’’ dated May 2004, and the provisions stipulated in the Legal Agreement. For each contract to be financed by the Credit, the different procurement methods or consultant selection methods, the need for prequalification, estimated costs, prior review requirements, and time fiame are agreed between the f3orrower and the Bank project team in the Procurement Plan. The Procurement Plan will be updated at least m u a l l y or as required to reflect the actual project implementation needs and improvements in institutional capacity.

Procurement of Works - The FLSTAC i s a Technical Assistance Laan aimed at developing institutional capacity o f the beneficiary institutions, therefore no works will be p d o m e d as part o f this project.

Goods - The total cost of goods under the IDA credit is estimated at U S $ 3.5 million. The procurement will be done using the Bank’s Standard 3idding Documents (SBD) for all International Competitive Bidding (ICB) and National S3D agreed with (or satisfactory to) the Bank.

Consultant Senices - The total cost o f IDA-financed consultant services and technical assistance i s estimated at US$ 6.7 mill ion equivalent. Short l ists o f consultants for services estimated to cost less than ~~00,000 equivalent per contract may be composed entirely o f national consultants in accordance with the provisions o f paragraph 2.7 o f the Consultants’ Guidelines.

57

B. Assessment of the Agency’s Capacity to Implement Procurement

To mitigate the inherent procurement risk, the Implementing Agency will establish a PIU staffed with a qualified team (listed in h e x 6 o f the PAD) through a competitive selection process in accordance with the Bank’s Consultants’ Guidelines. In the project team, there will be a procurement specialist whose qualifications and experience in Bank procurement procedures will be satisfactory to IDA. If IDA finds i t necessary (during i ts review o f the selection process o f the recommended candidate for the post), IDA will recommend and agree with the Implementing Agency an appropriate training plan for the Procurement Specialist. As part o f its routine supervision o f the management o f project implementation, ZDA will regularly monitor the performance o f the procurement specialist and discuss its findings and recommendations with the Implementing Agency for corrective measures o f deficiencies that it may detect in i ts evaluation o f performance.

C. Procurement Plan

As part o f the preparation o f the project, the Implementing Agency has prepared a draft procurement plan setting out: (a) the particular contracts for the goods and consultancy services required to carry out the project during the initial period o f 18 months; (b) the proposed method for procurement o f the contracts; and (c) the related Bank review procedures. The procurement plan will be updated annually or as needed throughout the duration o f the project.

D. Frequency of Procurement Supervision

In addition to the prior review supervision to be carried out from Bank offices, the capacity assessment o f the Implementing Agency has recommended biannual supervision missions to v is i t the field to carry out post review o f procurement actions.

58

m 0 0 N +I - 2

0 z 0 z 0 2

0 z

e3 52

e3 52

Q 0- 3

a 0

r- n 2

a 0

0 0 ry,

0, +.'- Lo *q g 3

2.

Assignment

strategy Devpt for

Consulting Services.

Cost Method (US$)

(a) List o f Consulting Assignments with short-list o f international firms.

Description of Estimated

fin. sector 150,000

Strategy Devpt for legal sector 150,000 Implement DFI Strategy 150,000

1

Ref. No.

1,

2.

3.

4.

F

Selection

SIC

QBS

SIC

Redew by Bank

(Prior I Post)

YES

Expected Proposals Comments Submission Date

1 * phase; March 2005 other phases

1 I

KPOSB financialhperational 50,000 CQ audits Drafting 3anking Law Amendments 200,000 SIC Restruchuing Advisor for DPF 400,000 SIC

YES March 2005

F e b q 2005 before delivery of IT

YES

60

1" p h e ; June 2005 other phases

to follow later

1

Ref. No.

2 3 4 5 6 7

Description of Estimated Selection Review Expected Proposals Comments Assignment Cost Method by 3ank Submission Date

(-US%) (Prior I Post) 1 I

(b) Consultancy services estimated to cost the equivalent o f US$50,000 or more per contract for individual consultants and the equivalent o f US~l00,000 or more per contract for f irms and al l Single Source selection o f consultants ( f ims) will be subject to prior review by the Bark.

18.

(c) Short lists composed entirely of national consultants: Short l ists o f consultants for services estimated to cost less than US$200~000 equivalent per contract, may be composed entirely o f national consultants in accordance with the provisions o f Paragraph 2.7 ofthe Consultant Guidelines.

I I Review Legal To be done framework for NPS 200,000 QC3S YES October 2005 after advisor i s

Technical Annex: 9: Economic and Financial. Analysis

KENYA: Financial and Legal Sector Technical Assistance Project

NOT APPLICABLE

Technical Annex 10: Safeguard Policies

KENYA: Financial and Legal Sector Technical Assistance Project

NOT APPLICABLE

62

Technical Annex 11: Project Preparation and Supenision

KENYA: Financial and Legal Sector Technical Assistance Project

Planned Actual PCN review July 16,2003 September 24,2003 Initial PID to PIC September 10,2003 March 30,2004 Initial ISDS to PIC September 10,2003 March 3 1,2004 Appraisal J a n m 26,2004 March 24,2004 Negotiations February 2004,2004 July 30,2004 3oaf.dlRVP approval February 2004,2004 Planned date o f effectiveness P l m e d date o f mid-term review Planned closing date

August 15,2004 March 2007

December 3 1,2009

Key institutions responsible for preparation o f the Project include: Ministry o f Finance (Republic o f Kenya), MOJCA and OAG, the Judiciary, and Central Bank o f Kenya, Bank staff and consultants who worked on the project included:

Name Unit Title Michael Fuchs AFTFS Lead Financial Economist Minneh Kane David F m d Abayomi Alawode Andrew Lovegrove John Randa Catherine Masinde Martin 0100 Katarina Mathemova Tfiorsten Beck John Byamulrama Robert Buergenhl Thordur Jonasson T o m s Inge Magnusson Pascal Dubois Nightingale Rukuba-Ngaiza Monica Sawyer Hisham Abdo Dahir W ~ § a m e Zeynep Kantur Gregorio hpavido Claire Grose Rowena Margaret Gorospe Moses Wasike Fatiha Amar Reviewers: Roberto Rocha Fred Kilby

LEGLR DFXD-UK

W L P F DFID-UK

AFTP2 DFID-UK DFID-UK

CICFI DECRG AFTFS LEGLR

OPD BCFBD LEGAF LEGEC LEGAF LEGAF AFTPC OPD OPD OPD

LEGLR AFTFM AFTPS

OPD AFTP2

Lead Counsel Financial Sector Specialist Senior Financial Sector Specialist Consultant Economist Private Sector Advisor Governance Advisor Senior private Sector Development Specialist Senior Financial Economist Financial Analyst Senior Counsel Senior Debt Specialist Principal Financial Officer Senior Counsel Senior Counsel Consultant Consultant Frocurement Specialist Financial Analyst Senior Financial Economist Senior Financial Specialist Operations Analyst Financial Management Specialist Language Program Assistant

Lead Financial Sector Economist Lead Economist

Patrick Hhnohan OPD Senior Financial Policy Advisor

53

Technical Annex 12: Documents in the Project File

KENYA: Financial and Legal Sector Technical Assistance Project

A. Project Implementation Plan

The Project Implementation Plan will be prepared before the project becomes effective and a procurement plan €or the activities o f the first 1 E: months will be prepared by Board presentation.

B. Bank Staff Assessments

1. 2.

Report on the National Bank o f Kenya Assessment Report on Central Government Debt Management and Domestic Debt Market Development Program (prepared jointly with the W)

C. Other

Missir

1. 2. 3. 4. 5. 6. 7. 8. 9.

Reports

Aide Memoire o f Exploratory Mssion - J a n w 2003 Statement of Mission Objectives for Pre-Identification Mission - May 2003 Aide Memoire o f Re-Identification Mission - May 2003 Statement o f Mission Objectives for Identification Mission - July 2003 Aide Mernoire and BTOR o f Identification Mission - July 2003 Statement o f Mission Objectives for Pre-Appraisal Mission - October 2003 Aide Memoire and BTOR o f Pre-Appraisal Mission - October 2003 Statement o f Mission Objectives for Pre-Appraisal - February 2004 Aide Memoire of and BTOR for Pre-Appraisal Mission - February 2004

~ ~ s c e ~ ~ ~ ~ ~ ~ ~ s Reports

1.

2.

The Govement 's Economic Recovery Strategy for Wealth and Employment Creation (ERSWC) Govement o f Kenya Banking Sector Reform Strategy

64

Annex 13: Statement of Loans and Credits KENYA: Financial and Legal Sector Technical Assistance Project

Difference between expected and actual

disbursements Original Amount in US$ Millions

ProiectIE) FY Pumose D3E)RD IDA SF GEF Cancel. Undisb. Oria. Fm. Rev'd

PO85007 2005 PO83131 2005 PO49618 2004 PO78209 2004 PO82396 2004 PO82615 2004 PO78058 2003 PO82378 2003 PO66490 2002 PO70920 2001 PO70718 2001 POW86 2001 Po45871 1997 PO01319 1996

MSME Competitiveness Project KE-Energy Sector Recovery N'rbi. Water & Sw'age Inst, &str.frqj.

Development Leaming Centre - LIL ICE-Agricu1tL" hoductivity Project Kenya Northern Corridor Transport

Kenya Arid Lands I1 Free Primary Educ. support

P ~ . S E ~ , M ~ ~ T . T A HIV/ADS Disaster Rep. (U"E11a)

Regional Trade Fa. Proj. - Kenya

Dxentr. Reprod. Health & HN/AIQS ICE-Lake Victoria Env. (GEF) UR3AN TRANSPORT

Total:

0.00 0.00 0.00

0.00 0.00 0.00 0.00 0.00

0.00 0.00 0.00 0.00 0,00 0.00

22.00 0.00 0.00 0.00 21.91 0.00 0.00 80.00 0.00 0.00 0.00 80.64 0.00 0.00 0.00 0.00 0.00 0.00 14.97 0.38 0.00 0.00 0.00 0.00 0.00 2.53 0.05 0.00

27.00 0.00 0.00 0.00 39.18 0.00 0.00 207.00 0.00 0.00 0.00 203.17 0,00 0.00

60.00 0.00 0.00 0.00 57.56 4.32 0.00 0.00 0.00 0.00 0.00 6.65 -9.35 0.00

15.00 0.00 0.00 0.00 7.06 9.13 0.00 50.00 0.00 0.00 0.00 25.87 16.44 0.00 25.00 0.00 0.00 0.00 14.78 6.84 0.00 50.00 0.00 0.00 0.00 33.42 23.00 15.54 9.80 0.00 I 9.80 0.00 4.85 4.88 0.00

115.00 0.00 0.00 0.00 25.31 35.28 0.00

0.00 550.80 0.00 9.80 0.00 538.00 90.97 15.54

KENYA STATEMENT OF IFC's

Held and Disbursed Portfolio In Millions o f U S Dollars

Disbursed

IFC FY Approval Company Loan Equity Quasi

ZOO0 AEF AAA Growers 0.44 0.00 0.00 1997 1997 1996 2000 1998 2000 1997 1%7 1982 1998 2001

AEF Ceres AEF Deras Ltd, AEF Equitea AEF Lesiolo AEF b l a n d AEF Magma AEF Makini AEF Redhill Flrs Diamond Trust

GBHL Gapco Kenya IPS(K)-Al$ack IPS(K)-Frigoken

0.93 1 .00 0.29 2.50 0.20 1.08 0.18 0.27 0.00 2.33 15.00 0.00 0.00

0.00 0.00 0.00 0.00

0.12 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.80 0.00 0.00 3.00 0.00 0.00 0.36 0,00 0.06 0.00

Partic. Loan Equity Quasi Partic,

0,00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

0,44 0.00 0.00 0.00 0.93 0.00 0.00 0.00 1 .00 0.00 0.00 0.00 0.29 0.12 0.00 0.00 2.50 0.00 0.00 0.00 0.20 0.00 0.00 0.00 1.08 0,00 0.00 0.00 0.18 0,00 0.00 0.00 0.27 0.00 0.00 0.00 0.00 0.80 0.00 0.00 2.33 0.00 3.00 0.00

10.00 0.00 0.00 0.00 0.00 0.36 0.00 0.00 0.00 0.06 0.00 0.00

IFS(K)-Prem Food 0.00 0.1 1 0.00 0.00 0.00 0.11 0.00 0.00 1994 intl Hotels-Ken 3.43 0.00 0.00 0.00 3.43 0.00 0.00 0.00 1996199 K-Rep Bank 0.00 0.43 0.00 0.00 0.00 0.12 0.00 0.00 2003 Kenair 15,00 0.00 0.00 0.00 6S3 0.00 0.00 0.00 1983191 LIK 0.00 0.03 0.00 0.00 0.00 0,03 0.00 0.00 2000 Mabati 4.50 0.00 4.50 0.00 4.50 0.00 4.50 0.00 2004 Magadi Soda Co. 22,00 0.00 4.00 0.00 0.00 0.00 0.00 0.00 1994196 Panafrican 15,58 0.00 0.00 0.00 15.58 0.00 0.00 0.00 1972 TPS (Kenya) 0.00 0.04 0.00 0.00 0.00 0.04 0.00 0.00 2000 Tsavo Power 14.65 0.83 1.11 18.18 14.65 0.83 1.11 18.18

Total portfolio: 99,38 2.78 12.61 18.18 63.91 2.47 8.61 18.18

Approvals Pending Commitment

FK Appval Company h a l l Equity Quasi Partic.

2004 BP Kenya 2003 Kenair 2005 Magadi Swap

0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Total pending commitment: 0.00 0.00 0.00 0.00

66

Annex 14: Country at a Glance

67.1 70.2 79.0 81.1 18.4 16.1 16.8 10.2

KENYA: Financial and Legal Sector Technical Assistance Project

-101

-GDI *GDP

Kenya

31.3 330 11.3

2 3 2.9

35 43 80 22 57 16 94 $5 93

1m

8.0 13.7 26.9 13.7 9,7

-2.3 2.5

88.2 31.1

2001

1.1

Sub- Saharan

Africa

6%% 450 308

2.4 2.5

33 43

103

58 37 33 92 80

2001 11.4 12.8 23.0 4.2 9.6

-2.8 0.7

49.5 13.9 33.7

146.6

2002

1 %

krw- inam%

2,495 430

1,072

1.9 2.3

30 59 81

73 37 93

103 87

2M12 121 148 25.5 8,7

13.1

0.6 51.1 9.8

2MMDB

3.5

1% of GDP)

lndustry

Sentices

Private consumption General govemment consumption Imports of gods and sewices

&dGUkUE

Mandmring

lavetage annual growth) Agdculiure Industry

Services

Private consumption General govemment consumpiion Gross domestic investment Imports of goods and sewices

MandCturing

T&e

T

Indebtedness

33.4 26.6 19.0 19.1 193 18.9 18.2 18.3 12.2 11.1 12.5 12.7 46.7 54.5 62.9 62.6

2.7 1.6 1.2 4.3 1.6 0.7 5.1 i .a 0.8 4.9 2 3 1.3

5.1 2.2 -4.4 3.6 6.6 4.3 5.2 1.5 4.3 2.3 3.8 5.7 5.5 -1.2 2.9

* The d i a m d s shm four kev indicitm in the munh fin bold) cornoar& wifh its i-rouo awraaoe. If data are nissino. the d i a m will be i n m l e t e .

67

Kenya PRICES and GOVERNMENT FINANCE

Domestic prices (% change) Consumer prices Implicit GDP deflator

Govemment finance (% of GDP, includes current grants) Current revenue Cumnt budget balance Overall surpluddeficit

TRADE

(US$ millions) Total exports (fob)

Fuel Coffee Manufactures

Total imports (cifl Food Fuel and enemy capita1 goods

Export price index (1995=1001 Import price index (1995=100) Terms of trade (1995=100J

BALANCE of PAYMENTS

(US$ millionsl Exports of goods and services Imports of goods and services Resource balance

Net income Net current transfers

Current account balance

Financing items (net) Changes in net serves

Memo: Reserves including gold (US$ millions) Conversion rate (DEC, /ocaVUS$)

EXTERNAL DEBT and RESOURCE FLOWS

(US$ millions) Total debt outstandinll and disbursed

IBRD IDA

Total debt service IBRD IDA

Official grants Official creditors Private creditors Foreign direct investment Porffolio equity

World Bank pwram Commitments Disbursements Principal repayments Net flows Interest payments Net transfers

Composition of net resource flows

1982

11.7

25.1 -1.5

-10.2

1982

894 223 227 107

1,415 83

523 250

77 112 69

1982

1,715 2,030 -315

-254 83

-305

139 167

248 10.9

1982

611 0 0

258 1 0

143 -15

-136 13 0

0 0 0 0 1

-1

1992

27.3 17.5

27.5 1.3

3.3

1992

1,013 69

128 144

4 *a 156 412 41 1

76 91 84

1992

2,149 2,152

-3

-355 68

-1 80

255 -75

182 32.2

1992

6,898 656

1,411

670 159 16

378 155 20 6 0

176 92

104 -12 71

-83

2001

3.9 11.3

22.5 1.5

-0.9

2001

1,732 115 88

274 3,182

290 810 756

74 100 74

2001

2 . m 3,939 -973

-80 761

-318

509 -191

1,097 78.6

2001

5,644 24

2,263

417 26 51

252 62

-103 5 0

93 116 58 58 20 39

2002

5.0 4.9

22.4 2.4

4.9

2002

1,742 101 97

310 3,137

300 809 803

74 104 71

2002

3,001 3,850 -848

-70 576

256

1,174 78.7

2002

6,207 13

2,447

299 13 60

1 -1 8

2 66 54 12 19 -7

lnflatlon (%)

2o T

GDP detlaior +CPI "I Export and Import levels (US$ mill.) 1

I

Current account balance to GDP ($4) c

:omposition of 2002 debt (US$ mill.)

A: 13 0: 863

i - IBRD E - Bilaieral B - IDA D - Other multilateral F - Privaie C-IMF G - Shohier

68

MAP SECTION