. Document o f

The World Bank

FOR OFFICIAL USE ONLY

Report No: 47963-IN

PROJECT PAPER

FOR A PROPOSED ADDITIONAL LOAN

IN THE AMOUNT OF US$400 MILLION

TO THE

SMALL INDUSTRIES DEVELOPMENT BANK OF INDIA

WITH THE GUARANTEE OF THE REPUBLIC OF INDIA

FOR A

SMALL- AND MEDIUM-ENTERPRISE FINANCING AND DEVELOPMENT

PROJECT

March 30,2009

Finance and Private Sector Development Unit South Asia Region

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

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B D S CART CF CGTMSE

C B I L DflD DIR DO E&S FIL FM FMR FX I C B I S R IUFR GAAP

Go1 IBRD

IFC IP M&E

CURRENCY EQUIVALENTS

(Exchange rate effective March 30,2009)

Currency Unit = Indian Rupees Rs 5 1.08 = US$ l

F I S C A L YEAR April 1 - March3 1

ABBREVIATIONS AND ACRONYMS Busin ss Development Services Credit Appraisal and Rating Tool Credit Facil ity Credit Guarantee Fund Trust for M i c r o Small and Med ium Enterprises Credit Information Bureau o f India Ltd. Department for International Development, UK Detailed Investigation Report Development Objectives Environmental and Social Financial Intermediary Loan Financial Management Financial Monitor ing Report Foreign Exchange International Competitive Bidding Implementation Supervision Report Inter im Unaudited Financial Reports Governance and Accountability Act ion Plan

Government o f India International Bank for Reconstruction and

M I S M o F N P L S PAD

PDO PFIs PMD PRC RAM R o A RBI RSF RSGC RTI S A R SMEs SMEFDP

S M E R A S I D B I

Management Information System Ministry o f Finance Non-Performing Loans Project Appraisal Document

Project Development Objectives Participating Financial Institutions Project Management Div is ion Project Review Committee Rating Appraisal Mode l Return o f Assets Reserve Bank o f India Risk-Sharing Facil ity Risk-Sharing Guarantee Company Right to Information South Asia Region Small and Medium Enterprises Small and Medium Enterprises Financing and Development Project S M E Rating Agency Small Industries Development Bank o f

Development India International Finance Corporation TA Technical Assistance Implementation Progress TOR Terms o f Reference Monitor ing & Evaluation WTO Wor ld Trade Organization

Vice President: Isabel M. Guerrero

Sector Director: Ernest0 M a y Sector Manager: Simon Be l l

Task Team Leader: Niraj Verma Co-Task Team Leader: Gabi Afiam

Country Director: N. Roberto Zagha

CONTENTS

I . INTRODUCTION .......................................................................................................... 1

I1 . BACKGROUND AND RATIONALE FOR ADDITIONAL FINANCING ................ 1

I11 . PROPOSED CHANGES .............................................................................................. 6

IV . CONSISTENCY WITH THE COUNTRY ASSISTANCE STRATEGY ................... 8

V . APPRAISAL OF SCALED-UP PROJECT ACTIVITIES ........................................... 8

V I . EXPECTED OUTCOMES ......................................................................................... 17

VI1 . BENEFITS AND RISKS .......................................................................................... 17

VI11 . FINANCIAL TERMS AND CONDITIONS FOR THE ADDITIONAL

FINANCING ..................................................................................................................... 21

ANNEX 1 : RESULTS FRAMEWORK AND MONITORING ....................................... 23

ANNEX 2: GOVERNANCE AND ACCOUNTABILITY ACTION PLAN (GAAP) .... 25

PROJECT PAPER DATA SHEET

Source

Project Name: SME Financing and Development Proj ect-Additional

Country Director: N. Roberto Zagha Environmental Category: FI

Responsible agency: Small Industries Development Bank o f India (SIDBI)

Current closing date: June 30, 2009

Revised project development objectives/outcomes There are no changes to the development objectives/outcomes indicators, but scope has been scaled-un

Local I Fo re im I Total Borrower

* Includes US$120 million under the SME Financing and Development Project and US$400 million o f additional financing.

I. INTRODUCTION

1. This Project Paper seeks the approval o f the Executive Directors to provide an additional loan for US$400 mi l l ion to the Small Industries Development Bank o f India (SIDBI), with the guarantee o f the Republic o f India, for the SME Financing and Development Project (SMEFDP, PO865 18, LN 7263-IN).

2. The proposed additional financing would scale up the project by facilitating an increased f low o f working capital and term lending to the S M E sector. Term lending; in particular, has become increasingly difficult to access as a result o f the recent global financial crisis’s impact on the Indian financial system. The additional financing would scale up the parent project and facilitate an: (i) increase in the geographical coverage o f the project; (ii) expansion o f innovative SME loan products, including possibly loans to smaller SMEs (‘downscaling’), and receivables financing; (iii) expansion o f SME lending through other participating financial institutions (PFIs), subject to demand; (iv) exploration o f the possibility o f providing loans to promote investments in energy- efficiency improvement technologies, subject to adequate demand f rom SMEs at the Small Industries Development Bank o f India (SIDBI) for such funding; and (v) expansion o f the coverage o f the innovative Risk-Sharing Facility (RSF) that was initiated under the parent project. The additional financing project will substantially increase the development outcomes from this project. The parent project has consistently performed wel l and project supervision ratings are Satisfactory for both Project Development Objectives and Implementation Progress.

3. The ongoing technical assistance (TA) component o f the parent project, which i s financed through parallel donor fbnding (from the United Kingdom’s Department for International Development, DflD), will continue in parallel with the additional financing.

11. BACKGROUND AND RATIONALE FOR ADDITIONAL FINANCING

Background

4. The parent SMEFDP project entailed Bank funding o f US$120 mi l l ion to S IDBI for S M E financing and development. SIDBI is an apex development finance institution with a mandate to support the SME sector. The project was approved o n November 30, 2004; became effective o n April 4, 2005; and i s currently scheduled to close on June 30, 2009. The project objective i s to improve SME access to finance (including term finance) and business development services, thereby fostering SME growth, competitiveness, and employment. The two Bank-financed components o f the project are a credit facility (CF), which is financed by US$115.0 mi l l ion o f Bank funds, and an RSF, which i s financed by US$5.0 mi l l ion o f Bank funds. Both have been fully disbursed. In addition, there is parallel financing by DflD o f US$37.0 mi l l ion for TA related to pol icy and institutional development. The TA component has provided assistance to help banks improve their credit appraisal processes. Amongst other activities, the component has also supported the creation o f a commercial credit bureau and an SME rating agency. The SMEFDP project was the Bank’s first engagement in India’s financial sector after a considerable

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hiatus. Through pol icy dialogue and collaboration on positive implementation results, the project has contributed to a growing relationship between the Bank and India’s financial sector.

Loan No. 7263 IN

Loan closing date 30-Jun-09 I Disbursement I ~ ~ $ 1 2 0 mil l ion (100%) I

Project Implementation Record and Project Performance

5. Throughout the project implementation period, the parent project has consistently performed well, and project supervision ratings are Satisfactory with respect to both Project Development Objectives (PDOs) and Implementation Progress (IP) (see also table 2). In terms o f disbursements, the project was fully disbursed by June 30, 2008, the original closing date. Performance on the PDO indicators-growth in the volumes o f lending to SMEs, growth in the volume o f term loans to SMEs, and reduction in nonperforming loans (NPLs)-has been impressive (see table 3). W h i l e targeted portfolio growth o f 37 percent and 26 percent was projected, respectively, for total SME lending and term lending, actual growth by the original closing date was 98 percent for both. On- lending to SMEs has covered 927 SMEs spread across 10 Indian states. In line with its mandate as a development finance institution, SIDBI channeled long-term loans to SMEs under the project. The average tenor o f loans provided under the project was five years, which i s not easily available f rom the banking sector. Recovery performance has been strong, and asset quality o f the branches involved in the CF has improved steadily and i s beyond targeted levels. The NPL ratio o f participating branches decreased from 12 percent in December 2004 to 1.9 percent in March 2008-a dramatic improvement that resulted in part f rom improved lending practices supported through the project’s TA component. Another factor influencing the improvement in the rate o f N P L s i s the participating branches’ increased focus and efforts to monitor and improve asset quality.

World Bank ISRs; S=Satisfactory and HS=Highly Satisfactory

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*

PDO Indicators

1. Participating financial institutions (PFIs) increase lending to SMEs

2. PFIs increase term-lending (loans with a maturity o f 3 to 15 years) to SMEs

their SME loan portfolios. 3, PFIs reduce nonperforming loan ratios on

Targets from project start to

end-March 2008

37%

26%

<9%

Objectives Actuals from

project start to end-March 2008

98%

98%

1.90%

6. The strong project performance results are also captured in the findings o f a baseline survey and draft impact evaluation report prepared o n SIDBI’s behalf. The impact evaluation reports an 18 percent growth in sales and a 17 percent growth in profits among the 300 beneficiary SMEs that were surveyed after they received long-term financing from S IDBI (further details o n the survey are provided in Section V below).

7. Despite the RSF’s delayed start when the Swiss Economic Secretariat was unable to proceed with expected co-financing, the component was successfully restructured in late FY2008 and has been implemented through the Credit Guarantee Fund Trust for Micro and Small Enterprises (CGTMSE). Since restructuring, the RSF component was fully disbursed to create the guarantee reserves. In this way, a new product, designed in l ine with good international practices for guarantee products, has been offered to the Indian financial sector by CGTMSE. Specifically, the f i rst six ini t ial agreements between CGTMSE and PFIs for guarantees worth Rs 475 mi l l ion (US$9.3 million) have been issued. Thus, this component is now on track, and within a span o f three months from the RSF’s launch the guarantees issued have enabled “additionality” by leveraging Bank funding to promote financing to SMEs.

8. After a slow start, the TA component (funded by parallel donor financing) has picked up momentum and resulted in positive synergies with the Bank-financed components. Good progress has led to commitments/disbursements o f around U S $ l O mi l l ion on the TA components with significant additional commitments expected in 2009. SIDBI has benefited from i t s ini t ial experience with the TA provided by the project. To avoid delays S IDBI has built a substantial pipeline o f additional activities that wil l be supported.

9. Activities initiated under the TA component are as follows.

i) The project has supported the establishment and operations o f India’s first credit bureau, the Credit Information Bureau o f India Limited (CIBIL), and India’s f i rst dedicated SME rating agency, the SME Credit Rating Agency

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(SMERA). Both institutions help improve financial infrastructure for SME financing. C I B I L has a database comprising over 123 million consumer accounts and over 1.98 mi l l ion commercial accounts, o f which an estimated 83 percent pertain to SMEs. SMERA has rated over 2,000 SMEs so far and completed risk- prof i l ing reports for over 24 SME clusters.

ii) The project has supported capacity building for financial institutions, including the Andhra Pradesh State Finance Corporation, to enhance their appraisal techniques and lending practices for S M E lending. Support to SIDBI has been provided to improve and implement i t s SME loan appraisal system, which now operates o n a software-driven platform and has increased its focus on assessing qualitative but critical factors such as the S M E promoter’s background, financial disclosure practices, management quality, etc. A s a result, branch staffs focus much more on these aspects than had previously been the case. In addition, the TA component supports a recently initiated “down-scaling” initiative.

iii) Business development services (BDS) for SMEs have been initiated with work ongoing in three clusters (Kanpur, Alleppy, and Pune), with plans for expansion to additional clusters in coming months.

iv) Research and advocacy on pol icy issues has been supported through the TA component. Activities include a study o n corporatization o f SMEs and the impact o f World Trade Organization (WTO) agreements o n SMEs. Pol icy workshops have been conducted on insolvency, bankruptcy, and risk capital. Going forward, S IDBI is considering establishing a cadre o f SME business advisors who would provide counseling to SMEs.

v) Implementation support to SIDBI has helped support the SIDBI Project Management Div is ion (PMD)-a dedicated team o f professionals overseeing overall project implementation.

Rationale for Additional Financing

10. Sustaining growth while making growth more inclusive remains a key challenge facing India’s policymakers. This i s reflected in the Government o f India’s (GoI’s) llth Five Year Plan (2007-12), which aims to put the economy o n a sustainable growth trajectory during the plan’s period while reducing economic disparities. Achieving and sustaining such growth and higher employment will require a sharp step up in industrial and services growth, spurred by small and medium enterprises, which have the greatest potential to provide employment for the two-thirds o f the labor force that is st i l l working in agriculture. For this reason, vibrant SMEs are regarded widely in India as being a key engine o f economic growth, j ob creation, and greater prosperity. However, several factors constrain the growth and competitiveness o f Indian SMEs. Key among these constraints are the problems that SMEs face in accessing adequate and timely financing on competitive terms, particularly longer tenure loans, but also, in the context o f the financial crisis, working capital loans.

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1 1. The proposed additional financing activities would help scale up the development impact o f the parent project to a larger geographical area and base o f SMEs while using the same implementation arrangements o f the parent project. The expanded CF would contribute to improved access to term loans for more SMEs through S IDBI and other PFIs, while the RSF would expand coverage to support banks and financial institutions, including potential clients o f the International Finance Corporation (IFC). The TA activities will contribute to better outcomes. For example, TA to select financial institutions to improve appraisal systems for S M E lending could be complemented by SIDBI refinancing o f such PFIs through the CF. TA could also provide capacity-building support to CGTMSE to fine tune i t s product, expand i t s coverage, and improve its monitoring capacity. Overall, a substantial portion o f the TA will be available and would go hand in hand with the additional financing project to support project implementation and monitoring (for example, supporting SIDBI’s monitoring o f project implementation and ensuring compliance with the project’s safeguards framework).

12. The additional financing will be especially important in the context o f the recent global financial crisis and i t s impact o n liquidity tightening in India’s financial sector. Foreign portfolio and debt financing i s drying up, and in recent months there have been periods o f serious domestic liquidity pressures. Despite several measures by the Reserve Bank o f India (RBI)-including a proposed new l ine o f credit for SME lending-tight liquidity in overnight markets had pushed up cal l rates. Credit default swap spreads for some major Indian banks and corporations have increased, and domestic spreads between corporate and government papers have also increased. A key concern i s that allocation o f credit to different sectors might undergo a change, including a decline in SME financing.

13. India has 13 mi l l ion SMEs in the manufacturing and services sector. Including the SME retail sector brings the count to around 30 mi l l ion SMEs. These SMEs are feeling the effects o f the credit crunch in two ways. First, until recently, large f i r m s have had access to financing through both the capital markets and the banks. As the capital market has witnessed a severe downturn and lost liquidity (losing over 50 percent o f i t s value since the beginning o f 2008), large f i r m s have resorted relatively more to bank lending-thereby offering banks a new l ine o f business that is more lucrative than lending to SMEs. Second, SMEs in India are typically o f three types: (i) firms supplying larger f i r m s as part o f the supply chain (business to business, or B2B), (ii) fi rms producing goods and services for final consumption (business to consumer, or B2C), and (iii) start-up entrepreneurs. Although the second group o f SMEs, for the most part, have not yet witnessed a significant slow down (as India’s growth has slowed but i s st i l l respectable), the f i rst group has been facing problems o f reduced orders, increased inventories, and thus higher working capital requirements as a result o f the global downturn. These SMEs have not yet experienced big decreases in profits (since the prices o f many o f their inputs have gone down with lower worldwide commodity prices). Nevertheless, their access to funding has been constrained, which i s affecting their ability to invest in capital goods, environmentally friendly technologies, and j o b creation.

14. The additional financing project i s part o f a larger program o f support in response to the Go1 request for assistance in light o f the financial crisis. I t i s targeted particularly at SME, to help address the credit crunch that has resulted from the financial crisis. The

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latest RBI statistics show that the year-on-year growth rate o f bank credit to SMEs fel l f rom 35.6 percent in 2007 to 7.4 percent in 2008, even while the overall year-on-year growth rate o f bank credit to industry (including large corporations) increased from 24.9 percent to 30.2 percent over the same period. The CF would contribute to the improvement o f access to finance for SMEs by making funding available to SIDBI-and to PFIs via SIDBI-for on-lending to SMEs. The funding would include otherwise scarce long-term funds. This would enable the project to reach out to 2,000 to 3,000 SMEs and increase the impact o f the ongoing TA component o f the parent project and the demonstration impact o f good lending practices and products for SME financing.

15. Consistent with South Asia Region’s Operational Guidelines, using the additional financing instrument i s more appropriate than a repeater project because the components remain the same as before and the proposed activities represent additions to and an expansion o f the parent project’s current activities. Moreover, the additional financing instrument enables a faster response to the client’s request to scale up the parent project and provide additional liquidity to the financial system for lending to SMEs. This ability to respond rapidly is particularly important in light o f the reduced liquidity and increased risk aversion that has resulted f rom the global financial crisis’s impact on India’s financial system. Additional financing also involves lower transaction costs both for the client and the Bank. Further, S IDBI has been a competent implementing agency, and the parent project, as described above, has a proven satisfactory track record. S IDBI has demonstrated i t s commitment to the project, and the Go1 strongly supports the additional financing project. The proposed additional financing would also enable the Bank to deepen i t s role and contribution to the financial sector in India.

111. PROPOSED CHANGES

16. The objectives and the Bank components o f the parent project wil l not be changed. The proposed additional financing o f US$400 mi l l ion i s to be allocated to scale up the two Bank funded components o f the parent project, namely Component A: the Credit Facility (CF) and Component B: the Risk-Sharing Facility (RSF). The additional financing wil l provide both working capital and term loans under the CF and wil l expand the coverage o f the RSF, thereby helping to scale up the development impact o f the parent project as follows.

17. With regard to Component A, the Credit Facility:

i) Channeling of long-term loans for SMEs in geographical areas beyond those covered in the parent project: The expanded geographical coverage would include lagging states, thereby not just facilitating the expansion o f credit but also channeling that expansion to new areas that have high potential SME clusters. In addition, the CF could be directed to those clusters where the BDS component under the DflD TA is being implemented, thereby maximizing the synergies between TA and the CF.

ii) Increased focus on developing new SME loan products to channel loans to more smaller SMEs than were covered in the parent project: This would entail

6

.

using techniques that are appropriate for smaller scale lending and would incorporate lessons from similar Bank or other donor supported “down-scaling” projects in other parts o f the world. Financing for smaller SME loans could be explored for those PFIs that have the interest and/or are being provided capacity- building support under the TA component o f the parent project for developing their “downscaling” techniques. The latter would involve TA interventions targeted at helping PFIs to develop new and appropriate financial products for smaller SMEs; new lending and delivery techniques, including the (re)design o f lending procedures; the development o f product promotion tools; and the training o f staff in marketing, financial service product delivery, and client servicing.

iii) Channeling a greater volume of loans through eligible PFIs, possibly those that have now been covered through the parent project’s TA component, subject to adequate demand for refinancing: The use o f refinancing support from SIDBI to other PFIs would facilitate CF project coverage beyond SIDBI, thereby increasing the project’s demonstration effect. I t i s noted that refinancing by SIDBI o f other eligible financial institutions did not happen in the parent project partly because market factors were not favorable when most o f the CF funds were utilized. Specifically, the interest rate o f the IBRD-sourced loan was not as attractive as it would be now relative to domestic interest rates. With the current market scenario and given that prevailing domestic interest rates have increased significantly, there is l ikely to be demand for refinancing from SIDBI. The refinancing wil l be o f loans through eligible PFIs that meet the eligibility criteria (in l ine with the provisions o f Operational Policy/OP 8.30) defined and captured in the Operational Manual. Such loans would typically entail an eligible PFI identifying a set o f eligible loans, conducting i t s due diligence, providing the required financing, and then getting refinanced through the CF by SIDBI.

iv) Exploring the possibility of providing loans for investments to improve energy efficiency, subject to adequate demand at SIDBI for such funding from SMEs: In this respect, the project would seek to coordinate with the proposed parallel Global Environment Facility technical assistance project that is being prepared.

18. With regard to Component By the Risk-Sharing Fund:

i) While the RSF component will, as before, fund the creation o f guarantee reserves, i t would aim to expand the coverage o f the recently introduced RSF product to a larger number o f banks and/or SMEs. Based o n the lessons from the scaling up o f the RSF, the implementing entity for this component, CGTMSE, could initiate the process o f shifting emphasis f rom i t s current main product to the more innovative product launched under the RSF.

19. The implementation arrangements under the proposed additional financing would remain the same as for the parent project. SIDBI would be the implementing agency and Borrower and would be responsible for implementing both o f the Bank-financed components. Component B (the RSF) would continue to be channeled through SIDBI to CGTMSE, which i s the arrangement currently used. The Department o f Financial

7

Services, Ministry o f Finance (GoI) wil l be the nodal department for the overall project. To coordinate project implementation, monitoring, and supervision, S IDBI will use i t s Project Management Div is ion (PMD), which has been coordinating the parent project. A committee comprising al l the partners in the project (the Project Review Committee, o f which IBRD i s a key member) has been established to oversee the project. Overall financial management arrangements and the safeguards framework would be broadly similar to those found in the parent project.

20. O f the total additional financing, US$380 m i l l i on would be allocated to the CF and US$10 mi l l ion to the RSF. The remaining amount would be unallocated. The time frame for the project is expected to be three years f rom the closing date o f the parent project, with an expected closing date o f June 30,2012.

IV. CONSISTENCY WITH THE COUNTRY ASSISTANCE STRATEGY

21. The proposed activities described above, under the additional financing project, are consistent with the India Country Assistance Strategy (CAS) 2004-2008, which emphasized private-sector-led growth. The project, by facilitating increased access by SMEs to long-term finds, also supports the pillar o f rapid and inclusive growth that is reflected in the new Country Strategy (2009-2012). By improving S M E access to finance and business development services (through continued implementation o f the DfID- financed TA component), the project would foster SME growth and employment creation, which are key to achieving rapid growth and making it more inclusive. The additional financing, l ike the parent project, wil l complement existing IFC activities. Synergies wil l exist, particularly on account o f the RSF’s coverage to PFIs that could be IFC’s clients.

V. APPRAISAL OF SCALED-UP PROJECT ACTIVITIES

22. I t i s confirmed that al l scaled-up activities to be financed under the additional financing meet normal appraisal standards for a Financial Intermediary Loan, as they are economically and financially viable and comply with the Bank’s fiduciary, environmental, and social safeguards. There are n o outstanding or unresolved fiduciary, environmental, or social issues. An OP 8.30 review o f the proposed additional financing found that the proposed additional financing was in compliance with Bank guidelines.

Economic and Financial Analysis

23. Significant economic and financial benefits have already accrued from the parent project, as can be seen from the findings o f the impact evaluation report prepared on behalf o f SIDBI. As mentioned above, this report shows that the nearly 300 beneficiary SMEs surveyed reported 18 percent growth in sales and 17 percent growth in profits after receiving long-term financing from SIDBI. Further, nearly two-thirds o f the SMEs that were financed upgraded their technology, which, in turn, helped increase productivity (from Rs 0.27 mi l l ion in sales per employee to Rs 0.41 million). Surveyed SMEs also reported impressive compliance with environmental clearances and practices under the project. The TA under the parent project and the additional financing wil l continue to

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improve credit market efficiency with respect to SMEs, develop the ability o f banks to appraise and manage SME loans, enhance profitable lending to viable SMEs, reduce banks’ SME-related NPLs, and develop select SME clusters, with positive impacts o n growth and employment creation.

24. SIDBI’s financial performance on criteria such as profitability, capital adequacy, asset quality, and liquidity, as reviewed under OP 8.30, continues to be very strong. A stress-testing analysis o f S IDBI showed considerable resilience to a potential downturn in i t s business and increased NPLs. This ability to withstand shocks is derived largely from the excellent strength o f SIDBI’s balance sheet, in particular the very high risk-weighted capital adequacy ratio. The analysis showed that even if gross N P L s were to increase by 60 percent over the end-March 2008 levels, S IDBI would remain marginally profitable and maintain i t s high capital adequacy. Even with a tenfold increase in gross NPLs, while earnings would be severely impacted, capital adequacy would s t i l l be more than twice the regulatory requirement (20 percent); only with a 14-fold increase in gross N P L s would the capital adequacy be reduced to near regulatory minimum levels.

25. Init ial analysis indicates that the scale o f the additional financing could be absorbed and implemented by SIDBI. In the parent project, SIDBI demonstrated ample capacity to implement the project well. Disbursements were ahead o f schedule and in accordance with the implementation arrangements, over 900 SMEs across 10 states were supported, and the project development outcome indicators were exceeded. SIDBI, which manages an SME portfolio o f over US$5.0 billion, has managed to sustain continued good financial performance while growing i t s business. I t s overall disbursements grew by 50 percent in FY2008, totaling Rsl50,870 mi l l ion (US$2.95 billion), while maintaining a net NPL ratio o f 0.25 percent. I t s capital adequacy ratio i s nearly 42 percent. From April to September 2008, SIDBI approved more than US$650.0 mi l l ion in loans for more than 1,000 firms, while NPL levels remain within control. Furthermore, increased financing by S IDBI wil l help it diversify i t s risk by expanding to other industries, regions, promoters, and sizes. Going forward, while there could be pressure o n SIDBI’s business, its strong capital base bodes wel l for the institution in the changed global financial environment.

26. In addition, SIDBI’s r i s k management framework is robust. SIDBI’s appraisal system i s rigorous and utilizes an internal rating system-the Credit Appraisal and Rating Tool (CART) for smaller SME loans and the Rating Appraisal Model (RAM) for larger S M E loans. These appraisal tools were supported under the DfD TA program. Going beyond just a financial appraisal, these tools emphasize a qualitative assessment o f the promoters’ credentials and background and the quality o f management. SIDBI ensures that monitoring o f loans i s undertaken with a view to risk mitigation, and annual reviews o f ratings are conducted for each borrower. Monitoring includes post-approval, onsite monitoring (for a l l loans, particularly those that are stressed or are expected to come under stress), post disbursement verification o f asset purchase, filing o f credit information with the credit bureau (CIBIL), assessing the role o f nominee directors, reviewing financial statements, etc. To mitigate asset concentration risks, SIDBI ’s board sets limits on sectoral exposures, which are reviewed every six months. S IDBI also proposes to undertake sensitivity analysis (with the high capital levels, the buffer

9

available wil l be substantial) and more detailed segmented analysis o f its portfolio. SIDBI’s foreign exchange (FX) exposure i s fully hedged, either by using FX resources for loans to exporters or by purchasing hedging products.

27. The reliability o f financial information reports i s high and the overall quality and independence o f potential PFIs and SIDBI’s management is good-including internal control systems and lending practices. The quality o f audited statements i s good. Financial reporting under the parent project has been adequate, especially in terms o f project monitoring indicators. SIDBI’s credit risk appraisal system i s robust with i t s use o f internal rating systems, adherence to portfolio concentration norms, and use o f appropriate project-specific r i sk mitigation measures (including postapproval assessment, cross-checking o f credit histories with the credit bureau, clear systems for monitoring stressed assets, etc).

28. With respect to the reliability o f financial information at the SME level, S IDBI collects this information and conducts due diligence through i t s loan appraisal, approval, and post-approval cycle, as envisaged in SIDBI’s Operational Manual. Adherence to the provisions o f the manual was reviewed during project supervision and found to be compliant. In addition, under the parent project, some SMEs and industry associations have received training and capacity building, which included, among other areas, preparation o f financial statements that PFIs would accept.

Governance

29. SIDBI’s corporate governance, as appraised during the parent project preparation and reviewed during supervision, was found to be satisfactory and in conformance with the standards specified by the RBI for financial institutions. SIDBI’s shares are held by public sector financial institutions, insurance companies, and commercial banks. SIDBI’s overall management vests with the Board o f Directors, which has a current strength o f 15 members. This includes eight directors appointed by GoI: the chairman and two full-time directors, two Go1 officers, and three experts. O f the remaining directors, three are nominated by the three largest shareholding institutions, while four can be elected by the public shareholders or coopted by the Board.

30. SIDBI has constituted f ive committees o f the Board including the Executive Committee, the Audit Committee, the Risk Management Committee, the Committee for Supervision o f State Finance Corporations, and an Empowered Committee on Microfinance. Amongst other things, the Executive Committee, which meets regularly, considers approvals of credit proposals above a certain threshold limit. The Audit Committee (which typically meets every other month) provides guidance on matters related to finalization o f accounts, observations f i om RBI inspections, etc. The Audit Committee also oversees the audit department’s fimctioning and reviews its major operations.

31. At the operational level S IDBI also adopts a committee system for the exercise o f delegated powers by executives to approve credit lines, settle impaired assets, and carry out other promotional and developmental activities at head office, zonal office, and

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branch levels. SLDBI also has a post approval reporting system to the next higher level. The Executive Committee handles approval o f credit lines above the delegated powers o f the Central Credit Committee (headed by the chairman and managing director). There are also delegations o f approval l imits at various levels.

32. In terms of the governance o f SMEs, these are mostly family-owned businesses; most decisions are taken by the owners. SIDBI’s appraisal standards ensure that adherence to the laws covering SMEs are in order prior to loan approval. Further, given that these owners are often personally liable for loan repayment (unlike larger f i r m s where managers and not owners are involved in running the business) and since SME owners place a premium on the time value o f money, activities f inded by the loans are typically implemented o n time. Loans are used either for working capital or the purchase o f goods. Given the SMEs’ obligation to repay the loans, there i s an inbuilt incentive to manage the costs and optimize the loans’ value and the purchases made using these loans.

Financial Management

33. A financial management (FM) assessment o f S I D B I was conducted by an independent consultant in June 2004. The assessment covered financial and credit r isk management, strategic and operational issues, and operational and management audits. The overall FM arrangements as reflected in the parent project’s Project Appraisal Document (PAD), and the FM arrangements for the parent project were reviewed in light o f experience during implementation, Areas that required strengthening were identified and agreements are being reached with SIDBI. Overall, the FM performance during the project was satisfactory, and audit reports did not identify significant issues. Some changes and improvements have also been agreed with a v iew to further strengthening project fiduciary assurance mechanisms.

34. Fundflows: The Loan Agreement i s between the Bank and SIDBI, and hence IBRD f inds would f low directly to a bank account designated by S IDBI for receiving disbursement f rom the World Bank-without routing the f inds through the Controller o f Aids Accounts and Audit in the Department o f Economic Affairs. S IDBI wil l request reimbursement in U S dollars, equivalent to the actual expenditure incurred in Indian rupees. A request for reimbursement for the World Bank project will come through the withdrawal application. S IDBI will request reimbursement to their existing account in N e w York. Funds f low in the original project was on the basis o f quarterly forecasts o f expenditure, as projected by SIDBI. In the additional financing project i t has been agreed that S IDBI will finance both components through i t s own budget and seek reimbursement for “actual expenditures” incurred.

35. Accounting/disbursement/financial reporting: All project costs and expenditures, including those related to the TA component, will be paid for and recorded in the books o f S IDBI in accordance with existing accounting policies and procedures. Each credit line o f S IDBI is allocated a separate account code within the books o f accounts. This helps in tracking progress under each credit l ine o f resources raised from various sources (liabilities) and assets (sub-borrowers, loans, and advances) created there-under. The Credit Facility under the proposed project would be allocated separate account codes to

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help distinguish transactions under this l ine f rom those under other existing credit lines. S IDBI wil l open or identify separate account codes in i t s accounting system for the purpose o f reporting on fund flows against the two components, the Credit Facility (CF) and the Risk-Sharing Facility (RSF). Under the CF, S IDBI will have account codes for the three modes o f lending under the Bank l ine o f credit: (i) Direct Finance Term Loan, (ii) Direct Finance Working Capital Loan, and (iii) Refinance Account. Expenditures booked against these codes will be consolidated to identify the routing o f Bank funds to their final utilization, both to the intermediate banks and to individual SME beneficiaries. A similar account code wil l be identified for the RSF transfers.

36. Disbursement wil l be on the basis o f reimbursement o f actual expenditure, as evidenced by the quarterly Interim Unaudited Financial reports, (IUFRs). For the CF, the “actual expenditures” wil l be defined as the actual amount o f loans advanced by S IDBI directly to the SMEs or through the PFIs. For the RSF, the actual expenditure i s defined as the “amounts transferred by S IDBI to the CGTSME in respect o f creating the guarantee reserves o f the RSF.” N o cash-forecast-based advances wil l be given to SIDBI from Bank funds. The IUFRs wil l also have an annex listing the names o f the SME beneficiaries who were recipients o f the subloans, the amounts advanced, and the purpose o f the loan as per the agreement. Retroactive financing as per Bank guidelines would be allowed to the extent o f 20 percent o f the loan amount and will be based o n separate, stand-alone, audited IUFRs, which wil l report details o f expenditures for which reimbursement i s sought. This will include loans made to the SMEs (direct and through PFIs) and direct payments by S IDBI to suppliers during the period o f retroactive financing.

37. Refinancing under the CF: Assessment of Intermediate Banks / PFIs: In the parent project, 60 percent o f the total funds allocated to the CF were to be utilized by S IDBI for on-lending to eligible commercial banks (PFIs) as refinancing o f their loans. Subject to demand, S IDBI will strive to channel loans by way o f refinancing through eligible PFIs, as per defined eligibility criteria. The eligibility criteria for banks / PFIs to participate in the CF, as defined in the Operational Manual, require that they have acceptable financial management arrangements in place. S IDBI wi l l ensure that the sub- borrowers (PFIs) have accounting and internal controls (and, where required, auditing arrangements) adequate to provide financial information o n implementation performance required by the agreements between the intermediary and the sub-borrowers.

38. The refinancing option and the eligibility criteria are documented in detail in the 2004 Operational Manual and the legal documentation o f the parent project. However, refinancing by S IDBI o f other eligible financial institutions did not happen in the parent project on account o f market factors not being favorable when most o f the CF finds were utilized. Before advancing loans to sub-borrowers under the CF, S IDBI wil l assess existing and new PFIs against the basic eligibility criteria and in accordance with parameters laid out in the Operational Manual.

39. The issue o f recycling term and working capital loans advanced by S IDBI (out o f repayments o f loans disbursed) during the period o f the IBRD loan has been reviewed. Given that S IDBI has other lines o f business l ike microfinance,

Recycling of Loans:

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venture capital, direct-retail credit, and treasury operations, there is a possibility that the recycled funds could be used for purposes other than SME lending. S IDBI has provided an assurance that the funds would be relent to SMEs and not diverted for any other purpose. I t was agreed that this aspect would be monitored as part o f the monitoring and evaluation process by watching the growth o f the overall portfolio o f SME loans advanced by SIDBI during the project period. I t would also be ensured that the outstanding amount o f SME loans at any moment i s higher than the amounts disbursed from the IBRD loan during the project’s l i fe . This will also be tracked through SIDBI’s financial statements as defined in the Results Framework.

Agency SIDBI

SIDBI

40. Statutory Audit: The terms o f reference (TORs) for statutory audit have been updated to strengthen the audit process and coverage and are acceptable to the Bank. The TORs also include procurement-related requirements and a detailed procurement checklist. In particular, the TORs require the statutory auditors’ to verify the end use o f funds for specific goods, works, and services by undertaking a detailed review o f a sample o f loans advanced to SME beneficiaries, either directly or through PFIs. The auditors are also required to provide an opinion o n the working o f internal controls in S IDBI and an assurance that these have been effectively applied to the Bank project. The audit TORs have been discussed with and agreed to by SIDBI. Given that this i s likely to be a fast-disbursing project with potentially substantial amounts o f upfront disbursement by way o f retroactive financing, six-monthly statutory audit reports are being proposed to provide timely assurance on the usage o f Bank funds (for the first two years, with annual reports thereafter). This wil l assist in monitoring the usage o f the loan proceeds and provide an opportunity for mid-course correction, if necessary. The fol lowing audit reports will be monitored in the Audit Report Compliance System:

Audit Report Audited by Due date Annual entity audit report SIDBI’s statutory 30 September

Six monthly audit o f project Statutory 30 June and auditors

CGTMSE financial statements auditors 31 December Annual audit report o f CGTMSE Statutory 30 September with a statement on expenditure against the RSF funding

41. Internal Audit: SIDBI’s internal auditors would retain responsibility for conducting an internal audit o f the Bank-funded project, as part o f their audit o f the Credit Department and individual branch offices. They will review a sample o f loans advanced by S IDBI to the SME beneficiaries under the CF (either directly by SIDBI or through PFIs), and verify that the funds have been used as per the relevant agreements between S IDBI and the beneficiary and for the purposes for which they have been advanced. The internal audit reports will be shared with the Bank during supervision missions.

auditors

’ The Bank has reviewed the profile o f the current statutory auditor, Ws AJ Shah & Co., and they are acceptable to the Bank for the project audit for the period o f their appointment. As and when a new statutory auditor i s appointed for SIDBI, the latter w i l l share the profile o f the auditor with the Bank for the purpose o f the project audit.

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42. Disclosure: The amount and type o f assets created in the project wil l be shown in a table under the “Resources Management” section in the Annual Report o f SIDBI. The project statutory audit report wil l also have a separate statement or schedule listing and certifying al l the assets created out o f the Bank loans, and an assurance that these assets have been financed exclusively through the Bank funds and that no other funds have been received by SIDBI for creating al l or part o f these assets. In addition, i t has been agreed that the project statutory audit report (and the “Management Letter”) will be posted on the external Web site o f SIDBI, along with SIDBI’s Annual Report.

43. FM Risk Assessment: Taking into account the high number o f beneficiary entities that wil l be covered-and the fact that SIDBI i s expected to channel a large percentage o f loans v ia the CF by way o f refinancing through PFIs, which in effect then become implementing entities that wil l f i rst need to be appraised by S I D B I for their eligibility- there are substantial FM risks. This risk assessment will be reviewed during the supervision missions after examining a sample o f SIDBI’s appraisal reports o f the PFIs.

Procurement

44. Guidelines o f M a y 2004, revised October 2006.

Procurement under the project wil l be as per the Wor ld Bank Procurement

45. Procurement under the CF Component: Under the CF component, the Bank loan wil l provide funds to SIDBI, to be reloaned to SMEs for the partial financing o f sub- loans. As per Section 3.12 o f Bank Procurement Guidelines, procurement wil l be undertaken by the respective beneficiaries in accordance with established commercial practices, acceptable to the Bank. Such commercial practices o f the beneficiary shall be compatible with the Procurement Principles for the project as agreed with the Bank and detailed in the Operational Manual. Procurement under this component will comprise capital investments in equipment and machinery for expansion or technology upgrading. N o procurements o f works or services are envisaged under the project. Under this component, Bank funds can also be used by S IDBI for refinancing other PFIs. In such a case, SIDBI’s agreement with the PFI wil l contain provisions governing procurement as mentioned in Bank Procurement Guidelines GL Section 3.16, that is, indicating that due attention to economy and efficiency would be undertaken and in accordance with procedures which meet requirements o f paragraph 1.5.

46. Procurement under RSF Component: Under the RSF component, pursuant to section 3.16 o f the Bank Procurement Guidelines, the goods and works financed by the loans guaranteed shall be procured with due attention to economy and efficiency and in accordance with procedures which meet the requirements o f Paragraph 1.5 o f the Bank Procurement Guidelines.

47. SIDBI’s Role and Capacity: SIDBI’s appraisal process involves technical, commercial, and management aspects o f subloan proposals f rom SMEs. S IDBI requires that its borrowers just i fy al l their purchases and adopt transparent and competitive procurement procedures. To ensure value for money, assumptions on project outlay are examined by inviting market inquiries on supplier credentials, comparative assessments

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. are made with earlier financing, and risk-rating models are used (detailed in SIDBI Credit Manual). The PMD is in charge o f implementing the Bank project. The PMD i s adequately staffed, has a full-time procurement consultant, and works with the credit department to ensure that supervision and oversight are undertaken in accordance with the Operational Manual.

48. Procurement Methods: Procurement under the project wil l fol low established commercial practices that have been reviewed and found acceptable. These shall be compatible with the Procurement Principles for the project, as agreed to by the Bank and detailed in the Operational Manual. However, for contracts estimated to be greater than U S $ l ,000,000, procurement wil l be done using the International Competitive Bidding (ICB) method (as described in Bank procurement guidelines and using Bank I C B documents). The threshold for I C B may be reviewed during project implementation based o n results o f Bank supervision, review o f such contracts, or any other feedback on performance. In cases where direct contracting (sole source) i s used (irrespective o f the value o f the contract), provision 3.6 o f the Bank Procurement Guidelines will apply. Further details are provided in the Operational Manual. Retroactive financing under the project will be as per the provisions o f the Bank’s Procurement Guidelines.

49. Bunk Review: All procurement transactions under the project that are greater than US$1 mi l l ion wil l be subject to Bank prior no objection before these are financed under the project. All other contracts under this project will be subject to postreview by the Bank andor its nominated consultants. The prior review threshold wil l be reviewed during Bank supervision missions and may be changed depending on the performance o f procurements funded under the project and the number o f such contracts that are funded. Requirements o f Bank review are defined in appendix 1 o f the Bank Procurement Guidelines.

50. Review by SIDBI: SIDBI wil l ensure that procurement complies with the above requirements. As part o f i t s appraisal processes, S IDBI would require SMEs to include procurement plan information which provides: (i) the l i s t o f proposed procurements and estimated value, (ii) the proposed procurement methods (competitive or sole source), and (iii) the agreed thresholds for contracts subject to prior versus post review. The final procurement plan for each, as agreed with SIDBI, should be maintained in S IDBI records for review by the Bank or auditors. As part o f S IDBI oversight arrangements, i t wil l obtain al l data related to awarded contracts under subloans, including the actual contract dates, names o f contractors, contract amounts, progress, and disbursements to date and wil l confirm that the procurement i s as per the agreed arrangements as defined in the Operational Manual. The procurement provisions mentioned in this note are based on the current versions o f documents shared by S IDBI that is, the Operational Manual and the Credit Manual (if there are further relevant or applicable changes to these, the Bank would be informed).

5 1. Procurement Audit: All procurements under the project are subject to audit by the project auditor based on the TORS agreed with the Bank. The audit report will be made available to the Bank once in six months during the f i rst two years and annually thereafter. The auditor report wil l be discussed with S IDBI during supervision missions.

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. 52. Procurement Risk: Procurement r isk in this project has been rated as moderate. This rating takes into account the internal controls o f SIDBI while appraising and approving a loan for any procurement. In addition, the SMEs are mostly family-owned businesses where the procurement decisions are taken by the owners who have to repay the loans and who are often personally liable. The owner therefore carries out extensive research and negotiations to ensure that the best value i s derived in such deals. Under the earlier Bank project there were no complaints, and disbursements were satisfactory. During implementation, the Bank’s focus wil l be to discuss and take feedback o n the functioning o f systems put in place by SIDBI, including but not l imited to subproject appraisal, costing, evaluation o f SMEs by SIDBI, and r isks identified by S IDBI while considering SME financing.

Environmental and Social Safeguards

53. There are no outstanding safeguards issues. In terms o f social safeguards, no safeguards have been triggered. The parent project has been categorized as “FI” and wil l continue as such during the period o f the proposed additional finance. In terms o f environmental safeguards, OP 4.0 1 has been triggered. A detailed Environmental and Social (E&S) safeguards framework was developed for the project and has been adhered to by S IDBI in the course o f parent project implementation. The framework and the existing institutional arrangements within SIDBI’s PMD have been reviewed and validated in the context o f the additional financing project. The current institutional arrangements include (a) screening by the loan officer at branch level o f the loans to SMEs and proposed activities being funded; (b) review o f safeguards framework compliance at Central Loan Processing Cell; (c) internal audit review, including at various stages o f loan disbursement; and (d) use o f a management information system (MIS) system to track loan performance, including any specific flags o n safeguards.

54. T o further strengthen monitoring o f compliance with the safeguards framework, the PMD will strengthen the current M I S system to reflect periodic monitoring reports for al l the loans to SMEs under the project and to prepare additional monitoring and reporting formats. In addition to branch-level regular monitoring o f al l SMEs loans financed under the project, the PMD will conduct periodic supervision o f at least 50 percent o f E-I category SMEs and a sample of E-I1 category SMEs. W h i l e the periodicity o f supervision will be determined by the nature o f activities funded under the loans to SMEs and their impact, supervision for the sample o f E-I SME loans wil l be conducted by PMD at least once annually. The PMD would proactively engage i t se l f in monitoring and assessing the social impact o f loans to SMEs through periodic supervision and commissioning o f studiedimpact assessment on a case-to-case basis. The PMD would make efforts to allocate resources for impact assessment and documentation o f innovative and good practices o f the SME loans in area o f social development. The PMD would also sensitize and train i t s staff on empowerment, social development, and the Right to Information Act.

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VI. EXPECTED OUTCOMES

55. The project’s outcome indicators are similar to those o f the parent project. However, the target values have been set at levels that recognize the impact o f the prevailing macro-environment climate resulting f rom the global financing crisis (see discussion on risks below). The framework for results monitoring for the scaled-up project activities i s presented in annex 1. SIDBI will provide the Bank with interim financial progress reports, information o n progress on key entity performance indicators, audited financial statements (within six months o f the end o f each financial year), and such other information as the Bank may reasonably require. These arrangements are working in a satisfactory manner under the ongoing parent project and wil l continue under the proposed additional financing.

VII. BENEFITS AND R I S K S

56. Benefits: As mentioned above, the parent project financed 927 SMEs spread across 10 states. The additional financing o f US$400 mi l l ion i s expected to more than double these benefits, expanding the coverage to two to three times as many SMEs, thereby creating additional jobs. Further, the project will (i) increase the geographical coverage; (ii) provide new, innovative SME loan products, including loans to smaller SMEs (“downscaling”) and loans through other PFIs; (iii) explore the possibility o f providing energy efficiency loans; and (iv) support the expanded coverage o f the innovative Risk-Sharing Facility. This wil l help improve SME credit market efficiency, develop the ability o f banks to appraise and manage SME loans, enhance profitable lending to viable SMEs, reduce banks’ SME-related NPLs, and develop select SME clusters. I t i s expected that these benefits from the project wil l result in positive impacts on growth, development, and employment creation for beneficiary SMEs. Ultimately, through i t s economy-wide demonstration effect, the project i s l ikely to generate benefits for a much larger number o f banks and SMEs, with wider implications for growth and poverty reduction.

57. Risks: The risks surrounding the project vary in scope and nature, from implementation and sustainability risks to fiduciary and safeguards r isks and finally to external risks from the macro-environment-especially the potential impact o f the global financial crisis. Table 4 summarizes the main risks and existing or suggested mitigation measures.

58. However, given the parent project’s successful implementation record, i t i s safe to say that the biggest r isk to the project’s ability to achieve its objectives and make disbursements on time lies in the effect that the global financial crisis and the ensuing worldwide recession could have on India’s SME sector. This effect could translate i t se l f into two different ways.

59. First, lower disbursements under the project could. i t s e l f be the result o f two factors. First would be lower levels o f business activity for SMEs and lower demand for loans from S IDBI or PFIs. This risk could materialize for SMEs in a certain sectors such as automotive components and textiles, which have been hardest hit by the crisis.

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?

However, not a l l sectors are affected to the same extent, and there exists a sizeable pool o f SMEs that continues to have vibrant businesses and growing needs for credit. Second, there could be risk aversion on the part o f the PFIs to lend to SMEs. SIDBI’s assessment is that there i s sufficient demand from SMEs that are viable and that are not seriously affected by the global financial crisis.

60. Second, the asset quality o f the PFIs, including SIDBI, could deteriorate as a result o f the slowdown, resulting in higher NPLs. (The excellent current asset quality o f SIDBI’s portfolio and i ts high capital adequacy and long years o f specialization in SME financing should, however, allow it to absorb any deterioration.) During project implementation, these risks wil l be closely monitored, and the impact o f the slowdown and the financial crisis will be reviewed, and corrective action will be undertaken whenever needed.

61. include the following:

Some o f the governance risks that might arise during project implementation

62. Lack o f transparency in the loan approval process by S IDBI and the PFIs: this might result in loan approval to ineligible SMEs as a result o f improper/fraudulent assessment by loan officers. This risk i s mitigated by an elaborate set o f lending standard and, loan appraisal and loan approval processes, which are described in detail in the project’s Operational Manual (and Credit Manual o f SIDBI) and which must be complied with. They involve appraisal o f technical, commercial, and management aspects o f SME loan proposals and stipulate that borrowers should report on the use o f h n d s and ensure quality in procurement. The loan approval process also involves a series o f thresholds and committees so that the loan approval i s vetted according to i t s size by either executives or committees (in such a way that individual decisions are always checked and scope for improper approval i s eliminated). In addition, significant emphasis i s placed on post- disbursement checks, direct payment to suppliers, and post-disbursement onsite visits. Finally, the TA component o f the project continues to provide assistance to improve these processes for S IDBI and PFIs;

63. Insufficient checks and balances in the disbursement policies and practices: these could result in disbursements to fraudulent purposes. T o mitigate this risk, disbursements to SMEs are not made except through trackable accounts, and payments to suppliers are made directly once the invoices are presented. Centralized loan disbursements through checks are made. Annex 2 summarizes some o f the potential governance issues related to the project, and in consultation with SIDBI, identifies time-bound mitigation measures, included in the Governance and Accountability Act ion Plan (GAAP).

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Risk

Table 4: Critical Project Risks and Mitigation Measures

Existing or Proposed Mitigation Measures

Risk o f moral hazard (the risk that through providing credit support the quality o f lending actually deteriorates)

Risk o f adverse selection (that the banks pass the risk for poorer loans on to the Risk-Sharing Facility while keeping better accounts to themselves)

Implementation ri3 FX, credit, and investment r isks

(provided throuih parallel financing by‘DfID) has minimized the risk o f moral hazard. A key condition for SIDBI and PFIs to access project funds under the CF has been an upfi-ont commitment to a time-bound action plan to implement improvements in SME credit appraisal and r i s k management /monitoring, and also to upgrade credit information and share the information with CIBIL. In turn, this has been supported by the TA program. Periodic progress reports on this front and on NPLs would help detect any deterioration o f credit quality. The RSF has been designed incorporating best practices on controlling adverse selection risks. The criteria for determining eligibility o f banks andor loardportfolios would ensure that the RSF does not create opportunities for adverse selection-selection o f portfolios i s based on random selection o f loan accounts from various rated categories o f a portfolio. The TA being provided under the project also helps participating banks improve their portfolio quality so as to be able to meet the eligibility criteria for participation in the RSF. Pricing must be seen to be “fair,” based on rigorous risk-assessment. Portfolio selection will be based on statistical principles aimed at avoiding adverse selection and PFIs would have to retain at least 50% o f the exposure at all times to minimize moral hazard risks.

-

+J

SIDBI will enter into hedging arrangements to mitigate the FX risk. SIDBI’s credit risk under the CF financed through IBRD and SIDBI’s own counterpart funds will be mitigated through SIDBI’s use o f the appropriate SME loan appraisal and bank eligibility/appraisal criteria and procedures. In the context o f the global financial crisis, in addition to other risk-mitigation measures, SIDBI has indicated that i t would undertake a detailed stress testing o f i t s portfolio to assess i t s resilience to potential, future adverse scenarios. SIDBI’s investment risk in the RSF will be mitigated through the fact that the CGTMSE i s operated on a commercial basis, with a strong focus on bank and SME loan portfolio selection for partial guarantee cover, controlling costs, charging appropriate fees, and maintaining prudent treasury management, including investments in safe securities. The risk management function for the RSF will be dealt with through ensuring a reasonable equity base in terms o f i t s capital structure, sound investment policies, and a lean but control-and- audit-focused staffing.

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.

Safeguards risks Inadequate environmental and social (EM) safeguards capacity at S IDBI

Lack o f compliance with the E&S safeguards at subproject level

Risk Slow disbursement risk

- An external consulting firm developed the E&S safeguards framework that S IDBI has been implementing, t a h n g into account the W o r l d Bank requirements. A nodal person in the PMD i s responsible for oversight, for coordinating implementation o f the framework, and for compliance with the monitoring and reporting requirements agreed with the Bank. Periodic review, supervision, and annual audit o f at least 50% o f E-I category SMEs and a sample o f E-I1 category SMEs will be undertaken by the PMD every six months. The PMD and the Bank will monitor and assess the social impact o f subprojects during supervision. The PMD i s committed to undertake periodic sensitization and training o f i t s staff o n specific social issues and o n the Right to Information Act. The impact assessment will cover specific social and environmental themes.

-

-

- -

-

Existing or Proposed Mitigation Measures In i t ia l analysis indicates that an increase in scale o f the additional financing could be absorbed and implemented by SIDBI, through scaling up both components o f the project. In the parent project, S I D B I demonstrated ample capacity to implement the project well. Disbursements were ahead o f schedule and in accordance with agreed implementation arrangements. Over 900 SMEs across 10 states were supported, and project outcome indicators were exceeded. SIDBI, which manages an S M E portfolio o f over US$5.0 bil l ion, has managed to sustain continued good financial performance while growing i t s business: i t s overall disbursements grew by 50 percent in FY2008 totaling Rs150,870 m i l l i on (US$2.95 billion), while maintaining a net NPL ratio o f 0.25%.

-

Mis-procurement by SMEs

S I D B I encourages i t s borrowers to justify the purchases and adopt transparent and competitive procurement procedures. Whi le disbursing to suppliers, S IDBI examines the sales agreement, warranties, rights, and obligations o f contracting parties as wel l as remedies in case o f disputes and nonperformance. Periodic visits before and during the implementation o f the project (at least twice a year) and, subsequently, o n i t s operations are undertaken. These include visits to the office/factory o f the assisted unit, physical verification o f equipment purchases, discussion with promoters, and informal discussions with the main purchasers o f and suppliers to the assisted units. SIDBI’s internal control measures are carried out by i t s Internal Audit Department and supervised by the Audit Committee o f the Board. SIDBI’s oversight arrangements include: postdisbursement checks o n the assets purchased and reviews to determine if there was any kind o f misappropriatioddiversion o f funds by the end-user f rom the intended use.

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t

4

Risk

Misuse o f funds

External and Maci Deterioration in the asset quality and r isks to the PDOs due to the changing macro- economic environment

Existing or Proposed Mitigation Measures All procurements under the project are subject to audit by the project auditor based o n the TOR agreed with the Bank. During implementation, the Bank will discuss and take feedback o n the functioning o f systems put in place by S IDBI including, but not l imi ted to, subproject appraisal, costing, evaluation o f SMEs by SIDBI, and r isks identified by S I D B I whi le considering SME financing. Procurement transactions will be subject to Bank review in l ine with the agreed procurement arrangements. The original project did not have a mechanism for appropriate reporting and disclosure o n the assets created out o f the Bank- funded loans. This issue was discussed with S I D B I and the Bank team, which requested that S IDBI disclose the assets financed (loans) out o f the Bank CF through the fol lowing measures: (i) the project statutory audit report will have a separate statement certifying the assets financed and an assurance that these assets have been financed through the Wor ld Bank funds and not through any other sources; (ii) the relevant information could be uploaded to the external Web site o f the project; and (iii) the same information will be captured in the account that i t i s agreed would be maintained. In addition, S IDBI will disclose the information o n assets financed through the Bank CF in i t s future annual reports over the project period.

-

-

-

-

-environment risks Some o f the success o f the parent project has been helped by India’s strong growth in recent years. However, the global fin-ancial crisis unfolding in recent months, and a slower forecasted growth for India, might negatively impact SMEs and their abil ity to repay. SIDBI’s very l o w NPL ratio (0.25%) and high capital adequacy ratio (nearly 42%) would al low it to absorb any such downtrends. Going forward, whi le there could be pressure o n i t s business, the strong capital base bodes wel l for S I D B I in the changed global financial environment. In addition, SIDBI’s robust r isk assessment framework includes undertaking periodic rating assessments o f i t s loan accounts. This i s being strengthened to factor in the changing macro-economic environment with careful reviews o f sectorhndustry wise exposures and lending practices. During project supervision, the impact o f the external environment, especially the global financial crisis, o n the performance o f SMEs as wel l as the uptake o f project funds will be keenly monitored and corrective action wil lbe-taken as and when needed.

VIII. FINANCIAL TERMS AND CONDITIONS FOR THE ADDITIONAL FINANCING

64. maturity including a five-year grace period, and annuity repayments.

The loan would be denominated in U S dollars with a variable spread, a 15-year

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65. and include the following:

The financial conditions for the additional financing mirror those under SMEFDP

i) with adequate powers, functions, staff, and resources.

SIDBI shall continue to maintain the PMD and the Internal Audit Department

ii) Under the CF, S IDBI wil l make subloans directly to SMEs and/or also lend through PFIs and wil l carry out appraisal, supervision, monitoring, and reporting in respect o f these activities.

iii) SIDBI shall take such steps as necessary to protect i tself against risk o f loss resulting from changes in the rates o f exchange between the currencies used in i t s operations, and shall assume the credit risk associated with lending to the PFIs and its direct SME financing.

iv) The E&S safeguards framework and its compliance requirements prepared as part o f the project documents for SME Financing and Development Project wil l continue to be mandatory for the additional financing project.

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ANNEX 1: RESULTS FRAMEWORK AND MONITORING

PDO The objective o f this project i s to improve SME access to finance (including te rm finance) and business development services, thereby fostering SME growth, competitiveness, and employment creation.

Component One: The Credit Facility: PFIs have better access to te rm financing and are able to increase longer term (3 year+) lending to SMEs.

Component Two: The Risk- Sharing Facility (RSF): PFIs lending to SMEs (including term lending) i s expanded, whde ensuring moderate NPLs.

30% increase in lending (including t e r m lending) to SMEs by PFIs branches and overall increase in SME portfolio

the SME loan portfolios o f a l l PFIs (at 3% or less)

SME business in all PFIs as measured by Return o f Assets (RoA) o f 1% or more

0 Scale-up benefiting SME’s operations (as measured by a 15% increase in turnover)

0 Controlled net NPL ratio on

Improved profitability o f

Component One: Evidence o f timely and satisfactory progress toward the delivery o f Component I outputs, as planned, including the following specific measures:

Percentage growth in number o f SMEs that receive the CF, and

0 Value (and %) o f the CF to PFIs disbursed to eligible SMEs.

Component Two: Evidence o f timely and satisfactory progress toward the delivery o f Component Two outputs, as planned, including the value (and %) o f the RSF guarantees issued.

Use of Outcome Information Yrs 1-2 gauge whether PFIs manage to expand lending to SMEs while managing NPLs and improving the profitability o f their SME business.

0 Yr 3 use the outcome information for project evaluation on SME’s.

Use o f Output Monitoring Component One: Information on outputs from t h i s component wi l l be used to track progress toward provision and availability o f long-term financing to SME’s through PFIs and to make changes in the project, if necessary, during implementation.

Component Two: Information on outputs f rom t h s component w i l l be used to track progress toward provision and availability o f long-term financing to SME’s through PFIs and to make changes in the project if necessary during implementation.

23

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