Document ofThe World Bank

FOR OFFICIAL USE ONLY

Report No. P7459-SK

REPORT AND RECOMMENDATION

OF THE

PRESIDENT OF THE

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE

EXECUTIVE DIRECTORS

ON AN

ENTERPRISE AND FINANCIAL SECTOR ADJUSTMENT LOAN

IN THE AMOUNT OF EURO 200 MILLION(US$177.3 MILLION EQUTIVALENT)

TO

THE SLOVAK REPUBLIC

July 2, 2001

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosed without WorldBank authorization

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

Pub

lic D

iscl

osur

e A

utho

rized

-11-

Currency Equivalents(as of December 2000)

Currency Unit = Slovak KorunaSk: = US$0.021

US$ = Sk48.8

Government Fiscal YearJanuary I to December 31

Abbrevhyf fls and Acroym

CAR - Capital Adequacy RatioDIF - Deposit Insurance Fund

EBRD - European Bank for Reconstruction and DevelopmentEFSAL - Enterprise and Financial Sector Adjustment Loan

EU - European lJnionFDI - Foreign Direct Investment

GDP - Gross Domestic ProductIAS - International Accounting StandardsIMF - International Monetary FundIRB - Investment Bank

KOB - Consolidation BankMOF - Ministry of FinanceNBS - National Bank of SlovakiaNLO - National Labor Office

OECD - Organization for Economic Cooperation andDevelopment

PCA - Prompt Corrective Action RulesROE - Return on EquitySDP - Supervisory Development Plan

Sk - Slovak KorunaSKA - Slovak Consolidation AgencySLSP - Slovak Savings Bank

SMP - Staff Monitored ProgramUK-DFID - United Kingdom Department for International

DevelopmentUSAID - United States Agency for International Development

VAT - Value Added TaxVUB - Commercial Bank

Vice President: Johannps F. LinnCountry Director: Roger Grawe

Sector Director: Paul J. SiegelbaumTeam Leader(s): Roberto Rocha/Hormoz Aghdaey

-iii- FOR OFFICIAL USE ONLY

PROPOSED ENTERPRISE AND FINANCIAL SECTOR ADJUSTMENT LOAN

LOAN SUMMARY

Borrower: The Slovak Republic

Amount: Euro 200 Million

Terms: Euro single currency fixed spread commitment linked loan.Annuity repayment with a final maturity of 14 years and graceperiod of 5 years. Expected disbursement period of 0-3 years.

Front End Fee: One percent of the loan amount.

Commitment Fee: Standard terms as applicable for fixed spread loans, less anywaiver.

Objectives and Description: The objective of the proposed loan is to support the Governmentof Slovakia's comprehensive program of bank and enterprisereforms. The program contains four broad components: (i)restructuring and privatization of the banking system, centered onthe privatization of the three large State banks, but also includingthe resolution of all troubled medium banks; (ii) substantialstrengthening of banking regulation and supervision; (iii) fullimplementation of a strategy to workout the large stock ofclassified claims; and (iv) substantial improvements in the legalframework, centered on the bankruptcy and collateral regimes,and the laws dealing with corporate governance.

Benefits: The reform actions sought under the EFSAL would improve thestability and efficiency of the banking system; promote enterpriserestructuring through the workout of bad assets and theimprovements in the legal framework; attract foreign investment;and ultimately contribute to the growth of output andemployment in the longer-run.

Risks: The risks to the proposed EFSAL arise mostly from the politicalsituation. The broad coalition could interrupt the implementationof some components, if faced with adverse short-run effects ofthe reform such as unemployment or a very low price for the badassets. However, this risk seems to be modest, given theadvanced implementation stage of the reforms.

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not be otherwise disclosed withoutWorld Bank authorization.

-Iv-

Schedule of Disbursements: The proposed loan would be disbursed in three tranches of Euro60 million, Euro 70 million, and Euro 70 million, respectively.

Poverty Category: Not applicable

Rate of Return: Not applicable

Project ID Number: PE-P064542

Map: Not applicable

The team for this operation consists of Roberto Rocha (team leader), Hormoz Aghdaey (co-teamleader), Emily Andrews (labor markets), Laura Ard (bank regulation and supervision), BruceCourtney (macroeconomic framework), Phillip Gray (utility reform), Gordon Johnson(insolvency and collateral reform), Cally Jordan (corporate governance), Mihaly Kopanyi(enterprise restructuring), Andrew Lovegrove (bank privatization and debt workouts), WilliamMako (debt workouts), John Nellis (enterprise restructuring). Lajos Bokros and Ilham Zuraykprovided valuable advice in the early stages of program design. Zoe Kolovou and Rohit Mehtaprovided legal, disbursement, and financial management support. The team worked closelytogether with the IMF team responsible for the preparation of the Staff Monitored Program.Lynn Gross and Andrea Toth provided administrative support in Washington D.C. and inBudapest, Hungary.

REPORT AND RECOMMENDATION OF THE PRESIDENT OF THEINTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE EXECUTIVE DIRECTORSON A PROPOSED ENTERPRISE AND FINANCIAL SECTOR ADJUSTMENT

LOANTO THE SLOVAK REPUBLIC

Table of Contents

PART I: INTRODUCTION ............................................. 1...................... I

PART II: OVERVIEW .................. .................................................. 1

PART III: SLOVAKIA' S SITUATION BEFORE THE REFORMS... 2

A. Macroeconomic Performance After Independence ............... ........................ 2

B. The Banking Sector at the End of the 1990s ............................ ..................... 3

C. The Enterprise Sector at the End of the 1990s ............................................... 6

PART IV: THE GOVERNMENT'S REFORM PROGRAM ................................................ 8

A. Overview ................................................................... 8

B. The Macroeconomic Framework ............................................................ 9

C. Banking Sector Reforms ................................................................... 14

D. Enterprise Sector Reforms ................................................................... 20

E. Unemployment and the Social Safety Net ................. ............................... 25

PART V: THE PROPOSED LOAN .................................................................... 26

A. The Bank's Assistance Strategy . ........................................................... 26

B. Loan Amount and Borrower . ............................................................... 26

C. Loan Design . . .27

D. Financial Management and Monitoring . . .27

E. Project Implementation .28

F. Monitoring Arangements .28

G. Environmental Assessment Requirements . . .28

H. Release of Funds and Tranching . . .28

I. Benefits and Risks .................. 28

PART VI: RECOMMENDATION . . . 30

-Vi-

ANNEXES:Annex I: Statement of Economic PoliciesAnnex II: Key Reforms to the Legal and Regulatory Framework for Banking ActivitiesAnnex III: Letter of Development PolicyAnnex IV: Matrix of Key ActionsAnnex V: Supervisory Development ConceptAnnex VI: Project Infornation DocumentAnnex VII: Status of World Bank and IFC Loans and CreditsAnnex VIII: Country at a Glance

TABLES:Table 1: Key Economic Indicators, 1993-2000Table 2: The Size and Performance of the Banking Sector Before the Reforms (June 1999)Table 3: The Structure and Performance of the Banking Sector Before the Reforms (June 1999)Table 4: Financial Results of Enterprises, 1994-1999Table 5: Key Economic Indicators, Base Scenario, 2001-2005Table 6: External Financing Requirements, 2000-2005Table 7: The Restructuring of the Three Large State BanksTable 8: Non-Performing Assets in the Workout Institutions and Tax Arrears, end-2000

REPORT AND RECOMMENDATION OF THE PRESIDENT OF THEINTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE EXECUTIVE DIRECTORSON A PROPOSED ENTERPRISE AND FINANCIAL SECTOR ADJUSTMENT LOAN

TO THE SLOVAK REPUBLIC

I. INTRODUCTION

1. I submit for your approval the following memorandum and recommendation on a proposedEnterprise and Financial Sector Adjustment Loan (EFSAL) to the Slovak Republic in the amountof Euro 200 million equivalent to support a comprehensive program of enterprise and financialsector reforms. The loan would be a Euro single currency fixed spread commitment linked, annuityrepayment loan with a final maturity of 14 years, a grace period of 5 years, and an expecteddisbursement of 0-3 years. The loan would be disbursed in three tranches of Euro 60 million, Euro70 million, and Euro 70 million, respectively.

1I. OVERVIEW

2. Slovakia became independent from the former Czechoslovak Federation in January 1993,after a peaceful process of separation. Slovakia's initial economic achievements afterindependence were impressive, and the country seemed poised to become a star performer amongtransitional countries. However, in the mid-1990s the country experienced severe internal andexternal imbalances, leading to episodes of instability in the balance of payments, and ultimately toa deterioration of growth performance. The faltering economic performance was accompanied byan increasing isolation from the international community, and the exclusion of Slovakia from thefirst group of candidates for EU accession.

3. The faltering economic performance and the increasing isolation from the internationalcommunity were the result of the dirigiste and nationalistic policies followed during the 1994-1998period. During the period, Slovakia privatized a large number of enterprises but the privatizationprogram was fraught with problems, favoring politically connected parties and practicallyexcluding foreign investors. The pervasive presence of the State in the banking system openedroom for extensive political interference in lending decisions. The legal framework for banking,enterprises, and capital market activities remained weak, depriving supervisors, creditors and smallshareholders of the most essential rights. The final outcome of these policies was devastating, asindicated by large enterprise losses, the insolvency of the banking system, large contingent fiscalliabilities, and the incapacity of the economy to generate growth and employment despite largeinvestment outlays.

4. In September 1998, Parliamentary elections resulted in the victory of a broad-basedcoalition of parties led by Prime Minister Mikulas Dzurinda. The new Government immediatelyannounced its intention to reverse the policies that threatened the country's economic and politicalstability, and moved rapidly to rebuild the ties with the international community. There were initialdoubts on the coalition's capacity to implement a coherent program, but the results to date have

-2-

been impressive. Since coming to power, the new Government has successfully stabilized theeconomy and has launched an ambitious program of structural reforms, including the privatizationof banks and utilities, the overhaul of the legal and regulatory framework, and the reformn of publicadministration. The Government's efforts have been recognized by the international community,as indicated by the resumption of accession negotiations with the EU in November 1999,Slovakia's entry into the OECD in May 2000, the continuous improvement in the country's creditratings, and the sharp decline in borrowing spreads.

5. Early in its tenure, the new Government requested support from the World Bank and otherdonors for the design and implementation of its program of bank and enterprise reforms, whichcommanded the highest priority in its overall reform agenda. Since early 1999, Bank staff havebeen collaborating closely with the Govemment in all aspects of program design andimplementation. The preparation of the reforms has been supported by a PHRD grant. During thistime, Bank staff has also liaised closely with the other donors (EU-PHARE, USAID, UK-DFID)supporting the Government's program. The program has reached an advanced stage ofimplementation, as indicated by the recent privatization of the largest State bank, the resolution ofmost troubled small and medium banks, the finalization of a new Banking Law and of amendmentsto several other laws, and the initial implementation of a scheme to workout a large volume of non-performing assets. The Government intends to complete the bank and enterprise reforms within thenext 18 months. The proposed EFSAL will contribute to the successful conclusion of theGovernment's reform program, by helping the Government finance the initial fiscal costs of bankrestructuring and providing the necessary technical assistance to all components of the program.

1II. SLOVAKIA'S SITUATION BEFORE THE REFORMS

A. Macroeconomic Performance After Independence

6. Slovakia registered one of the best macroeconomic performances in Central Europe after itsindependence from the Czechoslovak Federation in 1993. As shown in Table 1, inflation declinedto single digits in 1995, one of the lowest inflation rates in the region. At the same time, theeconomy initiated a strong, export-led recovery, despite a contraction of fiscal and investmentexpenditures. The initial output recovery seemed sustainable, as it was based on exports, and tookplace in a context of small fiscal deficits and current account surpluses. The prospects of highgrowth were reinforced by the highest investment ratio in the region, and the expectations ofimproved investment efficiency driven by fast privatization. By early 1996, Slovakia seemeddestined to become one of the leading performers in Central Europe.

7. In the 1996-1998 period, however, the current account shifted to persistent deficits of about10 percent of GDP, driven primarily by a dramatic increase in fixed investment (Table 1). Thesharp investment expansion did not raise much concern initially, as there were hopes that suchlarge investment outlays would increase export capacity and eventually repay themselves.However, it became apparent that much of this increase in investment included sub-optimalprojects driven by perverse incentives, generous public guarantees on foreign borrowings,extensive political interference in bank lending, and weak corporate governance. The inefficiency

-3-

of many investment projects was progressively revealed by the widespread reports of corruptionand the lack of enterprise restructuring (reflected in growing enterprise losses).

8. The increase in the current account deficit was exacerbated by an expansionary fiscalpolicy, as indicated by the shift from a fiscal surplus of 0.4 percent of GDP to deficits of around 5percent of GDP. These numbers understate the full extent of the expansionary policy, since largecontingent liabilities were also built up in the form of extensive guarantees on foreign borrowingsof enterprises and extra-budgetary funds.

9. In an effort to offset increasingly lax fiscal policies, and prevent the current account fromdeteriorating even further, the National Bank of Slovakia (NBS) progressively tightened monetarypolicy from 1996 to 1998. The tight monetary policy did contain the current account at 10 percentof GDP, but at the cost of very high real interest rates (real lending rates in excess of 20 percentp.a.) and repeated periods of turbulence in the foreign exchange market. Moreover, the tightmonetary policy was ultimately not able to sustain the exchange rate in the face of speculativeattacks related to the Russia crisis, forcing the NBS to float the currency in October 1998.

Table 1: Key Economic Indicators, 1993-2000(in % of GDP unless otherwise indicated)

Emergence of Period ofPost-Independence Growth Internal and External Stabilization and

with External Balance Imbalances Reform________________________ 1993 1994 1995 1996 1997 1998 1999 2000

Real SectorReal GDP growth (% p.a.) -3.7 4.9 6.7 6.2 6.2 4.1 1.9 2.2CPI Inflation (% p.a.) 23.2 13.4 9.9 5.8 6.1 6.7 10.6 12.0Unemployment rate(%) 12.9 14.6 13.7 12.6 12.8 13.8 17.5 18.2Exports/GDP 58.4 61.6 59.8 55.2 58.0 61.2 61.8 73.5Fixed Investment/GDP 31.6 28.3 26.4 34.2 35.9 38.0 30.8 30.0

General Government"Overall Balance/GDP -6.6 -1.2 0.4 -1.3 -5.0 -4.8 -3.6 -3.3Primary Balance/GDP -3.6 2.4 2.6 0.8 -3.2 -2.5 -0.8 -0.6Expenditures/GDP 48.5 45.1 45.7 46.6 47.7 44.9 44.8 42.5Debt/GDP .. 25.0 22.8 27.4 29.7 30.4 31.4 31.9

External AccountsCurrent Account Balance/GDP -4.7 4.6 2.1 -10.6 -9.6 -10.0 -5.0 -3.7Foreign Direct Investment/GDP 1.1 1.6 1.1 1.0 0.4 1.8 3.6 10.0Gross External Debt/GDP 26.9 32.0 30.9 38.8 48.4 55.9 53.4 56.3Net External Debt/GDP .. .. 2.9 10.0 16.6 27.4 31.1 30.1

1/: For 1998-2000, excludes privatization revenues and called guarantees.

B. The Banking Sector at the End of the 1990s

10. The Size, Structure and Performance of the Banking Sector. Slovakia has a largebanking sector, as indicated by bank assets and loans of 83 and 50 percent of GDP, respectively.The large size of banking assets relative to other transitional countries is not necessarily anindication of banking sector development, however, but simply of a smaller real erosion of balance

-4-

sheets in the early transitional period, due to lower inflation than other transitional countries. Infact, the Slovak banking system arrived at the end of the decade plagued by inefficiencies anddeeply insolvent. As shown in Table 2, classified loans accounted for more than half of totalbanking assets or the equivalent of 27 percent of GDP. The banking system was largelyunprofitable and had an average.capital adequacy ratio (CAR) close to zero.

11. At the end of the 1990s, the Slovak banking system consisted of 24 banks and 2 branches offoreign banks. The 3 large State banks suffered a sharp loss of market shares during the 1990s, butstill accounted for nearly half of total bank assets in 1999, as shown in Table 3. The group ofmedium and small banks comprised 8 banks with substantive foreign ownership and 9 domesticbanks with varying degrees of State participation. This group increased its share of total assets to35 percent in mid-1999, due primarily to the rapid growth of the better managed foreign-ownedbanks, but also included several inefficient and insolvent banks. The other groups accounted for,less than 20 percent of assets in the banking system. The group of special State institutions is,dominated by Konsolidacna Banka (KOB), a State workout institution created in the early 1990s tohandle bad assets. The branches of foreign banks include the Slovak branch of CSOB, a formerCzech State bank that was recently privatized.

Table 2: The Size and Perfonnance of the Banking Sector Before the Reforms (June 1999)Bank Assets/GDP Bank Loans/GDP Classified Loans (2 Classified Loans (3 Capital Return on Equity

(%) (%) to 5)/Total Loans to 5)/Total Loans Adequacy Ratio (%)(%) (%) (%)

83.0 50.3 54.7 39.3 0.7 -13.1Source: NBSNote: Standard loans are classified as 1. Loans under watch are classified as 2. Non-performing loans are classifiedfrom 3 to 5, depending on their quality.

Table 3: The Structure and Performance of the Banking SectorBefore the Reforms (June 1999)

1. Large 2. Small and 3. Special 4. Special State 5. Branches ofState Banks Medium Banks Savings Banks Institutions Foreign Banks

Number of Banks 3 17 2 2 2Share in Total Assets (%) 47.9 34.8 6.0 3.4 7.9Share of Classified Loans (2-5) 71.9 22.7 1.5 98.3 54.1in Group's Loan Portfolio (%)Share of Classified Loans (3-5) 48.7 16.7 0.7 94.1 43.1in Group's Loan Portfolio (%)Share of Group in Classified 67.2 13.1 0.1 13.3 6.4Loans (3-5) (%)Capital Adequacy Ratio (%) -6.6 13.2 35.5 -77.2 n.a.Return on Equity (%) -39.1 -4.0 57.4 -0.7 n.a.Source: NBS

12. The Financial Situation of the Large Banks. The financial situation of the three largebanks (SLSP, VUB, and IRB)' became critical in 1999, as a result of the continuing deteriorationof their asset portfolios. Classified loans accounted for almost three fourths of their total loans by

IVseobecna Uverova Banka (VUB), Slovenska Sporitelna (SLSP) and Investicna Rozvojova Banka (IRB).

-5-

mid-1999, or the equivalent of 20 percent of GDP (Table 3). Even excluding loans in the secondcategory (watch loans), the ratios were still very high-loans in categories 3, 4 and 5 (substandard,doubtful and loss loans, respectively) amounted to almost half of their total loans, or 13 percent ofGDP. The large stock of classified loans held by the large banks originated from a variety offactors, including bad loans inherited from the former regime, weak lending practices, politicalinterference in lending decisions, and weak collateral and insolvency regimes.

13. The CARs of the three large banks were significantly negative in 1999, and would havebeen even more negative, if credit portfolios had been subject to stricter classification criteria and ifcollateral had been accounted for at realizable value. Moreover, the trends in 1999 pointed to acontinued deterioration of their capital position, due to the increasing competition from the foreign-owned banks and the lack of a supportive tax environment, which prevented the deduction ofprovisions from taxable income. The large banks were allowed to continue operating under aspecial clause of the Banking Law which granted them regulatory forbearance, but which expiredin December 1999. LRB had already suffered a major deposit run in December 1997, and wasunder conservatorship by the NBS.

14. The Financial Situation of the Small and Medium Banks. The group of small andmedium banks generally performed better than the large banks in the 1990s, as indicated by thelower share of classified loans on their portfolios (17 percent in June 1999) and higher CARs. Thebetter performance of these banks was due to a variety of factors, including the absence of inheritedproblems (they started operating in the early 1990s), less political interference in lending decisions,and better corporate governance due to the presence of foreign strategic investors. However, thisgroup is not homogenous and included 7 medium and small banks with deep financial problems.These were primarily domestic banks with a significant State participation. Although thecombined assets of these 7 banks were not large enough to pose a systemic threat (about 10 percentof total banking sector assets), it became apparent that resolution of the troubled medium and smallbanks would have to be a component of the Government's reform program.

15. The Regulatory and Supervisory Framework for Banking Activities. Followingindependence, banking legislation consisted of two fundamental laws, the Banking Law and theNational Bank of Slovakia Law. The Banking Law included basic banking provisions, and wascomplemented by four prudential regulations on major borrowers, liquidity, loan loss provisions,and foreign exchange. The National Bank of Slovakia Law contained basic provisions onindependence, and defined the NBS' powers and responsibilities in the areas of monetary policyand bank supervision. The legal framework for banking contained several flaws, however. Onekey problem was the shared responsibility of the NBS and the Ministry of Finance (MOF) for banksupervision. The legal framework also failed to properly address key regulatory areas such as therequirements for strong board governance, supervisory and remedial powers, risk-based capitalrequirements, accounting and audit requirements, financial disclosure rules, and restrictions onconnected and affiliate transactions. The regulation on loan loss reserves was particularly weak, asit focused on delinquencies, allowing banks to understate their asset quality problems.

16. Throughout the 1990s, regulations were adopted and refined. In particular, severalamendments to the Banking Law were passed in October 1999, which included elements of board

-6-

governance, additional remedial measures (allowing the NBS to charge down bank capital againstlosses), financial disclosure requirements, and certain aspects of insider transactions. However, the1999 amendments still left serious gaps in all the above areas and in their implementation.

17. Bank supervision also remained deficient throughout the 1990s. The NBS established abank supervision department after independence from the Czechoslovak federation, but theindependence of the supervisory function was not well established. Many critical supervisorydecisions were shared with the MOF. Bank supervision was severely understaffed and lackedleadership and organizational structure. The NBS initiated a development program with foreigntechnical assistance, and by the end of the 1990s the supervision department housed many of thesupervisory functions practiced worldwide. However, these improvements were insufficient tocontain unsound banking practices and mounting bank distress. Significant improvements inidentifying problems at an early stage and initiating corrective actions had not been accomplished,and bank supervision remained severely constrained by the pervasive presence of the State introubled banks, and the continued shared responsibilities with the MOF.

C. The Enterprise Sector at the End of the 1990s

18. Progress at Privatization. By the end of the 1990s, most enterprises in Slovakia, excludingthose in the utilities sector, had been privatized and the private sector accounted for more than 80percent of GDP. The privatization program was implemented in two major waves. The firstwave-concluded in 1993-comprised the sale of about 9,500 small establishments for cash andthe privatization of more than 1,000 medium and large enterprises, primarily through a massvoucher privatization program. People could bid for enterprise shares with their vouchers, or placethem in newly created investment funds, designed to take the population's vouchers, bid forenterprise shares, and drive enterprise restructuring. However, due to the lack of adequatecompany and capital market regulation (adequate board governance, prohibition of insider trading,proper disclosure, minority shareholder protection rules), voucher privatization was followed byfraud and stripping of enterprise assets by insiders.

19. The second wave of privatization was expected to be implemented in 1995 through vouchermethods, but the Government of Prime Minister Meciar, formed in December 1994, canceled thesecond voucher privatization in favor of direct sales to domestic buyers. Unfortunately, the secondwave of privatization was also marked by lack of transparency and corruption. The selection ofbuyers was heavily influenced by political considerations, and these buyers acquired the enterprisesat very low prices and with generous financing terms. In January 1996, the Government exchangedthe outstanding second wave vouchers held by the population for 5-year privatization bonds with atotal value of Sk33 billion. About Sk3O billion remains outstanding and the bonds are due inDecember 200 1.

20. The major utilities in the energy, telecommunications, and water sectors, as well therailways and a number of enterprises in the armaments, machinery, and pharmaceuticals industrieswere excluded from privatization by the Strategic Companies Act of 1995. At the end of the1990s, many enterprises in the utilities sector suffered from a number of technical and economicproblems, including low administered tariffs and substantial cross-subsidies from industrial andcommercial users to households. A number of the utilities were suffering from severe financial

-7-

difficulties, and were proving to be an increasing burden on the State budget, which had to coverongoing operating losses while honoring State guarantees in most of their foreign borrowings.

21. Financial Performance of Enterprises. The financial performance of Slovak enterprisesremained poor throughout the 1990s, as indicated by the decline in gross profits and the increase ingross losses (Table 4). By 1999, Slovakia had one of highest ratios of losses to GDP in CentralEurope, and 35 percent of loss-making enterprises were not able to cover material and labor costs.The reasons for the insufficient restructuring and the persistence of large enterprise losses wererooted in the poor governance structures that emerged from the two waves of privatization, and thelack of creditor discipline that resulted from the lack of progress in bank privatization and thedysfunctional collateral and bankruptcy regimes. As in the case of other countries experiencingsituations of corporate distress, loss-making firms in Slovakia have financed their losses through avariety of sources, including unpaid interest, arrears on loan principals, tax arrears, and arrears tosuppliers.

Table 4: Financial Results of Enterprises, 1994-1999(in % of GDP)

1994 1995 1996 1997 1998 1999

Gross Profits 11.1 11.8 10.3 8.5 6.0 6.5

Gross Losses 7.4 6.7 7.3 8.9 10.2 10.8

Net Profits 3.6 5.1 3.0 -0.4 -4.2 -4.3

22. The Legal Framework for the Private Sector: Corporate Governance. The corporategovernance architecture in Slovakia is defined by a number of laws, including the CommercialCode, the Accounting Law, the Auditing Law, the Securities Law, and the Law on CollectiveInvestments. Despite some amendments to these laws during the 1990s, the corporate governancearchitecture remained poor through the decade, including weak accountability of boards toshareholders, poor financial disclosure rules, weak auditing standards, few constraints on insidertrading, and weak minority shareholder protection. Supervision of capital market activities wasconducted inside the MOF and also proved weak. The extensive stripping of corporate assetsassociated with the two waves of privatization, and allowed by weak regulation and supervision ofcompanies and capital market activities, generated a loss of confidence of the population on capitalmarket institutions that will take time to restore. At present, the equity market is barelyoperational, with less than a dozen corporations traded in the Bratislava Stock Exchange (BSE),down from the initial 1,000 enterprises from the first wave, and there have been no capitalincreases or initial public offerings.

23. The Legal Framework for the Private Sector: Bankruptcy and Collateral Regimes. Asmentioned before, the poor financial performance of Slovak enterprises was also due to weakmonitoring of enterprises by creditors. The lack of creditor discipline was partly due to thepresence of large State banks subject to political interference, but also to the failure of the legalsystem to provide strong rights to creditors. Indeed, both non-bankruptcy enforcement proceduresand the bankruptcy framework remained dysfunctional throughout the 1990s, constituting aseparate and powerful obstacle to creditor-imposed discipline.

-8-

24. Although the bankruptcy law was improved by a number of amendments in the 1990s, thebankruptcy system remained inefficient and dysfunctional, due to serious remaining problems withthe law itself, the weak institutional infrastructure, and weak enforcement. On its face, the lawallowed for both financial restructuring (compositions in Slovak parlance) and for liquidation(bankruptcy in Slovak parlance). However, the restructuring track was rarely used, and theliquidation track proved very inefficient, as indicated by the long period of completion (3-7 years),and very low recovery rates (3 percent of the claims). One of the most serious problems with thelaw was the lack of creditor rights under bankruptcy. Once the enterprise was declared bankrupt,the court selected a liquidator without input from the creditors, and the liquidator carried out theprocedures with very little participation from creditors. Several liquidators were criticized forlacking the requisite expertise to effectively carry out their tasks, and even for engaging in self-dealing. This problem, combined with the fraudulent transfer of assets prior to or in the context ofbankruptcy, resulted in long administrative delays and unsatisfactory outcomes.

25. Amendments to the Foreclosure (Execution) Law introduced in 1998 allowed morepossibilities for banks to foreclose on collateral. This strategy increased the bank's rate ofcollection of bad claims somewhat, but it did not necessarily produce optimal results for theeconomy as a whole. This is because foreclosures sometimes involved piecemeal liquidation ofenterprises, some of which could have been preserved as "going concerns", if submitted to properrestructuring under a well functioning bankruptcy framework. At the same time, collateralremained essentially restricted to real estate, because pledges over movable property remaineddifficult to achieve due to the absence of a modem secured transactions law and central registry forrecording pledges in movable assets. Due to these deficiencies, the collateral regime producedunsatisfactory outcomes throughout the 1990s. On the one side, distressed enterprises that couldhave been preserved as going concerns were frequently liquidated piecemeal, due to someimprovements in the foreclosure of collateral (real estate) not matched by improvements inbankruptcy procedures. On the other side, creditworthy enterprises were frequently deprived fromcredits due to the narrow range of allowable collaterals.

IV. THE GOVERNMENT'S REFORM PROGRAM

A. Overview

26. The Government has started to implement a comprehensive program of bank and enterprisereforms that comprises four basic components. The first is a program of bank restructuring andprivatization. The second is a substantial set of improvements in banking regulation andsupervision. The third is an ambitious scheme to workout the large volume of non-performingloans and tax arrears. Finally, the fourth component is an overhaul of the legal framework forcompanies and capital market activities. The Government intends to implement its reform programunder a stable macroeconomic framework, and has demonstrated its resolve by implementing asuccessful stabilization program in 1999 and 2000, and by adopting a macroeconomic program for2001 and 2002, endorsed in an IMIF Staff Monitored Program (SMP).

-9-

B. The Macroeconomic Framework

27. Stabilization Efforts Since 1999. Following a renewed bout of currency turbulence inMay 1999, the new Government introduced a package of stabilization measures which resulted in anearly 2 percent of GDP improvement in the primary deficit (Table 1). The new Government alsosignificantly increased administered prices (gas, electricity, heating, post, and railways) in tworounds, curtailed the granting of guarantees, and began structural reforms in the enterprise andfinancial sectors. These reforms resulted in a sharp decline of fixed investment from 38 to 31percent of GDP which, together with the tightened fiscal stance, contributed to a significantreduction in the current account deficit to 5.0 percent of GDP in 1999. The tightened fiscal stanceallowed the NBS to ease monetary policy somewhat. The improved policy mix and the structuralreforms contributed to a sharp reduction in real interest rates, a nominal appreciation of the koruna,an increase in foreign reserves, and a rapid decline in the spreads on Slovak eurobonds (Figure 1).

28. The deficit of the General Government was essentially unchanged in 2000, but the currentaccount deficit declined further to 3.7 percent of GDP. This improvement was underpinned bystrong export performance, following the acceleration of growth in the EU and strong productivitygrowth in exporting industries. At the same time, import growth was contained by a further declinein fixed investment (to 30 percent of GDP) and by a sharp 3.4 percent reduction in real privateconsumption resulting from a third round of increases in administered prices and the decline of realwages. Most importantly, FDI flows reached 10 percent of GDP, exceeding the current accountdeficit by a wide margin and leading to a reduction in net external debt for the first time since 1993(Table 1). The large FDI flows were in part the result of the successful privatization of the Slovaktelecom company. However, non-privatization related FDI reached nearly 4 percent of GDP in2000, reflecting the Government's policy of encouraging the entry of foreign capital.

29. The successful stabilization of the economy has come with large short-term costs, however.The contraction of domestic demand slowed GDP growth to about 2 percent in 1999 and 2000.The unemployment rate has risen from 13 percent to 19 percent, as a result of lower GDP growthand stronger financial discipline. Inflation has temporarily accelerated to an average of about 11percent in 1999 and 2000 following the overdue liberalization of administered prices and theincrease of VAT rates. Fortunately, these short-term costs do not seem to have decreased thepolitical will to consolidate the stabilization and complete the reform program.

-10-

Figure 1: Selected Economic Indicators

Real Intete h Raes 12 rnth movinwg averge Yearly Givwth of Money and Creit

20 < t 2515-2

10 , 1

ol , ,,0\ 5 -t.5

-5 O, ;11195 V1196 11V97 V1198 VV99 11/00 113V96 13197 V31/98 U31/99 131/00

- RealS Depost- Real SrLenng |- Boad Money TotaCrit

ew&i to Fnteprises in Perent of Total Cre(it E ca v Ratev.vs. Eun

90% 49

47

45

80% 43

41

39

70% 37V/13 31/5 1/l/97 1/199 1/M98 7/2/98 V2/99 7/2/99 V2/00 720O 1/2/01

Remves, exching gold SlovakEEurobonds: Spread over Cenman Bunds

4450 450400

3950 - 350s clicjnpxcew oje 300

3450 - 250-200

2950 150\ ) ~~~~~~~~~100

2450 - , , \t, , , 12128/98 6t28/99 12/28/99 6/28100

Jan-98 Ji-98 Jwn99 i-99 Jo00 Ji-00 8.0 % DM 1,000 mn 2003 -.-.-. 7.500 Euo500 mn 2004

-11-

30. The Medium-term Macroeconomic Framework. The Government's medium-termmacroeconomic framework is expected to consolidate the positive results of the 1999-2000stabilization program, and has been designed with two major objectives in mind: first, to ensure astable environment for the successful completion of the structural reforms and a resumption ofgrowth on a sustained basis; and second, to demonstrate the country's capacity to join the EU bythe middle of the decade. The Government's macroeconomic program for 2001 and 2002 has beenelaborated in collaboration with the IMF, as reflected in the Statement of Economic Policiesapproved by the Slovak Cabinet on March 28, 2001. The Fund has agreed to monitor this programin the context of a Staff Monitored Program (SMP). Macroeconomic policies in the period 2003-2005 will be primarily driven by the Government's objective to join the EU at the earliest possibledate. Meeting this objective will require a demonstrated capacity to maintain a stable economicenvironment and, shortly after accession, to comply with the terms of the EU's Stability andGrowth Pact which, inter alia, calls for structurally balanced budgets.

31. The 2001 budget was elaborated under difficult initial conditions, including a substantialloss in projected revenues and increases in expenditures due to external commitments. Therevenue loss-projected at 2 percent of GDP-is due primarily to the reduction in the corporateincome tax rate from 40 percent to 29 percent (a measure expected to promote foreign anddomestic investments) and the elimination of a temporary import surcharge introduced in 1999. Atthe same time, expenditures related to structural fiscal reforms will increase, including civil servicereform (though such a reform should result in savings in the medium-term), as will expendituresrelated to EU and NATO commitments.

32. The 2001 budget contains a number of measures designed to offset these revenue losses andexpenditure increases, but the offsetting is not full, because Parliament was reluctant to adopt avery stringent budget after two consecutive years of contracting real domestic demand and slowgrowth. As shown in Table 5, the 2001 budget agreed with the IMF in the context of the SMPimplies a small increase in the general government deficit (excluding privatization revenues, calledguarantees, and bank restructuring costs), from 3.3 percent of GDP in 2000 to 3.9 percent of GDPin 2001. The modest fiscal expansion in 2001 does not raise concern, however, because it is takingplace in a period of large privatization-related FDI, and because it is being underpinned by a strongpackage of structural public sector reforms agreed with the 1MF in the SMP (Annex 1). Suchreforms are expected to put Slovakia's public finances in a much sounder footing in the medium-term.

33. During the first quarter of 2001 the Government issued SK105 billion in special bonds torestructure the banks, the equivalent of nearly 11 percent of 2001 GDP, as shown in Table 5.These explicit Government bonds will replace temporary loans from the banks to the workoutagencies that were issued at the start of the bank restructuring program, and that have beenguaranteed by the Government (see the banking restructuring section). The increase in explicitGovernment debt will amount to only 5 percent of GDP, however, as the Government intends touse part of the large proceeds of privatization in 2001 (estimated at around 10 percent of GDP)2 to

2 The privatization of the gas sector will account for a large share of the total revenues expected for 2001.

-12-

retire its explicit debt, as well as the privatization bonds issued by the NPF.3 The Government alsointends to use the large privatization revenues for the repayment of other outstanding liabilities ofthe public sector, including the arrears of some social funds, and some borrowing guarantees.

Table 5: Key Economic Indicators, Base Scenario, 2001-20052000 2001 2002 2003 2004 2005

GDP Growth and Inflation:Real GDP growth (% p.a.) 2.2 3.0 4.4 5.1 5.3 5.5Inflation: Average CPI (% p.a.) 12.0 6.9 6.0 4.6 4.3 4.0

Min Components of GDP: (in % of GDP)Private Consumption 52.9 53.9 54.0 54.0 54.0 54.1Fixed Investment 30.0 30.4 30.6 30.8 31.0 31.2Fiscal Accounts:

General Government Deficit 1/ 3.3 3.9 3.2 2.7 2.3 1.9Government Debt 31.9 37.0 35.4 35.5 35.0 34.2External Accounts:Current Account Deficit 3.7 4.8 4.8 4.7 4.5 4.2Foreign Direct Investment 10.0 12.4 8.0 4.0 3.7 3.5Gross External Debt 56.3 51.6 46.5 43.2 40.5 38.1Net External Debt 30.1 19.1 12.7 10.3 8.5 6.9Foreign Reserves/Months of Imports 3.3 4.4 4.8 4.8 4.8 4.8

Memorandum items (% of GDP):Stock of Bank Restructuring Bonds -- 10.8 9.8 8.9 8.1 7.4Iterests on Restructuring Bonds 2' 0.4 0.6 0.8 0.7 0.6 0.51/: Excludes privatization revenues, called guarantees and bank restructuring costs.2/: Interest payments on restructuring bonds begin in 2002. For 2000 and 2001 data reflect interest payments on theguaranteed bridge loans to SKA and KOB (see banking restructuring section).

34. GDP growth is likely to increase slightly to 3 percent in 2001, driven by the modest fiscalexpansion, a resumption of private investment, and an increase in consumption resulting from theredemption of NPF bonds and a return to positive real wage growth after 2 years of decline. As aresult of the expected increase in domestic demand and the slowdown in exports due to slower EUgrowth, the current account deficit is projected to increase to about 4.8 percent of GDP in 2001, upfrom 3.5 percent of GDP in 2000. However, the larger current account deficit projected for 2001does not present much concern, as it is expected to be more than covered by the substantial FDIflows projected for the year-FDI is conservatively estimated at 12 percent of GDP due to largeprivatizations and a sustained increase in greenfield investment. As a result, external vulnerabilityshould decline further as net external debt continues to decline in 2001 and international reservesare expected to exceed 4 months of imports.

3The remaining 2.7 percent of GDP in outstanding NPF bonds will be redeemed in 2001. About 1.5 percent of GDPin NPF bonds are held by households.

-13-

35. GDP growth is expected to accelerate further to 4-6 percent p.a. in 2002-2005, driven by anincrease in private investment and consumption. The envisaged growth rates can be comfortablyachieved, given Slovakia's high ratio of investment to GDP and the expected increase in efficiencythat will result from the structural reforms. A prudent fiscal stance would call for a steadyreduction in the fiscal deficit to ensure that the current account deficit remains in a sustainablerange of 4 to 4.5 percent of GDP, despite the growth of private investment and consumption. Sucha level of current account deficit would be consistent with a declining path of the ratio of netexternal debt to GDP if, as seems likely, greenfield investment continues to flow at about 3 to 4percent of GDP in the years following 2002, when privatization revenues are expected to taper off.

36. The Government recognizes the need to tighten the fiscal stance in 2002, and has agreedunder the SMP to reduce the 2002 budget deficit to a range of 3.0 to 3.5 percent of GDP (excludingprivatization revenues, called guarantees and bank restructuring costs). Such a fiscal tighteningwould allow the authorities to rebalance the policy mix and relieve pressure on monetary policy in2002, which will have to continue to cope with large expected capital inflows (due primarily to theprivatization of electricity utilities). Such a fiscal tightening would leave more room for aresumption of growth in real credit to the private sector, following several years of decline, thusfacilitating a moderate increase in private investment.

37. In subsequent years the budget deficit is expected to be trimmed further by about 0.5percent of GDP per year, to fall below 2 percent of GDP by 2005. The fiscal path envisaged forthe 2002-2005 period involves an accumulated fiscal adjustment of roughly 1.5 percent of GDP,opening room for a moderate expansion of private investment and consumption relative to GDP,concurrent with a slight reduction in the current account deficit relative to GDP. The fiscal pathwould also ensure a steady reduction in public debt and total external debt relative to GDP, andwould place Slovakia closer to the balanced structural budget required by the Stability and GrowthPact (in the years following EU accession).

38. The medium-term macroeconomic framework includes a build up of official internationalreserves to nearly 5 months of imports, designed to strengthen Slovakia's external position andreduce further the country's vulnerability to external shocks. Such an annual build up of reservestogether with current account deficits of 4 to 4.5 percent of GDP and the stream of scheduledexternal amortizations define Slovakia's medium-term financing requirements (Table 6). FDI isexpected to cover more than half of these financing requirements during the 2001-2002 period andabout one third during 2003-2005, after the privatization program ends. With conservativeassumptions on portfolio investment and net short-term capital, an average of about US$1.7 billionper year in medium and long-term debt disbursements would be required during this period.Slovakia should have no difficulty in meeting such a level of debt financing, which is one third thelevel of new disbursements sustained in the mid- and late-1990s. The proposed EFSAL would notonly help Slovakia meet its financing requirements, but would also strengthen Slovakia'screditworthiness and ability to borrow in private international markets on termns more favorablethan in the late-1990s.

-14-

Table 6: External Financing Requirements, 2000-2005(in US$ million)

2000 2001 2002 2003 2004 2005Requirements 3277 3856 3228 3816 3701 3392Current Account Deficit 671 1005 1135 1229 1328 1381Amortization Payments 1827 1109 926 1860 1571 1171Reserve Build up 779 1741 1168 727 802 841

Financing 3277 3856 3228 3816 3701 3392FDI 1914 2568 1875 1052 1091 1154MLT Disbursements 2609 1038 1103 2314 2160 1788o/w EFSAL 0 54 126 0 0 0

Other net ' -1247 250 250 450 450 450Note: 1/ includes capital transfers, net portfolio flows, and short-term capital.

C. Banking Sector Reforms

39. The Government is aware that the pervasive presence of the State in the banking system haddevastating effects on the financial health of the banks and on the allocation of resources in theSlovak economy. To break this negative historical pattern, the Government has startedimplementing a banking sector reform that is based on the divestiture of the State from the bankingsystem and on the establishment of sound governance structures in the banks. Specifically, thebanking sector reformn has the following components: (i) the restructuring and privatization of thethree large State banks; (ii) a program to resolve troubled small and medium banks; (iii) the reformof the deposit insurance system; and, (iv) the substantial strengthening of the regulation andsupervision of the banking sector. The Government intends to complete the bank privatizationcomponent by the end of 2001, and to achieve substantial progress in improving the regulatory andsupervisory framework during the same period.

40. Restructuring and Privatization of the Three Large State Banks. In 1999 and 2000 theGovernment restructured the three large banks (VUB, SLSP, and IRB) through two basicoperations. The first was a Skl8.9 billion direct equity infusion, conducted at the end of 1999, andthe second was a SklO5 billion carve-out of bad assets, conducted in December 1999 and June2000. The bad assets were transferred to the Slovak Consolidation Agency (SKA) and toKonsolidacna Banka (KOB), and were replaced by State-guaranteed loans, from the restructuredbanks, to SKA and KOB earning an interest rate of 10 percent p.a. As shown in Table 7, theseoperations have restored the banks' profitability and increased their CARs to levels above 12percent, according to IAS. Although a residual stock of bad loans has remained in their balancesheets, these loans are adequately covered by collateral and provisions.

41. The recapitalization of the large State banks was implemented in the context of a sound andtransparent privatization program, and was accompanied by the imposition of conditions andcontrols on the banks during the pre-privatization period. At the end of 1999, the Governmentselected reputable privatization advisors for the three banks. To ensure the improvement of these

-15-

institutions during the pre-privatization period, the Government replaced the management of thebanks, and created an intra-agency bank privatization and control unit. This unit, which residesinside the MOF, also receives foreign technical assistance. Since these measures were introduced,the banks have undergone a process of self-restructuring, incorporating cost reductions, layoffs, andtechnological improvements.

Table 7: The Restructuring of the Three Large State BanksBank Cash Equity Total Carve- Share of Classified CAR Return on Equity

Infusion Outs Loans (3 to 5) (December 2000) (December 2000)(Sk billion) (Sk billion) (December 2000) (%) (%)

____ ~~~~~~~~~(%)VUB 8.9 66.2 20.5 16.1 43.6SLSP 4.3 32.4 13.8 12.4 45.1IRB 5.7 6.4 16.7 13.7 0.3Total 18.9 105.0 -- --

Source: NBS

42. The State-guaranteed loans to SKA and KOB were converted into State bonds in early2001. The first bond issue amounted to Sk83.7 billion and took place in January 2001. It wasfollowed by a bond issue of Sk2l.3 billion in March 2001. The bonds were issued with maturitiesof 5, 7, and 10 years with a combination of fixed and floating interest rates. The bonds will payinterest twice a year, with the first payment being made one year from the date of issue. Theconversion of guaranteed loans into State bonds was done to facilitate the privatization process andto assist the banks by providing assets which can be used to address liquidity and other risks.

43. The issue of SklO5 billion of State bonds (the equivalent of 11 percent of the 2001 GDP)implies a substantial increase in the Government's domestic debt. However, as mentioned before,the total public debt is not excessive-32 percent of GDP at end-2000-and will be reducedthrough the use of privatization revenues. The interest payments on the special bonds will amountto 0.8 percent of GDP in 2002, but will decline over time with GDP growth. Overall, the costs ofbank restructuring in Slovakia seem to be in line with the costs observed in some of the leadingtransitional countries-by way of comparison, Hungary and Slovenia spent initially the equivalentof 1.6 and 1 percent of GDP per year in interest payments, respectively, to restructure their bankingsystems.

44. The privatization of the large State banks gained momentum in early 2001, with the sale of4a 87 percent stake in SLSP to Erste Bank of Austria in January for US$400 million, and the sale a

25 percent stake in VUB to the EFC and the EBRD in February. The Government intends tocomplete as quickly as possible the privatization of VUB and IRB. In the case of VUB, the tenderprocess commenced in early February 2001, two reputable strategic investors have been qualified,and have initiated due diligence procedures. The Government expects to complete the sale of acontrolling stake in the bank to a strategic investor by mid-2001. The privatization of IRB has alsoreached an advanced stage, with the near completion of due diligence by a potential strategic

4 The revenues from bank privatization are expected to reduce the net costs of bank restructuring by at least 20 percent.The sale of SLSP alone amounted to 1.8 percent of GDP, or more than 15 percent of the total stock of recapitalizationbonds.

-16-

investor, and divestiture of the Government's stake should be completed by mid-2001. Conclusionof Privatization of VUB through sale of at least 67 percent of the bank's shares to private strategicinvestor(s), is a condition of second tranche release. The sale of not less than 67 percent of IRB'sshares to strategic investor(s) or initiation of alternative resolution procedures is a condition ofsecond tranche release.

45. The Consolidation of the Medium and Small Banks. In 2000, the Government and theNBS made substantial progress in implementing a plan to resolve the 7 medium and small bankswhich had become insolvent as a result of poor governance and political interference in creditdecisions. Three banks were placed in liquidation, one was sold to a foreign strategic investor, anda third was merged with SLSP (which was subsequently privatized). Two troubled medium bankswith assets amounting to 4 percent of total bank assets remained to be resolved in early 2001.Plans to resolve these two banks are already advanced, and the Government and the NBS have acommitment to complete their resolution by mid-2001. Full compliance of all banks with NBS'prudential regulations or initiation of conservatorship or liquidation for non-compliant banks is acondition of second tranche release. Full compliance of all banks with NBS's prudentialregulations is a condition of third tranche release.

46. In addition to progress in resolving the troubled medium banks, the Government is alsomaking progress in divesting from two other public banks that have been compliant with prudentialregulations. Komunalna Banka (a medium bank owned by several Slovak municipalities) was soldto foreign strategic investors in 2000, and the Government intends to complete the privatization ofBanka Slovakia (a small State bank) by end-2001. Sale of at least 67 percent of Banka Slovakia'sshares to private strategic investors is a condition of third tranche release.

47. Reform of the Legal and Regulatory Framework for Banks. As mentioned before, duringthe second half of 1999 the regulatory framework for the banking sector was significantlyimproved, through amendments to the Banking Law and amendments to the Act on the TaxTreatment of Reserves and Provision. The amendments to this latter Act introduced for the firsttime full deductibility of required loan loss provisions for banks. This eliminated a historicdistortion in the tax system that had led to the taxation of fictitious bank profits, encouraged themisclassification of bad loans, and hindered the build up of prudential reserves.

48. While the October 1999 amendments to the Banking Law represented meaningful stepsforward, it still failed to address weaknesses in key areas, including: (i) supervisory powers andindependence; (ii) responsibility and accountability of management and supervisory boards; (iii)special relationships (connected parties); (iv) affiliate relationships; (v) large exposures; (vi)regulatory reporting; (vii) financial disclosure, including, inter alia: financial statement amendmentand redisclosure in the event of mistakes in statements; (viii) risk management; (ix) capitaladequacy, and (x) bank closure rules and deposit insurance.

49. The NBS and the Government are aware of the need to strengthen all these areas of bankingregulation, in order to put an end to the culture of regulatory forbearance that has prevailed in thebanking system, enhance the accountability of all economic agents, and set the foundations for arobust banking sector. To this end, the Government and the NBS have prepared an impressivepackage of legal reforms that amount to an overhaul of the regulatory framework for banking

-17-

activities. The package includes amendments to the Slovak Constitution and the NBS Law, a newBanking Law, amendments to the Accounting Law and the Auditing Law, amendments to theDeposit Insurance Law, and several new NBS Decrees. These comprehensive reforms aresummarized below. More detailed information is provided in Annex II.

50. Amendments to the Slovak Constitution and the NBS Law. The first round of reformns tothe legal framework for banking has already taken place, with the Adoption by Parliament ofamendments to the Slovak Constitution and the NBS Law in the first half of 2001. Theseamendments will become effective in July 1, 2001 and May 1, 2001, respectively, and were aimedat strengthening the powers and the accountability of the NBS in the area of bank supervision. Theconstitutional amendments clarify the NBS powers to issue binding regulation, while theamendments to the NBS Law eliminate the role of the MoF in banking supervision, improves thelegal protection to NBS bank supervisors, and allows supervisors to share information with othersupervisory agencies. These amendments complement in a substantive way the strengthening ofsupervisory powers introduced by the new Banking Law.

51. The New Banking Law. The new Banking Law was drafted with the participation of theWorld Bank and addresses all the weaknesses identified above. In particular, the new Lawstrengthens effectively key areas of regulation, including bank governance rules, enforcementpowers, and accounting and auditing rules. The main improvements in these areas is summarizedbelow, whereas a more detailed account is provided in Annex II.

52. Improved rules for bank governance constitute an important part of the new Banking Law.The duties and responsibilities of management and supervisory boards will be much more clearlydefined. Supervisory boards will be made responsible for providing effective governance andsupervision, appointing qualified management teams, and approving key business strategies andrisk control policies. Management boards will be required to develop internal policies andprocedures to address the bank's risks. The failure of a bank's governing bodies to fulfill theirresponsibilities will be subject to legal action by the supervisor and bank investors.

53. The new Banking Law also contains several provisions that will strengthen the enforcementpowers of bank supervision in a fundamental way, and that complement the improvementsintroduced by the amendments to the Constitution and the NBS Law. Among other newprovisions, the new Law introduces prompt corrective action (PCA) rules which trigger supervisoryresponses based on certain capital thresholds. Additional powers to direct capital increase in casesof capital deficiency or higher risk conditions will be included. In addition, the new Law enablesthe NBS to enter into enforceable agreements with boards for plans of corrective action, and directsthe NBS to introduce conservatorship whenever the bank's CAR falls under 4 percent.

54. The new Banking Law also introduces several improvements in the areas of bankingaccounting, disclosure, and auditing, designed to enhance transparency and market discipline, andimprove the effectiveness of the supervision function. These include a number of new provisionsthat improve the frequency and quality of disclosure, including obligatory quarterly financialdisclosure, and obligatory re-disclosure in the case of material rnistakes. The new Banking Lawalso introduces important improvements in bank auditing, including increased independence ofauditors vis-a-vis bank management, greater control of bank supervisors over the appointment of

-18-

the auditor, and obligations for the auditor to report to the supervisor any breaches of law or risk ofmaterial insolvency of the bank. A new draft Banking Law containing all the improvementsdescribed above has already been submitted to Parliament. Adoption by Parliament of asatisfactory new Banking Law is a condition of second tranche release. Adoption of the Decreesand regulations necessary to support implementation of the new Banking Law is a condition ofsecond tranche release.

55. Amendments to the Accounting Law and the Auditing Law. The Govemment is awarethat some of the required improvements in bank accounting and auditing cannot be introduced bythe Banking Law alone, and is preparing the necessary amendments to the Accounting Law and theAuditing Law. In the accounting area, the Government is engaged in a major effort to harmonizeSlovak accounting standards with LAS, and expect to conclude this exercise during 2002.However, the Government intends to accelerate the harmonization with IAS for banks, in order toprotect the large public sector investment in the financial sector. Two critical improvements that.will be introduced ahead of the planned full transition to IAS include the mark to market valuationof securities in banks' portfolios on a quarterly basis, and the suspension of interest accrual forassets 90 days past due and longer. The first improvement will be introduced through an NBSDecree that will be enacted in the second half of 2001. The second improvement will beintroduced through amendments to the Accounting Law that will be submitted to Parliament in thesecond half of 2001. Enactment of an NBS Decree improving valuation of securities will be acondition of second tranche release. Completion of draft amendments to the Accounting Law andother relevant legislation stopping accrual of unpaid interest on assets past due 90 days or longeris a condition of second tranche release. Adoption by Parliament of these amendments is acondition of third tranche release.

56. In the auditing area, several improvements will also be introduced. These will includeintroducing a code of conduct for auditors, strengthening the licensing and monitoringresponsibilities of the Chamber of Auditors, and clarifying and increasing the legal liabilities ofauditors for negligence and misconduct. The Government will submit the necessary amendmentsto the Auditing Law to Parliament in the second half of 2001 and expects these amendments to beadopted in the first half of 2002. Completion of satisfactory amendments to the Auditing Law andother relevant legislation that, inter alia, increase the accountability and legal liability of auditorswill be a condition of second tranche release. Adoption by Parliament of these amendments will bea condition of third tranche release.

57. Reform of Bank Closure Rules and the Deposit Insurance System. The payment of theinsured deposits of the bankrupt small banks depleted the resources of the Deposit Insurance Fund(DIF) and forced the institution to borrow from the NBS in order to honor its legal obligations.This also placed an undue burden on the solvent banks, which have been subject to highcontributions to the DIF. Although these problems were due in part to the failure of banksupervision to intervene promptly in troubled banks, they were also due are deficiencies in the rulesfor bank closure that resulted in an excessive level of net liabilities to the DIF, and in the design ofdeposit insurance that reduced the incentive of depositors to monitor banks.

-19-

58. To address these problems, the Government will change the rules and procedures of bankclosure and deposit insurance, to avoid abuse, enhance market discipline, and improve the long-runviability of the DIF. These measures are particularly important given the need to increase thedeposit insurance coverage to EU norms in the future. First, in the second half of 2001 the DIEFwill start implementing a financial plan that will allow the institution to repay its liabilities to theNBS and build up its reserves to adequate levels. Second, by mid-2001 the new Banking Law willbecome effective, introducing much stricter rules for bank conservatorship. Adoption by the DIF ofa financing plan that restores its long-run financial viability will be -a condition of second trancherelease. Satisfactory implementation of this plan will be a condition of third tranche release.Adoption by Parliament of a new Banking Law introducing stricter conservatorship rules is acondition of second tranche release.

59. Finally, by mid-2001 the Government will submit to Parliament several amendments to theDeposit Insurance Law that will limit the liability of the DIEF, by, inter alia, reducing coverage ofinsured deposits to 90 percent of insured deposits above five times the average monthly wage,while maintaining the current limit of thirty times the average monthly wage.5 Submission ofsatisfactory amendments to the Deposit Insurance Law to Parliament is a condition of secondtranche release. Adoption by Parliament of satisfactory amendments to the Deposit Insurance Lawis a condition of third tranche release. Completion of a study for structural reform of the DIFcomparing the Slovak system to systems in the OECD and EU, and drawing recommendations forstructural re-design and improvement is a condition of third tranche release.

60. Improvements in Supervisory Capacity. Efforts to strengthen banking regulation and theenforcement powers of supervision are being supported by improvements in the skills, techniques,and resources of bank supervisors. In order to identify areas requiring improvement, acomprehensive evaluation of bank supervision (based on the Basle 25 Core Principles for EffectiveBank Supervision) was jointly carried out by World Bank and NBS staff in mid-2000. Using theresults of this evaluation, the NBS supervision department elaborated a comprehensive supervisoryconcept that has been endorsed by NBS Board, and that will be the basis for a multi-yearsupervisory development plan (SDP). The SDP refines the mission and focus of supervision,adopts an improved and more proactive approach to bank oversight through further developing ofon- and off-site functions, and the design of supervisory strategies for each institution. The NBSand the Government have a commitment to fully implement the SDP in 2001 and future years, andwill provide the necessary operational independence and the allocation of additional financial'andhuman resources to the supervision function. Adoption by the NBS Board of a satisfactorySupervisory Development Plan agreed with the Bank is a condition of second tranche release.Satisfactory progress in designing the policies and procedures for a proactive approach to banksupervision is also a condition of second tranche release. Satisfactory implementation of the SDPis a condition of third tranche release.

5The current limit is equivalent to roughly Euro 8,500. The Law prescribes a gradual increase in coverage to Euro20,000, which is the minimum level specified in the relevant EU directive.

-20-

D. Enterprise Sector Reforms

61. The Government has adopted a strategy to promote enterprise restructuring and reduceenterprise losses that has two central components. The first component is a comprehensiveprogram for the workout of bad assets, including the large volume of non-performing claims heldby SKA and KOB, and the large stock of tax and social contribution arrears. The secondcomponent is a comprehensive set of legal reforms, designed to improve the collateral andbankruptcy regimes, and the internal mechanisms of corporate governance. These reforms,combined with the banking sector reforms described above, are expected to lead to a transfer ofweak enterprises and/or their assets to better owners (through reorganization or liquidation),improve financial discipline in the enterprise sector, increase the access of small and mediumenterprises to credit, and ultimately result in a much better allocation of resources, with positiveconsequences for Slovakia's growth performance in the long-run.

62. The Workout Strategy. As mentioned before, in 1999 and 2000 a total of SklO5 billion ofclaims was carved out of the large State banks into SKA and KOB in support of the bankrestructuring program. Out of this total, approximately Sk95 billion were transferred to SKA andthe remaining SklO billion were transferred to KOB. Before the recent carve-outs, KOB alreadycontrolled an additional Sk3O billion of claims carved out of banks prior to 1999, of which Skl2billion consisted of distressed assets. Therefore, the total volume of distressed assets to be workedout amounts to Skl 17 billion, or the equivalent of 12 percent of 2001 GDP, as indicated in Table 8.The other assets held by KOB consist of old housing loans and other assets that do not requireprompt resolution.

Table 8: Non-Performing Assets in the Workout Institutions and Tax Arrears, end-2000SKA KOB Total NPLs in Tax Arrears1 Total NPLs and

Workout Tax ArrearsInstitutions

Sk billion 95.0 22.0 117.0 100.0 217.0

In percent of 2001 GDP 9.7 2.3 12.0 10.3 22.3

Sources: SKA, MOFNotes: 1/ Estimated for end-2000

63. The Government is aware that the restructuring of the enterprise sector will depend to alarge extent on a rapid transfer of ownership and management of SKA's and KOB's distressedassets to the private sector, where superior skills, resources, and incentives can be brought to bear.To achieve this, the Government has designed a multifaceted workout strategy using a combinationof sales of pools of loans to private investors, auctioning of individual loans to smaller investors,the outsourcing of collection through asset/legal management contracts, and, where appropriateafter suitable due diligence, the writing off of non-collectable claims. The legal framework is alsobeing strengthened, in order to facilitate the restructuring of distressed enterprises by investors, andto improve the price received in the sales.

64. The Government is setting up an institutional framework that will allow it to implement thisdiversified strategy in a relatively short period of time. In July 2001, KOB's banking license willbe withdrawn and its Sk22 billion of distressed assets will be transferred to SKA. The housing

-21-

loans and other assets will be transferred to the Guarantee Bank (a special, small State bank). KOBstaff experienced in workouts and restructuring will also be transferred to SKA. The mainrationale for transferring KOB's distressed assets to SKA lies in the fact that the two institutionshave several common borrowers, and consolidating these claims will both enhance their value toprivate sector purchasers and provide efficiencies in their management where sale is not possible.The scarcity of workout skills in Slovakia is another reason to combine the resources of the twoinstitutions. Finally, SKA has been created with more transparent governance structures andshould be able to handle the assets more independently and efficiently. Removal of KOB's licenseand transfer of its distressed assets to SKA is a condition of second tranche release.

65. In order to achieve the objective of the rapid resolution of distressed assets by SKA, theagency was established with good governance rules and transparent tendering procedures, requiredto attract the best qualified firms and investors to the purchase and management of its claims.These policies and procedures have included the creation of an investment board empowered toprovide advice to management and review and control decisions made by the management board.The investment board is composed of five independent members, at least two of whom are foreignexperts sponsored by donors, and will function using super majority voting rules designed to createpublic confidence in its decisions.

66. With extensive technical assistance by donors (EU-PHARE, USAID, UK-DFID), theGovernment has established ambitious workout targets for SKA, and expects most of the workoutsto be concluded by the end of 2002. Two tenders were completed in the first part of 2001. Thefirst comprises a pool of Sk 12.6 billion targeted for sale to specialized foreign investors, while thesecond consists of an auction of Sk3.6 billion of smaller loans to domestic investors and tradepurchasers. SKA has successfully concluded the sale of more than 10 percent of its assets to theprivate sector through these two pilot programs. These programs will provide useful experience forthe SKA in designing and executing further asset sales. Sale to the private sector or outsourcing tothe private sector, or writing off after appropriate due diligence, of not less than 30 percent of SKAassets is a condition of second tranche release. Sale to the private sector or outsourcing to theprivate sector, or writing off after appropriate due diligence, of not less than 50 percent of SKAassets is a condition of third tranche release. All sale and outsourcing contracts will be conductedthrough open tenders. The Government intends that this total will rise to 70 percent by end-2002and to 100 percent by end-2003.

67. The Government has also started consolidating claims held by the Tax Authorities, theHealth Insurance, Social Security, Pension, and Unemployment Funds. The consolidation of thesetax and social contribution arrears with claims held by SKA and KOB will eliminatecounterproductive competition between various State agencies, reducing administrative expensesand increasing the revenues generated by the sales of claims (by enabling investors to purchase allof the state's claims against a debtor in a single package). The Government intends to submitenabling legislation to Parliament in the second half of 2001, to remove legal obstacles toconsolidation, and expects this legislation to be adopted by Parliament in the first half of 2002, atwhich time management responsibility for all state claims will be passed to the SKA. Submissionto Parliament of a special law allowing the resolution of tax and public fund arrears includingprovisions allowing forgiveness, compromise, third party management of claims, and sale at a

-22-

discount is a condition of second tranche release. Adoption by Parliament of a special lawallowing the resolution of tax and public fund arrears including provisions allowing forgiveness,compromise, third party management of claims, and sale at a discount is a condition of thirdtranche release.

68. The Reform of the Insolvency Regime. In August 2000, a new set of amendments to thebankruptcy law became effective, which are designed to correct some the most serious problemswith the law, reported by creditors and practitioners alike. The new amendments provide creditorswith more reliable enforcement mechanisms for commencing bankruptcy procedures, based on astiffer test of insolvency that allows commencement within 30 days of default, and affords creditorsa stronger voice and role in the process, by calling more frequent meetings of creditors and inselecting a trustee of their choice. The process itself is also streamlined by imposing maximumtime limits for administration and by allowing for more flexible and transparent procedures foroperations pending a sale of the business or auction of assets. The amendments have only been inforce for a short period of time and it is premature to assess the benefits. However, it appears thatsome advances are already being made to strengthen the credit culture and impose greater financialdiscipline on the corporate sector, as reflected by an increase in the number of voluntary debtworkouts that are being negotiated between lenders and their borrowers. Likewise, lenders reporthigher recovery rates from borrowers, which they attribute to the benefits achieved through therecent amendments.

69. Despite these preliminary signs of improvements, the Government is aware that there is stillscope for improvements in the bankruptcy framework. The recent amendments have introducedsignificant improvements in liquidation mechanisms, which will speed the resolution of unviableenterprises and promote out-of-court restructurings (due to a more credible bankruptcy threat).However, whereas the amendments have also improved the rules for court-led restructuringmechanisms, there is still scope for improvements in this area. There is also scope forimprovements in the efficiency of bankruptcy procedures, through a better regulation of theprofessionals (e.g., trustees and liquidators) and improvements in the court system. In order toimplement a modern and fully functional bankruptcy system in Slovakia, an inter-agencycommission comprised of public and private sector representatives has been established to overseethe next phase of reforms in the insolvency process. The Commission will have a broad mandateto formulate recommendations for further reforms to the bankruptcy framework. The work of theCommission will proceed with funding and assistance provided under a grant from the InstitutionalDevelopment Fund of the World Bank, and will comprise the following major tasks.

70. The first task of the Commission will be an assessment of the effectiveness of recentamendments to the Bankruptcy Law. This assessment is expected to identify the remaining legal,regulatory, and institutional weaknesses in Slovakia' s bankruptcy regime, and will provideimportant inputs for the work agenda of the Commission in 2001 and 2002. Elaboration of thisassessment by the Commission will be a condition of second tranche release.

71. The second task of the Commission will be creation of a suitable regulatory frameworkgoverning the qualification, training, appointment and monitoring of trustees, liquidators, assetvaluators, and other professionals operating in the bankruptcy system. The regulatory framework

-23-

will establish a supervisory authority with full oversight responsibility for: (i) licensing liquidatorsand trustees and regulating and supervising their work; (ii) setting and enforcing professionalstandards for the administration of insolvency proceedings; (iii) maintaining a publicly accessiblerecord of bankruptcy and insolvency proceedings; (iv) recording and investigating complaintsregarding wrong doing by liquidators and administrators; and (v) appointment of interimliquidators and trustees. Enactment of a Decree introducing interim improvements in theregulation of liquidators and trustees will be a condition of second tranche release. Adoption byGovernment of the concept of a comprehensive regulatory framework for the insolvency systemcontaining a satisfactory implementation timeframe will be a condition third tranche release.

72. The third task of the Commission will be the elaboration of a modem and well articulatedinsolvency law, containing, among other things, procedures that promote effective enterpriserehabilitation. Elaboration of a report by the Commission, including identification of coreprinciples for modernizing the insolvency law based on the World Bank's Principles andGuidelines for Effective Insolvency Systems, and engagement of a drafting team for preparation ofnew insolvency legislation are conditions of second tranche release. Preparation of initial draft ofnew insolvency legislation is a condition of third tranche release.

73. The Government is aware of the need to change other laws in order to eliminate all theobstacles to enterprise restructuring, especially restructuring achieved through workouts conductedvoluntarily outside the court system. As mentioned above, an amendment has already been madeto the Law on the Tax Treatment of Bank Reserves and Provisions, in order to give banks taxdeductibility of their obligatory loan loss provisions. The Government now intends to change taxrules in the second half of 2001, to allow creditors and debtors to negotiate debt reductions anddebt-equity swaps without facing adverse tax implications. Submission to Parliament of changesin tax laws allowing proper tax treatment of debt write-offs and debt/equity swaps is a condition ofsecond tranche release. Adoption by Parliament of changes in tax laws allowing proper taxtreatment of debt write-offs and debt/equity swaps is a condition of third tranche release.

74. The Reform of the Collateral Regime. With the assistance of the EBRD and the WorldBank, the Government has undertaken a review of the laws that regulate the creation, registrationand enforcement of secured rights. Based on such a review, the Government drafted amendmentsto several laws that regulate the collateral system in Slovakia, and will submit these amendments toParliament in the second half of 2001. The new legislation will incorporate the basic coreprinciples for a modem collateral law articulated by the EBRD in its model law on securedtransactions. More specifically, the new collateral legislation will include, inter alia, introductionof concept of non-possessory pledge in movable assets; establishment of a registry for pledges inmovable assets; effective non-judicial procedures for enforcement of collateral rights (includingPublic Auction Law); and amendments governing priority of tax liens. These procedures will beintegrated and harmonized with those under the Bankruptcy Law governing treatment of securedrights and collateral in bankruptcy. Completion of satisfactory draft amendments to the lawsregulating collateral is a condition of second tranche release. Adoption by Parliament ofsatisfactory amendments to the laws regulating collateral is a condition of third tranche release.

-24-

75. Improving the Legal Framework for Corporate Governance. As mentioned above,strengthening the mechanisms of corporate governance will contribute significantly toimprovements in the future performance of Slovak enterprises. Some progress has already beenmade in this area, by establishing a new agency to regulate and supervise the securities market andthe insurance sector. This agency, however, lacks the necessary independence and powers to fullyenforce its mandate. The Government intends to improve the corporate governance architecturefurther, and is preparing important changes in three pieces of legislation in order to achieve thisobjective. The first is a new law designed to strengthen the independence and the operationalcapacity of the new supervision agency. The second is a set of comprehensive amendments to theCommercial Code, and the third is a new Securities Law.

76. The amendments to the Commercial Code will enhance corporate governance byintroducing or improving: board duties and liability provisions; regulation of mergers andtakeovers; minority shareholder protection rules; and introduction of shareholder legal action. TheGovernment will submit these amendments to Parliament in the second half of 2001, and expectsthese amendments to be adopted by Parliament in the first half of 2002. Submission to Parliamentof satisfactory amendments to the Commercial Code is a condition of second tranche release.Adoption by Parliament of satisfactory amendments to the Commercial Code is a condition of thirdtranche release.

77. The new Securities Law is expected to enhance further the governance of publicly tradedcompanies by improving, inter alia, disclosure requirements, insider trading rules, the regulation ofbrokers and dealers, and the registration of securities. The Government will submit theseamendments to Parliament in the second half of 2001, and expects these amendments to be adoptedby Parliament in the first half of 2002. Submission to Parliament of a satisfactory new SecuritiesLaw is a condition of second tranche release. Adoption by Parliament of a satisfactory newSecurities Law is a condition of third tranche release. Adoption by Parliament of a new lawstrengthening the legal, financial, and operational autonomy of the securities and insurancemarkets regulator is a condition of third tranche release.

78. Privatization and Regulation of Utilities. The new Government has demonstrated itsresolve to address the problems of the utility sector through a number of concrete steps. TheGovernment has significantly increased administered utility tariffs in four steps since June 1999.Cross subsidies still remain, especially in the gas sector, but the Government is committed toreducing these. A new regulatory body for telecommunications was established in May 2000, and anew regulatory body for the energy sector will be established in May 2001. Thetelecommunications regulator is due to merge with the new utilities regulator in 2002, and may alsotake over the remaining utilities.

79. In September 1999 the Government amended the Large Privatization Act, abolishing theStrategic Companies Act and removing the biggest obstacle to the privatization of utilities. Theprivatization of utilities started in the summer of 2000, with the sale of a 51 percent stake in SlovakTelecommunications to a strategic foreign investor for Eurol billion. In November 2000, aprivatization advisor was selected for SPP (the gas transport and distribution company which ownsand operates one of the main pipelines from Russia to Western Europe) and the privatization

-25-

advisor for Transpetrol (oil company) was selected in January 2001. The Government intends tocomplete divestiture of a 49 percent stake in both companies by October 2001. Privatization plansand pre-privatization restructuring plans for the Slovak Electricity company and the watercompanies will be adopted in 2001 and minority stakes will be sold in 2002.

E. Unemployment and the Social Safety Net

80. The rise in unemployment rates started in 1998, with the slowdown in GDP growth, andbecame more pronounced in 1999, as a result of the stabilization program implemented during thatyear (Table 1). The unemployment rate is currently around 19 percent and can be expected toremain so over 2001 and 2002, according to forecasts released by the Ministry of Labor, SocialAffairs and Family. The reason for the expected stability in the unemployment rate at high levels isdue to the combination of two offsetting factors. On the one hand, the ongoing bank and enterprisereforms will result in the reduction of loss-making activities and inevitably in some layoffs. On theother hand, the economy is expected to grow at higher rates in the next few years and absorb part ofthe unemployed. The ongoing restructuring of the Slovak economy should lead to higher growthrates and a sustained decline in unemployment after 2002. Recent experience in Hungary, whichwas at a similar point of high unemployment and restructuring in 1994-1996, and now enjoysunemployment rates lower than 7 percent, would suggest that the unemployment rate in Slovakiashould fall significantly by the middle of the decade.

81. During this transition period the wellbeing of the population during the next few years willdepend, in part, on the strength of the social safety net. This consists of (i) employment programsmanaged by the National Labor Office (NLO); (ii) social assistance administered by a network ofregional welfare offices; (iii) social insurance (pensions and short-term benefits) administered bythe Social Insurance Agency (SIA); and (iv) a new Guarantee Fund to pay back wages to workersin bankrupt companies. Recently, the NLO has administered a special jobs program funded out ofthe budget. Further, the NLO receives notification of redundancies from companies. This enablesanalysts to assess future caseloads. Overall, these programs provide a strong social safety netsimilar to those in developed market economies in Western Europe.

82. The safety net, except for pensions, is generally affordable, and government has beenresponsive to budgetary problems in the past. For example, unemployment benefits were reducedin both size and duration after the unemployment rate started to reach its current peak. Socialassistance expenditures, which provide means-tested benefits when unemployment runs out, aremore than 1 percent of GDP, an unusual figure in transition economies, which have tended tounder-finance their anti-poverty programs. While Government needs to take steps to reduce thenumber of recipients, especially among young people, the excess does not represent an undueburden on the budget. In the case of old-age pensions, contributions have not covered outlays inrecent years. Nonetheless, Government is aware of this situation and is currently preparing apension reform, which is to be sustainable in the long run.

-26-

V. THE PROPOSED LOAN

A. The Bank's Assistance Strategy

83. The Bank's Country Assistance Strategy (CAS) for Slovakia was discussed by theExecutive Directors on February 6, 2001. The overarching strategic objective for the proposed CASis to put Slovakia on a path of rapid and sustained growth that will promote convergence withWestern European countries and improve living conditions, particularly among the most vulnerablegroups in the population. Specifically, the CAS entails three clusters of activities: (i) completingSlovakia's economic transformation to restore and sustain high growth rates; (ii) strengtheningpublic institutions and public governance; and (iii) ensuring the efficiency and sustainability of thesocial sectors including health, education, and social protection.

84. The EFSAL plays a prominent role in the Bank's assistance strategy to Slovakia, and theBank has been working closely with the Government since early 1999 on the design of the bankand enterprise reforms. The loan will help the Government finance the costs of bank restructuringand to address major outstanding structural bottlenecks, placing Slovakia on a sustainable growthpath. The reform program to be supported under the loan will help the Government finalize therestructuring and privatization of several domestic banks, develop a robust banking regulatory andsupervisory framework; resolve a substantial amount of problem loans through an efficient marketbased mechanism; and implement a comprehensive set of legal reforms, designed to enhancecreditor rights and to improve the internal mechanisms of corporate governance.

85. IFC has played an important role in supporting private sector development and in helpingthe country conclude its transition to a full market economy. IFC expects to make significantcontributions to bank privatization, financial markets development, infrastructure financing andindustrial restructuring. At the request of the Government, IFC has recently invested together withthe EBRD in VUB. IFC's participation in VUB is expected to strengthen the bank's corporategovernance and financial and environmental risk management in the pre-privatization period. It isalso expected to enhance the credibility of the bank privatization program, and improve thesalability of VUB by attracting more reputable strategic investors. EFC is also expecting toparticipate in the restructuring of the classified claims being auctioned by SKA, by teaming up withthe bidding winner. Finally, IFC is exploring the opportunity to promote Slovakia's nascentmortgage finance market, and support the development of secondary market institutions.

B. Loan Amount and Borrower

86. The proposed Bank loan, in the amount of Euro 200 million, will be made to the SlovakRepublic. The loan would be a Euro single currency fixed spread commitment linked, annuityrepayment loan with a final maturity of 14 years and grace period of 5 years and an expecteddisbursement of 0-3 years. The loan would be disbursed in three tranches of Euro 60 million, Euro70 million, and Euro 70 million respectively.

-27 -

C. Loan Design

87. The principle objective of the proposed loan is to provide timely and responsive support toSlovakia's efforts to implement effective reform of its banking and enterprise. The loan wouldprovide fast-disbursing funds for fiscal assistance in support of the Government's reform program,specifically the interest costs associated with the recapitalization of the banks as a precondition fortheir successful privatization. The Government, in cooperation with the Bank and the IMF(through a Staff Monitored Program), would aim at maintaining a stable macroeconomicframework essential for the successful implementation of the structural reforms.

88. The main elements of the enterprise and financial sector reform program are:

* Reform of the Banking Sector- restructuring and privatization of the three large State-owned banks;- resolution of all troubled small and medium sized banks;- reform of the deposit insurance system; and- substantial strengthening of banking regulation and supervision.

• Reform of the Enterprise Sector- workout of a large volume of bad assets;- improvement of the legal framework for debt enforcement and bankruptcy,

in order to promote market-based debt and enterprise restructuring; and- improvement of the legal framework for corporate governance.

D. Financial Management and Monitoring

89. The MoF will have in place adequate accounting and financial management reportingsystems for the Deposit Account. The MoF will maintain records of all transactions under the loanin accordance with sound accounting practices. The Government will submit to the Bank amonthly receipts and payments account showing the transactions on the Deposit Account, startingwith the receipt of Bank funds and ending when the balance on the Deposit Account has beenreduced to nil. The Borrower shall: (a) have the Deposit Account audited in accordance withappropriate auditing principles consistently applied by independent auditors acceptable to the Bank;(b) furnish to the Bank as soon as available but in any case not later than three months after the dateof the Bank's request for such audit, a certified copy of the report of such audit by said auditors ofsuch scope and in such detail as the Bank shall have reasonable required; and (c) furnish to theBank such other information concerning the Deposit Account and the audit thereof as the Bankshall have reasonably requested.

90. The audit will be carried out at semi-annual intervals as agreed with the Bank, calculatedfrom the date of first tranche release, with suitable adjustments of timing depending on the dates ofsubsequent tranche releases and the funds left in the Deposit Account at any point in time. Theterms of reference for the audit will be agreed between the Bank and the Borrower. Audits wouldend once all funds have been transferred from the Deposit Account. In addition to the above, theBank may request that its own staff (or a specialist contractor working on its behalf) carry out

-28-

special reviews of the Deposit Account. If, after deposit into the Deposit Account, the proceeds ofthis loan are used for ineligible purposes, the Bank will require the Borrower to either: (i) returnthat amount to the account for use for eligible purposes, or (ii) refund the amount directly to theBank.

E. Project Implementation

91. The EFSAL will be implemented in accordance with standard Bank procedures foradjustment loans. The financial sector program will be implemented by the MoF and the NBS.Implementation arrangements will be fully consistent with Bank practice for adjustment loans.Upon notification by the Bank of loan effectiveness, the proceeds of the loan will be deposited bythe Bank into the designated Deposit Account at the request of the Borrower. In accordance withthe Operational Directive on the Simplification of Disbursement Rules under StructuralAdjustment and Sector Adjustment Loans (February 8, 1996), disbursements will not be linked to--specific purchases. Therefore, there will be no procurement requirements.

F. Monitoring Arrangements

92. The Ministry of Finance and the National Bank of Slovakia will be responsible for themonitoring and implementation of the program. The Bank will monitor the implementation of theprogram through periodic reviews.

G. Environmental Assessment Requirements

93. In accordance with the Bank's Operational Directive on Environmental Assessment (OD4.01), the proposed operation has been placed in category "C" and does not require anenvironmental assessment.

H. Release of Funds and Tranching

94. It is proposed that the loan be released in three tranches of Euro 60, Euro 70 and Euro 70million equivalent respectively. The first tranche will be eligible for disbursement uponeffectiveness of the loan. The second and third tranches will be eligible for disbursement uponsatisfaction of the proposed conditions for their release, as detailed in the attached Matrix of KeyActions (Annex IV). Loan tranches are expected to be approximately 6 months apart.

I. Benefits and Risks

95. The reform actions sought under the EFSAL would encourage private and financial sectordevelopment by accelerating reform in key structural areas. The Government's reform action willrestore the solvency and efficiency of the banking system, promote enterprise restructuring throughan ambitious workout scheme and improvements in the legal framework, and attract foreigninvestment. Restoring sustainable growth based on stronger microeconomic foundations shouldlead to more rapid employment growth with irnproved labor market performance.

-29-

96. The risks to the proposed EFSAL could be related grouped into political, macroeconomic,and absorption capacity risks.

* Political Risk. The governing coalition may not hold together if the political costs ofdecisive reform become too high. Alternatively, the perception of political risks could leadto delays in concluding some components of the program. For example, there could beadverse political reactions from increased unemployment or a very low price in the auctionsof bad loans. However, these risks seem to be low due to several reasons. First,implementation of some of the key reforms supported under the EFSAL are quite advanced.SLSP has already been sold to a major European bank, and VUB has been partially sold toIFC and EBRD with a view to successful sale to a strategic investor by mid-year. Theconsolidation of the small and medium banks is well underway, and new legislation in bothbanking and enterprise sector is expected to be submitted to Parliament this year. Second,the social safety net seems to be adequate. A labor market and social assistance assessmentof the impact of the EFSAL has been completed and findings indicate that the increase inunemployment will not be pronounced and that potential negative impacts can be largelymitigated by the existing social assistance programs. Finally, political risk is substantiallymitigated by the broad-based desire of the population to join the EU.

a Macroeconomic Risk. The severe external imbalances have been eliminated through the1999 stabilization program and the current account deficit is currently at a sustainable level.Moreover, the large FDI inflows expected for 2001 and 2002 should exceed the currentaccount deficit by a wide margin, leading to sizable reductions in Slovakia's net externaldebt. The 2002 elections raise the risk of larger fiscal deficits and a resumption of externalimbalances, but this risk will be contained by two factors. First, agreement with the IMF onStaff Monitored Program has reduced the risks of macroeconomic imbalances in 2001 and2002. Second, Slovakia's objective to join the EU in the middle of the decade implies acommitment with the European Commission to implement a stable medium-runmacroeconomic program compliant with the Maastricht criteria.

* Absorption Capacity Risk. Implementation of the reforms could be substantiallyundermined by the weak institutional capacity in the country. To mitigate this risk, anumber of initiatives are well under way. EU-PHARE, USAID and the UK-DIFD havebeen providing technical assistance for bank privatization and the work out of the bad debt,including development of policies and procedures for SKA, and packaging and auctioningof debt to private sector. The three donor agencies will provide assistance to an ambitiousprogram to strengthen bank supervision. Finally, an IDF grant has been provided by theBank to strengthen the institutional capacity for the implementation of the bankruptcyreforms, including training for judges, administrators, and court clerks.

-30-

VI. RECOMMENDATION

97. I am satisfied that the proposed loan will comply with the Articles of the Agreement of theBank and recommend that the Executive Directors approve it.

James D. WolfensohnPresident

by Sven Sandstrom

Washington, D.C.July 2, 2001

Annex IPage 1 of 2

SLOVAKIA - Enterprise and Financial Sector Adjustment LoanStatement of Economic Policies

The Government of Slovakia has agreed with the IMF on a Staff Monitored Programwhich articulates a number of key economic goals for the years ahead and policiesenvisaged in 2001 and 2002 to support these goals. These goals and policies are spelledout in the Government's Statement of Economic Policies (SEP) submitted to the IMF,and are summarized below:

* Privatization revenue in 2001 could exceed 10 percent of GDP. This revenue will beused to retire government liabilities with the exception of 0.1 percent of GDPearmarked for development projects. The Government intends to adopt a law in 2001on state debt and guarantees which will require that, beginning in 2002, all futureprivatization revenue will be used to retire state debt and finance pension reform.

* The Government will strictly control the issue of new state guarantees in 2001. Theaforementioned law on state debt and guarantees is envisaged to contain provisionswhich will ensure a reduction in the stock of guarantees (from current levels of 16percent of GDP) over the next few years.

* The Government has taken a number of steps to improve the budget process andincrease fiscal transparency. In 2001 most extra-budgetary funds will be merged withthe state budget. New rules expected to be adopted by Parliament will preventmembers of parliament from submitting proposals that would result in an increase inthe agreed budget deficit. Medium-term financial planning which began in 2001 willbe strengthened. A functional classification of state expenditures will be introducedand a treasury system will be created in 2002 to improve overall public financemanagement.

* The Government will subordinate the economic management of all sections of thegeneral government and state-owned enterprises to the control of the Ministry ofFinance. The Act on Financial Control which will provide the rules andorganizational structure for internal financial control will be drafted in 2001 andbecome effective in 2002. All companies receiving state subsidies will be thoroughlysupervised by financial control bodies. The Ministry of Finance will also haverepresentatives on supervisory boards of companies that received state guarantees.

* The Government will continue to implement a comprehensive reform of taxadministration with technical assistance from the IMF.

* The Government will prepare a comprehensive pension reform including theintroduction of multi-pillar pension system which is expected to become effective in2004.

Annex IPage 2 of 2

* The Government will begin to prepare a comprehensive reform of the health caresector to improve the efficiency and quality of health care services. The Governmentwill review the existing health insurance system and the establishment of asupplementary health insurance system. Also, the costs of medical procedures andpharmaceuticals will be minimized and co-payments for medical services will beintroduced. The Government will define an optimal network for institutionalhealthcare facilities, and for primary and secondary outpatient care.

Annex 11Page 1 of 3

SLOVAKIA - Enterprise and Financial Sector Adjustment LoanKey Reforms to the Legal and Regulatory Framework for Banking Activities

Critical Constitutional NBS Banking ActElement Law Act (as submitted to Parliament - 4/01)

(amendments 2/01) (amended )

1. Supervisory * NBS established as an * Provides NBS full authority to * Eliminates sharing supervisory responsibility withIndependence independent central bank. conduct banking supervision, MOF.

overseeing the safety and * Provides certain protections to supervisors whensoundness of the banking system. performing their jobs with due care.

* Allows NBS supervision to sharepertinent supervisory informationwith other supervisory bodies,including the DIF.

* Requires the NBS to performsupervision in an objective andimpartial manner.

2. Supervisory * NBS authorized to issue generally * Explicitly assigns NBS the * Provides authority to supervise on aPowers binding regulations authorized by primary authority to decide and consolidated basis.

the pertinent law. act on compliance and * Substantial enhancement of enforcementsupervisory issues. powers:

* Gives NBS more explicit Prompt corrective action (PCA):authority to verify compliance * Recovery plan at below 8% capitalwith law and to give adequacy ratio (CAR)recommendations for improving a Forced administration at 4% CARbank condition. * Revoke license at 2% CAR

* More explicitly establishes * Requires supervisory board approval ofsupervisory access to bank required recovery plan.information. * Can require a bank to dismiss a member of

* Further defines the supervisory management upon violation of certain specificauthority to: set rules of violations of law.prudential business practice, * Penalize individual members of a supervisoryrequire compliance with law and or management board.regulation, monitor compliance * Requires quarterly reporting and disclosure ofwith regulation, issue licenses, financial information.

Annex IIPage 2 of 3

and perform on and off site * Can direct the correction and re- publicationsupervision. of (quarterly) financial information previously

* Directs supervision on a reported incorrectly.consolidated basis. * Significant changes made to the Commercial

Code assigning personal liability to statutoryand supervisory boards (i.e. stronger corporategovernance). (See following pages)

* Obligation of NBS to inform enforcementauthorities of suspected criminal activity.

* Requires NBS notification of "new products".3. Responsibility * Requires the bank's supervisory board toand Accountability oversee the activities and performance of theof Management and management board and bank.Supervisory Boards * More specifically defines the duties of the

management board, including "safe andsound" (defined) operation of the bank, properrisk management and internal control,accurate financial reporting and disclosure. bymanagement.

* Can require management to pay "damages"caused by their imprudent actions.

* Requires supervisory board approval of headof internal control / audit and notification ofidentified shortcomings to same.

4. Special * Requires more transparency and clearerRelationships disclosure of a bank's closely connected(connected parties - groups.or "insiders") * Expanded and more explicitly defined those

who have "special relationships" with thebank.

* Requires terms with such parties to becommensurate with those of other clients.

* Requires approval of transactions by boards.5. Large Exposures * Expanded definition of borrower group,

combinations of indebtedness.

Annex IIPage 3 of 3

Critical Constitutional NBS Banking ActElement Law Act (as submitted to Parliament - 4/01)

(amendments 2/01) (amended)6. Auditing a Establishes right of NBS to prescribe a "long

form" supplement to annual audit.Requires auditors to inform NBS immediatelyof facts leading to qualification of opinion,bank is insolvent, or if regulatory reporting isfound to be inaccurate.

7. Forced * Tightens criteria for who can be appointedAdministration administrator.

* Requires administrator to act to preserve thevalue of the banks assets.

* Maximum time period in forcedadministration one year.

* NBS will draft internal instructions whichcontrol the activities which an administratorcan conduct.

8. Interpretive * Proposed law indicates that supportingDecrees interpretive decrees will be prepared by NBS

in areas of capital definitions and adequacy,large exposures, quarterly reporting anddisclosure, etc.

Letter of Development Policy Annex IIIPage 1 of 15

OFFICE OF THE GOVERNMENT OF THE SLOVAK REPUBLICNam. slobody 1, 813 70 Bratislava 1

Bratislava June 28, 2001

Mr. James D. WolfensohnPresidentThe World BankWashington DC 20433

Dear Mr. Wolfensohn,

1. We are writing this letter on behalf of the Government of the Slovak Republic.As you know, Slovakia became independent in 1993 and continued implementing thestructural reforms that had been initiated under the former Czechoslovak Federation. Atthe time of independence the universe of small enterprises had already been privatized.The first wave of privatization of large and medium enterprises had been completed aswell, through a mass coupon scheme that was considered innovative at that time. Thesecond wave of privatization was basically completed in 1998 through a differentstrategy, based on direct sales. The conclusion of the second wave of privatization in1998 increased the share of the private sector in GDP to over 80 percent. The bankingsector also experienced a fast transformation during this period, due primarily to the entryof new domestic and foreign banks. By 1997 the number of new banks and branches offoreign banks had increased to 28. As a result, the share of the three large, State-controlled banks in total bank assets had dropped to roughly half of total bank assets, andtwo of these three banks had been partly privatized. Also, during this period the NationalBank of Slovakia made progress in developing a modem regulatory framework for thebanking sector and building its supervisory capacity.

2. Since the current Government took office two years ago, we have reviewed theprogress of the bank and enterprise reforms and concluded that much remained to bedone. While the two waves of privatization allowed a rapid transfer of State enterprisesto the private sector, they did not generate the expected gains in efficiency, as indicatedby the increase in enterprise losses and in the number of loss-makers after 1993, and thelarge accumulation of arrears to banks and the tax authorities. The enterprises privatizedin the first wave suffered from weak internal governance due to a variety of causes,including the lack of skills and incentives of investment funds, fragmented ownership,and weak company and capital market regulation. In particular, the lack of transparencyand minority shareholder protection allowed controlling insiders to strip enterprise assets,to the detriment of minority shareholders, creditors, and workers. The second wave ofprivatization, from which foreign investors were practically excluded, did not producemuch better results because it was largely dominated by political factors.

Letter of Development Policy Annex IIIPage 2 of 15

3. The absence of creditor discipline also contributed to the mismanagement of largenumbers of enterprises. The three largest banks remained under State control and weresubject to political influence in their lending decisions. The extent of mismanagementand political interference in these banks is clearly reflected in their non-performing loans,which reached half of their loan portfolios in 1998, and which made these institutionsdeeply insolvent. The performance of several new medium and small banks also proveddisappointing. Many of these banks were partly or totally controlled by State enterprises,local governments, and branches of the central government, and also suffered from assetstripping and political interference in their operations. In some other cases the weakgovernance was due to the presence of inexperienced private investors, who were able toenter the system in the early 1990s when licensing criteria were lax. As a result of yearsof weak governance, several medium and small banks arrived at the end of the decadewith large volumes of bad loans and deeply insolvent. Finally, the lack of creditordiscipline was also due to the weak legal framework for bankruptcy and debtenforcement, which deprived creditors of the most essential rights and tools to monitortheir clients.

4. We are aware that the poor performance of banks and enterprises implies asubstantial loss of efficiency to the Slovak economy, with adverse consequences for thegrowth of output and employment in the long-run. In order to correct these deficiencies,and place Slovakia on a path of sustainable growth and successful entry into theEuropean Union, we are now implementing an ambitious program of bank and enterprisereforms. This program, which started in the Spring of 1999, comprises the restructuringand privatization of the large State banks, the consolidation of the group of small banksthrough privatization, mergers and liquidations, the workout of the large stock of badassets, and substantial improvements in the regulatory framework for banks andenterprises. We are determined to fully implement the reform program under a stable andconsistent macroeconomic framework. We intend to achieve these objectives over arelatively short period of time, and request the assistance of the World Bank in thefinalization and financing of our reform program, through an Enterprise and FinancialSector Adjustment Loan.

Macroeconomic Framework

Current Efforts at Stabilization

5. In the years following our independence from the Czechoslovak Federation in1993, our macroeconomic performance was among the best in Central Europe. Inflationdeclined from 23 percent in the first year of independence to single digits in 1995, one ofthe lowest inflation rates in the region. At the same time, the economy initiated a strong,export-led recovery, despite a contraction of fiscal expenditures and of fixed investment.The initial output recovery seemed sustainable, as it was based on exports, and took placein a context of low fiscal deficits and current account surpluses. The prospects of highgrowth were reinforced by the highest investment ratio in the region (about 26 percent ofGDP in 1995), and the expectations of improved investment efficiency driven by fastprivatization.

Letter of Development Policy Annex IIIPage 3 of 15

6. In 1996, however, the current account abruptly shifted to persistent deficits ofabout 10 percent of GDP, driven by a dramatic increase in fixed investment to 34 percentof GDP in 1996 and to 38 percent of GDP in 1998. The sharp investment expansion didnot raise much concern initially, as we hoped that such large investment outlays wouldincrease export capacity further and eventually repay themselves. However, it becameprogressively clear that much of this increase in investment included sub-optimal projectsdriven by distorting incentives, generous public guarantees on foreign borrowings,extensive political interference in bank lending, and weak corporate governance. Theinefficiency of much of the investment and the lack of enterprise restructuring wereprogressively revealed by the growing volume of enterprise losses and the number ofloss-makers.

7. The expansionary fiscal policy in the mid-1990's also contributed to the increasein the current account deficit. The deterioration in the fiscal balance from a surplus of 0.4percent of GDP in 1995 to a deficit of 5.0 percent of GDP in 1997 and 1998 actuallyunderstates the full extent of that expansionary policy, since large contingent liabilitieswere also built up in this period in the form of extensive guarantees on foreignborrowings of loss-making enterprises and extra-budgetary funds.'

8. In an effort to offset increasingly lax fiscal policies, and prevent the currentaccount from deteriorating even further, the NBS tightened monetary policy from 1996 to1998. This policy did contain the current account at 10 percent of GDP, but at the cost ofvery high real interest rates (in excess of 20 percent p.a.) and repeated periods ofturbulence in the foreign exchange market. The tight monetary policy was ultimatelyunable to sustain the exchange rate in the face of speculative attacks related to the Russiacrisis, forcing us to float the currency in October 1998. Also, the high real interest ratesmade it increasingly difficult for enterprises to service their debts and contributed to afurther deterioration in the loan portfolios of domestic banks.

9. Recognizing the extent of the macroeconomic imbalances, we introduced a firstpackage of stabilization measures in January 1999. Following a renewed bout ofcurrency turbulence in May 1999, we introduced a second package of stabilizationmeasures which resulted in a 2 percent of GDP improvement in the primary deficit. Wealso significantly increased administered prices (e.g. gas, electricity, heating, post, andrailways) in three rounds, tightened financial discipline (by limiting the issuance of newguarantees), and began structural reforms in the enterprise and financial sectors. Thesereformns resulted in a sharp decline of fixed investment to 31 percent of GDP, whichtogether with the tightened fiscal stance contributed to a significant reduction in thecurrent account deficit to 5.7 percent of GDP in 1999. The tightened fiscal stance allowedus to moderately ease monetary policy. The improved policy mix and the structuralreforms contributed to a sharp reduction in real interest rates, a nominal appreciation of

' All fiscal figures quoted in the letter follow the definition adopted in the Staff Monitored Program agreedwith the IMF, which excludes privatization revenues, called guarantees, and the fiscal cost of bankrestructuring.

Letter of Development Policy Annex IIIPage 4 of 15

the koruna, a significant increase in foreign exchange reserves, and a rapid decline insecondary market spreads on Slovak eurobonds.

10. The deficit of the General Government was essentially unchanged in 2000, but thecurrent account deficit declined further to 3.5 percent of GDP. This improvement wasunderpinned by strong export performance, following the acceleration of growth in theEU and strong productivity growth in our exporting industries. At the same time, importgrowth was contained by a further decline in the investment to GDP ratio to 30 percent,as tight credit markets continued and increased financial discipline took hold. The thirdround of increases in administered prices in February 2000 and the decline of real wagesled to a decline of real consumption by about 3.4 percent and also helped to containimports. Most importantly, FDI flows reached 10 percent of GDP, exceeding the currentaccount deficit by a wide margin and leading to a reduction in net external debt for thefirst time since independence. The large FDI flows were in part the result of oursuccessful privatization program. However, non-privatization related FDI reached nearly4 percent of GDP in 2000, reflecting our policy of encouraging the entry of foreigncapital.

11. The successful stabilization of the economy has come with large short-term costs.Unemployment has risen from about 13 percent of the labor force in the mid-1990's to 19percent in 2000. Inflation has temporarily accelerated to an average of about 11 percentin 1999 and 2000 following the long overdue liberalization of administered prices, theincrease of the lowest rates of VAT, and the temporary implementation of an importsurcharge. Finally, GDP grew by about 2 percent in 1999 and 2000, down from anaverage of 5.6 percent p.a. in 1994-1998. We consider these short-term costs to beinevitable, and expect the stabilization and the structural reforms outlined below to createthe conditions for a long period of high rates of GDP growth and low rates ofunemployment. However, we also want to point that we have a proper safety net in placeto mitigate the short-term impact of the stabilization and the reforms on the population.

The Macroeconomic Framework for the Medium-Run

12. Our medium-term macroeconomic framework is expected to consolidate thepositive results of the 1999-2000 stabilization program, and has been designed with twomajor objectives in mind: first, to ensure a stable environment for the successfulcompletion of our structural reforms and a resumption of growth on a sustained basis;second, to demonstrate our capacity to join the EU by the middle of the decade. Ourmacroeconomic program for 2001 and 2002 has been elaborated in collaboration with theIMF, as reflected in our Statement of Economic Policies approved on March 28, 2001.The IMF has agreed to monitor this program in the context of a Staff Monitored Program(SMP). Macroeconomic policies in the period 2003-2005 will be primarily driven by ourobjective to join the EU at the earliest possible date. We are aware that, in order to meetthis objective, we will have to demonstrate our capacity to maintain a stable economicenvironment and, shortly after accession, to comply with the terms of the EU's Stabilityand Growth Pact which, inter alia, calls for structurally balanced budgets.

Letter of Development Policy Annex IIIPage 5 of 15

13. The 2001 budget was elaborated under difficult initial conditions, including asubstantial loss in projected revenues and increases in expenditures due to externalcommitments. The revenue loss-projected at 2 percent of GDP-is due primarily to thereduction in the corporate income tax rate from 40 percent to 29 percent (a measureexpected to promote foreign and domestic investments) and the elimination of atemporary import surcharge introduced in 1999. At the same time, expenditures relatedto EU and NATO commitments will increase, as will expenditures related to structuralpublic sector reforms, including civil service reform (though such reforms should resultin savings in the medium-run).

14. The 2001 budget contains a number of measures designed to offset these revenuelosses and expenditure increases, but the offsetting is not full, because we were reluctantto adopt a very stringent budget after two consecutive years of contracting real domesticdemand and slow growth. The 2001 budget agreed under the SMP implies a modestincrease in the General Government deficit to 3.9 percent of GDP, from 3.3 percent ofGDP in 2000. We are not overly concerned about this modest increase in theGovernment deficit, however, because it is taking place in the context of largeprivatization-related FDI flows that will be used to retire public debt, and because it isbeing underpinned by a strong package of structural public sector reforms agreed in theSMP. We expect such reforms to put our public finances on a sounder footing in themedium-term.

15. We expect a modest increase in GDP growth to 3 percent in 2001, driven by themodest fiscal expansion, a return to positive real wage growth, and the one-off impact onconsumption resulting from the redemption of NPF bonds. As a result of the expectedincrease in domestic demand and the slowdown in exports due to slower EU growth, thecurrent account deficit is projected to increase to about 4.7 percent of GDP in 2001, upfrom 3.5 percent of GDP in 2000. However, the larger current account deficit projectedfor 2001 does not present a concern, as it is expected to be more than covered by thesubstantial FDI flows which we expect this year-FDI is conservatively estimated at 12percent of GDP due to some large privatizations and a sustained increase in greenfieldinvestments. As a result, we expect external vulnerability to decline further as netexternal debt will continue to decline in 2001 and international reserves will exceed 4months of imports.

16. We expect GDP growth to accelerate further to 4-6 percent p.a. in 2002-2005.We expect such growth rates to be driven primarily by a moderate increase in privateinvestment and consumption, and to be underpinned by an increase in efficiency resultingfrom our structural reforns. We understand that a prudent fiscal stance would entail areduction in the fiscal deficit to ensure that the current account deficit remains in asustainable range of 4 to 4.5 percent of GDP, despite the recovery of domestic demand.Such a level of current account deficit would be consistent with a declining path of netexternal debt to GDP ratio if, as seems likely, greenfield investment would continue toflow at about 3 percent of GDP p.a. in the years following 2002 as the privatizationprogram is completed.

Letter of Development Policy Annex IIIPage 6 of 15

17. We will start tightening the fiscal stance in 2002, in order to open room for anexpected expansion of private investment without adverse consequences for the currentaccount. We have thus agreed in the SMP to reduce the 2002 budget deficit to 3.0 to 3.5percent of GDP. Such a fiscal tightening will allow us to rebalance the policy mix andrelieve pressure on monetary policy in 2002, when large privatization related inflows areexpected to continue as the electricity utilities are privatized. Such a fiscal tighteningwould open room for a resumption of growth in real credit to the private sector followingseveral years of decline, thus facilitating an increase in private investment.

18. In subsequent years we intend to trim the budget deficit further by about 0.5percent of GDP per year, in order to reduce it to levels below 2 percent of GDP by 2005.This fiscal path entails an accumulated fiscal adjustment of 1.5 percent of GDP duringthe 2003-2005 period, opening room for a further moderate increase in the ratios ofprivate investment and consumption to GDP, concurrent with a gradual decline in thecurrent account deficit to around 4 percent of GDP. This would enable a reduction in theratios of gross and net external debt to GDP and reinforce Slovakia's external position.The fiscal path would also place Slovakia closer to the balanced structural budgetrequired by the Stability and Growth Pact in the years following EU accession.

Banking Sector Reform

19. We are aware that the pervasive presence of the State in the banking system haddevastating effects on the financial health of the banks and on the allocation of scarceresources in the Slovak economy. To break this negative historical pattern we havedesigned, and made significant progress with the implementation of, a banking sectorreform program that is based on the divestiture of the State's ownership stakes in thebanking system and on the establishment of sound governance structures for banksoperating in the Slovak Republic. Specifically, our program of banking sector reform hasfour main components: (i) the restructuring and privatization of the three large State-owned banks; (ii) a program to resolve troubled small and medium sized banks; (iii)reform of the deposit insurance system; and, (iv) substantial strengthening of theregulation and supervision of the banking sector. We intend to complete the bankprivatization component by the end of 2001, and to achieve substantial progress inimproving the regulatory and supervisory framework during the same period. Completionof the reform will give Slovakia a stable, competitive, well-capitalized and well-managedbanking sector, subject to a supervisory regime which meets international standards, andable to prudently meet the financing needs of the restructured enterprise sector.

The Restructuring and Privatization of the Three Large State Banks

20. As mentioned before, prior to 1999 the three large State-controlled banks, VUB,SLSP, and IRB, suffered from political interference and poor decision making. As aresult, the banks accumulated large amounts of poor quality assets and became deeplyinsolvent. In 1999 and 2000 we restructured these banks through two basic operations.The first was a Sk 18.9 billion direct equity infusion, conducted at the end of 1999, andthe second was a Sk 105 billion carve-out of bad assets, conducted in December 1999 and

Letter of Development Policy Annex IIIPage 7 of 15

June 2000. The loans were transferred to the Slovak Consolidation Agency (SKA) and toKonsolidacna Banka (KOB), and were replaced by loans to SKA and KOB guaranteed bythe Government. These operations have restored the capital adequacy ratio (CAR) ofthese banks to levels above 12 percent, according to IAS. Although a residual stock ofbad loans has remained in their balance sheets, these residual loans are adequatelycovered by collateral and provisions.

21. We also wish to point out that the recapitalization of the large State banks wasimplemented in the context of a sound and transparent privatization program and wasalso accompanied by the imposition of conditions and controls on the banks during thepre-privatization period. To ensure the improvement of these institutions during the pre-privatization period, we replaced the management of the banks and improved theirgovernance through the creation of an intra-agency bank privatization and control unit.This unit, which resides inside the Ministry of Finance (MoF), also receives foreigntechnical assistance. Since these measures were introduced, the banks have undergone aprocess of self-restructuring incorporating cost reductions, layoffs, and technologicalimprovements.

22. A further measure supporting the privatization of the banks was the conversion ofthe banks' state-guaranteed loans to SKA and KOB into state bonds in January and March2001. The bonds were issued with maturities of 5, 7, and 10 years, a combination of fixedand floating interest rates, and will pay interest twice a year with the first payment beingmade one year from the date of issue. The issuance of these bonds facilitates theprivatization process and will assist the banks in the future by providing assets which canbe used to manage liquidity and other risks.

23. We intend to complete as quickly as possible the privatization of the three largeState-owned banks. At the end of 1999, we selected reputable privatization advisors forthe three banks. In January 2001 a controlling share of SLSP was sold to a reputableforeign strategic investor. In the case of VUB, in February 2001 we completed the saleof 25 percent of the bank's shares to multilateral investors and simultaneouslycommenced the tender process to complete the sale of a controlling stake in the bank to aprivate strategic investor by mid-2001. In the case of IRB, we are committed tocompleting the divestiture of State shares to a private strategic investor in the second halfof 2001 or, if this cannot be achieved, to divesting state control of the bank by altemativemethods within the same time period.

The Consolidation of the Medium and Small Banks

24. During 1999, it became apparent that seven medium and small banks were deeplytroubled as a result of poor governance and extensive political interference in creditdecisions. This interference was facilitated by pervasive direct and indirect public sectorparticipation in the ownership of these banks. In 2000, we made substantial progress inimplementing a plan to resolve small and medium troubled banks, placing three inliquidation, selling two to foreign strategic investors, and merging a third with SLSP. Wewill ensure that, by mid-2001, the whole banking sector will be in full compliance with

Letter of Development Policy Annex IIIPage 8 of 15

NBS prudential regulations. The new banking law which is expected to become effectivein July 2001, will ensure that the NBS will have the powers to enforce prudentialregulations and achieve this objective.

25. In addition, we have commenced the privatization process for Banka Slovakia (asmall bank owned by the NPF which is compliant with prudential requirements) in 2000and will complete the divestiture of State-owned shares in this bank in the first half of2002.

Reform of the Deposit Insurance System

26. Payment of the insured deposits of three bankrupt small and medium sized bankshas depleted the resources of the Deposit Insurance Fund (DIEF) and forced the institutionto borrow from the NBS in order to honor its legal obligations. It has also placed anundue burden on the solvent banks in the system, which have been subject to an increasein their contributions to the DIF. We are aware that these problems have been partly dueto the failure of bank supervision to intervene promptly in troubled banks. The NBS andthe Government will correct these supervisory deficiencies by strengthening substantiallythe supervisory powers of the NBS, and by building supervision capacity, as describedbelow. However, we also acknowledge that there are deficiencies in the design of depositinsurance and in the rules for supervisory intervention. Deposits are fully insured (up to avalue of thirty times the average monthly wage), which tends to reduce the incentive ofdepositors to monitor banks. In addition, the current legal framework for bankconservatorship and liquidation contains loopholes that result both in an increase in theliabilities of the DIEF and a low recovery of bank assets, burdening the DIF from both theexpenditure and the revenue sides.

27. In 2001 we will change the rules and procedures of bank closure and depositinsurance, to avoid abuse, enhance market discipline, and improve the long-run viabilityof the DIF. These measures are particularly important given the need to increase thedeposit insurance coverage to EU norms in the future. First, in the second half of 2001the DIF will start implementing a financial plan that will allow the institution to repay itsliabilities to the NBS and build up its reserves to adequate levels. Second, by mid-2001the new Banking Law will become effective, introducing stricter rules for bankconservatorship. These stricter rules will, inter alia: (i) reduce the maximum period ofconservatorship from 2 years to 1 year; (ii) reduce the deadline for the submission of theconservator's plan, from 60 days to 30 days; (iii) impose on conservators the obligationto preserve the assets and property of the subject institution(s) without causing furtherliability or loss of revenue to the DIF; and (iv) empower the NBS to impose preciseguidelines for conservatorship, including stricter audit and reporting requirements. Third,by mid-2001 we will submit to Parliament several amendments to the Deposit InsuranceLaw that will limit the liability of the DIEF, by, inter alia, reducing coverage of insureddeposits to 90 percent of insured deposits above five times the average monthly wage,while maintaining the current limit of thirty times the average monthly wage (althoughthe Law also prescribes a gradual increase in coverage to the minimum levels of Euro20,000 specified in the relevant EU directive). Finally, we plan to complete, by mid-

Letter of Development Policy Annex IIIPage 9 of 15

2002, a study comparing the Slovak system to systems in the OECD and EU, providingrecommendations for structural improvement of the deposit insurance system.Bank Regulation and Supervision

28. The fundamentals of banking legislation and supervision have been in place sinceindependence, and many improvements have been introduced over the past few years.The latest round of improvements happened in 1999, through amendments to the BankingLaw and other related legislation. The amendments to the Banking Law were adopted inOctober 1999, and have strengthened the NBS supervisory authority, some elements ofcorporate governance, and financial reporting. The amendments also advanced theprocess of converging our banking legislation with that required by EU directives. The1999 amendments to the Banking Law were supported by amendments to the Law on theTax Treatment of Reserves and Provisions. These amendments have allowed fulldeductibility of required loan loss provisions for banks, finally eliminating a distortion inthe tax system that had led to the taxation of fictitious bank profits and hindered the buildup of prudential provisions.

29. While the 1999 amendments to the Banking Law represented meaningful stepsforward, the regulatory framework still contains weaknesses in key areas, including therules of bank governance, the enforcement powers and obligations of bank supervisors,and the quality of bank accounting and auditing. We understand that it is essential tostrengthen all these areas of banking regulation, in order to put an end to the culture ofregulatory forbearance that has prevailed in the banking system, enhance theresponsibility and accountability of all the relevant economic agents, and set thefoundations for a robust banking sector. To achieve this objective, Parliament hasalready passed amendments to the Constitution that clarify the NBS powers to issuebinding regulation, and has also passed amendments to the NBS Law that strengthens theenforcement powers of the NBS, by removing the MoF's responsibilities in banksupervision, strengthening the legal protection to NBS supervisors, and allowingsupervisors to share information with other supervisory agencies.

30. We have also completed the draft of a new Banking Law that incorporatessubstantial improvements to all areas of banking regulation, and would like to elaborateon the key improvements that are being introduced. The duties and responsibilities of themanagement and supervisory boards will be more clearly defined under the new BankingLaw (as well as under the proposed amendments to the Commercial Code, as notedbelow). Supervisory boards will be made responsible for providing effective governanceand supervision, for appointment of a qualified management team, and for thecommunication and approval of key business strategies and risk control policies.Management boards will be required to develop internal policies and procedures toaddress the risks posed by a bank's business strategy. The failure of a bank's governingbodies to fulfill their responsibilities will be subject to legal action by the supervisor andbank investors.

31. The enforcement powers and obligations of NBS bank supervisors will bestrengthened by, inter alia, introducing prompt corrective action (PCA) rules in the new

Letter of Development Policy Annex IIIPage 10 of 15

Banking Law that oblige the supervisor to act whenever the banks' CAR fall belowcertain pre-defined thresholds. The independence of the supervision function will also beenhanced by eliminating or substantially reducing the level of involvement of the MOF inbanking supervision. The new Banking Law containing all the improvements describedabove will be submitted to Parliament in the first half of 2001, and is expected to beadopted by Parliament during the summer of 2001.

32. We are also aware that bank accounting and auditing need to be substantiallyimproved, in order to enhance transparency and market discipline, and improve theeffectiveness of the supervision function. Some improvements are already beingintroduced by the new Banking Law. These include a number of new provisionsdesigned to improve the frequency and quality of disclosure, including obligatoryquarterly financial disclosure, amendments and re-disclosure in the case of materialmistakes, and error materiality tests. The new Banking Law also introduces importantimprovements in bank auditing, including increased independence of auditors vis-a-visbank management, greater control of bank supervisors over the appointment of theauditor, and obligations for the auditor to report to the supervisor any breaches of law orrisk of material insolvency of the bank.

33. We are aware that some of the necessary improvements in bank accounting andauditing cannot be introduced by the Banking Law. For this purpose, we preparingamendments to the Accounting Law and the Audit Law. In the accounting area, we areengaged in a major effort to harmonize Slovak accounting standards with IAS, and expectto conclude this exercise during 2002. However, we understand that it is essential toaccelerate the adoption of IAS for banks, in order to protect the large public sectorinvestment in the financial sector. Two critical improvements that will be introducedahead of the planned full transition to IAS include the mark to market valuation ofsecurities in banks' portfolios on a quarterly basis, and the suspension of interest accrualfor assets 90 days past due and longer. The first improvement will be introduced throughan NBS Decree that will enacted in the second half of 2001. The second improvementwill be introduced through amendments to the Accounting Law. We will submit theseamendments to the Accounting Law in the second half of 2001 and expect them to beadopted by Parliament in the first half of 2002.

34. In the auditing area, several improvements will be introduced. These will includeintroducing a code of conduct for auditors, strengthening the licensing and monitoringresponsibilities of the Chamber of Auditors, and clarifying and increasing the legalliabilities of auditors for negligence and misconduct. We will submit the necessaryamendments to the Auditing Law to Parliament in the second half of 2001 and expectthese amendments to be adopted in the first half of 2002.

35. We are fully aware that our efforts to strengthen banking regulation and theenforcement powers of supervision will not achieve their objective if they are notsupported by improvements in the skills, techniques, and resources of bank supervisors.In order to identify supervisory weaknesses, a comprehensive diagnostic evaluation ofbank supervision (based on the Basle 25 Core Principles for Effective Bank Supervision)

Letter of Development Policy Annex IIIPage 11 of 15

was carried out in mid-2000. Using the results of this evaluation, the NBS supervisionwill elaborate a comprehensive, multi-year supervisory development plan (SDP) that willbe endorsed by the NBS board in the second half of 2001. The SDP refines the missionand focus of supervision, adopts an improved and more pro-active approach to bankoversight through further developing of on- and off-site functions and the design ofsupervisory strategies for each institution. The NBS and the Government have acommitment to fully implement the SDP, and will provide the necessary operationalindependence and the allocation of additional financial and human resources to thesupervision function.

Enterprise Sector Reform

36. The financial performance of Slovak enterprises worsened in the second half ofthe 1990s, leading to further increases in the number and value of classified loans and taxarrears. By 1998 enterprise losses had increased to 10 percent of GDP (up from 7 percentof GDP in 1995), leading total classified loans and tax arrears to reach 27 and 10 percentof GDP, respectively. This poor financial performance was largely due to severeweaknesses in the mechanisms of corporate governance in Slovakia. The internalmechanisms of governance were weak due to flaws in the design and execution of theprivatization program, and a weak regulatory framework for companies and capitalmarket activities. The external mechanisms of governance were weak due to the poorlending practices of commercial banks and the weak framework for bankruptcy and debtenforcement, which deprived creditors of essential rights and tools to enforce theirclaims.

37. In 1999 we adopted a strategy to promote enterprise restructuring with two centralcomponents. The first component of our strategy is a comprehensive program of workoutof bad assets, including the classified loans carved out of the banks in 1999 and 2000 toSKA and KOB, the loans that were already in KOB's books, and also the arrears to thetax authority and social funds. The second component is a comprehensive set of legalreforms, designed to enhance creditor rights inside and outside bankruptcy, and toimprove the internal mechanisms of corporate governance. These reforms, combinedwith the banking sector reforms described above, are expected to substantially improvefinancial discipline in the enterprise sector and lead to a much better allocation ofresources in the Slovak economy, with positive consequences for our growthperformance in the long-run.

The Workout of Bad Assets

38. As mentioned before, in 1999 and 2000 a total of SK 105 billion of claims wascarved out of the large state banks in support of the bank restructuring program. Out ofthis total, SK 95 billion was transferred to SKA and SK 10 billion to KOB. In addition,KOB controls SK 30 billion of claims carved out of banks prior to 1999. Therefore,SKA's portfolio currently amounts to SK 95 billion, all of which consisting of distressedassets, and KOB's portfolio amounts to SK 40 billion, of which SK 22 billion consisting

Letter of Development Policy Annex IIIPage 12 of 15

of distressed assets requiring resolution. The remaining assets held by KOB consist ofhousing loans and other assets that do not require prompt resolution.

39. We recognize that the efficient resolution of the large stock of distressed claimsmay contribute significantly to the restructuring of the enterprise sector, by transferringownership of the underlying assets to new owners. We also recognize that the bestmethod of ensuring the rapid resolution of both SKA's and KOB's claims is to transferownership and management of these assets to the private sector, where superior technicalskills and resources can be brought to bear. The reform of the bankruptcy framework andthe collateral system which we are undertaking will provide support to this process andimprove the realizable value of the two institutions' and other state claims.

40. We are setting up an institutional framework that will allow us to achieve ourobjectives for the rapid resolution of SKA's and KOB's distressed assets, which togetheramount to SK 117 billion. In July 2001 we will remove KOB's banking license and willtransfer all of its SK 22 billion distressed assets to SKA. KOB staff experienced inworkouts and restructuring will also be transferred to SKA. The main rationale fortransferring KOB assets to SKA lies in the fact that the institutions have several commonborrowers, and consolidating these claims will both enhance their value to private sectorpurchasers and provide efficiencies in their management where sale is not possible. Thescarcity of workout skills in Slovakia is another reason to combine the resources of thetwo institutions. Finally, we also believe that SKA has been created with bettergovernance structures and will be able to handle the assets more efficiently.

41. We are ensuring that the SKA will have the financial stability, good governance,and transparent tendering procedures, required to attract the best qualified firms andinvestors to the purchase and management of its claims. In late 2000 the supervisoryboard of SKA approved a budget for 2001 containing adequate provision for hiring assetmanagement and legal firms to manage and service its assets. Recognizing the timinguncertainties inherent in cash flows from distressed assets, the SKA also established anadequate reserve from revenues received in 2000 which it will be permitted to draw uponin order to provide operational funding when shortfalls arise due to these timinguncertainties.

42. In order to ensure the good governance and transparency of SKA we have ensuredthat it has policies and procedures meeting best standards for similar institutions. Thesepolicies and procedures are supported by the creation of an investment board empoweredto review and control decisions made by the management board. The investment boardwill be composed of five independent members, two of whom are foreign expertssponsored by donors, and will base its decisions on super majority voting rules designedto create public confidence in its decisions.

43. With the support of extensive technical assistance resources already committed bydonors (EU-PHARE, USAID, UK-DFID), we have already initiated the resolution of theproblem assets of SKA. Two pilot transactions have already been completed and not lessthan 10 percent of SKA's claims have been sold during the first half of 2001. By late

Letter of Development Policy Annex IIIPage 13 of 15

2001, after the transfer of KOB's distressed assets to SKA, we will complete tenders forthe sale andlor private sector management, or written off after appropriate due diligence,of 30 percent of SKA's claims. By mid-2002, not less than 50 percent of SKA's assetswill have been sold or placed under private sector management, or written off afterappropriate due diligence, and we intend that this total will rise to at least 70 percent byyear end 2002.

Resolving Other State Claims

44. We also intend to consolidate the claims held by the Tax Authorities, the HealthInsurance, Social Security, Pension, and Unemployment funds, with claims held by theSKA. The consolidation of claims against individual debtors from these sources withclaims held by SKA will allow the rationalization of claim management and improve therevenues generated if they are sold to the private sector or placed under private sectormanagement on a consolidated basis. Harmful competition between various stateclaimants and the duplication of administrative expenses should be eliminated in theconsolidation process, and an additional obstacle to the transformation of the enterprisesector removed. Using SKA as the institution responsible for selling or arranging theprivate sector management of claims would take advantage of the skills and programsbeing developed by the agency and the extensive technical assistance resources beingprovided to it.

45. We intend to move forward as rapidly as possible with the consolidation process.Legal and regulatory obstacles to consolidation and to the use of workout techniqueshave already been identified. In the second half of 2001, we will submit enablinglegislation to Parliament to remove legal obstacles to consolidation and sale of Stateclaims. We expect that this legislation will be passed by Parliament in the first half of2002, and that management responsibility for all state claims will be passed to the SKAwithin the same period.

The Legal Framework for Debt Enforcement and Bankruptcy

46. As mentioned before, we are fully aware of the need to improve debt enforcementand bankruptcy regimes to promote more efficient liquidations, facilitate restructuring ofdistressed enterprises, enhance financial discipline, and improve the access of enterprisesto credit, particularly small and medium enterprises. To achieve these goals, we haveembarked on a number of legal reforms, including reforms to strengthen creditor rights tocollect debt or foreclose on collateral, and also reforms to the bankruptcy system.

47. Improvements in the Bankruptcy Framework Although the Bankruptcy Law wasamended several times since independence, the bankruptcy system remained inoperativethroughout the 1990s, due to a number of obstacles in the law itself, conflicts with otherlaws, and a weak judicial infrastructure and enforcement. The Law allows in principlefor both liquidation (bankruptcy) and for financial restructuring (compositions).However, the restructuring track has been rarely used, and the liquidation track has

Letter of Development Policy Annex IIIPage 14 of 15

proved very inefficient, as indicated by the long period of completion (3-7 years), andvery low recovery rates (3 percent of the claims).

48. In order to make the bankruptcy system a more effective tool, we introduced anumber of amendments to the Bankruptcy Law that became effective in August 2000,designed to correct the most serious problems in the Law. These amendments providecreditors with stronger enforcement mechanisms for commencing bankruptcy procedures,based on a stiffer test of insolvency that allows commencement within 30 days of default.It affords creditors a stronger role in the process, in calling more frequent meetings ofcreditors and in selecting a trustee of their choice. The process itself is also streamlinedby imposing maximum time limits of 18 months for administration and by allowing formore flexible and transparent procedures for operations, pending a sale of the business orauction of assets. Although the amendments have only been in force for a short period oftime, they have already resulted in changes in attitude promoting a more responsiblecredit culture and imposing greater financial discipline on the corporate sector. This isreflected by the significantly higher number of voluntary debt workouts that are beingnegotiated between lenders and their borrowers. In many instances, these workouts arebeing initiated by the borrowers themselves. Likewise, lenders report higher recoveryrates from borrowers, which they attribute to the benefits achieved through the recentamendments.

49. Despite these preliminary signs of improvements, we are aware that there is awide scope for further improvements in the bankruptcy framework. To that end, we haveestablished an inter-agency commission comprised of public and private sectorrepresentatives that is responsible for overseeing the next phase of reforms in theinsolvency process. The Commission will have a broad mandate to identify the needsand formulate principles and recommendations for: (i) a new modem insolvency law, (ii)strengthening of the institutions that oversee the process, and (iii) creating a suitableregulatory framework that governs the qualification, training, appointment andmonitoring of trustees. The Commission will also undertake a review of the institutionalframework to identify ways and means for strengthening institutional capacity, improvingefficiency in court operations, and imposing greater transparency, accountability andpredictability in the system. Finally, the Commission will make recommendations tobetter integrate and harmonize the insolvency law with the broader legal and commercialframework. This work will proceed with funding and assistance provided under anInstitutional Development Fund grant from the World Bank.

50. Improvements in the Collateral Regime. With the assistance of the EBRD and theWorld Bank, we have undertaken a review of the laws that regulate the creation,registration and enforcement of secured rights. Based on such a review, we are draftingamendments to several laws that regulate the collateral system in Slovakia, and willsubmit these amendments to Parliament in the second half of 2001, and expect adoptionby Parliament in early-2002. The new legislation will incorporate the basic coreprinciples for a modem collateral law articulated by the EBRD in its model law onsecured transactions. More specifically, the new collateral legislation will include, interalia, introduction of concept of non-possessory pledge in movable assets, establishment

Letter of Development Policy Annex IIIPage 15 of 15

of a registry for pledges in movable assets, effective non-judicial procedures forenforcement of collateral rights (including Public Auction Law), and amendmentsgoveming priority of tax liens. To the extent possible, we intend to integrate andharmonize these procedures with those under the bankruptcy law governing treatment ofsecured rights and collateral in bankruptcy.

51. Other legislative changes to promote debt and enterprise restructuring. We areaware of the need to change other laws in order to eliminate all the obstacles to enterpriserestructuring, especially restructuring achieved through workouts conducted voluntarilyoutside the court system. As mentioned above, we have already amended the Law on theTax Treatment of Bank Reserves and Provisions, in order to give banks tax deductibilityof their obligatory loan loss provisions. In the second half of 2001 we will submit toParliament legislation to allow the write-down of classified loans and the conversion ofdebt into equity without adverse tax implications for the parties engaged in restructuring,and expect Parliament to adopt these amendments by mid-2002.

The Legal Frameworkfor Corporate Governance

52. As mentioned above, strengthening the mechanisms of corporate governance willcontribute significantly to improvements in the future performance of Slovak enterprises.We have already made some progress in this area, by establishing a new agency toregulate and supervise the securities market and insurance companies, and are currentlypreparing a new law to strengthen its legal, regulatory, and budgetary independence. Weexpect this law to be adopted by Parliament in the second half of 2001. The Cabinet hasapproved amendments to the Commercial Code that will make members of statutorybodies more accountable to shareholders and creditors, that will enhance the rights ofshareholders, particularly minority shareholders, that will improve the regulation ofmergers and takeovers, and that will enable legal action by shareholders. We submittedthe amendments to the Commercial Code to Parliament in April 2001, and expectadoption by Parliament by Fall 2001. Finally, we have also started drafting. a newSecurities Law, to improve further the govemance of publicly traded companies. Thenew Securities Law will improve, inter alia, disclosure requirements, insider tradingrules, the regulation of brokers and dealers, and the registration of securities. We willsubmit the new Securities Law to Parliament in the second half of 2001 and expectParliament to adopt the new Law by early 2002.

Sincerely yours,

Brigita Schm rova Ivan MiklosMinister of Finance Deputy Prime Ministerof the Slovak Republic of the Slovak Republic

Annex IVPage 1 of 9

SLOVAKIA - Enterprise and Financial Sector Adjustment LoanMatrix of Key Actions

Area Board Conditions Second Tranche Third Tranche

1. Macroeconomic Framework Agreement with the IMF on a medium-term Satisfactory compliance with the Satisfactory compliance with themacroeconomic framework endorsed in a Staff macroeconomic framework, as macroeconomic framework, asMonitored Program. assessed by the World Bank and assessed by the World Bank and

the IMF. the IMF.

2. Bank Restructuring andPrivatization2.1 Three Large State Banks

2.1.1 Restructuring of the Carve-out of SklO5 billion in bad loansLarge Banks designed to recapitalize the banks to prudential

levels and restore profitability.

Full transfer of the bad loans to the SlovakConsolidation Agency (SKA) and KonsolidacnaBanka (KOB).

Adoption of State Budget Law for 2001replacing all guaranteed loans from the banks toSKA and KOB by State bonds, and payinginterest due on the guaranteed loans.

Full replacement of guaranteed loans from thebanks to SKA and KOB by State bonds designedto pay interest twice a year, beginning one yearafter issue, and payment of interest due.

2.1.2 Privatization of SLSP Sale of not less than 67% of SLSP's shares tostrategic investor(s).

2.1.3 Privatization of IRB Sale of not less than 67% of IRB'sshares to strategic investor(s), orinitiation of alternative resolutionprocedures.

2.1.4 Pnivatization of VUB Sale of not less that 25% of VUB's shares to Divestiture of State equitymultilateral financial institutions or private holdings in VUB, including sale ofinvestors. at least 67% of VUB's shares to

private strategic investors.

Annex IVPage 2 of 9

Area Board Conditions Second Tranche Third Tranche

2.2 Small and Medium Banks2.2.1 Banka Slovakia Initiation of privatization of Banka Slovakia. Sale of at least 67% of Banka

Slovakia's shares to privatestrategic investors.

2.2.2 Troubled Medium and Final resolution of five troubled small and Full compliance of all banks with Full compliance of all banks withSmall Banks medium banks, through privatization, merger, NBS' prudential regulations, and NBS' prudential regulations.

or removal of license and initiation of initiation of conservatorship orliquidation. liquidation for non-compliant

banks.Adoption of a plan by NBS for resolution of anybank not complying with prudentialrequirements as of 31 December 2000.

3. Bank Regulation andSupervision3.1 Bank Regulation

3.1.1 Constitution, NBS Law Adoption by Parliament of satisfactoryamendments to the Constitution and the NBSLaw that strengthen the supervisory powers ofthe NBS by:* Clarifying the NBS powers to issue binding

regulation;* Eliminating the role of the MOF in bank

supervision;* Strengthening the legal protection for bank

supervisors;* Allowing the NBS to share information

with other supervisory agencies and theDIF.

Annex IVPage 3 of 9

Area Board Conditions Second Tranche Third Tranche

3.1.2 Banking Law Submission to Parliament of a satisfactory new Adoption by Parliament of aBanking Law to strengthen: satisfactory new Banking Law.* Responsibility and accountability of

management and supervisory boards;* Supervisory powers and independence;* Sharing of information among supervisory

bodies;* Special relationships (connected parties);* Affiliate relationships;* Large exposures;* Quarterly financial disclosure;* Regulatory reporting, including, inter alia:

financial statement amendment andredisclosure in the event of mistakes instatements, strengthening of enforcementmeasures and establishment of errormateriality tests;

* Risk management;* Capital adequacy.

3.1.3 Bank Accounting Agreement on critical improvements in bank Enactment of NBS Decreeaccounting to be introduced ahead of the directing the banks to mark toplanned full transition to IAS, including: market the value of their securities* More frequent mark to market valuation of in their quarterly statements,

securities in banks' portfolios; whenever the market value falls* Non-accrual of interest on assets past due below the book value.

90 days or moreCompletion of draft amendments Adoption by Parliament ofto the Accounting Law and other amendments to the Accountingrelevant legislation, introducing Law and other relevant legislation,non-accrual of interest on assets introducing non-accrual of interestpast due 90 days or more. on assets past due 90 days or more.

Annex IVPage 4 of 9

Area Board Conditions Second Tranche Third Tranche

3.1.4 Bank Auditing Submission to Parliament of satisfactory new Adoption by Parliament ofBanking Law that include: satisfactory new Banking Law that* Requirements for greater independence of include:

external auditors vis-a-vis management; * Requirements for greater* Requirements for external auditors to report independence of external

to supervisor violations of law and auditors vis-a-visregulation, and material risk of insolvency. management;

* Requirements for externalauditors to report to supervisorviolations of law andregulation, and material risk ofinsolvency;

Completion of satisfactory draft Adoption by Parliament ofamendments to the Auditing Law satisfactory amendments to theand other relevant legislation that Auditing Law and other relevantinclude: legislation that include:* Introduction of code of * Introduction of code of

conduct for auditors; conduct for auditors;* Stronger licensing and * Stronger licensing and

monitoring responsibilities of monitoring responsibilities ofthe Chamber of Auditors; the Chamber of Auditors;

* Increased auditor liability for * Increased auditor liability fornegligence and misconduct. negligence and misconduct.

3.1.5 Supporting Banking Agreement with the World Bank on the Adoption of the agreed DecreesRegulations necessary Decrees and regulations to support and regulations.

implementation of the new Banking Law.3.1.6 Tax Treatment of Bank Adoption by Parliament of amendments to theReserves and Provisions Law on Tax Treatment of Reserves and

Provisions allowing full tax deductibility ofmandated provisions.

Annex IVPage 5 of 9

Area Board Conditions Second Tranche Third Tranche

3.1.7 Bank Closure and Development of a financing plan to restore the Adoption by the DIF of a Satisfactory progress inDeposit Insurance long-run solvency of the DIF. satisfactory financing plan. implementing the DIF financing

plan.

Completion of draft amendments to the Deposit Submission to Parliament of Adoption by Parliament ofInsurance Act and introduction of provisions in satisfactory amendments to the satisfactory amendments to thethe new Banking Act improving the rules of Deposit Insurance Act. Deposit Insurance Act.conservatorship and deposit insurance,including: Adoption by NBS board of Completion of a study for structural* Introducing co-insurance, by reducing satisfactory conservatorship rules. reform of the DIF comparing the

DIF's payments to 90 percent of amount Slovak system to systems in theabove 5 times the monthly average wage OECD and EU, and drawingwhile capping the overall payout to levels recommendations for structural re-below 20,000 Euro per insured account; design and improvement

* Reducing the maximum period ofconservatorship from 2 years to 1 year;

* Reducing the deadline for submission of theconservator's plan from 60 to 30 days;

* Raising the level of responsibility andliability of the conservator to preserve theassets of the bank without causing furtherliability or revenue loss to the DIF;

* Empowering the NBS to strengthenconservatorship rules and procedures.

3.2 Bank Supervision Adoption by the NBS of a satisfactory concept Adoption by the NBS board of a Satisfactory implementation of thefor the further development of banking detailed plan for the further supervision development plan,supervision. development of banking including satisfactory progress in

supervision based on the adopted implementing the proactiveconcept. approach to bank supervision.

Satisfactory progress in designingthe policies and procedures for aproactive approach to banksupervision.

Annex IVPage 6 of 9

Area Board Conditions Second Tranche Third Tranche

4. Enterprise Restructuring_4.1 Workout of Bad Assets

4.1.1 Establishment of the Enactment of Government Decree establishingSlovak Consolidation Agency the SKA as an autonomous workout agency with(SK4) the mandate to sell bad assets and outsource

management of bad assets to the private sector.4.1.2 SKA Governance Adoption of statutes and bylaws of tlhe SKA

defining roles and responsibilities of boards andensuring operational independence of the agency

4.1.3 SKA Budget and Adoption of measures ensuring the operationalOperations efficiency of the SKA, including:

* Approval of an adequate budget for 2001* Completion of hiring of staff* Transfer of title to all loans carved-out and

transferred to SKA.4.1.4 Consolidation Bank Adoption of a satisfactory plan to remove Removal of KOB's license and(KOB) KOB's license and to transfer its distressed transfer of its distressed assets to

assets to SKA. SKA.4.1.5 Resolution of Bad Assets Sale to the private sector or outsourcing to the Sale to the private sector or Sale to the private sector or

private sector through open tenders, or writing outsourcing to the private sector outsourcing to the private sectoroff assets after satisfactory due diligence, of not through open tenders, or writing through open tenders, or writing offless than 10 percent of the nominal value of off assets after satisfactory due assets after satisfactory dueSKA assets. diligence, of not less than 30 diligence, of not less than 50

percent of the nominal value of percent of the nominal value ofSKA assets. SKA assets. Satisfactory progress

in preparing transactions to disposeof a further 20 percent of SKA'sassets by December 2002.

4.1.6 Tax Treatment of Submission to Parliament of Adoption by Parliament of changesRestructuring Operations changes in tax rules allowing in tax rules allowing proper tax

proper tax treatment of debt write- treatment of debt write-offs andoffs and debtlequity swaps. debt/equity swaps.

4.1.7 Resolution of Tax Submission to Parliament of a Adoption by Parliament of aArrears special law allowing the resolution special law allowing the resolution

of tax and public fund arrears of tax and public fund arrearsincluding provisions allowing including provisions allowingforgiveness, compromise, third forgiveness, compromise, thirdparty management of claims, and party management of claims, andsale at a discount. sale at a discount.

Annex IVPage 7 of 9

Area Board Conditions Second Tranche Third Tranche

4.2 Legal framework forEnterprise Restructuring.

4.2.1 Improving the Adoption by Parliament of amendments to the Elaboration by the Commission ofInsolvency Regime Bankruptcy Law, designed to improve initiation an assessment of effectiveness of

rules, strengthen creditor rights, introduce time- recent amendments to Bankruptcybound procedures, and improving incentives for Law.trustees.Establishment by the Government of a Elaboration of report by Preparation of initial draft of newsatisfactory inter-agency Commission comprised Commissiono including: insolvency legislation.of public and private sector representatives with Commisio,ficuin ioey slomandate to: * Identification of core* Identify criteria for modernized insolvency modernizing insolvency law

law harmonized with legal and commercial based on the Government'sframeworks; assessment and on best

* Assess needs for improving institutional and international practices asregulatory insolvency frameworks; discussed in World Bank's

* Make recommendations for comprehensive final report on Principles andsystem improvements; Guidelines for Effective

* Liaise with consultants working on draft Insolvency Systems.amendments pertaining to legal, * Recommendations forinstitutional and regulatory framework strengthening institutionaldesigns. capacity, increasing

transparency, accountability,and efficiency of proceduresgoverning court operations.

* Identification and engagementof drafting team forpreparation of new insolvencylegislation, including efficientliquidation procedures andeffective reorganization track.

Annex IVPage 8 of 9

Area Board Conditions Second Tranche Third Tranche

Agreement on main components of an eftective Enactment of Decree introducing Adoption by Government of aregulatory framework for insolvency system, to iquidats to tregulatin concept of a comprehensiveform the basis of a study to be completed by liquidators and trustees, including regulatory framework for effectiveindependent consultants assessing regulatory the setting minimum insolvency system, and contamuingneeds and recommending proposals for creation setting of minimum standards for satisfactory timeframe forof regulatory framework; including: pessional conduct, s submission to Parliament of* Identification and establishment of a professional conduct. necessary legislation. The

regulatory authority; regulatory framework shall* Minimum education and qualification establish a supervisory authority

standards for professionals suitable to with full oversight responsibilitycomplexity of cases undertaken; for:

* Certification, training and supervisory * Licensing liquidators andstandards and procedures trustees and regulating and

supervising their work;* Setting and enforcing

professional standards for theadministration of insolvencyproceedings;

* Maintaining a publiclyaccessible record ofbankruptcy and insolvencyproceedings;

* Recording and investigatingcomplaints regarding wrongdoing by liquidators andadministrators;

* Appointment of interimliquidators and trustees.

Annex IVPage 9 of 9

Area Board Conditions Second Tranche Third Tranche

4.2.2 Improving the Collateral Adoption by Government of a concept of Completion of satisfactory draft Adoption by Parliament ofRegime comprehensive reform of the collateral regime amendments to the laws regulating satisfactory amendments to the

consistent with EBRD's core principles for collateral including resolution of laws regulating collateral.secured transactions, including: the issue of priority of tax liens.* Introduction of concept of non-possessory

pledge in movable assets;* Establishment of a registry for pledges in

movable assets;* Effective non-judicial procedures for

enforcement of collateral rights (includingPublic Auction Law);

* Mechanism for resolving the issue ofpriority of tax liens.

4.2.3 Improving the Legal Completion of initial draft of new Securities Submission to Parliament of a Adoption by Parliament of aFramework for Corporate Law designed to improve the governance of satisfactory new Securities Law. satisfactory new Securities Law.Governance publicly traded companies by introducing or

improving: Adoption by Parliament of new law* Disclosure requirements; to strengthen the legal, budgetary,* Insider trading rules; and operational autonomy of the* Regulation of dealers and brokers; securities and insurance markets* Securities Registrar. regulator.

Completion of draft amendments to the Submission to Parliament of Adoption by Parliament ofCommercial Code designed to enhance satisfactory amendments to the satisfactory amendments to thecorporate governance by introducing or Commercial Code. Commercial Code.improving:* Board liability provisions;* Regulation of mergers and takeovers;* Minority shareholder protection rules;* Introduction of shareholder legal action.

Annex VPage 1 of 9

SLOVAKIA - Enterprise and Financial Sector Adjustment LoanSupervisory Development Concept

Function Current Situation Recommended Action Output and TA Needs

1. Long Term Goals: Currently, limited long term Given the rapidly evolving nature of the banking Prepare and adopt a multi-year plan to furtherMulti-Year Plan planning is conducted with a sector, increasing domestic and international banking develop supervisory process to become a effective

view toward: competition, and Slovakia's future accession into the functioning member of the international community* the future role NBS bank EU, a global vision as to where banking supervision of bank supervisors. Ensure that bank supervision

supervision will play in would like to see its accomplishments, operating envisions its role as a global financial sectorthe international capacity, and its impact on banking sector condition participant is clearly outlined, committing tocommunity of bank should be developed. Intended future compliance raising standards and procedures to ansupervisors, with international supervisory standards should be at international, best practice level (BIS, EU, OECD).

* where bank supervision the core of the vision. This projection or vision should be prioritized andwould like to see its own carried through to the mission statement, operatingdevelopment, policies and procedures, and the practical

* and the development and implementation of the new supervisory approach.condition of the domesticbanking sector. Drafting of vision document by Supervision

department of NBS, with inputs from bankingsector, external auditors, and internationalcounterparts as available.

2. Plan to Achieve While much of the legal Design additional development steps necessary to Additional elements developed and added to theCompliance with Core framework exists to facilitate achieve compliance with international best Supervisory Development Plan by senior andPrinciples bank supervision, it requires supervisory practices as outlined in the Core executive supervisory management, with inputfrom

additional enhancement. Principles Assessment. Design and implement a plan international supervisory advisor. Approved bySimilarly, supervisory practice to keep abreast of current and developing best NBS Board. Interface with other authorities asand use of the existing legal practices and international norms, with a process necessary.tools require continued established to implement them as they becomeenhancement. applicable to NBS bank supervision.

Annex VPage 2 of 9

Function Current Situation Recommended Action

3. Mission statement The role and function banking Establish a mission statement for banking Drafting of mission statement by Supervisionsupervision plays in the supervision. The mission statement should department of NBS, with inputs from bankingfinancial sector is not emphasize that supervision will: sector, external auditors, and internationalsufficiently clear and counterparts as available.adequately communicated to * Ensure the safety and soundness of thethe sector, the public and the banking system; Approval of mission statement by NBS Board,authorities. * Protect the depositor and the public endorsement by the Government, and publishing of

investment in the system; statement by NBS.* Improve fair access to credit and

consumer protection.

The mission statement should convey the decliningrole of Government as shareholder in the system andas an involved party in banking supervision,emphasize the need to enhance the role of corporategovernance in the banks, and the role of thesupervision in this new market setting.

Set an annual review process for the NBS Board toreview objectives and supervisory strategy. Missionstatement should essentially remain the same,forming the bedrock for direction.

4. Independence During the period of bank Together with establishing the role of supervision, Agreement, reviewed and approved by NBS Boardprivatization, State interests in enter into written agreements with Government and Government.

4. a. Transitional banking sector will continue bodies influencing or participating in supervisoryarrangements during to create an inherent conflict oversight. Specifically detail what their role is, whenthe pre-privatization in executing supervisory it is triggered, what form of decision making orperiod duties. influence it will have, what the accountabilities are,

I and documentation of such decisions.

Annex VPage 3 of 9

Function Current Situation Recommended Action

4. b. Supervisory The Supervisor has no Explore means through which the Supervisor may Report on the means through which the SupervisorInterpretation of Law authority to issue provide interpretations of regulation. This may might issue interpretations of law and decrees.

interpretations of law. Given involve further issuance of "Recommendations"the strict codification of the similar to the one recently circulated on money List of existing issues which would benefit fromlegal system and the manner laundering. "Recommendations" issued by the NBS Board.in which the Supervisorinterprets the law, itdemonstrates reluctance toexpand the interpretation ofthe law and to subsequentlyapply it.

4. c. Budget and Resources are inadequate to a. Estimate staffing requirements based on new Comparative industry study, plan to raise salaryResources assure effective supervisory mission statement and on new bank supervisory and departmental budget to levels commensurate

oversight, including onsite strategies. Include staffing needs for specialist areas with industry and adequate enough to attractreviews, specialist support (bank insider activity, fraud, market risk and model qualified people.staff, and external auditors. reviews) and consider greater use of external audit.

Develop timeframes for presentation to theb. Conduct an industry survey, including private responsible authorities and their approval.banks and other bank supervisors in other countries.Compare current grade levels and salaries to those of Review and approval by NBS Board,others. Design a program to address divergence.

c. Based on current estimated expenditures, on theresources needed to fulfill the supervisory strategy(overall and bank specific), and on additionalfinancial resources needed for personnel, develop abudget. Review and evaluate budget with authoritiesand develop a plan for resource augmentation.

4. d. Code of Conduct Currently there is no specific, Prepare a code of conduct which clearly outlines the Code of Conduct, developed by senior supervisorywritten code of conduct for expected behavior of supervisors and executive management with the input of senior internationalbank supervisors and management. This would include addressing supervisory advisors. Reviewed and adopted by theexecutive management. potential conflicts of interests by inter alia, disclosing NBS Board.

financial interests and relationships with banks, andprohibiting staff and executive management fromowning shares in supervised entities and receivinggifts from banks. Bank supervisors' code should be

_______________ _______________ in addition to the existing NBS documents.

Annex VPage 4 of 9

Function Current Situation Recommended Action

5. Supervision Currently, supervision is a) Prepare a new working procedure on howFunction heavily driven by the offsite supervision will be conducted. Establish supervisory New supervisory procedures prepared by

monitoring process. Onsite strategies, supervisory cycles, minimum requirements supervisory staff with inputs from international5. a. Adoption of function operates primarily as and events which must be met each cycle (ex: senior supervisory experts.proactive approach a detection and verification quarterly communication with executive

function to verify bank data management; biannual communication withand condition. This results in supervisory board; complex examination each cycle Approval of document by NBS Board.more of a crisis mode as scoped according to risk profile).exams are typically initiatedafter a bank has begun to b) Strategies must be decided and approved jointlydeteriorate. Inadequate by onsite and offsite departments and CED.staffing as well as the currentsupervisory mode also c) Dedicate an onsite examiner to each bank,restricts a more proactive responsible for jointly crafting supervisory strategyapproach. with offsite and periodically reviewing condition and

providing supervisory follow-up.A revised and new proactiveapproach, consistent with the d) Establish internal procedures which direct certainguidelines herein, should be supervisory responses based on condition of eachprepared and adopted with the bank. Document procedures and document thegoal, also, to improve the supervisory response taken with each institution.internal governance of Create a history of supervision for each bank.banking supervision(management oversight, e) As a part of new procedure, set approval anddirection, accountability, and documentation standards for strategies and for all keydocumentation). decisions taken therein. Document supervisory

strategy decisions and recommendations not taken oroverturned (including onsite reviews,communications with boards and bank management,corrective action requests, remedial actionsrecommended (penalties, removals, etc).

Annex VPage 5 of 9

Function Current Situation Recommended Action Function

5. b. Implementation of a) Update evaluation of status, condition, risks, For each bank:new proactive rating, and corrective action plans for each bank. * assessment of condition, management, level ofapproach Endorse or change the risk rating to reflect the oversight provided by the owners and

current risk profile under the new supervisory supervisory board, internal risk managementprocedure. systems and controls, etc.

* Change or endorse bank risk rating.b) Stratify each bank according to risk level and * Supervisory strategy to ensure effectivepriority for supervisory oversight. Include in the ongoing oversight of institution, set in terms ofreview the 3 largest banks in the restructuring a time bound, supervisory cycle.program and the medium sized banks in government * Corrective action plan as needed.hands. * Contact supervisory boards and executive

management to formalize strategic plans andc) Prepare and document supervisory strategy for to formalize corrective action plans.ongoing monitoring and for onsite reviews for each Corrective action plans should be agreed tobank. and signed by supervisory board and executive

d) Review current corrective action program in place management.(or not) for each bank. Improve existing programs Requires inputs from international seniorwhere necessary. supervisory advisors. Approval by NBS senior &

executive management and review by NBS Board.

Annex VPage 6 of 9

Function Current Situation Recommended Action

5. c. Use of Remedial Current situation is a) See the Regulatory Matrix for recommendations Elaboration of new remedial procedure with inputsAction Tools and characterized by lack of on legal enforcement powers. from international senior supervisory experts.Corrective Action Plans prompt enforcement, Approval by NBS Board.

sometimes due to lack of b) Develop a remedial action procedure. Establishenforcement powers, triggers for various supervisory responses andsometimes due to supervisory actions. Develop templates for use in problem bankreluctance to use available situations in drafting agreements with banks.tools.

c) Revise and upgrade the current rating system toA more defined, methodical, communicate true levels of risk and concern and toand documented approach to trigger supervisory response. In cases where a bankmanagement decision making is rated 3 or worse, require supervisory response.should be established and Require ratings, along with supervisory strategies, toadopted, with the goal of be assigned jointly by on and off site staff.delivering more consistent andtransparent supervision to the d) Develop requirements for bank response tobanking industry and of remedial actions.improving the internalgovernance of bank e) Require periodic onsite review of remedial actionsupervision. program for the subject bank.

f) Establish documentation requirements. In caseswhere supervisory response is required by procedurebut not taken, require documentation in the databasesystem - in the condition and supervisory strategy,indicating approving management.

5. d. Enhance Internal Communication between Ensure that newly drafted supervisory policies are As a part of the new supervisory approach,Communications supervisory departments can designed to maximize internal communication among develop procedure for internal communications. .

be improved; certain supervisory staff and with management.information is not shared,making seamless supervision Develop internal policies and procedures detailingmore difficult. decision making responsibilities. Delegate decision

making responsibilities to the most effective level.Allow adequate access to developed databases(supervisory database recommended below and credit

I register) as needed.

Annex VPage 7 of 9

Function Current Situation Recommended Action Function

5. e. Enhance External Regular communications with a) As a part of the new supervisory strategy process Develop a procedure section specificallyCommunications with industry, through ongoing and procedure, require minimum communications addressing the nature andfrequency ofthe Banking Sector supervision and onsite with bank management and supervisory boards (4 communication with bank management and

examinations, are not well and 2 times a year, respectively). Regular supervisory boards.established. communications should include representatives from

on and offsite functions as well as management. Prepare a draft quarterly report to the bankingAllow supervisory staff to communicate with industry.management as necessary, coordinated throughassigned individuals (i.e. those responsible or Procedure and report to be approved by NBSassigned to the bank). Board.

b) Develop a template for a quarterly reportingprocess to banking industry, prepared by theSupervision Dept. Report should outline significantchanges in the banking sector over the last quarter,summary of remedial actions, and summary oflegislative and supervisory policy changes.

5. f. Ability of The ability of the supervisor to Evaluate the current examination and offsite Develop program to enhance analytical capacity inSupervisor to adopt assess and prioritize bank procedures used to identify areas of greatest bank key risk areas.. Include revisions to examinationproactive approach risks will become increasingly risk. Include a review of detailed procedures, use of and offsite reporting as necessary. Provide(supervision by risk) critical. the procedures, and the overall existing skill base to estimated timeframes and budget.

analyze such.Requires input from international senior

Recommend key supervisory steps to enhance the supervisory advisors together with supervisory staffoversight of bank's required "core processes" and selected to support effort. Senior and executivedevelop proposal to achieve improvement. management responsible for reviewing and

approving plan.5. g. Licensing The licensing and approval Review the licensing and application process. Refer Draft procedures which augment the existingEvaluation requirements are generally to Core Principle # 2 for expanded observations. process; make necessary recommendations for

comprehensive. There is a Recommend additional procedures to support legal changes to support process.need to provide additional evaluation of owners, management, acquisitions, andsupport when evaluating the the integrity and source of capital funds. Requires input from international senior"qualitative" aspects of supervisory advisors together with support frommanagement, owners, and licensing staff. Senior and executive managementrisks presented by affiliate responsible for review and approval. Approval by

I acquisitions. NBS Board.

Annex VPage 8 of 9

Function Current Situation Recommended Action Function

5. h. "Connected The relationships of bank Expanded requirements for connected parties and Prepare changes to procedures (on and off site)Parties" (insiders): connected parties and their their interests have been listed in the Regulatory and law where necessary.Supervisory Oversight related interests can pose Matrix.and Monitoring potential significant risk to the Requires input from international senior

banking sector. Develop additional procedures to enhance the manner supervisory advisors and support from supervisoryin which both the onsite and the offsite functions staff. Senior and executive supervisoryidentify, evaluate, and monitor insider activities. management responsible for review and approval.

Approval by NBS Board.S. i. Referrals of As a part of the onsite review Develop procedures for the identification, Draft changes to internal processing of potential"Suspicious Activity" process, referrals are made to documentation, and referral process of suspicious financial crimes referrals to financial police.to Financial Police financial police when activity to the financial police.

determined necessary. The Requires input from international senioridentification, documentation supervisory advisors and support from supervisoryand approval requirements for staff. Senior and executive supervisorysuch referrals are not well management approval. Approval by NBS Board.established.

6. Development of A good analytical database Develop the necessary information base necessary to Design of system template, proposal and budgetBank Information Base currently exists. However, house bank specific details: ownership, related for development.

bank specific information base interests, condition, ratings, supervisory strategy,is largely manual. A quarterly updates, communications, applications, Requires input from senior supervisory specialistssystematic and computerized approvals, and management decisions. Ensure with experience in such systems, and technicalsystem would enhance adequate access by all supervisory staff as needed. systems development support.information tracking, Ongoing oversight, review, and approval bydocumentation, and internal supervisory management. Approval by NBS Board.information access.

7. Regulatory The evolving nature of bank Conduct a review of the number and type of Design of new regulatory reports, includingReporting activities requires adequate regulatory reports received by the Supervisor. consolidated company formats. Prepare

reporting to detect and Determine if they provide the right types of accounting changes to reports as necessary.monitor changing risk information to allow for effective evaluation of risk.profiles. Consolidated bank Develop additional reporting requirements for Requires input from international supervisoryregulatory reporting will consolidated companies. advisors together with supervisory staff andbecome increasingly critical. accounting support. Review and approval by senior

and executive supervisory management. Approvalby NBS Board and other appropriate authorities asnecessary.

Annex VPage 9 of 9

Function Current Situation Recommended Action

8. Human Resources & Personnel resource is a) Structure a methodical developmental program for Personnel policy detailing developmentTraining inadequate to effectively incoming staff and for ongoing skills development. requirements for incoming, junior, and more senior

support supervisory Include a system of job rotation (across departments), staff Schedule and projected budget of proposedobjectives. Additional external and internal training, and certifications external training. Template of a qualifications testtraining and career testing. Ensure adequate training in developing to be taken by staff with approximately 3 - 4 yearsdevelopment is needed by all market trends. Consider possibility of "seconding" of experience.supervisory staff. selected staff to other supervisors.

Plan for increased human resource supportSupervision staffing is b) Develop a plan for a human resources function dedicated specifically to supervision.administered by the NBS dedicated specifically to supervision.. Includepersonnel department which adequate human resource staffing to adequately Requires input from senior internationalmay not be adequate to administer supervision specific requirements. individuals with experience in supervision and insupport specific supervisory human resource development. Review andneeds. approval by NBS senior and executive supervisory

____________________ _____ _management. Approval by NBS Board.

Annex VIPage 1 of 4

Project Information Document

Country Name: Slovak Republic

Project Name: Enterprise and Financial Sector Adjustment Loan

Region: Europe and Central Asia Region

Sector: Private and Financial Sectors

Project ID: PE-P064542-LEN

Borrower: Ministry of Finance

Implementing Agency: Ministry of FinanceCoordination Unit for Bank and Enterprise PrivatizationStefanovicova 5P.O. Box 8281742, Bratislava, Slovakia

Tel: (421-7) 5958-2033Fax: (421-7) 5958-2032

Environment Category: C

Date This PID Prepared: July 2, 2001

Projected Appraisal Date: March 20, 2001

Projected Board Date: August 2, 2001

Countiy and Sector Background

1. The Government of Slovakia that took office in October 1998 inherited aneconomy in critical conditions. Macroeconomic imbalances were very large, as indicatedby current account deficits of more then 10% of GDP, and structural reforms were largelyunfinished, as indicated by large enterprise losses (more then 9% of GDP), and extremelylarge volumes of non-performing loans in the major banks (around 27% of GDP). Theeconomy had grown by 6% p.a. in the mid-1990s, but these growth rates were notsustainable, as they were achieved through massive foreign borrowings and were notunderpinned by deep structural reforms. There is a risk that the economy will enter aphase of stagnation.

2. The new Government has demonstrated its willingness to take the challenge ofrestoring macroeconomic stability and preventing a balance of payments crisis, while also

Annex VIPage 2 of 4

sustaining growth in the long-run. In May 1999, the Government introduced a packageof stabilization measures that was able to reduce macroeconomic imbalances andstabilize Slovak koruna. The new Government started to implement an agenda ofstructural reforms, which is concentrated in a comprehensive program of bank andenterprise reforms, and that also includes a program of pension and health reforms, publicadministration reforms, and an anti-corruption program.

3. In early 1999, the Government requested support from the Bank in designing andimplementing its ambitious reform program through an Enterprise and Financial SectorAdjustment Loan (EFSAL).

4. The objective of the program is to establish sound microeconomic foundations forthe Slovak economy and open room for a resumption of sustained growth in the nearfuture. The restructuring program would contain four broad components: (i) restructuringand privatization of the banking system, centered on the three large troubled banks; (ii)strengthening of banking regulation and supervision; (iii) designing and implementationof a strategy to workout the large stock of classified claims; and (iv) the improvement inthe legal framework centered on the bankruptcy and collateral regimes, and the lawsdealing with corporate governance.

The Proposed Loan

5. The EFSAL plays a central role in the World Bank's program in Slovakia. TheGovernment and the Bank have agreed on a loan amount of Euro 200 million whichwould help the Government finance the fiscal costs of bank restructuring in the first twoyears of the program implementation.

6. Conditions for Board presentation include: (i) the recapitalization of the threelarge banks, designed to restore stability in the financial sector and reduce the risk of abanking crisis; conclusion of the privatization of at least one of the large banks;substantial progress in privatizing the other two large banks; substantial progress inresolving troubled small and medium banks; (ii) submission of new Banking Law toParliament with contents reviewed and agreed by the Bank, agreement on an institutionaldevelopment program for bank supervision; (iii) Approval by the Government of a fulland coherent strategy for the workout of bad loans; the establishment of an agencydesigned to coordinate the various workout components; and initial implementation ofthe workout strategy; (iv) substantial progress in legal reforms, including passage byParliament of improvements in the bankruptcy law; improvements in the relevant taxlaws, and agreement of improvements in the commercial code and the securities law.

7. Conditions for second tranche release include: (i) successful privatization of thetwo remaining large banks; resolution of all troubled small and medium banks; (ii)submission of amendments to the deposit insurance law; progress in implementing thesupervision development plan; (iii) substantial progress in working out a significant shareof the stock of bad loans; (iv) enactment of Decree improving the regulatory frameworkfor the bankruptcy system; submission to Parliament of amendments to the commercialcode and the securities law.

Annex VIPage 3 of 4

8. Conditions for third tranche release include: (i) substantial progress inimplementing the supervision development plan; (ii) substantial progress inimplementing the workout of bad assets; (iii) adoption of amendments to the commercialcode and the securities law, and drafting of a new insolvency law containing functionalreorganization track.

Implementation

9. The proposed EFSAL, financed by the IBRD, would be implemented by theMinistry of Finance of Slovakia. The tentative Loan amount is Euro 200 million. TheLoan funds will be released in three tranches of Euro 60 million, Euro 70 million andEuro 70 million, respectively, following Board presentation and upon fulfillment ofspecific tranche release conditions thereafter. The State Secretary of Finance has beenappointed chairman and an advisor to the Minister of Finance has been appointed as theEFSAL Program Manager who will ensure overall project coordination among allagencies involved in the design and implementation of the reform program.

10. The program is coordinated with other donors and international organizations,particularly IMF, EU-PHARE, DIFID and USAID. MoF officials and donors meetregularly to ensure appropriate coordination.

Poverty Category

11. Not Applicable

Environmental Aspects

12. Category C.

Project Benefits and Risks

13. The reform actions sought under EFSAL would encourage private and financialsector development by accelerating reform in key structural areas. The Government'sreform action will help improve the stability and efficiency of the banking system;promote enterprise restructuring through the workout of bad assets and the improvementsin the legal framework; and attract foreign investment.

14. The risks to the proposed EFSAL arise mostly from the political situation. Thebroad coalition could interrupt the implementation of some components if faced withadverse short-run effects of the reform, such as unemployment or a very low price for thebad assets. However, this risk seems to be modest, given the advanced stage of thereforms.

Annex VIPage 4 of 4

Contact Points:

Hormoz Aghdaey, ECSPF Roberto Rocha, ECSPFThe World Bank The World Bank1818 H Street N.W. 1818 H Street N.W.Washington, DC 20433 Washington, DC 20433Telephone No.: (202) 473-2688 (202) 473-0689Fax No.: (202) 522-0005 (202) 522-0005

Note: This is information on an evolving project. Certain components may notnecessarily be included in the final project.

Annex vii

Pagel1of 2

j!'j

i 1 21 t ~~~~~~~i t

I Z 8 8 9 R _ 8 I ! 7 t1 } 81 1 i g | ffi

Annex VIIPage 2 of 2

CAS Annex B8 (IFC) for Slovak Republic

Slovak RepublicStatement of IFC's

Held and Disbursed PortfolioAs of 12/31/2000

(In US Dollars Millions)

Held Disbursed

FY Approval Company Loan Equity Quasi Partic Loan Equity Quasi Partic1998100 SEF Scame Tatra 1.4 0 0 0 1.4 0 0 0

1999 SEF West Exp-Imp 1.76 0 0 0 1.76 0 0 0

Total Portfolio: 3.16 0 0 0 3.16 0 0 0

Approvals Pending CommitmentLoan Equity Quasi Partic

2000 Ruzomberok 0 0 0 02000 Ruzomberok BLINC 0 0 0 02001 VUB 0 50000 0 0

Total Pending Commitment: 0 50000 0 0

Annex VIII

Slovak Republic at a glance 9/12000 Page I of 2

Europe & Upper-POVERTY and SOCIAL Slovak Central middle-

Republic Asia Incomne Developmnent diamond

Population, mid-year (millions) 5.4 475 573 Life expectancyGNP per capita (Arias method, USS) 3,590 2.150 4.900GNP (Atlas method, USS billions) 19.4 1,022 2,811

Average annual growth, 1993-99

Population (%) 0.2 0.1 1.4 Labor force (%) 0.9 0.6 2.1 GNP Gross

per primaryMost recent estinate (latest year available, 1993-99) capita enrollment

Poverty (% of population below national poverty line; IUrban populabtion (% of total population) 57 67 76Life expectancy at birth (years) 73 69 70Infant mortality (per 1,000 live births) 9 22 27Child malnutrition (% of children under 5) 8 7 Access to safe waterAccess to improved water source (% of population) 78Illiteracy (% ot populatif? age 15#) ,, 3 10 SvRplGross primary enrollment (% of school-age population) 102 100 109 SlovakRepublic

Male 102 101 - Upper-middle-incomegroupFemale 102 99

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1979 1989 1998 1999Economic ratios

GOP (US$ billions; 17.8 20.4 188Gross domestc investment/GDP 31.8 39.4 33.8 TrdExports of goods and services/GDP 28.8 63.7 64.8 radeGross domestic savings/GDP 28.5 28.2 28.7Gross natbnal savings/GDP 29.3 28.0 ICurrent account balance/GDP -10.4 -5 7 Domestic Interest payments/GDP 0.6 2.6 2 3 InvestmentTotal debtGDP 10.3 58.5 55.6 Savings -

Total debt service/exports 13.9 13.6Present value of debt/GDP 44.9Present value of debtlexports 68.0

Indebtedness1979-89 1989-99 1"98 1999 1999403

(average annual growth)GDP 2.7 0.9 4.4 1.9 3.9 Slovak RepublicGNP per capita 2.2 0.6 4.1 1.0 U Upper-middle-income groupExports of goods and services 11.3 10.8 7.0 9.2 2

STRUCTURE of the ECONOMY1979 1989 1998 1999 Growth of Investment and GOP (%)

(% of GDP) eoAgriculture 9.4 4.4Industry 58.5 31.6 40

Manufacturing 23.2 20 -Services 32.2 64.0 0_

Private consumption 49.9 50.6 51.1 -20 _ 9 9r 97 98General government consumption 21.6 21.2 20.2 GDI S GDPImports of goods and services 32.1 74.8 69.9 1

(average annual growth) 1979-89 1989-99 1998 1999 Growth of exports and Imports (%)

Agriculture -1.6 -1.0 30Industry -6.6 -0.3 20

ManufacturingServices 7.6 7.5 1C

Private consumption -1.1 5.0 0.5 oGeneral government consumption 1.3 3.5 0.3 9s 96 97 MGross domestic investrnent 2.4 3.4 -13.7 - oImports of goods and services 8.3 9.6 -2.5 axporla : mportsGross national product 2.7 0.8 4.2 1.1

Note: 1999 data are preliminary estimates.

The diamonds show four key indicators in the country (in bold) compared with its income-group average, It data are missing, the diamond willbe incomplete

Annex VillPage 2 of 2

Slovak Repiblic

PRICES and GOVERNMENT FINANCE1979 1989 1998 1999 Inflation (%)

Domestic prices s(". change) TCorsumer prices 6 7 10 6 20Implicit GDP deflator 2 8 51 6 6

Government finance(% of GOP, includes current grains) oCurrent revenue 42 4 43 1 9. 9s 96 97 so 99

Current budget balance 1.6 3 4 -GOPcdeflator C wOverall surplusadeticil -50 -3 6 _ _ __ _ _ _ _ _

TRADETRASE millions)1979 1989 1998 1999 Export and import levels (USS mill.)(USS millions;

Totaliexports (lob 10,667 10,197 sooo

na.

Manufactures 8,535 8,130 10x 0 Total imports (c0: 19 11ol00

Food 1.41 1,301 00

Fuel and energy 1,419 1,301

Capital goods IIa

Exporl price index (1995=100) .. .. .. ..

Import price index (1995=100) .. Exports M IriportsTerms of trade (1995=100) . . .. .

BALANCE of PAYMENTS1979 1989 1998 1999 Current account balance to GOP (%)

(UJSS milfions;Exports of goods and services 13,015 12,191Imports of goods and services 15,348 13,145Resource balance -2,333 -954

Net income -157 -3029 5

Net current transfers 367 173

Current account balance -2,124 -1,083

Financing items (net) 1,641 1,550 " '

Changes in net reserves 483 -467 - z

Memo:Reserves including gold (US$ millions; 2,923 3,283Conversion rate DEC. focalJUS$) . 5 ' 35.2 41 4

EXTERNAL DEBT and RESOURCE FLOWS1979 1989 1998 1999

(USS millions; Composition of 1998 debt (US$ mill.)Total debt outstanding and disbursed 1,827 11,903 10,473

IBRD 0 239 226 2nIDA 0 0 0 1S

Total debt service 505 1,867 1,693tERO 0 31 34 4605 _

IDA 0 0 0

Composition of net resource flow3Official grants 52 .

Official creditors -13 .. 669.52

Private creditors -28Foreign direct investment 562 701Portfolio equity 0 624

World Bank programCommitments °0 0 0 A - IBRD E - ilateralDisbursements 0 15 3 8 --IDA 0 Other mIitateral F-PnvatePrincipalrepayments -- 0 1 7 20 C -IMF 0-Short-termNet flows 0 -2 -17 _ s

Interest payments 0 14 14Net transfers 0 -16 -31

Development Economics 9/1 22000