GOOD PRACTICE NOTE ADDRESSING FINANCIAL MANAGEMENT ISSUES IN DEVELOPMENT POLICY LENDING. Financial Management Sector Board

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1 GOOD PRACTICE NOTE ADDRESSING FINANCIAL MANAGEMENT ISSUES IN DEVELOPMENT POLICY LENDING Financial Management Sector Board October 2010

2 ABBREVIATIONS AND ACRONYMS CFAA DPO FM FMS IBRD ICR IDA IMF OP PEFA PFM Country Financial Accountability Assessment Development policy operation Financial management Financial management specialist International Bank for Reconstruction and Development Implementation Completion and Results Report International Development Association International Monetary Fund Operational Policy (statement) Public Expenditure and Financial Accountability Public financial management This Good Practice Note represents an update of the original GPN issued in 2005 in conjunction with Operational Policy/Bank Procedure 8.60, Development Policy Lending. This update reflects emerging lessons of experience and current guidance to staff on the preparation of development policy operations and is neither mandatory nor operational policy. For further updates and other Good Practice Notes, access the Operations Policy and Country Services (OPCS) website under development policy lending or contact the Country Economics Unit in OPCS.

3 ADDRESSING FINANCIAL MANAGEMENT ISSUES IN DEVELOPMENT POLICY LENDING CONTENTS I. Introduction... 1 II. Financial Management in Development Policy Operations... 1 A. Review of the PFM System... 2 B. Funds Flow Arrangements... 5 III. Documentation of Financial Management Issues... 9 A. Description of the PFM Program Content... 9 B. Description of Fiduciary Arrangements IV. Negotiations, Supervision, Monitoring, and Evaluation Box and Figure Box 1. Prior Actions, Triggers, and Tranche Release Conditions in DPOs... 3 Figure 1. Typical Funds Flow... 6 Annexes Annex A. Financial Management Issues in Subnational DPOs Annex B. Financial Management Issues in Sectoral DPOs Annex C. Additional Arrangements Annex D. Sample Confirmation of Loan Proceeds Deposit and Credit Annex E. Sample Terms of Reference for Audit of the Dedicated Account... 25

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5 ADDRESSING FINANCIAL MANAGEMENT ISSUES IN DEVELOPMENT POLICY LENDING I. INTRODUCTION 1. Development policy lending is rapidly disbursing policy-based financing, which the World Bank 1 provides to help a borrower address actual or anticipated financing requirements for designing and implementing its medium-term development policy agenda. The Bank may provide development policy lending to a member country or to a subnational division of a member country. The key features of development policy lending are described in Operational Policy (OP) 8.60, Development Policy Lending. 2. Purpose of this Note. This good practice note is intended to assist task teams and financial management specialists (FMSs) to address financial management (FM) issues in development policy lending. The framework for the Bank s fiduciary policies in development policy operations (DPOs) recognizes the need for professional judgment in each individual case; this note is intended to assist, not replace, that judgment. In this context, staff working on development policy lending should be fully conversant with the Bank s operational policies and procedures relating to development policy lending. 2 This note is updated periodically to reflect the lessons of experience. 3. Structure of this Note. Following this introduction, Section II discusses the main FM issues in DPOs and how they should be addressed, Section III explains how to document these issues, and Section IV deals with supervising, monitoring, and evaluating them. Annexes A and B present specific considerations regarding FM issues in subnational and sectoral operations, and Annexes C, D, and E provide supplementary information and sample documents. II. FINANCIAL MANAGEMENT IN DEVELOPMENT POLICY OPERATIONS 4. Financial management in DPOs focuses on two major areas: The country s public financial management (PFM) system. The Bank seeks reasonable assurance that the country s PFM system can and does manage the country s budget resources appropriately. Bank reviews in this area inform Bank staff s judgments on the adequacy of the PFM system and, when the DPO will support PFM actions, on the PFM program design and reforms to support the operation. 1 2 World Bank includes IBRD and IDA, loans includes credits and IDA grants, borrower includes IDA grant recipient, and subnational divisions refers to states or provinces. Refer to OP 8.60 and BP 8.60, Development Policy Lending. For additional guidance, refer to Good Practice Note 1 Designing Development Policy Operations. Good practice FM examples are also provided at the DPL Good Practice Database (work-in-progress), hereafter referred to as the FM DPL Good Practice Database.

6 2 Funds flow arrangements. These arrangements need to ensure that the loan proceeds will reach the country s official foreign exchange reserves and are on-budget (i.e., included in government budget estimates, in-year execution reports, and year-end financial statements). The Bank also obtains reasonable assurance regarding the foreign exchange control environment in which the DPO loan proceeds are deposited. The Bank s review informs fiduciary judgments on the adequacy of the funds flow arrangements and, as appropriate, on risk mitigation measures. A. Review of the PFM System 1. Analytic Underpinnings 5. All DPOs are underpinned by current knowledge of the country s PFM system. This knowledge is typically obtained through analytic work on the country s PFM systems work that may be carried out by the country, the Bank, or third parties, and that is increasingly undertaken collaboratively. Country teams should plan for PFM analytic work to ensure that knowledge of country PFM systems is current and adequate. This analysis normally focuses on such aspects as the credibility of the budget, comprehensiveness and transparency of the budget, the budget-policy link, predictability and control in budget execution, accounting recording and reporting, and external scrutiny and audit. If subnational governments manage a significant share of central budget funds, the analysis should also cover the quality of their management. The Bank s principal instruments for such analytic work on the country s system are Country Financial Accountability Assessments (CFAAs), Public Expenditure Reviews (PERs), and integrated products such as the Public Expenditure Management and Financial Accountability Review (PEMFAR), Country Integrated Fiduciary Assessment (CIFA), and Public Expenditure and Financial Accountability (PEFA) PFM Performance Report. In addition, Bank staff review published annual audit reports and financial statements of the government, and other relevant reports, to gain information about the working of the country s PFM system. 2. PFM System Performance Standards for a DPO 6. As early as possible in the planning and development of the operation, the Bank team forms a judgment as to whether the borrower s PFM system, taken together with the borrower s commitment to an acceptable reform program, is adequate to support the operation. The assessment of the PFM reform program takes account of several factors: progress to date, soundness and ownership of the PFM improvement program, quality of engagement on the PFM agenda, and support being provided for PFM reforms, including through any PFM-related prior actions, tranche conditions, and triggers for the DPO, and through support by other donors or through technical assistance. For sectoral and other DPOs that do not have PFM reform content, staff base their assessment of the adequacy of the PFM system on its current performance.

7 3 7. Performance Standards. No minimum standard of PFM has been established as a precondition for development policy lending. DPOs could be provided in a country that has a weak PFM environment if the country has committed to an adequate program of PFM improvement/reform and there is reasonable evidence that improvements are occurring in a timely manner. Including PFM prior actions in the DPO can help mitigate the fiduciary risks associated with the operation and demonstrate the borrower s commitment to reform. Improved PFM performance may therefore be an outcome of development policy lending, rather than a precondition. 8. Options When the PFM System is not Considered Adequate. When the analysis identifies weaknesses in the borrower s central bank control environment or budget management system, or when an acceptable action plan to deal with identified weaknesses is not in place, the Bank identifies additional steps that need to be taken to secure acceptable fiduciary arrangements for the DPO. For example, the Bank may require dedicated account(s) in foreign currency and/or local currency, and may exercise its right to request an audit of the dedicated account(s). 3 In addition, the task team and Management may consider one of the following actions: (a) delay the operation until additional analytic information is available and satisfactory measures have been adopted to address identified weaknesses and demonstrate commitment to reform; (b) add prior actions to address critical PFM weaknesses; or (c) do not proceed with the operation. In countries affected by crisis or conflict, where the Bank may need to make an unusually quick response, there may not be sufficient time or country capacity to develop a comprehensive policy program to address weaknesses identified by the Bank s diagnostic work on PFM. In such situations Bank staff need to set out the fiduciary arrangements by which the weaknesses in the PFM systems will be addressed. 3. Design of PFM Program Content in DPOs 9. PFM reforms are often an important program area supported by DPOs: more than 80 percent of DPOs covered by a 2008 Bank study included PFM-related prior actions. 4 DPO design measures include prior actions, triggers, and tranche release conditions (see Box 1). Box 1. Prior Actions, Triggers, and Tranche Release Conditions in DPOs Prior actions are a set of mutually agreed policy and institutional actions that are deemed critical to achieving the objectives of the program supported by a DPO and that a country agrees to take before the Board approves a loan. Triggers, as used in the context of programmatic series of DPOs, are the planned actions in the second or later year of a program that are deemed critical to achieving the results of the program and that will be the basis for establishing the prior actions for later operations. In other words, triggers are the expected prior actions for a subsequent operation. The details of prior actions for a subsequent operation in a programmatic series may differ somewhat from what had been defined previously as triggers, because of changes in circumstances or information. Triggers are not legally binding actions until they become prior actions. Tranche release conditions In a multiple-tranche operation, actions that a country agrees to take before a tranche is released are termed tranche release conditions. 3 4 See para. 15 of this note Development Policy Lending Retrospective: Public Financial Management and Fiduciary Issues, OPCFM, May 2009 (DPL FM Retrospective).

8 4 10. Principles. The following principles are relevant to designing PFM prior actions, triggers, and tranche release conditions: Linking PFM prior actions, triggers, and tranche release conditions to diagnostic work and to the country s PFM improvement plan. Results of diagnostic work contribute to the analysis and design of the PFM component of the operation, with adequate follow-up of major weaknesses and risks. The PFM actions also reflect priorities drawn from the country s PFM improvement plan. Appropriately sequencing PFM prior actions, triggers, and tranche release conditions. Continuity of actions is one consideration (actions generally do not disappear after one year, particularly in programmatic operations and multipletranche operations). The prior actions and triggers are determined for each operation in a programmatic series, building incrementally on progress and results achieved, and pushing boundaries as far as possible. In some cases, it may be appropriate to initially agree on a package of short-term measures (covering to the extent possible the various elements of the PFM cycle) that could serve as a platform or step for deeper improvements. Establishing the results chain that links PFM prior actions and triggers to the expected results. A clear results chain links the objectives, PFM prior actions and triggers, and the expected results or outcomes of the actions. There is a focus on fewer and better prior actions and triggers; not all the actions included in the country s PFM improvement program need to be included as prior actions or triggers. To the extent practicable, focusing PFM monitoring indicators on results, rather than inputs/processes. 5 The monitoring indicators capture the expected outcomes of the operation (or series of operations), with targets for each period covered by the series. They are quantified where possible, and are specific, significant, observable, time-bound, and measurable. Actual achievements against the targets are monitored for each year covered by the operation or series of operations. Including appropriate implementation arrangements for the PFM improvement program. It is important to discuss with the government the implementation measures needed and implementation responsibilities. For example, the operation may be complemented by training and technical assistance to assist the government in implementing the PFM improvement program. In more than three-quarters of recent DPOs involving PFM reform, complementary support was provided in the form of investment lending, nonlending technical assistance (e.g., Institutional Development Fund grants), and projects funded by other development partners. 6 However, achievement of prior actions should not be directly dependent on complementary support provided by the Bank. 5 6 Process-oriented indicators typically relate to reform preparation and design, executive decisions, the passing of legislation, or the process of implementing new systems and procedures. Results-oriented indicators typically capture the functioning or use of a new system or process or demonstrated improvements in PFM performance (as a guide, PEFA indicators are considered results-oriented). See DPL FM Retrospective.

9 5 An important first step is to review Good Practice Note 1 Designing Development Policy Operations for definitions, principles, and good practices for program design. B. Funds Flow Arrangements 11. The typical funds flows arrangements for a DPL are as follows (see Figure 1): Disbursement of funds from the Bank to the borrower. The Bank disburses the loan proceeds into a bank account denominated in foreign currency that forms part of the country s official foreign exchange reserves, normally held by the government at the central bank. Use of funds by the borrower. The borrower may use the proceeds as follows: (a) make budgeted foreign currency payments (such as for imports, foreign currency debt service, and so on) directly from this foreign currency bank account; (b) transfer amounts from the foreign currency bank account to a local currency bank account of the government, which the government then uses to make payments for its budget expenditures; or (c) a combination of these approaches. Loan proceeds are always part of the government s budget resources. However the borrower uses the loan proceeds, they always become a part of the country s budget resources; that is, they should always be on-budget and not off-budget. Therefore, on receipt of the loan, the borrower promptly accounts for the receipt of the loan in the country s budget management system, in an account used to finance budgeted expenditures (e.g., consolidated fund, treasury single account), using the country s regular or established procedures for such accounting. 7 7 Accounting is typically done in the country s local currency, and the exchange rate used is normally the rate that is in effect on the date the country receives the loan.

10 6 Figure 1. Typical Funds Flow National budget resources, accounted for in budget management system Government FX Account typically at Central Bank [Part of official FX reserves] Government Local Currency Account used for budgeted expenditures Payments of budgeted expenditures Budgeted foreign currency payments 12. End-use of DPL Funds. Once the funds enter the country s foreign exchange reserves and the budget, they are commingled with the government s other funds whose end use is then determined and tracked using the government s regular budgeting, accounting, and financial reporting systems. Therefore, the Bank does not normally require tracking the end-use of DPL funds. 8 DPL funds are also not therefore earmarked for specific line items in the budget. 13. Excluded Expenditures. In signing the legal documents for the loan, the borrower agrees that it will not use the loan proceeds to finance ineligible items (called the negative list or Excluded Expenditures ). 9 The Bank does not normally require specific FM measures to ensure compliance with the Excluded Expenditures provision of the legal agreement Due Diligence Measures by the Bank. The Bank takes the following due diligence measures: However, in certain cases, when additional fiduciary arrangements are put in place, the borrower may be required to deposit the funds in a dedicated foreign currency account, a dedicated local currency account, or both; and the Bank either requires an audit or reserves its right to request an audit of the dedicated account(s). These situations are discussed in para. 15 of this note. The negative list for development policy lending covers items such as alcoholic beverages; tobacco; radioactive and associated materials; nuclear reactors and parts thereof; jewelry of gold, silver, or platinum; goods intended for a military or paramilitary purpose or for luxury consumption; or expenditures for environmentally hazardous goods. Except when a dedicated account is put in place (see para. 15 of this note).

11 7 Review of the control environment for foreign exchange management (a) The IMF reviews the foreign exchange control environment through its Safeguards Assessments of central banks. 11 Bank staff review, and discuss with IMF staff as appropriate, the IMF s most recent Safeguards Assessment. Bank staff also review the IMF s most recent staff reports, which typically provide information on the status of implementation of recommendations of the Safeguards Assessments. Bank staff may also review published annual audit reports and financial statements of the central bank, to obtain additional information about the operation of internal controls. 12 (b) If there is no recent IMF Safeguards Assessment, it may be possible to confirm the adequacy of the foreign exchange control environment in other ways for example, by examining the annual audit reports and financial statements of the central bank and the Management Letter issued by the auditors, and holding discussions with IMF representatives and the auditors. The quality of the external auditors work is an important factor in deciding whether to rely on their work. (c) When the IMF s Safeguards Assessment (or any other Bank review) shows that the control environment of the central bank is satisfactory, or reveals issues for which the borrower has agreed to take remedial actions that are monitored by the IMF, the World Bank takes no further action. Confirmation from the government. The Bank obtains a confirmation from the government (normally within 30 days after loan disbursement) that (a) the loan proceeds were received into an account of the government that is part of the country s foreign exchange reserves (including the date and the name/number of the government s bank account in which the amount has been deposited), and (b) an equivalent amount has been accounted for in the country s budget management system (including the Chart of Accounts name/account number, the date, and the exchange rate used) Additional Arrangements to Mitigate Risks. In some circumstances, to mitigate fiduciary or reputational risks, the Bank may require additional arrangements with regard to funds flow: a dedicated foreign currency bank account, a dedicated local currency bank account, or both (these arrangements are illustrated in Annex C) The purpose of the Safeguards Assessment is to identify vulnerabilities in a central bank s control, accounting, reporting, auditing systems, and legal structure to identify any weaknesses that may impair the integrity of central bank operations, and to determine whether resources, including those provided by the Fund, are adequately monitored and controlled. A Safeguards Assessment does not seek to validate the actual use of foreign exchange reserves; it is limited in its scope to a review of control systems. More details on the Safeguards Assessment are available at The FM Anchor keeps copies of the IMF s Safeguards Assessment reports and makes them available to staff in response to a written request, copied to the staff member's manager, confirming that the report will be treated confidentially and that it will be used only for official business. Bank staff do not address matters concerning the management of foreign exchange reserves beyond the scope of the Safeguards Assessment, such as foreign exchange management policy; such matters are addressed by the IMF. A sample format for the confirmation is provided as Annex D.

12 8 Dedicated foreign currency bank account. The Bank may require a dedicated foreign currency bank account that is, an account that is used exclusively for the DPO loan proceeds in the following circumstances: (a) when the World Bank has inadequate knowledge of the borrower s central bank control environment (e.g., the IMF has not carried out a Safeguards Assessment); (b) audit reports of the central bank are not available or indicate weaknesses (e.g., no independent audit of the central bank, major issues regarding foreign exchange management indicated in audit reports); or (c) no acceptable IMF-monitored plan to deal with identified control weaknesses is in place. If the Bank requires the loan proceeds or counterpart funds to be deposited into a dedicated account, it may also require the account to be audited. 14 Such arrangements mitigate the fiduciary risk of any possible loss or diversion of the loan proceeds from the foreign currency Bank account into which loan proceeds are deposited. Dedicated local currency bank account. In exceptional circumstances including when there may not be sufficient time or country capacity to provide adequate analytic underpinnings or to determine how weaknesses in fiduciary arrangements might be addressed 15 the Bank may require such additional measures as (a) establishing a dedicated local currency bank account (an account used exclusively for DPO loan proceeds) into which all or part of the loan proceeds are transferred from the foreign currency account and from which payments are made, and/or (b) agreeing on specified purposes for which loan proceeds may be used (a positive list ). If the Bank requires these additional steps, it generally also requires that the dedicated local currency bank account be audited. 16 An important consideration in judging the appropriateness of using a dedicated local currency bank account is that it only mitigates the reputational risk to the Bank of DPO funds being associated with Excluded Expenditures; it does not mitigate fiduciary risk arising from weaknesses in the PFM system. Dedicated foreign and local currency bank accounts should be on-budget. Dedicated bank accounts (whether in foreign currency, local currency, or both) should be on-budget, and the transactions in them should be accounted for in the country s budget management system. Similarly, a dedicated foreign currency bank account should be part of the country s official foreign exchange reserves Sample terms of reference for such an audit are provided in Annex E. For example, in development policy lending to countries affected by crisis or conflict, and similar exceptional situations that call for an unusually quick response from the borrower and the Bank. Sample terms of reference for such an audit are provided in Annex E.

13 9 III. DOCUMENTATION OF FINANCIAL MANAGEMENT ISSUES 16. At the concept stage, the task team outlines in the draft Program Document the objectives, expected outcomes, and provisions of FM aspects of the proposed operation. If sufficient information is not available, the document indicates the proposed approach to develop these program aspects. It also indicates the status of and plans for analytic work (IMF Safeguards Assessment and work on the PFM system). In the Program Document, FM issues are typically presented in two areas: (a) for DPOs that include support for PFM reform, in the description of the program content; and (b) for all operations, in the fiduciary arrangements section. This section describes the issues to be covered in the Program Document in these two areas. Examples of the good documentation practice described here are available on the FM DPL Good Practice Database. 17 A. Description of the PFM Program Content 17. For DPOs supporting PFM actions, the Program Document provides a clear explanation of the rationale for the PFM content of the operation, including the assessment of weaknesses, the explanation of the government s reform program, and the link between these aspects and the policy actions. This explanation is captured in the Program Description Section and the Results Matrix of the Program Document. Specifically, the Program Document includes the following: A summary of the key strengths and weaknesses in the PFM system, showing how the findings of PFM diagnostic work and the country s reform plan contributed to the analysis and design of the PFM component of the operation. An overview of recent progress in PFM reform. A description of the country s PFM improvement program or plan to address identified weaknesses. An explanation of the PFM prior actions, triggers, and tranche release conditions in the main text of the Program Document and a summary in the policy matrix, with links to the country s PFM improvement plan. The PFM results expected from the operation. An explanation of the results chain linking the policy actions, triggers, and tranche release conditions with the expected results. 18 The indicators and indicator targets for monitoring results. 18. Multiple-Tranche and Programmatic Operations. For multiple-tranche operations, the Program Document indicates conditions for tranche releases, and the Tranche Release Document The FM DPL Good Practice Database describes selected examples of good documentation practice and provides links to the individual Program Documents. Annex 1 of the 2005 Good Practice Note - Results in Development Policy Lending provides a good practice example of the format of the policy and results matrix.

14 10 reports on the status of the program being supported under the operation. In programmatic operations, the Program Document indicates the progress in implementing the agreed triggers for the particular operation and the expected actions for the subsequent operation. When the operation is part of an ongoing programmatic series, the Program Document also provides (a) an assessment of progress against indicator targets, incorporating these monitoring results in the program analysis and rationale in the Program Document, and in the results matrix; and (b) an explanation of how the prior actions supported the achievement of significant results. B. Description of Fiduciary Arrangements 19. The fiduciary arrangements section of the Program Document covers both the PFM system and the funds flow arrangements, including the due diligence measures taken by the Bank. Information already provided in the description of the PFM program should be summarized and not duplicated in the description of the fiduciary arrangements. The section may be organized under these main headings. 1. Public Financial Management System 20. This section provides a clear and concise picture of the current performance of the PFM system (including public procurement 19 ), the progress of reform, the borrower s commitment to improvement, and the adequacy of these aspects together to support the operation. Specifically, it includes the following: A summary of PFM diagnostic work and its results, identifying key strengths and weaknesses. Recent progress in PFM reform. A summary of the country s PFM improvement program to address the identified weaknesses and risks (this includes actions that the borrower has taken and those it has committed to). An assessment of the level of commitment to future improvement (taking into account progress to date, soundness and ownership of the PFM improvement program, quality of engagement on the PFM agenda, PFM-related prior actions and tranche conditions where appropriate, and other support for PFM reform). A clear conclusion as to whether the PFM system and the government s commitment to reform, taken together, are adequate to support the operation. If additional measures have been taken to mitigate reputational risk arising from a weak PFM system, the exceptional circumstances are outlined and the additional steps described. 2. Funds Flow Arrangements 19 The section on the PFM system should be prepared in collaboration with Procurement colleagues to ensure comprehensive coverage of the fiduciary issues.

15 The Program Document describes whether the IMF has completed a Safeguards Assessment of the central bank, summarizing its major findings (e.g., whether the control environment is satisfactory) and the status of major agreed follow-up actions. (Note that Bank reports should record only information contained in the summaries of Safeguards Assessments that are submitted to the IMF s Board). If there is no recent IMF Safeguards Assessment, the Program Document refers to other due diligence undertaken, such as review of annual audit reports and confirmation of the quality of the audit Funds Flow. The Program Document describes the disbursement and funds flow arrangements, including the following: The account into which Bank loan proceeds would be deposited (specifying that this account forms part of the official foreign exchange reserves). Confirmation that the receipt of loan proceeds would be promptly accounted for in the government s budget system. The due date for the government to provide written confirmation that the loan has been received in an account that forms part of the country s official foreign exchange reserves and has been accounted for in the country s budget management system. Any additional arrangements with regard to funds flow (e.g., dedicated foreign currency or local currency Bank accounts, or both), and the reasons for such additional arrangements. Staff may review the government s or the central bank s financial statements and audit reports to better understand the working of the PFM system; however, the Bank does not require submission of these documents, and they should not be presented as part of the fiduciary arrangements in the Program Document. If it is appropriate in the country context, improvements to the timeliness and quality of government financial statements and audits can be included as part of the PFM reform program supported by the DPO. IV. NEGOTIATIONS, SUPERVISION, MONITORING, AND EVALUATION 23. FM aspects should be appropriately reflected in the legal documents and the Minutes of Negotiations. The FMS works with the country lawyer and other members of the task team to ensure that FM provisions are appropriately reflected in the legal agreements in accordance with the applicable policy framework. Issues regarding funds flow are among the items discussed at the negotiations stage, and specific provisions are reflected in the Minutes of Negotiations. The FMS coordinates with the borrower in advance to ensure that necessary information is 20 External audit reports are not equivalent to an IMF Safeguards Assessment.

16 12 available at the negotiations: (a) details of the bank account into which the loan will be deposited, (b) the specific mechanism for accounting for a credit equivalent to the loan or tranche in the government s budget management system, and (c) the format of and the due date for the confirmation to be provided by the government. When in exceptional circumstances an audit of the dedicated account(s) may be required, the terms of reference 21 are usually discussed at negotiations and included in the Minutes of Negotiations. 24. Supervision and Monitoring. The borrower implements the DPO, monitors progress during implementation, and evaluates results upon completion. Bank staff review implementation progress to verify that the borrower has fulfilled program conditions and complied with legal covenants, and to validate monitoring and evaluation findings. The task team consults and coordinates with the IMF and any cofinanciers in carrying out its supervision work. Major FM supervision issues involve the following: Monitoring that, following the disbursement of Bank loan proceeds, the agreed funds flow arrangements are complied with and the required confirmation is received from the government. 22 If timely confirmation is not received, follow-up with the government is required. Monitoring that any agreed additional arrangements for funds flow and audits are complied with. When an audit of the dedicated account(s) is required, the FMS monitors timely submission of the audit report and reviews the audit report. When such arrangements are not complied with e.g., the audit report is not submitted or the auditor gives a qualified or adverse opinion the FMS should consult with the task team leader and relevant Bank officials to determine an appropriate response consistent with the legal agreement. Options might include return of a specified amount to the dedicated account or a refund to the Bank. Reviewing the implementation of the agreed PFM actions. The Bank carries out a periodic (e.g., annual) assessment of PFM performance, indicating the extent of improvements. For multiple-tranche operations, the Bank assesses the borrower s progress toward meeting the conditions for release of the next tranche. For programmatic operations, the Bank assesses the borrower s progress in implementing the agreed triggers for the operation. 25. Evaluation. As appropriate, FM issues are covered in the Implementation Completion and Results Report (ICR). The ICR assesses (a) key factors affecting implementation and outcomes, (b) the extent to which the program achieved its development objectives and outputs as set out in the Program Document, (c) risks to development outcomes, and (d) Bank and borrower performance, including compliance with relevant Bank policies. It draws upon data and analysis to substantiate these assessments, and it identifies the lessons learned from implementation Sample terms of reference for the audit of a dedicated account are provided in Annex E. A sample format for the confirmation is provided in Annex D.

17 ANNEX A. FINANCIAL MANAGEMENT ISSUES IN SUBNATIONAL DPOS 1. This annex describes specific good practice features that apply to subnational DPOs, including DPOs that support sector-specific reforms at the subnational level. A. PFM System 2. The subnational government is the end recipient and the user of the funds in a subnational DPO. In general, therefore, the assessment of PFM performance and of the PFM reform/improvement program focuses on the subnational PFM system. 1 Analytic underpinnings. Analytic work on the subnational government s PFM system should be equivalent to the analytic work on the national PFM systems that is used for other DPOs. In addition, it should cover the links between the subnational and national PFM systems including national government control and oversight of subnational government finances if these aspects affect the subnational government s management of budget resources. Country teams should ensure that knowledge of the subnational PFM systems is current and adequate. 2 PFM reform program content. When PFM is included as one of the reform areas in the DPO, PFM actions typically focus on PFM improvements at the subnational level. For subnational sectoral DPOs, Annex B notes the additional sectoral PFM analysis that may be appropriate. B. Funds Flow Arrangements 3. The Program Document specifies which of the two basic funds flow models will apply to this subnational operation: The loan is made to the national government, which onlends the funds to the subnational government. In this case, the loan is accounted for in the budget management system of the national government as a receipt and transferred as a loan to the subnational government, which will also account for it in its budget management system as a loan receipt in its budgeted revenues. The loan is made directly to the subnational government. In this case the loan is accounted for in the subnational government s budget management system that is, it is on-budget. In either case, the loan is deposited into an account that forms part of the country s official foreign exchange reserves. 1 2 In some instances, the loan is made to the central government, which then allocates it to subnational governments through the normal central government budget allocation process (e.g., allocation to municipalities), and it is not possible to trace the specific allocation of DPO funds to these subnational governments. These cases are largely sectoral DPOs (supporting decentralization), and the approach set out in Annex B is used. Annex A of the CFAA Guidelines provides guidance on diagnostic work at the subnational level. The PEFA website (pefa.org) also provides examples of subnational PFM assessments.

18 14 4. Onlent Funding. When the loan is made to the national government and onlent to the subnational government, the following considerations are important: Due diligence work on the foreign exchange control environment is the same as for national DPOs, as described in this note. If the loan funds are deposited or transferred to an account held at a financial institution other than the central bank, additional steps are required (see Box A1). The flow of funds from the Bank to the national government, and from there to the subnational government, including the onlending terms, is agreed and documented before or at negotiations. In some countries, funds may flow from the national government account to a subnational government foreign exchange account, and on to a local currency account, as illustrated in Figure A1. If subnational governments are not permitted to hold foreign exchange accounts, the local currency equivalent of the loan is transferred from the national government account straight to the subnational local currency account (see Figure A2.) To secure acceptable fiduciary arrangements, additional arrangements such as establishment of a dedicated account and audit of the dedicated account may need to be put in place (see Annex E for sample audit terms of reference). Box A1. Due Diligence for Financial Institutions In some cases, loan funds may be deposited in or transferred to an account held at a financial institution other than the central bank or a branch of the central bank. The other financial institution is generally a fiscal agent nominated by the central bank, or a commercial bank that operates the treasury accounts of the subnational government. In such cases, Bank staff need to ensure that the financial institution is acceptable to the Bank in accordance with the Disbursement Guidelines for Projects (May 1, 2006, paragraph 5.5): To be acceptable to the Bank, the financial institution proposed by the borrower should generally meet all the following requirements: (a) be financially sound; (b) be authorized to maintain the Designated Account in the currency agreed between the Bank and the borrower; (c) be audited regularly, and receive satisfactory audit reports; (d) be able to execute a large number of transactions promptly; (e) be able to perform a wide range of banking services satisfactorily; (f) be able to provide a detailed statement of the Designated Account; (g) be part of a satisfactory correspondent banking network; and (h) charge reasonable fees for its services. Steps to make this determination may include the following: Review of the central bank s recent supervision report(s) for the financial institution. Review of the financial institution s recent audited financial statements, including the management letter. Consultation with the financial institution s authorities. Consultation with the subnational government authorities.

19 15 Figure A1. Typical Funds Flow for Onlending to a Subnational Government with Foreign Exchange Account Central Government FX Account typically at Central Bank [Part of official FX reserves] Subnational Sub-National Government budget resources, accounted for for in subnational in subnational management budget management budget system system Subnational Sub-National Government FX Account -at Central Bank or other financial institution [Part of official FX reserves] Budgeted foreign currency payments Subnational Sub-National Government Local Currency Account used for budgeted expenditures at financial institution where treasury accounts held Payments of budgeted expenditures. Figure A2. Typical Funds Flow for Onlending to a Subnational Government without Foreign Exchange Account Sub-National Subnational Government Government budget budget resources, resources, accounted accounted for in for subnational in subnational budget management budget management system system Central Government FX Account typically at Central Bank [Part of official FX reserves] Subnational Sub-National Government Local Currency Account used for budgeted expenditures at financial institution where treasury accounts held Payments of budgeted expenditures

20 16 The government confirms as in national DPOs that the loan proceeds were received into an account of the government that is part of the country s official foreign exchange reserves, and that the receipt of the loan has been accounted for in the subnational government s budget management system. Arrangements on who will submit this confirmation are also agreed and documented. 5. Direct Loan. When the loan is made directly to the subnational government, the following considerations are important: If the loan proceeds are deposited in the central bank, the Bank takes the same approach for its due diligence work on the foreign exchange control environment as for national DPOs. If the loan funds are deposited or transferred to an account held at a financial institution other than the central bank, additional steps are required (see Box A1). The flow of funds (example illustrated in Figure A3) is agreed and documented. In extraordinary circumstances, as per paragraph 19 of OP 8.60, the Bank may take additional steps to secure acceptable fiduciary arrangements, including establishment of a dedicated account and audit of the dedicated account (see Annex E for sample audit terms of reference). The subnational government confirms that the loan proceeds were received into an account of the government that is part of the country s official foreign exchange reserves, and that the receipt of the loan has been accounted for in the subnational government s budget management system.

21 17 Figure A3. Typical Funds Flow for Direct Lending to Subnational Government Subnational Sub-National Government Government budget resources, budget resources, accounted for accounted in subnational for budget in sub-national management budget system management system Sub-National Subnational Government FX Account - at Central Bank or other financial institution. [Part of Official FX reserves] Budgeted foreign currency payments Subnational Sub-National Government Local Currency Account used for budgeted expenditures at financial institution where treasury accounts held Payments of budgeted expenditures

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23 ANNEX B. FINANCIAL MANAGEMENT ISSUES IN SECTORAL DPOS 1. The arrangements for DPOs that support sector-specific reforms generally follow the same approach as those for other DPOs. This annex discusses specific aspects of the application of these good practices for sectoral DPOs. A. PFM System 2. The sector is part of the national (or subnational) government, and the whole government s PFM system generally covers all sectors. Budget releases to and use of funds by a sector are typically managed using the country (or subnational) PFM system. There is typically no presumption that the sector budget will directly be increased by the amount of the DPO funds, and loan proceeds are not specifically for use in the sector budget. Analytic underpinnings and assessment of PFM reforms. For sectoral DPOs, the analyses and assessments focus on the country (or subnational) PFM system. When individual sectors or departments are self-accounting entities with autonomous systems for budgeting, accounting, reporting, auditing, or oversight, additional analytic work may be necessary to gain specific knowledge of sector PFM systems. PFM reform program content. Although some sectoral DPOs may have no PFM content, in others, improvement of PFM in the sector is often essential to achieve the objectives of the DPO (e.g., when the DPO supports improving the institutional performance of the sector). Such DPOs may include specific measures to improve PFM at the sectoral level. Drill-down or in-depth analysis of the PFM systems in the sector may be appropriate, both to help develop a fuller understanding of sectoral PFM issues and to feed into the design of DPO prior actions and benchmarks. B. Funds Flow Arrangements 3. In sectoral DPOs, there are no special considerations with respect to funds flow and review of the foreign exchange control; the same approach is used as for national or subnational DPOs. See Annex A for the funds flow arrangements for subnational DPOs.

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25 ANNEX C. ADDITIONAL ARRANGEMENTS Figure C1. Dedicated Foreign Currency Bank Account for Loan Proceeds National budget resources, accounted for in budget management system Dedicated Government FX Account typically at Central Bank [Part of official FX reserves] Government Local Currency Account used for budgeted expenditures Payments of budgeted expenditures Budgeted foreign currency payments Audit Figure C2. Dedicated Local Currency Account for Loan Proceeds National budget resources, accounted for in budget management system Government FX Account typically at Central Bank [Part of official FX reserves] Dedicated Government Local Currency Account used for budgeted expenditures Payments of budgeted expenditures Budgeted foreign currency payments Audit

26 22 Figure C3. Dedicated Foreign Exchange and Local Currency Account for Loan Proceeds National budget resources, accounted for in budget management system Dedicated Government FX Account typically at Central Bank [Part of official FX reserves] Dedicated Government Local Currency Account used for budgeted expenditures Payments of budgeted expenditures Budgeted foreign currency payments Audit Audit

27 ANNEX D. SAMPLE CONFIRMATION OF LOAN PROCEEDS DEPOSIT AND CREDIT Sample format for confirmation that the loan proceeds have been deposited into an account that is part of the country s foreign exchange reserves and accounted for in the country s budget management system. [Date] Regarding: [ ] Loan, [Loan/Credit number] This is to confirm that the proceeds of this [Grant/loan] of $xxx million was deposited on [date] into [account number/name] that is held in the [central bank s name] and is part of [name of country] s official foreign exchange reserves. The equivalent amount of the loan i.e., [amount in local currency] was credited on [date] to the Government of [country] s [use the right name such as Consolidated Fund] [Chart of Accounts name and number] that is used to finance budget expenditures, using the applicable exchange rate of [amount] local currency/us$. [signature, designation]

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29 ANNEX E. SAMPLE TERMS OF REFERENCE FOR AUDIT OF THE DEDICATED ACCOUNT 1 Background [COUNTRY] [PROJECT NAME] Terms of Reference for Audit of the Dedicated Account 1. [Name of country] (the Recipient) has received financing of [currency and amount], for the [Project name] (DPC) from the International Development Association (the Association). Detailed information, including implementation and funds flow arrangements, is provided in the World Bank s Program Document dated. The Government of [country] entered into a Financing Agreement with the Association dated. 2. The proceeds of the Credit are deposited into an account maintained in US Dollars in the [name of Central Bank], used exclusively for the DPC proceeds (called the Dedicated Account ). Objective of the Audit 3. The objective of the audit of the dedicated account is to enable the auditor to express a professional opinion(s) on the Dedicated Account for the DPC at the end of each fiscal year, and on funds received and payments out of the Dedicated Account for the relevant accounting period. 4. The project books of accounts maintained by the [Ministry of Finance] provide the basis for preparation of the Summary of Transactions of the Dedicated Account and are established to reflect the financial transactions of the Dedicated Account. The [Ministry of Finance] is responsible for maintaining adequate internal controls and supporting documentation for transactions. Responsibilities 5. The implementing agency is responsible for selecting and applying accounting policies and for preparing the Summary of Transactions of the Dedicated Account, including adequate disclosure, in accordance with IPSAS. 6. The auditor is responsible for forming and expressing opinions on the Summary of Transactions of the Dedicated Account. As part of the audit process, the auditor may request from the implementing agency written confirmation concerning representations made in connection with the audit. 1 This sample Terms of Reference is written for audit of a dedicated foreign currency account. It can be adapted for audit of a local currency dedicated account.