Moving transition forward

Operational priorities for the medium term (26 March, 1999)

I. Taking stock

The region has changed substantially in the five years since the Bank last formulated its operational priorities in 1994. Accordingly, the Bank has carried out a careful strategic review of these priorities. The review was based on an examination of the achievements of the Bank’s operations and on an assessment of lessons learned and challenges ahead for the transition and for the Bank.

I.1 Achievements and experience

The contracting parties established the EBRD in 1991 as an international financial institution (IFI) with a unique mandate. Article 1 of the Agreement Establishing the EBRD states that "the purpose of the Bank shall be to foster the transition towards open market oriented economies and to promote private and entrepreneurial initiative in the Central and Eastern European countries committed to and applying the principles of multiparty democracy, pluralism and market economics". The Bank pursues transition impact by financing projects which expand and improve markets, help build the institutions necessary for underpinning the market economy, and demonstrate and promote market-oriented skills and sound business practices. In pursuing transition impact, the Bank applies sound banking principles to all its operations and ensures that it is additional to alternative market sources of finance.

In early 1994 the Bank adopted Operational Priorities to provide strategic guidelines for the implementation of its mandate. These emphasised: a focus on the private sector; the need to be active in all countries of operations; reaching local private enterprises; strengthening financial intermediation; an active approach to equity investment. The Operational Priorities of 1994 have stood the test of time and the Bank has delivered on them. It has committed, since 1991, EUR 12.0 billion for the financing of projects throughout the region representing an aggregate value of EUR 42.9 billion. Of total Bank commitments 68 per cent have been in the private sector; 20 per cent represented equity investments; 30 per cent were in the financial sector.

The Bank has operations and has established Resident Offices in all its countries of operations. It is recognised in the region and beyond as a strong and credible partner and catalyst for the transition process.

For the region as a whole, the achievements in economic and political transition have been remarkable. New democratic systems have shown resilience in the face of economic and other crises and the economies of the region are largely subject to market forces. In most countries, well over half the output is generated in the private sector. The prospect of a return to the command economy is now remote. But the experience of countries has differed strongly. Those that have shown sustained and effective commitment to reform are seeing the returns in terms of growth, investment and new enterprises, whereas those that have been unwilling or unable to develop this commitment have been more vulnerable to setback and crisis, such as occurred in 1998 in parts of the region.

I.2 Lessons and challenges for the transition

There are clear lessons from the last years. Experience of the last decade has shown that the transition will inevitably be a complex, demanding and lengthy process. The scale and nature of the difficult industrial and environmental legacy pose a major challenge. A market economy has to be supported by an effective institutional framework and a functioning state. In the region there are basic weaknesses in key institutions, particularly concerning finance, regulation and competition, corporate governance, and the rule of law and its enforcement. Problems of corruption and bureaucratic interference are pervasive. Thus a key lesson is that the transition requires greater attention and commitment to creating strong institutions.

Market mechanisms and fiscal discipline are central to the transition process and to restructuring of the economy. In order to secure public and political support, however, for transition and restructuring, they must be underpinned by an acceptable social framework. Weak institutions, the heavy burden of the industrial legacy and problems in establishing this framework have been key factors in the severe social strains and obstacles to reform experienced in the region.

The main challenges for the transition in the coming years lie in creating a reliable institutional and policy environment which attracts investment flows and encourages both the growth of the new private sector and the restructuring of the old, improves the functioning of markets, fosters entrepreneurial and market skills, and strengthens the confidence of the population in the reform process.

The primary responsibility for shaping the response to the transition challenges lies with the countries themselves. The political support for reform which is crucial to its success must be constructed internally. However, the international community – including the international financial institutions – can make a major contribution, working in partnership with the countries of the region. These countries have opened their markets and are reorienting their trade. The international community should work to promote the growth and further opening of its markets and the integration of the region into the world economy.

1.3 Lessons and challenges for the Bank

At the start of 1999 the Bank examined experience since its foundation. It took careful account of the impact on the Bank of adverse developments in international markets and of the crisis in Russia. Whilst the Bank was aware of the growing risks in Russia following the world financial crises of late 1997, with hindsight the probabilities of adverse scenarios were underestimated. And the Bank should have examined more rigorously how it could have used its influence and its project activities to help overcome the institutional problems which were a major factor in generating the crisis.

Response to crisis

In response to the impact of the events in the region of August 1998, the Bank strongly reconfirmed its commitment to all countries of the region. The Bank took immediate steps to protect the viability of its projects and enhance its focus on portfolio management. A detailed review showed that most of the Bank's portfolio remained strong, but the credit quality of a number of its projects had deteriorated. The Bank therefore significantly increased its level of loan and investment loss provisioning at the end of 1998, resulting in a substantial net loss for the year. Following this financial setback, rebuilding adequate reserves is a key priority, and thus early achievement of sustainable profitability is vital. For 1999 the Bank adopted a flexible business plan and budget in order to be able to respond appropriately to uncertain developments.

Operations

The Bank's experience has demonstrated the importance of project quality throughout its work, both in terms of transition impact and financial soundness in project selection and implementation and in the active management of the portfolio. It must also pay still closer attention to the quality of its project partners.

The Bank should ensure that its project experience and investor perspective are used effectively in the promotion of a sound investment climate and the strengthening of institutions that are important for the functioning of markets.

The Bank recognises that different international institutions have complementary roles to play, reflecting their particular strengths and mandates. The EBRD's special strengths lie in its project-based investor perspective and its work with enterprises. These should remain the foundation of its activities.

Financial viability

The Bank must take risks to implement its mandate. In order to be able to sustain its commitment to the transition process, particularly in a riskier environment for projects in countries in early and intermediate stages of transition, the EBRD must be a financially strong and viable bank.

The Bank aims at profitability after provisions year by year, whilst recognising that this may not always be achieved when unexpected developments occur, as experience has demonstrated. This is critical for the strengthening of the capital base necessary for an enhanced risk-taking capability, for internal business management discipline, for the Bank's standing as a borrower, for credibility as a catalyst for co-investment, and for sound demonstration effects. A healthy growth of a high-quality earning asset base is essential for the medium and long-term financial viability of the Bank.

The Bank is committed to cost-effective business management and strict budgetary discipline.

II. Operational priorities of 1999

The transition challenges ahead and enhanced risk in the region have strongly reinforced the relevance of the EBRD's mandate. The Bank works to foster transition in all countries of the region. At the same time, countries in which it operates must be committed to and applying the principles of multiparty democracy, pluralism and market economics. Opportunities for sound investment depend on the climate created for them. Thus, the level and nature of the Bank's activities in a given country will be strongly influenced by its commitment to reform. The Bank will be ready to respond in a positive and timely manner to advances in the transition.

II.1 Core business

The Bank's core business is the financing of projects which advance the transition. Its main focus is on the private sector. Its projects must satisfy sound banking principles. The Bank ensures that its activities are additional to alternative market sources of finance. Given the considerable flow of new commitments by the Bank in recent years, the stock of existing projects has become a substantial portfolio and its active and entrepreneurial management is now central to the Bank’s pursuit of sustained transition impact. The Bank seeks to mobilise and catalyse investment both by co-financing and demonstrating new opportunities. It requires sound business practices in all its business partners. The promotion of environmentally sound and sustainable development is an integral part of the Bank’s core business. It is implemented through the financing of environmental projects and those promoting energy efficiency and through environmental components of other projects.

II.2 Priority activities

In conducting its core business the Bank focuses on a number of priority activities, as follows.

• A successful transition requires a sound financial sector which commands the confidence of the population, facilitates transactions, and intermediates effectively and efficiently between savers and investors. The financial sector is therefore a priority for the Bank. The Bank's focus is on building financial sectors that serve the needs of the real economy, including those of small and medium-sized enterprises. The Bank will develop a strategic view of the challenges facing the financial sector in each country, paying special attention to competition, decentralisation and variety in the provision of services. It will help build the necessary financial institutions by investing in them, by transferring skills and by requiring sound business practices. Based on its investor experience and working with other IFIs and the national authorities, the Bank will promote sector reform, in particular sound regulation. It will work with a broad range of instruments and promote both bank and non-bank financial institutions and the development of capital markets.

• Business start-ups and the growth of small and medium-sized enterprises (SMEs) are vital to the transition particularly through the nurturing of entrepreneurship, new jobs and social stability. Building on its substantial experience, the Bank will intensify its activities to promote start-ups and the growth of SMEs. The Bank will use and combine a full range of instruments including credit lines, microlending, equity and venture funds and technical assistance. The EBRD supports banks and other financial institutions that have an institutional commitment to SMEs. The Bank sees its support for SMEs as part of a broader policy framework. This framework includes local and regional infrastructure, training and networks for self-help. It also includes efforts to dismantle impediments to SME development. As it cannot take on all elements of this framework itself, it will work closely with partners, particularly the European Union (EU), and including bilateral institutions and other IFIs.

• Sound, market-based and customer-oriented infrastructure is a key component of progress in the transition. Infrastructure operations are therefore a strong focus of the Bank's activities. The Bank pursues a full range of financing structures (including private, sovereign, sub-sovereign and public/private partnerships), identifying the most suitable structure for each project situation, while recognising that this is likely to vary by country and sector. At the same time, it seeks to promote commercialisation, to strengthen the institutional and regulatory framework, to expand the range of financing sources, and to enhance, where appropriate, the level of private sector involvement.

• The scale and nature of the industrial legacy of the command economy pose a major challenge for the transition process. Through the projects in its portfolio, the Bank has gained experience of enterprise restructuring. Building on this experience the Bank will also seek to support the restructuring of potentially viable large enterprises, carefully selecting a few projects that have a strong demonstration effect. Experience has demonstrated the importance of strategic investors for such projects and of partnership with the local authorities. The Bank will seek to develop a coordinated approach with the World Bank and other IFIs, so that restructuring is supported by complementary programmes, including the promotion of SMEs and local infrastructure, that can help manage the social strains of the restructuring process.

• Equity investment, if managed appropriately, can have a powerful transition impact in providing risk capital and promoting sound business practices and corporate governance. The Bank will therefore continue its active approach to equity investments. Equity investments can provide the Bank with strong additionality and significant returns in compensation for the risks it takes.

• A sound and reliable institutional and policy environment is essential for the generation of the investment flows required to take the transition forward. Building on its project activities and investor perspective, the Bank will seek to promote a sound investment climate and strengthen institutions that are important for the functioning of markets. A sound investment climate is based on a supportive and effective legal and regulatory framework, business integrity and sound corporate governance, limits to bureaucratic interference, a firm stance against corrupt practices, fair and predictable taxation, and transparent accounting. In addressing these issues, the Bank will be selective and focus on areas where it has particular expertise and comparative advantage. It will pursue clearly defined and achievable progress through project design, scope and monitoring and through its work on legal aspects of transition. The use of country strategies in policy dialogue will be intensified. The Bank will build on its work through Foreign Investment Advisory Councils. It will consider their promotion at the local level, drawing on its network of local clients.

III. Implementing the priorities

III.1 Strategic portfolio management

Effective transition impact requires a critical mass of projects. Volume, as well as quality of projects, is important. Moreover the Bank remains committed to the manageable growth strategy and the key financial policies contained in the 1995 Capital Resources Review. The greater size and complexity of the Bank's portfolio today and the sharp increase in risk in parts of the region imply that the Bank's work must be managed systematically from the perspective of the portfolio as a whole. For this purpose the Bank will adopt a strategic approach to portfolio management.

This approach means that both the stock of existing projects and the flow of new commitments will be managed to pursue transition impact whilst balancing, in the portfolio, risks, returns and costs. First, the achievement of transition impact and the implementation of the Operational Priorities must be assessed from the perspective of the portfolio as a whole. Second, the portfolio must be balanced across countries, products and other risk categories in order to achieve transition impact whilst safeguarding the financial viability of the Bank. Third, the approach highlights the importance of rigorous and entrepreneurial management of the existing projects in the portfolio, throughout their cycle.

Specific tools will be required to underpin this approach. These include the further development of the Bank's operational methods for ex ante and ex post assessment of transition impact, effective risk-based allocation of capital to the portfolio, and a more detailed framework within which the Bank can manage and monitor its costs and profitability. A review of the Bank’s loan pricing policy, and the way in which it reflects risk, will be part of the implementation of the strategic portfolio management approach.

III.2 Partnership and effectiveness

In pursuing the above priorities, the Bank will work with partners to exploit complementarities.

The Bank will work closely and constructively as a partner with countries and clients, finding together creative responses to the challenges of transition. Constructive partnership involves listening carefully and speaking out, where necessary, on risks and problems – for example, corruption and poor corporate governance.

The Bank will seek to combine its particular strengths and abilities with those of other international financial institutions and of the European Union to achieve common objectives. The EBRD's special strengths include its project work with the private sector, its promotion of commercial approaches in the public sector, its relationships with enterprises and its investor perspective and skills. These skills and perspectives should inform and complement those of the EU and other IFIs in designing appropriate approaches and programmes. The Bank will seek to intensify its coordination with the multilateral development banks. It will respond constructively to comprehensive development frameworks under development at the World Bank.

Working with official institutions, including the European Union, other IFIs and bilateral donors, and with private lenders and investors, the Bank will build on its strong co-financing record to enhance the mobilisation of official and private sources of finance for its projects.

The Bank will seek to enhance its impact by developing, where appropriate, a cluster approach designed to take advantage of complementarities between projects and other activities at the municipal, regional or sectoral level. It will select such efforts carefully, concentrating on reform-minded administrations committed to change. Municipal infrastructure projects and the promotion of SMEs will be key components of such an approach.

The Bank will seek to address transition challenges in a cross-border framework where possible. The Bank will promote the strengthening of trade within the region and of cross-border infrastructure. There is substantial scope in this area for co-financing with other IFIs.

III.3 Human resources and organisation

Effectiveness in implementing the Bank's mandate benefits strongly from a common Bank culture based on an understanding of its mandate and priorities and on guiding principles for the behaviour of staff in carrying out their work. It is essential to promote corresponding values, skills and experience, to foster the Bank's entrepreneurial strength and spirit, and to provide appropriate incentives to staff.

Developments in the operational environment and the Bank's business focus reinforce the importance of the Bank's local presence. This implies strengthening the role of the Bank’s Resident Offices and increasing the amount of time spent in the field by staff based in headquarters.

III.4 Communication and marketing

The Bank's activities in communications and marketing must ensure that its projects have the visibility to yield their demonstration effects, that business partners inside and outside the region are aware of the services the Bank can provide, that the Bank expresses itself clearly to authorities on the investment climate, and that the Bank speaks out, when necessary, in the interests of the transition of the countries of the region.

IV. Summary of Operational Priorities for the Medium Term

The Bank’s core business is the financing of projects, primarily in the private sector, which advance the transition. The Bank applies sound banking principles to all its operations. It ensures that its activities are additional to alternative market sources of finance. The active and entrepreneurial management of its existing portfolio is an essential part of its core business. The Bank requires sound business practices in all its business partners. An active approach to the environment is integrated into all its work.

The Bank fosters transition in all countries of operations taking careful account of a country's commitment to economic and political reform, and responding in a positive and timely manner to advances in the transition.

Particular priorities are to:

• help create sound financial sectors linked to the needs of enterprises and households

• provide leadership for the development of business start-ups and small and medium-sized enterprises

• pursue commercial approaches and a full range of financial structures for infrastructure development

• demonstrate, through carefully selected examples, effective approaches to restructuring viable large enterprises

• take an active approach to equity investment

• promote a sound investment climate and stronger institutions on the basis of its project experience and investor perspective.

In implementing these priorities, the Bank will:

• adopt a strategic approach to portfolio management in its work to foster the transition so that
  -  the portfolio as a whole embodies the transition objectives and operational priorities of the Bank
  -  the portfolio is balanced across countries, products and risk categories to achieve transition impact whilst safeguarding the Bank's financial viability
  -  all projects in the portfolio are actively managed throughout their cycle.

• pursue partnership and effectiveness through
  -  working as a creative and constructive partner with countries of operations and with clients
  -  working closely with other international financial institutions and the European Union
  -  enhancing the mobilisation of official and private sources of co-financing
  -  seeking to create clusters of activities in selected municipalities, regions or sectors
  -  promoting intra-regional infrastructure and trade.

• strengthen its presence in countries of operations, in particular through an enhanced role for the Resident Offices.