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					  Kosovo: SME Line
  of Credit Project

 00/KOS03/02/001 ICU,
00/KOS03/02/002 UNMIK

     Supervision Mission
       February 2002

European Agency for Reconstruction
Programming, Coordination & Evaluation Division
Evaluation Unit
Egnatia 4
GR-54626 Thessaloniki
Tel: +30-31-0505140
Fax: +30-31-0505172
E-mail: evaluation@ear.eu.int
Web Page: www.ear.eu.int
Kosovo: SME Line of Credit Project
Supervision Mission February 2002
Aide Mémoire - draft version, March 6
A World Bank mission visited Kosovo between February 19 and 27, 2002 to
supervise the progress of the SME line of Credit project including the TA component,
which includes the operation of the Interim Credit Unit (ICU) and training provided to
staff and local banks. The mission included Ms. Katalin Forgacs and Ms. Filloreta
Mengri. This was a joint supervision mission with the European Agency for
Reconstruction (EAR), which was represented by Dr. Luc V. Zwaenepoel, Evaluation
Unit, Thessaloniki. The findings have been arrived at in consensus.
Mr. Gerardo Corrochano and Mr. Ramin Shojai, World Bank (WB), and Mr. Crispin
Meelboom, European Agency for Reconstruction (EAR), further reviewed this Aide
Memoire. The mission visited four enterprises that have been approved for sub-loans
from the ICU. In addition, the mission held meetings with Mr. Richard Oaten, Acting
Minister for the Department of Trade and Industry (DTI), Mr. Paul Davis from the
USAID, the Steering Committee of the ICU, the Bank and Payment Authority (BPK),
the American Bank for Kosovo (ABK), Micro-Enterprise Bank (MEB), Kasa Bank, and
Banka Ekonomike. The mission would like to extend its thanks to all the officials with
whom it met and who gave substantial support to the mission’s work.
The supervision mission covered the following topics:
       Assessment of project progress against initial targets
       Monitoring the performance of the portfolio with regard to interest service,
        principal repayment and reviewing the operation of the ICU in terms of Credit
        Risk Management
       Summary of the findings of the auditor
       Updates on developments in the banking sector in light of possible exit
        mechanisms for the ICU. Follow up with BPK, EAR, DTI, and banks in Kosovo.
       Staffing, Training and Operations of the ICU
       Monitoring the use of the ICU credit line by targeted sectors and reviewing the
        impact of the line of credit on the SMEs in terms of enhanced productivity and
        job creation
This report briefly outlines the current status of the projects, and evaluates its
This Aide Mémoire is subject to the approval of World Bank’s and EAR’s

Summary: Assessment of project progress against initial
ICU has made good progress in the implementation of this project and has been
successful in adapting to the business environment of Kosovo.
The primary objective of the EAR/World Bank SME credit line was to serve as a pilot
project to provide financing to SMEs on market-based terms. This objective has
clearly been attained. However, the project also had a second objective which was
to reinforce reforms in the financial sector; to help establish basic credit management
SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                                   1
capacity and loan administration skills in newly emerging banks, and to assist SMEs
by increasing financial discipline and planning capacity through the credit process.
This second objective has not yet been reached at this time in the project life. (Ref.
Joint UNMIK, European Agency for Reconstruction and World Bank Project
Implementation Guidelines, July 2000)
The Project guidelines and the TA Terms of Reference have been too optimistic
about the future development of the financial sector in Kosovo and the potential
impact of the project. A number of recommendations are mentioned in the Aide
Mémoire to increase ICU’s assistance in enhancing financial discipline and planning
capacity through the credit process.
All the monitoring indicators required by the project for the primary objective have
been largely met. Given the fast pace of implementation and the robust pipeline of
sub-loans that have been built to date, EAR has agreed to provide additional funds (€
6 million). Thus, total funding available has increased to € 13,712,919. (€ 2,6 million
from EAR first Tranche, € 6 million from EAR second Tranche and € 5,112,919 from
the World Bank.)

   Monitoring Indicators                                      Current Status

   Loan Volume: An initial target of 60 “first Cycle” loans   The project currently has 60 first cycle sub-
   should be originated and an additional 43 loans            loan approvals.
   should be “recycled” in years 2-3 of the
   implementation period. Targets will be subject to
   flexibility, depending on the ability of the SME sector
   to present viable proposals, and the average size of
   the loan requests and disbursements made.

   Cumulative lending: Total Cumulative lending should         Currently, total approved loans stand at
   be at 92 and 171 percent of total loan funding             € 7,679,503 with disbursements amounting
   commitments by the end of year 2 and 3 of the              to € 6,562,295 as of 25 February 2002.
   implementation period, respectively                        Original funding commitment was € 7.7
                                                              million (without the new € 6 million Tranche
                                                              from EAR) This means that total approvals
                                                              reached 100% of total original funding
                                                              commitments by February 2002.

   Job Creation: Loans under the pilot SME line of credit     It is estimated that 1112 direct jobs have so
   are expected to directly generate some 600 new jobs,       far been created. This is very much in line
   and help to create about 1,500 jobs in total (including    with what was envisaged at the project
   contracting work)                                          design.

The ICU approved € 7,679,503 to 60 clients and disbursed € 6,562,295 to 52 clients
at the end of February 2002 (see Attachments 1 and 2). An audit of the ICU was
carried out very recently and the report has been made available to the mission.
Overall, the main recommendation of the audit is to record loan loss provisions to €
481,428 reflecting the status of the ICU’s portfolio at 31 August 2001. The mission
agrees with the recommendations of the auditors to establish the loan loss
provisions, given the high risk of doing business in Kosovo and the prevailing weak
regulatory environment, potential problems with enforcement of any security, and the
lack of financial instruments such as letters of credit.
Although the project has been operated under a grant, there is a need for loan loss
provisioning for the following reasons:
SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                                                     2
         (i)        It is the donors’ fiduciary responsibility to take good care of the funds
                    otherwise the market gets the wrong signals;
         (ii)       It is a useful tool to measure the effectiveness of the ICU management;
         (iii)      It is a sine qua non condition to assist with the realistic value of the
                    portfolio. All the possible exit options make it unavoidable for the donors
                    to insist on having       a substantiated knowledge about the fair net
                    present value of the assets.
The mission now requests that in the final report the auditor express an explicit
        As to the appropriateness of the loan classification methodology of the ICU;
        as to the fair net present value of the assets of the ICU.
The mission has also urged EAR to obtain the final report of the auditor as soon as
possible; otherwise, there will be a breach of the WB Grant agreement with UNMIK.
At the time of the mission’s visit, a total of 15 loans were identified by the mission as
potential problem loans. More specifically, twelve customers were in arrears with
their payments.1 Out of the twelve, eight borrowers had arrears longer than 60 days.
In addition, nine out of the fifteen were experiencing problems with timely
procurement of equipment. A few other customers are not in arrears with their
payments but have been found misusing funds. ICU has already launched court
proceedings against three sub borrowers because of the misuse of funds.
The ICU follows the auditors’ recommendations and updates the classification of
borrowers on a monthly basis now (Attachment 4). The mission recommends that the
classification policy (Attachment 3) be further refined on the basis of the overall
standing of the borrowers. In addition, it is recommended that for each Steering
Committee meeting, the ICU prepare a standard format table. Attachment 5 is a
suitable format to provide a regular update on problem loans.
The mission has made several suggestions, which are detailed in this Aide Mémoire,
to reduce the risks related to new sub-loans. More specifically, the suggestions
relate to: (i) introduction of a trial period of six months with more stringent
disbursement methods; (ii) the use of more liquid forms of collateral; (iii) re-wording of
the sub-loan agreement; (iv) improving the quality of credit files and (v) the
preparation of a standard format table for monitoring problem loans.
The review of the operators of ICU demonstrates positive results and the use of
sound accounting and management practices. The transfer of banking and credit
expertise to local staff through formal training, mentoring and coaching has been
successful at large, except for the gradual transfer of responsibilities to the local
credit officers.
A larger training needs assessment was made in October 2001, assessing existing
needs with all financial institutions in Kosovo. The reports stress the important
training gap with local banks on all management levels. The training expert judged
rightly that training support in the international banks of Kosovo is in place. The

1 Due to the intensive monitoring efforts of the ICU, however, five cases have since then been resolved. These five sub-
borrowers have caught up with their late payments and now these accounts have been put back into current status. See
Attachment No.5.

SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                                                                    3
training needs for local banks are well defined and cannot be solved with a general
type of formal bank training, if on-the-job training and the monitoring of impact and
progress do not support it. Another problem is that training initiated by ICU could be
seen as an interference by local banks, perceiving ICU as a competitor and not as a
temporary pilot project in SME lending, to which they can be associated.
For all these reasons, the Mission recommends attaching all future training activities
to other banks to the newly established Bankers’ Association and to design a clear
cooperation with their Bank Training initiatives.
The project is designed to operate for no more than three years, and one of the key
objectives is to provide direct lending to SMEs through the ICU only while financing
from the banking sector is lacking. In accordance with project concept and design,
this mission has put great emphasis on the identification of possible exit
mechanisms. The Joint Project Guidelines are very clear on eligibility criteria for
participating Banks: the licensed banks should have (i) adequate levels of risk-based
capital; (ii) growing assets of high quality; (iii) growing and strengthening earning
trends; (iv) demonstrated liquidity management capacity; (v) development of sound
internal audit and management information systems; (vi) improving and effective
corporate governance; and (vii) general movement towards adequate risk
management systems.
Based on the Missions qualitative and quantitative assessments of the existing
banks, no bank is, at this point in time, eligible to participate in an APEX system type
of on-lending through banks, with the exception of the two foreign owned banks
(MEB and American Bank of Kosovo).
 Due to the insufficient maturity and overwhelming governance issues in the local
segment of the banking sector in Kosovo, it is recommended that the concept of re-
conversion of the ICU into an APEX should be abandoned for the near future
because it could lead to the portfolio getting into the wrong hands. Instead, it is
proposed that a due diligence for three possible exit strategies be carried out in the
near future. These options are explained in detail under the heading “ Updates on
developments in the banking sector in light of the possible exit mechanisms for the ICU.”
Monitoring the performance of the portfolio with regard to interest service,
principal repayment and reviewing the operation of the ICU in terms of Credit
Risk Management
 The repayment history of sub-loans is starting to become evident, with some of the
sub-borrowers starting to repay principals after the six months grace period.
Consequently, the mission feels it is now time to arrive at a few conclusions on the
quality of repayment discipline. At the time of the mission’s visit, 12 clients were
classified as unsatisfactory According to this classification, all clients have been
classified as unsatisfactory whenever the account is in arrears; no equipment is in
place; second hand equipment has been purchased and the plant is not operational.
Attachment 5 provides a summary of the types of problems encountered.
The mission has reviewed all problem credit files and has discussed its
recommendations with ICU management.

1. Introduce more stringent disbursement practices
In the first few months of project implementation, the ICU accepted, in a few cases,
that due to the general poor credit standing of Kosovo, some borrowers had to make
100% advance payment to their suppliers in order to get their equipment delivered.
SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                                          4
Thus, in some cases, 100% of the funds were disbursed to the borrower’s account
against presentation of a pro-forma invoice. However, experience now shows that in
quite a number of cases it seems to be certain that the client never intended to use
the loan proceeds for the purposes stated in the business plan. Some clients still
cannot show documents evidencing the actual purchase of the equipment for which
the loan was intended and their plants are not operational. In some cases,
nevertheless, the client pays promptly all its obligations in due time, although there is
clear evidence of misuse of funds. The mission requests that ICU cancels and calls in
all loans where it believes there has been a misuse of funds 2 because this will give
an important signal to the market.
In order to reduce credit risk originating from pre-contemplated fraud, the mission
recommends that the ICU give consideration to the following measures.
       Whenever possible, pledge the appropriate amount of the loan with
        Commerzbank Frankfurt and ask Commerzbank to issue a guarantee to the
        foreign supplier so that payment can follow after delivery.
       With recent licensing of the American Bank in Kosovo, it has become possible
        to use Letters of Credits (LCs) as a standard form of payment. So, instead of
        disbursing the whole loan amount to the client, payments will be made to the
        suppliers, by way of LCs, enforcing compliance with the product indicators
        required by the purchaser and with appropriate delivery terms. MEB is
        another bank that is offering documentary services.
       In the case of start-up companies with no credit history, reject financing of the
        equipment up-front. Instead, offer refinancing of equipment already purchased
        (World Bank procurement rules allow this for 90 days.)
       In the case of companies with existing credit history where the use of LCs or
        bank guarantees is not applicable, limit the financing of equipment to 30% for
        a trial period of six months. Seventy percent of the financing should come
        from the client and be refinanced after the equipment is in place.

2. A shift to more liquid collateral
The mission commends the ICU for the establishment of strict and regular monitoring
of existing clients. The mission also commends the ICU for adjusting to the Kosovar
business environment where, as a rule, all credit decisions require not only mortgage
and pledge of movable assets but also the availability of personal guarantors who
provide joint and several guarantees in case the original debtor defaults. This
practice, borrowed from micro finance best practices, reflects the fact that
entrepreneurs in Kosovo rely on non-written oral agreements among relatives and
friends and breach of such agreements is hardly ever conceivable.
However, enforcement of mortgages is highly questionable in Kosovo because of the
lack of a comprehensive land reform and of a final resolution of land property rights.
For this reason, mortgages are considered to be the worst form of security.
Institutional capacity in Kosovo to protect secured transactions has been undermined
by continued uncertainty on ownership issues and the absence of bankruptcy and
mortgage legislation. Therefore, in light of the recent establishment of the Central
Pledge Registry, the mission requests that the ICU put more emphasis on more liquid

2 The loans to Albatros and Alba commerce should also be called in although these clients are not in
SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                                                5
forms of collateral. (According to Regulation 2001/5 on Pledges, titles and rights can
also be registered at the Central Pledge Registry.) More specifically, the mission
recommends that ICU request sub-borrowers to open accounts with the reputable
foreign owned local banks (i.e. American Bank in Kosovo and MEB) where western
banking standards are expected and then ask for further collateral: the assignment of
receivables of the client. The mission recommends that ICU insist on the pledge of
rights for monetary claims under the borrowers’ sales contracts. This pledge, in turn,
will give the right of set-off to ICU, the bank acting as its agent. MEB also expressed
its willingness to act as agent for the ICU with regard to this type of collateral.

3. Re-wording of the loan agreements
The October 2001 mission made a long list of recommendations with regard to the
changes that were deemed necessary to be introduced. In addition to these earlier
recommendations, the following changes are proposed:
        The loan agreement needs to spell out clearly when disbursement of the loan
         proceeds is in the form of a guarantee or an LC;
        The loan agreement needs to spell out clearly when disbursement is offered in
         the form of refinancing of already purchased equipment, stating the upper limit
         in days permitted by WB rules.
        The mission requests that the ICU procures a formal legal opinion from a
         major internationally affiliated law firm on the finalized version of the Loan

4. Improvement in the quality of credit files
The mission has, during the last three supervision missions, reviewed more than half
of the 60 loans already approved. It feels that it is time to establish a Credit
Administration Unit, which should ensure that all files are in conformity with the
procedures of the ICU, approved at the inception of the project. This Unit should
regularly check the credit files and circulate checklists to all credit officers reminding
them of the missing items in the files. More specifically, the mission requests that all
files contain a written credit appraisal in a uniform structure that should form part of
the loan approval documents. This should be produced retroactively in all cases
where such a credit proposal is missing.3
Monitoring reports and environmental reports should be typed out, as handwritten
notes are difficult to read.

3 The mission proposes the following uniform structure:
  1. Loan approval form, showing amount, purpose, maturity, grace period, all terms and conditions, all covenants, all pre-
     disbursement conditions, all collateral, all previous ICU exposure and the total of all exposures proposed (If applicable).
  2. Description of the proposed transaction with detailed use and source of funds; detailed time table
  3. Description of the Business: detailed description of activities, suppliers and customers, payment discipline, Management,
     major competitors
  4. Analysis and mitigation of major risks;
  5. Description of liquid collateral arrangements and other collateral
  6. Financial analysis of the company on the basis of an Investment/Business Plan; Sensitivity analysis, market analysis
  7. Sector analysis and Socio-economic impact
  8. Recommendations: Covenants and pre-disbursement conditions.

SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                                                                            6
A new regulation will be issued in early 2002 under the auspices of the CFA, on the
establishment of Kosovo Accounting Reporting Board, which will have seven
members and control the Licensing of auditors in Kosovo. In addition, the new
government tax policy will be administered by the CFA (Pillar 1V). These regulations
will cover profits tax for companies with annual turnovers above DM 200,000 and/or
with assets exceeding DM 100,000 which will be obligated to prepare and submit
financial statements following IAS standards, wages tax for employees, property tax
and a pension system to be paid by employees and employers. The mission
recommends that ICU put a strong emphasis on the submittal of financial statements
in this sub-borrower segment. The files should contain the financial statements of the
clients and ICU should also include in its quarterly monitoring whether the client is in
arrears with its tax payments.
Almost all of the lending projects that have been disbursed are for the amount of
300K and are for three years, with grace periods generally reaching 6 months. The
mission advised ICU to revert from this uniform approach and start reviewing loans
with lower lending requirements, with shorter repayment periods in an effort to
provide more sub-loans to smaller businesses and also to pay more attention to
sector diversification. The use of the grace period can vary in function of the activity
or investment. This must be made clear by the cash flow analysis of the client.

5. Standard forms for monitoring purposes
The ICU follows the auditors’ recommendations and updates the classification of
borrowers on a monthly basis now (Attachment 4). The mission recommends that the
classification policy (Attachment 3) be further refined on the basis of the overall
standing of the borrowers. In addition, it is recommended that for each Steering
Committee meeting, the ICU will prepare a standard format table. Attachment 5 is a
suitable format to provide a regular update on problem loans.

Summary of the findings of the auditor
An audit of the ICU was carried out in the autumn of 2001 for the period ending on 31
August 2001. The draft report was made available to the mission. Overall, the main
recommendation of the audit is the increase of the loan loss provision of ICU to
€ 481,428 reflecting the status of the portfolio at 31 August 2001.
The mission understands that under Kosovar conditions, it is very difficult to form an
opinion about the prudent provisioning level and more time is needed to make a
proper assessment of the repayment profile and the enforceability of collateral.
However, the mission feels that it is of paramount importance that the auditor should
express an explicit opinion about the required level of loan loss provisioning.
(Although according to the current accounting policy of the ICU, its financial
statements are based on cash inflows and outflows, the statements do include a loan
loss provisioning item.).
As indicated in this Aide Mémoire, there have already been a few circumstances
identified that represent a measurable indicator of an increase in credit risk, and,
accordingly, loan loss provisioning should be amended to reflect these factors.
Therefore, the mission requests that the auditor express an explicit opinion
       as to the appropriateness of the loan classification methodology of the ICU;
SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                                    7
        as to the fair net present value of the assets of the ICU.
The mission has also urged EAR to obtain the final report of the auditor as soon as
Updates on developments in the banking sector in light of the possible exit
mechanisms for the ICU
The project is designed to operate for no more than three years, and one of the key
objectives is to provide direct lending to SMEs through the ICU only while financing
from the banking sector is lacking. It was originally envisaged, that as more banks
are licensed in Kosovo, in accordance with project concept and design, the ICU will
rely on BPK to provide guidance on how to gradually reduce direct lending to SMEs
and eventually sell its assets to local banks or to operate as an APEX. (See also
Attachment No.7: ICU’s paper on Exit Strategy.)
The following five options have been discussed at length with the major players and
were also based on the proposed exit strategies prepared by the team leader of the
ICU. The mission advises that an early decision is taken on the continuation of the
project (SME credit line plus TA) beyond May 2003 for the WB and beyond
September 2003 for the EAR. For a similar intervention in SME lending in a post-
conflict situation in Kosovo is two years time too short to have a real impact. The
following options have a clear time schedule (1-2 year extra) and will demand extra
timing and a well-focused TA component assured.

Option 1. An auction system for the sale of the portfolio
This mission has reviewed in depth the Rules of the Banking and Payments Authority
of Kosovo. These Rules have established the following limitations on large exposures
and credit concentrations.
    “No bank shall extend credit to any one borrower or group of aggregated
    borrowers…which exceeds 10% of its Tier 1 Capital unless such extension has
    first been approved at a duly convened meeting of its Board of Governors at
    which a quorum was present and voted.”
    “No bank shall have outstanding in the aggregate, credits to borrowers or groups
    of aggregated borrowers…each of which is in excess of 10% of its Tier 1 capital, if
    the total of such outstanding aggregate credits exceeds 300% of the bank’s Tier 1
    “No bank shall have outstanding at any one time extensions of credit to any one
    borrower or group of related borrowers exceeding 20% of its Tier 1 capital.”
In light of these limitations, and also given the fact that most banks are
undercapitalised in absolute numbers as well, there is only one bank with
sufficient capital that could hypothetically be in the position to bid for the
assets of the ICU. This is the Micro Enterprise Bank (MEB), which was
established by Commerzbank, IFC and EBRD. All the other banks are not
sufficiently capitalized yet to be able to buy the assets of the ICU. The table
below summarizes the equity, loans and deposits of all licensed banks in
Kosovo, as of February 2002, in € thousands.
        Units       MEB        American    New      Bank for   Economic    Credit     Kasa
                                Bank of   Bank of    Private     Bank     Bank for    Banka
                                Kosovo    Kosovo    Business              Prishtina

SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                                            8
    Equity        7,720.526     2,903.158     1,612.632   1,998.689   1,616.842   1,583.421   1,583.421

    Loans            11,176           1,516     11,489       6,611       2,260         998       1,346

    Deposits        304,720          13,049     51,938      26,043       7,882       8,447       4,925

    No. of           80,135           4,424     20,964       9,059         412       1,483       1,564

As shown by this table, it is highly questionable that any single local bank can
participate in a potential open tender for the whole of the portfolio of the ICU, with the
exception of MEB. Selling the portfolio to the foreign owned and prudently managed
MEB would certainly ensure that credit losses are averted. This action would be in
line with the TA Terms of Reference, were it is stated that: “Clearly, measures will be
taken to ensure that the SME activities being channelled through the ICU will
complement and harmonize with the operations undertaken by the MEB as well as by
the KfW Refinancing Fund (2 million Euro) which is designed to encourage the
growth of commercial banks as well as micro-enterprises.”
However, this step would further strengthen the position of MEB which already holds
dominant positions in the whole of the banking sector; and, anyway, this bank has
not expressed great interest in taking over portions of the ICU portfolio, consisting
mainly of investment loans with maturities of three years as a rule. (MEB currently
offers loans up to DM 100,000, for short-term working capital purposes, with interest
rates usually around 22%. During an interview with the General Manager of the MEB,
however, he confirmed a future change in the Bank’s product mix by introducing SME
and Housing loans to his clients.) Parts of the portfolio, however, could eventually be
offered for sale on a continuous basis. The sub-borrower loan agreements need to
be amended so that certain portions of the loan portfolio could be sold to other
financial institutions. This will be very important to the implementation of the ICU’s
exit strategy. The ICU is also encouraged to enter into participation agreements with
the American Bank for Kosovo and MEB, provided that the agreements ensure pro
rata allocation of collateral/security eventually enforced.

Option 2. Transforming the ICU into an APEX
As to the local banks, in reference to the eligibility criteria for participating
banks, most of them show weaknesses in institutional capacity, and, first of all,
in effective corporate governance. Thus, in the case of transformation of the
ICU into an APEX, a deterioration of the loan portfolio is to be expected unless
extensive training is provided to these banks. Even then, there is a high
likelihood that corporate governance issues may emerge because of the
ownership structure of some of these banks. Many of the local banks are
owned by Kosovar companies and some shareholders have a very
questionable or even dubious reputation. Indeed it is questionable how undue
influence from these owners can be averted and how credibility of lending
decisions can be ensured. The mission has therefore reached the conclusion
that the conversion of the ICU into an APEX in the near future would not best
serve the interests of the Kosovar banking sector’s development.

SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                                                   9
Option 3. Merger with another bank
After consultation with the major banks that are actively involved in SME financing,
the mission believes, that, eventually, the feasibility of a merger with the newly
established American Bank for Kosovo (ABK, owned by KBFF, which is a fund
established by USAID and Rabobank) should be explored. At this bank, there is no
need for training and prudential standards of lending, and thus the quality of the loan
portfolio, can be preserved. This option would ensure that there is considerable
counterbalance created to the overwhelming position of MEB and this would
favourably enhance competition. A further argument in favour of this option is that
ABK has already made the investments needed in systems, building and security.
This bank seems to target the same niche as ICU does. ABK intends to concentrate
on smaller loans to small businesses, up to the maximum amount of DM 400,000.
Their average loan amount is DM 97,000. They do not offer grace periods. Interest
rates are in the same range as those of the ICU (14-17%). 4 However, this option will
require that the ICU be first transformed into a legal entity with true shareholders (an
NGO or a Trust would be feasible choices) and the merger would then be carried out
by this legal shell. A further favourable feature of this option is that there is no need
for a licensing process for the ICU to be carried out before the merger. The mission
feels that this option will require the extension of the closing date of the project by at
least one year. Discussions with USAID will need to be initiated on the subject and
legal preparatory work will also need considerable time.

Option 4. Acquisition of ICU by the American Bank of Kosovo
A merger scenario (option 3) would eventually result in complicated co-ownership
issues (voting rights, eventual subordinated positions, etc.). The mission was
informed by USAID Kosovo mission that the American Bank would be significantly
capitalized in the near future. It is estimated that its equity range would be in the
range of € 5 million by the end of this calendar year. Thus this bank would be in the
position to bid for the acquisition of the ICU. This acquisition scenario would be
different from the outright purchase of assets scenario (option 1) in that in the
framework of the acquisition, not only the assets, but also the employees and the
systems of the ICU would be taken over. It was agreed that USAID would contact
UNMIK and EAR officials in the near future to start discussions.

Option 5. Transforming the ICU into a fully licensed commercial bank
The ICU may eventually be licensed by the authorities as a specialist bank in the
SME area, limiting its scope to aspects of SME business (deposits, loans,
remittances, Letters of Credit, account keeping). With total funding available now
having been increased to €13,712,919, ICU has become one of the most important

4 Name                   Type of facility                                            Interest rate

Micro Enterprise Bank    Loans up to eighteen months – DM 2,000 to 100,000           20% to 22%

American Bank for        Loans up to two years – maximum DM 400,000                  17%
Kosovo (KBFF)

Private Business Bank    Family businesses – up to 1 year – DM 5,000 to DM 100,000   10.5% to 14%

SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                                                   10
players on the local market. It is questionable, however, whether a third fully fledged
commercial bank of a considerable size could be absorbed by the market
The mission feels that this option, too, will require the extension of the closing date of
the project by one more year at a minimum. Consultations with the BPK have made
it clear that the eventual licensing process would be a lengthy one because a
detailed business plan must be submitted to the authorities. The mission is also
convinced that there is a need for a due diligence to be carried out with regard to the
most efficient shareholder structure. The funds from EAR and the World Bank would
form the equity of the new legal entity. Potential solutions for eventual shareholder
structure comprise the use of an NGO or a Trust.
This option might eventually be further modified in that three existing EAR operations:
ICU, ABU (the Agribusiness Unit of the EAR); and, the eventual Housing Loan
program would be put under the same umbrella and the emerging bank would
comprise all these activities. This option would, however, need significant further
investments in terms of building, security, employees, systems and technical

Proposal: the following decisions need to be taken
        (1) Both EAR and the World Bank will examine the feasibility of the extension
        of the closing date of the project until December 2004.
        (2) New ToRs for the TA contract needs to be issued for the period 2003-2004
        in line with the updated project objectives;
        (3) The contract of the chief contractor will need to be re-tendered or extended
        until December 2004.
        (4) It was agreed with EAR that EAR would hire a consultant in the near future
        and this consultant would carry out the due diligence of the feasible options by
        the end of June 2002.

Staffing, Training and Operations of the ICU
Staffing: In line with the original project design, now four full-time international staff
are working in ICU. They include a project director, two-credit specialists, and an
accounting/financial management specialist. It is envisaged that the EAR will initiate
negotiations with the chief contractor ICC on contract extension or make a decision
with regard to re-tendering the contract. It is of paramount interest that this issue be
solved because the project (for WB until May 2003/for EAR until September 2003)
implementation period is one year longer than the contract with the consultants
contracted by ICC.
In addition, seven full-time local staff have been hired and most of them will be
trained to assist in the running of the ICU operation. They include three Credit
Officers, one accountant, one secretary, and two drivers. In light of the second
tranche from EAR, it has been agreed that two further local officers (one credit
officer and one business development officer) will be hired in the near future.
To provide advice on legal documentation, a local lawyer has been recruited on
a part-time basis.

SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                                     11
Staff Training: Training of the Credit Department local staff continued in November
2001 and January 2002. In this period, two full time courses were conducted:
“Appraisal of Loan Applications” and “Balance Sheet and Financial Analysis.” After
interviewing ICU staff and reviewing their training program, the mission finds their
progress to date to be satisfactory. Local staff training is already well underway.
However, training has been rather theoretical so far. Local credit officers have been
assigned only partial tasks and lack comprehensive familiarity with the lending
process as a whole. The mission has proposed that the international staff be
assigned supervisory activities and the local credit officers be given direct
responsibilities with regard to 10-15 borrowers each. This delegation of
responsibilities will enable staff to receive more on the job training and ensure better
understanding of the whole process of lending. Also, the use of the Entermod
projection model needs to be taught to local credit officers otherwise they will not be
able to understand on what basis credit decisions are made. The Entermod model
will be made available to the World Bank for eventual comments.
The mission also feels it is necessary to engage an SME-Business planning
specialist to teach both staff and customers. Many sub-borrowers have demonstrated
weaknesses in understanding how to compile a business plan. There is also a lack of
understanding as to how to enter into contractual arrangements with foreign suppliers
and how to defend their own interests. There is also a need to educate borrowers on
procurement rules. It is suggested that the World Bank organizes a seminar on
procurement in the near future.
The mission recommends hiring an International Business Development Expert,
seconded by a local officer. The strengthening of the staff in Business Development
will enhance the assistance to SMEs by increasing financial discipline and planning
activity through the credit process. The mission commends the ICU for the excellent
work done in the Skills Transfer of Financial Department Staff. (See Attachment

Performance based compensation scheme: The February 2002 Steering Committee
has approved a performance-based compensation scheme designed for local staff as
an inducement to positive portfolio performance. In light of this mission’s findings, it
is recommended to maintain such a system.

Training to local banks. An Association of Commercial Banks of Kosovo has recently
been established. The Founders are the following banks: MEB, ABK, Kasabanka,
New Bank of Kosovo, Private Bank of Business, Banka Ekonomike, and Banka
Kreditore. One of the major objectives of this new Association is “to organize and
provide training, conferences and seminars in the field of banking for the benefit of its
members and their managers and employees.” The mission proposes that future
training efforts be carried out in co-operation with this newly established organization.
It is also proposed that further funds should be made available for training purposes.
Under the umbrella of the Banking Association, not only bankers but also borrowers
should be offered courses. According to the banks interviewed, the major emphasis
should be on governance, company law, accounting, and interpretation of financial
statements seminars.

SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                                    12
Cost recovery: The aggregate amount of revenue generated from interest income
and fee income, up to 31 January 2002 is estimated to be € 580,196. This amount
will be more than sufficient to pay for the local operating cost. However, since the
local operating cost is being paid by the EAR contract, the revenue generated will be
added to the capital of the ICU and will be used for further lending.

Monitoring by sectors and job creation
It is estimated that there are about 700 SMEs in Kosovo with 10 or more
employees. It is further estimated that about 50% of these businesses have an
average credit investment need of € 150,000. Based on these assumptions, the
demand for credit could be as much as € 50 million. The term “SME” in
Kosovo diverges from the definitions applied in most Western European
countries.5 In Kosovo, the size of SME businesses is much smaller than in the
EU. This is clearly reflected by the statistics of the ICU with regard to the Size
of Businesses they lend to. Seventy two percent of the approved businesses
are small enterprises with less than 20 staff.

                         (%) Of sub-loans approved            Size of the Borrower
                                                              according to staff no.

                                      4%                                  0

                                      43%                               0-10

                                      22%                              11-20

                                      20%                              21-50

                                      8%                                51+

The Mission recommends that the monthly monitoring of sub borrowers ensure that
the job creation numbers are amended where necessary. Reporting on loan related
job creation should be included in progress reports and should be assessed over
time. The indicator of job creation was an important part of the World Bank log frame
and can be used for further social impact studies. According to the log frame, it was
expected that the disbursement of € 7.5 million loan amount would result in the
creation of 1,300 jobs. After interviews with the enterprises, it is expected that
approximately 1,112 new direct jobs will be created as a result of the 60 approved
loans. This will result in one job created for every € 6,887 lent. Seventy one percent
of sub-loans will create less than 20 jobs.

                         (%) Of sub-loans approved Number of Jobs created

5 According to the classification adopted by the European Union, the category “SME” comprises the
following enterprise categories:
SMALLEST: up to 9 persons employed
SMALL: up to 49 persons employed, net sales below 7 Million Euro and total Balance Sheet below € 5 Million.
MEDIUM: up to 249 persons employed, net sales below 40 Million Euro, and total BS below € 27 million E.
SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                                                            13
                                     72%               0-20

                                     20%               21-40

                                     8%                 41+

Gender: In the period ending in October 2001, the ICU had approved three loans to
women entrepreneurs totalling € 472,962 - DM 853,345. Since then a further loan
has been approved to a female Medical Specialist to enable her practice to buy new
equipment. While this is good progress, the ICU should maintain its efforts in
identifying bankable projects for women.
The mission indicated earlier that the access of women to the credit line is hampered
by a number of interrelated factors: access to resources, training and asset
ownership. Recent gender studies by the EAR Prishtina office highlight that women in
Kosovo have basically no ownership of land and other resource endowment. This
situation prevails largely due to the traditional laws of a rigid patriarchal society in
which women enjoy few rights (Kanun). However, in statutory law women have the
same entitlement to land as men. The impact study (Situation Analysis of Women in
the Rural Economy Kosovo, EAR Survey, 2000) rightly claims that: “Land ownership
is often the key to having control over other resources and services, the most
important of which is credit and training.”
In relation to the SME credit line, women entrepreneurs will have less access to
sub loans due to the mortgage and other guarantee regulations and the
amounts required are well below the ICU minimum. This leaves this category
of entrepreneurs to borrow money from families or micro financing institutions
to finance bankable projects in the rural and social economy.

Minority Groups: The existence of a well-developed Marketing Plan is still needed
before launching the new tranche of funds that are expected from EAR, in the
amount of € 6 million. It is proposed that 5% of this new second EAR Tranche be
made available to minorities, knowingly accepting the higher risks involved. The ICU
is requested to make more marketing efforts in the Mitrovica region. The
recommendations to use more liquid collaterals and to have custom-tailored variable
grace periods also apply to loans to minority groups.
A large portion of ICU time is devoted to this activity but the minority groups only
represent about 12% of the population. There have been three sub-loans to minority
groups in Kosovo -- one to a Kosovar-Bosnian and one to a Kosovar-Turk totalling
DM 390,000. A further loan was disbursed to a Kosovar-Serb in the Ski Resort for
DM 200,000. The other proposed loan to the Ski-Centre was not proceeded with as
the IMEX hotel chain provided their own funds. The ICU continues to look for
Kosovar -Serb loans, as they are the largest minority group. Progress in this area is
hampered by the security risk and lack of suitable openings for potential business in
these enclaves. There are also technical reasons, like the lack of sound and viable
business plans. To increase the publicity of the ICU and the sub-loans, several
seminar programs took place in several major towns.

SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                                   14
Environmental and Insurance Issues
Environmental Issues: Most sub-loans approved fall under Category I (low risk) and
Category II (Intermediate risk). The previous mission’s review of the projects has
shown that not all project appraisal reports have descriptions of environment
screening. This mission has found that the ICU has made good improvement in
establishing environmental monitoring reports. However, the missions recommend
that the environmental reporting should be more detailed and typed out.
Recommendations concerning standards and norms-in and outside the workplace-
will be in line with the EU Guidelines.

Insurance: A long awaited regulation of the UNMIK (Regulation No.2001/25) covers
the licensing, supervision and regulation of insurance companies. Under the ICU
credit agreements, it is the legal obligation of the sub-borrowers to get insurance
coverage for the machinery/equipment etc. financed under the facility. To date,
insurance coverage is provided by the manufacturers/suppliers of the equipment until
the goods are received by the sub borrower. At present, insurance coverage in
Kosovo is only available for motor vehicles. This new regulation is the first step
toward enabling licensed insurance companies to cover all types of insurance.
The ICU is now waiting for the BPK to license the individual companies in order to
start the insurance process.

SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                               15
Summary of Issues Raised at the last Mission and new Issues
Issues raised at previous mission                    Actions taken
ICU should establish a log frame with                Done
appropriate indicators
Training needs assessment of the local banks         Done
Better tracking of job creation by project            A job creation track needs to be in place by
                                                     April 1, 2002
Environmental reports to become integral part of     Done, but needs improvement in depth and in
credit files                                         line with EU requirements
Marketing plan with regard to efforts to be made     A new Marketing Plan needs to be proposed by
to target potential sub borrowers in minority        April 1, 2002
Monitoring system to be restructured and well
kept                                                 New proposal before April 1, 2002
Better tracking of Gender Development                On a continuous basis
Sector diversification to be emphasized              Sector diversification paper to be proposed
Loan agreement to be revised                         Still more work needs to be done and a legal
                                                     opinion on the finalized agreement will have to
                                                     be in place by April 1
Efforts to be made to reduce average loan size       ICU agreed-on a continuous basis
Do not disburse before valid supplier contract is    ICU agreed /strict monitoring is needed
Split investment loans from Working Capital          Done
loans, the latter to be disbursed upon evidencing
the arrival and launch of equipment
Consistently demand financial statements from        This will be done on an ongoing basis
sub borrowers with annual sales above 200,000
and/or total assets exceeding 100,000
Follow up with MEB and American Bank for             Not done/ Action required before April 1, 2002
Kosovo the payment methods and security
issues outlined in this Aide Memoire
Refine classification system of borrowers follow     Done
up on loan loss provisioning
New issues raised at this mission                    By when
Obtain Final report of the auditor through EAR       As soon as possible
Stop using the old credit agreement                  As of immediate effect
Apply more stringent disbursement methods and        As of immediate effect
stop financing 100% of the equipment up front
Shift to more liquid collateral                      As of immediate effect
Finalize new credit agreement                        As soon as possible
A uniform credit appraisal report should be          By April 2002,with retroactive effect
integral part of each file
Local credit officers need to be taught the use of   By May 2002
Entermod projection model
Delegate management/monitoring to local credit       On an ongoing basis; finish by May 2002
officers (10-15 borrowers each)
Set up a credit administration unit                  By April 2002
Refine Classification Policy                         By April 2002
Decision on hiring Business Development expert       New contract (August 2002)
and local officer
Training initiatives with Bankers Association        As soon as possible
Use of liquid collaterals and custom tailored        As soon as possible
grace periods

SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                                                    16
    1.   Approvals (to date)
    2.   Disbursements (to date)
    3.   Classification policy
    4.   Classification of Borrowers as of February 2002.
    5.   A Standard format for reporting problem loans
    6.   Quarterly report of the ICU for the period ending in January 2002
    7.   ICU’s Paper on Exit Strategy
    8.   ICU Skills Transfer –Financial Department Staff

SME Line of Credit Project, Kosovo
Supervision Mission, February 2002                                           17

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