As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

11/09/06  Int’l Bank for Reconstructio… Dev QRTLYRPT/A  6/30/06    1:6.8M                                   Merrill Corp-MD/FA

Document/Exhibit                   Description                      Pages   Size 

 1: QRTLYRPT/A  Amendment to Quarterly Report by an International   HTML   3.59M 
                          Development Bank                                       

 

International Bank for Reconstruction and Development

Management’s Discussion & Analysis
and
Financial Statements
June 30, 2006

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INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

MANAGEMENT’S DISCUSSION AND ANALYSIS
JUNE 30, 2006

Section 1: Overview		3
Section 2: Basis of Reporting		5
Section 3: Development Activities		10
Loans		10
Guarantees		15
Other Activities		16
Section 4: Liquidity Management		16
Section 5: Funding Resources		18
Equity		18
Borrowings		21
Section 6: Financial Risk Management		22
Governance Structure		22
Managing Risk-Bearing Capacity		24
Credit Risk		25
Market Risk		28
Liquidity Risk		32
Operational Risk		32
Section 7: Critical Accounting Policies		32
Section 8: Results of Operations		34
Section 9: Governance		37
Section 10: Reconciliation of Prior Year Current Value Financial Statements to Reported Basis		39
Glossary of Terms		41

 

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LIST OF BOXES, TABLES AND FIGURES

		Boxes
1		Selected Financial Data		4
2		Hedging Strategy and Use of Derivatives		5
3		Lending Operations Principles		9
4		Treatment of Overdue Payments		26
		Tables
1		Condensed Current Value Balance Sheets		7
2		Condensed Current Value Statements of Income		8
3		Summary of Current Value Adjustments		8
4		Impact of Currency Translation Adjustment		10
5		Lending Status		11
6		Contractual Terms of Currently Available Products		12
7		Contractual Terms of Previously Available Products		14
8		Loan Charge Waivers		15
9		Guarantee Exposure		16
10		Liquid Asset Portfolio Returns and Average Balances		18
11		Contractual Cash Obligations		19
12		Equity Capital		20
13		Capital Subscriptions of DAC Members of OECD Countries		21
14		Funding Operations Indicators		21
15		Accumulated provision for Losses on Loans by Portfolio		27
16		Credit Exposure, Net of Collateral Held, by Counterparty Rating		28
17		Financial Instrument Portfolios		29
18		Net Income		35
19		Net Noninterest Expense		36
20		Condensed Current Value Balance Sheet at June 30, 2005		40
21		Condensed Current Value Statement of Income for the year ended June 30, 2005		40
		Figures
1		Impact on Retained Earnings and Other Equity: FAS 133 vs. Current Value Adjustments		6
2		Commitments including Guarantee Facilities by Region		11
3		IBRD Lending Commitments		12
4		Loan Portfolio by Loan Product		15
5		Liquid Asset Portfolio Composition		18
6		Equity-to-Loans Ratio		19
7		New Medium- and Long-term Funding Excluding Swaps by Currency		22
8a		Effect of Swaps on Interest Rate Structures		23
8b		Effect of Swaps on Currency Composition		23
9		Top Eight Country Exposures		25
10		Relative Currency Composition of Significant Balance Sheet Components—Current Value Basis		31
11		Six-Month LIBOR Interest Rates U.S. Dollar		34
12		IBRD’s U.S. Dollar Funding Curve		37

 

 

 

 

1. OVERVIEW

The International Bank for Reconstruction and Development (IBRD) is an international organization established in 1945 and is owned by its member countries. IBRD’s main goals are promoting sustainable economic development and reducing poverty in its developing member countries. It pursues these goals primarily by providing loans, guarantees and related technical assistance for projects and for programs for economic reform. IBRD’s ability to intermediate funds from international capital markets for lending to its developing member countries is an important element in achieving its development goals. IBRD’s financial objective is not to maximize profit, but to earn adequate net income to ensure its financial strength and to sustain its development activities. Box 1 presents selected financial data for the last five fiscal years.

The financial strength of IBRD is based on the support it receives from its shareholders and on its array of financial policies and practices. Shareholder support for IBRD is reflected in the capital backing it has received from its members and in the record of its borrowing members in meeting their debt-service obligations to it. IBRD’s financial policies and practices have led it to build reserves, to diversify its funding sources, to hold a large portfolio of liquid investments, and to limit a variety of risks, including credit, market and liquidity risks.

IBRD’s principal assets are its loans to member countries. The majority of IBRD’s outstanding loans are priced on a cost pass-through basis. (See Tables 5 and 6 for loan pricing details).

To raise funds, IBRD issues debt securities in a variety of currencies to both institutional and retail investors. These borrowings, together with IBRD’s equity, are used to fund its lending and investment activities, as well as general operations.

IBRD holds its assets and liabilities primarily in U.S. dollars, euro and Japanese yen. IBRD mitigates its exposure to exchange rate risks by matching the currencies of its liabilities and equity with those of its assets. However, the reported levels of its assets, liabilities, income and expenses in the financial statements are affected by exchange rate movements in all the currencies in which IBRD transacts compared to IBRD’s reporting currency, the U.S. dollar. Since IBRD matches the currencies of its equity with those of its loans, the fluctuations captured in the cumulative translation adjustment for purposes of financial statement reporting do not significantly impact IBRD’s risk-bearing capacity.

Lending commitments to member countries in FY 2006 were $14.1 billion, reflecting an increase of $0.5 billion from the FY 2005 level of $13.6 billion.

For the purposes of this document Operating Income refers to net income before Board of Governors-approved transfers and the effect of net unrealized gains (losses) on non-trading derivative instruments, as required by FAS 133. FY 2006 Operating Income was $1,740 million, $420 million more than that for FY 2005. This had the effect of increasing IBRD’s return on equity(a) from 3.90% in FY 2005 to 5.05% in FY 2006 (see Box1).

During FY 2006, provisioning requirements for probable losses on loans and guarantees were reduced by $724 million due to the combined impact of changes in the creditworthiness of the loans portfolio, the annual update of the expected default frequencies (probability of default to IBRD), developments in the nonaccrual portfolio and the reduction in the volume of the loans portfolio.

In the context of assessing changes in IBRD’s operating environment, it is management’s practice to recommend each year the allocation of net income to augment reserves, waivers of loan charges to benefit eligible borrowers, and allocation of net income to support developmental activities.

On August 7, 2006, the Executive Directors approved the following allocations from FY 2006 net income: $1,036 million to the General Reserve and $64 million to the Pension Reserve. In addition, the Executive Directors recommended to IBRD’s Board of Governors the following transfers from unallocated net income: $140 million to Surplus, and $500 million to the International Development Association (IDA) as well as the transfer of $300 million to IDA out of Surplus.

The Executive Directors also approved a 100 basis point waiver of the front-end fee on all loans (other than special development policy loans) presented to the Executive Directors between August 7, 2006 and the date on which the Board approves a front-end fee waiver for FY 2008. The Executive Directors also approved that (i) interest charge waivers will be maintained at 5 basis points for old loans and 25 basis points for new loans, respectively, to eligible borrowers for payment periods commencing during FY 2007 and (ii) waivers of 50 basis points on commitment charges for FY 2007 will be maintained for all loans.

(a).       Before the effects of Board of Governors-approved transfers and FAS 133.

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Box 1: Selected Financial Data
As of or for the Years Ended June 30

In millions of U.S. dollars, except ratio and return data in percentages

		As Adjusted(a)
Lending		2006		2005		2004		2003		2002
Commitments to member countries(b)		14,135		13,611		11,045		11,231		11,452
Gross Disbursements(c)		11,883		9,722		10,109		11,921		11,256
Net Disbursements(c)		(1,741	)	(5,131	)	(8,408	)	(7,996	)	(812	)

 

Reported Basis		2006		2005		2004		2003		2002
Loan Income		4,864		4,155		4,403		5,742		6,861
Release of Provision for Losses on Loans and Guarantees		724		502		665		1,300		15
Investment Income		1,057		628		304		418		738
Borrowing Expenses		(3,941	)	(3,037	)	(2,789	)	(3,594	)	(4,907	)
Net Noninterest Expense		(964	)	(928	)	(887	)	(845	)	(783	)
Operating Income		1,740		1,320		1,696		3,021		1,924
Board of Governors-Approved Transfers		(650	)	(642	)	(645	)	(540	)	(402	)
Net unrealized (losses) gains on non-trading derivative instruments, as required by FAS 133		(3,479	)	2,511		(4,100	)	2,323		854
Net (Loss) Income		(2,389	)	3,189		(3,049	)	4,804		2,376
Net Return on Average Earning Assets(d)		1.34		0.96		1.18		2.06		1.29
after the effects Board of Governors-Approved Transfers and of FAS 133(c)		(1.84	)	2.32		(2.12	)	3.27		1.60
Return on Equity		5.05		3.90		5.21		10.32		7.09
after the effects Board of Governors-Approved Transfers and of FAS 133(c)		(6.84	)	9.26		(8.88	)	14.55		8.34
Equity-to-Loans Ratio(d)		32.96		31.45		29.35		26.59		22.90
Total Assets		212,326		222,008		228,910		230,062		227,454
Loans Outstanding		103,004		104,401		109,610		116,240		121,589
Accumulated Provision for Loan Losses		(2,296	)	(3,009	)	(3,505	)	(4,045	)	(5,053	)
Borrowings Outstanding(e)		95,835		101,297		108,066		108,554		110,263
Total Equity		36,474		38,588		35,463		37,918		32,313

 

		As Adjusted
Current Value Basis		2006		2005		2004		2003		2002
Net Income		640		402		484		2,896		2,451
of which current value adjustment		(446	)	(273	)	(513	)	394		881
Net Return on Average Earning Assets		0.49		0.28		0.33		1.90		1.60
Return on Equity		1.86		1.17		1.44		9.41		8.65
Equity-to-Loans Ratio		32.44		30.83		29.07		26.36		23.10
Unrestricted Cash and Liquid Investments		24,888		26,395		31,126		26,620		25,056
Loans Outstanding		103,885		107,549		112,608		122,593		126,454
Borrowings Outstanding(e)		95,258		105,691		109,675		116,695		114,502
Total Equity		37,590		36,943		36,421		35,675		32,466

(a).       IBRD’s Statement of Income has been adjusted for prior years as a result of a change in accounting principle retrospectively applied (see Change in Accounting Principle for Board of Governors-approved Transfers—Section 7 and Notes to Financial Statements—Note P).

(b).       Effective FY 2005 commitments include guarantee commitments and guarantee facilities.

(c).        Amounts include transactions with IFC and capitalized front-end fees.

(d).       Before the effects of Board of Governors-approved transfers and FAS 133.

(e).        Borrowings outstanding, excluding swaps, net of premium/discount.

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2. BASIS OF REPORTING

Financial Statement Reporting

IBRD prepares its financial statements in conformity with accounting principles generally accepted in the United States of America (U.S. GAAP) and referred to in this document as the ‘reported basis’.

As allowed under Statement of Financial Accounting Standards No.133, “Accounting for Derivative Instruments and Hedging Activities,” as amended (herein referred to as “FAS 133”), IBRD has marked all derivative instruments, as defined by this standard, to fair value, with changes in fair value being recognized immediately in earnings.

FAS 133 allows hedge accounting for qualifying hedging relationships, if certain criteria are met. While IBRD believes that its hedging strategies achieve its objectives, the application of these criteria to IBRD’s derivative portfolio would not consistently reflect its hedging strategies. Therefore, IBRD has elected not to define any qualifying hedging relationships and, as a result, all changes in the fair value of the derivative financial instruments are recognized immediately in earnings.

Effective July 1, 2005, IBRD ceased preparing financial statements in accordance with International Financial Reporting Standards (IFRS). This action was taken in order to allow IBRD to evaluate the Amendment to International Accounting Standard No. 39, Financial Instruments: Recognition and Measurement, The Fair Value Option, issued in June 2005, and in particular, to examine whether refinements to its loan valuation model would permit application of the fair value option to such financial assets.

Management Reporting

In implementing its risk management (interest rate and currency risk) and funding strategies, IBRD makes extensive use of derivatives. In addition, IBRD uses derivative instruments for asset/ liability management of individual positions and portfolios.

IBRD’s funding operations are designed to meet a major organizational objective of providing lower cost funds to borrowing members. Because of the extent of IBRD’s long-dated funding, the reported volatility under FAS 133 may be more pronounced than for many other financial institutions. The effects of applying FAS 133 may significantly affect reported results in each accounting period, depending on changes in market rates. However, IBRD believes that its funding and asset/liability management strategies accomplish its objectives of protection from market risk and provision of lower cost funding, and that a current value basis provides more meaningful information for risk management and management reporting.

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IBRD believes that a current value presentation reflects the economic value of all of its financial instruments. The current value model is based on the present value of expected cash flows. The model incorporates available market data in determining the cash flow and discount rates for each instrument. The current value financial statements do not purport to present the net realizable, liquidation, or market value of IBRD as a whole. Figure 1 below depicts the impact on IBRD’s total equity, from the effects of applying FAS 133 as compared to applying current value measurement.

Figure 1: Impact on Retained Earnings and Other Equity:
FAS 133 versus Current Value Adjustments

Current Value Basis

The Condensed Current Value Balance Sheets in Table 1 present IBRD’s estimates of the economic value of its financial assets and liabilities, after considering market and credit risks. The current year’s Condensed Current Value Balance Sheet is presented with a reconciliation to the reported basis. The prior year’s Condensed Current Value Balance Sheet is presented, with a reconciliation to the reported basis, in Table 20 in Section 10.

IBRD’s Condensed Current Value Statement of Income is presented in Table 2. The “Adjustments to Current Value” column provides a reconciliation between net income on a reported basis and net income on a current value basis. The movement in unrealized mark-to-market gains from the investment portfolio of $4 million, and the reduction in the provision for losses on loans and guarantees of $724 million are reversed from the year-to-date reported operating income, to arrive at $1,012 million in operating income on a current value basis before the effects of unrealized gains and losses. To arrive at net income on a current value basis, the Current Value adjustment of $446 million for market risk and the reduction in the provision for losses on loans and guarantees of $724 million reflecting credit risk are added while the $3,479 million effect of FAS 133 is reversed. The prior year’s Condensed Current Value Statement of Income is presented, with a reconciliation to the reported basis, in Table 21 in Section 10.

A summary of the effects on net income of the current value adjustments in the balance sheet is presented in Table 3.

Current Value Balance Sheets

Loan Portfolio

All of IBRD’s loans are made to or guaranteed by countries that are members of IBRD. In addition, IBRD may also make loans to the International Finance Corporation, an affiliated organization, without any guarantee. IBRD does not currently sell its loans, nor does management believe there is a market for loans comparable to those made by IBRD.

The current value of loans, including associated financial derivatives, is based on a discounted cash flow method. The estimated cash flows from principal repayments and interest are discounted using the rate at which IBRD would originate a similar loan at the reporting date. The cash flows of these instruments are based on management’s best estimates, taking into account market exchange rates and interest rates.

The current value also includes IBRD’s assessment of the appropriate credit risk, considering various factors including its history of payment receipts from borrowers. IBRD has always eventually collected all contractual principal and interest due on its loans. However, IBRD has suffered losses resulting from the difference between the discounted present value of payments for interest and charges, according to the loan’s contractual terms, and the actual timing of cash flows. To recognize the credit risk inherent in these and any other potential overdue payments, IBRD adjusts the value of its loans through its loan loss provision.

At June 30, 2006, the $881 million ($3,148 million— June 30, 2005) increase in IBRD’s loan portfolio from the reported basis to the current value basis reflects the fact that the loans in the portfolio, on average, carry a higher rate of interest than the rate at which IBRD would currently originate a similar loan at the reporting date. The $2,267 million decrease in the current value adjustment from June 30, 2005 was primarily due to the decrease in the mark on U.S. dollar denominated loans, consistent with the rise in the reference market yield curve for the U.S. dollar during this period (see Figure 12).

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Table 1: Condensed Current Value Balance Sheets at June 30, 2006 and 2005

In millions of U.S. dollars

		June 30, 2006												June 30, 2005
		Reported Basis			Reversal of FAS 133 Effects			Current Value Adjustments			Current Value Basis			Current Value Basis
Due from Banks		$	758								$	758		$	1,177
Investments		25,826									25,826			27,444
Loans Outstanding		103,004						$	881		103,885			107,549
Less Accumulated Provision for Loan Losses and Deferred Loan Income		(2,783		)							(2,783		)	(3,491		)
Swaps Receivable
Investments		7,525									7,525			9,735
Loans		87			$	2		*			89			90
Borrowings		70,036			24			(24		)	70,036			75,187
Other Asset/Liability		835			(94		)	94			835			878
Other Assets		7,038						(344		)	6,694			6,188
Total Assets		$	212,326		$	(68	)	$	607		$	212,865		$	224,757
Borrowings		$	95,835		$	(1,033	)	$	456		$	95,258		$	105,691
Swaps Payable
Investments		7,960									7,960			11,215
Loans		84			*						84			89
Borrowings		65,819			(252		)	252			65,819			65,404
Other Asset/Liability		1,014			(145		)	145			1,014			1,034
Other Liabilities		5,140									5,140			4,381
Total Liabilities		175,852			(1,430		)	853			175,275			187,814
Paid in Capital Stock		11,483									11,483			11,483
Retained Earnings and Other Equity		24,991			1,362			(246		)	26,107			25,460
Total Equity		36,474			1,362			(246		)	37,590			36,943
Total Liabilities and Equity		$	212,326		$	(68	)	$	607		$	212,865		$	224,757

* Indicates amounts less than $0.5 million.

Investment Portfolio

Under both the reported and current value basis, the investment securities and related financial instruments held in IBRD’s trading portfolio are carried and reported at fair values. Therefore, for the investment portfolio, no additional adjustment is necessary. Fair value is based on market quotations. Instruments for which market quotations are not readily available have been valued using market-based methodologies and market information.

Borrowings Portfolio

The borrowings portfolio on a current value basis includes debt securities and associated financial derivatives, and represents the present value of expected cash flows on these instruments discounted by the cost at which IBRD would obtain funding at the reporting date. The valuation model incorporates available market data in determining the expected cash flow and discount rates for each instrument. Market data include exchange rates and reference market interest rates. The current value for the borrowings portfolio includes current value adjustments for borrowings, swaps payable, swaps receivable and the reduction in other assets due to unamortized issuance costs.

At June 30, 2006 the $1,076 million ($2,793 million—June 30, 2005) increase in IBRD’s borrowings portfolio from the reported basis to the current value basis as shown in Table 3 reflects the average cost of the borrowings portfolio being higher than the rate at which IBRD could obtain funding at the reporting date. The $1,717 million decrease from June 30, 2005 in the current value adjustment was due primarily to the decrease in the mark-to-market adjustment on the U.S. dollar denominated debt consistent with the rise in the reference market yield curve for the U.S. dollar during this period (see Figure 12).

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Table 2: Condensed Current Value Statements of Income for the years ended June 30, 2006 and 2005

In millions of U.S. dollars

		FY 2006									FY 2005 As Adjusted(a)
		Reported Basis			Adjustments to Current Value			Current Value Comprehensive Basis			Current Value Comprehensive Basis
Income from Loans		$	4,864					$	4,864		$	4,155
Income from Investments, net		1,057			$	(4	)	1,053			624
Other Income		267						267			271
Total Income		6,188			(4		)	6,184			5,050
Borrowing Expenses		3,941						3,941			3,037
Administrative Expenses including contributions to Special Programs		1,228						1,228			1,194
Release of Provision for Losses on Loans and Guarantees		(724		)	724
Other Expenses		3						3			4
Total Expenses		4,448			724			5,172			4,235
Operating Income		1,740			(728		)	1,012			815
Board of Governors-Approved Transfers		(650		)				(650		)	(642		)
Current Value Adjustments					(446		)	(446		)	(273		)
Release of Provision for Losses on Loans and Guarantees—Current Value					724			724			502
Net unrealized (losses) gains on non-trading derivative instruments, as required by FAS 133		(3,479		)	3,479			—
Net (Loss) Income		$	(2,389	)	$	3,029		$	640		$	402

(a).       IBRD’s Statement of Income has been adjusted for prior years as a result of a change in accounting principle retrospectively applied (see Change in Accounting Principle for Board of Governors-approved Transfers—Section 7 and Notes to Financial Statements—Note P).

Table 3: Summary of Current Value Adjustments

In millions of U.S. dollars

		Balance Sheet Effects as of June 30, 2006												Total Income Statement Effect
		Loans			Borrowings			Other Asset/Liability			Less Prior Years’ Effects			FY 2006			FY 2005
Current Value Adjustments on Balance Sheet due to Interest Rates		$	881		$	(1,076	)(a)	$	(51	)	$	(342	)(b)	$	(588	)	$	(227	)
Unrealized Gains on Investments(c)														4			3
Currency Translation Adjustment(d)		347			(216		)	7						138			(49		)
Total Current Value Adjustments														$	(446	)	$	(273	)

(a).       Amount is net of the current value adjustments for swaps, and unamortized issuance costs.

(b).       Includes $116 million representing a one-time cumulative effect of recording the adoption, on July 1, 2000, of the current value basis of accounting.

(c).        Unrealized gains on the investment portfolio have been moved from Operating Income under the reported basis and included as part of current value adjustments for current value reporting.

(d).       The currency translation effects have been moved from Other Comprehensive Income under the reported basis and included in Current Value Net Income for purposes of current value reporting.

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Current Value Statements of Income

Income from Loans

Income from loans increased by $709 million during FY 2006 in comparison with FY 2005. The main reason for this increase was higher lending rates which contributed $1,005 million. This was partially offset by a $231 million reduction in income due to lower average loan balances outstanding.

Provision for Losses on Loans and Guarantees

During FY 2006, there was a $724 million release of provision for losses on loans and guarantees in comparison to a release of $502 million during FY 2005. The release of provision in each period reflects the combined impact of changes in the creditworthiness of the loans portfolio, changes in the volume and distribution of loans and guarantees outstanding, net of translation adjustments and the annual update of the expected default frequencies (probabilities of default to IBRD) and developments in the nonaccrual portfolio. The effect has been an increase in net income of $222 million between the two fiscal years.

Income from Investments

During FY 2006, income from investments increased by $429 million due to higher average short-term interest rates, in comparison with FY 2005 (see Figure 11). IBRD holds primarily short-term U.S dollar fixed income investments with an average duration of less than three months.

Borrowing Expenses

Borrowing expenses increased by $904 million during FY 2006, in comparison with FY 2005. With approximately two-thirds of borrowings based on short-term U.S. dollar interest rates, the increase in U.S. dollar six-month LIBOR in FY 2006 (see Figure 11), resulted in higher borrowing expenses. This was

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partly offset by a reduction in the average portfolio size.

Administrative Expenses (Including Contributions to Special Programs)

Administrative expenses increased by $34 million during FY 2006 compared to FY 2005. Costs related to pension and postretirement benefits accounted for $28 million of this increase. (see Table 19).

Current Value Adjustments

As part of its risk management strategy, IBRD closely aligns the duration (interest rate sensitivity) and the currency composition of its equity to that of its loan portfolio in order to minimize the impact of any interest rate and currency exchange rate movements on its risk bearing capacity. Therefore, on a current value basis while there will be some mark-to-market effect on equity, such an impact will not significantly affect IBRD’s risk bearing capacity. Consistent with the positive duration of IBRD’s equity, in a rising interest rate environment, the current value adjustment decreased net income in FY 2006 by $446 million (decrease of $273 million in FY 2005) as shown in Table 3.

Impact of changes due to interest rates

The current value effect on the Income Statement of negative $588 million, due to interest rate changes during FY 2006, was primarily due to the higher U.S. dollar reference market yield curve (see Figure 12). The negative $588 million adjustment was due to the decrease in the current value mark on the loans portfolio of $2,267 million partially offset by the decrease in the current value mark on the borrowings portfolio of $1,717 million. These adjustments have been explained under the Current Value Balance Sheet Section. Similarly during FY 2005, IBRD’s net income on a current value basis included a negative adjustment of $227 million, primarily reflecting the negative effects resulting from the upward movements in the discount curves for the major reference currencies with the exception of the euro. These losses were partially offset by net gains on the euro loans and borrowings portfolio, reflecting the significant decrease in the euro interest rate curve.

Impact of changes due to currency translation

The current value adjustment from currency translation adjustments of positive $138 million was primarily due to the appreciation of the euro (3.8%) offset by the depreciation of the Japanese yen (5.5%) against the U.S. dollar during FY 2006. Table 4 provides a breakdown of this adjustment by the loans and borrowings portfolios.  The loans portfolio contributed $347 million towards this increase. The euro and the Japanese yen accounted for approximately 16% and 4% of the total loan portfolio, and 97% of total non-U.S. dollar denominated loans at June 30, 2006. The borrowings portfolio accounted for a negative $216 million. The euro and the Japanese yen accounted for approximately 12% and 3% of the total borrowing portfolio, and 98% of total non-U.S. dollar denominated borrowings at June 30, 2006.

Table 4: Impact of Currency Translation Adjustment

In millions of U.S. dollars

		2006		2005
Loans		$347		$(84	)
Borrowings		(216	)	52
Other Asset/Liability		7		(17	)
Total		$138		$(49	)

 

In comparison, during FY 2005 the impact of exchange rate changes on IBRD’s net assets resulted in a negative translation adjustment of $49 million due to the slight depreciation of both the euro (1.6%) and the Japanese yen (0.5%) against the U.S. dollar.

Given IBRD’s risk management strategy, the stability of the current value equity-to-loans ratio is considered more significant than fluctuations in the net current value adjustments.

3. DEVELOPMENT ACTIVITIES

IBRD offers loans, related derivative products, and guarantees to its borrowing member countries to help meet their development needs. It also provides technical assistance and other advisory services to support poverty reduction in these countries.

Loans

From its establishment through June 30, 2006, IBRD had approved loans, net of cancellations, totaling $367,002 million to borrowers in 130 countries. A summary of cumulative lending is contained in Table 5.

At June 30, 2006, the total volume of outstanding loans was $103,004 million, $1,397 million lower than the $104,401 million of outstanding loans at June 30, 2005. This decrease was due primarily to negative net disbursements of $1,741 million, including $2,068 million of prepayments. Undisbursed balances at June 30, 2006 totaled $34,938 million, reflecting an increase of $1,194 million from June 30, 2005. This change was due to new commitments and positive currency translation adjustments, partially offset by cancellations and disbursements of loans.

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Table 5: Lending Status at June 30

In millions of U.S. dollars

		2006			2005
Cumulative Approvals(a)		$	367,002		$	354,058
Cumulative Repayments(b)		$	231,372		$	217,655

(a).       Net of cancellations

(b).       Multicurrency pool loan repayments are included at exchange rates in effect on the date of original disbursement. All other amounts are based on U.S. dollar equivalents at the time of repayment by borrowers.

During FY 2006, new loans, guarantee commitments and guarantee facilities to member countries were $14,135 million, ($13,611 million—FY 2005). During the four year period from FY 2003 to FY 2006, Latin America and the Caribbean region accounted for the largest share of commitments. Figure 2 presents the regional composition of commitments from FY 2001 to FY 2006.

Figure 2: Commitments including Guarantee Facilities by Region

Under IBRD’s Articles of Agreement (the Articles), as applied, the total amount outstanding of direct loans made by IBRD, including participation in loans and callable guarantees may not exceed the statutory lending limit. At June 30, 2006, outstanding loans and callable guarantees (net of the accumulated provision for losses on loans and guarantees) totaled $100,888 million, equal to 47% of the statutory lending limit.

IBRD’s lending operations have conformed generally to five principles derived from its Articles. These principles, taken together, seek to ensure that IBRD loans are made to member countries for financially and economically sound purposes to which those countries have assigned high priority, and that funds lent are utilized as intended. The five principles are described in Box 3. Within the scope permitted by the Articles, application of these principles must be developed and adjusted in light of experience and changing conditions.

Lending Cycle

The process of identifying and appraising a project, and approving and disbursing a loan, often extends over several years. However, on numerous occasions IBRD has shortened the preparation and approval cycle in response to emergency situations such as natural disasters.

Generally, the appraisal of projects is carried out by IBRD’s operational staff (economists, engineers, financial analysts, and other sector and country specialists). With certain exceptions(a), each loan must be approved by IBRD’s Executive Directors.

Loan disbursements are subject to the fulfillment of conditions set out in the loan agreement. During implementation of IBRD-supported operations, experienced IBRD staff review progress, monitor compliance with IBRD policies and assist in resolving any problems that may arise. The Independent Evaluation Group, an IBRD unit whose director reports to the Executive Directors rather than to the President, evaluates the extent to which operations have met their major objectives.

Lending Instruments

IBRD lending generally falls into one of two categories: investment or development policy lending (previously referred to as adjustment lending). Investment lending is generally used to finance goods, works, and services in support of economic and social development projects in a broad range of sectors. In contrast, development policy lending is generally provided in exchange for commitments by borrowers to implement social, structural, and institutional reforms. The majority of IBRD loans are for investment projects or programs. Figure 3 shows the percentage of IBRD loans approved for development policy lending over the past eight years.

(a).       For Adaptable Program Loans (APLs), the Board approves all first-phase APLs and delegates to Management the approval of subsequent phases subject to agreed procedures. Learning and Innovation Loans are loans of $5 million or less approved by Management.

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Figure 3:  IBRD Lending Commitments

In FY 2006, new IBRD commitments for development policy lending accounted for 35% of total commitments (31%—FY 2005; 40%—FY 2004).

Contractual Terms of Loans

Contractual Terms of Currently Available Products

IBRD currently offers a product mix that is intended to provide borrowers with the flexibility to select terms that are both compatible with their debt management strategy and suited to their debt-servicing capacity. As of June 30, 2006, IBRD offers the following two basic types of loan terms, each denominated in the currency or currencies chosen by the borrower provided it is a currency in which IBRD can efficiently intermediate: variable-spread loans, and fixed-spread loans. Variable-spread loans, which were introduced in FY 1993, have a variable spread over LIBOR that is adjusted every six months. Fixed-spread loans, which were introduced in FY 2000, have a fixed spread over LIBOR that is fixed for the life of the loan.

Borrowers selecting the fixed-spread loan product may, for a fee, change the currency or interest rate basis over the life of the loan. For example, borrowers have the option to fix, unfix, or re-fix the interest rate at market rates on all or a part of the disbursed amounts for up to the remaining maturity of the loan.

The transaction fees for changing the currency or interest rate basis of fixed-spread loans were revised during FY06. On undisbursed loans, the fee (based on percentage of principal amount converted) for currency conversion is an up-front charge of 0.125% of the principal to be converted. On disbursed loans, the fee for currency conversion is an annual charge of 0.02% of the amount converted.  Interest rate conversion carries no transaction fee.

Table 6 summarizes the contractual terms for these types of loans.

Table 6: Contractual Terms of Currently Available Products

Basis Points

		Variable Spread Loans (VSL)		Fixed Spread Loans (FSL)		Special Development Policy Loans
Reference Market Rate		Six month LIBOR		SIx month LIBOR		Six month LIBOR
Spread
Contractual Lending Spread		75 (new loans) 50 (old loans)		75		400
Market Risk Premium		—		5(a)		—
Funding Cost Margin		Weighted average spread to LIBOR of debt allocated to VSLs		Projected funding spread to LIBOR		—
Charges
Commitment charge on undisbursed balances		75		85(b)		75
Front-end fee on effective loans		100 (new loans) 0 (old loans)		100		100
Eligible for Waivers(c)
Interest		Yes		Yes		No
Commitment		Yes		Yes		No
Front-end fee(d)		Yes		Yes		No
Final Maturity		15-20 years		15-25 years		5 years
Grace period		3-5 years		3-8 years		3 years

(a).       The market risk premium compensates IBRD for additional funding risk associated with this product.

(b).       The commitment charge is 85 basis points for the first four years and 75 basis points thereafter for loans signed on or before July 19, 2006 to compensate IBRD for additional funding and refinancing risk associated with this product. All loans which are signed on or after July 20, 2006 will have a flat commitment charge of 75 basis points.

(c).        Waivers of a portion of charges and interest are determined annually, see Table 8 for details.

(d).       On August 7, 2006 the Board of Executive Directors approved a 100 basis point waiver of the front end fee on all loans (other than special development policy loans) to be presented to the Board between August 7, 2006 and the date on which the Board approves a front end fee waiver for FY 2008, in the context of the annual Allocation of Net Income and Waivers of Loan Charges paper.

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Repayment terms for fixed-spread loans are more flexible than for variable-spread loans, subject to certain constraints on the average repayment maturity and final maturity on a country basis. Within these constraints, borrowers have flexibility to configure grace periods and maturity profiles in a manner consistent with the purpose of the loan. Repayment profiles may be level repayment of principal, an annuity type schedule, a single lump-sum repayment, or a customized schedule. Repayment profiles cannot be changed after a loan is signed.

At June 30, 2006, 71% (63%—June 30, 2005) of loans outstanding were made on currently available terms.

Local Currency Lending

IBRD offers its borrowers products to convert or swap their IBRD loans into their domestic currencies to reduce their foreign currency exposure that do not generate foreign currency revenues. These local currency loans have Fixed Spread Loan terms. The balance of such loans outstanding at June 30, 2006 was $50 million.

As part of the initiative taken during FY 2005 by the Board of Executive Directors to increase the usability of local currency paid-in capital, IBRD entered into a Local Currency Loan Facility Agreement with IFC which is capped at $300 million. Under this agreement, IBRD would lend local currencies of its member countries, funded from paid-in capital, to IFC. These currencies would subsequently be used by IFC to finance projects in those member countries.  Loan commitments under this facility are subject to consents of the respective IBRD member countries whose currency is involved.  At June 30, 2006, loans outstanding equivalent to $50 million had been made under this facility.

Loans with a Deferred Drawdown Option

A Deferred Drawdown Option (DDO) for use with IBRD development policy loans gives IBRD borrowers the option of deferring the loan’s disbursement for up to three years. Loans with a DDO are subject to a commitment fee of 100 basis points, which is 25 basis points higher than that for standard IBRD loans. Also, the front-end fee which is normally payable at the time a loan becomes effective, is only payable for a DDO loan at the time it is disbursed.

Derivative Products

Along with the approval of the introduction of the fixed-spread loan product with its various risk management features such as rate fixing and currency conversion, IBRD also offers derivative products to borrowers. These products respond to borrowers’ needs for access to better risk management tools in connection with existing IBRD loans. These derivative products include currency and interest rate swaps, and interest rate caps and collars.

IBRD will pass through its market cost of the instrument to the borrower, and will charge a transaction fee comparable to the fee charged on the fixed-spread loan conversion features. These instruments may be executed either under a master derivatives agreement, which substantially conforms to industry standards, or in individually negotiated transactions. The first currency swap transaction was executed in FY 2004 between IBRD and one of its borrowers under a Master Derivatives Agreement. Further details are provided in the Notes to Financial Statements—Note D-Loans, Guarantees and Derivatives for Borrowers.

Contractual Terms of Previously Available Products

In previous years, IBRD offered loans with a variety of other contractual terms including: multicurrency pool loans and fixed-rate single currency loans.

Table 7 summarizes the contractual terms for variable-rate multicurrency and single-currency pool loans, and fixed-rate single-currency loans.

In 1980, IBRD established the currency pool system, funded primarily with fixed rate medium-to-long term borrowings. In 1982, IBRD mitigated its interest rate risk by moving from offering a fixed rate to a variable rate on these loans.

The currency composition of multicurrency pool loans is determined on the basis of a pool, which provides a currency composition that is the same for all loans in the pool. Pursuant to a policy established by the Executive Directors, and subject to their periodic review, at least 90% of the U.S. dollar equivalent value of the pool is in a fixed ratio of one U.S. dollar to 125 Japanese yen to one euro. The lending rate formulation for loans with single currency pool terms is the same as that for multicurrency pool loans. Single-currency pool loans are held in U.S. dollars, Japanese yen, and euro.

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Table 7: Contractual Terms of Previously Available Products

Basis Points

		Variable rate multicurrency pool loans (1982-2001)		Variable rate single currency pool loans(a) (1996-1998)		Fixed rate single currency Loans(b) (1995-1999)
Cost Base		Weighted average cost of allocated debt		Weighted average cost of allocated debt		LIBOR
Spread
Contractual Lending Spread		75 (new loans) 50 (old loans)		50		75 (new loans) 50 (old loans)
Market Risk Premium		—		—		0-10
Funding Cost Margin		—		—		IBRD’s funding spread to LIBOR
Charges
Commitment charge on undisbursed balances		75		75		75
Front-end fee on effective loans		100 (new loans) 0 (old loans)		— —		100 (new loans) 0 (old loans)
Eligible for Waivers(c)
Interest		Yes		Yes		Yes
Commitment		Yes		Yes		Yes
Final Maturity		15-20 years		based on original loan agreement		12-20 years
Grace period		3-5 years		based on original loan agreement		3 years

(a).       Converted from variable-rate multicurrency pool loans.

(b).       Cost base and spread are fixed on rate-fixing date for amounts disbursed during the preceding six months.

(c).        Waivers of a portion of charges and interest are determined annually, see Table 8 for details.

During FY 2006 the Executive Directors approved the revision of variable rate multi-currency pool and variable rate U.S. dollar pool lending rates to composite LIBOR + 100 basis points or the fixed rate equivalent thereof (at the borrower’s choice) for borrowers that agree to certain amendments to their loan agreements. This revision has been approved in order to adjust the pool lending rates, which are rising above market rates as these products are phased out, in a manner that was not envisioned at the time that borrowers signed their loan agreements. These revised loan terms will be offered from July 2006, and will apply on interest rate reset dates that occur on or after January 1, 2007.

Any fixed-rate multicurrency pool loans that were converted to single currency pools continued to carry their fixed rate.

Fixed-rate single currency loans carry lending rates fixed on semi-annual rate fixing dates for amounts disbursed during the preceding six months. For the interim period from the date each disbursement is made until its rate fixing date, interest accrues at the rate applicable to variable-spread loans.

At June 30, 2006, 29% (37%-June 30, 2005) of loans outstanding carried these previously available contractual terms.

Figure 4 presents a breakdown of IBRD’s loan portfolio by loan product. For more information, see the Notes to Financial Statements—Note D-Loans, Guarantees and Derivatives for Borrowers.

Waivers

Waivers of a portion of charges and interest owed by all eligible borrowers are determined annually and have been in effect since FY 1992. Eligibility for the partial waiver of interest is limited to borrowers that have made full payments of principal, interest and other charges within 30 calendar days of the due dates during the preceding six months, on all their loans. Waivers of a portion of the commitment charge owed on the undisbursed portion of loans are also determined annually and have been in effect since FY 1990. All borrowers receive the commitment charge waiver on their eligible loans. Table 8 presents a breakdown of IBRD’s loan charge waivers. Further details are provided in the Notes to Financial Statements—Note D-Loans, Guarantees and Derivatives for Borrowers.

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Figure 4: Loan Portfolio by Loan Product

In millions of U.S. dollars

(a).       Includes fixed-rate single currency loans for which the rate had not yet been fixed at fiscal year-end.

(b).       Includes loans issued prior to 1980, loans to IFC, and fixed-rate multicurrency pool loans.

(c).        Includes loans with non-standard terms.

*                    Indicates amounts less than 0.5%.

Table 8: Loan Charge Waivers

Basis points

		Interest Period Commencing
		FY 2007		FY 2006		FY 2005
Commitment charge waivers		50		50		50
Interest waivers(a)
Old loans		5		5		5
New loans		25		25		25
Average eligibility		n.a.		99.5	%	99.0	%
Front-end fee waivers(b)		100		75		50

(a).       On loans to eligible borrowers.

(b).       On August 7, 2006 the Board of Executive Directors approved a 100 basis point waiver of the front end fee on all loans (other than special development policy loans) to be presented to the Board between August 7, 2006 and the date on which the Board approves a front end fee waiver for FY 2008, in the context of the annual Allocation of Net Income and Waivers of Loan Charges paper.

Guarantees

IBRD offers guarantees on loans from private investors for projects in countries eligible to borrow from IBRD. These guarantees can also be offered on securities issued by entities eligible for IBRD loans, and in exceptional cases offered in countries only eligible to borrow from IDA. IBRD applies the same country creditworthiness and project evaluation criteria to guarantees as it applies to loans.

IBRD guarantees can be customized to suit varying country and project circumstances, and may be provided directly or via facilities. They can be targeted to mitigate specific risks or generally risks relating to political, regulatory and government performance, which the private sector is not normally in a position to absorb or manage.

Each guarantee requires the counter-guarantee of the member government. IBRD prices guarantees consistent with the way it prices its loans.

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IBRD generally provides the following types of guarantees:

Partial risk guarantees: These cover debt-service defaults on a loan that result from non-performance of government obligations.

Partial credit guarantees: These are used for public sector projects when there is a need to extend loan maturities and guarantee specified interest or principal payments on loans to the government or its agencies.

Policy-based guarantees: When partial credit guarantees are used in support of agreed structural, institutional and social policies and reforms, they are considered policy-based guarantees. Eligibility for IBRD development policy lending is a necessary condition for eligibility for policy-based guarantees.

Enclave guarantees: These partial risk guarantees are offered in exceptional cases for loans for foreign-exchange generating projects in a member country usually eligible only for credits from IDA. Fees charged for enclave guarantees are higher than those charged for non-enclave guarantees. The annual commitment of enclave guarantees is limited to an aggregate guaranteed amount of $300 million. As of June 30, 2006 commitments made under enclave guarantees were $30 million.

IBRD’s exposure at June 30, 2006 on its guarantees (measured by discounting each guaranteed amount from its first call date) is detailed in Table 9. For additional information see the Notes to Financial Statements—Note D-Loans, Guarantees and Derivatives for Borrowers.

Table  9: Guarantee Exposure

In millions of U.S. dollars

Other Activities

Consultation: In addition to its financial operations, IBRD provides technical assistance to its member countries, both in connection with, and independently of, lending operations. There is a growing demand from borrowers for strategic advice, knowledge transfer, and capacity building. Such assistance includes assigning qualified professionals to survey developmental opportunities in member countries, analyzing their fiscal, economic and developmental environment, assisting member countries in devising coordinated development programs, appraising projects suitable for investment and assisting member countries in improving their asset and liability management techniques.

Research and Training: To assist its developing member countries, IBRD—through the World Bank Institute and its partners-provides courses and other training activities related to economic policy development and administration for governments and organizations that work closely with IBRD.

Trust Fund Administration: IBRD, alone or jointly with IDA, administers on behalf of donors, funds restricted for specific uses. These funds are held in trust and are not included in the assets of IBRD. See the Notes to Financial Statements—Note J-Management of External Funds.

Investment Management: IBRD offers investment management services to several types of external institutions, including central banks of member countries. One objective of providing the services to central banks is to assist them in developing portfolio management skills. These managed funds are not included in the assets of IBRD. See the Notes to Financial Statements—Note J-Management of External Funds.

4. LIQUIDITY MANAGEMENT

IBRD’s liquid assets are held principally in highly-rated fixed income securities. These securities include obligations of governments and other official entities, time deposits and other unconditional obligations of banks and financial institutions, currency and interest rate swaps (including currency forward contracts), asset-backed (including mortgage-backed) securities, and futures and options contracts.

Liquidity risk arises in the general funding of IBRD’s activities and in the management of its financial positions. It includes the risk of being unable to fund its portfolio of assets at appropriate maturities and rates and the risk of being unable to liquidate a position in a timely manner at a reasonable price. The objective of liquidity management is to ensure the availability of sufficient cash flows to meet all of IBRD’s financial commitments.

As one component of liquidity management, IBRD maintained a $500 million line of credit as of June 30, 2006, with an independent financial institution.(a) This facility was used to cover any overnight

(a).  This line of credit is held jointly with the International Development Association (IDA), an affiliated organization.

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overdrafts that may have occurred due to failed trades. For further details about this facility, see the Notes to Financial Statements—Note E-Borrowings.

The primary objective for IBRD in the management of liquid assets is to protect the principal amount of these investments. In addition, IBRD seeks to achieve a reasonable return on the liquid asset portfolio using prudent asset and risk management techniques. The General Investment Authorization for IBRD approved by the Executive Directors provides the basic authority under which the liquid assets of IBRD can be invested. Further, all investment activities are conducted in accordance with a more detailed set of Investment Guidelines. The Investment Guidelines are approved by the Chief Financial Officer and implemented by the Treasurer. These Investment Guidelines set out detailed trading and operational rules including providing criteria for eligible instruments for investment, establishing risk parameters relative to benchmarks, such as an overall stop-loss limit and duration deviation, specifying concentration limits on counterparties and instrument classes, as well as establishing clear lines of responsibility for risk monitoring and compliance.

Under IBRD’s liquidity management guidelines, aggregate liquid asset holdings are kept at or above a specified prudential minimum in order to safeguard against cash flow interruptions. That minimum is equal to the highest consecutive six months of expected debt service obligations for the fiscal year, plus one-half of net approved loan disbursements as projected for the fiscal year. The FY 2007 prudential minimum liquidity level has been set at $15.5 billion, a decrease of $2.5 billion from that set for FY 2006. IBRD also holds liquid assets over the specified minimum to provide flexibility in timing its borrowing transactions and to meet working capital needs.

Liquid assets may be held in three distinct sub-portfolios: stable; operational; and discretionary, each with different risk profiles and performance benchmarks.

The stable portfolio is principally an investment portfolio holding the prudential minimum level of liquidity, which is set at the beginning of each fiscal year. Investment of up to 20% of the stable portfolio may be contracted out to external managers. Separate investment guidelines which conform to IBRD’s overall Investment Guidelines are provided to each external manager.

The operational portfolio provides working capital for IBRD’s day-to-day cash flow requirements.

The discretionary portfolio, when used, provides flexibility for the execution of IBRD’s borrowing program and can be used to take advantage of attractive market opportunities. During FY 2005, this portfolio was liquidated, however, in FY 2006, it was replenished by funds that were available above the requirements of the stable and oper56+ational portfolios.

Figure 5 represents IBRD’s liquid asset portfolio size and structure at the end of FY 2006 and FY 2005, excluding investment assets associated with certain other postemployment benefits. At the end of FY 2006, the aggregate size of the IBRD liquid asset portfolio was $24,655 million, reflecting a decrease of $1,515 million from FY 2005. Of this amount, $1,443 million ($1,383 million in FY 2005) in the stable portfolio was managed by external firms. IBRD’s liquid asset portfolio is largely composed of assets denominated in U.S. dollars with net exposure to short-term interest rates. The debt funding these liquid assets also shares similar currency and duration profiles. This is a direct consequence of IBRD’s exchange rate and interest rate risk management policies (see Section 6—Financial Risk Management), combined with appropriate investment benchmarks. In addition to monitoring gross investment returns compared to their benchmarks, IBRD also monitors overall investment earnings net of funding costs (see Section 8—Results of Operations).

The returns and average balances of the liquid asset portfolio in FY 2006 compared to FY 2005 are presented in Table 10. These returns exclude investment assets funding certain other postemployment benefits.

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Figure 5: Liquid Asset Portfolio Composition

In millions of U.S. dollars

Table 10: Liquid Asset Portfolio Returns and Average Balances

In millions of U.S. dollars

		Average Balances						Financial Return (%)
		FY 2006			FY 2005			FY 2006		FY 2005
IBRD Overall Portfolio		$	26,008		$	28,750		4.05		2.16
Stable		18,368			20,219			4.24		2.34
Operational		6,724			5,940			3.40		1.99
Discretionary		916			2,591			4.68		1.11

 

The higher returns in FY 2006 are due primarily to the higher average interest rate environment in FY 2006 as compared to FY 2005, as shown in Figure 11.

IBRD enters into derivative transactions to manage its investment portfolio. The main purposes of these derivative instruments are to enhance the return, and manage the overall duration, of the portfolio.

Contractual Obligations

In the normal course of business, IBRD enters into various contractual obligations that may require future cash payments. Table 11 summarizes IBRD’s significant contractual cash obligations, by remaining maturity, at June 30, 2006. Long-term debt includes direct medium- and long-term borrowings excluding swaps, but does not include any adjustment for unamortized premiums, discounts or effects of applying FAS 133 (additional information can be found in the Notes to Financial Statements—Note E—Borrowings). Operating lease expenditures primarily represent future cash payments for real estate-related obligations and equipment. Other long-term liabilities include accrued liabilities for staff compensation and benefits. Operating leases, contractual purchases and capital expenditures, and other long term obligations include amounts which will be shared with IDA, IFC and MIGA in accordance with individual cost sharing agreements (additional information can be found in the Notes to Financial Statements—Note I—Administrative Expenses, Contributions to Special Programs, and Other Income).

Excluded from Table 11 are a number of obligations to be settled in cash. These obligations are presented in IBRD’s balance sheet and include undisbursed loans; short-term borrowings; payable for currency and interest rate swaps; payable for investment securities purchased, and payable for transfers approved by the Board of Governors.

5. FUNDING RESOURCES

Equity

Total shareholders’ equity, as reported in IBRD’s balance sheet at June 30, 2006, was $36,474 million compared to $38,588 million at June 30, 2005. The decrease from FY 2005 primarily reflects the net loss of $2,389 million on a reported basis during FY 2006 brought about primarily by net unrealized losses of $3,479 million on non-trading derivative instruments, as required by FAS 133.

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Table 11: Contractual Cash Obligations

In millions of U.S. dollars

		Payments due by period
		Total			Less than 1 year			1-3 years			3-5 years			More than 5 years
Long-term debt		$	88,751		$	14,676		$	27,748		$	8,878		$	37,449
Operating leases		435			38			66			44			287
Contractual purchases and capital expenditures		69			64			5			—			—
Other long-term liabilities		426			76			57			56			237
Total		$	89,681		$	14,854		$	27,876		$	8,978		$	37,973

 

BRD’s equity base plays a critical role in securing its financial objectives. By enabling IBRD to absorb risk out of its own resources, its equity base protects shareholders from a possible call on callable capital. The adequacy of IBRD’s equity capital is judged on the basis of its ability to generate future net income sufficient to absorb potential risks and support normal loan growth, without reliance on additional shareholder capital.

For management purposes, IBRD closely monitors equity as defined and utilized in the equity-to-loans ratio. Table 12 presents the composition of this measure at June 30, 2006 and 2005, respectively.

The equity-to-loans ratio is a summary statistic that IBRD uses as one measure of the adequacy of its risk-bearing capacity. IBRD also uses a stress test as a measure of income-generating capacity and an input to the assessment of capital adequacy. See discussion in Section 6, Financial Risk Management—Managing Risk-Bearing Capacity.

As presented in Figure 6, IBRD’s equity-to-loans ratio increased during FY 2006, on both a reported basis (excluding cumulative translation adjustments associated with the FAS 133 adjustments) and a current value basis.

Figure 6: Equity-to-Loans Ratio

The increase in this ratio to 32.96% at June 30, 2006 from 31.45% at June 30, 2005 was due to the increase in equity in FY 2006. During FY 2006, IBRD increased the General Reserve in order to improve its risk-bearing capacity.

Capital

Shareholder support for IBRD is reflected in the capital backing it has received from its members. At June 30, 2006, the authorized capital of IBRD was $190,811million, of which $189,718 million had been subscribed. Of the subscribed capital, $11,483 million had been paid-in and $178,235 million was callable. Of the paid-in capital, $9,125 million was available for lending and $2,358 million was not available for lending. The terms of payment of IBRD’s capital and the restrictions on its use that are derived from the Articles and from resolutions of IBRD’s Board of Governors are as follows:

Paid-in Capital

(i)             $3,220 million of IBRD’s capital was initially paid in gold or U.S. dollars or was converted from the currency of the subscribing members into U.S. dollars. This amount may, under the Articles, be freely used by IBRD in its operations.

(ii)          $8,145 million of IBRD’s capital was paid in the national currencies of the subscribing members. Under the Articles this amount is subject to maintenance of value obligations and may be used for funding loans only with the consent of the member whose currency is involved, or used for administrative expenses without the need for consent of the member whose currency is involved. In addition, these national currencies may be used by IBRD following a decision by the Board of Executive Directors to invest or lend in that currency, or swap the national currency into another currency for investment or lending purposes, provided it has the consent of the member whose currency is involved. In accordance with such consents, $5,208 million of this amount was being used in IBRD’s lending and investment operations at June 30, 2006.

 

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Table 12: Equity Capital

In millions of U.S. dollars

		June 30, 2006			June 30, 2005
Usable Capital
Paid-in Capital		$	11,483		$	11,483
Restricted Paid-in Capital		(2,460		)	(2,509		)
Net Payable for Maintenance of Value		102			58
Total Usable Capital		9,125			9,032
Special Reserve		293			293
General Reserve, including allocation of FY 2006/FY 2005 net income		23,948			22,912
Cumulative Translation Adjustment(a)		(27		)	(165		)
Equity used in Equity-to-Loans Ratio—Reported Basis		$	33,339		$	32,072
Current Value Adjustments		(246		)	342
Equity used in Equity-to-Loans Ratio—Current Value Basis		$	33,093		$	32,414
Loans and Guarantees Outstanding, net of Accumulated Provision for Losses on Loans and Guarantees and Deferred Loan Income		$	101,140		$	101,990
Current Value Loans and Guarantees Outstanding, net of Accumulated Provision for Losses on Loans and Guarantees and Deferred Loan Income		$	102,021		$	105,138
Equity-to-Loans Ratio—Reported Basis		32.96		%	31.45		%
Equity-to-Loans Ratio—Current Value Basis		32.44		%	30.83		%

(a).       Excluding cumulative translation amounts associated with the FAS 133 adjustment.

(iii)                               $118 million of IBRD’s capital was converted to U.S. dollars from the currency of the subscribing members by providing U.S. dollar denominated nonnegotiable, non-interest bearing demand notes, encashable in the currency of the subscribing member. This amount may, under the terms of the note, be encashed for administrative expenses or, after all subscribed capital has been called, IBRD will have the right to encash the note to meet its obligations.

Callable Capital

(iv)                              $151,774 million of IBRD’s capital may, under the Articles, be called only when required to meet obligations of IBRD for funds borrowed or on loans guaranteed by it. This amount is thus not available for use by IBRD in making loans. Payment on any such call may be made, at the option of the particular member, either in gold, in U.S. dollars or in the currency required to discharge the obligations of IBRD for which the call is made.

(v)                                 $26,461 million of IBRD’s capital is to be called only when required to meet obligations of IBRD for funds borrowed or on loans guaranteed by it, pursuant to resolutions of IBRD’s Board of Governors (though such conditions are not required by the Articles). Of this amount, 10% would be payable in gold or U.S. dollars and 90% in the national currencies of the subscribing members. While these resolutions are not legally binding on future Boards of Governors, they do record an understanding among members that this amount will not be called for use by IBRD in its lending activities or for administrative purposes.No call has ever been made on IBRD’s callable capital. Any calls on unpaid subscriptions are required to be uniform, but the obligations of the members of IBRD to make payment on such calls are independent of each other. If the amount received on a call is insufficient to meet the obligations of IBRD for which the call is made, IBRD has the right and is bound to

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                                                make further calls until the amounts received are sufficient to meet such obligations. However, no member may be required on any such call or calls to pay more than the unpaid balance of its capital subscription.

At June 30, 2006, $103,604 million (58.1%) of the uncalled capital was callable from the member countries of IBRD that are also members of the Development Assistance Committee (DAC) of the Organization for Economic Cooperation and Development (OECD). This amount exceeded IBRD’s outstanding borrowings including swaps at June 30, 2006. Table 13 sets out the capital subscriptions of those countries and the callable amounts.

Table 13: Capital Subscriptions of DAC Members of OECD Countries

In millions of U.S. dollars

(a).       See details regarding the capital subscriptions of all members of IBRD at June 30, 2006 in Financial Statements—Statement of Subscriptions to Capital Stock and Voting Power.

The United States is IBRD’s largest shareholder. Under the Bretton Woods Agreements Act, the Par Value Modification Act and other U.S. legislation, the Secretary of the U.S. Treasury is permitted to pay up to $7,663 million of the uncalled portion of the subscription of the United States, if it were called by IBRD, without any requirement of further congressional action. The balance of the uncalled portion of the U.S. subscription, $22,303 million, has been authorized by the U.S. Congress but not appropriated. Further action by the U.S. Congress would be required to enable the Secretary of the Treasury to pay any portion of this balance. The General Counsel of the U.S. Treasury has rendered an opinion that the entire uncalled portion of the U.S. subscription is an obligation backed by the full faith and credit of the United States, notwithstanding that congressional appropriations have not been obtained with respect to certain portions of the subscription. For a further discussion of capital stock, restricted currencies, maintenance of value and membership refer to the Notes to Financial Statements—Note A-Summary of Significant Accounting and Related Policies and Note B-Capital Stock, Restricted Currencies, Maintenance of Value and Membership.

Borrowings

Source of Funding

IBRD diversifies its sources of funding by offering its securities to institutional and retail investors around the world, both through global offerings and by way of bond issues designed to meet the needs of specific markets or types of investors. Under its Articles, IBRD may borrow only with the approval of the member in whose markets the funds are raised and the member in whose currency the borrowing is denominated, and only if each such member agrees that the proceeds may be exchanged for the currency of any other member without restriction.

New medium- and long-term funding excluding swaps by currency for FY 2006, as compared to FY 2005, is shown in Figure 7.

Funding Operations

In FY 2006, medium- and long-term debt raised directly in financial markets by IBRD amounted to $10,233 million compared to $12,723 million in FY 2005. Table 14 summarizes IBRD’s funding operations for FY 2006 and FY2005.

Table 14: Funding Operations Indicators

(a).       Includes one-year notes and represents net proceeds on a settlement date basis.

(b).       Average maturity to first call date.

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Figure 7: New Medium- and Long-term Funding Excluding Swaps by Currency(a)

In millions of U.S. dollars equivalent

(a).       Includes one-year notes and represents net proceeds on a settlement date basis.

Funding raised in any given year is used for IBRD’s general operations, including loan disbursements, refinancing of maturing debt and prefunding of future lending activities. Funding opportunities in FY 2006 and FY 2005 remained relatively stable in terms of instruments, and IBRD followed a strategy of selective bond issuance, combining issues targeted to retail investors with private placements and public issues placed with large institutional investors. All proceeds from new funding are initially invested in the liquid asset portfolio until they are required for IBRD’s operations. Debt is allocated on a periodic basis to the different debt pools funding loans as necessary, in accordance with operating guidelines.

IBRD strategically repurchases, calls or prepays its debt to reduce the cost of borrowings and to reduce exposure to refunding requirements in a particular year or to meet other operational needs. In response to market conditions, during FY 2006, IBRD repurchased or called $3,918 million of its outstanding borrowings ($3,528 million during FY 2005).

Use of Derivatives

All new funding is initially swapped into floating-rate U.S. dollars, with conversion to other currencies or fixed-rate funding being carried out subsequently in accordance with loan funding requirements. Figures 8a and 8b illustrate the effect of swaps on both the interest rate structure and currency composition of the borrowings portfolio at June 30, 2006. Interest rate and currency swaps are also used for asset/liability management purposes to match the pool of liabilities as closely as possible to the interest rate and currency characteristics of liquid assets and loans. IBRD does not enter into derivatives for speculative purposes in the borrowings portfolio.

A more detailed analysis of borrowings outstanding is provided in the Notes to Financial Statements—Note E-Borrowings.

6. FINANCIAL RISK MANAGEMENT

IBRD assumes various kinds of risk in the process of providing development banking services. Its activities can give rise to four major types of risk: credit risk; market risk (interest rate and exchange rate); liquidity risk; and operational risk. The major inherent risk to IBRD is country credit risk, or loan portfolio risk.

Governance Structure

The risk management governance structure includes a Risk Management Secretariat supporting the Management Committee in its oversight function, particularly in the coordination of different aspects of risk management, and in connection with risks that cut across functional areas.

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Figure 8a: Effect of Swaps on Interest Rate Structures—June 30, 2006

Figure 8b: Effect of Swaps on Currency Composition—June 30, 2006

For financial risk management, there is a Finance Committee chaired by the Chief Financial Officer. The Finance Committee makes recommendations and, where appropriate to the topic, takes decisions in the areas of financial policy, the adequacy and allocation of risk capital, and oversight of financial reporting. Three subcommittees that report to the Finance Committee are the Market Risk and Currency Management Subcommittee, the Credit Risk Subcommittee and the Financial Instruments Subcommittee.

The Market Risk and Currency Management Subcommittee develops and monitors the policies under which market and commercial credit risks faced by IBRD are measured, reported and managed. The subcommittee also monitors compliance with policies governing commercial credit exposure and currency management. Specific areas of activity include reviewing and endorsing guidelines for limiting balance sheet and market risks, the use of derivative instruments, investing activities, and monitoring matches between assets and their funding. The Credit Risk Subcommittee monitors the measurement and reporting of country credit risk and reviews the impact on the provision for losses on loans and guarantees of any changes in exposure, risk ratings of borrowing member countries, or movements between the accrual and nonaccrual portfolios. The Financial Instruments Subcommittee reviews the financial, organizational and implementational issues of new products offered to IBRD borrowers.

Country credit risk, the primary risk faced by IBRD, is identified, measured and monitored by the Credit Risk Department, led by the Chief Credit Officer who reports to the Chief Financial Officer.  This unit is independent from IBRD’s business units. Moreover, in order to further protect the independence of the unit, individual country credit risk ratings are not shared with the Executive Directors. In addition to continuously reviewing the creditworthiness of IBRD borrowers, this department is responsible for assessing loan portfolio risk, determining the adequacy of provisions for losses on loans and guarantees, and monitoring borrowers that are vulnerable to crises in the near term.

Market risks, liquidity risks and counterparty credit risks in IBRD’s financial operations are identified, measured and monitored by the Corporate Finance Department, which is independent from the business units responsible for managing these risks. The Corporate Finance Department works with IBRD’s financial managers, who are responsible for the day-to-day management of these risks, to establish and document processes that facilitate, control and monitor risk. These processes are built on a

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foundation of initial identification and measurement of risks by each of the business units. Under the direction of the Finance Committee, policies and procedures for measuring and managing such risks are formulated, approved and communicated throughout IBRD. Senior managers represented on the Committee are responsible for maintaining sound credit assessments, addressing transaction and product risk issues, providing an independent review function and monitoring the loans, investments and borrowings portfolios.

The primary responsibility for the management of operational risk in IBRD’s financial operations resides with each of IBRD’s managers. These individuals are responsible for identifying operational risks and establishing, maintaining and monitoring appropriate internal controls in their respective areas using an operational risk management framework.

This framework requires each business unit to document operational risks and controls, assess the likelihood and impact of operational risks and evaluate the design and operating effectiveness of existing controls using guidelines established by IBRD. An independent operational risk control unit supports this process by undertaking periodic reviews, performing quality assurance testing and reporting exceptions.

The processes and procedures by which IBRD manages its risk profile continually evolve as its activities change in response to market, credit, product, operational and other developments. The Executive Directors, particularly the Audit Committee members, periodically review trends in IBRD’s risk profiles and performance, as well as any significant developments in risk management policies and controls.

Managing Risk-Bearing Capacity

The risk bearing capacity of IBRD is the adequacy of its capital to absorb credit shocks and still be able to lend for development purposes without the need for additional shareholder support. The Board of Executive Directors assesses IBRD’s risk-bearing capacity based on a variety of metrics, including a framework of stress testing and simpler measures such as the equity-to-loans ratio, to assess capital adequacy.

The risk that a significant portion of its loan portfolio may go into extended arrears is the most significant risk faced by IBRD, and almost all of IBRD’s equity capital is held against this risk. Credit risk is measured in terms of both probable and unexpected losses from protracted payments arrears. Probable losses are covered by IBRD’s accumulated provision for losses on loans and guarantees, and unexpected losses are covered by income-generating capacity and equity.

The framework of stress testing provides a basis for evaluating whether IBRD has sufficient financial capacity to be able to (i) absorb the income loss due to a credit shock,(a) and (ii) generate sufficient income to support loan growth in the following years. The first requirement on the degree of shock absorption is designed to reduce the probability of having to rely on additional shareholder support (in terms of additional paid-in capital or a call on callable capital). This is intended both to protect shareholders and to support IBRD’s credit standing, which reduces borrowing costs and correspondingly, lending rates for borrowers. The second requirement on loan growth reflects the view that as a development institution, IBRD needs to play a positive role in a crisis by maintaining the capacity to continue lending to assist recovery in borrowing member countries. One of the credit shock events used in the stress testing framework is an estimate of the amount of the loan portfolio that could enter nonaccrual status (payment arrears in excess of six months) in the next three years at an appropriate confidence level.

IBRD’s equity supports its risk-bearing capacity for its lending operations. IBRD strives to immunize its risk-bearing capacity from fluctuations in interest and exchange rates. Therefore, IBRD uses the equity-to-loans ratio (on a current value basis) as one tool to monitor the sensitivity of its risk-bearing capacity to movements in interest and exchange rates. One of IBRD’s financial risk management objectives is to seek to protect the equity-to-loans ratio from movements arising from market risks.

The sensitivity of IBRD’s operating income to interest rate movements arises primarily from the sensitivity of the “contribution of equity” (the income earned from that portion of IBRD’s assets funded with equity rather than with debt).The sensitivity of IBRD’s operating income to changes in market interest rates has been increasing as borrowers have chosen to borrow from IBRD primarily on floating rate terms since the introduction of LIBOR-based

(a).       Income loss arises from borrowers in nonaccrual status no longer paying interest on their loans. In addition, an increase in the loan loss provision is typically warranted as a result of the nonaccrual event. This increase in the provision must be recognized as an expense, which further reduces net income in the year of the shock, and through that, impacts the equity-to-loans ratio.

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loans. To the extent that the duration of its equity capital is matched to that of its loan portfolio, this ratio is protected against interest rate movements. To the extent that the currency composition of its equity capital is matched with that of its loan portfolio, the equity-to-loans ratio is also protected from exchange rate movements.

As presented in Figure 6 in Section 5, Funding Resources, IBRD’s equity-to-loans ratio on both the current value and reported basis has been on an upward trend.

Credit Risk

Country Credit Risk

Country credit risk is the risk of loss due to a country not meeting its contractual obligations. IBRD’s Credit Risk Department continuously reviews the credit risk of its borrowing member countries. These reviews are taken into account in determining IBRD’s overall country programs and lending operations, used to estimate the appropriate level of provisions for losses on loans and guarantees, and used to assess the adequacy of IBRD’s income-generating capacity and risk-bearing capital. In keeping with standard practice, probable losses inherent in the portfolio due to country credit risk are covered by the accumulated provision for losses on loans and guarantees, while unexpected losses due to country credit risk are covered by income-generating capacity and risk-bearing capital.

Portfolio concentration risk, which arises when a small group of borrowers account for a large share of loans outstanding, is a key concern for IBRD and is carefully managed, in part, through an exposure limit for loans outstanding plus the present value of guarantees to a single borrowing country. Under the current guidelines, IBRD’s exposure to a single borrowing country is restricted to the lower of an Equitable Access Limit or the Single Borrower Limit. The Equitable Access Limit is equal to 10% of IBRD’s subscribed capital, reserves and unallocated surplus. The Single Borrower Limit is established by assessing its impact on the overall portfolio risk relative to risk-bearing capacity, as measured by the level of usable equity. The Single Borrower Limit is determined by the Executive Directors each year at the time they consider the adequacy of IBRD’s reserves and the allocation of its net income from the preceding fiscal year. For FY 2007, the Single Borrower Limit is maintained at $14.5 billion, the same level as in FY 2006, and the Equitable Access Limit is $21.6 billion at June 30, 2006. As depicted in Figure 9, IBRD’s largest exposure (including the present value of guarantees) to a single borrowing country was $11.3 billion at June 30, 2006.

Figure 9: Top Eight Country Exposures at June 30, 2006

In billions of U.S. dollars

Since the current exposure data presented are at a point in time, evaluating these exposures relative to the limit requires consideration of the repayment profiles of existing loans, as well as disbursement profiles and projected new loans and guarantees.

Under certain circumstances, IBRD would be able to continue to lend to a borrower that was reaching the single borrower exposure limit by entering into an arrangement that would prevent its net exposure from exceeding the limit. Any such arrangement would need to be approved in advance by IBRD’s Executive Directors. As of June 30, 2006 IBRD had entered into one such arrangement with China. As of this date, China had not reached the single borrower exposure limit and therefore, activation of this arrangement was not required.

Overdue and Non-performing Loans

When a borrower fails to make payment on any principal, interest or other charges due to IBRD, IBRD has an option to suspend disbursements immediately on all loans. IBRD’s current policy however, is to exercise this option through a graduated approach as summarized in Box 4. These policies also apply to those member countries who are eligible to borrow from both IBRD and IDA, and whose payments on IDA credits may become overdue. For borrowers with IBRD loans who become overdue in their debt service payments on IDA credits, IBRD also applies the treatment described in Box 4.

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Box 4: Treatment of Overdue Payments

Overdue by 30 days	Where the borrower is the member country, no new loans to the member country, or to any other borrower in the country, will be presented to the Board of Executive Directors for approval, nor will any previously approved loan be signed, until payments for all amounts 30 days overdue or longer have been received. Where the borrower is not the member country, no new loans to that borrower will be signed or approved. In either case, the borrower will lose its eligibility for any waiver of interest charges in effect at that time.
Overdue by 45 days	In addition to the provisions cited above for payments overdue by 30 days, to avoid proceeding further on the notification process leading to suspension of disbursements, the country as borrower or guarantor and all borrowers in the country must pay not only all payments overdue by 30 days or more, but also all payments due regardless of the number of days since they have fallen due. Where the borrower is not the member country, no new loans to, or guaranteed by, the member country, will be signed or approved.
Overdue by 60 days	In addition to the suspension of approval for new loans and signing of previously approved loans, disbursements on all loans to or guaranteed by the member country are suspended until all overdue amounts have been paid. This policy applies even when the borrower is not the member country.
Overdue by more than six months	All loans made to or guaranteed by a member of IBRD are placed in nonaccrual status, unless IBRD determines that the overdue amount will be collected in the immediate future. Unpaid interest and other charges not yet paid on loans outstanding are deducted from the income of the current period. To the extent that these payments are received, they are included in income.
	At the time of arrears clearance, a decision is made on the restoration of accrual status on a case by case basis; in certain cases that decision may be deferred until after a suitable period of payment performance has passed.

 

See Notes to Financial Statements—Note D-Loans, Guarantees and Derivatives for Borrowers for a summary of countries with loans or guarantees in nonaccrual status at June 30, 2006.

Accumulated Provision for Losses on Loans and Guarantees

IBRD maintains an accumulated provision for losses on loans and guarantees to recognize the probable losses inherent in both the accrual and nonaccrual portfolios. The methodology for determining the accumulated provision for losses on loans and guarantees is discussed in Section 7, Critical Accounting Policies.

IBRD’s provision for losses on loans and guarantees covers probable credit losses from protracted arrears. The Credit Risk Subcommittee reviews the allowance for losses on loans and guarantees at least quarterly and, if necessary, adjustments are made to the provision. In addition, the Audit Committee is apprised by management at least twice a year on the accumulated provision for losses on loans and guarantees.

The accumulated provision for losses on both the accrual and nonaccrual loans portfolio decreased by $713 million (Table 15). This decrease comprises a release of provision for losses on loans (excluding guarantees) of $722 million and a negative translation adjustment of $9 million during FY 2006). This decrease was primarily due to the combined impact of changes in the creditworthiness of the loans portfolio, changes in the volume and distribution of loans and guarantees outstanding and the annual update of the expected default frequencies (probability of default to IBRD) and developments in the nonaccrual portfolio.

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Table 15: Accumulated provision for Losses on Loans by Portfolio as a Percentage of Total Loans Outstanding

In millions of U.S. dollars

		2006								2005
		Loans outstanding			Accumulated Provision			Accumulated Provision as a Percentage of Total Loans Outstanding		Loans outstanding			Accumulated Provision			Accumulated Provision as a Percentage of Total Loans Outstanding
Accrual Portfolio		$	101,966		$	1,480		1.4	%	$	100,858		$	1,578		1.5	%
Nonaccrual Portfolio		1,038			816			0.8	%	3,543			1,431			1.4	%
Total Loans Outstanding		$	103,004		$	2,296		2.2	%	$	104,401		$	3,009		2.9	%

 

Treatment of Protracted Arrears

In 1991, the Executive Directors adopted a policy to assist members with protracted arrears to IBRD to mobilize sufficient resources to clear their arrears and to support a sustainable growth-oriented adjustment program over the medium term. This policy is conditional on members agreeing to implement certain requirements including an acceptable structural adjustment program, adopting a financing plan to clear all arrears to IBRD and other multilateral creditors, and continuing to service their obligations to IBRD and other multilateral creditors on time.

It is IBRD’s practice not to reschedule interest or principal payments on its loans or participate in debt rescheduling agreements with respect to its loans. During FY 1996 and FY 2002, exceptions were made to that practice with regard to Bosnia and Herzegovina (BiH) and Serbia and Montenegro (SAM), formerly the Federal Republic of Yugoslavia, based on criteria approved by the Executive Directors in connection with the financial assistance package for Bosnia and Herzegovina in 1996. See the Notes to Financial Statements—Note A-Summary of Significant Accounting and Related Policies, for additional information.

Commercial Credit Risk

Commercial credit risk is the risk of loss due to a counterparty not honoring its contractual obligations.

IBRD’s commercial credit risk is concentrated in investments in debt instruments issued by sovereign governments, agencies, banks and corporate entities. The majority of these investments are in AAA and AA rated instruments.

In the normal course of its business, IBRD utilizes various derivatives and foreign exchange financial instruments to reduce funding costs through its borrowing activities and to meet the financial needs of its borrowers, to generate income through its investment activities and to manage its exposure to fluctuations in interest and currency rates.

The effective management of credit risk is vital to the success of IBRD’s funding, investment and asset/liability management activities. The monitoring and managing of these risks is a continuous process due to changing market environments.

IBRD controls the counterparty credit risk arising from investments, derivatives and foreign exchange transactions through its credit approval process, the use of collateral agreements and risk limits, and monitoring procedures. The credit approval process involves evaluating counterparty creditworthiness, assigning credit limits and determining the risk profile of specific transactions. Credit limits are calculated and monitored on the basis of potential exposures taking into consideration current market values, estimates of potential future movements in those values and collateral agreements with counterparties. If there is a collateral agreement with the counterparty to reduce credit risk, then the amount of collateral obtained is based on the credit rating of the counterparty. Collateral held includes cash and government securities.

For foreign exchange and derivative products IBRD treats the credit risk exposure as the replacement cost. This is also referred to as replacement risk or the mark-to-market exposure amount. While contractual principal amount is the most commonly used volume measure in the derivative and foreign exchange markets, it is not a measure of credit or market risk.

Mark-to-market exposure is a measure, at a point in time, of the value of a derivative or foreign exchange contract in the open market. When the mark-to-market is positive, it indicates the counterparty owes IBRD and, therefore, creates an exposure for IBRD.

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When the mark-to-market is negative, IBRD owes the counterparty and does not have replacement risk.

When IBRD has more than one transaction outstanding with a counterparty, and the parties have entered into a master derivatives agreement which contains legally enforceable close-out netting provisions, the “net” mark-to-market exposure represents the netting of the positive and negative exposures with the same counterparty. If this net mark-to-market is negative, then IBRD’s exposure to the counterparty is considered to be zero. For the contractual value, notional amounts and related credit risk exposure amounts by instrument, see the Notes to Financial Statements—Note G-Credit Risk.

Table 16 provides details of IBRD’s estimated credit exposure on its investments (excluding externally-managed assets—$1,443 million at June 30, 2006, $1,383 million at June 30, 2005) and swaps (excluding those with borrowing member countries), net of collateral held, by counterparty rating category.

The decrease in the proportion of AAA-rated investments and the corresponding increase in AA- and A-rated investments reflect (i) a reduction in investments in obligations of European agencies and official entities, including the German Landesbanks, (ii) some continued investments in short-term deposits with German Landesbanks after their downgrade as a result of the expiration of state guarantees and (iii) an increase in investments in Japanese government securities.  After the effects of netting arrangements, the credit exposure from swaps decreased from $8,167 million at June 30, 2005 to $4,375 million at June 30, 2006.  The swap credit exposure of $4,375 million is offset by collateral of $3,239 million which results in a total net swap exposure of $1,136 million.

Market Risk

IBRD faces risks which result from market movements, primarily changes in interest and exchange rates. In comparison to country credit risk, IBRD’s exposure to market risks is small. IBRD has an integrated asset/liability management framework to flexibly assess and hedge market risks associated with the characteristics of the products in IBRD’s portfolios.

Asset/Liability Management

The objective of asset/liability management for IBRD is to ensure adequate funding for each loan product and liquid asset at the most attractive available cost, and to manage the currency composition, maturity profile and interest rate sensitivity characteristics of the portfolio of liabilities supporting each lending product and liquid asset in accordance with the particular requirements for that product or liquid asset and within prescribed risk parameters. The current value information is used in the asset/liability management process.

Use of Derivatives

As part of its asset/liability management process, IBRD employs derivatives to manage and align the characteristics of its assets and liabilities. IBRD uses derivative instruments to adjust the interest rate repricing characteristics of specific balance sheet assets and liabilities, or groups of assets and liabilities with similar repricing characteristics, and to modify the currency composition of net assets and liabilities.

Table 17 details the current value information of each loan product, the liquid asset portfolio, and the debt allocated to fund these assets.

Table 16: Credit Exposure, Net of Collateral Held, by Counterparty Rating

In millions of U.S. dollars

		At June 30, 2006														At June 30, 2005					At June 30, 2004
		Investments
Counterparty Rating		Sovereigns			Agencies, Banks & Corporates			Net Swap Exposure			Total Exposure on Investments and Swaps			% of Total		Total Exposure on Investments and Swaps			% of Total		Total Exposure on Investments and Swaps			% of Total
AAA		$	340		$	6,693		$	288		$	7,321		29		$	11,208		42		$	12,266		40
AA		31			13,132			848			14,011			55		12,831			49		15,975			51
A		1,771			2,220			—			3,991			16		2,275			9		2,864			9
Total		$	2,142		$	22,045		$	1,136		$	25,323		100		$	26,314		100		$	31,105		100

 

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Table 17: Financial Instrument Portfolios

In millions of U.S. dollars

		At June 30, 2006								At June 30, 2005
		Carrying Value			Contractual Yield		Current Value Adjustments			Carrying Value			Contractual Yield		Current Value Adjustments
Loans(a)		$	103,004		5.25	%	$	881		$	104,401		4.30	%	$	3,148
Variable-Rate Multicurrency Pool Loans		11,859			5.16		1,059			14,806			4.59		1,816
Single Currency Pool Loans		9,334			4.92		179			12,696			5.23		372
Variable-Spread Loans(b)		41,677			5.10		(49		)	40,868			3.45		(58		)
Fixed-Rate Single Currency Loans		8,629			6.10		(3		)	10,710			6.18		456
Special Development Policy
Loans(c)		2,946			6.15		(5		)	3,962			4.45		(3		)
Fixed-Spread Loans		28,295			5.23		(300		)	21,117			4.15		563
Other Fixed Rate Loans		264			7.88		*			242			8.55		2
Liquid Asset Portfolio(d)		$	24,655		5.09	%				$	26,170		3.26	%
Borrowings Allocation (including swaps)(e)		$	92,083		4.88	%	$	1,076		$	94,841		3.61	%	$	2,793
Variable-Rate Multicurrency Pools		8,238			5.85		1,657			9,749			5.10		2,613
Single Currency Pools		6,379			5.66		198			8,284			4.10		304
Variable-Spread		26,764			4.62		(144		)	25,719			2.90		(121		)
Fixed-Rate Single Currency		5,479			5.71		(15		)	9,785			5.37		372
Special Development Policy		2,734			4.70		(5		)	3,994			2.87		(8		)
Fixed-Spread		16,604			4.38		(342		)	10,828			3.61		202
Other Debt(f)		25,885			4.82		(273		)	26,482			3.09		(569		)

(a).       Contractual yield is presented before the application of interest waivers.

(b).       Includes fixed-rate single currency loans for which the rate had not yet been fixed at fiscal year-end.

(c).        Includes loans with non-standard terms as described in Contractual Terms of Loans.

(d).       The liquid asset portfolio is carried and reported at market value and excludes investment assets associated with certain other postemployment benefits.The yield information represents the weighted average market yield to maturity.

(e).        Carrying amounts and contractual yields are on a basis which includes accrued interest and any unamortized amounts, but does not include the effects of applying FAS 133.

(f).           Includes amounts not yet allocated at June 30, 2006 and June 30, 2005.

*                    Indicates amounts less than $0.5 million.

Interest Rate Risk

There are two main sources of potential interest rate risk to IBRD. The first is the interest rate sensitivity associated with the net spread between the rate IBRD earns on its assets and the cost of borrowings, which fund those assets. The second is the interest rate sensitivity of the income earned from funding a portion of IBRD assets with equity. In general, lower nominal interest rates result in lower lending rates which, in turn, reduce the nominal earnings on IBRD’s equity. In addition, as the loan portfolio shifts from pool loans to LIBOR based loans, the sensitivity of IBRD’s operating income to changes in market interest rates will increase.

The borrowing cost pass-through formulation incorporated in the lending rates charged on most of IBRD’s existing loans has traditionally helped limit the interest rate sensitivity of the net spread earnings on its loan portfolio. Such cost pass-through loans currently account for 61% of the existing outstanding loan portfolio (65% at the end of FY 2005). All cost pass-through loans, including single currency and multicurrency pool loans as well as variable-spread loans, pose residual interest rate risk, given the lag inherent in the lending rate calculation.

Another potential risk arises because the cost pass-through currency pool products have traditionally been funded with a large share of medium- and long-term

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fixed-rate debt, to provide the borrowers with a reasonably stable interest basis. Given that the cumulative impact of interest rate changes over time has resulted in a decline in the level of interest rates, the cost of these historical fixed-rate borrowings in the multicurrency pool and the single currency pools is currently considerably higher than IBRD’s new borrowing costs. The amount of debt allocated to the multicurrency debt pool will exceed the balance of the multicurrency loan pool from FY 2008. The debt which funds these loans has maturities that extend beyond those of the loans. This debt overhang presents a risk of loss to IBRD because the debt carries fixed interest rates.

Over-funding of the multicurrency loan pool will reach a maximum of approximately $6.2 billion in FY 2016. Strategies for managing this risk include changing the interest rate characteristics of the over-funded portion of the debt from fixed to floating rates beyond FY 2008 through the use of forward-starting swaps. IBRD began executing these forward-starting swaps in FY 2000 and the cost to date has been approximately $708 million. The fair value of the debt overhang remaining to be hedged is approximately $2 million as of June 30, 2006. The cost of the overhang will vary with interest rates and prepayments.

Interest rate risk on non-cost pass-through products, which currently account for 39% of the existing loan portfolio (35% at the end of FY 2005), is managed by using interest rate swaps to closely align the rate sensitivity characteristics of the loan portfolio with those of their underlying funding. As the portfolio of fixed-spread loans increases, the proportion of non-cost pass-though products will grow.

The interest rate risk on IBRD’s liquid asset portfolio, which includes the risk that the value of assets in the liquid portfolio will fluctuate due to changes in market interest rates, is managed within specified duration-mismatch limits and is further limited by stop-loss limits.

Interest rate risk also arises from a variety of other factors, including differences in the timing between the contractual maturity or repricing of IBRD’s assets, liabilities and derivative financial instruments. On floating rate assets and liabilities, IBRD is exposed to timing mismatches between the re-set dates on its floating rate receivables and payables. To mitigate its exposure to these timing mismatches, IBRD has executed some overlay interest rate swaps.

Exchange Rate Risk

In order to minimize exchange rate risk in a multicurrency environment, IBRD matches its borrowing obligations in any one currency (after swap activities) with assets in the same currency, as prescribed by the Articles. In addition, IBRD’s policy is to minimize the exchange rate sensitivity of its equity-to-loans ratio. It carries out this policy by undertaking currency conversions periodically to align the currency composition of its equity to that of its outstanding loans. This policy is designed to minimize the impact of exchange rate fluctuations on the equity-to-loans ratio, thereby preserving IBRD’s ability to better absorb unexpected losses from arrears of loan repayments regardless of the market environment.

Figure 10 presents the currency composition of significant balance sheet components (net of swaps) at the end of FY 2006 and FY 2005.

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