2 Philbnk

The Past Performance of the Philippine Banking Sector and Challenges in the Postcrisis Period
Ma. Socorro Gochoco-Bautista
Ma. Socorro Gochoco-Bautista is Rosa S. Alvero Professor of Economics, University of the Philippines; and was formerly Assistant Professor of Economics, University of Hawaii.
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A STUDY OF FINANCIAL MARKETS
Executive Summary
A look back at the history of Philippine banking reveals a developmental role assigned to the banking system and a common pattern of frailty in the face of adverse shocks. Ceilings on interest rates, interest rate subsidies, and directed lending were intended to enable the banking system to promote economic growth by being the main source of development finance. While the system itself has displayed a flexibility and willingness to undertake reforms, these actions were often in response to, rather than preventive measures against, crises. Genuine reforms have usually come after, not before, crises and in the transition from crisis to stability (and one regulatory regime to a stronger one), the restoration of confidence in financial markets was agonizingly slow. The ensuing contraction in credit and intermediation has usually dragged down the rest of the economy. The occurrence of the Asian financial crisis has led to a rethinking of how best to strengthen banking systems so as to prevent banking crises, or to reduce banking system vulnerability to crises. There is apparently a greater appreciation for the idea that regulation and supervision must now increasingly focus on the less traditional and conventional methods. This study examines the structure and current state of the Philippine banking industry, reviews the history of financial reforms, discusses the measures taken by the authorities to strengthen the banking sector prior to and after the Asian crisis, identifies the remaining weaknesses and factors that contribute to the vulnerability of the Philippine banking industry, and makes some recommendations to address them. The original impetus for reform in the 1950s and 1960s was not the need to respond to crises, but the rapid growth and increasing fragmentation of the banking system. The increasing diversity of financial institutions and services challenged the ability of the central bank to adequately regulate them. However, prudential financial regulation at that stage was highly
undeveloped: capital adequacy standards for solvency were relevant, but required very simple and rudimentary implementation mechanisms; liquidity was managed by imposing the reserve requirement; and supervision and examination requirements were addressed through simple reporting systems. In 19721973, a Joint International Monetary Fund-Central Bank (IMF-CB) Banking Survey Commission recommended that several amendments be made to the General Banking Act and the Central Bank Act. These amendments were meant to (i) realign regulation by function rather than by type of bank; (ii) consolidate central bank authority over banks and nonbanks (except insurance companies); (iii) redefine the central banks responsibilities to exclude the promotion of economic growth; and (iv) impose restrictions on entry into the banking system, with concomitant efforts to improve the efficiency of existing banks. Along with the increasing dynamism of the financial sector and the need for more responsive financial structures to address financing needs, the moves toward rationalizing the central banks supervision over the banking sector led to increasing pressure to adopt more sophisticated prudential regulatory mechanisms and structures. While banking institutions remained the dominant financial intermediaries, nonbank private and quasi-public financial institutions emerged, constituting an alternative means of intermediation. The process of reform suffered an adverse shock in 1981 when businessman Dewey Dee, faced with millions of pesos in debt owed to various financial institutions, decided to abscond. The Dee incident triggered a financial crisis, a rash of insolvencies in investment houses and finance companies. This resulted in a flight-to-quality, as savers shifted their funds out of these institutions and into large commercial banks. The Aquino assassination in August 1983 precipitated an even bigger crisis, one that further eroded domestic and international confidence in the entire financial system. In response to the massive capital flight and persistent current account deficits, the
THE PAST PERFORMANCE OF THE PHILIPPINE BANKING SECTOR AND CHALLENGES IN THE POSTCRISIS PERIOD
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Government was forced to devalue the peso, impose a moratorium on external debt payments, ration foreign exchange, and raise interest rates. Years of protracted crisis took their toll on other aspects of the financial system. Uncertainty and risks in lending stifled the long-term loan market. The number of bank offices declined in absolute terms (as several banks collapsed), and so did the total assets of the banking system. Total lending by the banking system fell and did not reach the 1980 levels until the early 1990s. The rash of foreclosures followed the deterioration in loan portfolios and led to an increase in bank investments. To strengthen what remained of the banking system, the central bank pursued a rehabilitation program for weaker banks. Asset quality remained generally weak and, in the process, banks invested a large portion of their funds in highyielding government securities. The early 1990s saw a marked improvement in the state of the financial system. Bank branching was relaxed. The foreign exchange market was deregulated in 1992 to enhance market efficiency and achieve exchange rates more consistent with economic growth. Restrictions on foreign exchange transactions of banks were lifted and prudential limits on foreign exchange positions of banks were redefined. Unfortunately, the boom in the financial sector also planted the seeds for weakness and vulnerability in the 1990s. The reentry of the Philippine Government into the international capital markets encouraged many domestic banks and firms to follow suit. As a result, while relative indicators suggested that the foreign indebtedness of the public nonbank sector had been steadily declining, the foreign indebtedness of the private banking and private nonbank sectors steadily increased. The Philippine banking system experienced many of the symptoms that ultimately did in the banking systems in the countries worse hit by the crisis. These symptoms, which became particularly evident in the aftermath of the crisis, included macroeconomic vola-
tility, high property exposure and asset inflation, large amounts of foreign exchange liabilities, governmentdirected lending and related-party lending, fragility in the case of some banks, and weak supervision and underregulation in some others. The response of the monetary authorities to speculative pressure on the peso beginning in July 1997 was to sell dollars initially and, subsequently, to tighten liquidity. The latter resulted in raising interest rates on 91-day treasury bills from 10.5 percent in June 1997 to a high of 19.1 percent in January 1998. The central bank ultimately gave up its defense of the peso, which then depreciated by 15 percent on 11 July 1997. These events adversely affected the corporate sector, the financial sector, and the rate of economic growth. Bank profitability declined dramatically in 1998 relative to the two previous years. The return on equity (ROE) of commercial banks fell from 16.34 percent in 1996 to 12.42 percent in 1997 and to a low but still positive 6.6 percent at the end of 1998. By March 1999, it had decreased further to 1.69 percent. Nevertheless, most observers as well as Government authorities themselves agree that the Philippine banking system managed to survive the Asian financial crisis relatively unscathed and that there is no banking crisis in the Philippines. Over the last three years, the Bangko Sentral ng Pilipinas (BSP), the Philippines central bank, undertook measures to strengthen its prudential framework over banks so as to reduce system risks, strengthen regulatory oversight, and align domestic banking standards with international best practices. The major measures included the raising of capital requirements, tightening of provisioning requirements, and stricter loan classification subject to loan-loss provisioning. The BSP undertook a comprehensive reform program whose elements included (i) strengthening the prudential and supervisory systems, (ii) adopting an early intervention system and a bank resolution strategy to deal more effectively with problem banks and to safeguard the soundness of the banking system, (iii) undertaking special programs to strengthen
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and modernize government banks through privatization, (iv) adopting measures to reduce the intermediation costs of financial institutions, and (v) improving the legal and regulatory framework through legislation by Congress. Bank closures in 1997 and 1998 were few and the amount of total bank assets they represented was small. Notwithstanding the Asian financial crisis, the total resources and total operating network of the Philippine banking system expanded slightly in 1998 compared with a year earlier. The total resources of the banking system grew by close to 1 percent in 1998 relative to the end-1997 level. The asset quality problem of Philippine banks is not about solvency as it is in the cases of Indonesia, the Republic of Korea, and Thailand. In terms of portfolio loan quality, the nonperforming loan (NPL) ratio of the entire banking system increased from 4.7 percent in December 1997 to 12.1 percent in January 1998. The BSP continues to encourage mergers and consolidation within the banking sector, principally through increases in minimum capital requirements. There have been substantial improvements toward the prudential supervision of banks, including those on asset quality norms such as the interest accrual policy on past-due loans, the reversal of accrued interest income on NPLs, and the high provisioning requirements. Nevertheless, there are remaining weaknesses and vulnerabilities that must be addressed. The Philippines continues to be plagued by certain macroeconomic weaknesses. Among the countries in Asia, the Philippines has the lowest savings rate at 19 percent and it is second only to Indonesia in having the largest ratio of public sector debt to gross domestic product (GDP). Both these facts imply that, in the mean time, the Philippines will have to rely on foreign savings. GDP growth was negative in the last two quarters of 1998, but managed to rise to 1.5 percent in the first quarter of 1999 largely due to improved agricultural growth. On the inflation front, estimates of year-on-year average
inflation rate for 1999 are higher than those for neighboring countries. Some observers have associated the problematic outcomes of the liberalization of financial markets with a deficient state of institutional arrangements, such as good accounting systems and adequate disclosure. Several weaknesses in the prudential norms of Philippine banks remain. First, banks accrue income on restructured loans or immediately classify them as performing loans so long as the loans are current in status, or are fully secured by real estate with a loan value up to 60 percent of the appraised value of the real estate security and other qualified collateral. While there have been notable improvements in disclosure with respect to NPLs, loan-loss provisioning, and loan-loss reserves, as in many Asian banking sectors loan-loss provisioning requirements are typically net of collateral, which is usually property. Second, Philippine banks are active in loan-for-property swaps. Such loan-for-property swaps can take place without formal legal foreclosure proceedings. In many cases, these properties are actually unearned assets in the form of raw land and are booked as real and other property owned and acquired accounts (ROPOA) in bank balance sheets at realizable values. Philippine banks can directly foreclose pledged collateral once the borrowers are proven unable to service the interest or the principal or both. Third, reserve coverage against such ROPOA assets are not required until after five years from the time the property is booked. Some banks could use this to inflate collateral value since the property market is illiquid. Fourth, loan-loss reserves are currently not tax-deductible although the BSP has endorsed to Congress a plan to make such reserves deductible. Since this move involves tax revenues, it needs to be legislated. In general, while attempts should be made to lower financial intermediation costs and enhance the profitability of banks, the important point is that the industry must also become more contestable. Otherwise, such moves to reduce inter-
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mediation costs will simply strengthen an existing oligopoly. Fifth, the timing of loan write-offs is determined in part by its effect on the capital position of the bank and in part by its tax effect. Deferring write-offs is common and may materially overstate the value of assets and capital. The banking system continues to suffer from weak implementation of prudential norms and international supervisory standards. While the Bank for International Settlements (BIS) core principles for effective bank supervision put much emphasis on estimating a banks value at risk, the pace at which bank supervisors and examiners are implementing this is slow. The approach to bank examination in the Philippines focuses largely on borrower-related risks associated with loans, while secondary or product-related risks are not consistently taken into consideration. There seems to be much regulatory forbearance. Bank supervisors seem reluctant to effect the early closure of failing institutions. The credit culture is weak and inadequacies in addressing the long-term developmental needs of the economy have persisted. The Philippines has one of the lowest degrees of financial intermediation in Asia, with a loan- to-GDP ratio under 65 percent. The formal credit system serves only a small portion of the rural sector and other vital sectors. The Bank Secrecy Law may partly be responsible for bank examiners conservative approach to examination. This law makes it impossible for the BSP and Philippine Deposit Insurance Corporation (PDIC) examiners to verify individual account (deposit) balances. Because of this restriction, the examiners may not detect misstated deposit account balances and could then become more conservative in the other areas of their examination. NPL resolution needs to be more closely aligned with corporate governance and rehabilitation. A major impediment to doing so is that corporate rehabilitation is not defined anywhere. While it is a remedy provided under Presidential Decree 902-A, the procedures on how to avail of it, or the relief that goes
with it is not specified in the law. As with other forms of remedies for ailing corporations, the Securities and Exchange Commission (SEC) has exclusive jurisdiction over corporate rehabilitation; thus, corporate rehabilitation tends to be regulator-driven. However, the SEC has not adopted formal rules to govern the implementation of these remedies. Hence, it exercises a lot of discretion and power in the granting of these remedies, treating applications for the availment of remedies on a case-by-case basis. In general, the overall capacity of the SEC to perform its roles as corporate regulator and supervisor is being compromised because it is overburdened with so many tasks. The study makes the following recommendations and proposes measures to address the remaining weaknesses and vulnerabilities of the Philippine banking sector: Strengthen banks to meet the increasing requirements of globalization through the appropriate conduct of macroeconomic policy. This will provide the correct system of incentives, and raise the degree of efficient financial intermediation while addressing the demands of long-term development finance as well. Strengthen competition and efficiency in the banking industry by promoting contestable markets and greater foreign entry while encouraging bank mergers and acquisitions; undertaking privatization; strengthening the public listing requirements to improve corporate governance in the banking industry; reducing or eliminating financial intermediation taxes such as the gross receipts tax, the documentary stamp tax, AGRI/ AGRA (agricultural/agrarian) requirement, Magna Carta for small and medium-size enterprises (SMEs); and eventually removing implicit financial intermediation taxes such as the liquidity reserve requirements. Strengthen prudential regulation and supervision by adopting a formal framework and common terminology for risk assessment and risk management systems in banks; improving financial
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reporting, disclosure, and transparency, including repeal of the Bank Secrecy Law; implementing prudential norms and supervisory standards effectively; and reducing regulatory forbearance by such methods as legislating the adoption of preventive corrective action (PCA) measures. Improve the financial infrastructure by strengthening the legal/regulatory infrastructure on corporate and financial restructuring and bankruptcy. The SEC must improve corporate disclosure and transparency rules, adopt formal rules for implementing corporate rehabilitation, make the proceedings swift and time-bound, and creditorrather than regulator-driven. Concerning the BSPs role as supervisor and regulator of banks, there should be a clearer legal interpretation of its mandate in relation to mergers and acquisitions in the banking industry and the extent of the need for legislation for the industry to effect such mergers and acquisitions. In the final analysis, it can be said that while the Philippine banking system has survived the worst effects of the Asian financial crisis, the goals of the reform program that began in the early 1980s still have not been completely met. The challenge is to achieve those goals in a more volatile macroeconomic environment that is more integrated with the global economy.
A look back at the history of Philippine banking reveals a developmental role assigned to the banking system and a common pattern of frailty in the face of adverse shocks. Ceilings on interest rates, interest rate subsidies, and directed lending were intended to enable the banking system to promote economic growth by being the main source of development finance. Early on, the shocks that hit the system were mostly internal, arising from the inefficiencies that the flawed system of regulation and incentives engendered. The occurrence of the Asian financial crisis has led to a rethinking of how best to strengthen banking systems so as to prevent banking crises or to reduce banking system vulnerability to crises. There is apparently a greater appreciation for the idea that regulation and supervision must now increasingly focus on the less traditional and conventional methods. This study examines the structure and current state of the Philippine banking industry, reviews the history of financial reforms, discusses the measures taken by the authorities to strengthen the banking sector prior to and after the Asian crisis, identifies the remaining weaknesses and factors that contribute to the vulnerability of the Philippine banking industry, and makes some recommendations on how to address them.
Introduction
Throughout its history, the Philippine financial system has displayed characteristics typical of a developing financial system: periods of moderate to extreme financial repression followed by cycles of reform and deregulation; periods of strong domestic credit growth and growing risks of moral hazard, followed by severe crises and contraction in the supply of credit often leading to recessions. In addition to these difficulties, the performance of the Philippine financial sector has also been regularly undermined by inadequate regulation in the past and burdened by poor macroeconomic conditions.
Structure of the Philippine Financial System

The industry is presently composed of the categories of institutions listed in Table 1. 1 The central bank is responsible for implementing monetary policy and the prudential supervision and regulation of the banking system. The Securities and Exchange Commission (SEC) oversees the conduct of the stock and bond markets, and, to the extent that banks and nonbank financial intermediaries (NBFIs) participate in these markets, the SEC works with the central bank in supervising and regulating the activities of the latter institutions. Increasing financial sophistication has led to greater diver-
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Table 1: The Philippine Financial System

Type of Institution Components
Banking Institutions
Universal banks Commercial banks Thrift banks Rural banks Specialized government banks Investment houses Financing companies Securities dealers Investment companies Fund managers Lending investors Pawnshops Government NBFIsa Venture capital corporations Mutual building and loan associations Nonstock savings and loans associations
Nonbank Financial Intermediaries
The increasing diversity of financial institutions and services challenged the ability of the central bank to adequately regulate them. However, prudential financial regulation at that stage was highly undeveloped: capital adequacy standards for solvency were relevant but required very simple and rudimentary implementation mechanisms, liquidity was managed through the use of the reserve requirement, and supervision and examination requirements were ad4 dressed through simple reporting systems.
REFORMS IN THE 1970S
Nonbank Thrift Institutions
a Nonbank financial institutions. These include the Social Security System (SSS),
the Government Service Insurance System (GSIS), and the Home Development Mutual Fund (HDMF).
sification in the conduct of business in the financial services sector. However, this has also called for concomitant strengthening in the conduct of financial supervision and regulation, and administration of a policy consistent with macroeconomic and financial sector stability and efficiency in financial intermediation. As the history of the Philippine banking system suggests, these needs have not always been addressed in a timely and effective manner. The result has been a system historically vulnerable to shocks, with low domestic savings mobilization, a high risk of moral hazard, and a propensity for inefficiency.
The original impetus for reform in the 1950s and 1960s was not the need to respond to crises, but the rapid growth and increasing fragmentation of the banking 2 system. The fragmentation of the banking system was in part spurred by new legislation designed to develop rural banks, encourage deposit secrecy, and create new institutions, such as the Development Bank of the Philippines (DBP) and the Philippine 3 Deposit Insurance Corporation (PDIC).
History of Reforms
In 19721973, a Joint International Monetary FundCentral Bank (IMF-CB) Banking Survey Commission recommended that several amendments be made to the General Banking Act and the Central Bank Act. These amendments were meant to (i) realign regulation by function rather than by type of bank; (ii) consolidate central bank authority over banks and nonbanks (except insurance companies); (iii) redefine the central banks responsibilities to exclude the promotion of economic growth; and (iv) impose restrictions on entry into the banking system, with concomitant efforts to improve the efficiency of the existing banks. Along with the increasing dynamism of the financial sector and the need for more responsive financial structures to address financing needs, the moves toward rationalizing the central banks supervision over the banking sector led to increasing pressure to adopt more sophisticated prudential regulatory mechanisms and structures. While banking institutions remained the dominant financial intermediaries, nonbank private and quasi-public financial institutions emerged as an alternative means of intermediation. During this period, the central bank displayed a marked shift toward a more interventionist monetary and credit policy. Through its rediscounting window and other facilities, it began to implement various directed and selective developmental credit programs for Government, and also imposed ceilings on domestic interest rates in support of this function.
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Liberal lending and use of rediscounting facilities to support such policies, however, undermined the stability and solvency of the rural banking system. In response to the deterioration in asset quality associated with these programs, the Government tightened access to the rediscounting window. Subsequently, the ensuing efforts to address structural weaknesses in the banking sector proved ineffective. The late 1970s saw important institutional and policy reforms being implemented in the banking system. Following the World Banks recommendation, the central bank adopted the universal banking system, which enabled banks to undertake investment and commercial banking functions as well as engage in allied and nonallied financial activities. In 1980, interest rates on several types of deposit liabilities as well as on loans with maturity of over two years were deregulated. Ceilings on the interest rate on other loans were abolished in 1983. Table 2 enumerates the significant reforms and events in the Philippine financial system. Deregulation efforts, however, were not matched by enhancements to the system of financial intermediation. Rules on the treatment of past-due loans, the provisioning of reserves versus bad loans, and examination of deposit by central bank examiners continued to be either or both weak and inadequately enforced. The growing risks of moral hazard in a system with poorly and loosely supervised institutions were manifested in the actions of NBFIs, whose nonrecourse transactions were not being monitored by the central bank, but by the less-prepared SEC. These risks surfaced to the fore during the Dewey Dee scandal.
THE 1980S BANKING CRISIS
The process of reform suffered an adverse shock in 1981 when businessman Dewey Dee, faced with millions of pesos in debt owed to various financial institutions, absconded. The Dee incident triggered a financial crisis, a rash of insolvencies in investment houses and finance companies. This resulted in a
flight-to-quality, as savers shifted their funds out of those institutions and into large commercial banks. The central bank attempted to stabilize the system by infusing additional liquidity through the Industrial 5 Rehabilitation Fund and Stock Financing Program. Moreover, prudential measures were taken to shore up the quality of commercial papers and strengthen regulations on the trust activities of commercial banks. Among the other early manifestations of the impending crisis in the financial sector was the tremendous amount of dollar borrowing by domestic residents from foreign currency deposit units (FCDUs) of banks in the late 1970s and early 1980s. The accumulation of foreign debt was encouraged by the relaxation of capital controls and the negative real interest rates on such credit in 19791980. With mostly short-term foreign indebtedness, the Philippines would later plunge into a debt crisis. The Aquino assassination in August 1983 precipitated an even bigger crisis, one that further eroded domestic and international confidence in the entire financial system. In response to the massive capital flight and persistent current account deficits, the Government was forced to devalue the peso, impose a moratorium on external debt payments, ration for6 eign exchange, and raise interest rates. To control liquidity in the financial system, the central bank introduced its own debt instruments, the central bank 7 certificates of indebtedness (CBCIs), or Jobo bills. Another flight-to-quality ensued, as bank depositors switched out of bank deposits and into the higher yielding and safe CBCIs . A severe credit crunch followed, resulting in drastic falls in loans to the private sector. This led to a sharp real contraction in gross national product (GNP), in which real growth rates were negative in 19841985, the first time in the postwar history of the country. Instead of strengthening the system of prudential regulation to match the growing sophistication of the banking sector, the central bank actually relaxed its supervision in the early 1980s. After capital requirementsmeasured by the net worth-to-risk asset
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Table 2:
1980
Some Significant Events Affecting the Financial System

Introduction of universal banking. Lifting of interest rate ceilings for loans with maturities of more than four years. Deregulation of all interest rates, except for short-term loans and purchases of short-term receivables. Initiatives to set up a credit information and rating system. Expansion of the Central Banks (CBs) supervisory power to include the subsidiaries and affiliates of banks and nonbanks with quasi-banking functions. Increase in paid-up capital requirements of thrift and rural banks from P10 million to P20 million. Setting up of a credit information bureau. Deregulation of interest rate ceilings on short-term loans. CB institution of a prime rate monitoring system for expanded commercial banks (EKBs), commercial banks (KBs) and specialized government banks. Declaration of a 90-day moratorium on foreign debt payments. Adoption of the foreign exchange pooling system and import prioritization scheme. Provision of incentives to rural banks and EKBs that establish branches in areas inadequately served or unoccupied by rural banks. Imposition of requirement for KBs/thrift banks to purchase 5-year central bank certificates of indebtedness (CBCIs) to establish a branch. Continuation of moratorium on foreign debt payments. International Monetary Fund approval of the stand-by credit facility on 14 December 1984. Issuance of the CB Jobo bills. Implementation of blocked peso deposit scheme. Discontinuation of foreign exchange pooling and import prioritization by 15 October 1984. Liberalization of foreign exchange trading and establishment of the Bankers Association of the Philippines (BAP) reference rate. Suspension of bank branching in areas classified as heavily overbranched and ideally overbranched. Release of the tranches of the IMF stand-by facility. Drawdowns from the new money facility for foreign banks. First round of rescheduling of the Paris Club debt; signed with 10 countries. Rationalization and simplification of the rediscount window, e.g., elimination of bank spread. Approval of the 1986-1988 IMF Program. Implementation of the debt-to-equity program. Initiatives to rehabilitate Philippine National Bank (PNB) and Development Bank of the Philippines (DBP). Continuation of the first round of rescheduling of the Paris Club debt; signed with four countries. Initiatives to gradually phase out the CB bills and the revitalization of the treasury bill auction. Signing of a new agreement with foreign commercial bank creditors. Second round of rescheduling of the Paris Club debt. Conclusion of the rehabilitation of PNB and DBP and the transfer of accounts to the national Government. Launching of a rural bank rehabilitation program. Introduction of a new modality for open market operations: depositing with the CB the T-bill auction proceeds issued in excess of deficit financing requirement. Removal of the required investment in CBCIs for bank branching. Initiatives to enhance competition among banks. Removal of all restrictions on the opening of new branches in priority rural areas. Unification of reserve requirements. Increase in the required minimum capital for EKBs and KBs to P1 billion and P500 million, respectively. IMF approval of the Extended Fund Facility and Contingency and Compensatory Financing. Launching of the Philippine Assistance Program (PAP). A financing program from foreign commercial bank creditors. Third round of restructuring of the Paris Club debt. Lifting of moratorium on the entry of new domestic banks. Relief under the Brady Plan. Issuance of CB JoboBills and increased use of reverse Repurchase Agreements (RPs) for open market operations. Increase in the minimum paid-in capital requirement for thrift banks. Establishment of offsite automated teller machines (ATMs). Liberalization of bank branching: franchises to establish branches are auctioned off. Nationwide bank branching for rural banks. Increase in minimum capital requirements for EKBs and KBs. Incentives for bank mergers/consolidation. Establishment of ATMs in areas with no existing branch without any CB approval. Magna Carta for Small Enterprises: mandatory allocation. IMF approval of a new 18-month stand-by credit arrangement. Fourth round of rescheduling of Paris Club obligations. Agreement in principle on a comprehensive commercial bank financing package; finalized in 1992. Approval to increase the allowable retention limit of foreign exchange receipts by exporters to 40 percent effective January 1992.

1981
1982
1983
1984
1985
1986
1987
1988 1989
1990
1991
Continued next page
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Table 2: Some Significant Events Affecting the Financial System (Contd)

1992 Rural Bank Act of 1992. Incentive for branching: for every three branches established in 5th and lower class municipalities where there are less than four banks, a bank can establish a branch in first class cities or municipalities, without bidding, provided the area is still open to additional branches. Lifting of foreign exchange controls. Establishment of the Philippine Dealing System (PDS). Extension of the IMF 18-month standby arrangement to end in March 1993. Bank branching only subject to capital adequacy, liquidity, profitability and soundness of management. Further liberalization of foreign exchange transactions. New Central Bank Act. Relaxation of rules governing the establishment of ATMs. Suspension of the debt-to-equity program. Reserve requirement imposed on common trust funds. Liberalization of entry of foreign banks. IMF approval of a three-year Extended Fund Facility. Rediscounting reforms: adoption of market-based rediscount rates and removal of fixed spreads Revision in the minimum paid-in capital requirement for thrift banks. Conclusion of the Paris Club rescheduling negotiations; however, the government decided to set aside the terms of the agreement. Reduction of the required equivalent capital for a thrift bank to establish a branch. Lifting of prohibition to pay interest on demand deposits. Increase in the required minimum paid-in capital for banks. Thrift Bank Act of 1995. I. Strengthening of the Financial System 5 June 1997 Setting of maximum loan exposure to real estate at 20 percent, or 30 percent inclusive of loans to finance the acquisition of residential units amounting to no more than P3.5 million. Reduction of loanable value of real estate used as collateral for bank loans to not more than 60 percent of the appraised value. Housing loans under the National Shelter Program of the government are exempt from such ceiling. 30 percent of the 100 percent cover for all foreign exchange liabilities of foreign currency deposit units (FCDUs) of banks must be kept in liquid assets. Provision of guidelines governing the responsibilities and duties of the board of directions of the bank. Reduction of the number of installments in arrears from six to three months for monthly installments and from two to one quarter for quarterly installments. Banks must set up general loan-loss provisions over and above the provisions linked to individually identified bad accounts. They must maintain general loan-loss provisions equivalent to 2 percent of the gross loan portfolio. Banks given three years (until 2000) to comply with the requirement. Deadline for compliance accelerated to 1 October 1999. Adoption of internationally accepted standards relating to the risk-based capital requirements and clearly defining unsound practices. Universal banks required to have minimum capital of P4.5 billion by 24 December 1998, P4.95 billion by 31 December 1999, and P5.4 billion by 31 December 2000. Banks required to set aside additional specific reserves equivalent to 25 percent of the secured portion of substandard loans by 15 April 1999. II. Rationalization of Foreign Exchange Trading 22 July 1997 Banks required to obtain prior clearance for their sales of nondeliverable forward (NDF) contracts to nonresidents (including offshore banking units). BSP tightened allowable overbought foreign exchange position from 20 to 5 percent of unimpaired capital or US$10 million, whichever is lower. In addition, oversold position was increased from 10 to 20 percent to increase dollar supply in the PDS. Introduction of currency risk protection program (CRPP), also known as the NDF facility. It is a hedging facility offered by the BSP through the commercial banks to cover or limit the risk of eligible borrowers with existing unhedged foreign exchange liabilities to FCDUs.

1993
1994
1995
6 June 1997
1 October 1997
10 November 1997 11 March 1998
12 March 1998
31 July 1997
22 December 1997
Source: C. Paderanga (1996) and Deutsche Morgan Grenfell (1998).
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ratio for banks were reduced from 15 to 10 percent in 1973, they were further cut to 6 percent in 1980. In the 1970s, the rationale for the reduction in capital requirements was to enable banks to lend long8 term. After the Aquino assassination in 1983, the external sector collapsed, resulting in a full-blown liquidity crisis. The Government undertook various rescue efforts, including the takeover of certain private business enterprises and financial institutions. It tried to rescue five commercial banks and eventu9 ally ended up owning them. Given this fact and also the existence of a severe crisis, the central bank opted for some regulatory forbearance. The central bank also relaxed its rules regarding loans to directors, officers, stockholders, and related interests (DOSRI). These developments combined with weak enforcement of existing prudential rules to tremendously raise the risk of moral hazard in bank lending. Government financial institutions (GFIs) such as the Philippine National Bank (PNB) and DBP were declared technically insolvent after the quality of their asset portfolio deteriorated because of excessive exposure to DOSRI loans. All of the two institutions nonperforming assets had to be transferred to the national Government to strengthen other firms with significant exposures in these two institutions. Rehabilitation of banks of all types had to be carried out over several years. Monetary and financial indicators reflected the depth of the crisis. The ratio of M3 to GNP, an indicator of financial depth, plunged in 19841985 after rising in the preceding years (Table 3). Low real rates of returns on financial savings share some of the blame for the decline in financial system depth. To some extent, this was a result of the lack of competitiveness in the banking system. The banking system experienced a term transformation in the early 1980s, as the proportion of longterm loans grew. But the crisis led to a sharp reduction in this figure as well. The proportion of longterm loans picked up in 1987, but the trend was not sustained due to political instability.
Table 3:
Ratio of M3 to GNP
Year M3/GNP
1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998
0.29 0.31 0.32 0.24 0.24 0.25 0.24 0.25 0.28 0.28 0.28 0.28 0.32 0.35 0.39 0.39 0.42 0.41
Sources: Bangko Sentral ng Pilipinas; National Statistical Coordination Board.

The years of protracted crisis took their toll on the other aspects of the financial system. Uncertainty and risks in lending stifled the long-term loan market. The number of bank offices decreased in absolute terms (as several banks collapsed), and so did the total assets of the banking system. Total lending by the banking system declined and did not reach the 1980 levels until the early 1990s. The rash of foreclosures followed the deterioration in loan portfolios and led to an increase in bank investments. To strengthen what remained of the banking system, the central bank pursued a rehabilitation program for the weaker banks. Asset quality remained generally poor; in the rehabilitation process, banks invested a large portion of their funds in high-yielding Government securities. This was a natural consequence of the precarious state of the economy and the existence of high credit and default risks, as well as the deterioration in loan portfolios. The sharp reduction in domestic credit in the 1980s was aggravated by the debt crisis and the ensuing international credit constraints on the Philippine Government and domestic firms. Following the debt
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moratorium declared in 1983 and unable to tap domestic and international capital markets, domestic firms relied more on internal cash generation to finance investments. To strengthen the banking system as a whole, the central bank introduced a set of improved reporting requirements for commercial banks, and guidelines for asset valuation and loan-loss provisions. Measures to strengthen the rules on the single borrower limit and DOSRI loans were likewise introduced, as well as increases in minimum capital adequacy standards. The measures aimed to tighten and standardize criteria for all banks, and help curb abuses by insiders. The need for consolidation in the banking sector led the central bank to encourage mergers as a way of meeting minimum capital requirements. Entry into the banking sector was restricted until 1991. The policy of restricting entry came at the cost of increasing concentration in the banking sector. Between 1980 and 1990, the share in total deposits of the five largest banks rose from 30 to 52 percent. The increased concentration and apparent lack of competition in the banking sector to some extent mitigated the impact of interest rate deregulation. Banks continued earning high spreads, supported by low interest rates on deposits.
BANKING SYSTEM DEVELOPMENTS IN THE 1990S
The early 1990s saw a marked improvement in the state of the financial system. Bank branching was relaxed. In 1992 the foreign exchange market was deregulated to enhance market efficiency and achieve exchange rates more consistent with economic growth. The restrictions on the foreign exchange transactions of banks were lifted and prudential limits on the foreign exchange positions of banks were redefined. In addition, rules governing the remittance of export proceeds were relaxed, and exporters were allowed to take out loans from FCDUs. Moreover, restrictions on the repatriation of foreign investment income were lifted, and the
Foreign Investments Act of 1991 simplified the registration process for investments. The system for remittances was improved to facilitate payments, and rules for automated teller machines (ATMs) were loosened. In 1993, the new Central Bank Act was approved. This law aimed at ensuring the independence of the conduct of monetary policy from political interference. It also provided for the recapitalization of the central bank and the transfer of over P300 billion worth of losses of the old central bank to a board of liquidators. The new central bank is now known as the Bangko Sentral ng Pilipinas (BSP). In 1994, 10 foreign banks were allowed entry under specified modes. Monetary and financial variables have served as good indicators of the health of the banking system. Both M2-to-GNP and M3-to-GNP ratios rose significantly from 1993 to 1996, reaching 38 percent in 1996, reflecting a booming financial sector. The reliance of financial institutions on borrowings as a source of funds fell, and the share of deposit liabilities rose. The capital adequacy ratios of banks also improved. Freer entry and liberalization of bank branching, as well as greater reliance on improved technology spurred a sharp rise in the ratio of total deposits to GNP in 1994 1995. The improved atmosphere for competition led banks to find niche markets, with thrift banks increasingly tapping the retail markets and small depositors, and commercial banks increasingly servicing the more affluent clients. Growing competition also lowered bank spreads, at least with respect to lending rates and time deposit rates. Feebased activity also rose, as banks turned increasingly to off-balance-sheet financing. Unfortunately, the boom in the financial sector also planted the seeds for weakness and vulnerability in the 1990s. The reentry of the Philippine Government into the international capital markets encouraged many domestic banks and firms to follow suit. As a result, while foreign indebtedness of the public non-
41
bank sector had been steadily declining, those of the private banking and private nonbank sectors continuously increased. The relatively smaller proportion of public sector indebtedness following the Philippines reentry into the international capital markets is due to several factors: (i) the foreign debt service burden declined from 8 percent of gross domestic product (GDP) in 1990 to 5.6 percent in 1992 largely because of the implementation of the Brady Plan, 10 which began in 1990; (ii) after a long period of deficits, the national Government had a small surplus equivalent to 0.94 percent of GNP in 1994, owing 11 largely to the receipts from its privatization program; and (iii) by 1997, the consolidated public sector deficit also showed a modest surplus. Interest rate differentials prompted the Government to encourage exporters to tap FCDU credit facilities to sustain competitiveness. Short-term foreign capital inflows rose dramatically in 19951996, forcing the peso to appreciate and raising the countrys vulnerability to sharp reversals. Heavy short-term foreign portfolio flows translated into sharp increases in the growth of domestic credit due to the well-known limitations of the sterilization policy. First, as liquidity was reduced, domestic interest rates rose, attracting even more capital inflows. In the years when capital inflows as a percentage of GDP peaked, namely 1992, 1994, and 1996, the 91-day treasury bill annual average rates were 16.02 percent, 12.71 12 percent, and 12.34 percent, respectively. The rise in domestic interest rates likewise induced recessionary tendencies in the economy. Second, such a sterilization policy imposed a quasi-fiscal burden on the BSP as the latter exchanged high-yielding domestic assets for relatively lower yielding foreign assets. With the ineffectiveness of the sterilization policy and the growth in domestic credit, the banking sector became increasingly exposed to the real estate sector. A survey of the commercial banking sector found that combined loans and equity exposure to this sector came to about 52 percent of unimpaired capital.
The Asian Crisis and the State of the Philippine Banking System
The Philippine banking system experienced many of the symptoms that ultimately led to the collapse of the banking systems in the countries worse hit by the crisis. The symptoms became particularly evident in the aftermath of the crisis and included macroeconomic volatility, high property exposure and asset inflation, large amounts of foreign exchange liabilities, Government-directed lending and related-party lending, fragility in the case of some banks, and weak supervision and underregulation of some banks. The response of the monetary authorities to speculative pressure on the peso beginning in July 1997 was to sell dollars initially and, subsequently, to tighten liquidity. The latter resulted in raising interest rates on 91-day treasury bills from 10.5 percent in June 1997 13 to a high of 19.1 percent in January 1998. Ultimately, the authorities gave up on their defense of the peso, and the peso depreciated by 39 percent at the height of the crisis, going from an average of P29.47 to over P45 to the dollar in 1997. Further depreciation of the peso was prevented by the huge inflow of dollar remittances by overseas workers and of portfolio investments toward the end of 1998. These events adversely affected the corporate sector, the financial sector, and the rate of economic growth. Nevertheless, most observers as well as Government authorities themselves are in agreement that the Philippine banking system managed to survive the Asian financial crisis relatively unscathed and that there is no banking crisis in the Philippines. Table 4, for example, shows Deutsche Banks measure of the extent of the banking crisis in five Asian 14 countries in June 1998 and May 1999. The Asian financial crisis did not lead to the same kinds of deleterious effects on the Philippine banking system as it did in countries like Indonesia and Thailand. In part, this was due to the reforms undertaken by the
42
Table 4:
Measuring the Banking CrisisThen and Now

June 1998 Estimate

May 1999 Estimate NPL (% of loans) Losses (% of GDP)
Country
NPLs (% of loans)
Losses (% of GDP)

Indonesia Korea, Republic of Malaysia Philippines Thailand

GDP = gross domestic product, NPLs = nonperforming loans. Source: Deutsche Bank, 1999, p.7.
60 25 17 10 35
23 13 10 4 23
82 30 30 20 67
64 16 17 9 63
Government over the previous two decades, the relatively short period of accelerating GDP growth in the Philippines, and its relatively lower levels of financial intermediation. Also, Philippine banks, like Hong Kong and Singapore banks, had relatively strong capital bases at the start of the crisis. Bank closures in 1997 and 1998 were few and the amount of total bank assets they represented was small. Fourteen banks1 thrift bank and 13 rural 15 bankswere closed in 1997. Bank closures in 1998 increased further to 22, involving 1 commercial bank, 6 thrift banks, and 15 rural banks. These closures were only a small fraction of the total number of banks: 1.4 and 2.1 percent of total head offices in 1997 and 1998, respectively. In terms of total assets of the banking system, the assets of the closed banks, excluding rural banks, constituted about 0.01 and 0.04 percent in 1997 and 1998, correspondingly. The BSP continues to encourage mergers and consolidation within the banking sector, principally through increases in minimum capital requirements. In addition to encouraging mergers and consolidation among domestic banks, the BSP has endorsed reforms that would allow up to 100 percent foreign ownership of banks compared with the current limit 16 of 60 percent foreign equity. This is seen as a way to strengthen the domestic banking system but requires legislation. While endorsing 100 percent foreign ownership, the BSP is asking Congress to stipulate that 70 percent of the total resources of the banking system remain in the hands of Filipinos in order to have, in the words of the monetary authorities,
some macroeconomic protection for local banks. Ostensibly, this simply reflects the protectionist sentiment that permeates the banking industry and other vested interests in the Philippines. It is unclear whether Congress will pass this amendment to the law on foreign ownership, but it does seem that neither domestic banks nor BSP has been lobbying Congress for the passage of such an amendment. BSP had earlier recommended 100 percent ownership only in the case of distressed local banks, but the Senate apparently would like 100 percent foreign ownership to apply to newly created banks as well. In contrast to the Philippines current ceiling of 60 percent foreign bank ownership of domestic banks (30 percent limit on foreign nonbank ownership) and the limitation to 10 foreign banks through four specific modes of entry, Indonesia, the Republic of Korea, and Thailand allow 100 percent foreign ownership of banks. In Thailand, 100 percent foreign ownership of banks is allowed for 10 years, while in the Republic of Korea, the permission of the monetary authority is required. Only the bank merger between the Bank of Southeast Asia and the Development Bank of Singapore (DBS) was concluded in 1997. Currently, three mergers are under discussion. These are the mergers of Prudential Bank and Pilipinas Bank, Asianbank and the Standard Chartered Bank, and the Bank of Commerce and Traders Royal Bank. Recently, Equitable Bank and its partners, including Government financial institutions such as the Government Service Insurance System and the So-
43
cial Security System, bought the Lopez-Gokongwei shares in the Philippine Commercial and Industrial 17 Bank (PCIB). Several banks, including Manila Bank, have expressed interest in buying Prime Bank, a savings bank that has been on bank holiday since 4 June 1999. Notwithstanding the Asian financial crisis, the total resources and total operating network of the Philippine banking system expanded slightly in 1998. The total resources of the banking system grew by close 18 to 1 percent in 1998 relative to the end-1997 level. Total networkhead offices and branchesincreased by 645 offices between 1997 and 1998, even as the number of head offices declined from 1,003 to 996 in the same period. Bank profitability declined dramatically in 1998 19 relative to the two previous years. Table 5 shows the profitability trend for Philippine banks. The return on equity (ROE) of the Philippine banking system declined from 16.34 percent in 1996 to 12.42 percent in 1997 and to a low but still positive 5.81 percent at end-1998. By March 1999, this had fallen 20 further to 1.79 percent. The return on assets (ROA) before taxes decreased from 2.16 percent in 1996 to 1.66 percent in 1997, and further to 0.28 21 percent in March 1999. Nevertheless, in its assessment, Goldman Sachs states that the underlying profitability of Philippine banks is good, similar to that of Singapore and Hong Kong banks. In the case of the top six banks of the Philippines, preprovisioning operating profits to assets ratio was 2.9 percent in 1998, a decline from 3.31 percent in 1997 and 3.41 percent in 1996. This was due to falling net interest margins and loan growth. There was a 28 basis points decline in net interest margin, from 5.11 percent in 22 1997 to 4.83 percent in 1998. This occurred, despite higher average interest rates, as a result of rising nonearning assets. Gross loans declined by 7 percent year-on-year. Although this may not seem severe, it may be pointed out that the loan-to-GDP ratio in the Philippines at less than 65 percent is one of 23 the lowest levels of financial intermediation in Asia.
Other factors that tend to impact negatively on bank profitability are described in Table 6. These include (i) high capital adequacy requirements equivalent to 10 percent Tier 1 equity to total assets; (ii) high reserve requirements, even though statutory reserve requirements have been reduced to 9 percent and liquidity reserve requirements to 3 percent, or a total of 12 percent compared with the March level of 15 percent; (iii) increased loan-loss provisioning (all gross of collateral), in which banks are required to maintain general loan-loss reserves of 2 percent of outstanding loans in addition to specific reserves by October 1999 and loan-loss reserves of 5 percent against special mention/watchlist loans by April 1999; and (iv) mandatory lending to small and medium-size enterprises (SMEs) and the agriculture sector, which constitute 18 percent of 24 the total loanable funds of Philippine banks. The AGRI/AGRA stipulates that 25 percent of the loan portfolio be set aside for agriculture and agro-based activities. Likewise, the Magna Carta for SMEs requires the allocation of 6 and 2 percent of the loan portfolio to small and medium-size enterprises, respectively. Despite weak compliance with them, these requirements give rise to distortions and diversions that impose a substantial cost to banks, and raise intermediation costs and inefficiency in the allocation of capital. The BSP granted emergency loans to banks that remained solvent but found themselves temporarily illiquid. It provided a total of P18.1 billion in emergency loans and overdrafts to the banking system 25 from 15 July 1997 to 16 February 1999. This amount is equivalent to less than 0.7 percent of the 1998 nominal GNP or 1.1 percent of total bank loans in 1998. Of the amount extended to banks, P2.9 billion or about 16 percent has been repaid. The asset quality problem of Philippine banks is not a matter of solvency as it is in the cases of Indonesia, Republic of Korea, and Thailand. In terms of portfolio loan quality, the nonperforming loan (NPL) ratio of the entire banking system increased from
44
Table 5:
Profitability and Capital Adequacy of Philippine Banks

1998 Mar Jun Sep Deca
Item
1987
1988
1989
1990
1991
1992
1993
1994
1995
1996
1997
Mar 1999
Profitability ROE (Total Asset/Capital) (%) Philippine Banking System Commercial Banks Specialized Government Banks Thrift Banks Rural Banks ROA (Net Profit Before Tax/Total Assets) (%) Philippine Banking System Commercial Banks Specialized Government Banks

12.00 17.46 19.83 24.67 20.50 17.29 15.10 15.36 14.82 16.34 12.42 11.55 16.52 20.67 24.29 20.57 16.75 14.84 14.82 14.20 16.91 12.98 18.69 27.54 17.90 33.32 23.56 22.25 16.00 24.68 25.07
b b
3.52 3.85
b
5.77 6.37
b
6.85 7.59
b
5.81 6.33
b
1.79 1.69
b
3.68 12.31 18.41 21.23 20.64 20.91 18.59 13.93 13.82 11.92 9.89
7.48
0.91 3.75
0.79 6.19
0.84 6.19
1.01 8.15
0.98 7.87
8.98 11.34 13.29 10.57 10.34 11.74 11.87 14.94 15.53 14.40
1.66 1.45

2.42 2.07

2.54 2.34

3.13 2.80

2.77 2.62 6.74

2.38 2.21 5.05

1.94 1.83 3.05

2.03 1.85 4.91

2.07 1.92 4.77

2.16 2.17
b

1.66 1.67
b

0.51 0.54
b

0.82 0.87
b

1.00 1.07
b

0.88 0.93
b

0.28 0.26
b

7.90 13.86 10.72 14.67 0.39 1.85 1.22 1.66 1.88 2.08 2.70 2.58
Thrift Banks Rural Banks Capital Adequacyc Philippine Banking System Commercial Banks Specialized Government Banks Thrift Banks Rural Banks
2.54 2.07
2.63 2.04
2.28 2.28
2.13 2.15
2.09 2.53
1.92 2.58
1.38 2.36
0.17 0.63
0.15 1.04
0.16 1.04
0.20 1.37
0.19 1.36
12.04 11.72 11.61 18.00 19.50 20.24 19.19 18.55 18.79 16.84 16.03 17.28 17.27 15.82 10.47 15.67 15.48 17.28 19.38 18.61 17.92 18.73 16.64 15.87 17.10 16.94 41.99 69.92 68.99 55.23 44.81 29.88 26.17 23.50 20.40
b b b b
17.23 17.05
b
17.65 17.48
b
17.91 17.71
b
9.88 13.00 11.86 14.77 17.29 17.29 14.96 18.21 17.89 19.35 17.58 19.32 19.85 14.64 9.37 10.98 13.91 16.67 22.67 21.94 17.92 17.41 15.84 17.37 17.71 17.62
19.45 17.62
19.82
20.37
17.62d 17.95c,d,e
ROA = return on assets, ROE = return on equity. a Preliminary, data of rural banks as of September 1998. b Consolidated with commercial banks. c Computed by SRSO, beginning February 1998, data excludes one nonoperational bank. d As of 30 September 1998, latest available data. e Unadjusted net worth. Source: Department of Economic Research (DER) and Supervisory Reports and Studies Office (SRSO).
45
Table 6: Prudential Norms with Structural Impact on Profitability

Prudential Norms with Structural Positive Impact on ROA and ROE

Prudential Norms with Structural Negative Impact on ROA and ROE
Korea, Republic of Low reserve requirement (7%)
Indonesia 1. Inadequate provisioning on NPLs 2. Low reserve requirement (3%) 3. Low Tier-1 CAR = higher ROE
None noted
Malaysia 1. Inadequate provisioning on NPLs 2. NPL interest accrual up to six months, reversal from three months Philippines Inadequate provisioning on NPLs
1. Very strict provisioning requirements, gross of collaterals 2. Mandated lending to weak sectors, e.g. SMEs 1. High reserve requirement (15%) 2. Mandated lending to weak sectors e.g. Bumiputra parties, SMEs 3. Cap margins on low-cost housing loans and SME loans 1. High reserve requirement of 15% (10% in cash) 2. Mandated lending to weak sectors, e.g., agriculture, SMEs 3. High CAR requirement and actual CAR of 17% = lower ROE None noted
Thailand 1. Lenient loan provisioning requirements 2. Low Tier-1 capital adequacy ratio (CAR) = higher ROE 3. Low reserve requirement (6%) Hong Kong, China Low corporate tax rate (15%) Singapore None noted
1. High actual CARs = lower ROE 2. High liquidity ratio of 25% 1. High Tier-1 CAR requirements (10%) = lower ROE 2. High reserve requirement (18%) 3. 23% general loan-loss provisioning
CAR = capital adequacy ratio, NPL = nonperforming loan, ROA = return on assets, ROE = return on equity, SME = small and medium-size enterprises. Sources: Company reports, Goldman Sachs Investment Research estimates.

4.7 percent in December 1997 to 12.1 percent in January 1999 (Table 7). This rose further to 14.4 percent in May 1999 before declining to 13.1 percent in June 1999. While the ratio of structural NPL to total NPLs indicates that most NPLs are not structural, the ratio appears to be high for the Philippines compared with the other Asian economies (Table 8). Structural NPLs are not temporary and are not likely to be resolved with an improvement in the macroeconomic environment. Many of these structural NPLs relate to property bubble lending. Since Philippine banks have a credit culture that tends to be very reliant on collateral-based lending, the bursting of the property bubble gave rise to more structural NPLs. Some observers have pointed out that Philippine banks were headed in the direction of Thai-
land and Malaysia as far as property lending, large amounts of foreign currency borrowings, and excessive lending were concerned, but that the Asian crisis, specifically, the devaluation of the baht abruptly halted the process. There are several reasons for the rise in NPLs. First, corporate sector performance deteriorated rapidly between 1997 and 1998. This is evidenced, for example, by the number of firms that filed for debt payment suspension with the SEC. In 1997, 20 firms filed for suspension of debt payments, with total liabilities amounting to P12.8 billion or about 0.81 per26 cent of outstanding commercial bank loans. In 1998, 35 firms applied for a suspension of debt payments, with total liabilities amounting to P96.1 billion or 6.2 percent of outstanding commercial bank loans.
46
Table 7: Total Loans, Nonperforming Loans, and Loan-Loss Provisions of Commercial Banksa (in million pesos as of dates indicated)
Period Nonperforming Loans (NPLs) [1]

Total Loans [2]
NPLs/Total Loans [3] = [1]/[2]
Loan-Loss Provisions
1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 1998 Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec 1999 Jan Feb Mar Apr Mayb Junc
22,851 41,801 37,726 37,506 19,047 17,565 17,135 19,426 20,245 22,494 23,840 25,050 28,008 34,206 37,676 39,640 42,319 43,133 45,020 47,856 50,741 53,592 59,399 65,324 71,396 73,602 90,961 100,975 112,601 131,381 143,278 142,731 149,911 166,155 175,109 181,936 178,105 160,001 180,185 192,543 195,635 212,138 212,603 197,251
189,284 198,929 166,660 183,476 138,885 162,684 208,042 270,760 306,171 366,809 506,425 637,179 866,330 1,221,763 1,237,287 1,264,241 1,284,591 1,326,161 1,361,678 1,418,953 1,437,033 1,405,373 1,499,248 1,490,497 1,478,187 1,573,140 1,578,816 1,527,364 1,517,632 1,528,545 1,517,641 1,595,372 1,555,647 1,581,574 1,586,250 1,520,243 1,511,851 1,542,487 1,488,227 1,496,577 1,484,459 1,465,172 1,476,248 1,505,595
12.072 21.013 22.637 20.442 13.714 10.797 8.236 7.175 6.612 6.132 4.708 3.931 3.233 2.800 3.045 3.135 3.294 3.252 3.306 3.373 3.531 3.813 3.962 4.383 4.83 4.679 5.761 6.611 7.420 8.595 9.441 8.947 9.637 10.506 11.039 11.968 11.781 10.373 12.107 12.866 13.179 14.479 14.402 13.101
2,512 5,046 5,753 40,783 11,160 9,705 11,284 12,679 12,270 12,453 13,311 11,995 13,781 15,149 15,405 15,863 16,939 17,625 17,871 18,517 19,417 19,827 21,517 22,775 24,306 37,780 35,839 36,576 39,313 40,935 41,644 43,776 45,179 47,476 49,175 51,753 52,524 61,333 62,647 64,442 67,740 70,458 70,860 71,508
a Beginning February 1998, data does not include one nonoperational commercial bank. b Revised estimates of the Central Bank. c Preliminary, based on tentative reports of some commercial banks.
Source: Consolidated Statement of Condition (CSOC) of Commercial Banks.
47
Table 8: Estimates of Structural NPLs as Percentage of Total Implied NPLs, 1998

Economy Percent
Hong Kong, China Korea, Republic of Malaysiaa Philippines Singapore Thailand

a Rises to an estimated 72 percent in 1999.
26.4 34.8 27.0 46.6 13.9 47.4
Source: Goldman Sachs Investment Research, 1999b.
A second reason was the BSPs implementation of a more stringent definition of past due loans. In October 1997, the BSP strengthened its loan classification procedure with the release of Circular 143, which identified specific criteria to minimize the sub27 jectivity of examinations. Regulations were modified so that a loan is considered delinquent for BSP review purposes if one or more of the following apply: (i) there is a loan balance outstanding after the final payment date of the loan; and (ii) the borrower has missed the following number of payments depending on the payment cycle: monthly, three months in arrears; quarterly, one quarter in arrears; semestrally, one semester in arrears; and annual, one year in arrears. Installment loans constituted about 28 25 percent of total loans. The circular also states that the total outstanding balance of a loan will be considered past due regardless of the number of installments in arrears when the balance in arrears reaches 20 percent of the total outstanding balance of the loan receivable. The circular states that the entire balance of a loan receivable is considered delinquent when the past due amount reaches 10 percent of the outstanding loan balance for all modes of payment other than those listed in this paragraph. Another reason for the increase in the NPL ratio for commercial banks was the decline in abso29 lute loans. As of the first quarter of 1999, loans outstanding of commercial banks fell by 4.5 percent to P1.48 trillion from endDecember 1998. Year-on-year, the reduction amounted to 6.4 per-
cent, with only 18 of the countrys 52 commercial 30 banks expanding their loans in 1998. Both weak demand for loans and the banks more conservative lending stance amidst the economic slowdown have been cited as reasons for the decline in commercial bank loans. The NPL ratio briefly declined to 10.37 percent by December 1998. Several factors tended to reduce the NPL ratio. First, some attribute the decline to the waning effects of the crisis. Second, there has been a lot of loan restructuring, foreclosure, and loan-for-property swaps among banks, ostensibly to avoid having these problematic loans classified as NPLs, which carry necessary specific loan-loss provisions that could hurt earnings. Table 9 describes factors that materially overstate or understate book value, while Table 10 describes factors that materially overstate or understate reported earnings. The foreclosed loans are booked under real and other property owned and acquired (ROPOA) accounts. Between December 1998 and May 1999, ROPOA increased by 25 percent to P59.2 billion, but relative to the previous year, 31 ROPOA increased by 158 percent. For the top 10 banks, for example, the year-on-year change in ROPOA from the first quarter of 1998 to the first quarter of 1999 ranged from a low of 55.9 percent for PNB to a high of 444.4 percent for United Coconut Planters Bank, with all banks except PNB ex32 ceeding 100 percent. Monetary authorities pointed out that if the measure of banks poor quality were expanded beyond NPLs to include foreclosed assets and restructured loans as a ratio to total loans, the sum of NPLs, ROPOA, and restructured loans would decline slightly to 17.4 percent or P299.3 billion in December 1998 from 17.8 percent or P302.6 billion 33 in October 1998. In contrast to the official view, as of May 1999, it is estimated that NPLs are already close to 20 percent if restructured assets are included, equivalent to 9 percent of GDP despite the official 34 NPL figure of 12 percent in April. If economic activity and the real estate sector do not recover,
48
Table 9: Assessment of Book Values

Factors Materially Overstating Book Value
Factors Materially Understating Book Value

Conclusion
Thailand 1. Lenient provisioning norms on NPLs (phased in through 2000 year-end) 2. Potentially lenient collateral valuation guidelines leading to inadequate provisioning Philippines 1. Appraised collateral value can be overstated, lessens true provisioning needs 2. Banks can avoid provisions through loan for property swap agreements 3. Occasional loan refinancing to avoid NPL classification Indonesia 1. Low provisioning norm enforcement 2. Appraised collateral value can be overstated, lessens true provisioning needs 3. Frequent loan refinancing to avoid NPL classification Malaysia 1. Low provisioning norm (no substandard loan provisioning requirement) 2. Lenient interest accrual on NPLs to six months 3. Potentially lenient collateral valuation guidelines, leading to inadequate provisioning Korea, Republic of Cost accounting for associates rather than equity accounting Hong Kong, China None noted
None noted
Weak provisioning norms Generally overstated book values
None noted
Book value fairly stated for the most part, may be overstated for banks that are active in loan refinancing or loan-forproperty swap.
None noted
Weak enforcement and bank supervision generally lead to overstated book values.
None noted
Weak interest accrual and provisioning norms generally overstated book values.
None noted
Book value fairly stated for the most part
Cost accounting for associates rather than equity accounting

Book value fairly stated to modestly understated for the most part Book value understated for the most part
Singapore None noted
United States None noted
1. Excess loan-loss reserves 2. No revaluation of fixed assets

1. Excess loan-loss reserves 2. No revaluation of fixed assets 3. Sizable property investment holdings 4. Associates at book rather than equity accounting. To be changed to equity accounting from fiscal year 1999

Book value fairly stated or modestly understated for the most part
NPL = nonperforming loan. Source: Company reports, Goldman Sachs Investment Research estimates.
49
Table 10:
Assessment of Reported Earnings
Factors Materially Overstating Reported Earnings
Factors Materially Understating Reported Earnings

Conclusion
Thailand 1. Inadequate provisioning on NPLs 2. (phased in through 2000 year-end) 3. Nonrecurring items in other income 4. Loan provisions sometimes taken directly against retained earnings 5. No reversal of accrued interest income on NPLs (only required starting January 2000) Philippines 1. Inadequate provisioning on NPLs 2. Occasional loan refinancing to avoid classifying as NPLs
Nonrecurring expenses e.g., foreign exchange losses

Earnings overstated for the most part
Extreme rule for the accrual of interest on NPLs for noninstallment loans (75% of total loans); interest accrual stopped after 1 day past due, versus the 90-day rule used in the United States

Earnings fairly stated for the most part, may be overstated for banks with sharp rises in NPLs Earnings overstated for most banks
Indonesia 1. Inadequate provisioning on NPLs 2. Loan refinancing to avoid classifying as NPLs 3. Loan provisions sometimes taken directly against retained earnings 4. No reversal of accrued interest income on NPLs Malaysia 1. Inadequate provisioning on NPLs 2. NPL interest accrual up to six months, reversal from three months Korea, Republic of 1. Nonrecurring items in other income 2. Cost accounting for associates rather than equity accounting Hong Kong, China Nonrecurring items in other income
None noted

Intergroup loans may be extended at belowmarket rates

Earnings overstated for most banks
Nonrecurring expenses, e.g., foreign exchange losses

Earnings fairly stated for the most part, but focus on core earnings Earnings fairly stated for the most part, but focus on core earnings Earnings fairly stated to modestly overstated for the most part, but focus on core earnings Earnings fairly stated for the most part
Cost accounting for associates rather than equity accounting

Singapore Nonrecurring items in other income
1. High 2%-3% provision to new loans each year 2. Associates at book rather than equity accounting (to be changed to equity accounting from fiscal year 1999) None noted
United States None noted: banks are quick to provide against NPLs
NPL = nonperforming loan. Source: Company reports, Goldman Sachs Investment Research estimates.
50
then banks will have to carry these low-yielding assets on their books for some time to come, adversely affecting bank profitability. Banks are not required to disclose loan refinancing, although they may do so on a voluntary basis. Recently, the Bankers Association of the Philippines (BAP) expressed support for the proposal of the SEC to grant a five-year debt relief to companies experiencing cash flow problems, including freezing interest rates on these loans. Some are of the view that once a borrower turns for protection, banks will be more prone to restructure loans, which 35 would then revert the loans to current status. However, freezing interest rates and other such measures simply defer rather than address the main problem, namely, ignoring the need for both corporate and financial restructuring to take place in order for lending to resume. Improvements in the legal framework are necessary for orderly corporate restructuring and loan workouts, including strengthening of the bankruptcy law and implementation procedures. Third, the recent decline in interest rates will reduce the corporate sectors borrowing costs and cash flow strains and the banking sectors carrying costs of NPLs. It also decreases pressure on asset quality and the risk of a systemic banking crisis. With the further lowering of interest rates, as the BSP has forecast, economic growth and loan growth are expected to be revived in the second quarter of 1999, and stabilize if not further reduce NPLs. Goldman Sachs has calculated the implied NPL ratios assuming a decline in interest rates (Table 11). The BSP imposed a ceiling on bank lending to the real estate sector equal to 20 percent of total loans, exclusive of loans to finance the acquisition or improvement of residential units amounting to no more than P3.5 million. The real estate exposure of commercial banks fell from a peak level of 14.2 percent 36 in 1997 to 13.8 percent by September 1998. Monetary authorities pointed out that this is way below the 20 percent ceiling. They also noted that as of end-1998, the bulk of loans outstanding went to the
Revised Caseb
1999
Structural NPL Ratio Estimates
Prior Implied Estimates
10.8 7.7 6.7 7.2
NPL Ratioa
Revised Implied Estimates
13.0 4.9d
Current NPL Ratio
1999
(75)
Assumed Change in Borrowing Costs 1999 Over 1998 (bps)
Sep 1998 Report
(160) (135) no change (60)
no change
(130) (200) 70
(200) (300) (290)
11.0d 19.4d,e 40.0d
10.7d
6.2c
16.6 16.8 25.5 48.6
1998
18.5 14.5 26.3 43.0
1999
9.2
16.6 16.2 28.6 43.9
11.6
1998
19.6 18.9 33.8 49.5
14.8
1999
4.5 7.8 8.9 23.0
1998
1.0
3.4
13.5 8.0 9.8 23.9
1.2
3.9
Table 11: NPL Ratios Implied by Goldman and Sachs Bottom-Up EBITDA Model
bps = basis points, EBITDA = Earnings before interest, tax, depreciation and amortization, GS = Goldman and Sachs, NPL = nonperforming loan. a Percentage of surveyed debt belonging to companies where EBITDA falls below interest expense. b Percentage of surveyed debt belonging to companies where EBITDA is negative. c Global as of August 1998: 3.9% for Singapore loans only as of June. d As of September 1998. e Excluding precautionary loans. Includes NPLs purchased by Korea Asset Management Company (KAMCO) totaling 12.3% of all loans. Source: Goldman Sachs Investment Research, 1999a.
Short-term Interbank Rates (%)
Nov 1998
Sep 1998
Surveyed Debt as % of Total Bank Loan
14.4 9.3 37 53 Hong Kong, China Malaysia
79
Philippines Korea, Republic of Thailand
Singapore
Economy
40 53 22
13.9 10.2
5.3
13.4 7.7
2.3
5.9 6.6
51
manufacturing sector (26.5 percent), financial institutions, real estate and business services (25.8 per37 cent), and wholesale and retail trade (15.6 percent). Also, 47 of the 55 commercial banks, or 85 percent, have complied with the ceiling set on loan exposure 38 to the real estate sector. Banks loan exposure to the real estate sector raises several issues. First, the classification of sector lending lumps real estate with financial institutions and business services and thus makes it difficult to isolate bank exposure to the real estate sector alone. In fact, the BSP had to commission a special survey of 25 banks in March 1996, prior to the crisis, to be able to measure the average share of real estate loans. Second, while the sector average is under 20 percent, some individual banks, including large ones such as the PNB, have real estate loan expo39 sures above 20 percent. In the March 1996 survey, for example, one banks ratio went as high as 40 28.6 percent. Finally, funds are fungible. Therefore, once a bank lends to a borrower, even one classified as a manufacturer, there is no guarantee that the funds will be used in this business and not in real estate. This makes it difficult for the authorities to ascertain whether the bank is truly complying with the ceilings set. A case in point is the failure of the appliance maker EYCO. Creditor banks lent EYCO money ostensibly to finance the expansion of its appliance manufacturing business. Yet, like many other companies, EYCO had a real estate development subsidiary to which the funds were funneled. The loan soured when the property market collapsed. In terms of the Philippine banking systems capital adequacy against probable risks, the capital adequacy ratio stood at 17.65 percent at end-De41 cember 1998. It rose further to 17.91 percent as 42 of March 1999. This was higher than the statutory ratio as well as the Bank for International Settlements (BIS) standard of 8 percent. Monetary authorities noted that even as the BIS amended the 1988 Basle Accord to include market risk, and assuming amendments to the banking law to include
other types of risk, the current level of capital adequacy is still higher than the suggested level of an additional several percentage points above the BIS standard of 8 percent. The recent decline in the NPL ratio, from 14.40 percent in May 1999 to 13.10 percent in June 1999, has been attributed in part to the slight increase in the outstanding loans of the commercial banking sector, which rose by 0.3 percent in May 1999 after months of contraction, and by 2.5 percent in June 43 1999. The modest growth in outstanding loans can be ascribed partly to growth in the economy in the first quarter of 1999, in contrast to the slight contraction in 1998. This would tend to support the belief of some that the worst effects of the crisis are over and that the economy is on its way to recovery. On the other hand, the Monetary Board, in an effort to encourage lending by banks, has exempted loans given out after March 1999 from the 2 percent general loan-loss provisioning requirement. It is not clear whether such regulatory forbearance is primarily designed to help spur the economy, or simply window-dress the NPL ratio. It also sends confusing signals about the need to strengthen prudential norms versus giving banks some breathing space to recover from the crisis.
Major Measures Taken to 44 Strengthen the Banking System

Over the last three years, the BSP undertook measures to strengthen its prudential supervision over banks in order to reduce system risks, improve regulatory oversight, and align domestic banking standards with international best practices. The major measures included raising the capital requirements, tightening the provisioning requirements, and stricter loan classification subject to loan-loss provisioning. The BSP implemented a comprehensive reform program whose elements included (i) strengthening the prudential and supervisory systems, (ii) adopting an early intervention system and a bank resolution strategy so as to deal more effectively with problem
52
banks and to safeguard the soundness of the banking system, (iii) undertaking special programs to strengthen and modernize government banks through privatization, (iv) adopting measures to reduce the intermediation costs of financial institutions, and (v) improving the legal and regulatory framework through legislation in Congress.
STRENGTHENING THE PRUDENTIAL AND SUPERVISORY FRAMEWORK
Several measures are being implemented to strengthen the prudential and supervisory framework: Hike in minimum capital requirements by 2067 percent from the prescribed end-1998 levels, in two equal rounds to be completed by end-December 2000, depending on the type of bank. Monetary and nonmonetary sanctions for noncompliance with the minimum capital requirements. Requiring banks to set up a 2 percent general loan-loss provision and an additional specific loanloss provision on loans and other risk assets on a graduated basis as follows: 1 percent by 1 October 1998, 1.5 percent by 1 April 1999, and 2 percent by 1 October 1999. By 15 April 1999, loanloss reserve is 5 percent on especially mentioned loans, 25 percent on substandard but secured loans, 25 percent on substandard and unsecured loans, 50 percent on doubtful loans, and 100 percent on loan losses. Relative to the previous loanloss provisioning requirements, the only difference is that the first two categories have provisioning requirements now but none previously. The NPL ratios and loan reserve coverage for different types of banks are shown in Table 12. Sanctions on banks and quasi banks if they fail to set up allowance for probable losses on loans and other risk assets. Making the criteria for past due loans more strict by reducing the period of arrears for loans to be classified as NPLs: from six months to three months for loans payable in monthly installments,
and from three quarters to one quarter for loans payable in quarterly installments. Revising the guidelines on restructured loans of banks and nonbanks with quasi-banking functions by treating restructured loans as performing loans if they are in current status or are fully secured by real estate. Enhancing transparency in several areas, such as (i) granting of DOSRI loans; (ii) requiring listed banks to publish quantitative information on at least the level of NPLs, classified assets, and specific loan-loss provisions each quarter; (iii) expanding the daily required report on lending and deposit rates of banks; (iv) placing the external auditors of banks under an affirmative obligation to inform the BSP of factors that may materially and adversely affect banks in order to improve the quality of audits of financial institutions; (v) implementing a system of accrediting the external auditors of banks; and (vi) issuing guidelines on mark-to-market trading and equity portfolios and mark-to-market accounting procedures to raise the accounting and disclosure standards to an international level. Issuing stricter qualification and competency criteria for the grant of new bank licenses. Improving the quality of bank management by requiring prior BSP approval for the appointment of bank officers from the rank of senior vice president, prescribing the duties and responsibilities of the board of directors and officers of banks, and designating a compliance officer in each bank. Emphasizing a more analytical, risk-based approach of examination and consolidated supervision of banks and their subsidiaries and affiliates rather than the traditional checklist approach. Risk-based reporting of bank examination has been introduced and the examination process has been reoriented to be able to assess the risks and systems used by the banks to manage, identify, control, and monitor risk.
Table 12: NPL Ratios and Loan Reserve Coverage

Item Dec 1995 Dec 1996 Mar 1997 Jun 1997 Sep 1997 Dec 1997 Jan 1998 Feb 1998 Mar 1998 Apr 1998 May 1998 Jun 1998 Jul 1998 Aug 1998 Sep 1998 Oct 1998 Nov 1998 Dec 1998 Jan 1999
Total NPLs (P billion) All commercial banks Universal banks Nonuniversal banks Foreign banks Thrift banks Savings and mortgage banks Private development banks Private loan associations Rural banks Total loans NPLs/total loans (%)

39.0 28.0
48.4 34.2
57.3 42.3 33.8 4.4 4.1
64.5 47.9 37.9 5.5 4.6 11.3
79.9 59.4 45.9 7.1 6.5 14.9
94.0 73.7 56.8 9.6 7.1 14.8 7.4 4.0 3.5 71.9 103.3
140.3 115.6 91.8 15.7 8.0 18.8 9.1 5.6 4.1 5.9 1,696.8
171.7 179.5 194.7 142.7 149.9 166.2 116.5 17.6 8.7 22.7 10.0 7.7 4.9 6.3 6.8 6.8 22.8 21.7 138.2
204.4 175.1 182.0 178.4 160.0 180.2 146.9 153.5 150.0 130.5 150.0 19.5 8.7 22.5 10.7 7.0 4.8 6.8 0.0 23.6 11.3 7.4 4.9 19.2 10.3 21.3 10.0 6.6 4.7 20.1 10.1
7.0
9.5
9.9 6.0 2.6 1.3
4.0
4.7
5.1
5.4
5.4
5.4
4.0

3.5

3.9

4.0

4.7

5.4

8.3

9.7

10.4

11.1

11.5

All commercial banks Universal banks Nonuniversal banks Foreign banks Thrift banks Savings and mortgage banks Private development banks Private loan associations
NPL = nonperforming loan. Source: Bangko Sentral ng Pilipinas.
3.2
2.8
3.3 3.2 4.1 3.4
3.4 3.3 4.8 2.9 7.7
4.0 3.7 5.7 4.5 10.1
4.7 4.4 7.2 4.5 10.6 10.1 7.4 26.9
5.8
6.7 5.3
7.6 7.4 12 5.6 14.1 13.2 10.9 32.4
8.8 8.7 13.5 5.4
9.4 9.4 14.4 5.7
8.9 9.0 13.3 5.2 16.7 13.6 15.4 40.5
9.6
10.5 10.0
11.0 11.4 14.8 5.2
12.0 12.5
11.8 12.4
10.4 10.4 14.2 7.0 18.3 12.6 16.8 40.1
12.1 12.5 15.4 6.6
7.9
7.7
7.4 8.4 5.2 11.3
17.1
15.6
15.7 11.6 17.4 42.0
53
54
Revising the bank rating system from capital adequacy, asset quality, management, earnings, and liquidity (CAMEL) to capital adequacy, asset quality, management, earnings, liquidity, and systems (CAMELS). Intensifying off-site monitoring of banks. Adopting prudential measures such as imposing a ceiling of 20 percent of total loans on bank exposure to the real estate sector, reducing the allowable loan value of real estate security from 70 to 60 percent of appraised value, and requiring a 30 percent liquid cover on all foreign exchange liabilities of FCDUs. Training the BSP supervision staff on a continuing basis.
ADOPTING AN EARLY INTERVENTION MECHANISM AND A RESOLUTION STRATEGY FOR PROBLEM BANKS
PROHIBITING BANK OWNERS FROM BIDDING ON ANY RESTRUCTURED FINANCIAL INSTITUTION FOR SALE
The BSP, in coordination with the Department of Finance, undertakes special programs to strengthen and modernize banks that have full or substantial government share. The modalities include the sale of government shares to private investors.
TAKING MEASURES TO REDUCE INTERMEDIATION COSTS OF FINANCIAL INSTITUTIONS
The BSP has adopted several measures to identify and deal with potential problems of solvent and nearly solvent banks. These measures include the following: A crash program of intensified monitoring of selected banks using forward- and backwardlooking indicators to draw up a prioritized list of potential problem banks with the intention of conducting a special on-site examination on them. Formalizing sanctions on capital-deficient banks whose guidelines embody the principles of prompt corrective action (PCA), including the issuance of a memorandum of understanding. Sanctions are based on the degree of capital deficiency. Issuing guidelines for resolving problem bank issues. Providing additional incentives to promote and encourage mergers or consolidation of banks/ financial institutions. Developing a worst-case contingency plan for institutional or system crises.
Under Circular No. 166 dated 28 May 1998, statutory reserve requirements were lowered from 10 to 8 percent. Under Circular No. 188 dated 3 February 1999, liquidity reserves, on top of regular reserves, against peso demand, savings, time deposits, and deposit substitutes have been set at the following levels (and dates of effectivity): for expanded commercial banks and NBFIs with quasi-banking functions, 6 percent (1 February 1999) and 5 percent (1 March 1999); for thrift banks, 5 percent (1 February 1999) and 4 percent (1 March 1999); for rural banks, 2 percent (1 February 1999) and 1 percent (1 March 1999) for current accounts, and 0 for savings and time deposits.
IMPROVING THE LEGAL AND REGULATORY FRAMEWORK THROUGH LEGISLATION
The BSP has proposed major revisions to Republic Act (RA) 337, known as the General Banking Act as amended. The proposals encompass both structural and prudential reforms. The proposed structural reforms include updating bank classifications to cover universal, Islamic, and cooperative banks; liberalizing and rationalizing the equity and citizenship structure of banks; rationalizing the powers of universal and commercial banks to invest in allied and nonallied enterprises; and redefining the functions, authority, and minimum capitalization of trust entities.
55
Among the proposed prudential reforms are adopting the Basle framework for measuring a banks capital adequacy; strengthening the provisions against overexposure of a bank to DOSRI; adopting measures against the concentration of credit to certain borrowers; authorizing the Monetary Board to disqualify, remove, or suspend unfit and improper directors and officers; granting the Monetary Board the power to regulate compensation and other benefits of bank directors and officers, if warranted; providing guidelines and penalties for unsafe and unsound banking practices; and requiring periodic submission and publication of financial statements for greater transparency. The BSP has also proposed amendments to RA 7653, the New Central Bank Act. These include empowering the BSP to examine banks once every calendar year; granting the Monetary Board the authority to impose administrative sanctions on subsidiaries and affiliates of banks and quasi banks and their directors and officers; authorizing the issuance of regulations requiring bank subsidiaries and affiliates to maintain a balanced position in their foreign exchange transactions; giving the Monetary Board the authority to grant loans for liquidity purposes to banks in situations that, in the judgment of the board, could lead to illiquidity of the banking system; and removing the five-day consecutive period during which the deposit account of a bank with the BSP is overdrawn before it can be excluded from clearing. To summarize, there have been substantial improvements toward the prudential supervision of banks, particularly in asset quality norms such as the interest accrual policy on past-due loans, the reversal of accrued interest income on NPLs, and the high provisioning requirements. Goldman Sachs recently rated the overall banking system as fairly solid, with a fragility score of 10 on a scale of 0 to 24, where 24 45 is weakest. This represents an improvement from its previous assessment of 14 for system fragility, and is a rating similar to those for the Republic of Korea (11) and Malaysia (11). This improvement in
system fragility is shown by comparing the Goldman Sachs assessment at end-1997 with its assessment at end-1998 (Table 13). Nevertheless, the fact that the Philippine banking system is fairly strong relative to its regional counterparts is no reason to be complacent.
Remaining Weaknesses and Vulnerability

MACROECONOMIC POLICY
Transparency and incentives for prudent banking are lacking while the degree of uncertainty increases because of flawed macroeconomic policy. The incorrect exchange rate policy created incentives for foreign currency intermediation. The Asian crisis demonstrates, for example, that a policy of maintaining a fixed nominal exchange rate by keeping domestic interest rates high skewed the incentive system and encouraged overborrowing in foreign currencies as it obscured the currency risk and reduced the drawdown of corporate cash reserves by lowering interest payments. This move came at the price of raising financial risk from a depreciation of the domestic currency. With underdeveloped risk management systems and the inability of banks to assess the consequences of currency depreciation on the borrowers ability to pay, the banking system became more vulnerable to system fragility and failure. While the postcrisis exchange rate policy is seemingly more market-determined, as the BSP has largely remained on the sidelines at the Philippine Dealing System and has also made a conscious effort to reduce interest rates by decreasing its own overnight lending rate, it is difficult to say whether the authorities will continue with this stance. In light of the recent volatility that hit the peso allegedly due to external events, such as the crisis in East Timor and the depreciation of the baht, the BSP governor was quoted as saying that the monetary authorities had the tools to respond to the situation, but that he would not reveal exactly what they would do. In other words,
56
Table 13:
Assessment of Solidity of the Philippine Banking System

Hong Kong, China Indonesia Korea, Republic of Malaysia Philippines End-1997 End-1998 Singapore Thailand
Factors Contributing to Banking Crisis
Macroeconomic volatility High, rapidly rising credit/GDP ratio High property exposure, asset inflation High foreign exchange loans or foreign exchange liabilities? Financial liberalization destabilizing Government-directed lending Related-party lending Weak regulations, accounting disclosures Weak regulatory supervision, compliance Weak capital or loan reserve levels Fragility for individual banks?

Some
Yes
Yes
Yes Very high Yes No Some Some Some Improving Some Some Some

Yes Low, rising Yes Yes Some Some Some Improving No No Some

Stabilizing Low, steady Yes, stabilizing Yes No Some Some Strong Some Low reserves Some

Some High Some No Potentially Some No Opaque No No No

Yes Very high Yes Yes Yes Some Yes Improving Yes Yes Yes

Very high Low, rising Very high Yes Deposits No No No Some No No Some

Yes Yes Some Yes Yes Some Yes Some Yes

No Yes Yes Yes Yes Yes Yes Yes Yes

Weak or underregulated nonbanks? Fragility scorea Fragility score (previous) Overall solidity or fragility
a 1 = best, 24 = worst. Source: Goldman Sachs Investment Research, 1999b, p.17.
No 8 8 Solid
Yes 20 15 Fragile
Yes 22 18 Fragile
Yes 15 15 Some fragility
Some 14 13 Some fragility
Some 10 14 Fairly solid
No 7 7 Solid
Yes 22 22 Fragile
57
he was merely saying that the BSP would intervene if necessary. But it is this same kind of line that led to the highly interventionist and flawed exchange rate policy in the past. The tax of 7.5 percent on interest income on FCDU accounts instituted in January 1999 is ostensibly meant to discourage holding assets in the form of foreign currency to avoid putting pressure on the peso, and therefore also serves as a disincentive to foreign currency intermediation. Recently, there were moves to further raise this tax to 15 percent, but this seems to have been shelved in view of the strong opposition from the private sector, particularly banks. As usual, several complex forces are at work here: the perceived need to reduce pressure on the peso, the need to generate more government revenues in the face of sluggish growth and tax collections, the
need to raise efficiency in resource mobilization by trying to align the returns on domestic and foreign 46 assets through the imposition of the tax, etc. The Philippines continues to be plagued by certain macroeconomic weaknesses. Among the countries in Asia, the Philippines has the lowest savings rate at 19 percent in 1998. It has the second largest ratio of public sector debt to GDP for the same year, second only to Indonesia. These imply that, in the mean time, the Philippines will have to rely on foreign savings. Meanwhile, foreign bank lending to the country dropped to $17.8 billion in June 1998 com47 pared with $19.7 billion in December 1997. In general, the amount of foreign bank lending to the Philippines is small relative to that of other Asian countries and is comparable with the level in India. All these data are shown in Tables 14, 15, and 16.
Economy
Savings Ratioa (%)
Growth in Bank Deposits (YOY %)

Table 14: Savings Ratio, Bank Deposit Growth, and Inflation Rate in Selected Asian Economies
Estimated 1999 Inflation (CPI, %)
Hong Kong, China Indonesia Korea, Republic of Malaysia Philippines Singapore Thailand
41 25 29 35 19 53 35
10 55 19 7 12 10 11
4.7 2.4 5.5 3.2 6 6.3 25.9
CPI = Consumer Price Index, YOY = year on year. a As of October 1998, except for Korea (as of August 1998) and the Philippines (as of September 1998). Source: CEIC, central bank bulletins, Goldman Sachs Investment Research estimates.

Table 15:
Economy
Ratio of Public Sector Debt to GDP, 1998
Public Sector Debt ($ billion)

GDP 1998
Public Sector Debt as % of GDP
Crisis countries Indonesia Korea, Republic of Malaysia Thailand Noncrisis economies China, Peoples Republic of Hong Kong, China Philippines Taipei,China
69 102 35 28 124 3 46 84
83 304 71 110 981 167 65 258
82 34 50 25 13 2 71 32
GDP = gross domestic product. a Includes internal and external debts, and bond and nonbond issues. Source: Goldman Sachs Investment Research estimates, central bank bulletins.
58
Table 16: Foreign Bank Lending to Asia, December 1994 to June 1998 ($ million)
Country China, Peoples Republic of India Indonesia Malaysia Thailand Subtotal Korea, Republic of Total Total for Asia Dec 94 41,341 14,961 34,970 13,493 43,879 99,172 56,599 212,073 241,249 Dec 95 48,384 15,511 44,528 16,781 62,818 132,454 77,528 273,877 306,855

Jun 96 50,587 15,728 49,306 20,100 69,409 149,610 88,027 303,952 337,849
Dec 96 55,002 16,896 55,523 22,234 70,147 161,193 99,953 333,044 367,009
Jun 97 57,922 18,780 58,726 28,820 69,382 171,043 103,432 351,177 389,441
Dec 97 63,128 19,359 58,388 27,528 58,835 164,483 84,180 331,150 381,024
Jun 98 59,327 18,911 50,268 23,024 46,801 137,896 72,444 288,578 324,811
Source: Bank for International Settlements; Goldman Sachs Investment Research, 1999b, page 10.
GDP growth was negative in the last two quarters of 1998, but managed to rise to 1.5 percent in the first quarter of 1999 largely due to the improved agricultural growth. On the inflation front, Deutsche Bank estimates a 6.6 percent year-on-year average inflation rate for 1999. This is higher than its estimates for Thailand (0.3 percent), Republic of Korea (1.5 percent), and Malaysia (2.2 percent). The current account as a percentage of GDP is estimated at 4.2 percent for 1999, the same as in Indonesia, the 48 lowest in this group of countries. The BSP gradually reduced its overnight borrowing rates from a high of 32 percent in mid-July 1997 49 to 12.25 percent and further to 9 percent currently. Interest rates for the exporters dollar facility (EDF), which are based on the 3-month London interbank daily rate (LIBID), are also on the decline. However, while interest rates are currently falling, there are no guarantees that they will continue in this direction. If, for example, the US Federal Reserve Bank raises interest rates because of fears of an overheating economy or as a preemptive strike against inflationary pressures, domestic interest rates may rise. This would hamper the recovery in output growth and loan demand.
LIBERALIZATION WHEN INSTITUTIONAL FAILURES ARE PRESENT
The initial attempts at financial liberalization involved removing interest rate ceilings and other measures
meant to avoid disintermediation. The banking system was given a developmental role, particularly as a source of finance for investment projects. In some cases, there were successes, but there were also large failures as many of the financed projects turned out to be nonviable. Some analysts have associated these outcomes with a deficient state of institutional arrangements, such as weak accounting systems and 50 inadequate disclosure. Other institutional failings, such as the lack of well-developed asset markets, also hamper transparency, as market participants must use internal company estimates of values rather than those based on market-based observations. Interestingly, one of the possible explanations for the continued tolerance for weak institutional structures is that they provide a competitive advantage to domestic financial institutions, particularly in their role as intermediaries between international markets and do51 mestic agents. The sequencing of liberalization and reforms is also problematic. The pursuit of liberalization and reforms in itself may be difficult, but when undertaken in the absence of a strong supervisory and regulatory framework, a high degree of accountability and transparency, and competent bank management, the results, as the Asian crisis shows, can be disastrous. Attempts were made to increase the degree of financial intermediation through the banking sector, even as the authorities continued to encourage mergers and consolidations of banks. Unfortunately,
59
there were no moves to sufficiently ease entry into the industry and make it contestable. For a long time, no new banks could be established until 1990 and foreign banks could enter only starting in 1992 and in a limited way. Consequently, banks had some degree of monopoly power. They enjoyed high profits despite high costs. In 19881995, net profit to total assets ratio for Philippine banks was 2 percent while the average for 52 seven other economies was only 1.8 percent. The resulting inefficiency in the banking sector is seen in many ways. Philippine banks spend $3.75 for every $100 to run their business, banks in Hong Kong, China and Singapore spend $1.15, and Korean banks pay 53 $2.75 only. In fact, Philippine banks can afford to be inefficient because their interest margins are among the highest in the world, according to the presi54 dent of Thomson BankWatch Asia. Even though the average difference between deposit and lending rates has fallen from over 5 percent in 1997 to 4.7 percent in mid-1998 due to moral suasion by the BSP, this differential is still higher than the 1997 averages for countries in the region such as Indonesia (1.8 percent), Republic of Korea (1.1 percent), Malaysia 55 (2.7 percent), and Singapore (2.9 percent). Overheads as a ratio of total assets were as high as 4.4 percent for Philippine banks in 19881995, while
the average for seven other Asian economies was 56 only 1.8 percent. These inefficiencies may persist if no serious efforts are taken to open the industry, particularly to foreign participation.
REMAINING WEAKNESSES IN PRUDENTIAL NORMS
There are several weaknesses in the prudential norms 57 of Philippine banks. First, banks accrue income on restructured loans or immediately classify them as performing loans so long as the loans are current in status or are fully secured by real estate with a loan value up to 60 percent of the appraised value of the real estate security and other qualified collateral. Previously, banks could only restructure loans and declassify these as NPLs if such loans were fully current on interest payments. The change in norms may provide a way for some banks to refinance nonviable companies. While there have been notable improvements in disclosure with respect to NPLs, loan-loss provisioning, and loan-loss reserves, as in many Asian banking sectors loan-loss provisioning requirements are typically net of collateral, usually property. The Republic of Korea, Philippines, and Singapore all use collateral-based provisioning (Table 17). In contrast, Indonesia, Malaysia, and Thailand use time-based
Table 17: NPL Definition and Loan-Loss Provisioning Policies
Economy
NPL/Past Due Definition
NPL Cassification
Provisioning Requirements
Indonesia Korea, Republic of Malaysia Philippines Singapore Thailand United States
> three months > one month > three months
Hong Kong, China
Judgmental Usually > three months
Judgmental Time based Collateral based Time based Collateral based Collateral based Time based Judgmental
Net of collateral Net of collateral Gross of collateral Net of collateral Gross of collateral Net of collateral Net of collateral Net of collateral
> three months for installment loans > one day for non-installment loans Discretionary Usually three months > three months > three months

NPL = nonperforming loan. Source: Central banks, Goldman Sachs Investment Research estimates.
60
provisioning, while Hong Kong, China and the US utilize a judgmental system, based on the perceived risk and the likelihood of payment. Since Philippine banks implement collateral-based lending, in which the collateral is usually property, they are very sensitive to declines in property values. When property markets are illiquid, as they are in the Philippines and Thailand, loan-loss provisioning may not 58 reflect real losses. Second, Philippine banks are active in loan-forproperty swaps. Such practice can take place without formal legal foreclosure proceedings. In many cases, the properties are actually unearned assets in the form of raw land and are booked as ROPOA in bank balance sheets at realizable values. Philippine banks can directly foreclose pledged collateral once borrowers are proven unable to pay either interest or principal or both. It takes about 30 days for courts 59 to process foreclosure orders. The borrower is given a one-year redemption period to pay off his obligations and reclaim the loan. Third, reserve coverage against such ROPOA assets is not required until after five years from the time the property is booked. Some banks could use this to inflate collateral value since the property market is illiquid. Fourth, loan-loss reserves are currently not allowed as tax deductions. BSP has already endorsed a plan to Congress to make loan-loss reserves taxdeductible. Since this move involves tax revenues, it needs to be legislated. In general, while attempts should be made to lower financial intermediation costs and enhance the profitability of banks, the important point is that the industry must also become more contestable. Otherwise, such measures to reduce intermediation costs will simply strengthen an existing oligopoly. Fifth, the timing of loan write-offs is determined in part by the loans effects on the capital position of 60 the bank and on taxes. Deferring write-offs is common and may materially overstate the value of assets and capital. The ratio of loan write-offs to total
loans is one of the indicators used by supervisory authorities for off-site supervisory purposes. However, it is considered a reactive measure because the authorities take action only after actual losses have been incurred. With respect to the proposal to amend the General Banking Act so as to be able to adopt the Basle framework for measuring a banks capital adequacy, it must be noted that to calculate risk-asset equivalents, the Philippines uses a stricter method than that set forth by BIS. The minimum Tier 1 capital-toasset ratio is 10 percent versus the current 13 per61 cent (17 percent using the BIS standard). There seems to be little point in asking Congress to weaken the bank capital adequacy measure especially because such strong capital requirements are regarded as being largely responsible for the ability of Philippine banks to weather the Asian crisis. Table 18 shows the estimated recapitalization needs of the banking system as calculated by Goldman Sachs. Note that the Philippines and Malaysia are the only countries with existing surplus capital, and the Philippines is the only country that does not require new capital. Among the proposed amendments to the General Banking Act is the requirement that an enterprise that is wholly or majorityowned by a bank be subject to BSP examination. Banks can own allied or nonallied enterprises, meaning such enterprises that may or may not be related to banking. As long as these banks are majority owners of these enterprises, they would be subject to BSP examination. While the intent of such a proposal is laudable, in the sense that there seems to be an attempt to supervise on a globally consolidated basis, possible implementation problems may be large. First, the BSP is currently pressed, in terms of time and expertise, to examine banks even on a once-a-year basis as mandated by law. Second, the proposal could result in supervisory and regulatory overlap with the SEC, which is primarily charged with the regulation of corporations. Already, the BSP has proposed that the amendments to the General Banking Act include the proviso that
61
Table 18:
Estimated Recapitalization Needs of the Banking Systems (Static Analysis, ex-Earnings Power), as of 1998 (local currency billion)
Peoples Republic of China

Item
Indonesia
Republic of Korea
Malaysia
Philippines
Thailanda
Capital/Reserves to Cover Losses Equity Loan-loss Reserve Total Memo: Loan Reserves/Total Loans (%) Memo: Equity/Total Loans (%) Total Loans, Gross Peak NPL Ratio (%) Total NPLS Assumed NPL Loss Ratio (%) Estimated Loan Losses (1) Capital Surplus (deficit) After NPL Losses (local currency) ($ billion) Amount Needed to Recap to Minimum CAR Total Loans, Net of Provisions Required CAR (8% of loans)a Less: Existing Surplus Capital (2) Required New Capital (local currency) ($ billion) Total Recap Cost [(1)-(2)] (local currency) ($ billion) As % of GDP
675 77 752 0.9 7.9 8,545 30 2,563 65 1,666 (914) (110.3) 8,468 677 677 81.8 1,592 192.1 20
28,549 9,427 37,976 2.0 6.1 471,368 60 282,821 65 183,834 (145,857) (19.7) 461,941 27,716 27,716 3.7 173,574 23.5 28
61,860 19,492 81,352 3.2 10.2 609,140 27 164,468 50 82,234 (881) (0.7) 589,648 47,172 47,172 39.1 48,053 39.8 13
47 21 68 5.0 11.3 420 19 80 50 40 28 7.5 399 32 28 3 0.9 None 0.9 1
408 54 462 3.2 24.0 1,699 15 255 50 127 335 8.6 1,644 132 335 None None None None None
835 483 1,318 6.5 11.2 7,432 43 3,196 50 1,598 (280) (7.8) 6,949 417 417 11.6 697 19.5 18
CAR = capital adequacy ratio, GDP = gross domestic product, NPL = nonperforming loan. Tax credits on loan provisioning/net losses not factored into recapitalization calculations. In reality, these can reduce total recapitalization amount. a Comprises B5.462 billion loans by banks and B1.361 billion loans by fincos and securities. B461 billion by fincos. B148 billion by IFCs. b Using 8% Tier-1 CAR except for Indonesia and Thailand. Bank Indonesia recently brought down the minimum CAR requirement from 8 to 4% . Bank of Thailand has also reduced CAR to 4.25%. In both cases, we use 6% Tier-1 CAR for recap calculations. Source: Goldman Sachs Investment Research estimates, central bank bulletins. CEIC Table 19 Circular No. 176, Series of 1998.

the BSP be consulted about intracorporate disputes in banks, quasi banks, and trust entities that affect bank operations and transactions with the banking public. Presently, intracorporate disputes fall within the original and exclusive jurisdiction of the SEC. Perhaps the solution to global supervision is to have a unified structure of supervision, similar to that in the crisis-hit countries. Another proposed amendment to the General Banking Act is granting the Monetary Board the power to regulate compensation and other benefits of bank directors and officers, if warranted. This may give rise to conflict of interest and affect the ability of bank management to keep an arms-length relationship with the banks regulators. It may also limit the banks capability to pursue enhanced profitability
by infringing on its capacity to compensate bank officers and directors on the basis of performance.
WEAK IMPLEMENTATION OF PRUDENTIAL NORMS AND INTERNATIONAL STANDARDS OF SUPERVISION
The banking system continues to suffer from weak implementation of prudential norms and international supervisory standards. While the BIS core principles for effective bank supervision put much emphasis on estimating a banks value at risk, the pace at which bank supervisors and examiners are implementing this is very slow. The approach to bank examination in the Philippines focuses largely on borrower-related risks associated with loans, while secondary or product-related risks are not consistently taken into
62
consideration. Examiners focus on loans, equities, fiduciary activity, foreign transactions and treasury operations; check compliance with banking laws; assess internal controls; and appraise management. Loans are evaluated based on BSP standards and while examiners profile the loans, they do not necessarily focus on loans that are beginning to become delinquent. Examiners do not develop risk profiles of individual products or services, nor formally appraise risk management systems, although they claim that 62 they are moving in that direction. There seems to be much regulatory forbearance. Bank supervisors are reluctant to effect the early closure of failing institutions. In recent years, the most glaring examples are Orient Bank and, more recently, Prime Bank, both of which are on holiday. It is important for bank supervisors to close failing institutions early, at a positive level of capital, to prevent systemic risk as well as losses to the deposit insur63 ance fund. While the BSP has pursued attempts at enhancing transparency with respect to DOSRI loans and strengthened provisions against overexposure of a bank to DOSRI, it remains to be seen whether more Orient Bank-type experiences, in which 80 percent of the banks loans went to bank owners despite the 15 percent ceiling on DOSRI loans, will be avoided. In the case of Orient Bank, some alleged that the BSP knew about the DOSRI loan violations earlier on, but did not put a stop to it. Instead, it even gave Orient Bank an emergency loan whose 64 amount has not been revealed publicly. Equally important in reducing the cost and frequency of bank failures is the adoption of PCA measures. This involves early intervention of regulators in problem banks. However, even as examiners profile loans, they do not necessarily focus on loans that 65 are beginning to become delinquent. This would seem to preclude the adoption of PCA measures. The BSP recently issued Circular No. 181 that specifies PCA measures to be taken based on the severity of regulatory noncompliance by banks with respect to capital adequacy. Table 19 shows the pen-
alty to be imposed on banks depending on the percentage of capital deficiency, while Table 20 lists the PCA measures corresponding to the severity of undercapitalization. However, while the BSP has been actively pushing for all kinds of amendments to the General Banking Act, it is opposed to even mentioning the term PCA in the banking act. Its officials argue that they would rather deal with such matters administratively because it is difficult to get Congress to amend the law, and that, in any case, the circulars they issue have the force of law. Although one may not want to necessarily debate with the authorities on the legal basis of such circulars, the point is that legislated mandatory intervention, rather than regulatory discretion, is important in pro66 tecting the interests of the public. The problem does not seem to be that the authorities do not have sufficient power to implement PCA measures or to effect early closure of failing institutions; it is that when there is regulatory discretion, the intervention usu67 ally does not take place. Under the current law, Section 65 of the General Banking Act states that if a bank does not comply with the prescribed minimum (capital) ratio, the Monetary Board may limit or prohibit the distribution of net profits by such bank and may require that part or all of the net profits be used to increase the capital accounts of the institution until the minimum requirement is met. It is vague as to when sanctions may be levied, as it is not explicit with regard to sanctions related to specific levels of capital inadequacy. In the United States (US), for example, the Congress legislated mandatory intervention in the Federal Deposit Insurance Corporation (FDIC) Improvement Act instead of allowing PCA measures to be implemented using 68 regulatory discretion. Among the proposed amendments to the New Central Bank Act is empowering the central bank to examine banks once every calendar year. This proposal is surprising since it appears that the BSP needs Congress to carry out its constitutionally mandated task of bank supervision. Worse, it seems to
63
Table 19:
Sanctions on Banks Violating Capital Adequacy Regulation

Penalty

Capital Deficiency
Commercial Banks Up to 20%
Suspension Suspension Suspension Suspension Suspension
of authority to invest in nonallied undertakings (for EKBs only) of authority to invest in allied undertakings of securities and dealership functions (for EKBs only) of branching privileges of declaration of cash dividends
Up to 40%
Suspension of authority to invest in nonallied undertakings (for EKBs only) Suspension of authority to invest in allied undertakings Suspension of securities and dealership functions (for EKBs only) Suspension of branching privileges Suspension of declaration of cash dividends Restrictions on overall loan growth/investments (new loans to the extent of collections only) Restrictions on lending to affiliates Denial of access to BSP rediscounting facilities Suspension of authority to accept or handle government deposits Suspension of authority to invest in nonallied undertakings (for EKBs only) Suspension of authority to invest in allied undertakings Suspension of securities and dealership functions (for EKBs only) Suspension of branching privileges Suspension of declaration of cash dividends Restrictions on overall loan growth/investments (new loans to the extent of collections only) Restrictions on lending to affiliates Denial of access to BSP rediscounting facilities Suspension of authority to accept or handle government deposits Suspension of authority to engage in quasi-banking activities Suspension of authority to engage in derivative activities Suspension of FCDU/EFCDU activities Suspension of trust operations Suspension of authority to invest in nonallied undertakings (for EKBs only) Suspension of authority to invest in allied undertakings Suspension of securities and dealership functions (for EKBs only) Suspension of branching privileges Suspension of declaration of cash dividends Denial of access to BSP rediscounting facilities Suspension of authority to accept or handle government deposits Suspension of authority to engage in quasi-banking activities Suspension of authority to engage in derivative activities Suspension of FCDU and expanded activities Suspension of trust operations Suspension of international banking activities Suspension of lending activities
Up to 60%
Up to 80%
More than 80%
Suspension of clearing privileges Suspension of granting of bonuses/profit-sharing not covered by existing contracts or bylaws Cease and desist Suspension of branching privileges Suspension of declaration of cash dividends Suspension of branching privileges Suspension of declaration of cash dividends Restrictions on overall loan growth/investments (new loans to the extent of collections only) Restriction on lending to affiliates Denial of access to BSP rediscounting facilities Suspension of authority to accept or create demand deposits or operate NOW accounts Suspension of authority to accept government deposits
Thrift Banks Up to 20% Up to 40%
Continued next page
64
Table 19: Sanctions on Banks Violating Capital Adequacy Regulation (Contd)

Capital Deficiency Penalty

Up to 60%
Suspension of branching privileges Suspension of declaration of cash dividends Restrictions on overall loan growth/investments (new loans to the extent of collections only) Restrictions on lending to affiliates Denial of access to BSP rediscounting facilities Suspension of authority to accept or create demand deposits or operate NOW accounts Suspension of authority to accept government deposits Suspension of authority to engage in quasi-banking activities Suspension of FCDU activities Suspension of authority to invest in allied undertakings Suspension of trust operations Suspension of branching privileges Suspension of declaration of cash dividends Denial of access to BSP rediscounting facilities Suspension of authority to accept or create demand deposits or operate NOW accounts Suspension of authority to accept government deposits Suspension of authority to engage in quasi-banking activities Suspension of FCDU activities Suspension of authority to invest in allied undertakings Suspension of trust operations Suspension of lending activities Suspension of issuance of domestic letter of credit
Up to 80%
More than 80%
Suspension of clearing privileges Suspension of granting of bonuses/profit-sharing not covered by existing contracts or bylaws Cease and desist Suspension of branching privileges Suspension of declaration of cash dividends Suspension of branching privileges Suspension of declaration of cash dividends Restrictions on overall loan growth/investments (new loans to the extent of collections only) Denial of access to BSP rediscounting facilities Suspension of authority to accept or create demand deposits or operate NOW accounts Suspension of authority to accept government deposits Suspension of branching privileges Suspension of declaration of cash dividends Restrictions on overall loan growth/investments (new loans to the extent of collections only) Denial of access to BSP rediscounting facilities Suspension of authority to accept or create demand deposits or operate NOW accounts Suspension of authority to accept government Deposits Suspension of authority to invest in allied undertakings Suspension of branching privileges Suspension of declaration of cash dividends Denial of access to BSP rediscounting facilities Suspension of authority to accept or create demand deposits or operate NOW accounts Suspension of authority to accept government deposits Suspension of authority to invest in allied undertakings Suspension of lending/investment activities
Rural Banks Up to 20% Up to 40%
Up to 60%
Up to 80%
More than 80%
Suspension of clearing privileges Suspension of granting of bonuses/profit-sharing not covered by existing contracts or bylaws Cease and desist
BSP = Bangko Sentral ng Pilipinas, EKB = expanded commercial bank, EFCDU = expanded foreign currency deposit unit, FCDU = foreign currency deposit unit, LC = letter of credit, NOW = negotiable order of withdrawal.
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Table 20:
Capital Deficiency and Prompt Corrective Action

Capital Deficiency (under existing laws and regulations)
Prompt Corrective Action
Undercapitalized Up to 20 %
Require the bank to execute a memorandum of understanding (MOU) with Bangko Sentral ng Pilipinas (BSP), binding itself, among others, to implement a variable capital restoration plan acceptable to BSP within 30 days from date of notice Require intensified monitoring by BSP of banks financial condition BSP to conduct a special examination of the bank
Significantly Undercapitalized Up to 60%
BSP to call a meeting with bank directors/principal officers to discuss and agree on remedial measures to be taken and the timetable for implementation Intensify monitoring by the Supervision and Examination Sector of BSP of the banks financial condition BSP to conduct immediately an extensive on-site examination Require the bank to execute an MOU with BSP, binding itself, among others, to implement a viable capital restoration plan acceptable to BSP within 30 days from the date of discussion. Among the options to be considered are: (i) Disposition of a majority shareholders interest (ii) Sale of assets (iii) Issuance of additional stocks/capital infusion (iv) Sale of bank to highest bidder subject to terms set by BSP (v) Merger (assisted or unassisted) or consolidation with a stronger bank Require the creation of a separate unit in the bank-remedial asset management group, which will take care of banks bad assets and make progress reports to BSP Appoint an external auditor at the expense of the bank to perform a financial or operational audit under the terms of reference provided by BSP If necessary, appoint a consultant specialist to diagnose the problem and to recommend the appropriate remedial measures (i.e., introduce new profit opportunities, improve internal and accounting controls, etc.) to restore banks viability
Critically Undercapitalized More than 60%
Place the bank under Prompt Corrective Action Unit since this would require more than normal bank supervision BSP to call a meeting with banks principal shareholders/directors BSP to conduct immediately an extensive on-site examination BSP to conduct intensive monitoring of banks financial condition Require the bank to execute a Memorandum of Understanding (MOU) with BSP, binding itself, among others, to implement a viable capital restoration plan acceptable tot he BSP within 30 days from date of meeting. Among the options to be considered are: (i) Disposition of a majority shareholders interest (ii) Sale of assets (iii) Issuance of additional stock/capital infusion (iv) Sale of bank to highest bidder subject subject to terms set by BSP (v) Merger (assisted or unassisted) or (vi) Consolidation with a stronger bank Create a BSP Ad Hoc Committee to oversee the implementation of the action plan Require the creation of a separate unit in the bank - remedial asset management group to take care of banks bad assets and make progress reports to BSP Appoint an external auditor at the expense of the bank to perform financial or operational audit under the terms of reference of the BSP If the banks condition further deteriorates to the extent that depositors and creditors protection is at stake and its capital base is already deficient by more than 80%, appoint/assign a resident examiner comptroller or conservator, if legally feasible, to oversee/take over management of the bank If necessary, appoint a consultant specialists to diagnose the problem and to recommend the appropriate remedial measures (i.e. introducen ew profit opportunities, improve internal and accounting controls, etc.) to restore the banks viability
66
imply that better BSP supervision over banks has been hampered by the existing law in terms of the freedom to examine banks as frequently as possible or as needed. It is also unclear why examiners would want to examine banks only once a year or at least once a year and why Congressional approval is needed for them to do this. If the authorities were to ask Congress to pass the implementing law with regard to supervision, would it not make more sense to ask for the authority to examine banks as frequently as the authorities deem necessary? This seems to be a relic from the past when bank supervision meant on-site examination and is constrained by time and availability of personnel. However, the emphasis at present is on off-site examination that allows for greater disclosure and frequency of examination. In countries like Malaysia, such off-site examination allows for the daily monitoring of banks. In the Philippines, foreign exchange trading activities of banks are monitored daily.
WEAK CREDIT CULTURE AND INADEQUACIES IN ADDRESSING THE DEVELOPMENTAL NEEDS OF THE ECONOMY
The country has a weak credit culture. As mentioned previously, the Philippines has one of the lowest degrees of financial intermediation in Asia, with a loan-to-GDP ratio under 65 percent. The adequacy of credit to vital sectors of the economy, such as rural enterprise, private infrastructure, exports, SMEs, and the efficiency with which such credit is provided need to be addressed. It is a fact that the formal credit system provides only a small portion of the financing requirements of the rural sector. Yet, unless the needs of this sector and other vital ones are addressed sufficiently, the countrys long-term development will not advance. Two legislated provisions mandate banks to set aside a portion of their loan portfolio to agriculture and the agrarian reform sector, and to SMEs. As of March 1997, banks provided a total of P117 billion in
69
credit to the entire agriculture sector. Commercial banks provided P104 billion or 89 percent of the total agriculture loans of the banking system, thrift banks contributed P7.3 billion or 6.3 percent, and rural banks lent out P5.6 billion or 4.8 percent. However, the total bank loans were below the mandated loans to the sector by P55.2 billion, equivalent to a compliance ratio of only 17 percent versus the required 70 ratio of 25 percent. Nevertheless, the bulk of actual investments to SMEs has remained net eligible loans or actual funds lent out. In fact, loans to SMEs have been increasing at a higher rate than those of the total loan portfolio. The compounded annual growth rate of SME actual investment (loan) during the period 19911996 was 51 percent, while that of 71 the total loan portfolio was 33 percent. There are concerns that funds to SMEs may not have really reached the beneficiaries since they are not actual investments, and that banks have found ways to comply with the letter of the law by simply putting funds in an ever-expanding list of allowable 72 funds for compliance. Apart from the usual emphasis on credit provision to SMEs and the export sector, microfinance as a new approach to development finance has led to a more balanced view that low-income groups demand other financial services as well. Microfinance institutions in the Philippines are composed of rural banks, cooperatives, cooperative banks, credit unions, and credit-granting nongovernment organizations (NGOs). The latter have demonstrated some success in reach73 ing poor clientele. However, microfinance institutions need to mobilize more deposits (in the cases of rural banks and cooperative banks), tap the commercial loan market, and increase their equity so as to sustain their financial capability. It is estimated that some 2,362 microfinance institutions reach only 74 656,000 clients. There is some debate on whether transforming credit NGOs into banks and subjecting them to formal regulation and supervision will lead to a loss of focus and sense of mission to the poor.
67
In part, the conservative stance of banks and the weak credit culture may be blamed on bank examiners and regulators. There is widespread uncertainty and concern about the expectations and requirements of regulators and examiners. Bankers have considerable discretion in granting loans, but examiners have considerable discretion in evaluating the performance of bankers. Uncertainty and concern about examiners expectations discourage regulated institutions from undertaking innovative credit policies such as finding alternatives to collateral and formal financial statements as basis for lending, and encourage bankers to avoid activities in which they have to do sub75 jective judgments. This tends to make bankers extremely conservative in lending. Increased foreign participation is seen as a way to provide greater competition, and to improve the credit culture, management practices, and borrower repayment culture for Philippine banks.
BANK SECRECY LAW
Law will enhance system transparency and prevent systemic risk by allowing a quick payoff of depositors as soon as the bank is closed and preserving confidence in the system. The examiner must be able to trace accounting entries through 78 the deposit side of the balance sheet.
LINKAGES BETWEEN NPL RESOLUTION, AND CORPORATE GOVERNANCE AND REHABILITATION
The Bank Secrecy Law may be partly responsible for bank examiners conservative approach to ex76 amination. This law makes it impossible for BSP and PDIC examiners to verify individual account (deposit) balances. Because of this restriction, examiners may not detect misstated deposit account balances. They could then become more conservative in the other areas of their examination. PDIC officials have long sought access to bank deposit records before a bank is closed because it is difficult to effect quick liquidation when attempting to verify deposit records of the bank for the first time. Without the complete records of bank deposits beforehand, it will be difficult to know if these have been tampered with, especially during a time of imminent bank liquidation. Recently, the PDIC asked Congress to amend its charter and allow it to have access to the deposit records of banks that have had their insured 77 status terminated. Repealing the Bank Secrecy
The deterioration in corporate sector performance between 1997 and 1998, as evidenced by the increase in the number of firms applying for debt suspension with the SEC and whose total liabilities amounted to 6.2 percent of outstanding commercial loans in 1998, points to the need to parallel corporate debt resolution and the resolution of bank NPLs. The health of the banking system depends to a large extent on the health and performance of the corporate sector. Unfortunately the SEC, which is in charge of corporate sector supervision, is extremely burdened with many different functions. Both the effectiveness of existing corporate regulations, especially with regard to disclosure and transparency, and the capacity of the SEC to fulfill its corporate regulatory and supervisory functions need to be addressed. One of the major impediments to improving the resolution of corporate debts and ultimately, of bank NPLs, is the inadequacy of the existing law covering corporate rehabilitation. Corporate rehabilitation is 79 not defined anywhere. While it is a remedy provided under Presidential Decree 902-A, neither the procedures on how to avail of it, nor the relief that goes with it is specified in the law. As with other forms of remedies for ailing corporations, the SEC has exclusive jurisdiction over corporate rehabilitation and, thus, corporate rehabilitation tends to be regulator-driven. However, the SEC has not adopted formal rules to govern the implementation of these remedies. Hence, it exercises a lot of discretion and power in granting them, treating applications for
68
availment on a case-by-case basis. Many important questions, such as who will prepare the corporate rehabilitation plan, who will manage the corporation during the pendency of the petition, and can encumbered 80 assets be disposed of, remain unanswered. Unless the law covering corporate rehabilitation is improved to address all of these issues, banking sector reform will remain standing on one leg.
Recommendations
Strengthen Banks to Meet the Increasing Requirements of Globalization
First, it is necessary to conduct the macroeconomic policy appropriately. The previous macroeconomic regime gave rise to an inappropriate system of incentives for market participants, particularly in the area of recognizing and minimizing risks, which contributed to the fragility of the banking sector. The previous system of incentives, which attracted capital inflows for the wrong reasons and into the wrong sectors, must be avoided. It is important to conduct macroeconomic policy appropriately so that the proper incentive system evolves, moral hazard is avoided, with market participants aware of the need to recognize and minimize risks, banks owners and managers being accountable to depositors, and depositors willing to monitor the behavior of bank management. Such an incentive system would rely more on market-based incentives rather than on strong supervision by supervisory authorities. Second, there must be serious improvements in institutional arrangements and mechanisms that give rise to greater transparency and flows of information. An example of this is the development of wellbehaved asset markets so that corporate transparency is enhanced and valid financial information is based on market observations. However, it is a fact of life that inappropriate macroeconomic policy such as government financing of a large and recurring fiscal deficit either by borrowing through trea-
sury bill sales or through an inflation tax, or attempts to fashion a floor price for the exchange rate by keeping domestic interest rates high, will keep capital markets, both equity and debt markets, relatively underdeveloped. High interest rates will also make it difficult for borrowers to repay loans and will therefore raise the degree of fragility of the banking system. At present, IMF has allowed the Government to raise its deficit-to-GNP ratio to about 2.2 percent to pump-prime the economy. The Government is financing this increased spending primarily by borrowing from abroad to be able to keep domestic interest rates down. Care must be exercised, however, that the foreign borrowings do not translate into a difficult external debt service burden as they did in the early 1980s. Third, the banking system must respond to the developmental needs of the economy without compromising the banks commercial viability. Banks must learn to mobilize savings efficiently so that they can address the needs of specific sectors that have crucial developmental and social impact, such as exporters, SMEs, microfinance, etc. Transactions costs are effectively high for banks handling mandated credit programs because of an asymmetry of information that impacts directly on the credit decision and the credit risk between borrower and lender. These costs must be reduced by introducing market-based compliance mechanisms to minimize the information gap between financial institutions and the 81 mandated credit program market. The PDIC can also play a role in mobilizing savings in the poorer rural areas by providing the confidence needed for the rural depositor to place funds in local financial institutions. Under the national strategy for microfinance, issues such as performance standards for microfinance institutions, termination of subsidized directed credit programs, adoption of market-determined interest rates, and government support to capacity-building efforts of microfinance institutions are being attended to.
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Strengthen Prudential Regulation and Supervision

This entails strengthening prudential norms and addressing the remaining weaknesses identified, such as (i) the classification of restructured loans as performing loans, (ii) the treatment of loan-for-property swaps in bank balance sheets and the need for adequate and immediate provisioning, (iii) the tax treatment of loan-loss reserves, (iv) the advantages/ disadvantages of the current stricter definition of capital adequacy relative to the BIS standard, (v) the overemphasis on collateral as the basis for lending decisions, (vi) the scope of supervision beyond banks to include allied and nonallied bank-owned enterprises and the appropriate architecture of supervision, and (vii) the wisdom of allowing supervisory authorities to regulate the compensation of bank directors and officers. In addressing these weaknesses, it is necessary to have a formal framework and common terminology for risk assessment and risk management sys82 tems in banks. The disadvantage of the current system, which relies heavily on collateral when making lending decisions, is that it tries to mitigate risk more by avoiding rather than managing it. The adoption of good risk management techniques permits lenders to take on more risks, serve more borrowers, and earn higher returns associated with greater risk, and at the same time reduces the risk of loss. It must be pointed out that while the Basle Accord focuses on capital measurement and the setting of minimum capital adequacy standards, it does not offer standards for banks efforts to identify, mea83 sure, monitor, and control material risks. This means that the Basle Accord cannot be regarded as a complete international prudential agreement and that individual countries will have to find a way to interpret and implement the spirit of the accord, given their own levels of institutional and socioeconomic development. Another measure to strengthen prudential supervision is better implementation of prudential norms
and supervisory standards. It is important for bank examiners and supervisors to gain expertise in developing risk profiles of individual products and services and in being able to formally appraise risk management systems. Ways to improve the implementation of prudential norms and supervisory standards include training of bank supervisors and examiners in risk appraisal and management techniques, enlargement of the pool of competent bank examiners and supervisors by offering competitive salaries to attract and retain experts from the private sector, and opening the domestic banking industry to foreign participation to help produce such experts in the private sector. Another way is to emphasize transaction-based banking, rather than relationship banking, and to reduce regulatory forbearance. In the Philippines, many things are accomplished on the basis of relationships or connections, whether one is talking about getting a drivers license or being able to borrow from a bank. This makes it difficult to lend money, for example, simply on the basis of the merits of a transaction, on the viability of the project, and the borrowers ability to pay rather than on whether there is collateral. Relationship banking makes it difficult to put a stop to the abuses of related-party lending or to effect the early closure of failing institutions. Here, all the prudential standards and norms one can write into law will not matter unless there is a change in the way banks select their clients, and in the seemingly cozy relationship between the BSP as regulator and supervisor of 84 banks and the regulated banks themselves. Measures to reduce potential conflict-of-interest situations must be adopted. One way to maintain an arms-length relationship between the supervisor and regulator of banks and the banks themselves is to reduce regulatory discretion with respect to PCA measures by legislating mandatory intervention. If these measures are written into law, there will be greater transparency and both supervisor and banks will be accountable to entities other than themselves, such as Congress.
70
Raise the Degree of Competition and Efficiency in the Banking Industry

It is important for the banking industry to be contestable. This is accomplished primarily by removing barriers to entry. While the BSP is raising capital standards and encouraging mergers and acquisitions among banks, it must also allow entry or raise the threat of potential entry, particularly of foreign institutions. The dismal fact is that while raising capital standards and encouraging mergers have made domestic banks strong, there are no distinct signs that financial intermediation has become more efficient. The Philippines still has the lowest loan-to-GDP ratio and some of the highest interest rate spreads among Asian countries. This has remained so despite financial liberalization and reform moves since the early 1980s. It appears that capital hikes and voluntary mergers have acted as effective barriers to entry. While 100 percent foreign ownership of banks is being discussed, the BSP already has thought of ways to provide macroeconomic protection to the local banking industry by setting a ceiling on the percentage of the total industrys assets that can be foreign owned. It seems there are more benefits than there are disadvantages from complete foreign ownership of banks as shown by the experiences of Singapore and New Zealand. Privatization is also seen as a way of raising efficiency and competition in the industry. In this regard, the clinching of the PCIBank sale by the Equitable Group, with the participation of two government financial institutions, sends the wrong signal to market participants. The signal being given is that having the Government on your side ensures the winning bid. Worse, it could imply that the Government, because it has a stake in a particular bank, would ensure that the bank would not fail. This will give rise to the problem of moral hazard, which led to large losses and insolvency in government-owned corporations and financial institutions in the past as well as in banking systems in Asia during the crisis.
Public listing requirements must be strengthened to improve corporate governance in the banking industry. Measures to raise overall system transparency to make information readily available must be adopted so that each banking firm can compete on an equal footing. Financial intermediation taxes, such as gross receipts tax and documentary stamp tax, the AGRI/ AGRA requirement, and the Magna Carta for SMEs, must be eliminated or reduced, and implicit financial intermediation taxes, such as the liquidity reserve requirements, must eventually be removed. Currently, a World Bank Financial Sector Adjustment Loan is being utilized to assist in improving the banking sectors health and efficiency.
Improve the Financial Infrastructure

Accounting and disclosure systems have to be strengthened so that the true financial condition of banks, including their affiliates, is readily verifiable. Without a credible disclosure system, it will be difficult for authorities to act in a manner that is preemptive of a crisis situation or a situation of increased vulnerability. Better accounting and disclosure will also allow better off-site monitoring of banks and reduce the strain on personnel and time of conducting on-site inspections.
Improve the Legal System

The Bank Secrecy Law has to be repealed so as to allow bank examiners access to deposit records before a bank is in need of liquidation. The inability of the PDIC to review deposit account balances because of the Bank Secrecy Law makes it virtually impossible to protect the interests of depositors. To enhance the PDICs role in bank examination, legal impediments to the review of second-party verification of deposit accounts must be lifted. The repeal of the Bank Secrecy Law will also assist fiscal authorities in tax mapping and tracking down tax evaders. The linkages between NPL resolution and improving corporate governance and rehabilitation
71
must be recognized. Improvements are needed in the legal framework for orderly corporate restructuring and loan workouts, including strengthening the bankruptcy law and implementation procedures. Specifically, the SEC must adopt formal rules for implementing corporate rehabilitation, and make the proceedings swift and time bound, and creditor 85 rather than regulator driven. It is also necessary to have a clearer legal interpretation of the BSP mandate as supervisor and regulator of banks, and the extent of the legislation required to carry out such mandate. The legal basis of BSP-issued circulars is not always clear, nor is the need for Congress to legislate measures to effect the adoption of the Basle core principles of effective supervision apparent. It is ambiguous where BSP independence is at stake and where legislation is needed to minimize regulatory forbearance.
Summary and Conclusion

Like in many Asian countries, the Philippine banking system until the early 1980s was primarily tasked with a developmental role. It was viewed as the conduit of credit to sectors deemed as high priority by the State. Controls on interest rates, subsidies, and directed lending were some of the ways this was carried out. Financial repression was one of the results. Resource misallocation, lack of long-term finance, and inefficiency in the system of financial intermediation were among the main problems that emerged in the financial sector. An IMF-Central Bank study of the financial sector in 19721973 made recommendations to address those issues. Beginning in 1980, financial liberalization and reforms were undertaken. Ceilings on interest rates were lifted, bank consolidation and mergers were encouraged, the liberal discounting policy of the central bank was discontinued, etc. These reforms were implemented; however, bank entry was not allowed and certain prudential norms were not adopted. The 1980 reforms did not include rules on the treatment of overdue loans, the provisioning of
debt, and examination of deposit transactions by central bank examiners. In 1980, the capital adequacy requirements were even reduced. Rules regarding credit accommodation to DOSRI were relaxed. All these set the stage for the banking crisis in 1981, triggered by the collapse of the commercial paper market. Meanwhile, excessive public borrowing in the 1970s, which led to debt-driven growth in that decade, became an external debt burden in the 1980s when the second oil shock dried up foreign capital inflow toward the end of the 1970s. By October 1983, the Philippines had declared a moratorium on the service of external debt, which effectively meant that no new foreign inflows would be forthcoming for a while. The country experienced negative rates of growth for the first time in its postwar history in 1984 and 1985. The central bank raised domestic interest rates by issuing high-yielding debt instruments of its own called Jobo bills, and tamed inflation by inducing tremendous slack in the economy. Hence, although financial liberalization and reform measures were taken prior to the financial crisis in 1981, the macroeconomy itself was in bad shape, largely because of earlier excesses and the loss of foreign inflows. It was difficult under such circumstances to proceed with and deepen the financial sector reforms. Nevertheless, since the reform process was necessary, it did continue. The failure of several banks in the 1980s led the monetary authorities to strengthen prudential regulations in the latter part of the decade and early 1990s. The authorities strengthened regulations on single borrower limits, limits on DOSRI loans and interlocking directorships, capital adequacy, compliance with minimum risk-asset ratio, and provisions for loan losses. The Government also undertook the rehabilitation of the financial sector, particularly of PNB and DBP, two government-owned financial institutions that accounted for nearly 50 percent of all banking assets and which had become insolvent by 1985. The rural banking system, which experienced large failures after its primary source of funds,
72
namely the central banks discount window, aligned its rate with market rates, was also rehabilitated through a capital-buildup program. By the 1990s, bank branching and entry were liberalized. In 1994, foreign bank entry was allowed but was limited to 10 banks under specified modes of entry. The foreign exchange market was also liberalized during the early 1990s. By 1992, exporters could retain 100 percent of their foreign exchange earnings, restrictions on the purchase of foreign exchange were lifted, and the full and immediate repatriation of duly registered foreign investments was allowed without prior BSP approval. With the liberalization of the financial and capital markets in the Philippines, foreign capital inflows began to surge in the early 1990s, peaking at a little over 7 percent of GDP in 1996. Prior to the Asian crisis in July 1997, the monetary authorities once again strengthened certain prudential norms, including setting a 20 percent cap on real estate lending by banks, imposing a 30 percent liquid cover on all foreign exchange liabilities of banks, and prescribing guidelines governing the responsibilities and duties of a banks board of directors. However, while those measures helped prevent the collapse of the banking system, they were insufficient to control the dramatic increase in its NPL ratio from about 4 percent prior to the crisis to 13.1 percent as of June 1999. Although the Philippine banking system escaped the worst effects of the Asian crisis, its vulnerability to the crisis increased. This can be blamed on defective macroeconomic policy and premature liberalization of the capital market prior to the institution of a strong supervisory and regulatory framework for banks. The flawed policy of maintaining a fixed nominal exchange rate largely by keeping domestic interest rates high encouraged overborrowing from abroad, particularly in the last two years before the onset of the Asian crisis. It created an inappropriate incentive system, enabling domestic banks to borrow cheaply from abroad and relend locally at very high
rates. Most of the borrowed funds flowed into the real estate sector and created an asset bubble. For large corporations that were able to borrow directly from abroad, there were substantial interest cost savings. However, the ease with which foreign borrowing could be effected made market participants less than prudent in their borrowing and lending behavior. The lack of effective bank supervision allowed such situation to continue. Most of the borrowing was unhedged. Fixed nominal exchange rates obscured the currency risk, treating this as mere credit risk. When the peso defense was abandoned on 11 July 1998, many of the loans soured and contributed to the growing NPLs. Since the crisis, the monetary authorities have further strengthened prudential norms. They have redefined the criteria for past due loans by shortening the period of installment arrears; mandated a 2 percent general and specific loan-loss provision for banks, to be accomplished in several stages; raised capital requirements; and rationalized foreign exchange trading by introducing a dollar hedging facility to banks called the Currency Risk Protection Program (CRPP)which is also known as the nondeliverable forward (NDF) facilityby prescribing prior BSP clearance for sales of NDF contracts by banks, and adjusting the overbought/oversold foreign exchange position of banks. This study identifies factors that contribute to the remaining weaknesses and vulnerability of the Philippine banking system. They include structural weaknesses and difficulties in the conduct of macroeconomic policy, the problem of pursuing liberalization when institutional failures and deficiencies are present, weaknesses in prudential norms, poor implementation of prudential norms and international standards of supervision, a weak credit culture, and impediments in the legal infrastructure such as the Bank Secrecy Law and a weak legal framework for orderly corporate restructuring and loan workouts. To address these problems, the study recommends the following measures:
73
Strengthen banks to meet the increasing requirements of globalization through the appropriate conduct of macroeconomic policy. This will provide a correct system of incentives, which is necessary for improving financial intermediation efficiency while addressing the demands of longterm development finance as well. Foster competition and efficiency in the banking industry through (i) promotion of contestable markets and encouragement of greater foreign entry, mergers, and acquisitions; (ii) privatization; (iii) strengthening of public listing requirements to improve corporate governance in the banking industry; and (iv) reduction or elimination of financial intermediation taxes (such as gross receipts tax, documentary stamp tax, AGRI/AGRA requirement, Magna Carta for SMEs), and implicit financial intermediation taxes (such as liquidity reserve requirements). Strengthen prudential regulation and supervision by (i) adoption of a formal framework and common terminology for risk assessment and risk management systems in banks; (ii) improvement of financial reporting, disclosure, and transparency, including the repeal of the Bank
Secrecy Law; (iii) better implementation of prudential norms and supervisory standards; and (iv) reduction of regulatory forbearance by such methods as legislation of the adoption of PCA measures. Improve the financial infrastructure by strengthening the legal and regulatory system for corporate governance, financial restructuring, and bankruptcy. The SEC must upgrade standards of corporate disclosure and transparency, adopt formal rules for implementing corporate rehabilitation, make the proceedings swift and timebound, as well as creditor rather than regulatordriven. There must be a clearer legal interpretation of the BSPs mandate as supervisor and regulator of banks and the extent of the legislation needed to carry this out. In the final analysis, it can be said that while the Philippine banking system was spared from the worst effects of the Asian financial crisis, the goals of the reform program that began in the early 1980s still have not been completely achieved. The challenge is to accomplish these in a more volatile macroeconomic environment that is more integrated with the global economy.
74
Notes
1Formally known as the Bangko Sentral ng Pilipinas (BSP)
much higher than the official figure for commercial banks (20 percent versus 14.4 percent).
15Guinigundo, D.C. 1999. Current State of the Philippine
since 1993.
2Intal, P.S. and Llanto, G. M. 1998. Financial Reform and
Banking System. Paper presented at the Annual Meeting of the Philippine Economic Society, Makati, 12 March.
16Dumlao, D. 1999. BSP Moves to Ease Foreign Ownership
Development in the Philippines, 19801997: Imperatives, Performance, and Challenges, PIDS Discussion Paper Series 98-02. January.
3Bautista, E.D. 1992. A Study on Philippine Monetary and
Cap in Banks. Philippine Daily Inquirer, 31 May, p. B1.

17The participation of government financial corporations
Banking Policies. PIDS Working Paper Series 92-11. August.

4Ibid. 5Valenzuela, C. P. 1989. Bank Supervision and Examina-
in buying shares in PCIB has been criticized because it represented a move in the direction of Government intrusion into private business, a large portion of public funds were used for the buy-in (about 30 percent of the funds of these two institutions), and the shares were purchased without the buyers demanding a due diligence audit of PCIB.
18Guinigundo, 1999. 19Ibid. 20Bangko Sentral ng Pilipinas Supervisory Reports and
tion: 19481988A Historical Sketch. Central Bank Review 41(1).

6Interest rates on treasury bills jumped from 14 to 40 per-
cent in 1983.
7Named after Jose B. Jobo Fernandez, the central bank
Studies Office (SRSO).

21Ibid. 22Goldman Sachs Investment Research. 1999d. Philip-
governor at the time.

8Valenzuela, 1989, p. 6. 9Llanto, G. M., R. G. Manasan, M. B. Lamberte, and J.C.
Laya. 1998. Local Government Units Access to the Private Capital Markets. Makati: Philippine Institute for Development Studies. p.17.
10Bangko Sentral ng Pilipinas. Selected Economic Indi-
pine Banks, 28 April. p. 5.

23Goldman Sachs Investment Research, 1999c. Asia Banks:
Prudential Norms and Camelot II, March, p 17.

24Ibid., p.10. 25Guinigundo, 1999. 26Ibid. 27Fitzgerald, T.M., F. Miranda, Jr., D. S. Murphy, and G. C.
cators. Various issues.

11Bureau of the Treasury. National Government Cash Op-
erations. Cited in Bangko Sentral ng Pilipinas. Selected Economic Indicators. Various issues.
12Bangko Sentral ng Pilipinas. Selected Economic Indi-
cators. Various issues.

13Rana, P.B. and J. A. Y. Lim. 1999. The East Asian Finan-
Schulz. 1997. Regulatory Barriers to Innovative Lending Practices: Traditional Approaches to Bank Supervisions. IMCC Credit Policy Improvement Program, October.
28Goldman Sachs Investment Research, 1999c, p. 6. 29Goldman Sachs Investment Research, 1999d, p. 13. 30Dolor, F. A., Jr. 1999. Story Remains the Same: Bank
cial CrisisIssues in Designing and Sequencing Macroeconomic Policies. Paper presented at the ADB-ADBIIFMP High-Level Regional Workshop on the Asian Financial Crisis, Tokyo, 2526 March.
14As it turns out, Deustche Banks estimate of nonperform-
ing loans for the entire banking system in May 1999 is
Asset Quality Continues to Deteriorate in Q1. Business World, 17 May, p. 34.
75
31Ibid. 32Ibid. 33Guinigundo, 1999. 34Deutsche Bank. 1999. Is Asias Recovery Sustainable?
51Ibid., p. 220. 52Asian Development Bank. 1998. Philippines: Coun-
Global Emerging Markets Asia, May, p. 8.

35Deutsche Morgan Grenfell, 1998. Philippine Banks. March. 36Guinigundo, 1999. 37Ibid. 38Gochoco-Bautista, Maria Socorro, Soo-Nam Oh, and S.
try Economic Reports, p. 23, cites a study by Claessens and Glaessner. The seven other economies studied were the Peoples Republic of China; Hong Kong, China; India; Indonesia; Republic of Korea; Malaysia; and Thailand.
53Basilio, R. J. A., Jr. 1995. Asias Banks Still on Shaky
Ground. Business World, 5 July, p. 30.

54Ibid., p. 30. 55ADB, 1998, p. 23. 56Ibid. 57Goldman Sachs Investment Research, 1999c, pp. 1617. 58Ibid., p. 8. 59Goldman Sachs Investment Research. 1999a. Asia Banks:
Ghon Rhee. 1999. In the Eye of the Asian Financial Maelstrom: Banking Reforms in the Asia-Pacific Region. Paper presented at the ADB-ADBI-IFMP High-Level Regional Workshop on the Asian Financial Crisis, 2526 March, Tokyo.
39Deutsche Morgan Grenfell, 1998, p. 54. 40Intal and Llanto, 1998, p. 23. 41Gochoco-Bautista et al. 1999, p. 10. 42Bangko Sentral ng Pilipinas SRSO. 43Dumlao, D. 1999. Banks Bad Loans Down to 13.5%. Phil-
Asian Bank NPLs, 5 January, p.14.

60Fitzgerald, T. M. et al. 1997. Regulatory Barriers to Inno-
vative Lending Practices: Traditional Approaches to Bank Supervision. IMCC Credit Policy Improvement Program. October, p.13.
61Goldman Sachs Investment Research, 1999c, p. 16. 62Fitzgerald, et al., 1997, p. 9. 63Newspaper reports, for example, put Prime Banks capi-
ippine Daily Inquirer, 5 August, p. B2; and Bangko Sentral ng Pilipinas SRSO.
44This section summarizes the presentation by Philippine
monetary officials at the IFMP High-Level Regional Workshop, 1999.

45Goldman Sachs Investment Research. 1999b. Asian Banks
tal base at negative P200 million.

64This may or may not be related to the fact that the
1999: Issues and Outlook, 5 January. p.1.

46Local currency deposits are subject to a final withhold-
president of Orient Bank used to be a high official of the BSP.

65Fitzgerald, et al., 1997. p. 9. 66In an informal discussion in Congress regarding amend-
ing tax of 20 percent on the interest income.

47Goldman Sachs Investment Research, 1999b, p. 10. 48Deutsche Bank, 1999, p.17. 49Guinigundo, 1999. 50Frankel, A. B. 1998. Issues in Financial Institution Capi-
ments to the General Banking Act, some observers question the legal basis for the issuance of CB circulars.
67The low number of bank closures is seen by the au-
tal in Emerging Market Economies. Federal Reserve Bank of New York Economic Policy Review. October.
thorities as proof that they are doing a good job. In fact, the BSP Governor has been quoted as saying that in his term, only one commercial bank failed. He further pledged that there would be no failure among the countrys 53
76
commercial banks this year. See Torrijos E.R., and D. C. Dumlao. 1999. Banks Expect Better Times Ahead. Philippine Daily Inquirer, 10 May. p. D10.
68Aggarwal R., and K. T. Jacques. 1998. Assessing the
77PDIC Seeks Access to Deposit Records. 1999. Philip-
pine Daily Inquirer, 14 June.

78Fitzgerald, et al., 1997, p. 26. 79Concepcion, D. L. 1999. Corporate Rehabilitation: the Phil-
Impact of PCA on Bank Capital and Risk. Federal Reserve Bank of New York Economic Policy Review, p. 23.
69Goldman Sachs Investment Reseach, 1999b, p. 7. 70Medalla, F. ,and J. N. Ravalo. 1998. Impact of Industrial
ippine Experience. Paper presented at the Economic Policy Agenda Symposium Series, Mandaluyong City, 25 June.
80Ibid., pp. 1619. 81Medalla and Ravalo, 1998, pp. 3536. 82Fitzgerald et al., 1997, p.16. 83Frankel, 1998, p. 218. 84This notion of a cozy relationship between the BSP and
Credit Programs, CPIP Working Paper No. 8, p. 12.

71Ibid. , p. 18. 72Ibid, , p. 17. 73Llanto, et al.,1998, p. 3. 74Ibid., p. 4. 75Fitzgerald, et al., 1997, p. 9. 76Ibid., p.10.
banks will be even more difficult to dispel as the BSP governor was president of one of the countrys largest banks. In the past, this close relationship between banks and their supervisor was important in successfully keeping the nominal exchange rate essentially fixed.
85Concepcion, 1999, p. 5.
77
References
Aggarwal, Raj and Kevin T. Jacques. 1998. Assessing the Impact of PCA on Bank Capital and Risk. Federal Reserve Bank of New York Economic Policy Review October: 2332. Asian Development Bank. 1998. Philippines Country Economic Report. Manila. Bangko Sentral ng Pilipinas. 1997. Proposed Revised General Banking Act of 1997. December. __________. Various issues. Selected Economic Indicators. __________. Supervisory Reports and Studies Office. (Table on Selected Financial Ratios of the Philippine Banking System and Table on Total Loans, Nonperforming Loans and Loan-Loss ProvisionsCommercial Banks) Basilio, Robert JA Jr. 1999. Asias Banks Still on Shaky Ground. Business World, 5 July: 30. Bautista, Ernesto D. 1992. A Study on Philippine Monetary and Banking Policies, Philippine Institute for Development Studies (PIDS). Working Paper Series No. 92-11, August. Concepcion, Danilo L. 1999. Corporate Rehabilitation: The Philippine Experience. Paper presented at the Economic Policy Agenda Symposium Series, Mandaluyong City, 25 June. Demirguc-Kunt, Asli, and Enrica Detragiache. 1997. The Determinants of Banking Crises: Evidence from Developed and Developing Countries, May. Unpublished. Deutsche Bank. 1999. Is Asias Recovery Sustainable? Global Emerging Markets-Asia, May. Deutsche Morgan Grenfell. 1998. Philippine Banks. March. Dolor, Felicisimo A. Jr. 1999. Story Remains the Same: Banks Asset Quality Continues to Deteriorate in Q1. Business World, 17 May. p. 34. Dumlao, Doris. 1999. Allied Seen Bidding for Prime Bank. Philippine Daily Inquirer, 14 June. p. B1. __________. 1999. Banks Bad Loans Down to 13.5%. Philippine Daily Inquirer, 5 August. p. B2.
__________. 1999. BSP Moves to Ease Foreign Ownership Cap in Banks. Philippine Daily Inquirer, 31 May. p. B1. Fitzgerald, Thomas M., Feliciano Miranda Jr., David S. Murphy, and Gerald C. Schulz. 1997. Regulatory Barriers to Innovative Lending Practices: Traditional Approaches to Bank Supervision. IMCC Credit Policy Improvement Program, October. Frankel, Allen B. 1998. Issues in Financial Institution Capital in Emerging Market Economies. Federal Reserve Bank of New York Economic Policy Review, October 1998: 213223. Gochoco-Bautista, Maria Socorro. 1998. Prudential Regulation and Supervision: Comments on the Proposed Amendments to the GBA. Unpublished. Gochoco-Bautista, Maria Socorro, Soo-Nam Oh, and S. Ghon Rhee. 1999. In the Eye of the Asian Financial Maelstrom: Banking Sector Reforms in the Asia-Pacific Region. Paper presented at the ADB-ADB InstituteInstitute of Fiscal & Monetary Policy High-Level Regional Workshop on the Asian Financial Crisis, Tokyo, 2526 March. Goldman Sachs Investment Research. 1999a. Asia Banks: Asian Bank NPLs, 5 January. __________. 1999b. Asia Banks 1999: Issues and Outlook, 5 January. __________. 1999c. Asia Banks: Prudential Norms and CAMELOT II, 1 March. __________. 1999d. Philippine Banks, 28 April. Guinigundo, Diwa C. 1999. Current State of the Philippine Banking System. Paper presented at the Annual Meeting of the Philippine Economic Society. Makati, 12 March. Intal, Ponciano S. Jr., and Gilberto M. Llanto. 1998. Financial Reform and Development in the Philippines, 19801997: Imperatives, Performance, and Challenges. PIDS Discussion Paper Series No. 9802, January. Lamberte, Mario. 1993. Assessment of the Financial Market Reforms in the Philippines, 19801992. Journal of Philippine Development. No. 37. 2(2): 231259.
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Llanto, Gilberto M., Rosario G. Manasan, Mario B. Lamberte, and Jaime C. Laya. 1998. Local Government Units Access to the Private Capital Markets. Makati: Philippine Institute for Development Studies. __________. 1998. Policy and Regulatory Issues Facing Microfinance in the Philippines. Paper presented at the Coalition for Microfinance Standards National Summit, Asian Development Bank, Mandaluyong City, 2021 August. Medalla, Felipe, and Johnny Noe Ravalo. 1998. Impact of Mandated Credit Programs. Credit Policy Improvement Project Working Paper No. 8. Paderanga, Cayetano. 1996. Philippine Financial Developments: 19801995. In Raul V. Fabella and Kazuhisa Ito, eds. Financial Sector Issues in the Philippines. Institute of Developing Economies, Tokyo. pp. 126. PDIC Seeks Access to Deposit Records. 1999. Philippine Daily Inquirer, 14 June, p. B2. Philippines. Republic Act No. 337. An Act Regulating Banks and Banking Institutions and for Other Purposes. First Congress.
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The Past Performance of the Philippine Banking Sector and Challenges in the Postcrisis Period

Ma. Socorro Gochoco-Bautista

A STUDY OF FINANCIAL MARKETS

A STUDY OF FINANCIAL MARKETS

A STUDY OF FINANCIAL MARKETS

Structure of the Philippine Financial System

Table 1: The Philippine Financial System

Nonbank Financial Intermediaries

Nonbank Thrift Institutions

A STUDY OF FINANCIAL MARKETS

Some Significant Events Affecting the Financial System

Continued next page

A STUDY OF FINANCIAL MARKETS

Table 2: Some Significant Events Affecting the Financial System (Contd)

10 November 1997 11 March 1998

Source: C. Paderanga (1996) and Deutsche Morgan Grenfell (1998).

Sources: Bangko Sentral ng Pilipinas; National Statistical Coordination Board.

A STUDY OF FINANCIAL MARKETS

A STUDY OF FINANCIAL MARKETS

Measuring the Banking CrisisThen and Now

May 1999 Estimate NPL (% of loans) Losses (% of GDP)

Indonesia Korea, Republic of Malaysia Philippines Thailand

Profitability and Capital Adequacy of Philippine Banks

A STUDY OF FINANCIAL MARKETS

2.77 2.62 6.74

2.38 2.21 5.05

1.94 1.83 3.05

2.03 1.85 4.91

2.07 1.92 4.77

Table 6: Prudential Norms with Structural Impact on Profitability

Prudential Norms with Structural Negative Impact on ROA and ROE

Korea, Republic of Low reserve requirement (7%)

A STUDY OF FINANCIAL MARKETS

Total Loans [2]

NPLs/Total Loans [3] = [1]/[2]

Source: Consolidated Statement of Condition (CSOC) of Commercial Banks.

Table 8: Estimates of Structural NPLs as Percentage of Total Implied NPLs, 1998

Hong Kong, China Korea, Republic of Malaysiaa Philippines Singapore Thailand

26.4 34.8 27.0 46.6 13.9 47.4

Source: Goldman Sachs Investment Research, 1999b.

A STUDY OF FINANCIAL MARKETS

Table 9: Assessment of Book Values

Factors Materially Understating Book Value

Weak provisioning norms Generally overstated book values

Book value fairly stated for the most part

Cost accounting for associates rather than equity accounting

Singapore None noted

United States None noted

1. Excess loan-loss reserves 2. No revaluation of fixed assets

Assessment of Reported Earnings

Factors Materially Overstating Reported Earnings

Factors Materially Understating Reported Earnings

Nonrecurring expenses e.g., foreign exchange losses

Earnings overstated for the most part

Intergroup loans may be extended at belowmarket rates

Earnings overstated for most banks

Nonrecurring expenses, e.g., foreign exchange losses

Cost accounting for associates rather than equity accounting

Singapore Nonrecurring items in other income

A STUDY OF FINANCIAL MARKETS

Structural NPL Ratio Estimates

Prior Implied Estimates