Chapter

VI Banking System Reform

Author(s):
Markus Rodlauer
Published Date:
March 2000
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Author(s)
Enrique G. de la Piedra

Major improvements in financial and structural policies have played a key role in promoting the emergence of a modern banking system. Historically, the banking sector in the Philippines has suffered from the strong cyclical movements of the economy, and numerous structural problems have acted as obstacles to efficient financial intermediation. This situation, however, has improved noticeably in recent years. As the Philippine economy emerged in the 1990s, from a long period of stagnation and macro imbalances, the banking sector also became more efficient and more resilient against shocks. In particular, financial sector reforms since the mid-1980s have improved the system’s ability to perform its basic functions of financial intermediation and facilitation of payment flows. Those reforms were directed mainly at encouraging greater competition, strengthening supervisory and regulatory systems, and streamlining the tools of monetary policy.

Reforms of recent years have also helped shield the Philippine banking system from the worst effects of the Asian crisis in 1997–98. Even so, the banks came under significant stress. The authorities responded with a program of further reforms to strengthen the capacity of banks to face adverse shocks and to reinforce the institutional framework to deal with troubled banks.

This section describes the Philippine banking sector, provides an overall assessment of its soundness, followed by an overview of previous efforts at financial sector reform. It then discusses the authorities’ current reform program put in place in response to the regional crisis, and finally summarizes the agenda for further reform.

Philippine Banking System

Size of the Banking System

The banking system in the Philippines comprises 53 commercial banks,1 117 thrift banks, and 826 rural banks (see Box 6.1 for a description of the structure of the banking system). Total assets of the banking system amounted to more than £2.8 trillion by the end of 1998, roughly equivalent to annual GNP. Commercial banks as a whole (expanded, non-expanded, and foreign commercial banks) currently represent 90 percent of the banking system, up from 87 percent in 1991; thrift banks and rural banks account for 8 percent and 2 percent, respectively (Figure 6.1). There are also several kinds of non bank financial intermediaries (Box 6.2), although their importance is smaller than that of the banking sector. The central bank—Bangko Sentral ng Pilipinas—is the main supervisory agency of the banking system (Box 6.3).

Figure 6.1.Structure of the Banking System

(In percent of banking system assets)

Source: Bangko Sentral ng Pilipinas.

Trends in Banking System Activity

With the liberalization of the banking environment and improvement in the business environment during the 1990s, banking activity increased at a brisk pace until the onset of the 1997 regional financial crisis. Total deposits and loans of the banking system increased about 25 percent and 35 percent a year, respectively, during 1993 to mid-1996 (Figure 6.2). Thus, financial intermediation has deepened significantly in the Philippines, with the ratio of broad money to GDP nearly doubling from 34 percent in 1991 to 61 percent in 1997, and claims on the private sector rising from 18 percent of GDP to 56 percent of GDP during the same period. Nevertheless, the degree of financial deepening in the Philippines remains relatively low compared with other Asian countries affected by the regional crisis (Figure 6.3).

Figure 6.2.Deposit Liabilities and Loans of the Banking System

(In billions of perses)

Sources: Bangko Sentral ng Pilipinas; and IMF staff estimates.

Figure 6.3.Indicators of Financial Intermediation in the Philippiness and Other Asian Countries

Source: International Monetary Fund, International Financial Statistics.

From mid-1997, the growth of banking activity decelerated sharply and came to a virtual halt in 1998 (with total banking system loans contracting by 2 percent and deposits expanding by only 5 percent). The financial crisis and measures to strengthen the banking system prompted a more conservative lending posture of banks as they complied with new minimum capital and loan loss provisioning requirements in particular. Also, demand for credit slowed sharply with the slowdown of economic activity and higher interest rates.

Mirroring the overall trends in banking activity, financial intermediation in foreign currency grew significantly—owing in part to the prevailing institutional advantages for bank operations in foreign currency 2—followed by deceleration thereafter. Total foreign currency deposits in the banking system expanded at an annual rate of 38 percent during 1994–96, reaching over $16 billion in June 1997 (Figure 6.4). As a result, foreign currency deposits represented more than half of total bank liabilities, up from only 3 percent in 1990. Following the onset of the regional crisis, foreign currency deposits started to contract, falling by 17 percent between June 1997 and June 1998. Most of the banks’ foreign currency liabilities are to domestic residents, which could make the system less vulnerable to capital flight than the banking systems of other Asian countries. Although nonresidents’ deposits grew by 70 percent a year during 1994–97 and continued growing in the first half of 1998, they still accounted for less than 25 percent of total foreign currency deposits by June 1998.

Figure 6.4.Deposits in Commercial Banks’ Foreign Currency Deposit Units 1

(In millions of U.S. dollars)

Sources: Bangko Sentral ng Pilipinas; and IMF staff estimates

1 December data, except 1998 (June).

Banks’ derivative activity also grew rapidly in recent years, although it remains concentrated in relatively simple contracts; about two-thirds of such activity is conducted by foreign banks. Derivatives transactions of the banks in their regular books and their foreign currency deposit units reached about $8 billion and $1.6 billion, respectively, as of May 1998; almost the entire volume of banks’ derivative transactions were foreign exchange derivatives, mainly non deliverable forward contracts.

Concentration and Competition in the Banking System

The Philippine commercial banking system is highly concentrated. The 10 largest banks (which include nine domestic banks and one foreign bank) account for more than 55 percent of the banking systems’ resources and demand liabilities. Domestically owned private banks in the Philippines have been traditionally owned by family-run industrial groups;3 these families also have major interests in the nonfinancial sectors. The larger thrift banks are in some cases controlled by commercial banks; smaller thrifts are usually family-owned. Rural banks are either family-owned or run as cooperatives.

To increase competition in the banking sector, the authorities licensed 10 new foreign bank branches in 1995. As a result, competition increased in certain areas, such as project and trade finance, top-tier corporate customers, and wholesale portfolios. However, owing in part to limitations on the activities of foreign banks,4 domestic banks remain dominant in the retail banking sector, although they face some degree of competition from the smaller thrift and rural banks, which enjoy tax and reserve requirement advantages.

Soundness of the Banking System

The Philippine banking system is, on average, well capitalized. Nonetheless, banks have suffered significant stress following the onset of the regional crisis in mid-1997. After a brief description of the main effects of the Asian crisis on the banking sector, this section discusses the soundness of banks based on three indicators: capital adequacy, the quality of the asset portfolio, and earnings and profitability.

Box 6.1.Structure of the Philippine Banking Sector

There are five types of banks in the Philippines: universal banks (also called “expanded commercial banks”), commercial banks, thrift banks, rural banks, and government-owned banks. The difference between universal banks and commercial banks is that the former—which are the most important component of the banking sector—may perform the functions of an investment house (which includes underwriting securities), own equity in nonallied undertakings, and own a majority or all of the equity of a financial intermediary except a commercial bank. Among universal and commercial banks, only one bank—the Philippine National Bank—is partly owned by the government. Thrift banks—which include savings and mortgage banks, private development banks, and stock and savings associations—service mainly to the consumer retail market and small and medium-sized enterprises. The rural banking system services the needs of the agricultural sector, farmers, and rural cooperatives; rural banks are not allowed to issue mortgage certificates.

In general, foreign banks may operate in the Philippines at any time by acquiring up to 60 percent of the voting stock of an existing domestic bank or by investing in up to 60 percent of the voting stock of a new institution incorporated locally. In addition, foreign banks may set up branches in the Philippines, although the number of such branches has been capped at 14 since 1995, when 10 foreign banks were authorized to set up new branches. One of the 10 foreign bank branches, however, converted into a subsidiary in September 1998. The authorities have proposed a legislative amendment that, if approved, would allow foreign banks to invest in up to 100 percent of the voting stock of local banks in distress, although they would be required to reduce their ownership to 85 percent of the bank’s stock after five years and to 70 percent after 10 years. (This amendment may be further modified in the legislative process.) On average, foreign equity was just under one-fifth of total equity for universal banks, about 13 percent for commercial banks, and negligible in the case of thrift banks.

There are three fully government-owned banks, including the Land Bank of the Philippines, the Development Bank of the Philippines, and the Al Amanah Islamic Investment Bank of the Philippines. The Land Bank of the Philippines and the Development Bank of the Philippines are specialized development banks, although they also undertake some commercial banking functions (mainly for their traditional clients). The mandate of the Land Bank of the Philippines is to promote the growth of the agricultural sector. The main activities of the Development Bank of the Philippines are the on-lending, on a wholesale basis, of official development assistance funds (which amounts to 60 percent of its funds available for lending) and retail lending in certain areas not attended by commercial banks—mainly environmentally oriented investment projects. Both banks provide financial services to the government and to other official financial institutions, such as the Philippine Deposit Insurance Corporation.

The Banking Sector in the Wake of the Asian Crisis

The banking sector came under stress during 1997–98. Owing to the effects of the regional crisis and major drought, starting in 1997, economic growth in the Philippines slowed, the peso depreciated, interest rates increased, and corporate profits declined. As a result, since mid-1997, the quality of bank assets deteriorated, capital adequacy weakened, and bank lending slowed sharply. Banks’ recourse to central bank emergency lending increased from £4.5 billion at end-1997 to a peak of £14.3 billion in May 1998, The external shock of the crisis interacted with domestic vulnerabilities that had built up in the years preceding the crisis. In particular, there was rapid credit growth with growing exposure of the banking sector to real estate activities and unhedged foreign currency borrowing. These problems were particularly acute in the case of smaller commercial banks, thrift banks, and rural banks, owing to the characteristics of their asset portfolio,5 weak credit management systems, and generally slower response to the rapidly changing environment.

Owing in part to past reforms (described below), the financial condition of the Philippine banking system has remained better than in several of the neighboring countries, and major bank failures have been avoided.6 The recent tightening of prudential standards has helped improve this even further. Compared with countries in the region, banks in the Philippines are better capitalized—especially at the top end of the market—the corporate sector is less leveraged, and the real estate boom was not as long or as pronounced.7 At the same time, following the onset of the crisis, banks have stepped up credit collection efforts, reduced higher-risk exposures, and reappraised lending strategies, which should support an early recovery of bank lending.

Box 6.2.Nonbank Financial Intermediaries

The nonbank financial system in the Philippines comprises a number of different institutions, including investment houses, financing companies, investment companies, securities dealers and brokers, fund managers, pawnshops, lending investors, non stock savings and loan associations, building and loans associations, venture capital corporations, cooperatives, credit unions, and insurance companies (Lirio, 1998). As of mid-1998, the nonbank financial intermediaries accounted for 18 percent of the financial system’s assets and 8 percent of its liabilities (excluding the Bangko Sentral ng Pilipinas). Of all these institutions, only financing companies and investment houses may be authorized by the Monetary Board to engage in quasi-banking business and are then referred to as quasi banks: in this case, they are authorized to borrow funds for purposes of re-lending or purchasing of receivables, but are not permitted to issue deposit liabilities.

According to the provisions of the Bangko Sentral ng Pilipinas Act, only the following will ultimately remain under Bangko Sentral ng Pilipinas supervision: nonbank financial intermediaries with quasi-banking functions, trust or investment management authority, building and loan associations, nonstock savings and loan associations, trust companies, nonbank financial intermediaries that are subsidiaries or affiliates of banks or quasi banks, and nonbank financial intermediaries, such as pawnshops, placed under Bangko Sentral ng Pilipinas supervision in accordance with special laws. The supervision of insurance companies engaged in securities dealership or brokerage is the responsibility of the Office of the Insurance Commission and the Securities and Exchange Commission, although the Bangko Sentral ng Pilipinas has supervisory authority over those insurance companies and dealers or brokers that are subsidiaries or affiliates of other supervised institutions.

Box 6.3.Prudential Framework for the Banking System

According to the Bangko Sentral ng Pilipinas Act, the ultimate authority in the area of bank licensing and supervision in the Philippines is the seven-member Monetary Board of the Bangko Sentral ng Pilipinas, which is chaired by the Governor of the Bangko Sentral ng Pilipinas. Within the Bangko Sentral ng Pilipinas, the Supervision and Examination Sector, headed by a Deputy Governor who reports directly to the Governor, is charged with the supervision of all banks operating in the country as well as all nonbank financial intermediaries authorized to perform quasi-banking functions. Bangko Sentral ng Pilipinas guidelines require that all head offices of banks operating in the country, at least 50 percent of the branches of a bank, and at least 85 percent of a bank’s total resources be examined annually.

In addition, the Philippine Deposit Insurance Corporation—which is charged with insuring deposits and rehabilitating or liquidating banks closed and placed under receivership by the Monetary Board—is empowered by its charter to examine banks and to require them to submit relevant information. In the normal course of events, however, the Philippine Deposit Insurance Corporation makes extensive use of the supervisory information and findings of the Bangko Sentral ng Pilipinas.

Capital Adequacy

The banking system’s overall capital adequacy increased during 1998, reaching 17.6 percent by end-December. This increase reflected the slowdown in asset growth, concentration of new lending in zero-risk assets (government paper), and new minimum capital requirements (see below). This improvement followed a gradual decline of capital adequacy ratios since 1992 that had reflected the rapid growth of bank assets during the period. The current level of capital adequacy is well above the minimum regulatory requirement of 10 percent,8 which is somewhat higher than in most Asian countries (Figure 6.5). On average, all classes of banks enjoyed healthy capital adequacy ratios; among large banks, all except one have capital adequacy ratios in excess of 10 percent.

Figure 6.5.Selected Asian Countries: Capital Requirements

(In percent)

Sources: National central banks.

Asset Quality

The ratio of nonperforming loans to total loans reached 11 percent in December 1998,9 compared with only 4 percent in June 1997. The ratio is much higher among thrift banks and rural banks than in the case of commercial banks. The worsening of prudential indicators over the past two years reflects both the deterioration in asset quality as a result of weakening economic conditions, and the tightening of prudential standards, which has made the degree of loan portfolio impairment more transparent (Figure 6.6).

Figure 6.6.Nonperforming Loans of the Banking System

(In percent of total loans)

Source: Bangko Sentral ng Pilipinas.

Earnings and Profitability

Bank earnings have declined significantly since 1997, reflecting both the general slowdown in the business environment as well as the need to meet the new general and specific loan loss provisioning requirements. For the banking system as a whole, the average return on equity declined to 0.37 percent in June 1998, from 1.66 percent in 1997, and an average of more than 2.3 percent during 1990–96. At the same time, the ratio of operating expenses to operating income reached 90 percent.

Financial Sector Reforms Prior to 1997

After a major financial and balance of payments crisis of the early 1980s, the authorities started a process of financial sector reform that intensified in the early 1990s and set the stage for the dynamic expansion of the financial sector since then. These measures were aimed at strengthening the operations of the banking system by improving the regulatory environment, enhancing competition, and liberalizing the financial environment. In the initial stage, interest rates were liberalized, controls on foreign currency operations were eased, and the central bank streamlined its monetary policy instruments. At the same time, universal banking was introduced and minimum capital requirements were raised.

Throughout the 1980s, the financial sector suffered from the lingering effects of the 1982–83 crisis. The crisis had severely affected the health of the financial system,10 and led to a contraction of almost 55 percent in real terms of banks’ credit to the private sector between 1982 and 1986. In turn, the central bank provided significant levels of financial assistance to troubled banks. Also, weak financial and nonfinancial institutions were taken over by the government-owned banks, while the Philippine National Bank and the Development Bank of the Philippines were rehabilitated and restructured, in part by transferring their nonperforming assets to an agency created especially for this purpose.

Starting in the early 1990s, the authorities intensified the reform effort. A centerpiece of this effort was the restructuring and recapitalization in 1993 of the central bank, which had become technically insolvent following the crisis of the 1980s. The new central bank (the Bangko Sentral ng Pilipinas) also was granted independence from other branches of government. In addition, the authorities eased restrictions on the entry and operation of banks to increase competition and strengthen the banking system. In 1995, 10 new foreign banks were licensed to operate in the country (in addition to the four already operating) and foreign banks were authorized to purchase up to 60 percent of the equity of local banks; and the bank branching policies were liberalized. The authorities also lightened prudential regulations, including through higher minimum capital requirements and a liquid asset requirement on foreign currency deposit unit loans. Finally, several measures were adopted to reinforce the legal framework, including in the areas of banks* derivatives trading, thrift banks, and rural banks.

1998–99 Reform Program

Banking sector reforms were strengthened to face the problems arising from the regional crisis that broke out in 1997. The authorities in early 1998 adopted a comprehensive banking sector reform program aimed at strengthening banks’ capacity to withstand shocks and enhancing the authorities’ ability to deal with banks in financial difficulties. The strategy, developed in collaboration with the IMF and the World Bank,11 envisaged a decentralized private-sector led improvement of bank balance sheets and risk management practices, encouraged by a tightening of prudential and supervisory standards and development of a more transparent bank exit and resolution strategy. A separate (government-led) plan was designed to deal with the Philippine National Bank (the largest bank in distress, with 46 percent government ownership).

Bank Supervision and Regulation

Despite significant improvements in the supervisory framework prior to the onset of the Asian crisis, serious weaknesses undermined the effectiveness of bank supervision. The main issues related to the prudential standards in place, supervisory skills and practices, and enforcement of the bank regulatory and supervisory framework. In particular:

  • Even if average bank capital levels remained adequate, capital adequacy ratios had been declining since 1992. At the same time, average capital adequacy levels disguised the presence of individual institutions—especially smaller ones—which suffered from low capital levels.

  • Loan classification and provisionary standards deviated from best supervisory practice in several respects. In particular, collateralized substandard loans were not being provisioned for, and banks were not required to make general loan loss provisions.

  • The supervisory and risk assessment methodologies used by the Bangko Sentral ng Pilipinas were not in full agreement with best international practice.

  • Additional shortcomings were present in other areas of supervisory responsibility, including disclosure of information, bank licensing, and bank accounting practices.

To address the weaknesses in the regulatory and supervisory framework, the authorities took measures to strengthen the position of the banks as well as the ability of the Bangko Sentral ng Pilipinas to supervise them, along the lines of best international practice. The full implementation of these measures will be of key importance in ensuring the continued soundness of the banking system.

Minimum Capital and Loan Loss Provisioning Requirements

To strengthen the ability of banks to deal with adverse shocks, the authorities announced an ambitious plan to increase bank capital and enhance provisioning by banks against substandard loans.

  • An increase in minimum capital requirements for banks through end-2000, with intermediate levels for end-1998 and end-1999, was announced in March 1998.12 At the same time, the lower capital adequacy ratio of 8 percent (instead of the usual 10 percent) in place for certain universal banks was phased out in January 1999.13

  • New loan loss provisioning requirements, following the tightening of loan classification guidelines, were announced on October 1997.14 The new provisioning requirements are generally in line with best international practice and those in place in other Asian countries. Banks are now required to make a general loan loss provision (gradually rising to 2 percent by October 1999)15 as well as specific loan loss provisions for “especially mentioned” and collateralized substandard loans.

Supervision Methodologies

Fundamental changes have been initiated in the focus and methodology of bank supervision to enhance the capacity to assess the health of individual banks and to detect cases of bank distress early on.

  • The Bangko Sentral ng Pilipinas is changing the focus of supervision from a purely compliance-based and check list-driven process to a forward-looking and risk-based framework. This change has been well received by banks. The examination process is being reoriented to assess the various elements of risk, and the systems used by banks to manage those risks (including liquidity, interest rate, and foreign exchange risks, as well as risks arising from off-balance-sheet activities).

  • Improvements have also been made in bank rating methodologies. The CAMEL rating system 16 has been revised to ensure that the composite rating will never be better than a bank’s individual factor rating for capital adequacy.17 In addition, as of July 1998, “sensitivity to market risk” has been added to the traditional CAMEL rating system. Also, the composite rating system 18 will be based on the weighted sum of the component ratings, with weights depending on the size, complexity of activities, and risk profile of the institution being rated. Examiners are also starting to use qualitative analysis to determine the component ratings.19 Finally, a revised examination format has been introduced,20 to replace the detailed examination report in use until recently.

  • The authorities have initiated action to undertake consolidated supervision of financial conglomerates. An amendment of the Genera) Banking Act has been submitted to Congress that would impose consolidated capital requirements and extend consolidated supervision of financial institutions to include their interests in nonfinancial ventures. As a preliminary step, the Bangko Sentral ng Pilipinas is conducting consolidated supervision of banks and quasi banks based on the inclusion of their financial subsidiaries and affiliates.21 The authorities have also started to compile a list of the laws and regulations that would need to be modified to fully implement consolidated supervision.

  • External auditors have been required to report to the Bangko Sentral ng Pilipinas all matters that could adversely affect the financial condition of a bank. In this regard, the authorities will begin a system of accreditation of external auditing firms that banks are authorized to hire for the examination of their balance sheets. If an auditing firm fails to properly inform the Bangko Sentral ng Pilipinas on the problems of a bank, it would be “blacklisted” by the Monetary Board (for a period during which banks would not be permitted to engage its services).

Other Supervisory Issues

Several other initiatives have been taken to strengthen the soundness of the banking system and the Bangko Sentral ng Pilipinas’ ability to monitor it.

  • To enhance transparency and market discipline, banks listed by the Philippine Stock Exchange are now required to disclose publicly, on a quarterly basis, the level of nonperforming loans, the ratio of nonperforming loans to the total loan portfolio, the amount of classified assets and other risk assets, and the extent of specific and general loan loss reserves.22

  • Stricter licensing guidelines for new banks have been in place since July 1998 23. Also, the Bangko Sentral ng Pilipinas has announced that it will impose higher profitability guidelines on thrift banks and rural banks wishing to set up additional branches.

  • To improve banks’ accounting practices, the Bangko Sentral ng Pilipinas has required them to mark to market their trading securities portfolio.24

Bank Exit and Resolution

Traditionally, there have been several impediments to a smooth process of bank exit in the Philippines. Bank supervisors have been hampered by the lack of immunity for actions related to the discharge of their responsibilities and by bank secrecy regulations. The Monetary Board typically has not been subjected to specific time limitations governing the different steps that it must take before placing a bank under receivership. Also, the Bangko Sentral ng Pilipinas could suffer financial losses if a decision is taken to close a bank,25 Finally, the Philippine Deposit Insurance Corporation has been constrained in its role as receiver (because it cannot dispose of the assets of a bank under receivership as soon as it is closed), in its role as insurer (because the secrecy law prevents it from accessing vital deposit information before a bank is closed), and in its role as liquidator (because it cannot proceed rapidly and on a timely basis mainly because of the inefficiency of the judicial system).

Recent Measures to Enhance Bank Resolution

A number of measures have been adopted to enhance the Bangko Sentral ng Pilipinas’ ability to deal with troubled banks. As a result, the Bangko Sentral ng Pilipinas is now better prepared to identify early on cases of bank distress, and have better instruments to deal with banks that develop problems. Also, steps have been taken to enhance the role of the Philippine Deposit Insurance Corporation as receiver, and to reduce the financial risk for the Bangko Sentral ng Pilipinas associated with bank closures.

  • To permit early detection of problems, the Bangko Sentral ng Pilipinas has compiled a list of banks in potential distress.26 On the basis of this list, which is updated regularly, the Bangko Sentral ng Pilipinas has adopted a program of intensified monitoring and special examinations of selected batiks. The Monetary Board has allowed the supervision services of the Bangko Sentral ng Pilipinas to conduct such special examinations without the need for specific previous authorization.27

  • The Bangko Sentral ng Pilipinas has issued a matrix of sanctions and a matrix of corrective actions to be taken according to the degree of capital shortfall of individual banks.28 Also, the Bangko Sentral ng Pilipinas has issued harsher nonmonetary penalties to deal with banks that are in violation of supervisory rules, and has submitted draft legislation to allow for a 10-fold increase in the current value of monetary penalties. The Bangko Sentral ng Pilipinas has formulated contingency plans to deal with any systemic bank problems, in cooperation with the Philippine Deposit Insurance Corporation and the Department of Finance.

  • To improve the ability of the Philippine Deposit Insurance Corporation to act as the receiver of banks, it has been determined that once the Philippine Deposit Insurance Corporation recommends that a bank be liquidated, the Monetary Board will approve the liquidation within 10 days. Also, the authorities are proposing legislation that would allow it to sell distressed bank assets to pay for the administration costs related to receivership.

  • The Monetary Board has approved additional guidelines for emergency loans to banks. These guidelines—which restrict the activities of the bank concerned, halt the distribution of dividends, and impose certain obligations on the banks’ owners and officers—reaffirm the fully collateralized nature of emergency loans, and represent an important step forward in insulating the Bangko Sentral ng Pilipinas from the risk of financial loss. The Bangko Sentral ng Pilipinas is also aware of the risk of financial loss arising from undo I lateralized overdrafts to banks, and has submitted a proposal to amend the Bangko Sentral ng Pilipinas Act to eliminate this practice. In the meantime, the Bangko Sentral ng Pilipinas has issued regulations to require thrift banks to provide collateral against all Bangko Sentral ng Pilipinas overdrafts,29 and intends to issue similar regulations for commercial banks.

Philippine National Bank

Strengthening the Philippine National Bank on a sustainable basis is an important part of the authorities’ banking reform program. The Philippine National Bank, the second largest bank in the country and partially owned by the government, suffered to a greater degree than other banks from the fallout of the regional crisis (see Box 6.4). The authorities have announced publicly their intention to privatize the bank by mid-2000, at the latest. In the meantime, the Philippine National Bank has moved to write down its capital from £22 billion to £15 billion to reflect the impairment of its assets, while at the same time instituting additional loan loss provisions and phasing out obsolete information systems. The Philippine National Bank management intends to recapitalize the bank through the sale of undervalued assets, and possibly a rights issue to existing owners during 1999.

Initial Results and Agenda for Further Reform

Implementation of the banking reform program adopted in early 1998 has been largely on track, and initial results are positive. Banks are seeking market-based solutions to capital deficiencies (including fresh capital infusions and merges), and loan loss provisions have been strengthened significantly. Corrective supervisory action, supported by appropriate sanctions, has encouraged the pace of resolution. These measures included memoranda of understandings with noncompliant banks (regarding minimum capital requirements), supervision of certain banking activities, downgrading of licenses, and closure of banks. As a result, while the financial condition of banks had deteriorated over the past year, the situation is under control.

Looking ahead, to further strengthen the soundness of the system and reinforce supervisory capabilities, continued reforms should focus on (1) reducing distortions in financial intermediation; (2) further strengthening the prudential framework; (3) streamlining the process of bank exit and resolution; and (4) the Philippine National Bank.

Reducing Distortions in Financial Intermediation

Although important steps to improve the efficiency of financial intermediation have been taken, further progress is needed. In particular, the authorities should:

  • Eliminate the bias in the tax system and in the regulatory framework against financial intermediation in pesos.30 This would help reduce vulnerability to exchange rate volatility and lower costs of peso intermediation.

  • Reduce and avoid frequent changes in reserve requirements. Since reserve requirements are mostly nonremunerated, they impose a tax on financial intermediation. In addition, their frequent modification imposes a cost for banks as they adapt their balance sheets, and could result in banks’ permanently holding excess reserves.31

  • Eliminate mandatory credit allocation programs to avoid misallocation of resources.32 Currently, banks are required to lend 25 percent of their credit to agriculture and agroprocessing industries and 10 percent to small and medium-sized enterprises.

  • Allow further foreign participation in the banking sector, Additional top-rated international banks should be allowed to open branches in the Philippines, and existing limits to the expansion of such branches should be liberalized (including limits on foreign ownership of local banks, the number of branches that foreign banks can open, and restrictions on financing from abroad for foreign banks).

Strengthening the Prudential Framework

The Bangko Sentral ng Pilipinas should continue to implement the strengthened prudential framework rigorously. In particular, it should:

  • Enforce full and prompt compliance with minimum capital and loan provisioning requirements. Noncompliant banks should be subject to the procedures for prompt corrective action approved by the Monetary Board.

  • Prudential forbearance and pressures to dilute the new standards for loan provisioning, classification standards, and disclosure requirements should be resisted. The 2-percent general provision requirement, and the recent exemption of incremental loans, should be reviewed at an early date.

  • Specific loans loss provisions should be made tax deductible, and in accordance with best international practice.33

Box 6.4.The Philippine National Bank

The Philippine National Bank, established in 1916, has more than 320 branches and accounts for about 10 percent of the banking sector’s assets. It is the country’s largest bank in terms of liabilities and the second largest in terms of assets. It lags behind industry leaders in a number of areas, however, including credit and risk management policies and the degree of automation of its operations. In June 1996, the government reduced its ownership in the Philippine National Bank from 100 percent to 45.6 percent. The stock in private hands is widely dispersed.

The Philippine National Bank’s financial performance has deteriorated significantly in the past few years, following a series of large corporate loan defaults (including Philippine Airlines). Return on assets remains the lowest among the large banks in the country. The difficulties of the Philippine National Bank were exacerbated by the onset of the 1997 regional financial crisis and the accompanying devaluation of the peso and economic downturn. The Philippine National Bank was particularly vulnerable because it had lent aggressively in foreign currency; at about 35 percent of total loans, it had the highest proportion of credit in foreign currency among the large banks. Also, the bank is highly exposed to the property sector (14 percent of its loan portfolio). After a drop in net income of 75 percent in 1997, compared with an average increase of 10 percent in the net income of the four other largest banks in the Philippines, financial results in 1998 continued to worsen.

In early 1999, provisions of £8.9 billion (about 7 percent of the loan book) were constituted retroactively for 1998; obsolete information systems were written off; the cost of unfunded pensions and retrenchment packages were explicitly allowed for; and capital was written down from £22 billion to about £15 billion, reducing the capital adequacy ratio to about one-half the required 10 percent. Management of the bank has indicated its intention to remedy the capital shortfall through the sale of undervalued assets (including its headquarters building) and a rights issue.

Banks’ Vulnerability to Exchange Rate Volatility

Continued strengthening of prudential standards will be critical to the management of cross-border flows and associated risk. Banks are subject to caps on their overbought and oversold foreign exchange positions and to cover requirements for their foreign currency liabilities. In addition, banks should maintain adequate assets to cover for all foreign currency liabilities, as well as appropriate control and reporting systems regarding their foreign exchange exposure. Banks should be asked regularly to submit detailed information on their foreign exchange transactions, including positions by currency and maturity of the spot and forward books. At the same time, additional prudential requirements should be market-based and compatible with maintaining an open capital account.

Supervisory Resources and Training

Bangko Sentral ng Pilipinas supervisory resources should be focused on supervision of large banks. Although expanded commercial banks make up more than two-thirds of the banking system’s assets, only about one-fourth of Bangko Sentral ng Pilipinas supervisory staff is involved in their supervision (while more than one-third is dedicated to supervising rural banks—which account for 2 percent of total assets). Of course, the necessary focus of resources on larger potential problem banks needs to be balanced against the need to enforce prompt corrective action vis-à-vis all noncompliant banks.

To ensure the successful implementation of modern supervisory methodologies, Bangko Sentral ng Pilipinas and the Philippine Deposit Insurance Corporation supervisory staff should continue to receive intensive training in the area of risk-based supervision, including assessment of risk, appraisal of banks’ risk management, and forward-looking assessment of banks.

Legal Protection for Bank Supervisors

It would be desirable to clarify the protection for bank supervisors by way of clear and explicit legal statute. Although in principle no public officer in the Philippines is civilly liable for official acts, unless there is a clear showing of bad faith, malice, or gross negligence,34 the courts have allowed civil lawsuits to be brought against individual bank supervisors in connection with such acts.

Bank Secrecy

Current legislation on bank secrecy should be modified to bring bank supervisors within the perimeter of the law. The present situation is at variance with best international practice; it prohibits banks from releasing any information on their deposit accounts, except when the depositor authorizes it or under a court order. As a result, the supervisory authorities do not have detailed information on the banks’ primary funding source. The law also impedes speedy resolution of bank failures as the Philippine Deposit Insurance Corporation has no information on individual depositors prior to closure of the bank.

Banks’ Trust Activities

The Bangko Sentral ng Pilipinas should clarify the relationship between trust accounts and the bank, including regulations on conflict of interest. There is a widespread perception among bank clients that a bank’s trust activities are fully guaranteed by the parent bank.

Streamlining the Process of Bank Exit and Resolution

The framework for bank resolution must be strengthened further.

  • As soon as a bank is placed under receivership, the Philippine Deposit Insurance Corporation should be able to resolve it as soon as possible to avoid a further deterioration in the value of the bank’s portfolio. In particular, the Philippine Deposit Insurance Corporation should be authorized to swiftly carve out bad assets from a bank under receivership to improve the chances for a quick sale to a new owner.

  • To enhance transparency, just as Philippine Deposit Insurance Corporation receivership is subject to time limits (up to 90 days),35 it would be useful also to set time limits for the Monetary Board’s actions in the area of bank resolution.

  • Banks should not be allowed unilaterally to declare “bank holidays” (suspension of operations) without full intervention by the supervisory authorities. In line with best international practice, any bank that declares a bank holiday should be immediately placed under receivership or conservatorship.36

  • To limit the risk for the Bangko Sentral ng Pilipinas arising from financial assistance to troubled banks, all forward emergency assistance should be fully collateralized, and the limit on emergency loans related to the size of a bank’s capital rather than deposits.37

References

    AlexanderWilliam E.Tomás J. T.Baliño and CharlesEnoch1995The Adoption of Indirect Instruments of Monetary PolicyIMF Occasional Paper 126 (Washington: International Monetary Fund).

    EscolanoJulio1997“Tax Treatment of Loan Losses of Banks,”in Banking Soundness and Monetary Policyed. byCharlesEnoch and John H.Green (Washington: International Monetary Fund).

    FryMaxwell J.1988Money Interest and Banking in Economic Development (Baltimore: The Johns Hopkins University Press).

    HardyDaniel C.1997“Reserve Requirements and Monetary Management: An Introduction,”in Instruments of Monetary Management: Issues and Country Experiencesed. byTomás J. T.Baliño and Lorena M.Zamalloa (Washington: International Monetary Fund).

    LirioRicardo P.1998“The Central Bank and Non-Bank Financial Intermediaries,”in Philippine Financial Almanac 1997/98 (Manila).

    NascimentoJean-Claude1991 “Crisis in the Financial Sector and the Authorities’ Reaction: The Philippines,”in Banking Crises: Cases and Issuesed. byV.Sundararajan and Tomás J. T.Baliño (Washington: International Monetary Fund).

    NellorDavid C. L.1998“Tax Policy and the Asian Crisis” (Washington: International Monetary Fund).

    TanEdita A.1993 “Interlocking Directorates of Commercial Banks, Other Financial Institutions and Bon-Financial Corporations,in Philippine Review of Economics and Business Vol. 30 No. 1 (Manila: June).

    World Bank1998Banking Sector Reform Loan (Washington: World Bank).

    World Bank1998Country Economic Memorandum (Washington: World Bank).

Excluding one small commercial bank—Orienl Bank—now under receivership and not operating.

See Nellor (1998). After u long period in which interest income from foreign currency operations was fully tax exempt, it is now subject only to a 7.5 percent withholding tax (compared with 20 percent in the case of peso deposits). At the same time, profits from the bank’s foreign currency deposit units operations are taxed at a 10 percent preferential rate on gross income, compared to the standard tax rate of 35 percent on net profit from other operations. Also, domestic banking activity is subject to the gross receipts and documentary stamp taxes, while transactions in foreign currency with nonresidents and with oilier foreign currency deposit units are exempt. Finally, while peso deposits are subject to significant reserve requirements, largely unremunerated, foreign currency deposits are not subject to reserve requirements.

The number of branches that foreign banks are authorized to open cannot exceed six, while their borrowing from head offices cannot exceed $4 for every $1 of domestically held capital.

Real estate loans, lending to small businesses, and consumer loans Figure more prominently in the portfolio of these banks, compared with bigger banks, which lend to have a more diversified portfolio.

Since the start of the current difficulties in the financial sector in 1998, one small commercial bank, six thrift banks, and 33 rural banks were closed: the combined size of These banks’ assets, however, is small and thus their problems have not had any systemic implications.

Property demand in the Philippines was flat during 1989-94, which in turn prevented a boom and subsequent oversupply of real estate projects (the office vacancy rate in Manila by early 1997 was about 2 percent, compared with about 12 percent in Jakarta and Bangkok), At the same time, the prevalence of presold projects helped limit large-scale reliance on bank finance for real estate purposes. In addition, the Bangko Sentral ng Pilipinas in 1997 took measures to limit bank lending for real estate projects.

For capital adequacy, the Bangko Sentral ng Pilipinas has adopted a net worth-to-risk asset ratio, which measures capital in relation to the degree of risk of different categories of assets. The risk weighting methodology includes two weights: zero for highly liquid assets and 100 percent for the remainder of the balance sheet items, that is, fixed assets, loans, and investments.

The ratio increased Further to 13.1 percent in March 1999.

Banking sector reform is a major component of the program supported by the current Stand-By Arrangement with the IMF: and the World Bank in December 1998 approved a Banking Sector Reform Loan.

Circular 156 of March 19, 1998, Bangko Sentral ng Pilipinas. Office of the Governor.

Circular 168 of July 3, 1998, Bangko Sentral ng Pilipinas, Office of the Governor.

Monthly installment loans are now to be considered nonperforming after three months in arrears rather than six. whereas quarterly installment loans are to be treated as nonperforming after one quarter in arrears rather than two,

In April 1999, as a measure to encourage new lending by banks, the stock of loans above the end-March 1999 level was exempted from the general loan loss provision.

“CAMEL” stands for Capital, Assets, Management, Earnings, and Liquidity.

Supervision and Examination Sector Order 3, of March 6, 1998.

The rating system is now called CAMELS.

Supervision Guidelines No. 98-7, of May 22, 1998.

Supervision and Examination Sector Order No, 10 of November 28, 1997.

Monetary Board Decision 553 of April 15, 1998, Bangko Sentral ng Pilipinas.

Circular 157 of March 19, 1998.

Monetary Board Resolution 832 of June 10, 1998, Bangko Sentral ng Pilipinas.

Circular 161 of March 30, 1998.

Such losses may arise from three sources: uncollateralized overdraft lending to a troubled bank: inability by the Bangko Sentral ng Pilipinas to execute the collateral backing emergency loans to banks—in part owing to valuation problems; and the fact that, in the event of insufficient resources, the Philippine Deposit. Insurance Corporation has unlimited access to Bangko Sentral ng Pilipinas credit.

The list is compiled on the basis of forward as well as backward-looking indicators.

In principle, no bank can be inspected more than once a year without authorization of the Monetary Board. However, the Monetary Board has granted a blanket authorization to conduct bank inspections on a rolling six-month basis. An amendment to the Bangko Sentral ng Pilipinas Act has been proposed to make this authorization permanent.

Circular 176 of September 7, 1998, and Circular 181 of November 15, 1998.

Circular 163 of April 8, 1998, and Implementing Guidelines of September 3, 1998.

See Hardy (1997) for a discussion of the drawbacks of reserve requirements as an instrument of monetary control.

See Alexander, Balino, and Enoch (1995) for an analysis of the adverse effects of directed credit and other direct instruments of monetary policy.

See Escolano (1997) for an analysis of the tax treatment of loan losses and loan reserves of banks.

Executive Order No. 292, July 1987.

Extendable live times by an additional 30 days each, through Monetary Board Resolution.

The Bangko Sentral ng Pilipinas can use two institutional arrangements to oversee operations of banks in trouble that have not yet been closed. A comptroller is named automatically when a bank is granted an emergency loan. The powers of the Comptroller are limited, however, involving only reports to the Monetary Board but without authority to override the decisions of the bank’s board. Conservatorship is a more powerful arrangement, as the conservator has the authority to override the decisions of the bank’s board and management.

Currently, emergency loans are capped al 50 percent of deposits. There is a strong element of moral hazard because a bank in distress has an incentive to increase its deposits by any means possible—and thus further complicate its difficulties—before approaching the Bangko Sentral ng Pilipinas for an emergency loan.

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