Between 1981 and the middle of 1987, the Philippine economy faced a major crisis in the financial sector. Three commercial banks, 128 rural banks, and 32 thrift institutions failed, and 2 other private banks were under intervention. In addition, the biggest commercial bank, the Philippines National Bank, and the Development Bank of the Philippines, both government owned, became de facto insolvent and, in 1986, were bailed out by a transfer of their nonperforming assets (about ₱ 108 billion, equivalent to 80 percent of their combined assets) to the Asset Privatization Trust (APT), specially constituted to administer problem assets. The crisis began on a limited scale during 1980 and 1981 and intensified thereafter, culminating by the end of September 1986 in a significant contraction of the financial system (excluding the Central Bank of the Philippines—CBP). For the purpose of analysis, three distinct phases of the crisis have been identified.

Between 1981 and the middle of 1987, the Philippine economy faced a major crisis in the financial sector. Three commercial banks, 128 rural banks, and 32 thrift institutions failed, and 2 other private banks were under intervention. In addition, the biggest commercial bank, the Philippines National Bank, and the Development Bank of the Philippines, both government owned, became de facto insolvent and, in 1986, were bailed out by a transfer of their nonperforming assets (about ₱ 108 billion, equivalent to 80 percent of their combined assets) to the Asset Privatization Trust (APT), specially constituted to administer problem assets. The crisis began on a limited scale during 1980 and 1981 and intensified thereafter, culminating by the end of September 1986 in a significant contraction of the financial system (excluding the Central Bank of the Philippines—CBP). For the purpose of analysis, three distinct phases of the crisis have been identified.

The first phase, which spanned all of 1981, featured a crisis of confidence triggered by fraud in the commercial paper market.1 Although the crisis initially affected only a small part of the system outside the commercial and development banks, whose combined assets accounted for 16.5 percent of total assets of the financial system in 1980, the crisis had a lasting impact on confidence. The commercial paper market collapsed and many nonbank money market institutions went out of business. The two largest investment houses belonging to two major holding companies went bankrupt, provoking the failure of the holding companies themselves and leading to the bankruptcy or takeover of their numerous corporate subsidiaries. Wealth holders shifted funds to the highest-quality paper and to more stable and conservative banks.

The loss of confidence spread to the thrift banking system. Also, failures of rural banks, which had sharply increased in 1980, continued to rise in 1981. However, the assets of failed rural and thrift banks accounted for only 1.6 percent of the total assets of the banking system in 1981, and the failures among them did not pose a threat to stability but served to weaken confidence further.

In the second phase, which spanned 1982(I)—1983(III), the Government intensified its assistance to nonfinancial and financial institutions, which served to alleviate the growing distress among nonfinancial corporations but widened the budget deficit. The Government increased its emergency lending and equity contributions to public corporations, arranged for the takeover of troubled private banks by government financial institutions2 in order to facilitate their restructuring and eventual disposition, and supported the takeover by the government financial institutions of numerous nonfinancial firms in distress. The Government was attempting to prevent widespread private corporate failures and banking problems, while stepping up public investment to offset the slump in private sector investment. During this phase, political uncertainty became widespread and foreign exchange difficulties grew, although the problem was initially masked by swap and forward cover operations by the CBP as well as by irregular banking operations.3

When the third phase, which spanned 1983(IV)-1986(IV), began, there was widespread uncertainty in the economy, stemming from the unstable political environment of the first half of 1983 and the balance of payments crisis of October 1983. The effects spilled over to the banking system. Indeed, in October 1983, the authorities’ announcement of a moratorium on external debt payments to foreign commercial banks provoked financial panic; a series of runs on the banks ensued, and this time commercial banks were included. Large-scale flight to currency and outflows of capital occurred. The capital outflows that were recorded during this period may have occurred even earlier and been obscured by the banking irregularities. The disclosure or sudden loss of reserves in mid-October undermined confidence and exacerbated the crisis.

By the end of this phase the hardest hit financial institutions were the two largest government-owned banks—the DBP and the PNB. The depth of the crisis during this phase is illustrated by three events:

  • A staggering decline in commercial bank credit to the private sector, which fell by 53 percent in real terms between the end of September 1983 and the end of September 1986.

  • A massive restructuring of the DBP and the PNB, which led in November 1986 to a transfer of ₱ 108 billion of nonperforming assets (representing nearly 30 percent of total bank assets) to a government agency—the APT.4 Included in the transfer were ₱ 23.4 billion of nonperforming assets from the PNB, which contributed to a decline of 20.5 percent, in real terms, in commercial bank credit to the private sector during the last quarter of 1986.

  • Continued government intervention in weak private banks and the closing of three private commercial banks.5

Against this background, this chapter examines the causes and manifestations of the crisis in the Philippine financial sector and the reaction of the authorities to that crisis. Attention here is on the behavior of the financial system before and during the crisis; the aim is to clarify the linkages among financial reform, financial crisis, and macroeconomic performance.

The main conclusion of the chapter is that factors within the financial system caused and exacerbated the crisis. Although the political and economic climate of the late 1970s and early 1980s increased the fragility of the financial sector, weaknesses of the regulatory framework and loose banking practices triggered and exacerbated the crisis. In the end, the interventions by the authorities prevented the banking sector from collapsing, but at a high financial cost to taxpayers.

Section I discusses the background to the crisis and the role of the macroeconomic and regulatory environment. Section II discusses the manifestations of the crisis, with emphasis on money and credit developments. Section III describes the measures taken to deal with the crisis. Section IV highlights the main findings.

I. Setting of the Crisis

Three factors within and outside the financial system are examined here in order to differentiate their effects on the crisis: (1) the macroeconomic setting and political climate before and during the crisis; (2) the structure of the financial sector and its liberalization initiated in 1972 and completed in 1981; and (3) prudential regulation and supervision of financial institutions and related institutional practices.

Macroeconomic Setting

During the 1970s the economy experienced strong growth in real GNP, despite the low productivity of investment (see Table 1 and Chart 1). The unprecedented, demand-driven economic boom reflected the authorities’ development strategy based on intensive investment growth.6 The financing of the investment boom resulted in a widening of external imbalances and a sharp rise in foreign savings (in percent of nominal GNP) (Table 1). Also, the growth of domestic bank credit accelerated, particularly to the private sector (see Table 2). PNB and DBP accounted for a substantial portion of credit to the private sector, which often was granted on the basis of political, rather than economic, considerations.

During the late 1970s and early 1980s, a deterioration in world economic conditions further weakened the external position, while the limited crisis of confidence in 1981 seemed to dampen investors’ expectations regarding growth projections; these developments affected private investments adversely in the 1980s.7 By the second half of 1983, the effects of rapid expansion in earlier years, the growing uncertainty in the political climate, and unfavorable external conditions combined to cause a balance of payments crisis, which led to the announcement of a temporary moratorium on external debt repayments in October. This event triggered a run on banks, a cut-off of external financing, and some capital flight, all of which had significant feedback effects on the macroeconomy, particularly the balance of payments. In late 1983, CBP reacted by injecting reserve money to meet the increase in currency demand (see Table 2). The sharp increase in reserve money during 1983 also reflected large losses on swap operations.8 As a result, inflation and depreciation of the peso accelerated during 1983/84.

Chart 1.
Chart 1.

Selected Macroeconomic Indicators, 1970–86

(In percent)

Note: Shaded areas indicate crisis periods.Sources: International Monetary Fund, International Financial Statistics, 1988; and Table 1.
Table 1.

Selected Macroeconomic Indicators, Selected Years, 1970–86

(In percent)

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Sources: International Monetary Fund, International Financial Statistics, 1986, and IMF staff estimates.

Figures for 1970-80 are official data from the National Economic and Development Authority (NEDA); because these data are overstated, they are not comparable with the 1981–86 series, which represent IMF staff estimates.

Includes losses of government financial institutions 1 PNB, DBP, and CBP).

As measured by the consumer price index in Manila.

Before rescheduling.


Table 2.

Monetary Conditions, Selected Years, 1970–86

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Sources: International Monetary Fund, International Financial Statistics, 1967; and data provided by the authorities.

Starting in 1977, the authorities adopted a new classification system.

Starting in 1981, the figures include treasury bills and central bank certificates of indebtedness (CBCIs) held outside the banking sytem Thus, between 1970 and 1980, liquidity is equal to M3, which includes demand, savings, and time deposits collected by the banking system.

Between 1970 and 1980, excess reserves were calculated by multiplying the required reserve ratio by the deposit base and subtracting the result from bank reserves. Afterward, data are from IMF country reports.

End of November.

After transfer of ₱ 23 billion of nonperforming loans from the PNB to the Government.

Calculated by subtracting the inflation rate as measured by the consumer price index in Manila.

The subsequent tightening of monetary policy, the soaring interest rates during 1984/85, and the continued devaluations of the peso all contributed to the spread of distress among financial and nonfinancial corporations. Indeed, the high real interest rate and the peso devaluation aggravated the debt-servicing problems of firms with foreign currency debt.9

With very high interest rates, growing uncertainty, and weakening of confidence, aggregate demand dropped, leading to a deep recession. Bank credit, especially to the private sector, fell sharply in real terms.

Structure of Financial Sector and Its Liberalization

To finance the development strategy based on intensive investment growth, CBP introduced numerous reforms between 1972 and 1981. Institutional reforms included the liberalization of controls on foreign capital. Regulatory reforms included the progressive liberalization of interest rates and the introduction of “universal banks.”10 Prudential reforms included the elimination of restrictions on the entry of foreign banks and on their equity participation in domestic banks, and higher barriers to entry for domestic banks (e.g., higher minimum capital requirements).

Liberalization of Controls on Foreign Capital

Evidence shows that the liberalization of controls on foreign capital, together with lending practices largely influenced by political considerations, increased the financial fragility of nongovernment entities. In the subsections that follow, the specific policy measures are presented and their impact on the external debt burden and the financial structure of nongovernment entities is discussed.

Measures. During the 1970s, CBP introduced the foreign currency deposit (FCD) system, created offshore banking units, and eased controls on direct foreign investment. These measures were aimed at attracting foreign capital and permitting wider portfolio selection for domestic investors.

Under the foreign currency deposit system, resident and nonresident nationals could hold foreign currency deposits with eligible banks.11 In turn, CBP allowed foreign currency deposit banks to make foreign currency loans to domestic residents subject to prior CBP approval, or peso loans after these banks had converted their foreign currency into pesos under a swap arrangement with CBP.12 Secrecy laws protected investors’ deposits. Depositors were also free to withdraw their funds or transfer them abroad. Interest rates on these foreign currency deposits were unregulated. Beginning in 1978, these banks’ foreign exchange operations were subject to open position limits.13

Under the offshore banking unit system, both domestic banks and nonresidents were allowed to hold foreign currency deposits with offshore banking units. Banks’ lending operations required prior CBP approval. In addition, banks were not allowed to make loans with a maturity exceeding 360 days.14

The relaxation of foreign capital controls included the following measures:

  • (1)Foreign direct cash investment made after 1973 became freely repatriable;

  • (2)Foreign-owned companies were granted authorization to raise loans in domestic currency;

  • (3)Foreign banks were allowed to take equity participation, with minority or majority ownership, in domestic banks. Although significant capital controls remained, the removal or relaxation of restrictions stimulated capital inflows.

Overindebtedness and Unsound Debt Structure. As a result of these developments and of the foreign financing of the investment boom, the external debt burden rose sharply while the maturity of this debt shortened (see Table 1). These developments disputed the contention that liberalization of capital controls would reduce foreign borrowing.15 Rather, these developments suggested that liberalization of the foreign capital flow contributed to excessive external borrowing, which permitted domestic investment to accelerate before the crisis.16

Incomplete financial reforms, combined with the political climate, encouraged such borrowing. Indeed, the authorities eased capital controls while maintaining controls in other areas, such as credit allocation and trade transactions.17 Excessive foreign borrowing and domestic protection contributed to weakening the financial position of nongovernment entities.

As large foreign capital inflows exerted strong inflationary pressures during the second half of the decade, real lending rates became negative by 1980 (see Table 2). Along with high trade barriers, these negative rates created widespread misallocation of resources and encouraged debt finance. Indeed, during the 1970s enterprises and banks had relied heavily on debt finance, especially foreign, to expand their activities.18 Consequently, the total outstanding debt of the nongovernment sector (both in real terms and in percent of national income) doubled between 1972 and 1980; the share of this debt denominated in foreign currency quadrupled to 40 percent in 1980 (see Table 3). For enterprises, the changes in the level and structure of indebtedness were even more dramatic. As a result of these changes, the quality of banks’ portfolios (especially of the DBP and PNB) and the soundness of their liability structure had deteriorated by 1980.

Until 1983, the rise in the debt burden and the weakening of the liability structure of nongovernment entities accelerated, reflecting the end of the economic boom and deterioration in the political and economic climate during that period. Thereafter, a massive liquidation of debt took place, as domestic and foreign creditors curtailed sharply the supply of funds (see Tables 1 and 3).

Interest Rate Liberalization

The statistical analysis in the subsections that follow suggests that despite a fairly open capital account, domestic monetary conditions played a significant role in explaining the behavior of interest rates after the liberalization. Between 1984 and 1986 these conditions, reflected in indicators of excess demand for real money (M3),19 were influenced largely by the uncertain environment and by CBP policy efforts to bring down inflation. The main reforms are presented first and the behavior of interest rates following the reforms is discussed.

Table 3.

Indicators of Indebtedness of Nongovernment Sectors

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Sources: Central Bank of the Philippines, Statistical Bulletin, 1982 and 1983; and Philippines Financial Statistics, 1982—1985; and International Monetary Fund.

Domestic and foreign debt (converted into pesos at the peso/U.S. dollar rate at end of period) of the nongovernment sector composed of enterprises, commercial banks, and individuals.

Composed of private and public corporations, single proprietorships, partnerships and associations, and cooperatives. The overwhelming share of the debt belonged to corporations.

Excludes the peso loans that were re-lent by the Central Bank of the Philippines or a commercial bank. As the ultimate borrowers (i.e., enterprises) assumed the exchange rate risk, this debt was included in foreign debt contracted in U.S. dollars. These data also exclude: overdue loans, items in litigation, domestic and foreign bills, “clean.”

Calculated by netting out indirect taxes (net of subsidies) and income plus profit taxes from nominal GNP.

Reforms. During the 1970s CBP administered the level and structure of interest rates. It tried to maintain positive rates in real terms and to keep nominal interest rates aligned with foreign interest rates. In 1976 the usury law was abolished, and CBP introduced ceilings on money market rates applied to deposit substitutes.20

In 1981, CBP deregulated all bank rates except short-term lending rates. Ceilings on all deposit rates were lifted in July; those on medium- and long-term lending were lifted in October. The ceiling on short-term lending rates was eliminated at the end of 1982. Meanwhile, in March 1982, to enhance transparency in the credit and deposit markets, both a Prime Rate and a Manila Reference Rate (MRR) began to be compiled and announced.21

Determinants of Interest Rate Levels. Following the liberalization, nominal interest rates first rose gradually, then shot up between 1984 and 1985, before declining in 1986 (see Chart 2). Despite a fairly open capital account, foreign factors (e.g., foreign interest rates and expected exchange rate changes) were not the only determinants of nominal interest rates after the liberalization.

Indeed, the uncovered interest arbitrage relation explained only part of the interest rate fluctuation from 1981(I) to 1986(IV). Empirical equations for domestic interest rates (nominal) indicated that the estimated short and long-run coefficients of the foreign interest rate (adjusted for ex post devaluations) were 0.1 and 0.5, respectively (see Table 4).22 The estimated coefficient of the dummy variable was statistically insignificant—a fact that points to a stable interest arbitrage relationship before and after the announcement of the moratorium. To test the significance of domestic factors affecting nominal interest rates, a more general relationship was estimated by including a variable measuring monetary disequilibrium.23 The statistical significance of this variable (defined as the difference between actual M3 and the estimated value of the demand for money, both in real terms) was evidence of the strong presence of the “liquidity” effect on nominal interest rates (see Table 4).

This liquidity effect was governed by both the CBP’s policy stance and the banks’ behavior. In 1982 and 1983 expansionary policies created an excess supply of real balances, which, in turn, put downward pressure on interest rates (see Chart 2). Although the expansionary stance was maintained in the first half of 1984, a shortage of real balances subsequently emerged because of the sharp decline in the money multiplier, which put strong upward pressure on interest rates; the fall in the money multiplier resulted from banks’ cautious lending policies in the presence of widespread economic uncertainty. The upward pressure on interest rates persisted in 1985 and 1986, as the monetary policy stance became tight (see Section II below).

Determinants of Interest Rate Structure. The gross margin between lending and deposit rate fluctuated by an average of about 4 percentage points annually between 1980 and 1984, and rose sharply between 1985 and 1986 (see Table 5).24 But quarterly data show that this margin was often larger and that it fluctuated sharply, particularly for short-term rates (see Chart 3). The larger margin for short-term rates was caused by the inverted term structure of bank lending rates which reflected the increase of inflationary expectations.25 Indeed, bankers took a cautious stance, incorporating a risk premium for inflation in their lending rates (see Buhat (1986)).26 Also, the gross margin between the short-term lending rate and the short-term deposit rate measured by the 90-day MRR rose steadily until 1983(III); this rise reflected a decline in the MRR soon after its introduction (see Chart 3, Panel (A). Fry (1988) suggests that the initial decline in the MRR pointed to oligopolistic pricing, whereas Buhat (1987) interprets this decline as a move by banks to offset the increase in other elements of their costs of funds (e.g., the cost of the promotional campaign for deposits). Evidence supports the latter interpretation, especially in view of the low concentration ratio in the banking industry (described later) and of the evolution of the net interest margin.

Chart 2.
Chart 2.

Movements of Nominal Rates, 1982(I)–1986(IV)

(In percent per annum; period average)

Sources: Central Bank of the Philippines, CB Review, Vols. 38 and 39, 1986.1 London interbank offered rate.
Table 4.

Estimates of Selected Financial Relationships, 1981(II)—1986(IV)1

(Annual percentages)

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Source: IMF staff calculations.Notes: Table shows quarterly average data. Note also that: (i) Figures in parentheses represent the t-statistic whose critical value at 95 percent significance level is tc = 1.708 for 25 observations; and (ii) DW is the Durbin-Walson statistic.

Their specification posits a slow market-clearing process. Thus, the estimates reported are short-term coefficients with the coefficients of (Mt/Pt-1) and it-1, representing the adjustment lag coefficient in equations (1), (2), and (3), respectively.

The demand for real money (defined as M3) was assumed to depend positively on real GNP. and negatively on inflation (used as the opportunity cost variable capturing the substitution effect between money and goods). The adjustment process in the market for real money assumed that prices adjust to monetary imbalance with a lime lag; this process is decribed by the following equation:


The estimated equation was specified in semilog linear form. The reduced-form equation of this demand for money was tested, using an Orcutt-Cochrane procedure. The dummy variable taking a value of one before the announcement of the moratorium and zero thereafter was included to test the presence of a structural shift between these two periods.

A constant was added to this regulation to assess the presence of persistent deviation between domestic and foreign rates. Following a liberalization of foreign capital flows, the constant is expected not to be significant, while the long-run coefficient of (i* + e) would be close to one. Because of an adjustment lag, the short-term coefficient could be much lower than one within the period.

In essence, this equation tests the presence of a “liquidity” effect in the uncovered interest arbitrage relationship. In the short run, an excess supply of real money (demand) would cause the real interest rate to fall (rise); through the Fisher equation, this would cause the nominal interest rate to fall (rise). The monetary disequilibrium variable (i.e., actual real money minus the predicted value of the estimated demand for real money—equation (1)) is negatively correlated with the interest rate.

Chart 3.
Chart 3.

Banks’ Gross Interest Margins, 1982(1)–1986(IV)

(In percent per annum; period average)

Sources: Central Bank of the Philippines, CB Review, Vols. 38 and 39.
Table 5.

Banks’ Interest Margins, Selected Years, 1970–86

(In percent; period average)

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Sources: Buhat (1987); and IMF staff calculations.Definitions:iL-id= difference between lending (iL) and deposit rate (id), as defined in footnote 21, page 188.r = Required reserve ratio.ir = Interest rate on required reserves deposited at the CBP.inL = Net interest income per peso lent. iLn=i(1t)(1a)(1r)t = Gross tax receipts on lending operations; t = 5 percent on each unit income from lending.a = Agri/agra required ratio; a = 15 percent of banks’ loan portfolio.ia = Interest rate on treasury bill that banks can hold to meet other agri/agra required ratio. Thus, the net income per peso lent is derived by adding interest earnings on treasury bills held to meet the agri/agra requirement and on required reserves: in=iLn+ir.r+ia.a(1r).

The net interest margin—after allowing for the cost of reserve requirements and other regulatory factors27—fell sharply between 1980 and 1983, but rose between 1984 and 1986 (see Table 5). The regulatory factors contributed about 5 percentage points to the average intermediation cost between 1984 and 1986; their impact on the marginal intermediation cost was even higher (around 8 percent) particularly in times of inflation and high interest rates. Thus, the reserve requirements and other regulatory factors served to aggravate the crisis by disproportionately raising the borrowing costs of firms. As noted earlier, the increase in overdue loans also contributed to widening the margins (to reflect risk premiums) and further raised borrowing costs. Particularly during 1984 and 1985, the increase in loan losses and the resulting caution in lending policies by banks served to raise lending rates and both gross and net margins.

Monetary Control Reforms

The reforms of monetary policy instruments facilitated greater flexibility in interest rates and rapid adjustments to major shocks, but the financial crisis itself strongly influenced the evolution of the instruments.

First, during the 1970s, CBP set a uniform legal reserve ratio of 20 percent across both institutions and instruments. In 1980, CBP announced a plan to lower gradually the legal reserve ratio to 16 percent, beginning in January 1982. The plan was to reduce the ratio by 1 percentage point every six months. During 1982, the plan went into effect and the legal reserve ratio declined from 20 percent to 18 percent at the end of 1982. As the crisis worsened in 1983, the plan was frozen; in 1984, CBP raised the legal reserve ratio to 24 percent in order to contain liquidity pressures.

Second, until 1983, CBP actively pursued selective credit policies. Special rediscount facilities were opened as an incentive to banks, especially development banks, to extend credit to priority sectors and activities (e.g., foodgrain production, land irrigation, promotion of small businesses). Following the crisis of confidence in 1981, CBP also opened a special rediscount window for medium- and long-term loans and equity investment to help government financial institutions finance the takeover and acquisition of troubled entities hit by the crisis. In November 1983, CBP also opened a liquidity window to counter the increasing pressures on the banking system. During 1984 and 1985, however, CBP drastically modified the rediscounting policy. It set access limits on the refinance facilities, raised the rediscount rates to market-related levels, unified the terms of access of these facilities, and, in November 1985, reduced the number of regular rediscount windows from five to one.

Third, beginning in the mid-1970s, CBP relied increasingly on open market operations, based on its own securities, to regulate the domestic liquidity of the banking system. Indeed, until 1981, CBP used central bank certificates of indebtedness (CBCIs) with maturities longer than 180 days.28 In 1983, however, CBP stopped issuing CBCIs by auction and sold them on tap at a fixed yield.29 In 1984, CBP introduced central bank bills with maturities of less than 180 days; during 1985 and 1986, auctions of central bank bills would become the main instrument for the dramatic tightening of monetary policy.

Finally, CBP introduced swap operations in 1982. This instrument, which became more important as the 1980s progressed, aimed at improving CBP’ s foreign exchange position and providing liquidity to deposit money banks so as to smooth out short-term interest rates. Because of the fall in the value of the peso, CBP incurred huge foreign exchange losses on these swap operations.

On the whole, these reforms had positive effects, because they allowed CBP to react promptly to the numerous monetary shocks (e.g., bank runs, portfolio shifts, increased domestic financing of budgetary deficits) that buffeted the economy between 1983 and 1986, and to transmit its policy actions to the banking system swiftly via interest rates. Through high interest rates, CBP was able to meet its reserve money targets and to bring down inflation by 48 percentage points within two years; in 1986, inflation stood at 1.8 percent.30 The adaptations of discount window policies served to prevent a collapse of the banking system.

The timing and sequencing of some measures, however, seemed to exacerbate instability. In view of expectation of further devaluation of the peso against the U.S. dollar as a result of the persistent weakening of the external position and accelerating rate of devaluation of the peso between 1979 and 1982, the introduction of swap operations with foreign exchange guarantees seemed ill-timed; CBP was able to finance unsustainable balance of payments deficits, but it risked large exchange losses if the trend in the peso depreciation continued.31 Furthermore, the opening of numerous special rediscount facilities, in addition to the emergency facility, between 1981 and 1983 was inconsistent with interest rate deregulation, insofar as access to these facilities by financial institutions weakened the effectiveness of open market operations. (Banks could obtain refinancing from CBP at below-market rates and at their own initiative.) As expected, these measures had inflationary effects between 1981 and 1983. The appropriate sequencing of the regulatory reforms should have been to modify the rediscount mechanism while interest rates were deregulated, not after.

Banking Structure

Measures. Between 1971 and 1981 CBP attempted to consolidate the domestic banking system while promoting greater competition by allowing foreign banks to enter. In 1972, CBP substantially raised the minimum capital requirement for all banks (see Table 6). After 1975, banks that could not comply with this requirement were permitted to merge with other domestic and foreign banks. However, CBP also actively encouraged banks to open branches, particularly in rural areas.

In 1980, CBP enacted legislation permitting the establishment of “universal” banks.32 They also raised the minimum capital requirement again. The previous functional classification of thrift banks into savings banks, private development banks, and savings and loan associations was eliminated. Thrift banks were allowed to carry on all operations performed by commercial banks except foreign exchange operations. The fact that they were also subject to lower reserve requirements gave them a cost advantage. Entry requirements for rural banks, which lend to farmers and rural entrepreneurs, were very liberal; capital requirements were low and limited management experience was accepted.33

Impact of the Crisis. The crisis significantly altered the banking structure. First, in terms of the volume of assets, by 1980 banks had increased their dominant position among financial institutions (see Table 7), but tiers had developed in the banking sector. The first tier consisted of a few commercial banks and development banks whose size had increased sharply during the 1970s, The second tier consisted of a large and growing number of rural and thrift banks, mostly small ones (see Table 8), A disproportionate number of institutions in this segment of the banking system were hit hard by the crisis, partly as a result of the weaknesses in entry regulations and the limited subsequent supervision. At the end of 1986, a total of 30 commercial banks in the Philippines (9 unibanks, 17 domestic commercial banks, and 4 foreign banks) accounted for 41 percent of the gross assets of the financial system (60 percent in 1980). In addition, there were 3 specialized government banks (16 percent),34 114 thrift banks (2.7 percent), and 877 rural banks (1 percent). Between 1981 and 1986, the relative position of banks was eroded somewhat by the growing role of the CBP in financing government budget deficits and in supporting troubled financial institutions because of the crisis itself.35

Table 6.

Selected Prudential Ratios of Central Bank, 1972 and 1980

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Source: Central Bank of the Philippines.

Applies to newly established institutions.

For existing ones, it remains at ₱ 100 million.

In other places, it is ₱ 10 million for new institutions and ₱ 5 million for existing ones.

By unibanks; for commercial banks, it remains at zero percent.

CB Circular No. 357 dated January 22, 1973. K = the aggregate ceiling on capital accounts net of recommended valuation reserves. (This refers to net value of capital accounts.)

Table 7.

Assets of Financial Institutions, Selected Years, 1970–85

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Source: Central Bank of the Philippines.

Second, government-owned banks played a central role within the banking system, and the concentration of risks in some of them was a critical factor in the crisis.36 Their share of total bank assets, which averaged about 33 percent between 1970 and 1980, rose to 36 percent by the end of 1985. DBP alone accounted for 29 percent of total bank assets. Their troubles threatened the stability of the banking system and culminated in the major restructuring and rehabilitation of two of the largest state-owned institutions that became insolvent.

Third, significant parts of the banking system were characterized by a bank-holding-company structure. Twelve holding companies had interrelated ownership and interests in private banks and nonfinancial corporations. They controlled commercial or savings banks, investment houses, and insurance companies. Such was the case with the Herdis Group,37 which, between 1979 and 1980, controlled Summa Savings and Mortgage Banks, the Summa Insurance Corporation, the Equipment Credit Corporation, and Interbank and Commercial Bank of Manila.38 Furthermore, most groups had many interlocking directorships within the corporate business sector (see Doherty (1983)).

Table 8.

Number of Banking Institutions, Selected Years, 1975–86

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Sources: Central Bank of the Philippines, Private Development Banks, Annual Report, 1981.Note: For 1975, data reproduced from World Bank (1979).

Includes private development banks, savings banks, and stock savings and loan associations.

Includes DBP, Land Bank, and, starting in 1980, the Philippine Amanah Bank, which operates under Islamic principles.

As measured by the Herfindahl-Hirschman index.

The number and size distribution of banks-—the Herfindahl-Hirschman index showed a ratio of only 0.10 as of December 31, 1986—suggest that the degree of concentration was not a problem.39 The previously noted fall in net interest margins between 1980 and 1983 following the deregulation of interest rates also suggests a competitive banking system. The rise in net interest margins between 1984 and 1986 was attributable to tighter monetary policies, high reserve requirements, and an increase in loan losses. Thus, oligopolistic pricing does not seem to have been a factor in interest rate developments. However, the bank-holding-company structure, together with the supervisory weaknesses discussed in the next section, permitted excessive risk taking following deregulation, and this risk taking seems to have helped cause and aggravate the crisis.

Prudential Regulation and Supervision and Related Institutional Practices

Supervisory weaknesses were conducive to loose banking practices, which later led to numerous bank failures. Also, the existence of a deposit insurance scheme did little to prevent or contain the crisis. In the following subsections, the supervisory system that regulates and oversees the conduct of banks’ operations is described, and the role of this system in ensuring the soundness and stability of the financial sector is discussed.

Supervisory Authority

Although CBP exercises supervisory authority over the banking institutions, the ultimate supervisory authority is the Monetary Board (MB), the policymaking body of CBP.40

The Department of Bank Supervision and Examination is the operational arm of CBP for supervision. Supervisory procedures in the Philippines, which include reporting requirements and examination, are regular, comprehensive, and thorough.41 Officers of the Department of Bank Supervision and Examination are responsible for bank examination to assess the soundness of operations and the solvency and liquidity of the bank. Reports of these bank examinations are then transmitted to the MB, which decides what action to take when a bank is found to be in trouble.

When a bank faces protracted liquidity or solvency problems, the MB may appoint a conservator to take charge of the assets, liabilities, and management of the bank in order to protect depositors and other creditors. If the conservator is unable to restore the viability of the bank, the bank is declared insolvent.42 The MB then appoints a receiver to take charge of all assets and liabilities of the bank, and forbids the bank from doing business. Within 60 days, the MB decides whether to liquidate the bank or to reorganize it to permit the resumption of business. In the former case, CBP appoints a liquidator to carry out the decision, provided no court challenges the decision.

The ultimate enforcement resides with the MB, and the closing of a troubled bank is subject to due process, which may take a long time, especially when litigation is brought by owners.

Supervisory Rules

Between 1972 and 1982, CBP also modified the main prudential regulations on commercial banks. Capital requirements, defined as a ratio of net worth to risk assets, were lowered from 15 percent in 1972 to 10 percent in 1973 (see Table 6). After 1980, ratios as low as 6 percent became permissible with the prior approval of the MB. The authorities sought to provide banks with greater leverage to expand their asset portfolios.

CBP relaxed its rules regarding credit accommodation to directors, officers, stockholders, and related interests (DOSRI). In 1973, DOSRI credit had an upper limit equal to a bank’ s total capital account, net of valuation reserves.43 By 1980, this limit had become less restrictive for commercial banks, because the authorities had somewhat relaxed the provisions designed to limit conflicts of interest between a bank and another financial or nonfinancial institution that were linked by interlocking directorate.44 In addition, regulations governing relations between a bank and its subsidiaries were eliminated.

To restrict banks’ risk exposure, the authorities established a single-borrower limit of 15 percent (including loans and equity investment) of the bank’ s net worth; the rule had been in force during the 1970s and is still valid, although exceptions have been made. For example, in 1983, the Government’ s takeover of the Construction and Development Corporation of the Philippines (CDCP) through the PNB violated this limit. After the takeover, PNB’ s total exposure (in equity alone) in CDCP went to 60 percent of its net worth.

In contrast to the trend toward relaxation of prudential regulations, CBP expanded the institutional coverage of bank supervision after 1972 in order to include the nonbank quasi-banks (NBQB). CBP also monitored the nonbank quasi-banks’ issues of commercial paper “with recourse” and regulated its terms, conditions of rollover, physical delivery, and the like.

Loose Lending Practices

As a result of the political climate both before and during the crisis, CBP failed to enforce supervisory rules regarding DOSRI credit, supervision of nonbank quasi-bank activities, and, most important, the treatment of past due loans and their provisioning.

DOSRI Credit. Failure by the MB to enforce the rules reportedly led to substantial bank lending to DOSRI, to the detriment of other legitimate borrowers.45 Inappropriate loans to DOSRI are cited as a major contributor to bank failures over the past decade. In reaction to the 1981 crisis, CBP tightened the regulations on DOSRI credit.46 Bank credit to firms with interlocking directorship/officership was tightened again (reversing the earlier stance), but the restrictions regarding institutional relationships between holding companies and subsidiaries were loosened.

Supervision of Money Market Operations.47 Prior to 1980, regulations governing the functioning of the money market were differentiated by type of participant and type of operation, each type falling under the purview of a different supervisory authority. CBP supervised only banks and nonbank quasi-banks and monitored only transactions on a “with recourse” basis. The Securities and Exchange Commission supervised other participants, while monitoring transactions on a “without recourse” basis. Subsequently, CBP imposed regulations on nonbank quasi-banks. These regulations included the requirement that nonbank quasi-banks hold 20 percent of their liabilities—deposit substitutes—in the form of deposits with the CBP; a ceiling on interest rates of these institutions (the maximum rate paid for borrowing was 17 percent; the rate charged for lending was 18 percent); and a minimum trading lot. Because nonbank financial institutions were not subject to such regulations by the Securities and Exchange Commission, nonbank quasi-banks lost their competitiveness. In response, nonbank quasi-banks started to deal in paper on a “without recourse” basis; this paper was issued mostly by subsidiaries or affiliates of “groups” to which the nonbank quasi-banks belonged. This practice allowed nonbank quasi-banks not only to circumvent CBP regulations and monitoring of their money market activities, but also to help businesses of their “group” to mobilize short-term funds by issuing less-than-prime commercial paper. These unsound lending practices contributed to the collapse of the commercial paper market in 1981.48

Accounting Rules. The 1980 reforms did not cover CBP rules governing the treatment of overdue loans, the provisioning for bad debt, and scrutiny of deposit transactions by CBP examiners. The inadequacies of these rules, which remained unchanged until 1986, played a significant role in the worsening of the financial crisis.

CBP used the following rules for its own assessment of bank conditions: demand loans were considered past due if payment was not received within six months of a written demand. For loans payable in installments, the determining factor was the number of payments in arrears, a number that varied with the repayment schedule of the loan (monthly, quarterly, semiannually, or annually). The threshold for monthly installment loans was ten missed installments. For other loans, the period varied between one and two years. Whenever 20 percent of the outstanding balance of a loan was in arrears, the entire loan was to be considered overdue; once a loan was classified as overdue, interest could no longer be accrued. In practice, however, banks differed considerably in their treatment of overdue loans. Conservatively managed banks generally placed loans on a nonaccrual status more promptly than did the schedule used by CBP, in order to avoid the tax on gross revenues; other banks followed loose practices, especially as they began facing financial distress.

Regarding provisions for bad debt, CBP is empowered by law to establish rules, either generally or in individual cases. CBP has not enforced the rules, however, leaving reserve or provisioning policies to bank managements.49 In the supervisory process, the CBP does compare the reserves established by a bank with those it believes are required on the basis of its own assessment of asset quality. Under the law, banks are allowed to write off bad loans up to ₱ 100,000, but they must have CBP approval before writing off loans above that amount. Requests for writeoff approval concerning DOSRI loans are passed on to the MB; other requests are handled by CBP staff.

Examiners are not allowed to investigate deposit transactions that are protected by strict secrecy rules, unless they are duly authorized by the MB. The MB may permit scrutiny of deposit transactions only if it is satisfied that a bank fraud or serious irregularity has been committed and that it is necessary to look at deposit transactions to determine the facts.

Negligible Role of Philippines Deposit Insurance Company (PDIC). Because of its severe staffing constraints and low capital base, PDIC played no significant role in improving depositors’ confidence in the banking system during the crisis period of the 1980s.50 Despite the capital increase from ₱ 20 million to ₱ 2 billion in 1985, PDIC’ s resources, human and financial, were insufficient.51 As a result, PDIC faced major difficulties in settling the growing claims of insured depositors of failed banks (see Table 9).52 Thus, CBP was compelled to tie up most of its supervisory staff in helping PDIC settle these claims.


The absence of significant reforms in prudential supervision aggravated the banking crisis. First, the existing rules were not enforced in practice, although the MB was informed promptly of the problem-bank cases. Second, some of the accounting rules themselves were not codified to ensure consistency and transparency. This situation encouraged troubled banks to book accrued interest on nonperforming loans and to distribute the book profits. The main problem with provisioning rules arose after the crisis of 1981. The MB had to decide between forcing banks to provision for bad debt so as to maintain confidence in banking institutions or remaining tolerant on this issue to give troubled banks time to overcome their financial difficulties. The MB took the second option, which accelerated the deterioration of bank finances.

Table 9.

PDIC Payments to Insured Depositors of Failed Banks as of June 1987

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Source: Philippine Deposit Insurance Corporation.

Covers the 1981—87 period; figures for the 1970—80 period amount to zero.

II. Manifestations of the Crisis and Its Monetary Effects

The manifestations of the crisis—loss of public trust in the banking system and the spread of financial distress and bank failures—and the monetary effects of the crisis, which complicated the conduct of CBP monetary policy and caused a severe credit crunch, are described in this section.

Loss of Public Trust

During the crisis, financial wealth holders lost trust in the banking system, causing both runs on banks and “flight to quality.”53 The spread of banking distress weakened the public’ s confidence in financial institutions, adding fears about the safety of banks’ deposits.

Surge in Demand for Reserve Money

As noted earlier, the Dewey Dee affair triggered a crisis of confidence that provoked bank runs and capital flight in 1981.54 The bank runs caused an increase in the ratio of currency to narrow money in 1981, which was a sharp reversal of the declining trend in the ratio during the 1970s. Evidence pointed also to capital flight (see Table 10).

The currency ratios continued to increase in 1982 and jumped in 1983; these increased ratios reflected a major erosion of confidence in the banking system. The largest increase occurred in the last quarter of 1983 after the authorities announced, in late September 1983, the suspension of repayments on external debt. Capital flight intensified in 1983 (see Table 10), because the announcement of the moratorium raised concern among foreign creditors and led to the cutoff of suppliers’ credit.

“Flight to Quality”

The 1981 panic also caused a redeployment of funds, mostly to institutions perceived as sound, namely, the commercial banks. As already noted, investors in the commercial paper market switched to bank deposits. Indeed, as shown in Table 11, banks’ deposit accounts increased as a whole by ₱ 1.6 million (from ₱ 21 million in 1980 to ₱ 22.6 million in 1981), but there was also a switch of deposits away from thrift banks. Whereas total bank deposits increased by 11 percent between 1980 and 1981, deposits of thrift banks fell by 9 percent, triggering failures among these institutions.55 In addition, commercial banks gained 3.2 million deposit accounts in 1981—a 32 percent increase over 1980, while thrift and savings banks lost 2.1 million accounts—a decline of about 30 percent over the same period.

Table 10.

Selected Financial Ratios and Years, 1970–86

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Sources: International Monetary Fund, International Financial Statistics, 1987; Table 2; and IMF staff estimates.

Short-term capital (net), including errors and omissions (these flows represent nonmonetary capital flows); this ratio is used as a rough measure of capital flight (minus sign), including the trade credit squeeze.

After 1983, financial investors again redeployed their funds, this time toward safe securities with high yields. Specifically, the public shifted out of deposits and into treasury and central bank bills. The ratio of M3 to total liquidity fell sharply after 1983 (Table 2), owing in part to the sharp increases in interest rates on treasury and central bank bills beginning in 1984. Banks as a group lost a large number of deposit accounts.

Banking Distress

Between 1981 and 1985, financial difficulties of corporate businesses steadily worsened, increasing the distress among banking institutions.56 The limited data on the financial performance of the top 1,000 corporations from 1980 to 1984 showed a sharp increase in debt/equity ratios in 1982, declining profitability from 1981 to 1983 with negative net incomes in 1982 and 1983, and a sizable weakening of the liquidity positions of firms (as measured by the ratio of current assets to current liabilities) between 1980 and 1984 (Appendix Table 2). The sharp increase in the debt/equity ratio and in the indebtedness of the nongovernment sector (Table 3) in 1982 and 1983 when real lending rates were at a peak seems to suggest that distress borrowing was a significant factor. These developments were reflected in the evolution of overdue loans in the banking system. Overdue loans rose from ₱ 12.5 billion (11.5 percent of total loans) in 1980 to ₱ 16.6 billion (13.2 percent) in 1981. The situation deteriorated sharply after 1983, and overdue loans rose to a record high of 19.3 percent in 1986.

Until 1983, the ratio of nonperforming loans to banks’ loan portfolio remained below the critical ratio of 15 percent that is perceived by bankers and the public as a threshold for individual banks’ solvency.57 Between 1981 and 1984, banks’ ratio of capital to outstanding loans remained above banks’ ratio of overdue to outstanding loans. Hence until 1983, banks as a whole appear to have been sufficiently capitalized to provision for bad debt and absorb eventual losses from bad loans. Beginning in 1985, the ratio of capital to outstanding bank loans fell below the ratio of overdue loans, indicating major solvency problems in the banking system. The size of overdue loans was contained in part by the authorities’ rescue of (at least) 123 failing businesses and by the troubled banks’ practice of keeping bad loans current by renegotiating them at maturity.58 In addition, the Government alleviated the banking distress by acquiring six troubled commercial banks between 1981 and 1983.

The authorities’ rescue of distressed banks significantly helped to limit the number of liquidations among commercial banks. By the end of 1986, only three sizable commercial banks had failed. The liquidations occurred mostly among the many small rural and thrift banks.

Between 1981 and 1983, 138 thrift and rural banks failed; this number amounts to 12 percent of all banks existing in 1980 (Table 10). Although these failures did not threaten the stability of the banking system, they tied down CBP supervisory staff. In addition, the Philippines Deposit Insurance Corporation, with its low capital base and inadequate contributions, found it increasingly difficult to settle the growing claims of depositors of the failed banks.

Table 11.

Indicators of the Financial Crisis, Selected Years, 1970—87

(In percent)1

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Source: Central Bank of the Philippines.

Unless otherwise specified.

For 1970 and 1975, data refer to cumulative amounts between 1970 and 1974 and 1975 and 1979, respectively. Data for the rate of bank failure exclude the five commercial banks in distress which have been acquired by CFIs; they are: Republic Planters’ Bank (1978); International Corporate Bank (1982); Union Bank of the Philippines (1982); Associated Bank (1983); and Philipinas Bank (1979). The numbers in parentheses refer to the year of acquisition by government financial institutions.



Capital defined as “net worth” or unimpaired capital plus free reserves.

Monetary Management During the Crisis

Actions on Supply of Banks’ Reserves

Between 1981 and 1986, CBP had increasing difficulty in achieving its often conflicting objectives of monetary stability, confidence in the banking system, and credit allocation to priority sectors, as both the financial crisis and the recession deepened.

Between 1981 and 1983, CBP gave priority to containing the spread of financial distress and stepping up selective credit policies. As a lender of last resort, CBP intervened appropriately by providing emergency credit during 1981 and by absorbing excess liquidity as the crisis abated in 1982 (see Table 12). Meanwhile, CBP increased concessional rediscount credit to financial institutions. In the aftermath of the banking panics of 1983 CBP also replenished the banks’ loss of deposits and began to realize exchange losses on swap operations; as a result of these developments, reserve money jumped 48 percent between the end of 1982 and the end of 1983.

Between 1984 and 1986, to offset the expansionary effects on reserve money of the earlier policies and to restore monetary stability, the CBP absorbed huge amounts of liquidity from financial institutions through massive sales of its own securities and tighter access to rediscount facilities.59 However, the effect of these actions was mitigated by the huge financing of the public sector deficit in 1984, following the drastic cutback in foreign financing of these deficits.60 This policy stance caused inflation to jump from 12 percent in 1983 to 50 percent in 1984, and led to a crowding out of the private sector. Between 1985 and 1986, CBP finally brought inflation under control by maintaining a tight policy.

CBP continued to provide extensive emergency assistance between 1984 and 1985, reacting essentially to financial distress rather than to panics as in earlier years. To prevent failures of financially distressed firms, CBP, through the decisions of the MB, adopted a remedial rather than punitive approach. This approach, however, led to a trade-off between short-run stability and long-run cost effectiveness of rescue operations.

The long negotiations over corrective actions to rehabilitate troubled institutions may have prolonged the public’ s perception of uncertainty and raised the ultimate cost of rescue operations. Also, CBP’ s attempt to seek additional capital and merger partners for troubled banks proved difficult between 1983 and 1986, when all domestic hanks faced financial difficulties. As the MB was deliberating the appropriate disposition of problem institutions, CBP continued to extend emergency loans, overdrafts, and equity lending to prevent a collapse of the banking system. This policy, combined with the Government’ s massive issuance of treasury bills to finance its budget deficit, had expansionary effects on total liquidity after 1983 despite the decline in the money multiplier (see Charts 4 and 5).

Table 12.

Descriptive Statistics for Reserve Money and CBP Credit During the Crisis, 1981 (I)-1986(IV)

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Source: IMF staff calculations.

Defined as the ratio (in percent, between the standard deviation (σ) and the mean (X).

Complications from Portfolio Shifts

Empirical results showed that the estimated demand for real M3 shifted downward in 1983(III) because investors shifted from deposit substitutes into treasury and central bank bills; as a result, M3 became an unreliable indicator of monetary policy.61 CBP’ s overestimation of actual M3 contributed to the loose monetary policy and skyrocketing inflation observed until late 1984.

CBP then reversed its stance to bring inflation under control and began targeting reserve money. CBP tightened the supply of bank reserves through massive sales of central bank bills, but the surge in the demand for reserve money (partly reflecting the currency flight) probably led to excessive tightening and thereby caused the steep increases in nominal interest rates from late 1985 to the middle of 1986. Large increases in domestic government borrowing added upward pressure on nominal interest rates, and contributed to crowding out the private sector. Such increases, which occurred despite the tightening of fiscal policy, stemmed from the drying up of foreign financing after the announcement of the moratorium.

Credit Crunch

After 1981, declining economic growth compounded the negative effect of rising interest rates on the demand for real credit, particularly in the private sector. The increase in overdue loans, many of which were renegotiated between 1984 and 1986, mitigated the sharp decline in this demand. Indeed, with private investment (in percent of GNP) plummeting in 1981 and debts being liquidated, demand for new investment loans by the private sector nearly came to a halt.

Nonetheless, banks apparently curtailed the supply of real credit to the private sector by more than the drop in demand, thereby resorting to credit rationing as the crisis deepened. Between 1983 and the end of September I986, real credit to the private sector fell a staggering 53 percent, and cumulative output fell by 9 percent. Consistent with their prudent lending policy, the uncertain economic outlook, and the chronic shortage of reserves, banks may have preferred to stop lending rather than to charge higher interest rates. Furthermore, banks found investing their liquidity in public securities (of treasury bills and central bank bills) more attractive than lending, for safety reasons. Banks’ holdings of public securities rose sharply during the crisis, particularly between 1984 and 1986.62 Banks’ shift of funds to the public sector crowded out the private sector. Therefore, the banks’ actions seem to have exacerbated the shortage of funds in the credit market and worsened the recession.

Chart 4.
Chart 4.

Movements of Seasonally Adjusted Aggregates, 1981(I)-1986(III)

Sources: International Monetary Fund, International Financial Statistics.1 Deflated by consumer price index in Manila (end of period).
Chart 5.
Chart 5.

Evolution of Selected Monetary Ratios, 1981 (I)-1986(III)

(In percent; end of period)

Source: International Monetary Fund, International Financial Statistics Year Book, 1989.

III. Measures to Deal with the Crisis

Measures to deal with the crisis included, in addition to emergency assistance and some liquidations, recapitalization through government funds, financial assistance to nonfinancial corporations, takeover of weak financial and nonfinancial firms by government financial institutions, and eventually a massive restructuring of some of the government financial institutions themselves.

Financial Assistance to Troubled Entities

During the 1981-86 crisis period, CBP and the Government provided massive financial assistance to troubled entities under various schemes.


When the 1981 crisis broke out, the CBP lender-of-last-resort facility did not cover quasi-banks. To enable these quasi-banks to meet the demand for withdrawal of funds, CBP provided emergency loans through a special rediscount facility.63 However, the primary issuers of commercial papers, mostly corporate businesses, continued to face liquidity problems and failed to honor their obligations as they came due. At that point, quasi-banks were the major holders of this paper.

CBP then set up the Industrial Fund with resources from CBP and the national government budget. Through the GFIs and unibanks, the Industrial Fund, in turn, lent these funds to troubled corporations, which then settled their obligations to the quasi-banks.64 The latter, in turn, repaid the CBP emergency loans. This scheme amounted to a conversion of short-term emergency loans extended through the special rediscount window into long-term CBP lending through the Industrial Fund.

In early 1982, the Industrial Fund was replaced by a CBP special rediscount window, through which CBP extended medium- and long-term loans to universal banks, including PNB and DBP, to allow them to finance their acquisition of and merger with troubled entities (see Lamberte (1985)). That same year, CBP began to provide emergency loans and overdrafts to financial institutions facing unexpected liquidity shortages.

Similarly, the Government provided emergency lending and equity contributions to nonfinancial public corporations (mostly from 1981 to the middle of 1983) and to the government financial institutions (mostly from 1983 to 1985). The Government channeled its financial assistance directly through the capital budget, which recorded large deficits. Direct financial assistance to distressed public sector firms in 1981 and 1982 was aimed both at financing their operating deficits and at stepping up public investment to offset the decline in private investment after 1981. Assistance to government financial institutions, beginning in 1983, was aimed mostly at financing their acquisition and merger of distressed entities, and facilitated the conversion of debt owed to government financial institutions into equity. The Government provided both loans and equity funds to government financial institutions, thus allowing these institutions to absorb the loan losses and to assist distressed corporations by converting the bad loans provided to these corporations into equity. Because no dividends were expected from these corporations for a long time, this operation amounted to forgoing interest payments. In fact, the PNB lost an estimated ₱ 400 million in annual interest payments from the Construction Development Corporation of the Philippines as a result of such debt/equity conversion.

Government financial institutions took over large businesses that were virtually bankrupt, including the largest conglomerates that had been hit severely by the 1981 crisis. To illustrate, the National Industrial Development Corporation—a government financial institution and subsidiary of PNB—took over 9 corporations of the Construction and Development Corporation of the Philippines (CDCP) and 15 corporations of the Herdis Group; DBP and PNB took over 87 other CDCP corporations and 14 Herdis corporations.65 The Social Security System (SSS), which had put 24 percent of its investment portfolio into the hotel sector during the 1970s, took over 9 hotels.


Between 1981 and 1985, the volume of financial assistance that the authorities granted to troubled entities mirrored the intensity of the crisis over its three phases. This volume more than doubled during the 1981 episode, continued to rise in 1982, and doubled again between 1983 and 1984 (Table 13). In addition, the role played by CBP and the Government, as well as the destination of their financial assistance, differed over these phases. During 1981 and in the period from late 1983 to 1985, both the CBP and the Government provided massive financial assistance to financial corporations. In 1982 and 1983, however, the Government provided the bulk of financial assistance, mostly to public corporations (financial and nonfinancial).

As the crisis progressed, the main recipients of government financial assistance shifted gradually from nonfinancial to financial public corporations. Until 1982, the Government provided assistance to troubled nonfinancial firms in part to maintain overall domestic investment, and in part to finance takeovers and acquisition of distressed and bankrupt corporations by government financial institutions. Beginning in 1983, the Government curtailed public investment to reduce budget deficits. As a result, financial assistance to nonfinancial corporations declined somewhat; but assistance to financial corporations accelerated.

Over the whole crisis period, the Government’ s financial assistance to troubled entities, which rose from 13.6 percent of all government expenditure in 1980 to 20.1 percent in 1985, aggravated the Government’ s own position.

Terms of CBP Financial Assistance

The terms of the CBP financial assistance rapidly shifted from penalty rates to subsidized rates. In 1981, for emergency loans and overdrafts of 60 days, CBP applied a rate of interest of 24 percent, plus 2 percent for each rollover of outstanding amount. Compared with the market rate of 16 percent charged by banks on short-term borrowing, this amounted to a heavy penalty rate. Moreover, CBP extended emergency loans against any collateral that troubled institutions could submit, even collateral previously unacceptable to CBP. With the establishment of the Industrial Fund in the middle of 1981, however, CBP provided an implicit interest subsidy. On the medium- and long-term resources provided by that fund, CBP charged an interest rate of 16 percent, compared with the long-term market rate of 21.6 percent.

Table 13.

Authorities’ Financial Assistance Flows to Distressed Corporations, 1980—95

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Sources: International Monetary Fund, International Financial Statistics, 1988; data provided by the authorities; and IMF staff estimates.

These figures represent changes from end of period stock. They exclude ₱ 700 million of promissory notes of Union Bank’ s borrowers such as the Rancom Corporation, and ₱ 2.8 billion of National Investment and Development Corporation promissory notes accepted as payments to clear emergency loans of Intercom (financed from the rediscount window). The figure for 1980 refers to commercial banks only.

To government financial institutions only, financed from the budget.

Between 1983 and 1985, CBP continued to accept less than first-rate collateral for its emergency loans. Furthermore, between 1984 and 1985, CBP provided interest rate subsidies on emergency loans and overdrafts as well as on medium- and long-term equity loans provided through the special rediscount window. For instance, on short-term loans of 180-day maturity CBP charged an interest rate of 27 percent (MRR plus 2 percent, see Table 14), which was lower than the comparable treasury bill rates.66 Similarly, on medium- and long-term equity loans to finance mergers and acquisitions, CBP charged 11 percent, which was well below market rates.

Disposition of Private Banks in Distress

During the crisis, the authorities arranged for government financial institutions to take over four private commercial banks with ₱ 13.5 billion in assets in order to work out appropriate rehabilitation and decide on eventual disposition. If the two banks acquired in the late 1970s prior to the crisis are included, the Government owned, by the end of 1986, six formerly private banks with ₱ 20.3 billion in assets (12.7 percent of the total assets of the private banking sector).67 The rehabilitation scheme for these banks consisted of an initial capital infusion from the government financial institution that took over each bank, placement of a central bank comptroller (if warranted) to work out restructuring, continued central bank financial assistance where needed, and arrangement of new private sector partners for mergers or acquisitions (sometimes on a “clean balance-sheet basis”).68

The eventual disposition of these banks has varied with the depth of their problems and the complexity of the litigation that followed. As of 1988, two banks had been successfully rehabilitated and were about to be reprivatized. Two others have been declared insolvent; one of these has been closed, but lawsuits by the owners have delayed liquidation of the other.69 The fate of the other two banks remained undecided. The authorities intended to divest themselves and reprivatize all government-acquired banks. Change in ownership and management of these troubled banks was not always required. In one case, old stockholders were even allowed to maintain their equity position.

Table 14.

Terms of financial Assistance to Distressed Corporations, 1982–85

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Source: International Monetary Fund.

Medium - and long-term; also covers lending for working capital in connection with a proposed or ongoing expansion development program, and investment in high-grade securities.

Or as may be provided for under a Monetary Board resolution.

MRR = Manila Reference Rate.

TB = treasury bill.