Abstract
This Selected Issues paper analyzes the factors behind the relatively strong performance of the Philippines in recent years (1990s) as well as the remaining reform agenda. The paper highlights that the Philippines has received considerable attention in recent years as it “emerged” in the early 1990s from a long period of slow growth and economic imbalances, and then managed to escape the “Asian crisis” relatively unscathed. The paper examines the public finances for the Philippines. It also analyzes the monetary sector, external sector, and the banking sector reforms.
VI. BANKING SYSTEM REFORM1
A. Introduction
1. 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. However, this situation 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.
2. 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.
3. The chapter is organized as follows. Following a description of the Philippine banking sector in Section B, this chapter provides an overall assessment of its soundness (Section C), followed by an overview of previous efforts at financial sector reform (Section D). Section E discusses the authorities’ current reform program put in place in response to the regional crisis. Finally, the last section summarizes the agenda for further reform.
B. Philippine Banking System
Size of the banking system
4. The banking system in the Philippines comprises 54 commercial banks,2 118 thrift banks, and 839 rural banks (see Box VI.1 for a description of the structure of the banking system). Total assets of the banking system amounted to over
Philippines: Structure of the Banking System
(In percent of banking system assets)
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Source: Bangko Sentral ng Pilipinas.Philippines: Structure of the Banking System
(In percent of banking system assets)
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Source: Bangko Sentral ng Pilipinas.Philippines: Structure of the Banking System
(In percent of banking system assets)
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Source: Bangko Sentral ng Pilipinas.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 underwrite securities and own equity in non-financial enterprises while commercial banks may not. Among universal and commercial banks, only one bank—the Philippine National Bank (PNB)—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 ten foreign banks were authorized to set up new branches. 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 ten 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 two fully government-owned banks, the Land Bank of the Philippines (LBP) and the Development Bank of the Philippines. These are specialized development banks, although they also undertake some commercial banking functions (mainly for their traditional clients). The mandate of the LBP is to promote the growth of the agricultural sector. The main activities of the DBP are the on-lending, on a wholesale basis, of official development assistance funds (which amounts to 60 percent of its 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 other official financial institutions, such as the Philippine Deposit Insurance Corporation (PDIC).
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 (see 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 BSP), 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 relending or purchasing of receivables, but are not permitted to issue deposit liabilities.
According to the provisions of the BSP Act, only the following will ultimately remain under BSP supervision: non-bank financial intermediaries with quasi-banking functions, trust or investment management authority, building and loan associations, non-stock savings and loan associations, trust companies, nonbank financial intermediaries which are subsidiaries or affiliates of banks or quasi-banks, and nonbank financial intermediaries, such as pawnshops, placed under BSP 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 BSP has supervisory authority over those insurance companies and dealers or brokers which are subsidiaries or affiliates of other supervised institutions.
The Prudential Framework for the Banking System
According to the BSP Act, the ultimate authority in the area of bank licensing and supervision in the Philippines is the seven-member Monetary Board of the BSP, which is chaired by the Governor of the BSP. Within the BSP, the Supervision and Examination Sector (SES), 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. BSP 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 on a yearly basis.
In addition to the BSP, the Philippine Deposit Insurance Corporation (PDIC) has some supervisory responsibilities. In particular, PDIC—which is charged with insuring deposits and rehabilitating or liquidating banks closed and placed under receivership by the Monetary Board—is also empowered by its charter to examine banks and to require them to submit relevant information. In the normal course of events, however, the PDIC makes extensive use of the supervisor information and findings of the BSP.
Trends in banking system activity
5. 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 around 25 percent and 35 percent a year, respectively, during 1993 to mid-1996 (Figure VI.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 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 VI.3).
Philippines: Deposit Liabilities and Loans of the Banking System, 1993-98
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Sources: Bangko Sentral ng Pilipinas; and Fund staff estimates.Philippines: Deposit Liabilities and Loans of the Banking System, 1993-98
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Sources: Bangko Sentral ng Pilipinas; and Fund staff estimates.Philippines: Deposit Liabilities and Loans of the Banking System, 1993-98
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Sources: Bangko Sentral ng Pilipinas; and Fund staff estimates.
Indicators of Financial Intermediation in the Philippines and other Asian Countries
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Sources: IMF, International Financial Statistics.Indicators of Financial Intermediation in the Philippines and other Asian Countries
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Sources: IMF, International Financial Statistics.Indicators of Financial Intermediation in the Philippines and other Asian Countries
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Sources: IMF, International Financial Statistics.6. 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.
7. 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 currency3—followed by deceleration thereafter. Total foreign currency deposits in the banking system expanded at a annual rate of 38 percent during 1994–96, reaching over US$16 billion in June 1997 (Figure VI.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.
Philippines: Deposits in Commercial Banks’ Foreign Currency Deposit Units (FCDUs), 1993-98 1/
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Sources: Bangho Sentral ng Pilipinas; and Fund staff estimates.1/ December data, except 1998 (June).Philippines: Deposits in Commercial Banks’ Foreign Currency Deposit Units (FCDUs), 1993-98 1/
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Sources: Bangho Sentral ng Pilipinas; and Fund staff estimates.1/ December data, except 1998 (June).Philippines: Deposits in Commercial Banks’ Foreign Currency Deposit Units (FCDUs), 1993-98 1/
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Sources: Bangho Sentral ng Pilipinas; and Fund staff estimates.1/ December data, except 1998 (June).8. Banks’ derivatives activity also grew fast in recent years, although it remains concentrated in relatively simple contracts; around two-thirds of such activity is conducted by foreign banks. Derivatives transactions of the banks in their regular books and their FCDUs reached about US$8 billion and US$1.6 billion, respectively, as of mid-1998; almost the entire volume of banks’ derivative transactions were foreign exchange derivatives, mainly nondeliverable forward contracts (NDFs).
Concentration and competition in the banking system
9. The Philippine commercial banking system is highly concentrated. The ten 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;4 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.
10. In order to increase competition in the banking sector, the authorities licensed ten 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,5 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.
C. Soundness of the Banking System
11. 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.
The banking sector in the wake of the Asian crisis
12. The banking sector come 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
13. However, 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.7 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.8 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.
Capital adequacy
14. 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 very rapid growth of bank assets during the period. The current level of capital adequacy is well above the minimum regulatory requirement of 10 percent,9 which is somewhat higher than in most Asian countries (Figure VI.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.
Selected Asian Countries: Capital Adequacy Requirements
(In percent)
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Sources: National central banks.Selected Asian Countries: Capital Adequacy Requirements
(In percent)
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Sources: National central banks.Selected Asian Countries: Capital Adequacy Requirements
(In percent)
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Sources: National central banks.Asset quality
15. The ratio of nonperforming loans (NPLs) to total loans reached 11 percent in December 1998,10 compared to a level of 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 VI.6).
Philippines: Nonperforming Loans of the Banking System, 1993-98
(In percent of total loans)
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Source: Bangko Sentral ng Pilipinas.Philippines: Nonperforming Loans of the Banking System, 1993-98
(In percent of total loans)
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Source: Bangko Sentral ng Pilipinas.Philippines: Nonperforming Loans of the Banking System, 1993-98
(In percent of total loans)
Citation: IMF Staff Country Reports 1999, 092; 10.5089/9781451831221.002.A006
Source: Bangko Sentral ng Pilipinas.Earnings and profitability
16. 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 (ROE) declined to 0.37 percent in June 1998, from 1.66 percent in 1997 and an average of over 2.3 percent during 1990–96. At the same time, the ratio of operating expenses to operating income reached 90 percent.
D. Financial Sector Reforms Prior to 1997
17. 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.
18. 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,11 and led to a contraction of almost 60 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 non performing assets to an agency created especially for this purpose.
19. 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 BSP) also was granted substantial 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. Ten 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 bank; and the bank branching policies were liberalized. The authorities also tightened prudential regulations, including through higher minimum capital requirements and a liquid asset requirement on FCDU loans. Finally, several measures were adopted to reinforce the legal framework, including in the areas of banks’ derivatives trading, thrift banks, and rural banks.
E. 1998–99 Reform Program
20. 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 Fund and the World Bank,12 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
21. 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—that 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 methodologies used by the BSP were outdated and not geared to the assessment of risk.
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 a set of measures to strengthen the position of the banks as well as the ability of the BSP 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
22. 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 1998.13 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 1999.14
New loan loss provisioning requirements, following the tightening of loan classification guidelines, were announced on October 1997.15 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)16 as well as specific loan loss provisions for “especially mentioned” and collateralized substandard loans.
Supervision methodologies
23. 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 BSP 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 the 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 system17 has been revised to ensure that the composite rating will never be better than a bank’s individual factor rating for capital adequacy.18 In addition, as of July 1998, “sensitivity to market risk” has been added to the traditional CAMEL rating system.19 Also, the composite rating system 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.20 Finally, a revised examination format has been introduced,21 to replace the very detailed examination report in use until recently.
The authorities have initiated action to undertake consolidated supervision of financial conglomerates. An amendment of the General 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 non-financial ventures. As a preliminary step, the BSP is conducting consolidated supervision of banks and quasi-banks based on the inclusion of their financial subsidiaries and affiliates.22 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 BSP 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 BSP 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
24. Several other initiatives have been taken to strengthen the soundness of the banking system and the BSP’s 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 NPLs, the ratio of NPLs to the total loan portfolio, the amount of classified assets and other risk assets, and the extent of specific and general loan loss reserves.23
Stricter licensing guidelines for new banks have been in place since July 1998.24 Also, the BSP 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 BSP has required them to mark to market their trading securities portfolio.25
Bank exit and resolution
25. 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 BSP could suffer financial losses if a decision is taken to close a bank.26 Finally, the Philippine Deposit Insurance Corp. (PDIC) 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 a 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
26. A number of measures have been adopted to enhance the BSP’s ability to deal with troubled banks. As a result, the BSP 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 PDIC as receiver, and to reduce the financial risk for the BSP associated with bank closures.
To permit early detection of problems, the BSP has compiled a list of banks in potential distress.27 On the basis of this list, which is updated regularly, the BSP has adopted a program of intensified monitoring and special examinations of selected banks. The Monetary Board has allowed the supervision services of the BSP to conduct such special examinations without the need for specific previous authorization.28
The BSP 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.29 Also, the BSP 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 ten-fold increase in the current value of monetary penalties. The BSP has formulated contingency plans to deal with any systemic bank problems, in cooperation between the PDIC and the Department of Finance.
To improve the ability of the PDIC to act as the receiver of banks, it has been determined that once the PDIC 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 BSP from the risk of financial loss. The BSP is also are aware of the risk of financial loss arising from uncollateralized overdrafts to banks, and has submitted a proposal to amend the BSP Act to eliminate this practice. In the meantime, the BSP has issued regulations to require thrift banks to provide collateral against all BSP overdrafts,30 and intends to issue similar regulations for commercial banks.
PNB
27. Strengthening the PNB on a sustainable basis is an important part of the authorities’ banking reform program. The Philippine National Bank (PNB), 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 VI.4). The authorities have announced publicly their intention to privatize the bank by mid-2000, the latest. In the meantime, PNB has moved to write down its capital from
F. Initial Results and Agenda for Further Reform
28. Implementation of the banking reform program adopted in early 1998 has been largely on track, and initial results are positive. Banks are seeking market-bases 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, down-grading 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.
PNB
PNB, established in 1916, has over 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. However, it lags behind industry leaders in a number of areas, including credit and risk management policies and the degree of automation of its operations. In June 1996, the government reduced its ownership in PNB from 100 percent to 45,6 percent. The stock in private hands is widely dispersed.
PNB’s financial performance has deteriorated significantly in the last few years, following a series of large corporate loan defaults (including Philippine Airlines (PAL)). Return on assets remains the lowest among the large banks in the country. The difficulties of PNB were exacerbated by the onset of the 1997 regional financial crisis and the accompanying devaluation of the peso and economic downturn. PNB 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 to 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, [Net loss of
In early 1999, provisions of
29. Looking ahead, to further strengthen the soundness of the system and reinforce supervisory capabilities, continued reforms should focus on: (i) reducing distortions in financial intermediation; (ii) further strengthening the prudential framework; (iii) streamlining the process of bank exit and resolution; and (iv) the PNB.
Reducing distortions in financial intermediation
30. 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.31 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 n the banks as they adapt their balance sheets and could result in banks’ permanently holding excess reserves.32
Eliminate mandatory credit allocation programs, to avoid misallocation of resources.33 Currently, banks are required to lend 25 percent of their credit to agriculture and agro-processing 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
31. The BSP 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 two-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.34
Banks’ vulnerability to exchange rate volatility
32. 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
33. BSP 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-quarter of BSP 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.
34. To ensure the successful implementation of modern supervisory methodologies, BSP and PDIC 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
35. 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,35 the courts have allowed civil laws suits to be brought against individual bank supervisors in connection with such acts.
Bank secrecy
36. 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 PDIC has no information on individual depositors prior to closure of the bank.
Banks’ trust activities
37. The BSP 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 banks’ trust activities are fully guaranteed by the parent bank.
Streamlining the process of bank exit and resolution
38. The framework for bank resolution must be strengthened further.
As soon as bank is placed under receivership, the PDIC 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 PDTC 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 PDIC receivership is subject to time limits (up to 90 days),36 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.37
To limit the risk for the BSP arising from financial assistance to troubled banks, all forward emergency assistance should be fully collateralized, and the limit on emergency loans related it to the size of a bank’s capital rather than deposits.38
References
Alexander, William E., Tomás J. T. Baliño, and Charles Enoch, 1995, “The Adoption of Indirect Instruments of Monetary Policy,” IMF Occasional Paper 126 (Washington: International Monetary Fund, June).
Escolano, Julio, 1997, “Tax Treatment of Loan Losses of Banks,” in Banking Soundness and Monetary Policy ed. by Charles Enoch and John H. Green (Washington: International Monetary Fund).
Fry, Maxwell J., 1988, Money, Interest and Banking in Economic Development (Baltimore: The Johns Hopkins University Press).
Hardy, Daniel C., 1997, “Reserve Requirements and Monetary Management: An Introduction,” in Instruments of Monetary Management. Issues and Country Experiences, ed. by Tomás J. T. Baliño and Lorena M. Zamalloa (Washington: International Monetary Fund).
Lirio, Ricardo P., 1998, “The Central Bank and Non-Bank Financial Intermediaries” in Philippine Financial Almanac 1997/98 (Manila).
Nascimento, Jean-Claude, 1991, “Crisis in the Financial Sector and the Authorities’ Reaction: The Philippines,” in Banking Crises: Cases and Issues ed. by V. Sundararajan and Tomás J. T. Baliño (Washington: International Monetary Fund).
Nellor, David C. L., 1998, “Tax Policy and the Asian Crisis” (Washington: International Monetary Fund, December).
Tan, Edita A., 1993, “Interlocking Directorates of Commercial Banks, Other Financial Institutions and Bon-Financial Corporations,” in Philippine Review of Economics and Business, Vol. XXX, No.1 (Manila: June).
World Bank, 1998, Banking Sector Reform Loan.
World Bank, 1998, Country Economic Memorandum.
Prepared by Enrique G. de la Piedra.
One small commercial bank, Orient Bank, is now under receivership and is not operating.
See Nellor (1998). After a long period in which interest 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 banks1 foreign currency deposit units (FCDU) 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 non residents and with other FCDUs are exempt. Finally, while peso deposits are subject to significant reserve requirements, largely unremunerated, foreign currency deposits are not subject to reserve requirements.
See Fry (1988) and Tan (1993).
The number of branches that foreign banks are authorized to open cannot exceed six, while their borrowing from head offices cannot exceed US$4 for every US$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 tend to have a more diversified portfolio.
Since the start of the current difficulties in the financial sector, one small commercial bank, seven thrift banks, and 18 rural banks have failed; however, the combined size of these banks’ assets is very small—less than 1 percent of the assets of the banking system—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 around 2 percent, compared to about 12 percent in Jakarta and Bangkok). At the same time, the prevalence of pre-sold projects helped limit large-scale reliance on bank finance for real estate purposes. In addition, the BSP in 1997 took measures to limit bank lending for real estate projects.
For capital adequacy, the BSP 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, i.e., fixed assets, loans, and investments.
The ratio increased further to 13.1 percent in March 1998.
See Nascimento (1991).
Banking sector reform is a major component of the program supported by the current standby arrangement with the Fund, and the World Bank in December 1998 approved a Banking Sector Reform Loan (BSRL).
Circular 156 of March 19, 1998, BSP, Office of the Governor.
Circular 168 of July 3, 1998, BSP, Office of the Governor.
Monthly installment loans are now to be considered non performing after three months in arrears rather than six, whereas quarterly-installment loans are to be treated as non performing 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. 17
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, BSP.
Circular 157 of March 19, 1998.
Monetary Board Resolution 832 of June 10, 1998, BSP.
Circular 161 of March 30, 1998.
Such losses may arise from three sources: uncollateralized overdraft lending to a troubled bank; inability by the BSP 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 PDIC has unlimited access to BSP 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 BSP 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 footnote 3 above.
See Hardy (1997) for a discussion of the drawbacks of reserve requirements as an instrument of monetary control.
See Alexander, Baliño 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 five times by an additional 30 days each, through Monetary Board Resolution.
The BSP 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. However, the powers of the comptroller are very limited, 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 at 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 BSP for an emergency loan.
