This Selected Issues paper for the Philippines has been prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. Spillovers have been particularly prominent for countries with financial systems with high foreign bank participation, large exposures to ailing global financial institutions and structured products, and high external liabilities, including through wholesale funding. With a nascent capital market, the economy’s exposure to securitization and off-balance sheet activities is limited. The presence of foreign capital remains low in both the capital market and the banking system.


This Selected Issues paper for the Philippines has been prepared by a staff team of the International Monetary Fund as background documentation for the periodic consultation with the member country. Spillovers have been particularly prominent for countries with financial systems with high foreign bank participation, large exposures to ailing global financial institutions and structured products, and high external liabilities, including through wholesale funding. With a nascent capital market, the economy’s exposure to securitization and off-balance sheet activities is limited. The presence of foreign capital remains low in both the capital market and the banking system.

I. Contagion of the recent global financial turmoil1

A. Introduction

1. The global financial turmoil has impacted most emerging market countries, including the Philippines. Spillovers were particularly prominent for countries with financial systems with high foreign bank participation, large exposures to ailing global financial institutions and structured products, and high external liabilities, including through wholesale funding. Fortunately, none of these characteristics were salient in the case of the Philippines. However, the Philippine financial system is exposed to both external and domestic channels of risk. This chapter tries to identify the main channels of risk and discuss policies to counter any further fallout from the global financial crisis.

B. Channels of Contagion

2. So far, the spillovers from the global financial crisis on the Philippines have been relatively muted. With a nascent capital market, the economy’s exposure to securitization and off-balance sheet activities is limited. Presence of foreign capital remains low both in the capital market and the banking system. Nevertheless, equity prices have fallen and banks’ debt holdings were adversely affected through rising interest rates and risk premia; direct exposure to distressed global banks; and tightening of interbank dollar funding.

Equity markets

3. Equity prices have dropped by close to 50 percent so far in 2008, with the PSE index showing strong correlation with U.S. equity indices. The correlation between S&P 500 and the PSE index since June 2007 was 0.90, broadly in line with regional peers.2 A pair-wise granger causality test also confirms the transmission of shocks from the United States to the Philippine equity market.

Table I.1.

Correlation Between Asian and U.S. Stock Indices

(July 2, 2007–October 30, 2008)

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Table I.2.

Granger Causality Between the Philippine and U.S. Equity Prices

(July 2, 2007–October 30, 2008)

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Note: Null hypothesis is A does not granger cause B (A ≠>B). Number in each cell entry represents the p-value corresponding to the test statistics.

4. However, the local banks’ direct exposures to the equity market are limited. The Philippines’ stock market capitalization (US$44 billion) is half of Indonesia’s (US$71 billion) and Thailand’s (US$87 billion). The ratio of free floats is estimated at about 20 percent and the shallow market has resulted in lack of interest in portfolio equity by banks, which are active investors in fixed income market.3 As the result, only P 6 billion of bank equity holdings, or equivalent to 1 percent of banking system capital, are subject to fair value accounting.

5. That said, a protracted large decline in equity price may have some consequences for the financial sector. Banks will face difficulty in raising fresh capital in a bear market and some nonbank financial institutions (e.g., insurance companies) are more exposed to equities. Moreover, banks would be indirectly exposed as corporate clients would also find it more difficult to raise capital in local equity markets.

Debt markets

6. Bank exposure to marketable bonds is substantial. As of June 2008, Philippine banks held P 1.2 trillion of debt securities. Out of this, P 313 billion were recorded at cost, either as held-to-maturity securities or unquoted debt securities classified as loans. The rest, P 906 billion are primarily comprised of government securities and are priced at fair value. They either feed directly into income statements (17 percent) or into capital sections of balance sheets as unrealized gains or losses (83 percent). This P 906 billion amounts to 1.6 times the banking system capital and 17 percent of the asset, well above the exposures in regional peer countries.

Table I.3.

Exposure to Marketable Securities

(June 2008)

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Note: 1/ Trading account and available for sale securities.

7. The exposure makes Philippine banks susceptible to domestic and international interest risks, sovereign spread risks, and corporate credit risks. About 40 percent of all mark-to-market debts consist of peso-denominated government bonds with fairly long duration.4 Hence, they are subject to domestic interest rate risks. Roughly half of the total marketable securities are denominated in foreign currency (mainly U.S. dollar), the bulk of which are Republic of Philippines foreign currency-denominated bonds (ROPs) or credit linked notes (CLNs) linked to ROPs. The CLNs are typically levered up for yield enhancement by doubling or tripling the notional amount of the credit default swap from the principal amount of the host note.

8. ROPs and CLNs are sensitive to sovereign spread risks. Since the beginning of 2008, the EMBI+ Philippines widened by 360 bps, although it remained below EMBI+ Global and EMBI+ Asia. The correlation coefficient between EMBI+ Philippines and U.S. High Yield and average CDS spread for major global banks rose up to 0.9 since the beginning of 2007. Philippine banks are estimated to hold about US$5 billion of ROPs and US$2 billion of CLNs. Assuming an average duration of four years for both securities, and leverage of 2 for the CLN, a 100 basis point increase of the sovereign spread will result in a mark-to-market loss of US$0.4 billion (or 3 percent of banking system equity5). Further, CLNs entail credit risks related to the host security issuer. For example, some large Philippine banks suffered hefty losses on their holdings of CLNs issued by Lehman Brothers.

Table I.4.

Correlation - Philippine and the Global Credit Market

(January 1, 2007–September 15, 2008)

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Interbank dollar funding

9. The drying up of global liquidity has also affected the Philippine interbank dollar market. Bulk of banks’ demand for dollar settlement balance results from intermediating international trades. Net outflows of portfolio capital, with its elevated volatility since the crisis outbreak, also added to day-to-day funding pressure. Finally, the Bangko Sentral ng Pilipinas’s (BSP) asset cover rules on foreign currency deposit units (FCDU), which requires 100 percent cover of FCDU liability by dollar assets, also created additional demand for dollars6 as mark-to-market losses kept growing on ROPs and CLNs. However, a steady inflow of remittances helped mitigate dollar shortage. Even so, short-term funding has become costlier and more volatile.

Figure I.1.
Figure I.1.

FX Swap Implied Interbank Peso Lending Rates

Citation: IMF Staff Country Reports 2009, 063; 10.5089/9781451831443.002.A001

Source: Bloomberg.Notes: PHIREF = Currency swap implied interbank peso lending rate. 1M, 3M, 6M, and ON stands for swap maturity (1 month to overnight).

Exposure to distressed global banks

10. Thus far, Philippine banks’ disclosed direct exposure to faltering global banks has been limited. Philippine banks had no direct subprime exposure and only minimal exposure to CDOs. The exposure to potentially distressed foreign financial institutions (seven U.S. and four European) was $1.5 billion or 1.4 percent of total banking assets.7 Their exposure to Lehman Brothers amounted to US$350 million (3 percent of total banking equity) and has mostly been provisioned for. That said, these exposures are concentrated on a handful of banks.

Exposure to foreign funding

11. Philippine banks’ exposure to foreign funding is modest. Currently, Philippine banks’ foreign liability stands at P 444 billion, amounting to 28 percent of private credit and 14 percent of deposits. This is somewhat higher than peer group countries, but banks’ foreign assets are substantially larger than foreign liabilities. Resident or remittance-related dollar deposits, a substitute for foreign funding, also outstrip banks’ foreign liability and have held up well so far. Further, the share of banks’ short term to total foreign debts amounts to 60 percent, which is less than that of Indonesia (70 percent), Korea (70 percent), and Malaysia (90 percent).

C. Mitigating Contagion

12. Spillovers from the global financial crisis have so far not led to severe systemic financial strains in the Philippines. However, despite substantial remedies already made, bank exposure to sovereign spread still poses the greatest risk. An unforeseen further worsening of global liquidity clogging can result in further widening of the sovereign spread and a tightening of dollar-funding conditions for the Philippine banks.

13. Going forward, the real economic cycle will increasingly weigh on the soundness of the financial system. The economic slowdown could reduce bank earnings and worsen asset quality as households and SMEs, including export-oriented firms, find it more difficult to service their debt. Third-quarter income statements already show a decline in profitability of the top five banks. The decline took place despite several banks taking advantage of the BSP’s relaxation of accounting rules (see below). Trading gains and losses led the profit deterioration for Banco De Oro, Bank of the Philippine Islands, and Philippine National Bank.8 Loss provisioning also drove down net income for some banks.

Table I.5.

Top Five Banks - Recent Earnings

(In millions of pesos)

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Source: Bloomberg.

Mitigating risks

14. Regulators need to act judiciously and timely to mitigate risks of crisis transmission. The BSP has already taken a number of steps to this end including: through a reduction in the reserve requirement ratio, a doubling of its rediscount capacity, accounting and regulatory forbearance, and stepped-up dollar liquidity provision. All of these measures were appropriate and timely. Going forward, the deposit insurance framework should be given sufficient flexibility. Targeted efforts will also be needed on strengthening the capital base of banks, particularly for banks with large sovereign spread or foreign counterparty exposures.

Exposure to sovereign spread risk

15. Banks will need to limit losses by reducing their ROP and CLN exposures. By adopting October 2008 amendments to International Accounting Statement (IAS) 39, the BSP allowed Philippine banks to reclassify mark-to-market securities to the held-to-maturity (HTM) account at any price prevailing between July 1 and November 14, 2008. Importantly, the BSP exempted CLNs and other hybrid (of derivative and nonderivative host instrument such as a corporate note) linked to ROPs from the requirement for bifurcation. Hence, structured instruments linked to ROPs can be reclassified without stripping its derivative components.9 10

16. Although these steps provided substantial relief, they are not eliminating exposure to sovereign spread risks. So far, only part of banks’ current holdings of ROPs and CLNs—most of which are linked to ROPs—have been reclassified to HTM due to the liquidity implication of reclassification (securities cannot be sold out of HTM).11 Banks worry that reclassification may backfire in times of dire liquidity shortage. Hence, many banks are likely to continue to be exposed to market risks of ROPs and CLNs. Further, practical difficulties limit the scope for hedging these exposures.12

17. In the end, banks will need to gradually deleverage their sovereign spread exposure. Banks have shortened the duration of their ROP and CLN holdings. Such efforts could be strengthened. At the same time, the embedded leverage in CLN structures needs to be gradually scaled back. Ultimately, banks with higher exposure will need more capital.13

Exposure to international banks

18. Exposure to international banks also needs enhanced monitoring. The frequency of BSP monitoring on such exposures should increase and thematic on-site examination be implemented as needed. In fact, Lehman Brothers bankruptcy was a good wake up call that structured products such as CLNs entail counterparty risks, apart from the risk of the reference entity. Moreover, banks should be encouraged to reduce their counterparty concentration over time. They should also strengthen due diligence on complicated financial products. At the same time, banks with heavier exposure should be led to raise more capital.

Pressure on dollar liquidity

19. The BSP has already taken a number of measures to alleviate pressures in dollar funding. It has introduced a U.S. dollar-denominated deposit facility and repurchase agreement with banks. The BSP has also exempted until March 31, 2009, unrealized mark-to-market losses from the calculation of bank’s FCDU asset cover requirement and began to directly intervene in the foreign exchange swap market as well. Yet, a substantial chunk of the unrealized mark-to-market losses are likely to remain beyond the March 31, 2009 expiration of the relief and the dollar funding pressure may revive at the expiration.

D. Lessons From Global Turmoil

Enhancing risk management capabilities and oversight

20. Closely aligning the economy’s risk management capabilities with the pace of innovation would be imperative. The losses that Philippine banks suffered on structured products such as CLNs illustrate how banks underestimated the true risks of such products. Banks should be required to step up due diligence and risk management on this front. Oversight and disclosure of off-balance sheet activities, including the unit investment trust funds (UITFs), should also be stepped up.14 Even in more advanced emerging markets (e.g., Korea), mutual fund type instruments sold at bank often expose banks to litigation and negative publicity. Most importantly, the BSP should ensure compliance with the existing regulation on disclosure and investor competence. At the same time, banks will need to incorporate reputational, litigational risks, and other contingency risks from their off-balance sheet activities in their overall risk management framework.

Improving capital adequacy

21. Bank capital adequacy proved critical in anchoring confidence in the banking system. Despite much progress in efforts to align economic and regulatory capital, the global turmoil showed that even the largest global banks were not adequately capitalized. The average capital adequacy ratio of the Philippine banks is higher than U.S. banks before and after the turmoil. However, this does not exempt the Philippines from the on-going global efforts to improve capital adequacy and re-establish better norm and benchmark in this regard. It would be important to remove obstacles to capital measurement transparency, such as oversized foreclosed assets that remains on the bank balance sheet. Reliability of capital measurement also depends on quality, legal power, and independence of bank examiners and auditors15.

22. The BSP’s regulation tool kit for capital adequacy and provisioning will also have to be stepped up. For one, bank-by-bank differentiation of regulatory capital requirement would help safeguard the system without exacerbating procyclicality embedded in the Basel II framework. The BSP is already working on strengthening pillar 2 in order to implement individually differentiated capital adequacy ratios, which factors in business profile and risk capacity of a bank. Going forward, dynamic provisioning over a full economic cycle could also be considered to boost banks’ capital reserves while mitigating excessive credit cycles.

Strengthening contingency framework

23. Many countries expanded their deposit scheme either in the form of increased deposit insurance ceiling or blanket guaranty. U.S. FDIC deposit insurance temporarily increased its ceiling from US$100,000 to US$250,000 until the end of 2009. Other countries, including Irish and Greek governments temporarily introduced blanket guaranty. The turmoil proved that deposit guarantee is still very important to contain a system-wide bank run. The Philippines deposit insurance (PDIC) system’s capacity to address such challenges leaves scope for improvement. The authorities plan to raise the deposit insurance ceiling to P 500,000 from P 250,000.16 Greater flexibility in the PDIC law regarding the maximum coverage and recapitalization of PDIC should also be allowed.

E. Conclusion

24. Overall, the Philippine financial system has so far remained resilient to the spillovers from the global financial crisis. However, the banking sector is exposed to further mark-to-market losses on their large ROP and CLN holdings if country risk premia rise further; external funding conditions could tighten, although the large deposit base provides a cushion; and off-balance sheet activities could constitute reputational risks in the event of strong redemption pressures from the unit investment trust. From the domestic side, the earnings and asset quality will decline as the economy slows.

25. A number of mitigating steps have already been taken, including heightened monitoring; accounting and regulatory forbearance; and liquidity provision. However, there are scopes for additional measures to mitigate the risks. BSP should step up monitoring of off-balance sheet activities, enhance stress-testing exercises, and strengthen banks’ risk management capabilities, including liquidity risk management. The regulatory forbearance should not be allowed to impair transparency about financial soundness. Going forward, a gradual reduction of banks’ sovereign spread exposure is needed and capitalization should be stepped up, possibly through a proactive application of pillar 2 of the Basel II framework. The BSP should stand ready to flexibly apply existing liquidity facilities and the proposed doubling of deposit insurance could be supplemented by a legal provision allowing for a temporary blanket guarantee under extreme stress.


  • Edward Frydle and Kenneth Kang, 2008, Impact and Lessons from the Global Financial Turmoil, Japan: Selected Issues, Chapter I, July (Washington: International Monetary Fund).

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  • International Monetary Fund, 2008, Global Financial Stability Report, October (Washington: International Monetary Fund).

  • International Monetary Fund, 2008, “Implication of the Global Financial Crisis for Asia’s Outlook,” Chapter II, Regional Economic Outlook forthcoming (Washington: International Monetary Fund).

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  • International Monetary Fund, 2002, Detailed Assessment of the Observance of the Financial Sector Standards and Codes, Financial Sector Assessment Program: Philippines, July (Washington: International Monetary Fund).

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  • Reserve Bank of India, Discussion Paper on Prompt Corrective Action, Department of Banking Supervision Central Office, Policy Planning Division (

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Prepared by Jack Joo Ree.


In fact, the PSE demonstrated substantially stronger correlation than Asian peers with U.S. stock indices until September 2008.


The Philippines adopts universal bank system where banks are allowed to fully own both financial and nonfinancial allied enterprises. This reduces banks’ incentive to participate in portfolio equity as a minority shareholder in nonallied cooperates, which tend to be closely held. Banking law (RA 8791) sets 50 percent of net worth limit on total equity investment. However, the limit generally leaves plentiful slacks.


The average maturity of peso-denominated government bond is about 19 years.


All of the exposures are assumed to be marked to market.


Before the BSP’s temporary relaxation of the asset cover rule, banks making unrealized losses on the FDCU assets were required to immediately transfer eligible foreign currency assets from regular banking unit (RBU) to FCDU as credit (due to RBU – FDCU/EFDCU unrealized losses recognized in profit or loss and in equity; this account is not subject to asset cover requirement.). Thus, mark-to-market losses on ROPs and CLNs either shrank the dollar liquidity surplus or widened the dollar liquidity deficit of a bank.


This figure is based on BSP’s survey of counterparty exposure as of September 30, 2008. It did not include exposure to Citigroup though. Citibank Philippines branch’s total asset amounts to P 200 or 4 percent of total banking system asset. Hence, the overall exposure to distressed global banks must have been much larger if Citigroup exposure were accounted for.


Each bank took advantage of the BSP’s accounting relief (option to reclassify mark-to-market assets to held-to-maturity at predated transfer price) to a different degree. For example, third quarter trading account profit can be a reflection of larger reclassification rather than better trading desk performance.


This exception has no foundation in IFSR. IFSR requires that all financial instruments that are derivatives or have an embedded derivative be classified as Fair Value through Profit and Loss (FVTPL) and measured at fair value. And the IAS39 amendment specifically prohibits the reclassification of anything that is classified as FVTPL


All other hybrid financial assets (other than CLNs) may be reclassified into the AFS/HTM/UDSCL only after bifurcating the embedded derivative from the host instrument and booking the derivatives under Derivatives with Positive/Negative Fair Value. Only the remaining host contract will be reclassified using predating.


Philippine Accounting Standard (PAS) has largely converged the IFRS, particularly in terms of stringency of the tainting rules. The tainting rule effectively prohibits reversal of reclassification decision, as any security sold from the HTM will trigger a forced reclassification of all HTM securities to AFS.


Market participants noted that they did not favor hedging strategy using derivatives (e.g., CDX). A key reason is their concern on reported earning volatility, which can occur when securities in AFS is matched with derivatives, which must be classified as FVTPL. Further, market liquidity of hedging instruments may grow very thin in a one-way market.


As many banks are adopting standardized framework for market risk calculation, rather than an internal VAR model, rise in sovereign spread volatility will not result in automatic adjustment of regulatory capital. Hence, a proactive supervisory review will be needed on capital adequacy to tighten the alignment between economic and regulatory capital.


Investors in UITFs participate in a share of net asset values (NAVs) of the investment pool, which are marked to market daily. Disclosure and competency rules are in place, so that investors ideally understand that the fund’s invest performance are fully passed through to them. The UITFs are not allowed to take leverage. As such, redemptions are made by drawing on liquidity reserve of the fund or by liquidating portion of the asset portfolio.


In general, practices such as “ever greening” and delayed recognition of asset impairment can significantly inflate income, current year profits, and capital.


The audited net assets of the Philippine Deposit Insurance Corporation (PDIC) are relatively low at 1 ½ percent of system deposits (P 49 billion; end-2006). Moreover, premiums are uniformly capped at 0.2 percent of the insured amount, irrespective of risk profiles of banks.