ma. socorro gochoco-bautista - regional...

The Past Performance of thePhilippine Banking Sector and

Challenges in the Postcrisis Period

Ma. Socorro Gochoco-Bautista

Ma. Socorro Gochoco-Bautista is Rosa S. Alvero Professor of Economics, University of the Philippines;and was formerly Assistant Professor of Economics, University of Hawaii.

30 A STUDY OF FINANCIAL MARKETS

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Executive Summary

A look back at the history of Philippine banking re-

veals a developmental role assigned to the banking

system and a common pattern of frailty in the face

of adverse shocks. Ceilings on interest rates, inter-

est rate subsidies, and directed lending were intended

to enable the banking system to promote economic

growth by being the main source of development fi-

nance. While the system itself has displayed a flex-

ibility and willingness to undertake reforms, these

actions were often in response to, rather than pre-

ventive measures against, crises. Genuine reforms

have usually come after, not before, crises and in the

transition from crisis to stability (and one regulatory

regime to a stronger one), the restoration of confi-

dence in financial markets was agonizingly slow. The

ensuing contraction in credit and intermediation has

usually dragged down the rest of the economy.

The occurrence of the Asian financial crisis has

led to a rethinking of how best to strengthen banking

systems so as to prevent banking crises, or to reduce

banking system vulnerability to crises. There is ap-

parently a greater appreciation for the idea that regu-

lation and supervision must now increasingly focus

on the less traditional and conventional methods.

This study examines the structure and current

state of the Philippine banking industry, reviews the

history of financial reforms, discusses the measures

taken by the authorities to strengthen the banking

sector prior to and after the Asian crisis, identifies

the remaining weaknesses and factors that contrib-

ute to the vulnerability of the Philippine banking in-

dustry, and makes some recommendations to ad-

dress them.

The original impetus for reform in the 1950s and

1960s was not the need to respond to crises, but the

rapid growth and increasing fragmentation of the

banking system. The increasing diversity of financial

institutions and services challenged the ability of the

central bank to adequately regulate them. However,

prudential financial regulation at that stage was highly

undeveloped: capital adequacy standards for solvency

were relevant, but required very simple and rudimen-

tary implementation mechanisms; liquidity was man-

aged by imposing the reserve requirement; and su-

pervision and examination requirements were ad-

dressed through simple reporting systems.

In 1972–1973, a Joint International Monetary

Fund-Central Bank (IMF-CB) Banking Survey Com-

mission recommended that several amendments be

made to the General Banking Act and the Central

Bank Act. These amendments were meant to (i)

realign regulation by function rather than by type of

bank; (ii) consolidate central bank authority over

banks and nonbanks (except insurance companies);

(iii) redefine the central bank’s responsibilities to ex-

clude the promotion of economic growth; and (iv)

impose restrictions on entry into the banking system,

with concomitant efforts to improve the efficiency

of existing banks. Along with the increasing dyna-

mism of the financial sector and the need for more

responsive financial structures to address financing

needs, the moves toward rationalizing the central

bank’s supervision over the banking sector led to in-

creasing pressure to adopt more sophisticated pru-

dential regulatory mechanisms and structures. While

banking institutions remained the dominant financial

intermediaries, nonbank private and quasi-public fi-

nancial institutions emerged, constituting an alterna-

tive means of intermediation.

The process of reform suffered an adverse shock

in 1981 when businessman Dewey Dee, faced with

millions of pesos in debt owed to various financial

institutions, decided to abscond. The Dee incident

triggered a financial crisis, a rash of insolvencies in

investment houses and finance companies. This re-

sulted in a flight-to-quality, as savers shifted their funds

out of these institutions and into large commercial

banks. The Aquino assassination in August 1983 pre-

cipitated an even bigger crisis, one that further eroded

domestic and international confidence in the entire

financial system. In response to the massive capital

flight and persistent current account deficits, the

31THE PAST PERFORMANCE OF THE PHILIPPINE BANKING SECTOR AND CHALLENGES IN THE POSTCRISIS PERIOD

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Government was forced to devalue the peso, impose

a moratorium on external debt payments, ration for-

eign exchange, and raise interest rates.

Years of protracted crisis took their toll on other

aspects of the financial system. Uncertainty and risks

in lending stifled the long-term loan market. The num-

ber of bank offices declined in absolute terms (as

several banks collapsed), and so did the total assets

of the banking system. Total lending by the banking

system fell and did not reach the 1980 levels until the

early 1990s. The rash of foreclosures followed the

deterioration in loan portfolios and led to an increase

in bank investments. To strengthen what remained

of the banking system, the central bank pursued a

rehabilitation program for weaker banks. Asset qual-

ity remained generally weak and, in the process,

banks invested a large portion of their funds in high-

yielding government securities.

The early 1990s saw a marked improvement in

the state of the financial system. Bank branching

was relaxed. The foreign exchange market was

deregulated in 1992 to enhance market efficiency

and achieve exchange rates more consistent with

economic growth. Restrictions on foreign exchange

transactions of banks were lifted and prudential

limits on foreign exchange positions of banks were

redefined.

Unfortunately, the boom in the financial sector also

planted the seeds for weakness and vulnerability in

the 1990s. The reentry of the Philippine Government

into the international capital markets encouraged

many domestic banks and firms to follow suit. As a

result, while relative indicators suggested that the

foreign indebtedness of the public nonbank sector

had been steadily declining, the foreign indebtedness

of the private banking and private nonbank sectors

steadily increased.

The Philippine banking system experienced many

of the symptoms that ultimately did in the banking

systems in the countries worse hit by the crisis. These

symptoms, which became particularly evident in the

aftermath of the crisis, included macroeconomic vola-

tility, high property exposure and asset inflation, large

amounts of foreign exchange liabilities, government-

directed lending and related-party lending, fragility in

the case of some banks, and weak supervision and

underregulation in some others. The response of the

monetary authorities to speculative pressure on the

peso beginning in July 1997 was to sell dollars ini-

tially and, subsequently, to tighten liquidity. The latter

resulted in raising interest rates on 91-day treasury

bills from 10.5 percent in June 1997 to a high of 19.1

percent in January 1998. The central bank ultimately

gave up its defense of the peso, which then depreci-

ated by 15 percent on 11 July 1997.

These events adversely affected the corporate sec-

tor, the financial sector, and the rate of economic

growth. Bank profitability declined dramatically in 1998

relative to the two previous years. The return on eq-

uity (ROE) of commercial banks fell from 16.34 per-

cent in 1996 to 12.42 percent in 1997 and to a low but

still positive 6.6 percent at the end of 1998. By March

1999, it had decreased further to 1.69 percent.

Nevertheless, most observers as well as Govern-

ment authorities themselves agree that the Philip-

pine banking system managed to survive the Asian

financial crisis relatively unscathed and that there is

no banking crisis in the Philippines. Over the last

three years, the Bangko Sentral ng Pilipinas (BSP),

the Philippines’ central bank, undertook measures to

strengthen its prudential framework over banks so

as to reduce system risks, strengthen regulatory over-

sight, and align domestic banking standards with in-

ternational best practices. The major measures in-

cluded the raising of capital requirements, tightening

of provisioning requirements, and stricter loan clas-

sification subject to loan-loss provisioning.

The BSP undertook a comprehensive reform pro-

gram whose elements included (i) strengthening the

prudential and supervisory systems, (ii) adopting an

early intervention system and a bank resolution strat-

egy to deal more effectively with problem banks

and to safeguard the soundness of the banking sys-

tem, (iii) undertaking special programs to strengthen


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and modernize government banks through

privatization, (iv) adopting measures to reduce the

intermediation costs of financial institutions, and (v)

improving the legal and regulatory framework through

legislation by Congress.

Bank closures in 1997 and 1998 were few and

the amount of total bank assets they represented was

small. Notwithstanding the Asian financial crisis, the

total resources and total operating network of the

Philippine banking system expanded slightly in 1998

compared with a year earlier. The total resources of

the banking system grew by close to 1 percent in

1998 relative to the end-1997 level. The asset quality

problem of Philippine banks is not about solvency as

it is in the cases of Indonesia, the Republic of Korea,

and Thailand. In terms of portfolio loan quality, the

nonperforming loan (NPL) ratio of the entire bank-

ing system increased from 4.7 percent in December

1997 to 12.1 percent in January 1998.

The BSP continues to encourage mergers and

consolidation within the banking sector, principally

through increases in minimum capital requirements.

There have been substantial improvements toward

the prudential supervision of banks, including those

on asset quality norms such as the interest accrual

policy on past-due loans, the reversal of accrued

interest income on NPLs, and the high provisioning

requirements.

Nevertheless, there are remaining weaknesses and

vulnerabilities that must be addressed.

The Philippines continues to be plagued by cer-

tain macroeconomic weaknesses. Among the coun-

tries in Asia, the Philippines has the lowest savings

rate at 19 percent and it is second only to Indonesia

in having the largest ratio of public sector debt to

gross domestic product (GDP). Both these facts

imply that, in the mean time, the Philippines will have

to rely on foreign savings. GDP growth was nega-

tive in the last two quarters of 1998, but managed

to rise to 1.5 percent in the first quarter of 1999

largely due to improved agricultural growth. On the

inflation front, estimates of year-on-year average

inflation rate for 1999 are higher than those for

neighboring countries.

Some observers have associated the problem-

atic outcomes of the liberalization of financial mar-

kets with a deficient state of institutional arrange-

ments, such as good accounting systems and ad-

equate disclosure.

Several weaknesses in the prudential norms of

Philippine banks remain. First, banks accrue income

on restructured loans or immediately classify them

as performing loans so long as the loans are current

in status, or are fully secured by real estate with a

loan value up to 60 percent of the appraised value of

the real estate security and other qualified collateral.

While there have been notable improvements in dis-

closure with respect to NPLs, loan-loss provisioning,

and loan-loss reserves, as in many Asian banking

sectors loan-loss provisioning requirements are typi-

cally net of collateral, which is usually property. Sec-

ond, Philippine banks are active in loan-for-property

swaps. Such loan-for-property swaps can take place

without formal legal foreclosure proceedings. In many

cases, these properties are actually unearned assets

in the form of raw land and are booked as real and

other property owned and acquired accounts

(ROPOA) in bank balance sheets at realizable val-

ues. Philippine banks can directly foreclose pledged

collateral once the borrowers are proven unable to

service the interest or the principal or both. Third,

reserve coverage against such ROPOA assets are

not required until after five years from the time the

property is booked. Some banks could use this to

inflate collateral value since the property market is

illiquid. Fourth, loan-loss reserves are currently not

tax-deductible although the BSP has endorsed to

Congress a plan to make such reserves deductible.

Since this move involves tax revenues, it needs to

be legislated. In general, while attempts should be

made to lower financial intermediation costs and

enhance the profitability of banks, the important point

is that the industry must also become more con-

testable. Otherwise, such moves to reduce inter-


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mediation costs will simply strengthen an existing

oligopoly. Fifth, the timing of loan write-offs is de-

termined in part by its effect on the capital position

of the bank and in part by its tax effect. Deferring

write-offs is common and may materially overstate

the value of assets and capital.

The banking system continues to suffer from weak

implementation of prudential norms and international

supervisory standards. While the Bank for Interna-

tional Settlements (BIS) core principles for effective

bank supervision put much emphasis on estimating a

bank’s value at risk, the pace at which bank supervi-

sors and examiners are implementing this is slow.

The approach to bank examination in the Philippines

focuses largely on borrower-related risks associated

with loans, while secondary or product-related risks

are not consistently taken into consideration. There

seems to be much regulatory forbearance. Bank su-

pervisors seem reluctant to effect the early closure

of failing institutions.

The credit culture is weak and inadequacies in

addressing the long-term developmental needs of the

economy have persisted. The Philippines has one of

the lowest degrees of financial intermediation in Asia,

with a loan- to-GDP ratio under 65 percent. The for-

mal credit system serves only a small portion of the

rural sector and other vital sectors.

The Bank Secrecy Law may partly be respon-

sible for bank examiners’ conservative approach to

examination. This law makes it impossible for the

BSP and Philippine Deposit Insurance Corporation

(PDIC) examiners to verify individual account (de-

posit) balances. Because of this restriction, the ex-

aminers may not detect misstated deposit account

balances and could then become more conservative

in the other areas of their examination.

NPL resolution needs to be more closely aligned

with corporate governance and rehabilitation. A major

impediment to doing so is that corporate rehabilita-

tion is not defined anywhere. While it is a remedy

provided under Presidential Decree 902-A, the pro-

cedures on how to avail of it, or the relief that goes

with it is not specified in the law. As with other forms

of remedies for ailing corporations, the Securities and

Exchange Commission (SEC) has exclusive jurisdic-

tion over corporate rehabilitation; thus, corporate re-

habilitation tends to be regulator-driven. However,

the SEC has not adopted formal rules to govern the

implementation of these remedies. Hence, it exer-

cises a lot of discretion and power in the granting of

these remedies, treating applications for the availment

of remedies on a case-by-case basis. In general, the

overall capacity of the SEC to perform its roles as

corporate regulator and supervisor is being compro-

mised because it is overburdened with so many tasks.

The study makes the following recommendations

and proposes measures to address the remaining

weaknesses and vulnerabilities of the Philippine bank-

ing sector:

• Strengthen banks to meet the increasing require-

ments of globalization through the appropriate

conduct of macroeconomic policy. This will pro-

vide the correct system of incentives, and raise

the degree of efficient financial intermediation

while addressing the demands of long-term de-

velopment finance as well.

• Strengthen competition and efficiency in the

banking industry by promoting contestable mar-

kets and greater foreign entry while encourag-

ing bank mergers and acquisitions; undertaking

privatization; strengthening the public listing re-

quirements to improve corporate governance in

the banking industry; reducing or eliminating fi-

nancial intermediation taxes such as the gross

receipts tax, the documentary stamp tax, AGRI/

AGRA (agricultural/agrarian) requirement, Mag-

na Carta for small and medium-size enterprises

(SMEs); and eventually removing implicit finan-

cial intermediation taxes such as the liquidity re-

serve requirements.

• Strengthen prudential regulation and supervision

by adopting a formal framework and common

terminology for risk assessment and risk man-

agement systems in banks; improving financial


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reporting, disclosure, and transparency, includ-

ing repeal of the Bank Secrecy Law; implement-

ing prudential norms and supervisory standards

effectively; and reducing regulatory forbearance

by such methods as legislating the adoption of

preventive corrective action (PCA) measures.

• Improve the financial infrastructure by strength-

ening the legal/regulatory infrastructure on cor-

porate and financial restructuring and bankruptcy.

The SEC must improve corporate disclosure and

transparency rules, adopt formal rules for imple-

menting corporate rehabilitation, make the pro-

ceedings swift and time-bound, and creditor-

rather than regulator-driven. Concerning the

BSP’s role as supervisor and regulator of banks,

there should be a clearer legal interpretation of

its mandate in relation to mergers and acquisi-

tions in the banking industry and the extent of

the need for legislation for the industry to effect

such mergers and acquisitions.

In the final analysis, it can be said that while the

Philippine banking system has survived the worst

effects of the Asian financial crisis, the goals of the

reform program that began in the early 1980s still

have not been completely met. The challenge is to

achieve those goals in a more volatile macroeco-

nomic environment that is more integrated with the

global economy.

IntroductionThroughout its history, the Philippine financial sys-

tem has displayed characteristics typical of a devel-

oping financial system: periods of moderate to ex-

treme financial repression followed by cycles of re-

form and deregulation; periods of strong domestic

credit growth and growing risks of moral hazard, fol-

lowed by severe crises and contraction in the supply

of credit often leading to recessions. In addition to

these difficulties, the performance of the Philippine

financial sector has also been regularly undermined

by inadequate regulation in the past and burdened by

poor macroeconomic conditions.

A look back at the history of Philippine banking

reveals a developmental role assigned to the bank-

ing system and a common pattern of frailty in the

face of adverse shocks. Ceilings on interest rates,

interest rate subsidies, and directed lending were

intended to enable the banking system to promote

economic growth by being the main source of de-

velopment finance. Early on, the shocks that hit the

system were mostly internal, arising from the inef-

ficiencies that the flawed system of regulation and

incentives engendered.

The occurrence of the Asian financial crisis has

led to a rethinking of how best to strengthen banking

systems so as to prevent banking crises or to reduce

banking system vulnerability to crises. There is ap-

parently a greater appreciation for the idea that regu-

lation and supervision must now increasingly focus

on the less traditional and conventional methods.

This study examines the structure and current state

of the Philippine banking industry, reviews the his-

tory of financial reforms, discusses the measures

taken by the authorities to strengthen the banking

sector prior to and after the Asian crisis, identifies

the remaining weaknesses and factors that contrib-

ute to the vulnerability of the Philippine banking in-

dustry, and makes some recommendations on how

to address them.

Structure of the PhilippineFinancial SystemThe industry is presently composed of the catego-

ries of institutions listed in Table 1.

The central bank1 is responsible for implement-

ing monetary policy and the prudential supervision

and regulation of the banking system. The Securi-

ties and Exchange Commission (SEC) oversees the

conduct of the stock and bond markets, and, to the

extent that banks and nonbank financial intermedi-

aries (NBFIs) participate in these markets, the SEC

works with the central bank in supervising and regu-

lating the activities of the latter institutions. Increas-

ing financial sophistication has led to greater diver-


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sification in the conduct of business in the financial

services sector. However, this has also called for

concomitant strengthening in the conduct of finan-

cial supervision and regulation, and administration

of a policy consistent with macroeconomic and fi-

nancial sector stability and efficiency in financial

intermediation. As the history of the Philippine bank-

ing system suggests, these needs have not always

been addressed in a timely and effective manner.

The result has been a system historically vulner-

able to shocks, with low domestic savings mobiliza-

tion, a high risk of moral hazard, and a propensity

for inefficiency.

History of ReformsThe original impetus for reform in the 1950s and 1960s

was not the need to respond to crises, but the rapid

growth and increasing fragmentation of the banking

system.2 The fragmentation of the banking system

was in part spurred by new legislation designed to

develop rural banks, encourage deposit secrecy, and

create new institutions, such as the Development

Bank of the Philippines (DBP) and the Philippine

Deposit Insurance Corporation (PDIC).3

The increasing diversity of financial institutions and

services challenged the ability of the central bank to

adequately regulate them. However, prudential fi-

nancial regulation at that stage was highly undevel-

oped: capital adequacy standards for solvency were

relevant but required very simple and rudimentary

implementation mechanisms, liquidity was managed

through the use of the reserve requirement, and su-

pervision and examination requirements were ad-

dressed through simple reporting systems.4

REFORMS IN THE 1970S

In 1972–1973, a Joint International Monetary Fund-

Central Bank (IMF-CB) Banking Survey Commis-

sion recommended that several amendments be made

to the General Banking Act and the Central Bank

Act. These amendments were meant to (i) realign

regulation by function rather than by type of bank;

(ii) consolidate central bank authority over banks and

nonbanks (except insurance companies); (iii) rede-

fine the central bank’s responsibilities to exclude the

promotion of economic growth; and (iv) impose re-

strictions on entry into the banking system, with con-

comitant efforts to improve the efficiency of the ex-

isting banks. Along with the increasing dynamism

of the financial sector and the need for more re-

sponsive financial structures to address financing

needs, the moves toward rationalizing the central

bank’s supervision over the banking sector led to

increasing pressure to adopt more sophisticated pru-

dential regulatory mechanisms and structures. While

banking institutions remained the dominant finan-

cial intermediaries, nonbank private and quasi-pub-

lic financial institutions emerged as an alternative

means of intermediation.

During this period, the central bank displayed a

marked shift toward a more interventionist monetary

and credit policy. Through its rediscounting window

and other facilities, it began to implement various

directed and selective developmental credit pro-

grams for Government, and also imposed ceilings on

domestic interest rates in support of this function.

Table 1: The Philippine Financial System

a Nonbank financial institutions. These include the Social Security System (SSS),the Government Service Insurance System (GSIS), and the HomeDevelopment Mutual Fund (HDMF).

Type of Institution Components

Banking Institutions Universal banksCommercial banksThrift banksRural banksSpecialized government banks

Nonbank Financial Investment housesIntermediaries Financing companies

Securities dealersInvestment companiesFund managersLending investorsPawnshopsGovernment NBFIsa

Venture capital corporations

Nonbank Thrift Mutual building and loanInstitutions associations

Nonstock savings and loansassociations


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Liberal lending and use of rediscounting facilities to

support such policies, however, undermined the stabil-

ity and solvency of the rural banking system. In re-

sponse to the deterioration in asset quality associ-

ated with these programs, the Government tightened

access to the rediscounting window. Subsequently,

the ensuing efforts to address structural weaknesses

in the banking sector proved ineffective.

The late 1970s saw important institutional and policy

reforms being implemented in the banking system.

Following the World Bank’s recommendation, the

central bank adopted the universal banking system,

which enabled banks to undertake investment and

commercial banking functions as well as engage in

allied and nonallied financial activities. In 1980, in-

terest rates on several types of deposit liabilities as

well as on loans with maturity of over two years

were deregulated. Ceilings on the interest rate on

other loans were abolished in 1983. Table 2 enumer-

ates the significant reforms and events in the Philip-

pine financial system.

Deregulation efforts, however, were not matched

by enhancements to the system of financial inter-

mediation. Rules on the treatment of past-due loans,

the provisioning of reserves versus bad loans, and

examination of deposit by central bank examiners

continued to be either or both weak and inad-

equately enforced. The growing risks of moral haz-

ard in a system with poorly and loosely supervised

institutions were manifested in the actions of NBFIs,

whose nonrecourse transactions were not being

monitored by the central bank, but by the less-pre-

pared SEC. These risks surfaced to the fore during

the Dewey Dee scandal.

THE 1980S BANKING CRISIS

The process of reform suffered an adverse shock in

1981 when businessman Dewey Dee, faced with

millions of pesos in debt owed to various financial

institutions, absconded. The Dee incident triggered

a financial crisis, a rash of insolvencies in investment

houses and finance companies. This resulted in a

flight-to-quality, as savers shifted their funds out of

those institutions and into large commercial banks.

The central bank attempted to stabilize the system

by infusing additional liquidity through the Industrial

Rehabilitation Fund and Stock Financing Program.5

Moreover, prudential measures were taken to shore

up the quality of commercial papers and strengthen

regulations on the trust activities of commercial banks.

Among the other early manifestations of the im-

pending crisis in the financial sector was the tremen-

dous amount of dollar borrowing by domestic resi-

dents from foreign currency deposit units (FCDUs)

of banks in the late 1970s and early 1980s. The ac-

cumulation of foreign debt was encouraged by the

relaxation of capital controls and the negative real

interest rates on such credit in 1979–1980. With

mostly short-term foreign indebtedness, the Philip-

pines would later plunge into a debt crisis.

The Aquino assassination in August 1983 precipi-

tated an even bigger crisis, one that further eroded

domestic and international confidence in the entire

financial system. In response to the massive capital

flight and persistent current account deficits, the

Government was forced to devalue the peso, impose

a moratorium on external debt payments, ration for-

eign exchange, and raise interest rates.6 To control

liquidity in the financial system, the central bank in-

troduced its own debt instruments, the central bank

certificates of indebtedness (CBCIs), or Jobo bills.7

Another flight-to-quality ensued, as bank depositors

switched out of bank deposits and into the higher

yielding and safe CBCIs . A severe credit crunch

followed, resulting in drastic falls in loans to the pri-

vate sector. This led to a sharp real contraction in

gross national product (GNP), in which real growth

rates were negative in 1984–1985, the first time in

the postwar history of the country.

Instead of strengthening the system of prudential

regulation to match the growing sophistication of the

banking sector, the central bank actually relaxed its

supervision in the early 1980s. After capital require-

ments—measured by the net worth-to-risk asset


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Table 2: Some Significant Events Affecting the Financial System

1980 Introduction of universal banking. Lifting of interest rate ceilings for loans with maturities of more thanfour years.

1981 Deregulation of all interest rates, except for short-term loans and purchases of short-termreceivables. Initiatives to set up a credit information and rating system. Expansion of the CentralBank’s (CB’s) supervisory power to include the subsidiaries and affiliates of banks and nonbankswith quasi-banking functions.

1982 Increase in paid-up capital requirements of thrift and rural banks from P10 million to P20 million. Settingup of a credit information bureau.

1983 Deregulation of interest rate ceilings on short-term loans. CB institution of a prime rate monitoringsystem for expanded commercial banks (EKBs), commercial banks (KBs) and specializedgovernment banks. Declaration of a 90-day moratorium on foreign debt payments. Adoption of theforeign exchange pooling system and import prioritization scheme. Provision of incentives to ruralbanks and EKBs that establish branches in areas inadequately served or unoccupied by rural banks.Imposition of requirement for KBs/thrift banks to purchase 5-year central bank certificates ofindebtedness (CBCIs) to establish a branch.

1984 Continuation of moratorium on foreign debt payments. International Monetary Fund approval of thestand-by credit facility on 14 December 1984. Issuance of the CB “Jobo” bills. Implementation ofblocked peso deposit scheme. Discontinuation of foreign exchange pooling and import prioritizationby 15 October 1984. Liberalization of foreign exchange trading and establishment of the Bankers’Association of the Philippines (BAP) reference rate. Suspension of bank branching in areasclassified as heavily overbranched and ideally overbranched.

1985 Release of the tranches of the IMF stand-by facility. Drawdowns from the new money facility forforeign banks. First round of rescheduling of the Paris Club debt; signed with 10 countries.Rationalization and simplification of the rediscount window, e.g., elimination of bank spread.

1986 Approval of the 1986-1988 IMF Program. Implementation of the debt-to-equity program. Initiatives torehabilitate Philippine National Bank (PNB) and Development Bank of the Philippines (DBP).Continuation of the first round of rescheduling of the Paris Club debt; signed with four countries.Initiatives to gradually phase out the CB bills and the revitalization of the treasury bill auction.

1987 Signing of a new agreement with foreign commercial bank creditors. Second round of reschedulingof the Paris Club debt. Conclusion of the rehabilitation of PNB and DBP and the transfer of accountsto the national Government. Launching of a rural bank rehabilitation program. Introduction of a newmodality for open market operations: depositing with the CB the T-bill auction proceeds issued inexcess of deficit financing requirement.

1988 Removal of the required investment in CBCIs for bank branching.

1989 Initiatives to enhance competition among banks. Removal of all restrictions on the opening of newbranches in priority rural areas. Unification of reserve requirements. Increase in the required minimumcapital for EKBs and KBs to P1 billion and P500 million, respectively. IMF approval of the ExtendedFund Facility and Contingency and Compensatory Financing. Launching of the Philippine AssistanceProgram (PAP). A financing program from foreign commercial bank creditors. Third round ofrestructuring of the Paris Club debt.

1990 Lifting of moratorium on the entry of new domestic banks. Relief under the Brady Plan. Issuance ofCB “Jobo”Bills and increased use of reverse Repurchase Agreements (RPs) for open marketoperations. Increase in the minimum paid-in capital requirement for thrift banks. Establishment ofoffsite automated teller machines (ATMs).

1991 Liberalization of bank branching: franchises to establish branches are auctioned off. Nationwidebank branching for rural banks. Increase in minimum capital requirements for EKBs and KBs.Incentives for bank mergers/consolidation. Establishment of ATMs in areas with no existing branchwithout any CB approval. Magna Carta for Small Enterprises: mandatory allocation. IMF approval of anew 18-month stand-by credit arrangement. Fourth round of rescheduling of Paris Club obligations.Agreement in principle on a comprehensive commercial bank financing package; finalized in 1992.Approval to increase the allowable retention limit of foreign exchange receipts by exporters to 40percent effective January 1992.

Continued next page


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Table 2: Some Significant Events Affecting the Financial System (Cont’d)

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

1992 Rural Bank Act of 1992. Incentive for branching: for every three branches established in 5th andlower class municipalities where there are less than four banks, a bank can establish a branch infirst class cities or municipalities, without bidding, provided the area is still open to additionalbranches. Lifting of foreign exchange controls. Establishment of the Philippine Dealing System (PDS).Extension of the IMF 18-month standby arrangement to end in March 1993.

1993 Bank branching only subject to capital adequacy, liquidity, profitability and soundness of management.Further liberalization of foreign exchange transactions. New Central Bank Act. Relaxation of rulesgoverning the establishment of ATMs. Suspension of the debt-to-equity program. Reserverequirement imposed on common trust funds.

1994 Liberalization of entry of foreign banks. IMF approval of a three-year Extended Fund Facility.Rediscounting reforms: adoption of market-based rediscount rates and removal of fixed spreadsRevision in the minimum paid-in capital requirement for thrift banks. Conclusion of the Paris Clubrescheduling negotiations; however, the government decided to set aside the terms of theagreement. Reduction of the required equivalent capital for a thrift bank to establish a branch. Liftingof prohibition to pay interest on demand deposits.

1995 Increase in the required minimum paid-in capital for banks. Thrift Bank Act of 1995.

I. Strengthening of the Financial System

5 June 1997 Setting of maximum loan exposure to real estate at 20 percent, or 30 percent inclusive of loans tofinance the acquisition of residential units amounting to no more than P3.5 million. Reduction ofloanable value of real estate used as collateral for bank loans to not more than 60 percent of theappraised value. Housing loans under the National Shelter Program of the government are exemptfrom such ceiling.

6 June 1997 30 percent of the 100 percent cover for all foreign exchange liabilities of foreign currency depositunits (FCDUs) of banks must be kept in liquid assets. Provision of guidelines governing theresponsibilities and duties of the board of directions of the bank.

1 October 1997 Reduction of the number of installments in arrears from six to three months for monthly installmentsand from two to one quarter for quarterly installments. Banks must set up general loan-lossprovisions over and above the provisions linked to individually identified bad accounts. They mustmaintain general loan-loss provisions equivalent to 2 percent of the gross loan portfolio.

10 November 1997 Banks given three years (until 2000) to comply with the requirement.

11 March 1998 Deadline for compliance accelerated to 1 October 1999. Adoption of internationally acceptedstandards relating to the risk-based capital requirements and clearly defining unsound practices.Universal banks required to have minimum capital of P4.5 billion by 24 December 1998, P4.95 billion by31 December 1999, and P5.4 billion by 31 December 2000.

12 March 1998 Banks required to set aside additional specific reserves equivalent to 25 percent of the securedportion of substandard loans by 15 April 1999.

II. Rationalization of Foreign Exchange Trading

22 July 1997 Banks required to obtain prior clearance for their sales of nondeliverable forward (NDF) contracts tononresidents (including offshore banking units).

31 July 1997 BSP tightened allowable overbought foreign exchange position from 20 to 5 percent of unimpairedcapital or US$10 million, whichever is lower. In addition, oversold position was increased from 10 to20 percent to increase dollar supply in the PDS.

22 December 1997 Introduction of currency risk protection program (CRPP), also known as the NDF facility. It is ahedging facility offered by the BSP through the commercial banks to cover or limit the risk of eligibleborrowers with existing unhedged foreign exchange liabilities to FCDUs.


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ratio— for banks were reduced from 15 to 10 per-

cent in 1973, they were further cut to 6 percent in

1980. In the 1970s, the rationale for the reduction in

capital requirements was to enable banks to lend long-

term.8 After the Aquino assassination in 1983, the

external sector collapsed, resulting in a full-blown

liquidity crisis. The Government undertook various

rescue efforts, including the takeover of certain pri-

vate business enterprises and financial institutions. It

tried to rescue five commercial banks and eventu-

ally ended up owning them.9 Given this fact and also

the existence of a severe crisis, the central bank opted

for some regulatory forbearance.

The central bank also relaxed its rules regarding

loans to directors, officers, stockholders, and related

interests (DOSRI). These developments combined

with weak enforcement of existing prudential rules

to tremendously raise the risk of moral hazard in bank

lending. Government financial institutions (GFIs) such

as the Philippine National Bank (PNB) and DBP

were declared technically insolvent after the quality

of their asset portfolio deteriorated because of ex-

cessive exposure to DOSRI loans. All of the two

institutions’ nonperforming assets had to be trans-

ferred to the national Government to strengthen other

firms with significant exposures in these two institu-

tions. Rehabilitation of banks of all types had to be

carried out over several years.

Monetary and financial indicators reflected the

depth of the crisis. The ratio of M3 to GNP, an indi-

cator of financial depth, plunged in 1984–1985 after

rising in the preceding years (Table 3).

Low real rates of returns on financial savings

share some of the blame for the decline in financial

system depth. To some extent, this was a result of

the lack of competitiveness in the banking system.

The banking system experienced a term transfor-

mation in the early 1980s, as the proportion of long-

term loans grew. But the crisis led to a sharp re-

duction in this figure as well. The proportion of long-

term loans picked up in 1987, but the trend was not

sustained due to political instability.

The years of protracted crisis took their toll on the

other aspects of the financial system. Uncertainty

and risks in lending stifled the long-term loan mar-

ket. The number of bank offices decreased in abso-

lute terms (as several banks collapsed), and so did

the total assets of the banking system. Total lending

by the banking system declined and did not reach the

1980 levels until the early 1990s. The rash of fore-

closures followed the deterioration in loan portfo-

lios and led to an increase in bank investments. To

strengthen what remained of the banking system, the

central bank pursued a rehabilitation program for the

weaker banks. Asset quality remained generally poor;

in the rehabilitation process, banks invested a large

portion of their funds in high-yielding Government

securities. This was a natural consequence of the

precarious state of the economy and the existence

of high credit and default risks, as well as the dete-

rioration in loan portfolios.

The sharp reduction in domestic credit in the 1980s

was aggravated by the debt crisis and the ensuing

international credit constraints on the Philippine Gov-

ernment and domestic firms. Following the debt

Table 3: Ratio of M3 to GNP

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

Year M3/GNP

1981 0.29

1982 0.31

1983 0.32

1984 0.24

1985 0.24

1986 0.25

1987 0.24

1988 0.25

1989 0.28

1990 0.28

1991 0.28

1992 0.28

1993 0.32

1994 0.35

1995 0.39

1996 0.39

1997 0.42

1998 0.41


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moratorium declared in 1983 and unable to tap do-

mestic and international capital markets, domestic

firms relied more on internal cash generation to fi-

nance investments.

To strengthen the banking system as a whole, the

central bank introduced a set of improved reporting

requirements for commercial banks, and guidelines

for asset valuation and loan-loss provisions. Mea-

sures to strengthen the rules on the single borrower

limit and DOSRI loans were likewise introduced,

as well as increases in minimum capital adequacy

standards. The measures aimed to tighten and stan-

dardize criteria for all banks, and help curb abuses

by insiders. The need for consolidation in the bank-

ing sector led the central bank to encourage mergers

as a way of meeting minimum capital requirements.

Entry into the banking sector was restricted until

1991. The policy of restricting entry came at the cost

of increasing concentration in the banking sector.

Between 1980 and 1990, the share in total deposits

of the five largest banks rose from 30 to 52 percent.

The increased concentration and apparent lack of

competition in the banking sector to some extent miti-

gated the impact of interest rate deregulation. Banks

continued earning high spreads, supported by low

interest rates on deposits.

BANKING SYSTEM DEVELOPMENTS IN THE 1990S

The early 1990s saw a marked improvement in the

state of the financial system. Bank branching was

relaxed. In 1992 the foreign exchange market was

deregulated to enhance market efficiency and

achieve exchange rates more consistent with eco-

nomic growth. The restrictions on the foreign ex-

change transactions of banks were lifted and pru-

dential limits on the foreign exchange positions of

banks were redefined. In addition, rules governing

the remittance of export proceeds were relaxed, and

exporters were allowed to take out loans from

FCDUs. Moreover, restrictions on the repatriation

of foreign investment income were lifted, and the

Foreign Investments Act of 1991 simplified the reg-

istration process for investments. The system for

remittances was improved to facilitate payments, and

rules for automated teller machines (ATMs) were

loosened. In 1993, the new Central Bank Act was

approved. This law aimed at ensuring the indepen-

dence of the conduct of monetary policy from politi-

cal interference. It also provided for the recapital-

ization of the central bank and the transfer of over

P300 billion worth of losses of the old central bank to

a board of liquidators. The new central bank is now

known as the Bangko Sentral ng Pilipinas (BSP). In

1994, 10 foreign banks were allowed entry under

specified modes.

Monetary and financial variables have served

as good indicators of the health of the banking sys-

tem. Both M2-to-GNP and M3-to-GNP ratios rose

significantly from 1993 to 1996, reaching 38 per-

cent in 1996, reflecting a booming financial sec-

tor. The reliance of financial institutions on bor-

rowings as a source of funds fell, and the share of

deposit liabilities rose. The capital adequacy ra-

tios of banks also improved. Freer entry and lib-

eralization of bank branching, as well as greater

reliance on improved technology spurred a sharp

rise in the ratio of total deposits to GNP in 1994–

1995. The improved atmosphere for competition led

banks to find niche markets, with thrift banks in-

creasingly tapping the retail markets and small de-

positors, and commercial banks increasingly ser-

vicing the more affluent clients. Growing competi-

tion also lowered bank spreads, at least with re-

spect to lending rates and time deposit rates. Fee-

based activity also rose, as banks turned increas-

ingly to off-balance-sheet financing.

Unfortunately, the boom in the financial sector also

planted the seeds for weakness and vulnerability in

the 1990s. The reentry of the Philippine Government

into the international capital markets encouraged

many domestic banks and firms to follow suit. As a

result, while foreign indebtedness of the public non-


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bank sector had been steadily declining, those of the

private banking and private nonbank sectors continu-

ously increased. The relatively smaller proportion of

public sector indebtedness following the Philippines’

reentry into the international capital markets is due

to several factors: (i) the foreign debt service bur-

den declined from 8 percent of gross domestic prod-

uct (GDP) in 1990 to 5.6 percent in 1992 largely

because of the implementation of the Brady Plan,

which began in 1990;10

(ii) after a long period of

deficits, the national Government had a small surplus

equivalent to 0.94 percent of GNP in 1994, owing

largely to the receipts from its privatization program;11

and (iii) by 1997, the consolidated public sector defi-

cit also showed a modest surplus.

Interest rate differentials prompted the Govern-

ment to encourage exporters to tap FCDU credit

facilities to sustain competitiveness. Short-term for-

eign capital inflows rose dramatically in 1995–1996,

forcing the peso to appreciate and raising the

country’s vulnerability to sharp reversals. Heavy

short-term foreign portfolio flows translated into sharp

increases in the growth of domestic credit due to the

well-known limitations of the sterilization policy. First,

as liquidity was reduced, domestic interest rates rose,

attracting even more capital inflows. In the years

when capital inflows as a percentage of GDP peaked,

namely 1992, 1994, and 1996, the 91-day treasury

bill annual average rates were 16.02 percent, 12.71

percent, and 12.34 percent, respectively.12

The rise

in domestic interest rates likewise induced

recessionary tendencies in the economy. Second,

such a sterilization policy imposed a quasi-fiscal bur-

den on the BSP as the latter exchanged high-yield-

ing domestic assets for relatively lower yielding for-

eign assets. With the ineffectiveness of the steriliza-

tion policy and the growth in domestic credit, the

banking sector became increasingly exposed to the

real estate sector. A survey of the commercial bank-

ing sector found that combined loans and equity ex-

posure to this sector came to about 52 percent of

unimpaired capital.

The Asian Crisis andthe State of the PhilippineBanking System

The Philippine banking system experienced many of

the symptoms that ultimately led to the collapse of

the banking systems in the countries worse hit by the

crisis. The symptoms became particularly evident in

the aftermath of the crisis and included macroeco-

nomic volatility, high property exposure and asset in-

flation, large amounts of foreign exchange liabilities,

Government-directed lending and related-party lend-

ing, fragility in the case of some banks, and weak

supervision and underregulation of some banks. The

response of the monetary authorities to speculative

pressure on the peso beginning in July 1997 was to

sell dollars initially and, subsequently, to tighten li-

quidity. The latter resulted in raising interest rates on

91-day treasury bills from 10.5 percent in June 1997

to a high of 19.1 percent in January 1998.13

Ulti-

mately, the authorities gave up on their defense of

the peso, and the peso depreciated by 39 percent at

the height of the crisis, going from an average of

P29.47 to over P45 to the dollar in 1997. Further

depreciation of the peso was prevented by the huge

inflow of dollar remittances by overseas workers and

of portfolio investments toward the end of 1998.

These events adversely affected the corporate

sector, the financial sector, and the rate of economic

growth. Nevertheless, most observers as well as

Government authorities themselves are in agreement

that the Philippine banking system managed to sur-

vive the Asian financial crisis relatively unscathed

and that there is no banking crisis in the Philippines.

Table 4, for example, shows Deutsche Bank’s mea-

sure of the extent of the banking crisis in five Asian

countries in June 1998 and May 1999.14

The Asian

financial crisis did not lead to the same kinds of

deleterious effects on the Philippine banking system

as it did in countries like Indonesia and Thailand. In

part, this was due to the reforms undertaken by the


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Government over the previous two decades, the rela-

tively short period of accelerating GDP growth in

the Philippines, and its relatively lower levels of fi-

nancial intermediation. Also, Philippine banks, like

Hong Kong and Singapore banks, had relatively strong

capital bases at the start of the crisis.

Bank closures in 1997 and 1998 were few and

the amount of total bank assets they represented was

small. Fourteen banks—1 thrift bank and 13 rural

banks—were closed in 1997.15

Bank closures in

1998 increased further to 22, involving 1 commercial

bank, 6 thrift banks, and 15 rural banks. These clo-

sures were only a small fraction of the total number

of banks: 1.4 and 2.1 percent of total head offices in

1997 and 1998, respectively. In terms of total assets

of the banking system, the assets of the closed banks,

excluding rural banks, constituted about 0.01 and 0.04

percent in 1997 and 1998, correspondingly.

The BSP continues to encourage mergers and con-

solidation within the banking sector, principally

through increases in minimum capital requirements.

In addition to encouraging mergers and consolidation

among domestic banks, the BSP has endorsed re-

forms that would allow up to 100 percent foreign

ownership of banks compared with the current limit

of 60 percent foreign equity.16

This is seen as a way

to strengthen the domestic banking system but re-

quires legislation. While endorsing 100 percent for-

eign ownership, the BSP is asking Congress to stipu-

late that 70 percent of the total resources of the bank-

ing system remain in the hands of Filipinos in order

to have, in the words of the monetary authorities,

some “macroeconomic” protection for local banks.

Ostensibly, this simply reflects the protectionist sen-

timent that permeates the banking industry and other

vested interests in the Philippines. It is unclear

whether Congress will pass this amendment to the

law on foreign ownership, but it does seem that nei-

ther domestic banks nor BSP has been lobbying Con-

gress for the passage of such an amendment. BSP

had earlier recommended 100 percent ownership

only in the case of distressed local banks, but the

Senate apparently would like 100 percent foreign

ownership to apply to newly created banks as well.

In contrast to the Philippines’ current ceiling of 60

percent foreign bank ownership of domestic banks

(30 percent limit on foreign nonbank ownership) and

the limitation to 10 foreign banks through four spe-

cific modes of entry, Indonesia, the Republic of Ko-

rea, and Thailand allow 100 percent foreign owner-

ship of banks. In Thailand, 100 percent foreign own-

ership of banks is allowed for 10 years, while in the

Republic of Korea, the permission of the monetary

authority is required.

Only the bank merger between the Bank of South-

east Asia and the Development Bank of Singapore

(DBS) was concluded in 1997. Currently, three merg-

ers are under discussion. These are the mergers of

Prudential Bank and Pilipinas Bank, Asianbank and

the Standard Chartered Bank, and the Bank of Com-

merce and Traders Royal Bank.

Recently, Equitable Bank and its partners, includ-

ing Government financial institutions such as the

Government Service Insurance System and the So-

Table 4: Measuring the Banking Crisis—Then and Now

GDP = gross domestic product, NPLs = nonperforming loans.Source: Deutsche Bank, 1999, p.7.

June 1998 Estimate May 1999 Estimate

NPLs Losses NPL LossesCountry (% of loans) (% of GDP) (% of loans) (% of GDP)

Indonesia 60 23 82 64

Korea, Republic of 25 13 30 16

Malaysia 17 10 30 17

Philippines 10 4 20 9

Thailand 35 23 67 63


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cial Security System, bought the Lopez-Gokongwei

shares in the Philippine Commercial and Industrial

Bank (PCIB).17

Several banks, including Manila

Bank, have expressed interest in buying Prime Bank,

a savings bank that has been on bank holiday since 4

June 1999.

Notwithstanding the Asian financial crisis, the to-

tal resources and total operating network of the Phil-

ippine banking system expanded slightly in 1998. The

total resources of the banking system grew by close

to 1 percent in 1998 relative to the end-1997 level.18

Total network—head offices and branches—in-

creased by 645 offices between 1997 and 1998, even

as the number of head offices declined from 1,003 to

996 in the same period.

Bank profitability declined dramatically in 1998

relative to the two previous years.19

Table 5 shows

the profitability trend for Philippine banks. The re-

turn on equity (ROE) of the Philippine banking sys-

tem declined from 16.34 percent in 1996 to 12.42

percent in 1997 and to a low but still positive 5.81

percent at end-1998. By March 1999, this had fallen

further to 1.79 percent.20

The return on assets

(ROA) before taxes decreased from 2.16 percent in

1996 to 1.66 percent in 1997, and further to 0.28

percent in March 1999.21

Nevertheless, in its as-

sessment, Goldman Sachs states that the underlying

profitability of Philippine banks is good, similar to that

of Singapore and Hong Kong banks. In the case of

the top six banks of the Philippines, preprovisioning

operating profits to assets ratio was 2.9 percent in

1998, a decline from 3.31 percent in 1997 and 3.41

percent in 1996. This was due to falling net interest

margins and loan growth. There was a 28 basis points

decline in net interest margin, from 5.11 percent in

1997 to 4.83 percent in 1998.22

This occurred, de-

spite higher average interest rates, as a result of ris-

ing nonearning assets. Gross loans declined by 7 per-

cent year-on-year. Although this may not seem se-

vere, it may be pointed out that the loan-to-GDP ra-

tio in the Philippines at less than 65 percent is one of

the lowest levels of financial intermediation in Asia.23

Other factors that tend to impact negatively on

bank profitability are described in Table 6. These

include (i) high capital adequacy requirements equi-

valent to 10 percent Tier 1 equity to total assets;

(ii) high reserve requirements, even though statu-

tory reserve requirements have been reduced to 9

percent and liquidity reserve requirements to 3 per-

cent, or a total of 12 percent compared with the

March level of 15 percent; (iii) increased loan-loss

provisioning (all gross of collateral), in which banks

are required to maintain general loan-loss reserves

of 2 percent of outstanding loans in addition to spe-

cific reserves by October 1999 and loan-loss re-

serves of 5 percent against special mention/watchlist

loans by April 1999; and (iv) mandatory lending to

small and medium-size enterprises (SMEs) and the

agriculture sector, which constitute 18 percent of

the total loanable funds of Philippine banks.24

The

AGRI/AGRA stipulates that 25 percent of the loan

portfolio be set aside for agriculture and agro-based

activities. Likewise, the Magna Carta for SMEs

requires the allocation of 6 and 2 percent of the

loan portfolio to small and medium-size enterprises,

respectively. Despite weak compliance with them,

these requirements give rise to distortions and di-

versions that impose a substantial cost to banks,

and raise intermediation costs and inefficiency in

the allocation of capital.

The BSP granted emergency loans to banks that

remained solvent but found themselves temporarily

illiquid. It provided a total of P18.1 billion in emer-

gency loans and overdrafts to the banking system

from 15 July 1997 to 16 February 1999.25

This

amount is equivalent to less than 0.7 percent of the

1998 nominal GNP or 1.1 percent of total bank loans

in 1998. Of the amount extended to banks, P2.9 bil-

lion or about 16 percent has been repaid.

The asset quality problem of Philippine banks is

not a matter of solvency as it is in the cases of Indo-

nesia, Republic of Korea, and Thailand. In terms of

portfolio loan quality, the nonperforming loan (NPL)

ratio of the entire banking system increased from

44A

ST

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Table 5: Profitability and Capital Adequacy of Philippine Banks

Mar Jun Sep Deca MarItem 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1999

Profitability

ROE (Total Asset/Capital) (%)

Philippine Banking System 12.00 17.46 19.83 24.67 20.50 17.29 15.10 15.36 14.82 16.34 12.42 3.52 5.77 6.85 5.81 1.79

Commercial Banks 11.55 16.52 20.67 24.29 20.57 16.75 14.84 14.82 14.20 16.91 12.98 3.85 6.37 7.59 6.33 1.69

Specialized Government Banks 18.69 27.54 17.90 33.32 23.56 22.25 16.00 24.68 25.07 b b b b b b b

Thrift Banks 3.68 12.31 18.41 21.23 20.64 20.91 18.59 13.93 13.82 11.92 7.48 0.91 0.79 0.84 1.01 0.98

Rural Banks 9.89 8.98 11.34 13.29 10.57 10.34 11.74 11.87 14.94 15.53 14.40 3.75 6.19 6.19 8.15 7.87

ROA (Net Profit Before Tax/Total Assets) (%)




Thrift Banks 0.39 1.22 1.88 2.70 2.54 2.63 2.28 2.13 2.09 1.92 1.38 0.17 0.15 0.16 0.20 0.19

Rural Banks 1.85 1.66 2.08 2.58 2.07 2.04 2.28 2.15 2.53 2.58 2.36 0.63 1.04 1.04 1.37 1.36

Capital Adequacyc




Thrift Banks 9.88 13.00 11.86 14.77 17.29 17.29 14.96 18.21 17.89 19.35 17.58 19.32 19.85 19.45 19.82 20.37

Rural Banks 14.64 9.37 10.98 13.91 16.67 22.67 21.94 17.92 17.41 15.84 17.37 17.71 17.62 17.62 17.62d 17.95c,d,e

ROA = return on assets, ROE = return on equity.a Preliminary, data of rural banks as of September 1998.b Consolidated with commercial banks.c Computed by SRSO, beginning February 1998, data excludes one nonoperational bank.d As of 30 September 1998, latest available data.e Unadjusted net worth.Source: Department of Economic Research (DER) and Supervisory Reports and Studies Office (SRSO).

1998


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Table 6: Prudential Norms with Structural Impact on Profitability

CAR = capital adequacy ratio, NPL = nonperforming loan, ROA = return on assets, ROE = return on equity, SME = small and medium-size enterprises.Sources: Company reports, Goldman Sachs Investment Research estimates.

Prudential Norms with StructuralPositive Impact on ROA and ROE

Indonesia1. Inadequate provisioning on NPLs2. Low reserve requirement (3%)3. Low Tier-1 CAR = higher ROE

Korea, Republic ofLow reserve requirement (7%)

Malaysia1. Inadequate provisioning on NPLs2. NPL interest accrual up to six months, reversal from

three months

PhilippinesInadequate provisioning on NPLs

Thailand1. Lenient loan provisioning requirements2. Low Tier-1 capital adequacy ratio (CAR) = higher ROE3. Low reserve requirement (6%)

Hong Kong, ChinaLow corporate tax rate (15%)

SingaporeNone noted

Prudential Norms with StructuralNegative Impact on ROA and ROE

None noted

1. Very strict provisioning requirements, gross ofcollaterals

2. Mandated lending to weak sectors, e.g. SMEs

1. High reserve requirement (15%)2. Mandated lending to weak sectors e.g. Bumiputra

parties, SMEs3. Cap margins on low-cost housing loans and SME loans

1. High reserve requirement of 15% (10% in cash)2. Mandated lending to weak sectors, e.g., agriculture,

SMEs3. High CAR requirement and actual CAR of 17% = lower

ROE

None noted

1. High actual CARs = lower ROE2. High liquidity ratio of 25%

1. High Tier-1 CAR requirements (10%) = lower ROE2. High reserve requirement (18%)3. 2–3% general loan-loss provisioning

4.7 percent in December 1997 to 12.1 percent in

January 1999 (Table 7). This rose further to 14.4

percent in May 1999 before declining to 13.1 per-

cent in June 1999. While the ratio of structural NPL

to total NPLs indicates that most NPLs are not struc-

tural, the ratio appears to be high for the Philippines

compared with the other Asian economies (Table

8). Structural NPLs are not temporary and are not

likely to be resolved with an improvement in the

macroeconomic environment. Many of these struc-

tural NPLs relate to property bubble lending. Since

Philippine banks have a credit culture that tends to

be very reliant on collateral-based lending, the burst-

ing of the property bubble gave rise to more struc-

tural NPLs. Some observers have pointed out that

Philippine banks were headed in the direction of Thai-

land and Malaysia as far as property lending, large

amounts of foreign currency borrowings, and exces-

sive lending were concerned, but that the Asian cri-

sis, specifically, the devaluation of the baht abruptly

halted the process.

There are several reasons for the rise in NPLs.

First, corporate sector performance deteriorated rap-

idly between 1997 and 1998. This is evidenced, for

example, by the number of firms that filed for debt

payment suspension with the SEC. In 1997, 20 firms

filed for suspension of debt payments, with total li-

abilities amounting to P12.8 billion or about 0.81 per-

cent of outstanding commercial bank loans.26

In 1998,

35 firms applied for a suspension of debt payments,

with total liabilities amounting to P96.1 billion or 6.2

percent of outstanding commercial bank loans.


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Table 7: Total Loans, Nonperforming Loans, and Loan-Loss Provisions of Commercial Banksa

(in million pesos as of dates indicated)

a Beginning February 1998, data does not include one nonoperational commercial bank.b Revised estimates of the Central Bank.c Preliminary, based on tentative reports of some commercial banks.Source: Consolidated Statement of Condition (CSOC) of Commercial Banks.

Period Nonperforming Loans (NPLs) Total Loans NPLs/Total Loans Loan-Loss Provisions[1] [2] [3] = [1]/[2]

1983 22,851 189,284 12.072 2,512

1984 41,801 198,929 21.013 5,046

1985 37,726 166,660 22.637 5,753

1986 37,506 183,476 20.442 40,783

1987 19,047 138,885 13.714 11,160

1988 17,565 162,684 10.797 9,705

1989 17,135 208,042 8.236 11,284

1990 19,426 270,760 7.175 12,679

1991 20,245 306,171 6.612 12,270

1992 22,494 366,809 6.132 12,453

1993 23,840 506,425 4.708 13,311

1994 25,050 637,179 3.931 11,995

1995 28,008 866,330 3.233 13,781

1996 34,206 1,221,763 2.800 15,149

1997 Jan 37,676 1,237,287 3.045 15,405

Feb 39,640 1,264,241 3.135 15,863

Mar 42,319 1,284,591 3.294 16,939

Apr 43,133 1,326,161 3.252 17,625

May 45,020 1,361,678 3.306 17,871

Jun 47,856 1,418,953 3.373 18,517

Jul 50,741 1,437,033 3.531 19,417

Aug 53,592 1,405,373 3.813 19,827

Sep 59,399 1,499,248 3.962 21,517

Oct 65,324 1,490,497 4.383 22,775

Nov 71,396 1,478,187 4.83 24,306

Dec 73,602 1,573,140 4.679 37,780

1998 Jan 90,961 1,578,816 5.761 35,839

Feb 100,975 1,527,364 6.611 36,576

Mar 112,601 1,517,632 7.420 39,313

Apr 131,381 1,528,545 8.595 40,935

May 143,278 1,517,641 9.441 41,644

Jun 142,731 1,595,372 8.947 43,776

Jul 149,911 1,555,647 9.637 45,179

Aug 166,155 1,581,574 10.506 47,476

Sep 175,109 1,586,250 11.039 49,175

Oct 181,936 1,520,243 11.968 51,753

Nov 178,105 1,511,851 11.781 52,524

Dec 160,001 1,542,487 10.373 61,333

1999 Jan 180,185 1,488,227 12.107 62,647

Feb 192,543 1,496,577 12.866 64,442

Mar 195,635 1,484,459 13.179 67,740

Apr 212,138 1,465,172 14.479 70,458

Mayb 212,603 1,476,248 14.402 70,860

Junc 197,251 1,505,595 13.101 71,508


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A second reason was the BSP’s implementation

of a more stringent definition of past due loans. In

October 1997, the BSP strengthened its loan classi-

fication procedure with the release of Circular 143,

which identified specific criteria to minimize the sub-

jectivity of examinations.27

Regulations were modi-

fied so that a loan is considered “delinquent” for BSP

review purposes if one or more of the following ap-

ply: (i) there is a loan balance outstanding after the

final payment date of the loan; and (ii) the borrower

has missed the following number of payments de-

pending on the payment cycle: monthly, three months

in arrears; quarterly, one quarter in arrears;

semestrally, one semester in arrears; and annual, one

year in arrears. Installment loans constituted about

25 percent of total loans.28

The circular also states

that the total outstanding balance of a loan will be

considered past due regardless of the number of in-

stallments in arrears when the balance in arrears

reaches 20 percent of the total outstanding balance

of the loan receivable. The circular states that the

entire balance of a loan receivable is considered de-

linquent when the past due amount reaches 10 per-

cent of the outstanding loan balance for all modes of

payment other than those listed in this paragraph.

Another reason for the increase in the NPL ra-

tio for commercial banks was the decline in abso-

lute loans.29

As of the first quarter of 1999, loans

outstanding of commercial banks fell by 4.5 per-

cent to P1.48 trillion from end–December 1998.

Year-on-year, the reduction amounted to 6.4 per-

cent, with only 18 of the country’s 52 commercial

banks expanding their loans in 1998.30

Both weak

demand for loans and the banks’ more conserva-

tive lending stance amidst the economic slowdown

have been cited as reasons for the decline in com-

mercial bank loans.

The NPL ratio briefly declined to 10.37 percent

by December 1998. Several factors tended to re-

duce the NPL ratio.

First, some attribute the decline to the waning ef-

fects of the crisis. Second, there has been a lot of

loan restructuring, foreclosure, and loan-for-property

swaps among banks, ostensibly to avoid having these

problematic loans classified as NPLs, which carry

necessary specific loan-loss provisions that could hurt

earnings. Table 9 describes factors that materially

overstate or understate book value, while Table 10

describes factors that materially overstate or under-

state reported earnings. The foreclosed loans are

booked under real and other property owned and

acquired (ROPOA) accounts. Between December

1998 and May 1999, ROPOA increased by 25 per-

cent to P59.2 billion, but relative to the previous year,

ROPOA increased by 158 percent.31

For the top 10

banks, for example, the year-on-year change in

ROPOA from the first quarter of 1998 to the first

quarter of 1999 ranged from a low of 55.9 percent

for PNB to a high of 444.4 percent for United Coco-

nut Planters Bank, with all banks except PNB ex-

ceeding 100 percent.32

Monetary authorities pointed

out that if the measure of banks’ poor quality were

expanded beyond NPLs to include foreclosed assets

and restructured loans as a ratio to total loans, the

sum of NPLs, ROPOA, and restructured loans would

decline slightly to 17.4 percent or P299.3 billion in

December 1998 from 17.8 percent or P302.6 billion

in October 1998.33

In contrast to the official view, as

of May 1999, it is estimated that NPLs are already

close to 20 percent if restructured assets are included,

equivalent to 9 percent of GDP despite the official

NPL figure of 12 percent in April.34

If economic

activity and the real estate sector do not recover,

Table 8: Estimates of Structural NPLs asPercentage of Total Implied NPLs, 1998

a Rises to an estimated 72 percent in 1999.Source: Goldman Sachs Investment Research, 1999b.

Economy Percent

Hong Kong, China 26.4

Korea, Republic of 34.8

Malaysiaa 27.0

Philippines 46.6

Singapore 13.9

Thailand 47.4


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Table 9: Assessment of Book Values

NPL = nonperforming loan.Source: Company reports, Goldman Sachs Investment Research estimates.

Factors Materially Overstating Book Value

Thailand1. Lenient provisioning norms on NPLs

(phased in through 2000 year-end)2. Potentially lenient collateral valuation

guidelines leading to inadequateprovisioning

Philippines1. Appraised collateral value can be

overstated, lessens true provisioningneeds

2. Banks can avoid provisions throughloan for property swap agreements

3. Occasional loan refinancing to avoidNPL classification

Indonesia1. Low provisioning norm enforcement2. Appraised collateral value can be

overstated, lessens true provisioningneeds

3. Frequent loan refinancing to avoid NPLclassification

Malaysia1. Low provisioning norm (no

substandard loan provisioningrequirement)

2. Lenient interest accrual on NPLs to sixmonths

3. Potentially lenient collateral valuationguidelines, leading to inadequateprovisioning

Korea, Republic ofCost accounting for associates ratherthan equity accounting

Hong Kong, ChinaNone noted

SingaporeNone noted

United StatesNone noted

Factors Materially Understating Book Value

None noted

None noted

None noted

None noted

None noted

Cost accounting for associates ratherthan equity accounting

1. Excess loan-loss reserves2. No revaluation of fixed assets3. Sizable property investment holdings4. Associates at book rather than equity

accounting. To be changed to equityaccounting from fiscal year 1999

1. Excess loan-loss reserves2. No revaluation of fixed assets

Conclusion

Weak provisioning normsGenerally overstated bookvalues

Book value fairly stated forthe most part, may beoverstated for banks thatare active in loanrefinancing or loan-for-property swap.

Weak enforcement and banksupervision generally lead tooverstated book values.

Weak interest accrual andprovisioning norms generallyoverstated book values.

Book value fairly stated forthe most part

Book value fairly stated tomodestly understated forthe most part

Book value understated forthe most part

Book value fairly stated ormodestly understated forthe most part


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Table 10: Assessment of Reported Earnings

NPL = nonperforming loan.Source: Company reports, Goldman Sachs Investment Research estimates.

Factors Materially Overstating Reported Earnings

Thailand

1. Inadequate provisioning on NPLs

2. (phased in through 2000 year-end)

3. Nonrecurring items in other income

4. Loan provisions sometimes taken directly

against retained earnings

5. No reversal of accrued interest income on

NPLs (only required starting January 2000)

Philippines


2. Occasional loan refinancing to avoid

classifying as NPLs

Indonesia


2. Loan refinancing to avoid classifying as

NPLs

3. Loan provisions sometimes taken directly

against retained earnings

4. No reversal of accrued interest income on

NPLs

Malaysia


2. NPL interest accrual up to six months,

reversal from three months

Korea, Republic of

1. Nonrecurring items in other income

2. Cost accounting for associates rather than

equity accounting

Hong Kong, China

Nonrecurring items in other income

Singapore

Nonrecurring items in other income

United States

None noted: banks are quick to provide

against NPLs

Factors Materially Understating Reported Earnings

Nonrecurring expenses e.g., foreign exchange

losses

Extreme rule for the accrual of interest on NPLs

for noninstallment loans (75% of total loans);

interest accrual stopped after 1 day past due,

versus the 90-day rule used in the United States

Intergroup loans may be extended at below-

market rates

None noted

Nonrecurring expenses, e.g., foreign exchange

losses

Cost accounting for associates rather than

equity accounting

1. High 2%-3% provision to new loans each

year

2. Associates at book rather than equity

accounting (to be changed to equity

accounting from fiscal year 1999)

None noted

Conclusion

Earnings overstated

for the most part

Earnings fairly stated

for the most part,

may be overstated

for banks with sharp

rises in NPLs

Earnings overstated

for most banks

Earnings overstated

for most banks


for the most part, but

focus on core

earnings


for the most part, but

focus on core

earnings


to modestly

overstated for the

most part, but focus

on core earnings


for the most part


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then banks will have to carry these low-yielding as-

sets on their books for some time to come, adversely

affecting bank profitability. Banks are not required

to disclose loan refinancing, although they may do so

on a voluntary basis.

Recently, the Bankers’ Association of the Philip-

pines (BAP) expressed support for the proposal of

the SEC to grant a five-year debt relief to compa-

nies experiencing cash flow problems, including

freezing interest rates on these loans. Some are of

the view that once a borrower turns for protection,

banks will be more prone to restructure loans, which

would then revert the loans to current status.35

How-

ever, freezing interest rates and other such measures

simply defer rather than address the main problem,

namely, ignoring the need for both corporate and fi-

nancial restructuring to take place in order for lend-

ing to resume. Improvements in the legal framework

are necessary for orderly corporate restructuring and

loan workouts, including strengthening of the bank-

ruptcy law and implementation procedures.

Third, the recent decline in interest rates will re-

duce the corporate sector’s borrowing costs and cash

flow strains and the banking sector’s carrying costs

of NPLs. It also decreases pressure on asset quality

and the risk of a systemic banking crisis. With the

further lowering of interest rates, as the BSP has

forecast, economic growth and loan growth are ex-

pected to be revived in the second quarter of 1999,

and stabilize if not further reduce NPLs. Goldman

Sachs has calculated the implied NPL ratios assum-

ing a decline in interest rates (Table 11).

The BSP imposed a ceiling on bank lending to the

real estate sector equal to 20 percent of total loans,

exclusive of loans to finance the acquisition or im-

provement of residential units amounting to no more

than P3.5 million. The real estate exposure of com-

mercial banks fell from a peak level of 14.2 percent

in 1997 to 13.8 percent by September 1998.36

Mon-

etary authorities pointed out that this is way below

the 20 percent ceiling. They also noted that as of

end-1998, the bulk of loans outstanding went to the Tabl

e 11

:N

PL

Rat

ios

Imp

lied

by

Go

ldm

an a

nd

Sac

hs

Bo

tto

m-U

p E

BIT

DA

Mo

del

Ass

um

ed C

han

ge

in

Cu

rren

t

Rev

ised

Pri

or

Str

uct

ura

lS

urv

eyed

Deb

tB

orr

ow

ing

Co

sts

NP

L

Imp

lied

Imp

lied

NP

L R

atio

as %

of

Sh

ort

-ter

m I

nte

rban

k R

ates

(%

)19

99 O

ver

1998

(b

ps)

Rat

io

Est

imat

esE

stim

ates

Est

imat

es

Eco

no

my

Tota

l B

ank

Lo

anS

ep 1

998

No

v 19

98S

ep 1

998

Rep

ort

1999

1998

1999

1998

1999

1998

1999

Sin

gapo

re79

5.3

2.3

no c

hang

e(7

5)

6.2

c7.

26.

77.

710

.81.

01.

2

Hon

g K

ong,

Chi

na37

14.4

5.9

no c

hang

e(1

60

)4.

9d13

.09.

211

.614

.83.

43.

9

Mal

aysi

a53

9.3

6.6

(60

)(1

35

)10

.7d

16.6

18.5

16.6

19.6

4.5

13.5

Phi

lippi

nes

401

3.9

13

.4(1

30

)(2

00

)11

.0d

16.8

14.5

16.2

18.9

7.8

8.0

Kor

ea,

Rep

ublic

of

531

0.2

7.7

(20

0)

(30

0)

19.4

d,e

25.5

26.3

28.6

33.8

8.9

9.8

Tha

iland

227

0(2

90

)40

.0d

48.6

43.0

43.9

49.5

23.0

23.9

bps

= ba

sis

poin

ts, E

BIT

DA

= E

arni

ngs

befo

re in

tere

st, t

ax, d

epre

ciat

ion

and

amor

tizat

ion,

GS

= G

oldm

an a

nd S

achs

, NP

L =

nonp

erfo

rmin

g lo

an.

aP

erce

ntag

e of

sur

veye

d de

bt b

elon

ging

to c

ompa

nies

whe

re E

BIT

DA

falls

bel

ow in

tere

st e

xpen

se.

bP

erce

ntag

e of

sur

veye

d de

bt b

elon

ging

to c

ompa

nies

whe

re E

BIT

DA

is n

egat

ive.

cG

loba

l as

of A

ugus

t 199

8: 3

.9%

for S

inga

pore

loan

s on

ly a

s of

Jun

e.d

As

of S

epte

mbe

r 199

8.e

Exc

ludi

ng p

reca

utio

nary

loan

s. In

clud

es N

PLs

pur

chas

ed b

y K

orea

Ass

et M

anag

emen

t Com

pany

(KA

MC

O) t

otal

ing

12.3

% o

f all

loan

s.S

ourc

e: G

oldm

an S

achs

Inve

stm

ent R

esea

rch,

199

9a.

NP

L R

atio

aR

evis

ed C

aseb


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manufacturing sector (26.5 percent), financial insti-

tutions, real estate and business services (25.8 per-

cent), and wholesale and retail trade (15.6 percent).37

Also, 47 of the 55 commercial banks, or 85 percent,

have complied with the ceiling set on loan exposure

to the real estate sector.38

Banks’ loan exposure to the real estate sector

raises several issues. First, the classification of sec-

tor lending lumps real estate with financial institu-

tions and business services and thus makes it diffi-

cult to isolate bank exposure to the real estate sector

alone. In fact, the BSP had to commission a special

survey of 25 banks in March 1996, prior to the crisis,

to be able to measure the average share of real es-

tate loans. Second, while the sector average is under

20 percent, some individual banks, including large

ones such as the PNB, have real estate loan expo-

sures above 20 percent.39

In the March 1996 sur-

vey, for example, one bank’s ratio went as high as

28.6 percent.40

Finally, funds are fungible. There-

fore, once a bank lends to a borrower, even one clas-

sified as a manufacturer, there is no guarantee that

the funds will be used in this business and not in real

estate. This makes it difficult for the authorities to

ascertain whether the bank is truly complying with

the ceilings set. A case in point is the failure of the

appliance maker EYCO. Creditor banks lent EYCO

money ostensibly to finance the expansion of its ap-

pliance manufacturing business. Yet, like many other

companies, EYCO had a real estate development

subsidiary to which the funds were funneled. The

loan soured when the property market collapsed.

In terms of the Philippine banking system’s capi-

tal adequacy against probable risks, the capital ad-

equacy ratio stood at 17.65 percent at end-De-

cember 1998.41

It rose further to 17.91 percent as

of March 1999.42

This was higher than the statutory

ratio as well as the Bank for International Settle-

ments (BIS) standard of 8 percent. Monetary au-

thorities noted that even as the BIS amended the

1988 Basle Accord to include market risk, and as-

suming amendments to the banking law to include

other types of risk, the current level of capital ad-

equacy is still higher than the suggested level of an

additional several percentage points above the BIS

standard of 8 percent.

The recent decline in the NPL ratio, from 14.40

percent in May 1999 to 13.10 percent in June 1999,

has been attributed in part to the slight increase in

the outstanding loans of the commercial banking sec-

tor, which rose by 0.3 percent in May 1999 after

months of contraction, and by 2.5 percent in June

1999.43

The modest growth in outstanding loans can

be ascribed partly to growth in the economy in the

first quarter of 1999, in contrast to the slight contrac-

tion in 1998. This would tend to support the belief of

some that the worst effects of the crisis are over

and that the economy is on its way to recovery. On

the other hand, the Monetary Board, in an effort to

encourage lending by banks, has exempted loans

given out after March 1999 from the 2 percent gen-

eral loan-loss provisioning requirement. It is not clear

whether such regulatory forbearance is primarily

designed to help spur the economy, or simply win-

dow-dress the NPL ratio. It also sends confusing

signals about the need to strengthen prudential norms

versus giving banks some breathing space to recover

from the crisis.

Major Measures Taken toStrengthen the Banking System

44

Over the last three years, the BSP undertook mea-

sures to strengthen its prudential supervision over

banks in order to reduce system risks, improve regu-

latory oversight, and align domestic banking standards

with international best practices. The major measures

included raising the capital requirements, tightening

the provisioning requirements, and stricter loan clas-

sification subject to loan-loss provisioning.

The BSP implemented a comprehensive reform

program whose elements included (i) strengthening

the prudential and supervisory systems, (ii) adopting

an early intervention system and a bank resolution

strategy so as to deal more effectively with problem


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banks and to safeguard the soundness of the bank-

ing system, (iii) undertaking special programs to

strengthen and modernize government banks through

privatization, (iv) adopting measures to reduce the

intermediation costs of financial institutions, and

(v) improving the legal and regulatory framework

through legislation in Congress.

STRENGTHENING THE PRUDENTIAL

AND SUPERVISORY FRAMEWORK

Several measures are being implemented to

strengthen the prudential and supervisory framework:

• Hike in minimum capital requirements by 20–67

percent from the prescribed end-1998 levels, in

two equal rounds to be completed by end-De-

cember 2000, depending on the type of bank.

• Monetary and nonmonetary sanctions for non-

compliance with the minimum capital require-

ments.

• Requiring banks to set up a 2 percent general

loan-loss provision and an additional specific loan-

loss provision on loans and other risk assets on a

graduated basis as follows: 1 percent by 1 Octo-

ber 1998, 1.5 percent by 1 April 1999, and 2 per-

cent by 1 October 1999. By 15 April 1999, loan-

loss reserve is 5 percent on especially mentioned

loans, 25 percent on substandard but secured

loans, 25 percent on substandard and unsecured

loans, 50 percent on doubtful loans, and 100 per-

cent on loan losses. Relative to the previous loan-

loss provisioning requirements, the only differ-

ence is that the first two categories have provi-

sioning requirements now but none previously.

The NPL ratios and loan reserve coverage for

different types of banks are shown in Table 12.

• Sanctions on banks and quasi banks if they fail

to set up allowance for probable losses on loans

and other risk assets.

• Making the criteria for past due loans more strict

by reducing the period of arrears for loans to be

classified as NPLs: from six months to three

months for loans payable in monthly installments,

and from three quarters to one quarter for loans

payable in quarterly installments.

• Revising the guidelines on restructured loans of

banks and nonbanks with quasi-banking func-

tions by treating restructured loans as perform-

ing loans if they are in current status or are fully

secured by real estate.

• Enhancing transparency in several areas, such

as (i) granting of DOSRI loans; (ii) requiring listed

banks to publish quantitative information on at

least the level of NPLs, classified assets, and

specific loan-loss provisions each quarter; (iii)

expanding the daily required report on lending

and deposit rates of banks; (iv) placing the ex-

ternal auditors of banks under an affirmative

obligation to inform the BSP of factors that may

materially and adversely affect banks in order to

improve the quality of audits of financial institu-

tions; (v) implementing a system of accrediting

the external auditors of banks; and (vi) issuing

guidelines on mark-to-market trading and equity

portfolios and mark-to-market accounting pro-

cedures to raise the accounting and disclosure

standards to an international level.

• Issuing stricter qualification and competency

criteria for the grant of new bank licenses.

• Improving the quality of bank management by

requiring prior BSP approval for the appointment

of bank officers from the rank of senior vice

president, prescribing the duties and responsi-

bilities of the board of directors and officers of

banks, and designating a compliance officer in

each bank.

• Emphasizing a more analytical, risk-based ap-

proach of examination and consolidated super-

vision of banks and their subsidiaries and affili-

ates rather than the traditional checklist ap-

proach. Risk-based reporting of bank examina-

tion has been introduced and the examination

process has been reoriented to be able to assess

the risks and systems used by the banks to man-

age, identify, control, and monitor risk.

53TH

E PA

ST P

ER

FOR

MA

NC

E O

F THE

PH

ILIPP

INE

BA

NK

ING

SE

CTO

R A

ND

CH

ALLE

NG

ES

IN TH

E P

OS

TCR

ISIS

PE

RIO

D

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Table 12: NPL Ratios and Loan Reserve Coverage

Dec Dec Mar Jun Sep Dec Jan Feb Mar Apr May Jun Jul Aug Sep Oct Nov Dec JanItem 1995 1996 1997 1997 1997 1997 1998 1998 1998 1998 1998 1998 1998 1998 1998 1998 1998 1998 1999

Total NPLs (P billion) 39.0 48.4 57.3 64.5 79.9 94.0 140.3 171.7 179.5 194.7 204.4

All commercial banks 28.0 34.2 42.3 47.9 59.4 73.7 115.6 142.7 149.9 166.2 175.1 182.0 178.4 160.0 180.2

Universal banks 33.8 37.9 45.9 56.8 71.9 103.3 91.8 116.5 138.2 146.9 153.5 150.0 130.5 150.0

Nonuniversal banks 4.4 5.5 7.1 9.6 15.7 17.6 19.5 19.2 20.1

Foreign banks 4.1 4.6 6.5 7.1 8.0 8.7 8.7 10.3 10.1

Thrift banks 7.0 9.5 9.9 11.3 14.9 14.8 18.8 22.7 22.8 21.7 22.5 0.0 23.6 21.3

Savings and mortgage banks 6.0 7.4 9.1 10.0 10.7 11.3 10.0

Private development banks 2.6 4.0 5.6 7.7 7.0 7.4 6.6

Private loan associations 1.3 3.5 4.1 4.9 4.8 4.9 4.7

Rural banks 4.0 4.7 5.1 5.4 5.4 5.4 5.9 6.3 6.8 6.8 6.8

Total loans 1,696.8

NPLs/total loans (%) 4.0 3.5 3.9 4.0 4.7 5.4 8.3 9.7 10.4 11.1 11.5

All commercial banks 3.2 2.8 3.3 3.4 4.0 4.7 5.8 6.7 7.6 8.8 9.4 8.9 9.6 10.5 11.0 12.0 11.8 10.4 12.1

Universal banks 3.2 3.3 3.7 4.4 5.3 7.4 8.7 9.4 9.0 10.0 11.4 12.5 12.4 10.4 12.5

Nonuniversal banks 4.1 4.8 5.7 7.2 12 13.5 14.4 13.3 14.8 14.2 15.4

Foreign banks 3.4 2.9 4.5 4.5 5.6 5.4 5.7 5.2 5.2 7.0 6.6

Thrift banks 7.9 7.7 7.4 7.7 10.1 10.6 14.1 16.7 17.1 15.6 15.7 18.3

Savings and mortgage banks 8.4 10.1 13.2 13.6 11.6 12.6

Private development banks 5.2 7.4 10.9 15.4 17.4 16.8

Private loan associations 11.3 26.9 32.4 40.5 42.0 40.1

NPL = nonperforming loan.Source: Bangko Sentral ng Pilipinas.


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• Revising the bank rating system from capital ad-

equacy, asset quality, management, earnings, and

liquidity (CAMEL) to capital adequacy, asset

quality, management, earnings, liquidity, and sys-

tems (CAMELS).

• Intensifying off-site monitoring of banks.

• Adopting prudential measures such as imposing

a ceiling of 20 percent of total loans on bank

exposure to the real estate sector, reducing the

allowable loan value of real estate security from

70 to 60 percent of appraised value, and requir-

ing a 30 percent liquid cover on all foreign ex-

change liabilities of FCDUs.

• Training the BSP supervision staff on a continu-

ing basis.

ADOPTING AN EARLY INTERVENTION

MECHANISM AND A RESOLUTION

STRATEGY FOR PROBLEM BANKS

The BSP has adopted several measures to iden-

tify and deal with potential problems of solvent and

nearly solvent banks. These measures include the

following:

• A crash program of intensified monitoring of

selected banks using forward- and backward-

looking indicators to draw up a prioritized list of

potential problem banks with the intention of

conducting a special on-site examination on

them.

• Formalizing sanctions on capital-deficient banks

whose guidelines embody the principles of

prompt corrective action (PCA), including the

issuance of a memorandum of understanding.

Sanctions are based on the degree of capital

deficiency.

• Issuing guidelines for resolving problem bank is-

sues.

• Providing additional incentives to promote and

encourage mergers or consolidation of banks/

financial institutions.

• Developing a worst-case contingency plan for

institutional or system crises.

PROHIBITING BANK OWNERS FROM

BIDDING ON ANY RESTRUCTURED

FINANCIAL INSTITUTION FOR SALE

The BSP, in coordination with the Department of Fi-

nance, undertakes special programs to strengthen and

modernize banks that have full or substantial gov-

ernment share. The modalities include the sale of

government shares to private investors.

TAKING MEASURES TO REDUCE

INTERMEDIATION COSTS

OF FINANCIAL INSTITUTIONS

Under Circular No. 166 dated 28 May 1998, statu-

tory reserve requirements were lowered from 10 to

8 percent. Under Circular No. 188 dated 3 February

1999, liquidity reserves, on top of regular reserves,

against peso demand, savings, time deposits, and

deposit substitutes have been set at the following lev-

els (and dates of effectivity): for expanded commer-

cial banks and NBFIs with quasi-banking functions,

6 percent (1 February 1999) and 5 percent (1 March

1999); for thrift banks, 5 percent (1 February 1999)

and 4 percent (1 March 1999); for rural banks, 2

percent (1 February 1999) and 1 percent (1 March

1999) for current accounts, and 0 for savings and

time deposits.

IMPROVING THE LEGAL AND

REGULATORY FRAMEWORK

THROUGH LEGISLATION

The BSP has proposed major revisions to Republic

Act (RA) 337, known as the General Banking Act

as amended. The proposals encompass both struc-

tural and prudential reforms.

The proposed structural reforms include updating

bank classifications to cover universal, Islamic, and

cooperative banks; liberalizing and rationalizing the

equity and citizenship structure of banks; rationaliz-

ing the powers of universal and commercial banks to

invest in allied and nonallied enterprises; and rede-

fining the functions, authority, and minimum capitali-

zation of trust entities.


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Among the proposed prudential reforms are adopt-

ing the Basle framework for measuring a bank’s

capital adequacy; strengthening the provisions against

overexposure of a bank to DOSRI; adopting mea-

sures against the concentration of credit to certain

borrowers; authorizing the Monetary Board to dis-

qualify, remove, or suspend unfit and improper di-

rectors and officers; granting the Monetary Board

the power to regulate compensation and other ben-

efits of bank directors and officers, if warranted;

providing guidelines and penalties for unsafe and

unsound banking practices; and requiring periodic

submission and publication of financial statements

for greater transparency.

The BSP has also proposed amendments to RA

7653, the New Central Bank Act. These include

empowering the BSP to examine banks once every

calendar year; granting the Monetary Board the au-

thority to impose administrative sanctions on subsid-

iaries and affiliates of banks and quasi banks and

their directors and officers; authorizing the issuance

of regulations requiring bank subsidiaries and affili-

ates to maintain a balanced position in their foreign

exchange transactions; giving the Monetary Board

the authority to grant loans for liquidity purposes to

banks in situations that, in the judgment of the board,

could lead to illiquidity of the banking system; and

removing the five-day consecutive period during

which the deposit account of a bank with the BSP is

overdrawn before it can be excluded from clearing.

To summarize, there have been substantial im-

provements toward the prudential supervision of

banks, particularly in asset quality norms such as the

interest accrual policy on past-due loans, the rever-

sal of accrued interest income on NPLs, and the high

provisioning requirements. Goldman Sachs recently

rated the overall banking system as fairly solid, with

a fragility score of 10 on a scale of 0 to 24, where 24

is weakest.45

This represents an improvement from

its previous assessment of 14 for system fragility,

and is a rating similar to those for the Republic of

Korea (11) and Malaysia (11). This improvement in

system fragility is shown by comparing the Goldman

Sachs assessment at end-1997 with its assessment

at end-1998 (Table 13). Nevertheless, the fact that

the Philippine banking system is fairly strong relative

to its regional counterparts is no reason to be com-

placent.

Remaining Weaknessesand VulnerabilityMACROECONOMIC POLICY

Transparency and incentives for prudent banking

are lacking while the degree of uncertainty increases

because of flawed macroeconomic policy. The in-

correct exchange rate policy created incentives for

foreign currency intermediation. The Asian crisis

demonstrates, for example, that a policy of main-

taining a fixed nominal exchange rate by keeping

domestic interest rates high skewed the incentive

system and encouraged overborrowing in foreign

currencies as it obscured the currency risk and re-

duced the drawdown of corporate cash reserves

by lowering interest payments. This move came at

the price of raising financial risk from a deprecia-

tion of the domestic currency. With underdeveloped

risk management systems and the inability of banks

to assess the consequences of currency deprecia-

tion on the borrowers’ ability to pay, the banking

system became more vulnerable to system fragility

and failure.

While the postcrisis exchange rate policy is seem-

ingly more market-determined, as the BSP has largely

remained on the sidelines at the Philippine Dealing

System and has also made a conscious effort to re-

duce interest rates by decreasing its own overnight

lending rate, it is difficult to say whether the authori-

ties will continue with this stance. In light of the re-

cent volatility that hit the peso allegedly due to exter-

nal events, such as the crisis in East Timor and the

depreciation of the baht, the BSP governor was

quoted as saying that the monetary authorities had

the tools to respond to the situation, but that he would

not reveal exactly what they would do. In other words,

56A

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Table 13: Assessment of Solidity of the Philippine Banking System

Hong Kong, Korea,Factors Contributing to Banking Crisis China Indonesia Republic of Malaysia Philippines Singapore Thailand

End-1997 End-1998

Macroeconomic volatility Some Yes Yes Yes Yes Stabilizing Some Yes

High, rapidly rising credit/GDP ratio Very high Low, rising Very high Very high Low, rising Low, steady High Very high

High property exposure, asset inflation Yes Yes No Yes Yes Yes, stabilizing Some Yes

High foreign exchange loans or foreign exchange liabilities? Deposits Yes Yes No Yes Yes No Yes

Financial liberalization destabilizing No Some Yes Some Some No Potentially Yes

Government-directed lending No Yes Yes Some Some Some Some Some

Related-party lending No Yes Yes Some Some Some No Yes

Weak regulations, accounting disclosures Some Some Yes Improving Improving Strong Opaque Improving

Weak regulatory supervision, compliance No Yes Yes Some No Some No Yes

Weak capital or loan reserve levels No Some Yes Some No Low reserves No Yes

Fragility for individual banks? Some Yes Yes Some Some Some No Yes

Weak or underregulated nonbanks? No Yes Yes Yes Some Some No Yes

Fragility scorea 8 20 22 15 14 10 7 22

Fragility score (previous) 8 15 18 15 13 14 7 22

Overall solidity or fragility Solid Fragile Fragile Some fragility Some fragility Fairly solid Solid Fragile

a 1 = best, 24 = worst.Source: Goldman Sachs Investment Research, 1999b, p.17.


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he was merely saying that the BSP would intervene

if necessary. But it is this same kind of line that led to

the highly interventionist and flawed exchange rate

policy in the past.

The tax of 7.5 percent on interest income on

FCDU accounts instituted in January 1999 is osten-

sibly meant to discourage holding assets in the form

of foreign currency to avoid putting pressure on the

peso, and therefore also serves as a disincentive to

foreign currency intermediation. Recently, there were

moves to further raise this tax to 15 percent, but this

seems to have been shelved in view of the strong

opposition from the private sector, particularly banks.

As usual, several complex forces are at work here:

the perceived need to reduce pressure on the peso,

the need to generate more government revenues in

the face of sluggish growth and tax collections, the

need to raise efficiency in resource mobilization by

trying to align the returns on domestic and foreign

assets through the imposition of the tax, etc.46

The Philippines continues to be plagued by cer-

tain macroeconomic weaknesses. Among the coun-

tries in Asia, the Philippines has the lowest savings

rate at 19 percent in 1998. It has the second largest

ratio of public sector debt to GDP for the same year,

second only to Indonesia. These imply that, in the

mean time, the Philippines will have to rely on for-

eign savings. Meanwhile, foreign bank lending to the

country dropped to $17.8 billion in June 1998 com-

pared with $19.7 billion in December 1997.47

In gen-

eral, the amount of foreign bank lending to the Phil-

ippines is small relative to that of other Asian coun-

tries and is comparable with the level in India. All

these data are shown in Tables 14, 15, and 16.

Table 14: Savings Ratio, Bank Deposit Growth, and Inflation Rate in Selected Asian Economies

CPI = Consumer Price Index, YOY = year on year.a As of October 1998, except for Korea (as of August 1998) and the Philippines (as of September 1998).Source: CEIC, central bank bulletins, Goldman Sachs Investment Research estimates.

Economy Savings Ratioa (%) Growth in Bank Deposits (YOY %) Estimated 1999 Inflation (CPI, %)

Hong Kong, China 41 10 4.7

Indonesia 25 55 2.4

Korea, Republic of 29 19 5.5

Malaysia 35 7 3.2

Philippines 19 12 6

Singapore 53 10 6.3

Thailand 35 11 25.9

Table 15: Ratio of Public Sector Debt to GDP, 1998

GDP = gross domestic product.a Includes internal and external debts, and bond and nonbond issues.Source: Goldman Sachs Investment Research estimates, central bank bulletins.

Economy Public Sector Debt ($ billion) GDP 1998 Public Sector Debt as % of GDP

Crisis countries

Indonesia 69 83 82

Korea, Republic of 102 304 34

Malaysia 35 71 50

Thailand 28 110 25

Noncrisis economies

China, People’s Republic of 124 981 13

Hong Kong, China 3 167 2

Philippines 46 65 71

Taipei,China 84 258 32


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GDP growth was negative in the last two quar-

ters of 1998, but managed to rise to 1.5 percent in

the first quarter of 1999 largely due to the improved

agricultural growth. On the inflation front, Deutsche

Bank estimates a 6.6 percent year-on-year average

inflation rate for 1999. This is higher than its esti-

mates for Thailand (0.3 percent), Republic of Korea

(1.5 percent), and Malaysia (2.2 percent). The cur-

rent account as a percentage of GDP is estimated at

4.2 percent for 1999, the same as in Indonesia, the

lowest in this group of countries.48

The BSP gradually reduced its overnight borrow-

ing rates from a high of 32 percent in mid-July 1997

to 12.25 percent and further to 9 percent currently.49

Interest rates for the exporters’ dollar facility (EDF),

which are based on the 3-month London interbank

daily rate (LIBID), are also on the decline. How-

ever, while interest rates are currently falling, there

are no guarantees that they will continue in this di-

rection. If, for example, the US Federal Reserve Bank

raises interest rates because of fears of an over-

heating economy or as a preemptive strike against

inflationary pressures, domestic interest rates may

rise. This would hamper the recovery in output growth

and loan demand.

LIBERALIZATION WHEN INSTITUTIONAL

FAILURES ARE PRESENT

The initial attempts at financial liberalization involved

removing interest rate ceilings and other measures

meant to avoid disintermediation. The banking sys-

tem was given a developmental role, particularly as

a source of finance for investment projects. In some

cases, there were successes, but there were also

large failures as many of the financed projects turned

out to be nonviable. Some analysts have associated

these outcomes with a deficient state of institutional

arrangements, such as weak accounting systems and

inadequate disclosure.50

Other institutional failings,

such as the lack of well-developed asset markets,

also hamper transparency, as market participants must

use internal company estimates of values rather than

those based on market-based observations. Interest-

ingly, one of the possible explanations for the contin-

ued tolerance for weak institutional structures is that

they provide a competitive advantage to domestic

financial institutions, particularly in their role as in-

termediaries between international markets and do-

mestic agents.51

The sequencing of liberalization and reforms is

also problematic. The pursuit of liberalization and

reforms in itself may be difficult, but when under-

taken in the absence of a strong supervisory and regu-

latory framework, a high degree of accountability

and transparency, and competent bank management,

the results, as the Asian crisis shows, can be disas-

trous. Attempts were made to increase the degree

of financial intermediation through the banking sec-

tor, even as the authorities continued to encourage

mergers and consolidations of banks. Unfortunately,

Table 16: Foreign Bank Lending to Asia, December 1994 to June 1998 ($ million)

Source: Bank for International Settlements; Goldman Sachs Investment Research, 1999b, page 10.

Country Dec 94 Dec 95 Jun 96 Dec 96 Jun 97 Dec 97 Jun 98

China, People’s Republic of 41,341 48,384 50,587 55,002 57,922 63,128 59,327

India 14,961 15,511 15,728 16,896 18,780 19,359 18,911

Indonesia 34,970 44,528 49,306 55,523 58,726 58,388 50,268

Malaysia 13,493 16,781 20,100 22,234 28,820 27,528 23,024

Thailand 43,879 62,818 69,409 70,147 69,382 58,835 46,801

Subtotal 99,172 132,454 149,610 161,193 171,043 164,483 137,896

Korea, Republic of 56,599 77,528 88,027 99,953 103,432 84,180 72,444

Total 212,073 273,877 303,952 333,044 351,177 331,150 288,578

Total for Asia 241,249 306,855 337,849 367,009 389,441 381,024 324,811


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there were no moves to sufficiently ease entry into

the industry and make it contestable. For a long time,

no new banks could be established until 1990 and

foreign banks could enter only starting in 1992 and in

a limited way.

Consequently, banks had some degree of monopoly

power. They enjoyed high profits despite high costs.

In 1988–1995, net profit to total assets ratio for Phil-

ippine banks was 2 percent while the average for

seven other economies was only 1.8 percent.52

The

resulting inefficiency in the banking sector is seen in

many ways. Philippine banks spend $3.75 for every

$100 to run their business, banks in Hong Kong, China

and Singapore spend $1.15, and Korean banks pay

$2.75 only.53

In fact, Philippine banks can afford to

be inefficient because their interest margins are

among the highest in the world, according to the presi-

dent of Thomson BankWatch Asia.54

Even though

the average difference between deposit and lending

rates has fallen from over 5 percent in 1997 to 4.7

percent in mid-1998 due to moral suasion by the BSP,

this differential is still higher than the 1997 averages

for countries in the region such as Indonesia (1.8

percent), Republic of Korea (1.1 percent), Malaysia

(2.7 percent), and Singapore (2.9 percent).55

Overheads as a ratio of total assets were as high as

4.4 percent for Philippine banks in 1988–1995, while

the average for seven other Asian economies was

only 1.8 percent.56

These inefficiencies may persist

if no serious efforts are taken to open the industry,

particularly to foreign participation.

REMAINING WEAKNESSES

IN PRUDENTIAL NORMS

There are several weaknesses in the prudential norms

of Philippine banks.57

First, banks accrue income on

restructured loans or immediately classify them as

performing loans so long as the loans are current in

status or are fully secured by real estate with a loan

value up to 60 percent of the appraised value of the

real estate security and other qualified collateral.

Previously, banks could only restructure loans and

declassify these as NPLs if such loans were fully

current on interest payments. The change in norms

may provide a way for some banks to refinance non-

viable companies.

While there have been notable improvements in

disclosure with respect to NPLs, loan-loss provision-

ing, and loan-loss reserves, as in many Asian bank-

ing sectors loan-loss provisioning requirements are

typically net of collateral, usually property. The Re-

public of Korea, Philippines, and Singapore all use

collateral-based provisioning (Table 17). In contrast,

Indonesia, Malaysia, and Thailand use time-based

Table 17: NPL Definition and Loan-Loss Provisioning Policies

NPL = nonperforming loan.Source: Central banks, Goldman Sachs Investment Research estimates.

Economy NPL/Past Due Definition NPL Cassification Provisioning Requirements

Hong Kong, China Judgmental Judgmental Net of collateral

Usually > three months

Indonesia > three months Time based Net of collateral

Korea, Republic of > one month Collateral based Gross of collateral

Malaysia > three months Time based Net of collateral

Philippines > three months for installment loans Collateral based Gross of collateral

> one day for non-installment loans

Singapore Discretionary Collateral based Net of collateral

Usually three months

Thailand > three months Time based Net of collateral

United States > three months Judgmental Net of collateral


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provisioning, while Hong Kong, China and the US

utilize a judgmental system, based on the perceived

risk and the likelihood of payment. Since Philippine

banks implement collateral-based lending, in which

the collateral is usually property, they are very sen-

sitive to declines in property values. When prop-

erty markets are illiquid, as they are in the Philip-

pines and Thailand, loan-loss provisioning may not

reflect real losses.58

Second, Philippine banks are active in loan-for-

property swaps. Such practice can take place with-

out formal legal foreclosure proceedings. In many

cases, the properties are actually unearned assets in

the form of raw land and are booked as ROPOA in

bank balance sheets at realizable values. Philippine

banks can directly foreclose pledged collateral once

borrowers are proven unable to pay either interest

or principal or both. It takes about 30 days for courts

to process foreclosure orders.59

The borrower is

given a one-year redemption period to pay off his

obligations and reclaim the loan.

Third, reserve coverage against such ROPOA

assets is not required until after five years from the

time the property is booked. Some banks could use

this to inflate collateral value since the property mar-

ket is illiquid.

Fourth, loan-loss reserves are currently not al-

lowed as tax deductions. BSP has already endorsed

a plan to Congress to make loan-loss reserves tax-

deductible. Since this move involves tax revenues,

it needs to be legislated. In general, while attempts

should be made to lower financial intermediation

costs and enhance the profitability of banks, the

important point is that the industry must also be-

come more contestable. Otherwise, such measures

to reduce intermediation costs will simply strengthen

an existing oligopoly.

Fifth, the timing of loan write-offs is determined

in part by the loan’s effects on the capital position of

the bank and on taxes.60

Deferring write-offs is com-

mon and may materially overstate the value of as-

sets and capital. The ratio of loan write-offs to total

loans is one of the indicators used by supervisory

authorities for off-site supervisory purposes. How-

ever, it is considered a reactive measure because

the authorities take action only after actual losses

have been incurred.

With respect to the proposal to amend the Gen-

eral Banking Act so as to be able to adopt the Basle

framework for measuring a bank’s capital adequacy,

it must be noted that to calculate risk-asset equiva-

lents, the Philippines uses a stricter method than

that set forth by BIS. The minimum Tier 1 capital-to-

asset ratio is 10 percent versus the current 13 per-

cent (17 percent using the BIS standard).61

There

seems to be little point in asking Congress to weaken

the bank capital adequacy measure especially be-

cause such strong capital requirements are regarded

as being largely responsible for the ability of Philip-

pine banks to weather the Asian crisis. Table 18 shows

the estimated recapitalization needs of the banking

system as calculated by Goldman Sachs. Note that

the Philippines and Malaysia are the only countries

with existing surplus capital, and the Philippines is

the only country that does not require new capital.

Among the proposed amendments to the General

Banking Act is the requirement that an enterprise

that is wholly or majority–owned by a bank be sub-

ject to BSP examination. Banks can own allied or

nonallied enterprises, meaning such enterprises that

may or may not be related to banking. As long as

these banks are majority owners of these enterprises,

they would be subject to BSP examination. While

the intent of such a proposal is laudable, in the sense

that there seems to be an attempt to supervise on a

globally consolidated basis, possible implementation

problems may be large. First, the BSP is currently

pressed, in terms of time and expertise, to examine

banks even on a once-a-year basis as mandated by

law. Second, the proposal could result in supervisory

and regulatory overlap with the SEC, which is pri-

marily charged with the regulation of corporations.

Already, the BSP has proposed that the amendments

to the General Banking Act include the proviso that


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the BSP be consulted about intracorporate disputes

in banks, quasi banks, and trust entities that affect

bank operations and transactions with the banking

public. Presently, intracorporate disputes fall within

the original and exclusive jurisdiction of the SEC.

Perhaps the solution to global supervision is to have

a unified structure of supervision, similar to that in

the crisis-hit countries.

Another proposed amendment to the General

Banking Act is granting the Monetary Board the

power to regulate compensation and other benefits

of bank directors and officers, if warranted. This may

give rise to conflict of interest and affect the ability

of bank management to keep an arm’s-length rela-

tionship with the bank’s regulators. It may also limit

the bank’s capability to pursue enhanced profitability

by infringing on its capacity to compensate bank of-

ficers and directors on the basis of performance.

WEAK IMPLEMENTATION OF

PRUDENTIAL NORMS AND INTERNATIONAL

STANDARDS OF SUPERVISION

The banking system continues to suffer from weak

implementation of prudential norms and international

supervisory standards. While the BIS core principles

for effective bank supervision put much emphasis

on estimating a bank’s value at risk, the pace at which

bank supervisors and examiners are implementing

this is very slow. The approach to bank examination

in the Philippines focuses largely on borrower-re-

lated risks associated with loans, while secondary or

product-related risks are not consistently taken into

Table 18: Estimated Recapitalization Needs of the Banking Systems (Static Analysis, ex-Earnings Power),as of 1998 (local currency billion)

CAR = capital adequacy ratio, GDP = gross domestic product, NPL = nonperforming loan.Tax credits on loan provisioning/net losses not factored into recapitalization calculations. In reality, these can reduce total recapitalization amount.a Comprises B5.462 billion loans by banks and B1.361 billion loans by fincos and securities. B461 billion by fincos. B148 billion by IFCs.b Using 8% Tier-1 CAR except for Indonesia and Thailand. Bank Indonesia recently brought down the minimum CAR requirement from 8 to 4% . Bank of Thailand has also reduced

CAR to 4.25%. In both cases, we use 6% Tier-1 CAR for recap calculations.Source: Goldman Sachs Investment Research estimates, central bank bulletins. CEIC Table 19 Circular No. 176, Series of 1998.

People’sRepublic Republic

Item of China Indonesia of Korea Malaysia Philippines Thailanda

Capital/Reserves to Cover LossesEquity 675 28,549 61,860 47 408 835Loan-loss Reserve 77 9,427 19,492 21 54 483Total 752 37,976 81,352 68 462 1,318Memo: Loan Reserves/Total Loans (%) 0.9 2.0 3.2 5.0 3.2 6.5Memo: Equity/Total Loans (%) 7.9 6.1 10.2 11.3 24.0 11.2

Total Loans, Gross 8,545 471,368 609,140 420 1,699 7,432Peak NPL Ratio (%) 30 60 27 19 15 43Total NPLS 2,563 282,821 164,468 80 255 3,196Assumed NPL Loss Ratio (%) 65 65 50 50 50 50Estimated Loan Losses 1,666 183,834 82,234 40 127 1,598(1) Capital Surplus (deficit) After NPL Losses

(local currency) (914) (145,857) (881) 28 335 (280)($ billion) (110.3) (19.7) (0.7) 7.5 8.6 (7.8)Amount Needed to Recap to Minimum CARTotal Loans, Net of Provisions 8,468 461,941 589,648 399 1,644 6,949Required CAR (8% of loans)a 677 27,716 47,172 32 132 417Less: Existing Surplus Capital 28 335

(2) Required New Capital (local currency) 677 27,716 47,172 3 None 417($ billion) 81.8 3.7 39.1 0.9 None 11.6

Total Recap Cost [(1)-(2)] (local currency) 1,592 173,574 48,053 None None 697($ billion) 192.1 23.5 39.8 0.9 None 19.5As % of GDP 20 28 13 1 None 18


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consideration. Examiners focus on loans, equities,

fiduciary activity, foreign transactions and treasury

operations; check compliance with banking laws;

assess internal controls; and appraise management.

Loans are evaluated based on BSP standards and

while examiners profile the loans, they do not neces-

sarily focus on loans that are beginning to become

delinquent. Examiners do not develop risk profiles of

individual products or services, nor formally appraise

risk management systems, although they claim that

they are moving in that direction.62

There seems to be much regulatory forbearance.

Bank supervisors are reluctant to effect the early

closure of failing institutions. In recent years, the most

glaring examples are Orient Bank and, more recently,

Prime Bank, both of which are on holiday. It is im-

portant for bank supervisors to close failing institu-

tions early, at a positive level of capital, to prevent

systemic risk as well as losses to the deposit insur-

ance fund.63

While the BSP has pursued attempts at

enhancing transparency with respect to DOSRI loans

and strengthened provisions against overexposure of

a bank to DOSRI, it remains to be seen whether

more Orient Bank-type experiences, in which 80

percent of the bank’s loans went to bank owners

despite the 15 percent ceiling on DOSRI loans, will

be avoided. In the case of Orient Bank, some al-

leged that the BSP knew about the DOSRI loan vio-

lations earlier on, but did not put a stop to it. Instead,

it even gave Orient Bank an emergency loan whose

amount has not been revealed publicly.64

Equally important in reducing the cost and fre-

quency of bank failures is the adoption of PCA mea-

sures. This involves early intervention of regulators

in problem banks. However, even as examiners pro-

file loans, they do not necessarily focus on loans that

are beginning to become delinquent.65

This would

seem to preclude the adoption of PCA measures.

The BSP recently issued Circular No. 181 that

specifies PCA measures to be taken based on the

severity of regulatory noncompliance by banks with

respect to capital adequacy. Table 19 shows the pen-

alty to be imposed on banks depending on the per-

centage of capital deficiency, while Table 20 lists the

PCA measures corresponding to the severity of

undercapitalization. However, while the BSP has

been actively pushing for all kinds of amendments to

the General Banking Act, it is opposed to even men-

tioning the term PCA in the banking act. Its officials

argue that they would rather deal with such matters

“administratively” because it is difficult to get Con-

gress to amend the law, and that, in any case, the

circulars they issue have the force of law.

Although one may not want to necessarily debate

with the authorities on the legal basis of such circulars,

the point is that legislated mandatory intervention,

rather than regulatory discretion, is important in pro-

tecting the interests of the public.66

The problem does

not seem to be that the authorities do not have suffi-

cient power to implement PCA measures or to ef-

fect early closure of failing institutions; it is that when

there is regulatory discretion, the intervention usu-

ally does not take place.67

Under the current law,

Section 65 of the General Banking Act states that if

a bank does not comply with the prescribed mini-

mum (capital) ratio, the Monetary Board may limit

or prohibit the distribution of net profits by such bank

and may require that part or all of the net profits be

used to increase the capital accounts of the institu-

tion until the minimum requirement is met. It is vague

as to when sanctions may be levied, as it is not

explicit with regard to sanctions related to specific

levels of capital inadequacy. In the United States

(US), for example, the Congress legislated manda-

tory intervention in the Federal Deposit Insurance

Corporation (FDIC) Improvement Act instead of

allowing PCA measures to be implemented using

regulatory discretion.68

Among the proposed amendments to the New

Central Bank Act is empowering the central bank

to examine banks once every calendar year. This

proposal is surprising since it appears that the BSP

needs Congress to carry out its constitutionally man-

dated task of bank supervision. Worse, it seems to


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Table 19: Sanctions on Banks Violating Capital Adequacy Regulation

Capital Deficiency

Commercial BanksUp to 20%

Up to 40%

Up to 60%

Up to 80%

More than 80%

Thrift BanksUp to 20%

Up to 40%

Penalty

• Suspension of authority to invest in nonallied undertakings (for EKBs only)• Suspension of authority to invest in allied undertakings• Suspension of securities and dealership functions (for EKBs only)• Suspension of branching privileges• Suspension of declaration of cash dividends

• Suspension of authority to invest in nonallied undertakings (for EKBs only)• Suspension of authority to invest in allied undertakings• Suspension of securities and dealership functions (for EKBs only)• Suspension of branching privileges• Suspension of declaration of cash dividends• Restrictions on overall loan growth/investments (new loans to the extent of collections only)• Restrictions on lending to affiliates• Denial of access to BSP rediscounting facilities• Suspension of authority to accept or handle government deposits

• Suspension of authority to invest in nonallied undertakings (for EKBs only)• Suspension of authority to invest in allied undertakings• Suspension of securities and dealership functions (for EKBs only)• Suspension of branching privileges• Suspension of declaration of cash dividends• Restrictions on overall loan growth/investments (new loans to the extent of collections only)• Restrictions on lending to affiliates• Denial of access to BSP rediscounting facilities• Suspension of authority to accept or handle government deposits• Suspension of authority to engage in quasi-banking activities• Suspension of authority to engage in derivative activities• Suspension of FCDU/EFCDU activities• Suspension of trust operations

• Suspension of authority to invest in nonallied undertakings (for EKBs only)• Suspension of authority to invest in allied undertakings• Suspension of securities and dealership functions (for EKBs only)• Suspension of branching privileges• Suspension of declaration of cash dividends• Denial of access to BSP rediscounting facilities• Suspension of authority to accept or handle government deposits• Suspension of authority to engage in quasi-banking activities• Suspension of authority to engage in derivative activities• Suspension of FCDU and expanded activities• Suspension of trust operations• Suspension of international banking activities• Suspension of lending activities

• Suspension of clearing privileges• Suspension of granting of bonuses/profit-sharing not covered by existing contracts or bylaws• Cease and desist

• Suspension of branching privileges• Suspension of declaration of cash dividends

• Suspension of branching privileges• Suspension of declaration of cash dividends• Restrictions on overall loan growth/investments (new loans to the extent of collections only)• Restriction on lending to affiliates• Denial of access to BSP rediscounting facilities• Suspension of authority to accept or create demand deposits or operate NOW accounts• Suspension of authority to accept government deposits

Continued next page


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Table 19: Sanctions on Banks Violating Capital Adequacy Regulation (Cont’d)

Capital Deficiency

Up to 60%

Up to 80%

More than 80%

Rural BanksUp to 20%

Up to 40%

Up to 60%

Up to 80%

More than 80%

Penalty

• Suspension of branching privileges• Suspension of declaration of cash dividends• Restrictions on overall loan growth/investments (new loans to the extent of collections only)• Restrictions on lending to affiliates• Denial of access to BSP rediscounting facilities• Suspension of authority to accept or create demand deposits or operate NOW accounts• Suspension of authority to accept government deposits• Suspension of authority to engage in quasi-banking activities• Suspension of FCDU activities• Suspension of authority to invest in allied undertakings• Suspension of trust operations

• Suspension of branching privileges• Suspension of declaration of cash dividends• Denial of access to BSP rediscounting facilities• Suspension of authority to accept or create demand deposits or operate NOW accounts• Suspension of authority to accept government deposits• Suspension of authority to engage in quasi-banking activities• Suspension of FCDU activities• Suspension of authority to invest in allied undertakings• Suspension of trust operations• Suspension of lending activities• Suspension of issuance of domestic letter of credit


• Suspension of branching privileges• Suspension of declaration of cash dividends

• Suspension of branching privileges• Suspension of declaration of cash dividends• Restrictions on overall loan growth/investments (new loans to the extent of collections only)• Denial of access to BSP rediscounting facilities• Suspension of authority to accept or create demand deposits or operate NOW accounts• Suspension of authority to accept government deposits

• Suspension of branching privileges• Suspension of declaration of cash dividends• Restrictions on overall loan growth/investments (new loans to the extent of collections only)• Denial of access to BSP rediscounting facilities• Suspension of authority to accept or create demand deposits or operate NOW accounts• Suspension of authority to accept government Deposits• Suspension of authority to invest in allied undertakings

• Suspension of branching privileges• Suspension of declaration of cash dividends• Denial of access to BSP rediscounting facilities• Suspension of authority to accept or create demand deposits or operate NOW accounts• Suspension of authority to accept government deposits• Suspension of authority to invest in allied undertakings• Suspension of lending/investment activities


BSP = Bangko Sentral ng Pilipinas, EKB = expanded commercial bank, EFCDU = expanded foreign currency deposit unit, FCDU = foreign currency deposit unit, LC = letter ofcredit, NOW = negotiable order of withdrawal.


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Table 20: Capital Deficiency and Prompt Corrective Action

Capital Deficiency(under existing lawsand regulations)

UndercapitalizedUp to 20 %

SignificantlyUndercapitalized

Up to 60%

CriticallyUndercapitalized

More than 60%

Prompt Corrective Action

• Require the bank to execute a memorandum of understanding (MOU) with Bangko Sentral ngPilipinas (BSP), binding itself, among others, to implement a variable capital restoration planacceptable to BSP within 30 days from date of notice

• Require intensified monitoring by BSP of bank’s financial condition• BSP to conduct a special examination of the bank

• BSP to call a meeting with bank directors/principal officers to discuss and agree on remedialmeasures to be taken and the timetable for implementation

• Intensify monitoring by the Supervision and Examination Sector of BSP of the bank’s financialcondition

• BSP to conduct immediately an extensive on-site examination• Require the bank to execute an MOU with BSP, binding itself, among others, to implement a

viable capital restoration plan acceptable to BSP within 30 days from the date of discussion.Among the options to be considered are:(i) Disposition of a majority shareholder’s interest(ii) Sale of assets(iii) Issuance of additional stocks/capital infusion(iv) Sale of bank to highest bidder subject to terms set by BSP(v) Merger (assisted or unassisted) or consolidation with a stronger bank

• Require the creation of a separate unit in the bank-remedial asset management group, whichwill take care of bank’s bad assets and make progress reports to BSP

• Appoint an external auditor at the expense of the bank to perform a financial or operationalaudit under the terms of reference provided by BSP

• If necessary, appoint a consultant specialist to diagnose the problem and to recommend theappropriate remedial measures (i.e., introduce new profit opportunities, improve internal andaccounting controls, etc.) to restore bank’s viability

• Place the bank under Prompt Corrective Action Unit since this would require more than normalbank supervision

• BSP to call a meeting with bank’s principal shareholders/directors• BSP to conduct immediately an extensive on-site examination• BSP to conduct intensive monitoring of bank’s financial condition• Require the bank to execute a Memorandum of Understanding (MOU) with BSP, binding itself,among others, to implement a viable capital restoration plan acceptable tot he BSP within 30days from date of meeting.

• Among the options to be considered are:(i) Disposition of a majority shareholder’s interest(ii) Sale of assets(iii) Issuance of additional stock/capital infusion(iv) Sale of bank to highest bidder subject subject to terms set by BSP(v) Merger (assisted or unassisted) or(vi) Consolidation with a stronger bank

• Create a BSP Ad Hoc Committee to oversee the implementation of the action plan• Require the creation of a separate unit in the bank - remedial asset management group to take

care of bank’s bad assets and make progress reports to BSP• Appoint an external auditor at the expense of the bank to perform financial or operational audit

under the terms of reference of the BSP• If the bank’s condition further deteriorates to the extent that depositors and creditors protection

is at stake and its capital base is already deficient by more than 80%, appoint/assign a residentexaminer comptroller or conservator, if legally feasible, to oversee/take over management ofthe bank

• If necessary, appoint a consultant specialists to diagnose the problem and to recommend theappropriate remedial measures (i.e. introducen ew profit opportunities, improve internal andaccounting controls, etc.) to restore the bank’s viability


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imply that better BSP supervision over banks has

been hampered by the existing law in terms of the

freedom to examine banks as frequently as possible

or as needed. It is also unclear why examiners would

want to examine banks only once a year or at least

once a year and why Congressional approval is

needed for them to do this. If the authorities were to

ask Congress to pass the implementing law with re-

gard to supervision, would it not make more sense to

ask for the authority to examine banks as frequently

as the authorities deem necessary? This seems to be

a relic from the past when bank supervision meant

on-site examination and is constrained by time and

availability of personnel. However, the emphasis at

present is on off-site examination that allows for

greater disclosure and frequency of examination. In

countries like Malaysia, such off-site examination

allows for the daily monitoring of banks. In the Phil-

ippines, foreign exchange trading activities of banks

are monitored daily.

WEAK CREDIT CULTURE AND INADEQUACIES

IN ADDRESSING THE DEVELOPMENTAL NEEDS

OF THE ECONOMY

The country has a weak credit culture.69

As men-

tioned previously, the Philippines has one of the low-

est degrees of financial intermediation in Asia, with

a loan-to-GDP ratio under 65 percent. The adequacy

of credit to vital sectors of the economy, such as

rural enterprise, private infrastructure, exports, SMEs,

and the efficiency with which such credit is provided

need to be addressed. It is a fact that the formal

credit system provides only a small portion of the

financing requirements of the rural sector. Yet, un-

less the needs of this sector and other vital ones are

addressed sufficiently, the country’s long-term de-

velopment will not advance.

Two legislated provisions mandate banks to set

aside a portion of their loan portfolio to agriculture

and the agrarian reform sector, and to SMEs. As of

March 1997, banks provided a total of P117 billion in

credit to the entire agriculture sector. Commercial

banks provided P104 billion or 89 percent of the total

agriculture loans of the banking system, thrift banks

contributed P7.3 billion or 6.3 percent, and rural banks

lent out P5.6 billion or 4.8 percent. However, the

total bank loans were below the mandated loans to

the sector by P55.2 billion, equivalent to a compli-

ance ratio of only 17 percent versus the required

ratio of 25 percent.70

Nevertheless, the bulk of ac-

tual investments to SMEs has remained “net eligible

loans” or actual funds lent out. In fact, loans to SMEs

have been increasing at a higher rate than those of

the total loan portfolio. The compounded annual

growth rate of SME actual investment (loan) during

the period 1991–1996 was 51 percent, while that of

the total loan portfolio was 33 percent.71

There are concerns that funds to SMEs may not

have really reached the beneficiaries since they are

not actual investments, and that banks have found

ways to comply with the letter of the law by simply

putting funds in an ever-expanding list of allowable

funds for compliance.72

Apart from the usual emphasis on credit provision

to SMEs and the export sector, microfinance as a

new approach to development finance has led to a

more balanced view that low-income groups demand

other financial services as well. Microfinance institu-

tions in the Philippines are composed of rural banks,

cooperatives, cooperative banks, credit unions, and

credit-granting nongovernment organizations (NGOs).

The latter have demonstrated some success in reach-

ing poor clientele.73

However, microfinance institu-

tions need to mobilize more deposits (in the cases of

rural banks and cooperative banks), tap the commer-

cial loan market, and increase their equity so as to

sustain their financial capability. It is estimated that

some 2,362 microfinance institutions reach only

656,000 clients.74

There is some debate on whether

transforming credit NGOs into banks and subjecting

them to formal regulation and supervision will lead to

a loss of focus and sense of mission to the poor.


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In part, the conservative stance of banks and the

weak credit culture may be blamed on bank examin-

ers and regulators. There is widespread uncertainty

and concern about the expectations and requirements

of regulators and examiners. Bankers have consid-

erable discretion in granting loans, but examiners have

considerable discretion in evaluating the performance

of bankers. Uncertainty and concern about examin-

ers’ expectations discourage regulated institutions

from undertaking innovative credit policies such as

finding alternatives to collateral and formal financial

statements as basis for lending, and encourage bank-

ers to avoid activities in which they have to do sub-

jective judgments.75

This tends to make bankers ex-

tremely conservative in lending. Increased foreign

participation is seen as a way to provide greater com-

petition, and to improve the credit culture, manage-

ment practices, and borrower repayment culture for

Philippine banks.

BANK SECRECY LAW

The Bank Secrecy Law may be partly responsible

for bank examiners’ conservative approach to ex-

amination.76

This law makes it impossible for BSP

and PDIC examiners to verify individual account

(deposit) balances. Because of this restriction, ex-

aminers may not detect misstated deposit account

balances. They could then become more conserva-

tive in the other areas of their examination. PDIC

officials have long sought access to bank deposit

records before a bank is closed because it is difficult

to effect quick liquidation when attempting to verify

deposit records of the bank for the first time. With-

out the complete records of bank deposits before-

hand, it will be difficult to know if these have been

tampered with, especially during a time of imminent

bank liquidation.

Recently, the PDIC asked Congress to amend

its charter and allow it to have access to the de-

posit records of banks that have had their insured

status terminated.77

Repealing the Bank Secrecy

Law will enhance system transparency and pre-

vent systemic risk by allowing a quick payoff of

depositors as soon as the bank is closed and pre-

serving confidence in the system. The examiner

must be able to trace accounting entries through

the deposit side of the balance sheet.78

LINKAGES BETWEEN NPL RESOLUTION,

AND CORPORATE GOVERNANCE AND

REHABILITATION

The deterioration in corporate sector performance

between 1997 and 1998, as evidenced by the increase

in the number of firms applying for debt suspension

with the SEC and whose total liabilities amounted to

6.2 percent of outstanding commercial loans in 1998,

points to the need to parallel corporate debt resolu-

tion and the resolution of bank NPLs. The health of

the banking system depends to a large extent on the

health and performance of the corporate sector.

Unfortunately the SEC, which is in charge of corpo-

rate sector supervision, is extremely burdened with

many different functions. Both the effectiveness of

existing corporate regulations, especially with regard

to disclosure and transparency, and the capacity of

the SEC to fulfill its corporate regulatory and super-

visory functions need to be addressed.

One of the major impediments to improving the

resolution of corporate debts and ultimately, of bank

NPLs, is the inadequacy of the existing law covering

corporate rehabilitation. Corporate rehabilitation is

not defined anywhere.79

While it is a remedy pro-

vided under Presidential Decree 902-A, neither the

procedures on how to avail of it, nor the relief that

goes with it is specified in the law. As with other

forms of remedies for ailing corporations, the SEC

has exclusive jurisdiction over corporate rehabilita-

tion and, thus, corporate rehabilitation tends to be

regulator-driven. However, the SEC has not adopted

formal rules to govern the implementation of these

remedies. Hence, it exercises a lot of discretion and

power in granting them, treating applications for


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availment on a case-by-case basis. Many important

questions, such as who will prepare the corporate re-

habilitation plan, who will manage the corporation dur-

ing the pendency of the petition, and can encumbered

assets be disposed of, remain unanswered.80

Unless

the law covering corporate rehabilitation is improved

to address all of these issues, banking sector reform

will remain standing on one leg.

RecommendationsStrengthen Banks to Meetthe Increasing Requirementsof GlobalizationFirst, it is necessary to conduct the macroeconomic

policy appropriately. The previous macroeconomic

regime gave rise to an inappropriate system of in-

centives for market participants, particularly in the

area of recognizing and minimizing risks, which con-

tributed to the fragility of the banking sector. The

previous system of incentives, which attracted capi-

tal inflows for the wrong reasons and into the wrong

sectors, must be avoided. It is important to conduct

macroeconomic policy appropriately so that the

proper incentive system evolves, moral hazard is

avoided, with market participants aware of the need

to recognize and minimize risks, banks owners and

managers being accountable to depositors, and de-

positors willing to monitor the behavior of bank man-

agement. Such an incentive system would rely more

on market-based incentives rather than on strong

supervision by supervisory authorities.

Second, there must be serious improvements in

institutional arrangements and mechanisms that give

rise to greater transparency and flows of informa-

tion. An example of this is the development of well-

behaved asset markets so that corporate transpar-

ency is enhanced and valid financial information is

based on market observations. However, it is a fact

of life that inappropriate macroeconomic policy

such as government financing of a large and recur-

ring fiscal deficit either by borrowing through trea-

sury bill sales or through an inflation tax, or attempts

to fashion a floor price for the exchange rate by

keeping domestic interest rates high, will keep capi-

tal markets, both equity and debt markets, relatively

underdeveloped. High interest rates will also make

it difficult for borrowers to repay loans and will

therefore raise the degree of fragility of the bank-

ing system. At present, IMF has allowed the Gov-

ernment to raise its deficit-to-GNP ratio to about

2.2 percent to pump-prime the economy. The Gov-

ernment is financing this increased spending pri-

marily by borrowing from abroad to be able to keep

domestic interest rates down. Care must be exer-

cised, however, that the foreign borrowings do not

translate into a difficult external debt service bur-

den as they did in the early 1980s.

Third, the banking system must respond to the

developmental needs of the economy without com-

promising the banks’ commercial viability. Banks must

learn to mobilize savings efficiently so that they can

address the needs of specific sectors that have cru-

cial developmental and social impact, such as ex-

porters, SMEs, microfinance, etc. Transactions costs

are effectively high for banks handling mandated

credit programs because of an asymmetry of infor-

mation that impacts directly on the credit decision

and the credit risk between borrower and lender.

These costs must be reduced by introducing mar-

ket-based compliance mechanisms to minimize the

information gap between financial institutions and the

mandated credit program market.81

The PDIC can

also play a role in mobilizing savings in the poorer

rural areas by providing the confidence needed for

the rural depositor to place funds in local financial

institutions.

Under the national strategy for microfinance, is-

sues such as performance standards for microfinance

institutions, termination of subsidized directed credit

programs, adoption of market-determined interest rates,

and government support to capacity-building efforts

of microfinance institutions are being attended to.


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Strengthen Prudential Regulationand SupervisionThis entails strengthening prudential norms and ad-

dressing the remaining weaknesses identified, such

as (i) the classification of restructured loans as per-

forming loans, (ii) the treatment of loan-for-prop-

erty swaps in bank balance sheets and the need for

adequate and immediate provisioning, (iii) the tax

treatment of loan-loss reserves, (iv) the advantages/

disadvantages of the current stricter definition of

capital adequacy relative to the BIS standard, (v)

the overemphasis on collateral as the basis for lend-

ing decisions, (vi) the scope of supervision beyond

banks to include allied and nonallied bank-owned

enterprises and the appropriate architecture of su-

pervision, and (vii) the wisdom of allowing supervi-

sory authorities to regulate the compensation of bank

directors and officers.

In addressing these weaknesses, it is necessary

to have a formal framework and common terminol-

ogy for risk assessment and risk management sys-

tems in banks.82

The disadvantage of the current

system, which relies heavily on collateral when mak-

ing lending decisions, is that it tries to mitigate risk

more by avoiding rather than managing it. The adop-

tion of good risk management techniques permits

lenders to take on more risks, serve more borrow-

ers, and earn higher returns associated with greater

risk, and at the same time reduces the risk of loss.

It must be pointed out that while the Basle Accord

focuses on capital measurement and the setting of

minimum capital adequacy standards, it does not

offer standards for banks’ efforts to identify, mea-

sure, monitor, and control material risks.83

This

means that the Basle Accord cannot be regarded

as a complete international prudential agreement

and that individual countries will have to find a way

to interpret and implement the spirit of the accord,

given their own levels of institutional and socioeco-

nomic development.

Another measure to strengthen prudential super-

vision is better implementation of prudential norms

and supervisory standards. It is important for bank

examiners and supervisors to gain expertise in de-

veloping risk profiles of individual products and

services and in being able to formally appraise risk

management systems.

Ways to improve the implementation of prudential

norms and supervisory standards include training of

bank supervisors and examiners in risk appraisal and

management techniques, enlargement of the pool of

competent bank examiners and supervisors by of-

fering competitive salaries to attract and retain ex-

perts from the private sector, and opening the do-

mestic banking industry to foreign participation to help

produce such experts in the private sector.

Another way is to emphasize transaction-based

banking, rather than relationship banking, and to re-

duce regulatory forbearance. In the Philippines, many

things are accomplished on the basis of relationships

or “connections,” whether one is talking about getting

a driver’s license or being able to borrow from a bank.

This makes it difficult to lend money, for example, sim-

ply on the basis of the merits of a transaction, on the

viability of the project, and the borrower’s ability to

pay rather than on whether there is collateral. Rela-

tionship banking makes it difficult to put a stop to the

abuses of related-party lending or to effect the early

closure of failing institutions. Here, all the prudential

standards and norms one can write into law will not

matter unless there is a change in the way banks se-

lect their clients, and in the seemingly cozy relation-

ship between the BSP as regulator and supervisor of

banks and the regulated banks themselves.84

Measures to reduce potential conflict-of-interest

situations must be adopted. One way to maintain an

arm’s-length relationship between the supervisor and

regulator of banks and the banks themselves is to

reduce regulatory discretion with respect to PCA

measures by legislating mandatory intervention. If

these measures are written into law, there will be

greater transparency and both supervisor and banks

will be accountable to entities other than themselves,

such as Congress.


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Raise the Degree ofCompetition and Efficiencyin the Banking IndustryIt is important for the banking industry to be contest-

able. This is accomplished primarily by removing

barriers to entry. While the BSP is raising capital

standards and encouraging mergers and acquisitions

among banks, it must also allow entry or raise the

threat of potential entry, particularly of foreign insti-

tutions. The dismal fact is that while raising capital

standards and encouraging mergers have made do-

mestic banks strong, there are no distinct signs that

financial intermediation has become more efficient.

The Philippines still has the lowest loan-to-GDP ra-

tio and some of the highest interest rate spreads

among Asian countries. This has remained so de-

spite financial liberalization and reform moves since

the early 1980s. It appears that capital hikes and

voluntary mergers have acted as effective barriers

to entry. While 100 percent foreign ownership of

banks is being discussed, the BSP already has thought

of ways to provide macroeconomic protection to the

local banking industry by setting a ceiling on the per-

centage of the total industry’s assets that can be for-

eign owned. It seems there are more benefits than

there are disadvantages from complete foreign own-

ership of banks as shown by the experiences of

Singapore and New Zealand.

Privatization is also seen as a way of raising effi-

ciency and competition in the industry. In this regard,

the clinching of the PCIBank sale by the Equitable

Group, with the participation of two government fi-

nancial institutions, sends the wrong signal to market

participants. The signal being given is that having the

Government on your side ensures the winning bid.

Worse, it could imply that the Government, because

it has a stake in a particular bank, would ensure that

the bank would not fail. This will give rise to the

problem of moral hazard, which led to large losses

and insolvency in government-owned corporations

and financial institutions in the past as well as in bank-

ing systems in Asia during the crisis.

Public listing requirements must be strengthened

to improve corporate governance in the banking in-

dustry. Measures to raise overall system transpar-

ency to make information readily available must be

adopted so that each banking firm can compete on

an equal footing.

Financial intermediation taxes, such as gross re-

ceipts tax and documentary stamp tax, the AGRI/

AGRA requirement, and the Magna Carta for SMEs,

must be eliminated or reduced, and implicit financial

intermediation taxes, such as the liquidity reserve

requirements, must eventually be removed.

Currently, a World Bank Financial Sector Adjust-

ment Loan is being utilized to assist in improving the

banking sector’s health and efficiency.

Improve the Financial InfrastructureAccounting and disclosure systems have to be

strengthened so that the true financial condition of

banks, including their affiliates, is readily verifiable.

Without a credible disclosure system, it will be diffi-

cult for authorities to act in a manner that is preemp-

tive of a crisis situation or a situation of increased

vulnerability. Better accounting and disclosure will

also allow better off-site monitoring of banks and

reduce the strain on personnel and time of conduct-

ing on-site inspections.

Improve the Legal SystemThe Bank Secrecy Law has to be repealed so as to

allow bank examiners access to deposit records be-

fore a bank is in need of liquidation. The inability of

the PDIC to review deposit account balances be-

cause of the Bank Secrecy Law makes it virtually

impossible to protect the interests of depositors. To

enhance the PDIC’s role in bank examination, legal

impediments to the review of second-party verifica-

tion of deposit accounts must be lifted. The repeal of

the Bank Secrecy Law will also assist fiscal authori-

ties in tax mapping and tracking down tax evaders.

The linkages between NPL resolution and im-

proving corporate governance and rehabilitation


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must be recognized. Improvements are needed in

the legal framework for orderly corporate restruc-

turing and loan workouts, including strengthening

the bankruptcy law and implementation procedures.

Specifically, the SEC must adopt formal rules for

implementing corporate rehabilitation, and make the

proceedings swift and time bound, and creditor

rather than regulator driven.85

It is also necessary to have a clearer legal inter-

pretation of the BSP mandate as supervisor and

regulator of banks, and the extent of the legislation

required to carry out such mandate. The legal basis

of BSP-issued circulars is not always clear, nor is

the need for Congress to legislate measures to ef-

fect the adoption of the Basle core principles of ef-

fective supervision apparent. It is ambiguous where

BSP independence is at stake and where legislation

is needed to minimize regulatory forbearance.

Summary and ConclusionLike in many Asian countries, the Philippine banking

system until the early 1980s was primarily tasked

with a developmental role. It was viewed as the con-

duit of credit to sectors deemed as high priority by

the State. Controls on interest rates, subsidies, and

directed lending were some of the ways this was

carried out. Financial repression was one of the re-

sults. Resource misallocation, lack of long-term fi-

nance, and inefficiency in the system of financial in-

termediation were among the main problems that

emerged in the financial sector.

An IMF-Central Bank study of the financial sec-

tor in 1972–1973 made recommendations to address

those issues. Beginning in 1980, financial liberaliza-

tion and reforms were undertaken. Ceilings on inter-

est rates were lifted, bank consolidation and merg-

ers were encouraged, the liberal discounting policy

of the central bank was discontinued, etc. These re-

forms were implemented; however, bank entry was

not allowed and certain prudential norms were not

adopted. The 1980 reforms did not include rules on

the treatment of overdue loans, the provisioning of

debt, and examination of deposit transactions by cen-

tral bank examiners. In 1980, the capital adequacy

requirements were even reduced. Rules regarding

credit accommodation to DOSRI were relaxed. All

these set the stage for the banking crisis in 1981,

triggered by the collapse of the commercial paper

market. Meanwhile, excessive public borrowing in

the 1970s, which led to “debt-driven growth” in that

decade, became an external debt burden in the 1980s

when the second oil shock dried up foreign capital

inflow toward the end of the 1970s. By October 1983,

the Philippines had declared a moratorium on the

service of external debt, which effectively meant that

no new foreign inflows would be forthcoming for a

while. The country experienced negative rates of

growth for the first time in its postwar history in 1984

and 1985. The central bank raised domestic interest

rates by issuing high-yielding debt instruments of its

own called Jobo bills, and tamed inflation by inducing

tremendous slack in the economy.

Hence, although financial liberalization and re-

form measures were taken prior to the financial

crisis in 1981, the macroeconomy itself was in bad

shape, largely because of earlier excesses and the

loss of foreign inflows. It was difficult under such

circumstances to proceed with and deepen the fi-

nancial sector reforms. Nevertheless, since the re-

form process was necessary, it did continue. The

failure of several banks in the 1980s led the mon-

etary authorities to strengthen prudential regulations

in the latter part of the decade and early 1990s.

The authorities strengthened regulations on single

borrower limits, limits on DOSRI loans and inter-

locking directorships, capital adequacy, compliance

with minimum risk-asset ratio, and provisions for

loan losses. The Government also undertook the

rehabilitation of the financial sector, particularly of

PNB and DBP, two government-owned financial

institutions that accounted for nearly 50 percent of

all banking assets and which had become insolvent

by 1985. The rural banking system, which experi-

enced large failures after its primary source of funds,


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namely the central bank’s discount window, aligned

its rate with market rates, was also rehabilitated

through a capital-buildup program.

By the 1990s, bank branching and entry were lib-

eralized. In 1994, foreign bank entry was allowed

but was limited to 10 banks under specified modes

of entry. The foreign exchange market was also lib-

eralized during the early 1990s. By 1992, exporters

could retain 100 percent of their foreign exchange

earnings, restrictions on the purchase of foreign ex-

change were lifted, and the full and immediate repa-

triation of duly registered foreign investments was

allowed without prior BSP approval.

With the liberalization of the financial and capital

markets in the Philippines, foreign capital inflows

began to surge in the early 1990s, peaking at a little

over 7 percent of GDP in 1996. Prior to the Asian

crisis in July 1997, the monetary authorities once

again strengthened certain prudential norms, includ-

ing setting a 20 percent cap on real estate lending

by banks, imposing a 30 percent liquid cover on all

foreign exchange liabilities of banks, and prescrib-

ing guidelines governing the responsibilities and du-

ties of a bank’s board of directors. However, while

those measures helped prevent the collapse of the

banking system, they were insufficient to control

the dramatic increase in its NPL ratio from about 4

percent prior to the crisis to 13.1 percent as of June

1999. Although the Philippine banking system es-

caped the worst effects of the Asian crisis, its vul-

nerability to the crisis increased. This can be blamed

on defective macroeconomic policy and premature

liberalization of the capital market prior to the insti-

tution of a strong supervisory and regulatory frame-

work for banks.

The flawed policy of maintaining a fixed nominal

exchange rate largely by keeping domestic interest

rates high encouraged overborrowing from abroad,

particularly in the last two years before the onset of

the Asian crisis. It created an inappropriate incen-

tive system, enabling domestic banks to borrow

cheaply from abroad and relend locally at very high

rates. Most of the borrowed funds flowed into the

real estate sector and created an asset “bubble.” For

large corporations that were able to borrow directly

from abroad, there were substantial interest cost sav-

ings. However, the ease with which foreign borrow-

ing could be effected made market participants less

than prudent in their borrowing and lending behavior.

The lack of effective bank supervision allowed such

situation to continue. Most of the borrowing was

unhedged. Fixed nominal exchange rates obscured

the currency risk, treating this as mere credit risk.

When the peso defense was abandoned on 11 July

1998, many of the loans soured and contributed to

the growing NPLs.

Since the crisis, the monetary authorities have fur-

ther strengthened prudential norms. They have re-

defined the criteria for past due loans by shortening

the period of installment arrears; mandated a 2 per-

cent general and specific loan-loss provision for

banks, to be accomplished in several stages; raised

capital requirements; and rationalized foreign ex-

change trading by introducing a dollar hedging facil-

ity to banks called the Currency Risk Protection Pro-

gram (CRPP)—which is also known as the

nondeliverable forward (NDF) facility—by prescrib-

ing prior BSP clearance for sales of NDF contracts

by banks, and adjusting the overbought/oversold for-

eign exchange position of banks.

This study identifies factors that contribute to the

remaining weaknesses and vulnerability of the Phil-

ippine banking system. They include structural weak-

nesses and difficulties in the conduct of macroeco-

nomic policy, the problem of pursuing liberalization

when institutional failures and deficiencies are

present, weaknesses in prudential norms, poor imple-

mentation of prudential norms and international stan-

dards of supervision, a weak credit culture, and im-

pediments in the legal infrastructure such as the Bank

Secrecy Law and a weak legal framework for or-

derly corporate restructuring and loan workouts.

To address these problems, the study recommends

the following measures:


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• Strengthen banks to meet the increasing require-

ments of globalization through the appropriate

conduct of macroeconomic policy. This will pro-

vide a correct system of incentives, which is

necessary for improving financial intermediation

efficiency while addressing the demands of long-

term development finance as well.

• Foster competition and efficiency in the banking

industry through (i) promotion of contestable mar-

kets and encouragement of greater foreign en-

try, mergers, and acquisitions; (ii) privatization;

(iii) strengthening of public listing requirements

to improve corporate governance in the banking

industry; and (iv) reduction or elimination of fi-

nancial intermediation taxes (such as gross re-

ceipts tax, documentary stamp tax, AGRI/AGRA

requirement, Magna Carta for SMEs), and im-

plicit financial intermediation taxes (such as li-

quidity reserve requirements).

• Strengthen prudential regulation and supervi-

sion by (i) adoption of a formal framework and

common terminology for risk assessment and

risk management systems in banks; (ii) improve-

ment of financial reporting, disclosure, and

transparency, including the repeal of the Bank

Secrecy Law; (iii) better implementation of pru-

dential norms and supervisory standards; and

(iv) reduction of regulatory forbearance by such

methods as legislation of the adoption of PCA

measures.

• Improve the financial infrastructure by strength-

ening the legal and regulatory system for corpo-

rate governance, financial restructuring, and

bankruptcy. The SEC must upgrade standards

of corporate disclosure and transparency, adopt

formal rules for implementing corporate reha-

bilitation, make the proceedings swift and time-

bound, as well as creditor rather than regulator-

driven. There must be a clearer legal interpreta-

tion of the BSP’s mandate as supervisor and

regulator of banks and the extent of the legisla-

tion needed to carry this out.

In the final analysis, it can be said that while the

Philippine banking system was spared from the worst

effects of the Asian financial crisis, the goals of the

reform program that began in the early 1980s still

have not been completely achieved. The challenge

is to accomplish these in a more volatile macroeco-

nomic environment that is more integrated with the

global economy.


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Notes

1Formally known as the Bangko Sentral ng Pilipinas (BSP)since 1993.

2Intal, P.S. and Llanto, G. M. 1998. Financial Reform andDevelopment in the Philippines, 1980–1997: Imperatives,Performance, and Challenges, PIDS Discussion PaperSeries 98-02. January.

3Bautista, E.D. 1992. A Study on Philippine Monetary andBanking Policies. PIDS Working Paper Series 92-11. Aug-ust.

4Ibid.

5Valenzuela, C. P. 1989. Bank Supervision and Examina-tion: 1948–1988—A Historical Sketch. Central Bank Re-view 41(1).

6Interest rates on treasury bills jumped from 14 to 40 per-cent in 1983.

7Named after Jose B. “Jobo” Fernandez, the central bankgovernor at the time.

8Valenzuela, 1989, p. 6.

9Llanto, G. M., R. G. Manasan, M. B. Lamberte, and J.C.Laya. 1998. Local Government Units’ Access to the Pri-vate Capital Markets. Makati: Philippine Institute forDevelopment Studies. p.17.

10Bangko Sentral ng Pilipinas. Selected Economic Indi-cators. Various issues.

11Bureau of the Treasury. National Government Cash Op-erations. Cited in Bangko Sentral ng Pilipinas. SelectedEconomic Indicators. Various issues.

12Bangko Sentral ng Pilipinas. Selected Economic Indi-cators. Various issues.

13Rana, P.B. and J. A. Y. Lim. 1999. The East Asian Finan-cial Crisis—Issues in Designing and Sequencing Macro-economic Policies. Paper presented at the ADB-ADBI-IFMP High-Level Regional Workshop on the Asian Fi-nancial Crisis, Tokyo, 25–26 March.

14As it turns out, Deustche Bank’s estimate of nonperform-ing loans for the entire banking system in May 1999 is

much higher than the official figure for commercial banks(20 percent versus 14.4 percent).

15Guinigundo, D.C. 1999. Current State of the PhilippineBanking System. Paper presented at the Annual Meetingof the Philippine Economic Society, Makati, 12 March.

16Dumlao, D. 1999. BSP Moves to Ease Foreign OwnershipCap in Banks. Philippine Daily Inquirer, 31 May, p. B1.

17The participation of government financial corporationsin buying shares in PCIB has been criticized because itrepresented a move in the direction of Government intru-sion into private business, a large portion of public fundswere used for the buy-in (about 30 percent of the funds ofthese two institutions), and the shares were purchasedwithout the buyers demanding a due diligence audit ofPCIB.

18Guinigundo, 1999.

19Ibid.

20Bangko Sentral ng Pilipinas Supervisory Reports andStudies Office (SRSO).

21Ibid.

22Goldman Sachs Investment Research. 1999d. Philip-pine Banks, 28 April. p. 5.

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

24Ibid., p.10.

25Guinigundo, 1999.

26Ibid.

27Fitzgerald, T.M., F. Miranda, Jr., D. S. Murphy, and G. C.Schulz. 1997. Regulatory Barriers to Innovative LendingPractices: Traditional Approaches to Bank Supervisions.IMCC Credit Policy Improvement Program, October.

28Goldman Sachs Investment Research, 1999c, p. 6.

29Goldman Sachs Investment Research, 1999d, p. 13.

30Dolor, F. A., Jr. 1999. Story Remains the Same: BankAsset Quality Continues to Deteriorate in Q1. BusinessWorld, 17 May, p. 34.


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31Ibid.

32Ibid.

33Guinigundo, 1999.

34Deutsche Bank. 1999. Is Asia’s Recovery Sustainable?Global Emerging Markets — Asia, May, p. 8.

35Deutsche Morgan Grenfell, 1998. Philippine Banks. March.

36Guinigundo, 1999.

37Ibid.

38Gochoco-Bautista, Maria Socorro, Soo-Nam Oh, and S.Ghon Rhee. 1999. In the Eye of the Asian Financial Maelstrom:Banking Reforms in the Asia-Pacific Region. Paper presentedat the ADB-ADBI-IFMP High-Level Regional Workshop onthe Asian Financial Crisis, 25–26 March, Tokyo.

39Deutsche Morgan Grenfell, 1998, p. 54.

40Intal and Llanto, 1998, p. 23.

41Gochoco-Bautista et al. 1999, p. 10.

42Bangko Sentral ng Pilipinas SRSO.

43Dumlao, D. 1999. Banks’ Bad Loans Down to 13.5%. Phil-ippine Daily Inquirer, 5 August, p. B2; and Bangko Sentralng Pilipinas SRSO.

44This section summarizes the presentation by Philippinemonetary officials at the IFMP High-Level Regional Work-shop, 1999.

45Goldman Sachs Investment Research. 1999b. Asian Banks1999: Issues and Outlook, 5 January. p.1.

46Local currency deposits are subject to a final withhold-ing tax of 20 percent on the interest income.

47Goldman Sachs Investment Research, 1999b, p. 10.

48Deutsche Bank, 1999, p.17.

49Guinigundo, 1999.

50Frankel, A. B. 1998. Issues in Financial Institution Capi-tal in Emerging Market Economies. Federal Reserve Bankof New York Economic Policy Review. October.

51Ibid., p. 220.

52Asian Development Bank. 1998. Philippines: Coun-try Economic Reports, p. 23, cites a study by Claessensand Glaessner. The seven other economies studied werethe People’s Republic of China; Hong Kong, China;India; Indonesia; Republic of Korea; Malaysia; andThailand.

53Basilio, R. J. A., Jr. 1995. Asia’s Banks Still on ShakyGround. Business World, 5 July, p. 30.

54Ibid., p. 30.

55ADB, 1998, p. 23.

56Ibid.

57Goldman Sachs Investment Research, 1999c, pp. 16–17.

58Ibid., p. 8.

59Goldman Sachs Investment Research. 1999a. Asia Banks:Asian Bank NPLs, 5 January, p.14.

60Fitzgerald, T. M. et al. 1997. Regulatory Barriers to Inno-vative Lending Practices: Traditional Approaches to BankSupervision. IMCC Credit Policy Improvement Program.October, p.13.

61Goldman Sachs Investment Research, 1999c, p. 16.

62Fitzgerald, et al., 1997, p. 9.

63Newspaper reports, for example, put Prime Bank’s capi-tal base at negative P200 million.

64This may or may not be related to the fact that thepresident of Orient Bank used to be a high official of theBSP.

65Fitzgerald, et al., 1997. p. 9.

66In an informal discussion in Congress regarding amend-ments to the General Banking Act, some observers ques-tion the legal basis for the issuance of CB circulars.

67The low number of bank closures is seen by the au-thorities as proof that they are doing a good job. In fact,the BSP Governor has been quoted as saying that in histerm, only one commercial bank failed. He further pledgedthat there would be no failure among the country’s 53


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commercial banks this year. See Torrijos E.R., and D. C.Dumlao. 1999. Banks Expect Better Times Ahead. Philip-pine Daily Inquirer, 10 May. p. D10.

68Aggarwal R., and K. T. Jacques. 1998. Assessing theImpact of PCA on Bank Capital and Risk. FederalReserve Bank of New York Economic Policy Review,p. 23.

69Goldman Sachs Investment Reseach, 1999b, p. 7.

70Medalla, F. ,and J. N. Ravalo. 1998. Impact of IndustrialCredit Programs, CPIP Working Paper No. 8, p. 12.

71Ibid. , p. 18.

72Ibid, , p. 17.

73Llanto, et al.,1998, p. 3.

74Ibid., p. 4.


76Ibid., p.10.

77PDIC Seeks Access to Deposit Records. 1999. Philip-pine Daily Inquirer, 14 June.


79Concepcion, D. L. 1999. Corporate Rehabilitation: the Phil-ippine Experience. Paper presented at the Economic PolicyAgenda Symposium Series, Mandaluyong City, 25 June.

80Ibid., pp. 16–19.

81Medalla and Ravalo, 1998, pp. 35–36.

82Fitzgerald et al., 1997, p.16.

83Frankel, 1998, p. 218.

84This notion of a cozy relationship between the BSP andbanks will be even more difficult to dispel as the BSPgovernor was president of one of the country’s largestbanks. In the past, this close relationship between banksand their supervisor was important in successfully keep-ing the nominal exchange rate essentially fixed.

85Concepcion, 1999, p. 5.


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