Document of

The World Bank

FOR OFFICIAL USE ONL,Y

Report No. P-7235-PH

REPORT AND RECOMEMENDATION

OF THE

P]RESIDENT OF THE

INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT

TO THE

E,XECUTIVE DIRECTORS

ON A

PROPOSED LOAN

IN THE AMOUNT OF US$ 300 MILLION

TO THE REPUBL IC OF THE PHILIPPINES

1FOR

BANKING SYSTEM REFORM\/

November 4, 1998

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosed withoutWorld Bank authorization.j

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CURRENCY EQUIVALENTS(As of November 4, 1998)

Currency Unit = Peso$1.00 = 39.40 pesos

1.00 peso = $0.025

FISCAL YEAR

January 1 - December 31

ABBREVIATIONS AND ACRONYMS

APT - Asset Privatization TrustBAP - Bankers Association of the PhilippinesBSP - Bangko Sentral Ng PilipinasCAMEL - Capital, Asset Quality, Management, Earnings and LiquidityCAS - Country Assistance StrategyCPSD - Consolidated Public Sector DeficitDBP - Development Bank of the PhilippinesDOF - Department of FinanceDST - Documentary Stamp TaxEFF - Extended Financing FacilityFCDU - Foreign Currency Deposit UnitsGFI - Govermment-Owned Financial InstitutionGDP - Gross Domestic ProductGNP - Gross National ProductGRT - Gross Receipts TaxIFAC - Effects of Non-ApplicationNPL - Nonperforming LoanPDIC - Philippines Deposit Insurance CorporationPNB - Philippine National BankSCL - Single Currency LoanSEC - Securities and Exchange CommissionSLIM - Solvency, Liquidity, Income and ManagementSME - Small and Medium EnterpriseTA - Technical AssistanceVAT - Value-Added Tax

Vice-President: Jean-Michel Severino, EAPVPCountry Director: Vinay Bhargava, EACPFSector Manager: Jacques Loubert, EASFSTask Manager: Sanjay Dhar, EASPR

FOR OFFICIAL USE ONLY

REPUBLIC OF THE PHILIPPINESBANKING SYSTEM REFORM LOAN

TABLE OF CONTENTS

Page No.

LOAN AND PROGRAM SUMMARY ............................................................ i

I. THE ECONOMIC CONTEXT .......................... .................................. IA. Impact of the Regional Economic Crisis ............................................................ I

II. THE BANKING SYSTEM: PAST PROGRESS AND CURRENTCONCERNS ............................................................ 5

A. Past Financial Reforms: An Overview ............................................................ 5B. The Current Banking Environment ....................................... ..................... 6C. The Corporate Sector ............................................................ 11

1II. REFORM AGENDA FOR THE BANKING SYSTEM .............................. 12A. Strengthening the Prudential Framework ............................................................ 13B. Refining the Intervention and Resolution Strategy ........................ .................... 15C. Strengthening Government Owned or Controlled Banks ................................... 18D. Reducing Regulatory Arbitrage and Intermediation Costs .............. ................... 19E. Legislative and Regulatory Agenda ............................................................ 20

IV. THE PROPOSED LOAN ............................................................ 22A. Background and Rationale .................. .......................................... 22B. Loan Objectives ............................................................ 23C. Loan Description, Conditions and Tranching .................................................... 24D. Loan Administration ............................................................ 26E. Benefits and Risks ............................................................ 26

V. RECOMMENDATION ............................................................ 27

This loan was prepared by a team led by Sanjay Dhar and includes contributions from McDonald Benjamin, CarlosEscudero. Patrick Honohan, Niels Minners. Vincent Polizatto, Owen Camey (banking consultant) and Ross Delston(legal consultant). David Bisbee provided research assistance and Hedwig Abbey assisted with documentprocessing.

This document has a restricted distribution and may be used by recipients only in theperformance of their official duties. Its contents may not otherwise be disclosed withoutWorld Bank authorization.

ANNEXES

Annex 1: Letter of Development Policy

Annex 2: Policy Matrix-Objectives and Sequencing of ActionsSummary Notes on Proposed Policy Actions

Annex 3: Terms of Reference for the Financial Advisor to the Department of Finance for PNB

Annex 4: Recent Measures Taken or Announced to Strengthen the Banking System

Annex 5: StatisticsTable 1: Selected Economic Indicators. 1993-99Table 2: Balance of Payments, 1992-98Table 3: Selected Interest RatesTable 4: External Debt, 1992-97Table 5: The Philippine Banking SystemTable 6: Nonperforming Loans in the Banking System

Annex 6: Status of Bank Group Operations in Philippines Operations Portfolio

Annex 7: Philippines at a Glance

REPUBLIC OF PHILIPPINESBANKING SYSTEM REFORM LOAN

LOAN AND PROGRAM SUMMARY

Borrower: Republic of Philippines

Amount and terms: $300 million floating rate single currency loan in US Dollars for 20years including 5 years grace at the Bank's standard amortizationterms, grace period and interest rate for floating rate US dollarloans with an expected disbursement period of less than three yearswill apply.

Objective: The purpose of the loan is to support the Borrower's bankingreform program. whose goal is to strengthen the banking systemand enable it to better withstand current difficulties and futureshocks.

Description: Reforms to strengthen the banking system include policies to:improve the prudential framework and supervisory effectiveness;enhance market discipline and owner incentives; reduce regulatoryarbitrage and intermediation costs; refine the intervention andresolution framework for troubled banks; and initiate a program tostrengthen state-owned/controlled banks. Legislative changes areessential to the success of the program.

A fast disbursing loan is proposed. The loan would disburse inthree equal tranches in accordance with conditions noted in thePolicy Matrix and supporting summary notes (Annex 2).

Benefits and risks: Associating the Bank with policy advice and lending for bankingreform can strengthen the quality of the reform program andimprove confidence in the banking system, which has beenweakened with the onset of the regional crisis. Maintaining asustained effort to strengthen the banking system will remainessential in the medium term. Even assuming a rapid return tonormalcy within the region, the banking system would benefitfrom the enhanced prudential framework envisaged under thereform program, in order to exercise the appropriate degree ofrestraint in intermediating potentially large private capital flows.

The Philippine economy remains vulnerable to a sustaineddeterioration in the regional environment, which would exert added

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pressure onto a fragile external position and adversely impactfinancial markets. Even without unanticipated macroeconomicdeterioration, the banking system faces a period of increased stressfrom a slowdown in growth, high interest rates. peso depreciationand weaker real estate prices that have strained corporate balancesheets. A number of banks could fall short of capital adequacyrequirements as the burden of nonperforming loans grows. andindividual institutions remain subject to sudden depositwithdrawals that can render the entire system more vulnerable.

While economic and banking risks are significant. the Bank canmitigate these by improving the quality of the banking reformprogram and also enhance investor confidence. thereby improvingits prospects of succeeding. Macroeconomic risks are beingaddressed within the context of a two year IMF stand-by programapproved on March 27. 1998.

Poverty category: Not applicable

Estimateddisbursements: The loan would be disbursed in three equal amounts.

Disbursements would be conditioned upon satisfactorymacroeconomic performance and financial sector policies asdescribed in the Letter of Development Policy.

Schedule ofDisbursements: US$ million US$ million

Bank FY 1999 2000Annual 100 200Cumulative 100 300

Project ID Number: PH-56524

REPUBLIC OF THE PHILIPPINES

BANKING SYSTEM REFORM LOAN

1. I submit for your approval the following report and recommendation on aproposed adjustment loan of U.S. $300 million to the Republic of the Philippines tostrengthen the banking system and enable it to cope more effectively with the increasedfinancial market volatility since mid-1997.

I. THE ECONOMIC CONTEXT

A. Impact of the Regional Economic Crisis

2. The Philippine economy was among the first in the region to be adverselyimpacted by the Thai crisis. Yet the cumulative impact of the subsequent region-widecrisis on the economy and financial sector. although substantial, has been less severe thanin most neighboring economies: there has been no need thus far for the Government torecapitalize private banks and the majority of large corporations remain current on theirdomestic and foreign obligations. This may be attributed to several factors: theexperience gained by bankers and foreign creditors during the crises of the 1980s andearly 1990s led to a more cautious approach to credit use; hence external debt build up bythe private sector was slower; corporations are less highly leveraged; and bankingproblems stemming from the 1980s stimulated reforms which, prior to the onset of thecurrent regional crisis, had produced a stronger banking regulatory and supervisoryenvironment than that prevailing in some of the Philippines' neighbors. Nevertheless,slowing economic activity and continued instability in financial markets has increasedstress on the banking and corporate sectors, with smaller banks and enterprises onaverage impacted more severely.

3. Impact on Financial Markets. In early 1997. financial markets began to exhibitincreased anxiety over the Philippines' rising trade deficit, rapid pace of credit expansion,and the impact of a possible correction in property prices on banks and real estatedevelopers-key economic indicators are provided in Table 1. The impact of suchconcern was first felt in the stock market which reached a record high in early February1997. but had fallen to a 6 year low by early September 1998. As of November 4, stockprices had recovered strongly-by 58 percent-from their low on September 11, 1998,but were still 50 percent below their previous high on February 3. 1997.

4. Faced with a sustained attack on the peso, particularly after the Thai devaluationon July 2. 1997 the central bank (BSP) substantially reduced its intervention in theforeign exchange market as of July 11, after which the peso fell to a low of P46/US$ inearly January 1998. The peso has recovered during the course of 1998 while beingsubjected to ongoing bouts of regional instability. As of November 3, 1998, the peso hadstrengthened beyond P40/US$, again consistent with the recent trend towards

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strengthening in regional currencies. After building reserves over a number of years (inthe process of intervening to prevent a more rapid market-driven real exchange rateappreciation), the BSP's reserve loss in 1997 amounted to $3.4 billion, with much of thisoccurring in the nine days between the floating of the Thai baht and Philippine peso. Atend-1997, adjusted gross reserves had fallen to $7.6 billion, equivalent to 1.7 months ofimports and 28 percent of broad money. As of October 9. 1998. adjusted gross reserveshad however recovered to $9.1 billion, or about 2.3 months of import cover. reflecting animport decline and shift towards current account balance during the year.

5. Net inflows of foreign capital fell from some $8 billion in 1996 to less than $1billion in 1997. The initial shift in investor sentiment was driven by foreign capital, butsubsequent pressure on the exchange rate was also domestic-driven. in part by the desireto hedge against foreign currency obligations.'

6. The BSP has used temporary increases in its overnight rates to defend thecurrency during periods of heightened speculation-its overnight borrowing rate rose to ahigh of 32 percent in July 1997-but has also been cognizant of the impact of sustainedincreases in overnight rates on corporate and government borrowing costs. Marketinterest rates therefore peaked in late 1997 and early 1998 but have declined since then:the benchmark 91-day Treasury bill rate had fallen to below 14 percent by August 1998from a peak of nearly 20 percent in January; and prime lending rates have stabilizedrecently at 16-17 percent from a high of over 25 percent in late 1997 (inflation iscurrently at 10 percent). The initially higher interest rate structure relative to pre-crisislevels reflected several factors: an increased risk premium on the peso; increasedperceptions of risk and preference for liquidity among bankers; and the increased cost ofmaintaining the deposit base particularly among smaller banks, some of which have beensubjected to deposit withdrawals. Since early 1998, a reduction in financialintermediation costs through adjustments in reserve requirements and an informalagreement coordinated by the Bankers Association of the Philippines (BAP) to limitcommercial lending rates have brought down real interest rates to approximately pre-crisis levels. though credit access for non-prime borrowers has deteriorated.

7. Economic Impact. The impact of financial market turbulence on economicactivity was restrained in 1997 but has become more severe in 1998. Real GDP growthslowed to 5.4 percent in 1997 but export growth accelerated to 23 percent, and theincrease in inflation was modest. During the first half of 1998, real GDP growth waspractically flat-seasonally adjusted GDP growth is estimated at about -1.4 percent-notwithstanding maintenance of robust export growth. Agricultural production fell by 7.5percent in the first half of 1998 reflecting the severe drought, while industrial productionalso declined as credit conditions tightened and private investment fell. The

Total foreign currency exposure of banks and corporations (including foreign currency deposits) isestimated at $30 billion as of March 1998. Corporations owed about $23 billion in foreign currency,of which about $11 billion was owed to domestic banks. Banks foreign currency liabilities totaled$18.6 billion (covered by position limits).

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Government's revised targets under the IMF's stand-by program include GDP growth ofI percent in 1998, average inflation of 9.5 percent. public sector and current accountdeficits of 2.9 percent and 1.5 percent of GNP, respectively, but with improvements ineach of these variables projected for 1999 (Table 1). Attainment of the 1998 growthtarget would require a significant recovery during the second half of the year.

8. Social Impact. 2 The Philippines has made notable gains against poverty in recentyears: preliminary data indicate a decline in poverty incidence to 32.1 percent in 1997from 35.5 percent in 1994. The repercussions of the financial turbulence include: reducedaffordability and access to credit for the poor and informal sectors; lower real incomes(due primarily to the drought); reduced government services; and increased risk oflayoffs. These stresses have occurred as the drought-induced crop damage from El Ninointensified through mid-1998. particularly in Mindanao. Unemployment in April 1998had risen sharply relative to April 1997, but as of July 1998 it was up only marginally (to8.9 percent versus 8.7 percent in July 1997). The relatively stable unemployment figurefor July however reflects reductions in both the labor force as well as employmentrelative to 1997, which appears to indicate a decline in new job opportunities.

9. External Financing Environment. The volume of capital flows will clearlyimpact the economic outturn. Yet the nature of private capital flows in the near term isparticularly difficult to predict in view of the prohibitive increase in recent months in thecost of capital in international markets for emerging markets including the Philippinesand the uncertain evolution of the regional crisis.3

10. The scenario outlined below envisages a current account deficit that falls from 5percent of GNP in 1997 to below one percent by 1999-00 reflecting export growthaveraging 14 percent and a recovery of imports following their decline in 1998. Whileshort-term debt is assumed to be rolled over on a regular basis, the build up of reserves isassumed to remain constrained by the private capital flow uncertainties and theintermittent pressure still felt on the exchange rate. The projections for foreigninvestment are driven primarily by direct investment flows as portfolio flows are assumedto be approximately flat in net terms. Debt finance is projected to fall relative to pre-crisis levels, and its composition to shift towards official and multilateral resources,reflecting the deterioration in access and terms to private capital.

2 Through its social impact assessment and review of social expenditures, the Bank is developing acommon understanding with the Government of the social impact of the financial crisis and a strategyto address the consequences.

The interest rate spread for Philippine long-term dollar-denominated paper had declined to below 600basis points at end October 1998 from a peak of 987 basis points on September 1, 1998.

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Philippines: External Financing Requirements and Sources, 1998-00

($ Billion)

1998 1999 2000

Requirements 4.7 5.4 6.2Current account deficit 1.0 0.5 0.4Amortization 2.6 3.5 3.7Net Reserve Increase 1.1 1.4 2.1(excludes ST debt rollover)

Sources 4.7 5.4 6.2Foreign Investment 0.7 0.8 0.9MLT Loans and Bonds 5.9 6.6 6.8ST, Comm. Banks, E&O -1.9 -2.0 -1.5

Source: IMF

11. Economic Policy Responses to the Regional Crisis'. The policy response to thedifficult environment since mid-1997 has been positive overall. The conduct of monetarypolicy has on balance been appropriate when evaluated against: the periodic pressures onthe peso emanating in large part from regional repercussions; the limited resourcesavailable for intervention by the central bank; and the need to balance the negative impactof depreciation on foreign currency debtors with the damage from higher interest rates oncorporations, banks and economic activity.

12. The consolidated public sector deficit (CPSD) is projected to rise by about twopercentage points of GNP to nearly 3 percent in 1998 reflecting slower growth, weakercorporate profits. and the adverse impact of interest and exchange rate trends on debtservice. Although the Government has mandated additional restraints on publicexpenditure in anticipation of fiscal pressure, efforts to protect real expenditure on vitalsocial services and effective safety net programs are also ongoing. For 1999, the CPSD istargeted to decline to about 2 percent of GNP assuming the resumption of growth ofabout 3.5 percent.

13. Following the peso float in July 1997, the government immediately negotiated anextension and augmentation of its existing Extended Financing Facility (EFF) with theIMF, which was successfully completed on March 27, 1998. On the same date, the IMFBoard approved a new two year SDR 1,021 million precautionary stand-by program,which recognizes the need for a cyclical increase in public deficits but also envisages

4 Reforms within banking are described in the following sections.

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adjustments to improve medium-term fiscal sustainability.5 At the Government's request,the IMF has activated its program following a Board meeting on October 30. 1998,making available SDR 197.4 million.

11. THE BANKING SYSTEM: PAST PROGRESS AND CURRENT CONCERNS

A. Past Financial Reforms: An Overview

14. The Philippine financial sector has undergone significant reform over the pastdecade in response to the economic and financial crises of the mid 1980s. The twolargest development banks at the time-the Philippine National Bank (PNB) and theDevelopment Bank of the Philippines (DBP) underwent substantial restructuring in 1987that included: transfer of nonperforming loans (NPLs) to a separate public agency (theAsset Privatization Trust (APT): branch closings, approval and implementation of revisedcharters and rehabilitation programs, strengthened internal governance: etc. Throughmost of the subsequent decade, these banks remained profitable and financially sound;and PNB was formally incorporated as a private commercial bank in May 1996 followingthe Government's reduction of its ownership stake to 45.5 percent.

15. The central bank, which had become technically insolvent on account of thelosses accumulated over the past decade. was restructured and recapitalized in 1993 andacquired substantial independence from other branches of government throughconstitutional change. Since this major reform, the new BSP has been able to focus moreeffectively on the conduct of monetary policy and supervision and regulation of banks.

16. Complementary reforms in the early 1990s included: strengthening supervisoryand regulatory systems for commercial banks: transferring directed credit programs fromgovernment departments to the restructured DBP: and reducing the proportion of loanscommercial banks were required to allocate to agrarian reform, agricultural credit, andsmall and medium enterprises (SMEs):6 and a recapitalization of the Philippines DepositInsurance Corporation (PDIC). The PDIC is charged with rehabilitating or liquidatingbanks closed and placed under receivership by the Monetary Board, and insures depositsof up to P100.000-in contrast to the experience in other regional economies, there hasbeen no need to offer unlimited deposit insurance during the current crisis.

17. In 1994. the maximum foreign equity participation in domestic banks was raisedfrom 40 to 60 percent: and in 1995. licenses were granted to 10 new foreign banks,

As described in Section IV. there has been significant coordination between the Bank and Fund indeveloping with the authorities a banking reform agenda. The IMF stand-by includes measures tostrengthen the banking system within its structural benchmarks.

6 These requirements are not unduly burdensome since they can be satisfied by placing resourcesinstead in government securities and corporations involved with agriculture.

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bringing the total number to 14, and providing the impetus for domestic banks to improveefficiency and to modernize. Together with increases in minimum capital requirementsannounced in 1995, 1997 and most recently in March 1998, the entry of foreign banks hasled to a number of bank mergers and is expected to accelerate the process ofconsolidation within the banking system.

18. A series of measures were taken in response to heightened concerns about banks'vulnerability to real estate exposure, credit expansion and foreign exchange risk during1996-97. In April 1997, the BSP adopted two measures to tighten regulations on realestate lending by banks: it lowered the ceiling on an individual bank's exposure to realestate from 30 to 20 percent of loan portfolio, giving banks one year to comply; and itlowered the permissible ceiling on the loan-to-value ratio for real estate lending from 70to 60 percent of the market value of the property. In June 1997, the objective ofimproving the maturity profile of banks' foreign currency asset structure was announced:since December 1997, banks have had to maintain a 15 percent foreign exchange liquidasset requirement on their FCDU holdings; this ratio was raised to 30 percent in June1998.

19. A two percent general loan loss provision requirement (over two years) wasannounced in late 1997, and in March 1998, the implementation period for this provisionwas brought forward by one year to October 1, 1999. The criterion for classifying NPLswas also tightened effective from April 1998, reducing from six to three months theperiod for which overdue loans can be termed current. And as the risks to the bankingsystem have increased the authorities have been refining their intervention and resolutionstrategies as discussed in Section III.B.

B. The Current Banking Environment

20. The Philippine banking system has withstood the impact of the current crisisbetter than several neighboring countries as major bank failures or a systemic crisis havebeen avoided. This reflects stronger capitalization of the top tier banks and greaterresiliency within the corporate sector.

21. Nevertheless, the banking and corporate sectors are encountering greater stress.The quality of bank assets has deteriorated, capital adequacy has weakened, and onceexceptionally strong earnings have fallen. Annualized loan growth has slowed toapproximately 10 percent, which incorporates conversions of dollar to peso-denominatedloans and interest capitalization. Several banks have withdrawn from the SME andconsumer credit markets and, rather than lend to new borrowers, have stayed liquid andused their funds to invest in government securities. Moreover, the banking system mayhave to go through a period of further consolidation and retrenching-this will depend inlarge part on the speed and vigor with which economic recovery can be attained. Thissection summarizes the main concerns.

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(i) Financial Condition of the Banking System

22. Total assets of the banking system stood at about P2.77 trillion at end-1997 (aboutequal to GNP), a 31 percent increase over 1996 (Table 5). Universal and commercialbanks account for 90 percent of total assets; thrift and rural banks hold about 8 and 2percent of assets respectively.7 Preliminary data through mid-1998 indicate a markeddeceleration in asset growth.

23. As a group, universal and commercial banks reported healthy profit levels through1997, largely as a result of widening gross interest margins. Nevertheless, rising NPLs.increased incidences of rollovers. rescheduling and corporate recourse to legal suspensionof payments. falling real estate collateral values, use of BSP liquidity support by selectedinstitutions, and difficulties in complying with legal reserve requirements for some banks,all point to increasing signs of stress. The BAP expects commercial bank earnings todrop by 10 to 25 percent in 1998. The problems are more acute among smallercommercial banks, thrift banks, and rural banks owing to the characteristics of their assetportfolios-comprising higher shares of lending to small businesses, consumer loans andreal estate-weaker credit management systems. and a slower response capacity to thechanging environment.

24. The growth of NPLs illustrates the increasing stress. BSP figures indicate theratio of NPLs for all banks rose to 9.7 percent in June 1998. compared to 3.4 percent ayear earlier. NPLs of commercial banks stood at 8.9 percent in June 1998, and those ofthrift and rural banks stood at 16.7 percent and 15.4 percent. respectively (Table 6).

25. Capital Adequacy. As of June 1998. the banking system's average capitaladequacy ratio is officially estimated at 17.1 percent, among the highest in the region.But, even as minimum capital requirements are being raised. capital levels will fall asbanks fully provision for collateralized loans and restructured nonperforming loans. Inmost banks, capital will be further strained as the banks begin to follow internationalaccounting standards and mark their trading books to market.

26. Moreover, the quatility of bank capital is as much a concern as its quantity, giventhe interlocked balance sheets of many groups owning financial and nonfinancial entities.If the interlocked balance sheets were fully consolidated, what appears as capital in thebank may. in fact. be offset by a liability to another bank through a related party.Through double leverage bank capital therefore could be supporting more assets than isreadily apparent from viewing an individual bank's balance sheet.

27. Off-Balance Sheet Activities. The single largest component of such activity istrust department accounts, which are equivalent to about 14 percent of total assets. Most

7 Universal (or 'expanded commercial banks") are licensed for commercial and investment banking.There are 54 universal and commercial banks (of which 14 foreign), 117 thrift banks, and 832 ruralbanks.

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trust departments purchase loans from the commercial side of the bank or extend creditdirectly to borrowers who also borrow from the commercial bank. Although legallyseparated from the bank's operations. many market participants believe that in the eventof problems, banks would have to stand behind their trust assets, particularly the trustholdings of loans. BSP regards common trusts to be 'deposit substitutes" and subjectsthem to deposit reserves. But trust loan holdings are not considered when determiningthe adequacy of bank capital or loan loss reserves.

28. Banks continue to be active in derivatives. However, the bulk of derivativesactivity is concentrated in relatively simple contracts. particularly foreign exchangeforwards and swaps. About two-thirds of these transactions are undertaken by foreignowned banks. The credit and market risks associated with Philippine bank derivative useare small in comparison with the credit risk exposure within the banks' loan books.

29. Transparency. Aside from the difficulties in interpreting true NPL and capitallevels, transparency has been hampered by inadequate financial disclosure standards.Furthermore, the accounting industry is dominated by a single firm that audits most of themajor banks' financial statements.

30. Loan Classification and Provisioning. Until recently, loan loss provisions werenot required for assets backed by collateral even if such assets were classified assubstandard, or for assets criticized as especially mentioned.8 While specific assetsamong these categories may not be immediately identified as having loss potential, thereis loss potential within the aggregate of these assets, indicating the need for some form ofprovisioning.

31. Real Estate Exposure. The average outstanding real estate loan exposure ofbanks is relatively modest, about 12 percent of total loans in mid- 1998. Banks' exposureto the property sector however appears understated as it does not include their equitystakes in real estate companies and projects, or loans to individual investors whosecapacity to repay depends upon the sale of the real estate. It is difficult to obtain arealistic value of real estate because there is little liquidity in the market. Overall, realestate is reported to have lost around 25 percent value since its recent peak in the high-end market but only 5 percent in the low/medium cost market. Bank exposures to themiddle and low cost segments of the property sector appear less risky as the buyers tendto be end-users and not investors or speculators.

32. Systemic Liquidity. The interbank lending market has become segmented, withmany larger banks reducing or ceasing credit lines to smaller banks. To help bankssuffering from liquidity problems, the BSP's extension of emergency loans has increasedsignificantly since the onset of the crisis. However, lack of detailed information on

8 A recent BSP directive however addresses this deficiency effective as of end 1998. A general loanloss provision was also introduced in October 1997, which is to reach 2 percent by October 1999(Annex 4).

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liquidity support to the banking sector, including foreign currency funding. prevents a fullassessment of current and potential liquidity problems.

33. Entry and Exit. The number of banks in the financial system has strainedsupervisory capacity. Entry into the system has been lax on occasion-e.g. Orient Bankobtained a commercial bank license less than a year before it ran into serious difficulty.and despite indications it was not a well managed thrift bank. The BSP recently imposedstricter criteria for new bank entry. Senior bank officers must now have at least two yearsexperience in banking. BSP will also require the submission of a detailed plan ofoperation, chart of organization. and a manual of operations before a bank is issued apermit to operate. Exit from the system is constrained by weaknesses in the legalframework (para. 41). The current market environment also complicates the troubledbank resolution strategy. In 1998 through October. 21 banks had been closed, including14 rural banks, six thrift banks. and the first commercial bank to be closed since the onsetof the crisis. An average of 15 (primarily rural) banks have been closed annually since1995.

34. Orient Bank. In February 1998. the Orient Commercial Banking Corporation,with assets of P8 billion, declared a self-imposed bank holiday after experiencing heavydeposit withdrawals. The bank had P2.3 billion and only P1 billion of these deposits areinsured. A huge concentration of insider loans was discovered after the "holiday" wasdeclared, and NPLs were reportedly 75 percent of assets. In mid-October, after protractednegotiations, the bank was finally placed under receivership by the Monetary Board.

Thrift and Rural Banks

35. Thrift and rural banks in aggregate are experiencing far greater stress thancommercial banks, and several may have difficulty meeting the BSP's new capital andloan loss provisioning requirements.

36. As of June 1998. thrift banks' NPLs were reported at 16.7 percent; whencombined with totals of foreclosed and repossessed assets and loans reported asrestructured, the total of all loans not performing according to original schedule rises toabout 30 percent of total thrift loans. Three quarters of the total loans held by thrifts areconcentrated in the ten largest thrift banks. and two have received open bank assistancefrom the BSP. Overall thrift profitability is down, and a number of thrift banks areexpected to show losses in 1998. As of March 1998, 15.4 percent of rural bank loanswere reported past due, rising to about 19 percent of total rural bank loans applying theabove criteria. This level of performance is consistent with that of prior periods.

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(ii) Supervisory Effectiveness 9

37. On-site Examinations. On-site examinations have tended to focus excessivelyon compliance with numerous rules and are overly process and check-list driven. Therehas been too little prioritization of issues or criticisms. Examination reports have tendedto emphasize asset quality at the near exclusion of: assessment of the bank's overallfinancial condition and performance and the quality of its management: liquidity; assetand liability management; profitability; the adequacy of capital; and the efficiency of thebank's risk management systems. Other weaknesses have included a lack of flexibility inexamination scheduling, slow report processing. and a failure to adequately communicatereport findings to a bank's board of directors.

38. The need for a more analytical approach. whereby assessments of the riskmanagement practices of each bank and other important banking risks are thoroughlyevaluated, solvency is assessed on a consolidated basis, and the results are communicatedto bank management on a timely basis is now recognized.

39. Off-site Monitoring. The off-site monitoring of banks also requiresstrengthening. For instance, the early warning system (known as SLIM for solvency,liquidity, income, and management) takes selected ratios in isolation, weights them, andcomputes an aggregate score for the bank. The previous mechanistic approach isbecoming more analytical.

40. Until recently, CAMEL ratings did not necessarily portray the financial conditionof the institutions rated realistically. For example. to determine the overall rating,individual component ratings were summed and averaged, and the process lacked theelement of judgment that is the supervisor's most important skill. Progress towards amore judgmental approach is now underway. and CAMEL ratings have also beenimproved: the new CAMEL rating can never be higher than a bank's capital adequacyrating.

41. Legal Concerns and Enforcement. Supervisory effectiveness and enforcementof regulatory standards have been constrained by a number of factors including: anunusual degree of personal liability of supervisors in the conduct of official business;bank secrecy provisions that restrict supervisor access to deposit information; inadequatepenalties for bank noncompliance with regulatory norms; constraints on the examinationcycle that discourage timely follow-up of corrective action; and a number of obstacles toclosure of insolvent banks by the Monetary Board and prompt resolution of failed banksby the PDIC. Section III.E describes the legislative initiatives to address theseconstraints.

9 This section summarizes problems within supervision at the onset of the crisis. Significant progress isbeing made towards supervisory effectiveness in the past two years as described in Section III.A.

(iii) Structural Distortions in the Banking System

42. Distortions in the financial sector have led to significant regulatory and taxarbitrage across institutions and currency. Differences in the tax structure and in thetreatment of reserve requirements on peso versus foreign currency deposits haveencouraged dollar intermediation in the past. although the disincentives to pesointermediation were reduced recently with the introduction of a 7.5 percent tax on interestincome of foreign currency deposits and a 30 percent liquid asset requirement on foreigncurrency assets of FCDUs.

43. The differentiated tax treatment across financial institutions may have prompteddisintermediation from the commercial banking sector into bank-substitutes that may beless well-regulated. The uneven tax treatment, for example. has motivated some banks toestablish thrifts subsidiaries. while the non-uniformity of prudential regulation may haveled banks to establish foreign exchange subsidiaries. Peso intermediation is furtherdiscouraged by a peso payment system that appears less liquid and less efficient than thedollar payment system.

C. The Corporate Sector

44. The Philippine corporate sector has been spared from the massive disruptionsexperienced in neighboring countries. This primarily reflects smaller exposure to foreigndebt and lower debt-to-equity ratios.'° Nonetheless, a prolonged period of weakeningactivity or renewed financial market instability would pose additional problems.

45. The sector is dominated by a relatively small number of large groups. In additionto owning major manufacturing and services sectors, these groups control many of themajor banks in the country. This linkage has been a source of stability as bank loans areconcentrated towards the largest corporations, which have proved more creditworthy.Yet it also carries additional risks. In particular, it may be more difficult for corporategroups that themselves face additional stress to also maintain capital at required levelswithin the banks they own or control. The near closure of Philippine Airlines points tosuch vulnerability.

46. The framework governing debt restructuring consists of arbitration by the courtsor by the Securities and Exchange Commission (SEC), but both approaches haveencountered problems. A debtor can apply in court for suspension of payments but thisdoes not prevent secured creditors from foreclosing, making rehabilitation difficult orimpossible. To remedy this problem. the SEC has had the authority (since 1976) to granta payments suspension. However. since the SEC has the sole authority to decide on arehabilitation plan. the rights of secured creditors may not be adequately protected.

'° The debt-equity ratio for the top 5,000 corporations in the Philippines is estimated at 1.9 as of March1998. This compares (at end-1997) to 2.2 in Malaysia; 2.3 in Indonesia; 4.1 in Thailand; and 6.4 inKorea.

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Moreover, SEC's capacity to handle its increasing workload has been strained and couldface further pressure.

47. In the short run, the SEC's capability to handle its larger caseload of debtrestructuring needs to be strengthened. The Government also needs to decide whether totransfer the SEC's quasi-judicial functions to, for example. a special bankruptcy court.which would enable the SEC to concentrate on its regulatory responsibilities. Disclosurestandards within corporations also need to be strengthened and better enforced; theconcentrated ownership structure and cross-holdings between banks and corporationsmakes improved disclosure especially important. Finally, there is a need to examine theadequacy of current bankruptcy legislation and the efficacy of the judicial process forhandling liquidation of insolvent firms.

48. Bank and Fund staff jointly have initiated dialogue on these issues. The Bank'srecently approved financial sector PHRD grant for the Philippines intends to strengthencapacity within the SEC. and the Government has requested further assistance from theBank to strengthen corporate debt restructuring procedures and policies and prepare anew bankruptcy law.

111. REFORM AGENDA FOR THE BANKING SYSTEM

49. The East Asian crisis has highlighted the vulnerability of small open economies tocapital flow shocks. Given the dominance of the banking system in intermediatingfinancial flows within the Philippines. the authorities recognize the importance ofstrengthening the banking system-both in its capacity to withstand further shocksstemming from the current crisis. and in its resilience towards handling future shocks andcapital flow volatility. Hence the authorities have embarked upon a comprehensivereform agenda within the banking sector that would: significantly raise prudentialbanking standards and supervisory effectiveness; enhance market discipline throughstricter disclosure requirements and transparency; reduce regulatory arbitrage andintermediation costs; and adapt an intervention and resolution strategy for troubled banksin a manner that preserves confidence but does not distort owner incentives. In addition,the Government has decided to sell its shares in PNB-the second largest bank in thecountry-to a strategic private investor and has initiated a process to strengthen PNBduring the interim period. A significant legislative agenda is being prepared forsubmission to the new Congress to support these objectives. Sections A through E belowdescribe the reform program that is underway or anticipated and would be supported bythe proposed loan.

50. Underlying the banking reform program is a vision for the medium term that bankowners, buttressed by higher capital and stricter provisioning requirements and subjectedto more stringent scrutiny from supervisors and market participants, will be morediscriminating in intermediating financial flows particularly as they involve foreigncurrency, major term transformation, or lending to volatile sectors such as real estate.

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While the reform program is comprehensive in design. it is also pragmatic in that thetiming and sequencing of proposed measures has been structured so as not to undermineeconomic recovery.

51. An essential complement to such a vision is the parallel development of thebroader financial system in order to encourage equity finance and longer-term debtinstruments and avoid over-reliance on the banking system and external finance. In thisregard, there is considerable scope for expanding the pool of contractual savings (pensionfunds. pre-need, and life insurance companies) and transforming these into more efficientvehicles for capital market development and domestic long-term savings mobilization."

A. Strengthening the Prudential Framework

(i) Prudential Standards

52. In March 1998, the authorities announced a schedule to raise minimum capitalrequirements through December 2000. and intend to extend the 10 percent capitaladequacy requirement to universal banks previously exempted.'2 To complement therecently accelerated schedule to raise the general loan loss provision requirement to twopercent. banks have been instructed to make a 25 percent loan loss provision for all loansclassified substandard and a 5 percent provision for especially mentioned loans by April15, 1999, with intermediate provisions of 12.5 and 2.5 percent respectively set for end-1998.

53. Stricter qualification and competency criteria for new licenses have been put inplace as of March 1998 to facilitate the intended consolidation of the banking system. Atthe same time, it is recognized that unrestricted ownership of domestic financialinstitutions by major multinational banks could be an important means of resolving bankfailures and enhancing competition. Hence qualified foreign banks are to be allowed fullownership of troubled domestic banks (for up to five years-see Section III.E) asexceptions to the current 60 percent foreign share ownership limit.

54. To enhance transparency and market discipline. BSP issued Circular 157(effective from December 1998) obligating listed banks to disclose and discuss publiclymore detailed information on a quarterly basis, including information relating to the levelof non-performing loans, classified assets, and loan loss reserves (both specific andgeneral). Additional disclosure requirements are to be imposed on both listed and non-listed banks in agreement with the Bank (LDP para. 20). In addition, commercial banks

The Bank is discussing with the Philippine Government the scope for reforming the contractualsavings system and housing finance (which relies heavily on pension fund resources) to further theseobjectives.

The specifics on these and other policies are contained in the explanatory notes of the Policy Matrix(Annex 2) and Annex 4.

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will be required to make public statements on a quarterly basis about whether they arefully complying with prudential rules and whether the internal risk control is adequate.BSP has issued a circular pertaining to mark-to-market trading and equity portfolios andmark-to-market accounting procedures conforming to international norms. which becameeffective in September 1998. Finally. the quality of audits of financial institutions isslated to improve by placing external auditors under an affirmative obligation to informBSP of factors that materially affect the soundness of a financial institution and byimplementing a system of BSP accreditation of external auditors that may be hired bybanks and quasi-banks.

55. The Monetary Board has developed formal policies with respect to concentrationsof credit or investment in borrowers or borrower groups associated with a bank's owners.During the transition toward consolidated supervision, all equity investments in affiliatesand nonfinancial firms where the bank is the majority or controlling owner are to bededucted from bank capital. given the concern noted with respect to the quality of capital.

(ii) Supervisory Effectiveness

56. The Monetary Board's role in the supervisory process is being redefined to focuson the definition of broad policy goals and strategies and on improvement of BSP's legaland prudential standards, rather than on direct involvement in day-to-day supervisoryoperations. The authorities are also considering better alignment of the use ofsupervisory resources with systemic concerns by developing a hierarchy-of-risk modelthat establishes priority for the allocation of resources.

57. Regulatory oversight is being strengthened by a shift away from a check-listdriven type of examination to a more analytical approach. which focuses on anassessment of the consolidated risk management practices of each bank and its affiliates.A revised "risk based" report of examination has been tested and is replacing theunnecessarily detailed examination report previously in use.

58. The examination process is being reoriented to assess risk and the systems usedby a bank to manage risk, including liquidity, interest rate. foreign exchange risks, andrisks accruing from derivatives and other off-balance sheet activities. This can beachieved by more in-depth training of personnel in new examination methodologies,updating examination tools and processes. and implementing the proposed revised reportof examination. As part of this reorientation, responsibility for evaluating foreignexchange activities will be rolled into bank supervision. All examination activities are tofocus on the consolidated banking group, so that no significant activity is permitted toescape supervision and the application of sound prudential rules and requirements. Stafftraining is proposed to facilitate the change from a largely mechanistic use of CAMELand SLIM ratings to a more judgmental use, in order to more accurately portray thecondition of a bank.

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59. Greater flexibility has been introduced in the scheduling of examinations andexamination activities so that resources can be employed in areas of greatest risk andfollow-up corrective action can be taken in a timely manner. To bypass current legalrestrictions on the one examination per year limit, the BSP is using its specialexamination authority to schedule examinations more frequently in banks exhibitinghigh-risk characteristics.

60. Examination findings are being made more timely. This is being accomplished byusing the proposed revised report of examination, eliminating the vast amount of detail inthe reports, introducing computers into the examination process, and minimizing the roleof the Monetary Board in routine report review matters. All examination reports are to bediscussed directly with the bank's board of directors in the case of troubled banks.Communications are being improved by prioritizing the examination report's presentationof issues and criticisms so that bank management and the bank's board of directors maymore readily understand the relative importance of the various findings.

61. To strengthen off-site monitoring, the data collected through prudential reportingare to be presented in a comprehensive manner and logical format that provides animproved basis for analysis. Monitoring activities will focus not only on individualbanks, but also on systemic concerns such as the potential impact posed byconglomerates and major shareholders, industry concentrations, new instruments, anddependence on volatile sources of funding.

1B. Refining the Intervention and Resolution Strategy

62. The true level of capitalization of the Philippine banking system has undoubtedlybeen weakened by macroeconomic events over the past year. Moreover, the bankingsystem may be subjected to further stress. Hence the authorities' initiatives to developand implement a strategy for identifying and dealing with insolvent or undercapitalizedbanks is timely.

63. As with any appropriate resolution strategy, the authorities' initiatives includethree distinct elements.

(i) A Crash Program of Intensified Monitoring of Selected Banks

64. A "watch list" of potential problem banks has been drawn up by BSP with a viewto conducting a special program of supplementary on-site inspections. The forwardlooking criteria being used in drawing up this list includes: recourse to BSP emergencylending; significant and continuous reductions in deposits; off market interest rates ondeposits for a prolonged period; rapid loan growth; heavy reliance on borrowing from theinter-bank market; inadequate risk management capability; funding vulnerabilitiesespecially rollover risk for foreign exchange liabilities and liquidity cover; andinadequate processes and systems that contribute to poor asset quality. Backward looking

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criteria include: CAMEL ratings; capital adequacy, asset quality; sound managementcriteria; earnings and liquidity. The list gives priority to institutions potentially posingthe greatest systemic risks.

65. The Monetary Board has given approval for supplementary on-site inspections ofcommercial, thrift and rural banks on the list. thereby effectively overriding the normalarrangement whereby inspections have been limited to once-a-year. Hence theauthorization for special inspections would become a blanket one to allow BSP to movepreemptively.

66. The special inspections that are being conducted by elite monitoring teamsfocusing on asset quality as well as liquidity pressures are expected to adopt a moreconservative approach on loan quality assessment likely leading to much higherprovisioning requirements.

67. It is recognized that timeliness is of the essence: hence the main preliminaryfindings of the inspection are to be reported to the Monetary Board within one week fromthe end of the on-site inspection with the full report available soon thereafter. Thisfinding would include a critical assessment of capital adequacy adopting more realisticforward-looking projections and paying particular attention to loans that, though current,have been extended.

(ii) Explicit Procedures and Rules Establishing a Graduated Response to CapitalShortfalls

68. The second element of the early intervention and resolution strategy, is toformalize the rules to address the capital deficiencies that are uncovered, with theobjective of providing banks an explicit set of sanctions and corrective actions to beapplied automatically, thereby strengthening regulatory authority and providing banksappropriate incentives to take preemptive steps on their own initiative.

69. In September 1998. a Circular was issued that provides for a matrix of sanctionsaccording to the degree of capital deficiency, with sanctions differentiated by capitaldeficiencies ranging from up to 20. 40. 60, 80 percent, and more than 80 percent-including, for the latter, the issuance by the authorities of a "cease and desist" order,which allows the Monetary Board to prevent the institution from doing business in thePhilippines and designate the PDIC as receiver.

70. This matrix of sanctions is to be complemented by a matrix of corrective actionsto be issued shortly by the BSP. Such a matrix will clarify to the banks the regulatoryactions they would face as the capital adequacy ratio falls below the mandated level.Included among these actions would be the signing of a Memorandum of Understandingby the bank drawn in consultation with the BSP, specifying the actions to be followed tosolve the problem; and signing of a binding agreement on a recapitalization andrestructuring plan. elaborated by the BSP in consultation with the bank's management.

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71. An important objective of the corrective actions is to initiate earlier interventionin failing banks to minimize public losses and facilitate options other than liquidation.Proposed legislation to complement these actions include: increased penalties fornoncompliance; tighter criteria for emergency lending; broader grounds for placing abank under receivership, including when the capital to risk assets ratio falls below 2percent; and enhanced ability of PDIC to dispose of assets (Section III.E).

(iii) Strategy for Problem Bank Resolution

72. The authorities are assessing the range of resolution strategies (including variantsof the good bank/bad bank approaches). consistent with existing law and proposedamendments, since the open bank assisted preferred merger option may not be availablein all cases. Since intervention actions need to be taken speedily, it will be desirable toadopt and communicate to the banks a set of templates representing the range of possibleforms of intervention. The design of such templates would be geared towards ensuringthat existing owners can be successfully removed from control of the bank but will guardagainst pre-commitment of public funds.

73. Other advance preparation will include the establishment of a roster of pre-qualified persons that can be called upon to take over the management of intervenedbanks. The BAP may be able to assist in identifying suitable persons.

74. In order to be better prepared for the eventuality, however remote, that problemscould arise simultaneously at a large number of banks, the authorities recognize the needto widen the horizon of the current contingency planning exercise to cover a worst casescenario of systemic problems. Such a scenario might not be amenable to the currentpreferred approach of resolution through merger in the short run. Dealing with theliquidity, management and ownership issues efficiently in such a circumstance willrequire a clear division of responsibilities and a common view as to the trigger points forthe various responses.

75. A prime concern of intervention is to avoid contagious depositor runs. The risk ofcontagion will be minimized by conducting interventions in a prompt, well-coordinatedand systematic manner. The need to extend depositor guarantees beyond what is alreadyestablished by PDIC is not currently anticipated. Nevertheless, contingency planning isbeing undertaken to address scenarios in which liquidity support and deposit guaranteesmay have to be broadened, and to determine the trigger points and modalities of fundingin such cases. The authorities recognize that dealing with the liquidity, management andownership issues efficiently in such circumstances will require an integrated approachand close cooperation between government agencies.

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C. Strengthening Government Owned or Controlled Banks

76. An essential element for enhancing the overall soundness of the banking system isto strengthen on a sustainable basis the financial performance of PNB, which among themajor banks has suffered disproportionately during the current crisis. The currentownership structure of PNB-in which the Government is the largest single shareholderwith a 45.5 percent stake and where private share ownership is highly dispersed (withsome 30,000 small shareholders)-has not proved conducive to compete effectively withthe other major banks, particularly in the current environment.'4 For example. credit andrisk policies and the degree of automation lag behind those of industry leaders.

77. The Philippine authorities have therefore concluded that the ultimate means oftransforming PNB into a top rated bank is to seek a private equity partner that would havethe incentive and ability to raise and maintain PNB's competitiveness, loan portfolio andcapital adequacy up to the top tier of industry standards. The Government has thereforeinitiated a process to sell its shares in PNB as soon as feasible. It is recognized that givenPNB's status as the second largest bank in the country, only respected foreign and localbanks will be included among those invited to bid for strategic ownership.

78. To ensure that the sale of government shares is conducted according tointernational best practice, the Department of Finance (DOF) intends to contract theservices of a reputable financial advisory firm on all aspects of the sale (financial advisorterms of reference are contained in Annex 3). The advisory firm will be charged withpreparing an information memorandum prior to sale of government shares. BSP's specialinspection of PNB is being updated (using information as of September 30, 1998) tofacilitate the financial advisor's due diligence. and to ensure that regulatory oversight ofPNB continues to proceed on the basis of up-to-date information. In addition, it isexpected that the advisory firm will need to conduct or commission a thorough audit ofPNB in order to prepare the requisite information memorandum and to determine thenature of actions that need to be undertaken prior to the sale of government shares. Theterms of reference for such an audit will be made satisfactory to the World Bank. (Asample terms of reference has been provided to the Government). The Governmentintends to work with PNB's new management and Board and cooperate with the advisoryfirm to improve PNB's financial performance and thereby also facilitate the objective ofselling its shares to a respected private investor through a transparent and internationallyaccepted bidding process.

79. While management control of PNB is be shifted to the private sector, theimportance of maintaining strong standards of governance over the government ownedbanks-the Development Bank of the Philippines (DBP) and the Land Bank of thePhilippines (LB)-is recognized. In the context of proposed financial intermediationloans from the World Bank to these institutions, which addresses the objective ofmaintaining credit access to SMEs, the Government intends to commission audits based

14 Of PNB's II Board members, the majority including the chairman are appointed by the Government.

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on international best practices of DBP and LB, and to implement the recommendationsarising from these audits.

D. Reducing Regulatory Arbitrage and Intermediation Costs

80. Increases in interest rates since mid 1997 have had the effect of increasing theburden of reserve requirements and the gross receipts tax (GRT). This has added tointermediation costs and thus to the cost of borrowing."5 In addition. the differentiatedtreatment of foreign currency and peso deposits. and of thrifts and commercial banks, hasled to a degree of regulatory arbitrage. The ongoing reforms in prudential supervisiondescribed above should reduce the prudential risks associated with such arbitrage, butreduction of the underlying distortions is also desirable.

81. In 1998. the authorities have on balance lowered peso intermediation costs whileminimizing unintended liquidity side-effects. In two stages. during March and May 1998,reserve requirements on commercial banks were reduced from 13 to 8 percent. andreserve requirements for demand deposits. NOW accounts and deposit substituteliabilities in thrift and rural banks were also reduced to 8 percent. Compensatingincreases in liquidity reserves were enforced in March 1998."6 Reserve requirements oncommercial banks were raised in early October to 10 percent in a (successful) effort tostabilize the foreign exchange market. However, to minimize the impact onintermediation costs. the interest rate paid by the BSP on 40 percent of the banks'balances with the BSP was commensurately raised to 4.5 percent from 4 percent. Theauthorities recognize that remaining reserve requirement differences between functionallyequivalent deposits in commercial banks and thrifts need to be removed to eliminatearbitrage opportunities. However. given that thrift banks as a group are under relativelygreater stress than commercial banks. the current environment is not consideredconducive to equalize reserve requirements across banking categories-which wouldrequire legislative action.

82. The authorities have taken additional measures to reduce the differential in taxand reserve treatment between peso and foreign exchange business in order to reduce theincentive for currency substitution. A withholding tax of 7.5 percent was introduced inJanuary 1998 to apply to interest payable to residents on foreign currency deposits. (Thewithholding tax on peso deposits is 20 percent.) A 15 percent liquid asset requirement onforeign currency assets was introduced in December 1997, and this was raised to 30percent in June 1998. These measures appear to have contributed to a sizeable reductionin the share of foreign currency intermediation since mid 1997 (which, however, is also at

5 For example. it is estimated that the fiscal and quasi-fiscal contribution to the marginal cost ofintermediation increases from 260 basis points when the net marginal cost of funds is 10 percent to500 basis points when this cost is 20 percent.

lb Liquidity reserves are invested in government securities bearing interest rates 100 basis points belowmarket.

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least partly the result of the financial turbulence). Should foreign currency intermediationresume growth at an unsustainable pace, the authorities remain committed to adoptadditional corrective measures in the direction of harmonized treatment of intermediationin different currencies.

83. In 1997, tax legislation in relation to the withholding tax on government securitieswas amended to close what had been a significant revenue loophole benefiting banks.The authorities also intend to reduce the burden of the documentary stamp tax (DST) andthe GRT, as part of a longer-term reform of the taxation of financial institutions whoseobjective would be to enhance efficiency in a broadly revenue neutral manner. In such areform, which will require further study. the DST and GRT would likely be replaced by aVAT-like charge based on each bank's profits and salaries.

84. Finally, to encourage better reserving practice leading to sounder bankmanagement decisions, the authorities intend to allow tax deductibility to be claimed bybanks on the recently implemented provisions for specific loan-losses. It is recognizedthat to the extent such tax deductibility improves provisioning practices and contributesto sounder bank management practices. it could potentially save budgetary costs in thelonger term and also help to lower intermediation costs. However, in light of the sharplyincreased fiscal pressure in 1998, and the initial cash-flow cost to the budget of thismeasure, proposed legislation to Congress is being temporarily deferred.

E. Legislative and Regulatory Agenda

85. The legislative and regulatory agenda to support the above goals has three broadobjectives:

- to protect officials of the Monetary Board and BSP and PDIC personnel from suitsarising out of their official conduct,

* to enhance the supervisory and enforcement powers of BSP and PDIC; and* to augment the legal authority of BSP and PDIC to resolve insolvent banks.

86. The first objective is to protect banking officials from litigation arising fromthe performance of their responsibilities. Currently, banks regulated by BSP andinsured by PDIC. may sue for damages or file a criminal complaint on the basis of actionsthat regulatory officials have taken in the course of supervising or closing a bank. Suchsuits and the threat of litigation appear to have constrained the ability of supervisors toconduct full and unfettered examinations of banks, as well as to take appropriate actionsto resolve insolvent banks. In addition. the ability of BSP to close insolvent banks needsto be strengthened. The leading Philippine Supreme Court case in this area was a 1991decision in which the central bank's closing of a bank was overturned, its finding ofinsolvency ruled inadequate and the bank reopened (and the original owners reinstated)after some five years of litigation. Most recently, the owners of Orient Bank havebrought a civil lawsuit against senior BSP officials alleging "undue haste" in placing the

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bank under receivership (as of October 13. 1998). The Bank has proposed a number ofamendments to relevant laws that would limit the ability of a private party to bring suitfor damages and would enhance legal protection for bank examiners.

87. To restrict the ability of a bank to challenge its closing. BSP has proposedlegislation that banks seeking emergency loans would have to reimburse the BSP for anylosses incurred by the central bank from lawsuits contesting the appointment of aconservator or receiver in the event that the bank is eventually closed. However, theauthorities are not convinced that further legislation would be effective in providinggreater protection to banking officials, and have pointed to an Executive Order (E.O. 292)that already provides a degree of legal protection to public officers. Further work on thistopic is therefore to be commissioned and concluded by January 1999. If the outcome ofthis forthcoming review calls for measures to strengthen legal protection for bankexaminers, an action plan and timetable for implementation would be incorporated intothe conditions for the proposed loan, as described in the LDP and Policy Matrix.

88. The second objective is to enhance the supervisory and enforcement powersof the BSP and PDIC. New legislation is being proposed to substantially increase thecivil and criminal penalties that may be imposed by the BSP or the PDIC for violations ofbanking laws, to empower BSP to suspend and remove directors and officers forviolations of law, and to broaden the grounds on which BSP may appoint a receiver. Inaddition, legislation has been proposed to permit bank examinations outside the annualcycle at the discretion of senior BSP officials but without the need for pre-approval by theMonetary Board. Tightening requirements for the use of BSP emergency advances, andrestricting access of banks to overdrafts from BSP in the absence of collateral are also tobe proposed.

89. New legislation is also needed to allow BSP and PDIC bank examiners routineaccess to the identities of depositors as an exception to the Law on Secrecy of BankDeposits. Such access is an important part of banking supervision, facilitates a number ofprudential and failure resolution functions. and is considered an international bestpractice. The authorities have recognized the benefits of such access (LDP, para. 48), buthave expressed concern that actions to permit routine supervisory access could provokedepositor flight particularly in the current market environment. In the meantime, theGovernment stands ready to cooperate with international anti-money laundering effortson a case-by-case basis.

90. The third objective is to augment the legal authority of BSP to close insolventbanks and PDIC to resolve closed banks promptly. As described in Section III.B, aseries of sanctions and corrective actions to address capital deficiencies within banks isbeing enacted. To complement these measures, legislation is being proposed to allowBSP to place banks under receivership if: their capital to risk assets ratio falls below 2percent, if they declare a holiday; or they remain open but do not pay depositors. PDIC'sability to resolve bank failures is also being enhanced to minimize government losses andallow depositors prompter access to their insured deposits. Thus, once the Monetary

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Board has placed a bank under PDIC receivership, it has been clarified that PDIC will beable to clean the bank's assets without the need for further approval from the MonetaryBoard and without being obliged to entertain rehabilitation proposals from existingowners.

91. Other supportive measures to enhance PDIC's ability to resolve insolvent banksare under consideration. For example. the ability to conduct "purchase and assumption"transactions would facilitate resolution outcomes other than liquidation of failing banks.And the PDIC could be given the authority to charter a "bridge bank," when needed tostem runs by depositors or to resolve a major insolvent bank.

92. In order to increase transparency in the rehabilitation or resolution ofundercapitalized or insolvent banks, the BSP and PDIC will need to take actions to: spellout the rules for open bank assistance. including treatment of shareholders, new capitalrequirements. and treatment of bad assets; and lay out the rules for bidders well inadvance of any bid deadline. along with copies of any financing agreements as to whicheither agency will be a party. The bidders need to know what is expected of them andwhat they should expect from the regulators as early as possible in the bidding process.

93. Liberalized ownership of domestic financial institutions by foreign banks could bean important means of increasing the number of bidders to resolve insolvent banks, whichwould bring new capital, technology and management expertise into the system, and alsoenhance competition. In this regard. the Government's legislative proposal calls forallowing 100 percent ownership for troubled banks (while requiring dilution of foreignownership to 85 percent within five years and 70 percent within ten years).

94. Finally, the legislative implications of dealing with large scale bankinginsolvencies, as have occurred in neighboring countries, is undergoing greater scrutiny.PDIC has assessed that its insurance fund is fully adequate to handle the routineinsolvencies that it typically addresses (primarily involving rural banks). The authoritiesnevertheless recognize that emergency legislation would be required to make availablebudget resources to deal with the failure of a large bank or more widespread distress insmaller institutions if such distress were to constitute a threat to the stability of thefinancial system.

IV. THE PROPOSED LOAN

A. Background and Rationale

95. The Bank has been actively engaged in the reform of the Philippine financialsector since the early 1980s: indeed. the Bank played a significant role in several of thekey reforms described in Section II.A.'' Prior to the current regional crisis, technical

17 As described most recently in the OED's Philippines Country Assistance Review (March 2, 1998)

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assistance on strengthening the banking system was most recently provided by the Bankon two occasions in 1996.

96. The proposed loan, which is consistent with the objectives of the CAS progressreport submitted to the Executive Board in March 1998. responds to a request from thePhilippine authorities for assistance from the Bank. Specifically. the authoritiesrequested technical assistance and balance of payments financing to strengthen thefinancial sector and improve confidence in the current uncertain external financingenvironment.

97. In response, a Bank team working in parallel with a mission from the IMF'sMonetary and Exchange Affairs (MAE) Department. provided technical assistance to theauthorities in February 1998 on strengthening the banking system.'8 Since then, there hasbeen an active dialogue on banking with the authorities. Ongoing TA on banking wouldbe facilitated in the course of supervision of the proposed loan. In addition, the Bank willprovide TA through a PHRD grant recently approved by Japan to strengthen supervisioncapabilities within the BSP and PDIC and to strengthen the SEC's capacity to addressissues relating to corporate distress. Finally. European Union financed ASEM funds areproposed to be used to finance diagnostic audits of the three major governmentowned/controlled banks.

B. Loan Objectives

98. The purpose of the proposed loan is to support a medium-term reform program tostrengthen the banking system and enable it to better withstand current difficulties andfuture shocks. The major elements of this program are to:

- Improve on an ongoing basis the incentives for supervisors, bank owners, and themarket to strengthen the framework for prudent banking;

* Enhance the framework and the authorities' preparedness for early intervention andresolution of troubled banks:

* Strengthen PNB towards the standards maintained by the top tier banks in thecountry, and

* Reduce the incentives for regulatory and tax arbitrage across financial institutions andbetween the peso and foreign currencies.

99. The proposed loan would provide balance of payments support to the Philippineswhen the country's access to private capital has been sharply reduced. Hence it would

Is The Bank's February 1998 mission also provided TA in the areas of contractual savings, housingfinance, and capital market development.

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support the authorities objectives to build international reserves. reduce the pressure ondomestic resources to finance the budget deficit. and enhance market confidence in thebanking reform program.

C. Loan Description, Conditions and Tranching

100. A fast disbursing floating rate single currency loan (SCL) in US dollars in theamount of $300 million is proposed. to be disbursed in three equal tranches as describedbelow. The loan would have a repayment period of 20 years with a 5 year grace period.The Bank's standard grace period. amortization terms and interest rate for floating rateUS dollar SCL loans with an expected disbursement period of less than three years willapply. Cofinancing possibilities with Japan's EXIM Bank has been explored at therequest of the Philippine authorities.

101. Loan Conditions, Timing and Tranching. The Letter of Development Policy(Annex 1) was signed by the Philippine authorities on October 29. 1998. Releaseconditions of the subsequent two tranches are provided in Schedule 3 of the LoanAgreement. The Policy Matrix (Annex 2-also finalized on October 29. 1998)categorizes the actions by the major objectives of the loan, and sequences these accordingto a feasible tranching arrangement; the explanatory notes to the matrix provide furtherspecificity to the actions expected. The 17 actions/agreements that are conditions forBoard presentation are provided in Annex 2 and have been satisfied, the selection of afinancial advisory firm for PNB. is a condition for loan effectiveness. Annex 3 providesa draft terms of reference for the selection and functions of the financial advisory firm,which is to advise the Government on the audit. action plan. and transfer of managementand control of PNB to a strategic private investor.

102. The conditions for release of the second tranche are as follows:

(a) BSP shall have put into effect rules satisfactory to the Bank requiring: (i) externalauditors to be placed under affirmative obligation to inform BSP of factors that materiallyaffect the soundness of a financial institution. and (ii) the accreditation of externalauditors engaged by banks.

(b) BSP shall have. in a manner satisfactory to the Bank, supervised seven bankingorganizations on a consolidated basis and shall have evaluated prudential norms on therisks of the entire banking organization.

(c) BSP shall have: (i) completed supplementary on-site examinations for 51 banks inaccordance with its program of intensified monitoring of institutions at risk; and (ii)imposed appropriate corrective actions.

(d) BSP shall have developed and put into effect, satisfactory to the Bank: (i)guidelines for corrective actions by banks corresponding to their degree of capitaldeficiency; (ii) guidelines for intervening and resolving insolvent and near-insolventbanks, and (iii) a contingency plan to handle systemic crises.

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(e) The Borrower shall have adopted an action plan satisfactory to the Bank topromote strategic private investment in PNB. including: (i) an in-depth audit of PNB byexternal auditors, with qualifications. experience. terms of reference and selectionprocedures acceptable to the Bank, and (ii) development and implementation of a courseof actions for the strengthening of PNB's financial performance consistent with thefindings of the above-mentioned audit.

(f) The Borrower shall have adopted an action plan satisfactory to the Bank to protectBSP and PDIC staff from lawsuits brought against them in connection with actions takenin their official capacities.

103. The conditions for the release of the third tranche are as follows:

(a) BSP shall have put into effect disclosure requirements. satisfactory to the Bank.for listed and non-listed banks.

(b) BSP shall have, in a manner satisfactory to the Bank. supervised an additional 10banking organizations on a consolidated basis and shall have evaluated prudential normson the risks of the entire banking organization.

(c) The Borrower shall have adopted bidding rules satisfactory to the Bank for theselection of a strategic private investor to transfer management and control of PNB.

(d) The Borrower shall have carried out the action plan referred to in paragraph 102(f) above in a manner satisfactory to the Bank.

(e) The Borrower shall have adopted a regulatory framework for the banking system,satisfactory to the Bank that shall. inter alia: (i) limit legal challenges to bank closingsordered by the Monetary Board and provide that only money damages will be available insuch cases; (ii) authorize BSP to suspend and remove bank directors, officers andemployees who have violated banking laws from any further involvement in any bank;(iii) increase monetary penalties imposed by BSP and PDIC for banking law violations bya factor of at least 10; (iv) allow bank examinations at the discretion of the BSPGovernor. Deputy Governor (SES) or Managing Director (SES); (v) give PDIC theauthority to dispose of a bank's assets immediately upon its closing by the MonetaryBoard; (vi) put a bank under receivership if its capital to risk assets ratio falls below 2%;and (vii) allow up to 100 percent foreign ownership of distressed domestic banks.

104. Release of any tranche would in addition be subject to maintenance of a soundmacroeconomic framework, consistent with the objectives of the Program.

105. The proposed tranching design is linked to the loan requirements and theCongressional timetable. For example, the speed with which the financial advisor canprepare an information memorandum for strategic private investment in PNB will dependon the nature of the audit/due diligence findings. And this timing will depend on thenature of prior actions within PNB that are needed. The speed with which the new

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Congress can consider and enact the banking legislative agenda is also difficult to predict.The loan contains a number of policy actions, which cannot be implemented prior toBoard presentation but need not wait till management control of PNB has beentransferred or legislation is fully enacted. Including an intermediate tranche fordisbursement when these are completed hence provides an appropriate means for theBank to monitor the reform progress.

D. Loan Administration

106. Disbursement and Procurement. The Government will open and maintain adeposit account with the BSP. Upon effectiveness and prior to each subsequent tranche,the Government will submit a simplified withdrawal application to the Bank. againstwhich the Bank will disburse the loan proceeds into the deposit account. Disbursementswill not be linked to specific purchases, and supporting evidence for disbursements istherefore not required. The proceeds of the Loan will not be used to finance expendituresfor ineligible purposes as defined in the Loan Agreement.

107. Accounts and Audit. BSP. on behalf of the Government, will maintain theaccounts for this loan in accordance with sound auditing practices. The accounts underthe program will be audited by an independent auditor within four months of Bankrequest; receipt of a satisfactory audit report of the prior tranche would be a condition ofsubsequent tranche releases. The loan Closing Date will be June 30. 2000.

108. Monitoring Arrangement. DOF and BSP will be responsible for monitoring theimplementation program with the help of the Letter of Development Policy. Schedule 3of the Loan Agreement. and the performance indicators agreed upon at negotiations.

109. Environmental Assessment Requirements. In accordance with the Bank'sOperational Directive on Environmental Assessment (OD 4.00. Annex A), the proposedoperation has been placed in Category 'C" and will not require an environmentalassessment.

E. Benefits and Risks

110. Benefits. Strengthening the banking system under current circumstances isamong the more important priorities for the Philippine authorities, and indeed will remainessential over the medium term. Even assuming a rapid return to normalcy within theregion. the banking system would benefit from the enhanced prudential frameworkenvisaged under the reform program. in order for it to exercise the appropriate degree ofrestraint in intermediating large private capital flows in the future. By associating theBank with policy advice and financing in the area of banking, confidence in the economicpolicy of the incoming government can be increased, particularly if the reform program isseen to be proactive and can demonstrate visible results.

111. Risks. The Philippine economy remains vulnerable to a deterioration in theregional environment which would further pressure financial markets and a fragile

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external position. Even without unanticipated macroeconomic deterioration, the bankingsystem faces continuing risks from the environment of slower growth, tighter credit, pesodepreciation and weaker real estate prices that has strained corporate balance sheets.Available data indicate the banking system is not at risk of imminent crisis, although anumber of banks are likely to fall short of capital adequacy requirements if the burden ofnonperforming loans grows. And banks remain subject to sudden deposit withdrawalsthat can render segments of the banking system more vulnerable.

112. While the economic and banking risks cannot be downplayed, our judgment isthat by engaging the authorities in an ongoing dialogue, the Bank can both strengthen thebanking reform program and enhance investor confidence in the program, therebyimproving its prospects of succeeding. The alternative of not responding to the requestfor assistance for financial sector reforms would add to the risks facing the Philippineeconomy.

V. RECOMMENDATION

113. 1 am satisfied that the proposed loan complies with the Articles of Agreement ofthe Bank and recommend that the Executive Directors approve it.

James D. WolfensohnPresident

by Sven Sandstrom

Washington D.C.November 4, 1998

Annexes

ANNEX 1Page I of 14

LETTER OF DEVELOPMENT POLICY

October 29, 1998Mr. James D. WolfensohnPresidentInternational Bank for Reconstruction and Development1818 H St. N.W.Washington D.C.

Subject: Proposed Banking System Reform Loan

I. Background

1. Prior to the regional economic crisis, the Philippine economy had madeimpressive progress, reflecting the implementation of prudent macroeconomic policiesand sound structural reforms, as well as a favorable external environment. By 1996, realGNP growth had accelerated to about 7 percent. led by exports and investment, inflationhad fallen to well within single digits; and the external position had strengthened withrapid export growth, increasing reserves, and a steady reduction of the debt burden.

2. Particularly since the floating of the Thai baht in July 1997, financial marketshave come under severe pressure. Economic and financial policies were adjusted tomanage these pressures and contain their impact on the real economy. In particular, thepeso was allowed to float more freely. accompanied by a tightening of fiscal andmonetary policies, while we have moved forward with our structural reform agendanotwithstanding the difficult economic environment.

3. Our efforts, which were supported by an extension and augmentation of thePhilippines' extended arrangement with the IMF in July 1997, met with initial success.In particular, economic growth held up well in 1997 (real GNP grew by 5.3 percent),export growth accelerated to 23 percent, inflation was maintained below target, theconsolidated public sector deficit (CPSD) was limited to 1.4 percent of GNP, and theadverse impact of financial market volatility on banks, corporations and social welfarewas well contained relative to experiences elsewhere in the region.

4. Economic performance and the short-term outlook have however deterioratedwith the deepening of the regional crisis, deterioration of the global outlook andenvironment for private capital flows to developing countries, and adverse effects of the"EI Nino" induced drought on agriculture. While export growth during the first half of1998 remained relatively robust at 19 percent and the current account position adjustedrapidly to the changing domestic and international environrment, real GNP growth in the

ANNEX 1Page 2 of 14

first half slowed to 0.6 percent, inflation has increased to about 10 percent, andunemployment has risen. While stress within the corporate and financial system hasincreased, the Philippines has thus far avoided the systemic banking and corporateproblems experienced elsewhere in the region, notwithstanding comparable declines inthe exchange rate and equity prices. Nevertheless, as the environment for banking hasdeteriorated, access to credit for small enterprises and the informal sector has beenreduced. While the priority is to manage the present crisis effectively and restoreconfidence as soon as possible. we also recognize that recent financial market turbulencehas exposed certain vulnerabilities within the economy, particularly in the financialsector. Our goal is to contain these risks through an economic program that involvesprudent macroeconomic management; bolstering our pro-active strategy to strengthen thebanking sector; and pursuing other complementary reforms as described below.

5. Beyond the immediate concerns of crisis management. economic policies arebeing focused to address the remaining barriers to sustained growth and povertyreduction. Key medium-term requirements in this respect are to raise domestic saving.strengthen the financial system. reduce external vulnerability, and ensure fiscalsustainability. In order to support our economic program, we reached a two-yearprecautionary stand-by arrangement with the IMF. which was approved by the IMFBoard on March 27. 1998. Furthermore, at the request of the Philippine authorities, theIMF Board is due to consider activation of the program on October 30, 1998.

II. The Economic Program for 1998-99

6. Our main priority is to sustain economic growth. limit the adverse effects of thecrisis on the most vulnerable groups of the population. and provide for an early, strong,and lasting recovery. We are aiming at real GDP growth of about I percent in 1998,followed by a recovery to around 3.5 percent in 1999 and averaging over 5 percentthereafter. Given the volatile regional situation, we have formulated policies to deal withthe contingency of possibly weaker economic activity and to prevent a slide of theeconomy into recession. Other key program targets are to limit average inflation to about9.5 percent in 1998 (based on the 1988 CPI basket). 8 percent in 1999, and 5-6 percent insubsequent years: reduce the current account deficit to 1.5 percent of GNP in 1998 and0.7 percent in 1999. and to increase reserve cover to 2.8 months of imports by 1999. Ourpolices are centered on sustained fiscal and monetary prudence, further banking sectorreforms, continuation of trade and investment liberalization, and a deepening of otherstructural reforms, including medium-term fiscal and corporate sector reforms.

ANNEX 1Page 3 of 14

Fiscal, Monetary and External Policies

7. The fiscal program accommodates the effects of the weaker economy on revenuesand allows for somewhat higher expenditures for well-targeted social spending. At thesame time, it incorporates measures to prevent an unduly large deficit and to ensuremedium-term fiscal sustainability. For 1998 as a whole. we are now targeting a nationalgovernment (NG) deficit of P40 billion. For 1999. the draft NG budget submitted toCongress targets a deficit of P18 billion. Should growth be weaker than we currentlyexpect, a somewhat higher deficit could result from the working of automatic stabilizers.We are, however. committed to limiting the underlying CPSD to P82 billion (2.9 percentof GNP) in 1998 and P64 billion (2.0 percent of GNP) in 1999.

8. Despite the adverse impact of higher inflation and interest payments, expenditureshave been kept broadly on track in nominal terms. To control expenditures. we havesustained the across-the-board sequestration of all non-wage expenditures of agencies. aswell as the other measures effected during the first half of the year. However. to mitigatethe adverse impact of the slowing economy on the most vulnerable groups, thesequestration of the most socially sensitive expenditures for basic education. nutrition,welfare and public health programs have been rescinded. Moreover, in collaboration withthe World Bank, we are conducting a thorough evaluation of our social expenditures, andin the context of a proposed Social Investment Loan from the Bank. we intend to re-orientbudget expenditures towards well-targeted social expenditures.

9. Revenues this year have been lower than programmed due to deterioration in theeconomic environment and delays in implementing some measures. Henceimplementation of the action plan to strengthen tax administration, drawn up incollaboration with the IMF. which focuses on large tax payers and an audit plan toimprove tax compliance is of the utmost importance. A comprehensive rationalization oftax incentives together with the introduction of new user fees on a range of services willbe effective for 1999. Finally. restructuring and privatization of the National PowerCorporation is also high on the legislative agenda.

10. Monetary policy will continue to focus on limiting inflation and containingdownward pressure on the peso. The twelve-month rate of broad money (M3) growth isprojected to remain at around 17 percent through end-1999, though this target will bemodified as appropriate. Our interest rate policy will remain flexible to counter renewedexchange market pressures if necessary as in early August 1998 when the BSP raised itsovernight interest rates by 5 percentage points, which subsequently have been partiallyreversed. To reduce bank intermediation costs, we have reduced reserve requirements onpeso deposits on two occasions in 1998 while at the same time avoiding undesiredliquidity expansion. The more recent increase in reserve requirements in October 1998,which was needed to mop up undesired liquidity arising from banks' cautious lendingpolicy, was accompanied by an increase in the interest rate paid by BSP on banks' reservebalances in order to limit the impact on bank intermediation costs.

ANNEX IPage 4 of 14

11. While the current account has adjusted rapidly. narrowing to near balance duringthe first half of the year, the capital account remains under pressure and spreads for bondissues in international markets have recently become prohibitive for many developingcountries. To help finance the budget in a noninflationary manner, the Government hastherefore arranged for a $610 million Foreign Currency Deposit Unit (FCDU) loan fromdomestic banks, which we intend to repay as additional program financing from the JapanEXIM bank, the World Bank and Asian Development Bank materializes. We intend toreturn to international financial markets with planned bond issues as soon as marketconditions turn more favorable.

III. The Banking System Reform Program

12. We recognize the need to strengthen the banking system through a comprehensivereform program that will enable the system to better withstand current difficulties,strengthen its resiliency to future shocks and confront with confidence the challenges thatlie ahead. It is in this context that we are requesting support from the World Bank for aBanking System Reform Loan. Complementing this operation, we have initiated workwith the Bank on the recently approved financial sector technical assistance program(Japan PHRD grant), which will provide technical assistance to the BSP. PhilippineDeposit Insurance Corporation (PDIC) and Securities and Exchange Commission (SEC).And as described in Section IV, we will continue to strengthen other aspects of thefinancial system and corporate governance in consultation with the World Bank and othermultilateral institutions.

13. There are five main elements to our banking reform strategy. First, we arestrengthening our prudential and supervisory systems. reshaping incentives of bankowners to encourage prudent banking practices and exposing bankers to greater marketdiscipline. Second. our bank resolution strategy is geared to the twin objectives ofdealing expeditiously with problem banks while safeguarding the soundness of thebanking system. Third. we have initiated a process within the nation's second largestbank to enhance governance and efficiency and strengthen financial performance on asustainable basis. inter alia. through acquisition of management and control by a strategicprivate investor. Fourth. we are taking measures to reduce peso intermediation costs andto reduce disparities between intermediation in different currencies and regulatorytreatment across different institutions. Finally, we are preparing legislation to Congressthat will improve the legal and regulatory framework for banking by allowing banksupervisors and regulators to perform their duties in a less constrained manner than iscurrently feasible and by strengthening the Government's ability to address furthershocks.

14. Underlying our banking reform program is a vision for the medium term that bankowners, buttressed by higher capital and stricter provisioning requirements and subjectedto more stringent scrutiny from supervisors and market participants, will be morediscriminating in intermediating financial flows particularly as they involve foreigncurrency. major term transformation, or lending to volatile sectors such as real estate.

ANNEX 1Page 5 of 14

While the reform program is comprehensive in design. it is also pragmatic in that thetiming and sequencing of proposed measures has been structured so as not to undermineprospects for economic recovery. Efforts are also underway to counteract the weakenedaccess to credit within agriculture and small and medium enterprises (SMEs) since theonset of the regional crisis.

15. An essential complement to such a vision is the parallel development of thebroader financial system in order to encourage equity finance and longer-term debtinstruments and avoid over-reliance on the banking system and external finance. In thisregard, there is considerable scope for expanding the pool of contractual savings andtransforming these into more efficient vehicles for capital market development anddomestic long-term savings mobilization.

A. Strengthening the Prudential Framework

16. To maintain the fundamental health of the banking system. we are fullycommitted to accelerating ongoing efforts to improve our prudential and supervisorysystems. This involves a medium-term program to raise capital. impose moreconservative accounting standards and provisioning requirements, enhance transparencythrough tougher disclosure requirements. and improve the focus and timeliness ofsupervisory oversight and redirect its efforts towards areas of potential systemic risk.

(i) Prudential Standards

17. The BSP took a number of measures to strengthen the prudential frameworkduring 1997, including: imposing limits on real estate lending in April; a phased increasein capital requirements for banks in October, tighter standards for past-due loans inOctober (effective as of April 1998); requiring a 2 percent general loan loss provision inOctober (to be phased over a three-year period beginning October 1998); and extendingforeign currency exposure limits applicable to banks to include holdings of affiliatedsubsidiary foreign exchange operations.

18. In March 1998. we announced a series of further measures that will improve thesystem's capacity to withstand shocks and transform provisioning rules towardsinternational norms. These measures included: a schedule to raise minimum capitalrequirements through December 2000 that is expected to encourage further consolidationwithin the banking industry (Annex 4): accelerated implementation of the general loanloss provision to bring forward the end level of 2 percent to October 1, 1999, withintermediate levels retained at 1 percent by October 1, 1998 and 1.5 percent by April 1,1999; and the announcement of specific loan loss provisions for loans classified as.substandard-secured" and "special mention" to 25 percent and 5 percent, respectively byApril 15. 1999. with intermediate requirements by end 1998 of 12.5 percent and 2.5percent. These measures will be complemented by extending the 10 percent capitaladequacy requirement to universal banks previously exempted to take effect by end 1998.

ANNEX IPage 6 of 14

19. Stricter qualification and competency criteria for new licenses have been put inplace as of July 1998. At the same time, it is recognized that unrestricted ownership ofdomestic financial institutions by major multinational banks could be an important meansof resolving bank failures, bringing new capital, technology and managerial expertise intothe system, and enhancing competition. Hence, we intend that qualified foreign banks beallowed full ownership of troubled domestic banks for a period of five years.

20. To enhance transparency and market discipline. the BSP issued Circular 157(effective from December 1998) obligating listed banks to disclose and discuss publiclymore detailed information on a quarterly basis, including information relating to the levelof non-performing loans, classified assets, and loan loss reserves (both specific andgeneral). We recognize that additional disclosure requirements are desirable to furtherenhance transparency; yet the timing of the additional requirements will need to becalibrated in order not to unsettle financial markets during a period of stress. We willtherefore agree with the World Bank on a schedule for implementing further disclosurerequirements for listed and non-listed banks, and on the form, manner and frequency ofsuch disclosures. The additional disclosure requirements are expected to include thefollowing: an individual bank's credit rating; capital ratio; large concentrations of creditto specific sectors; aggregate exposure to directors. officers, shareholders and their relatedinterests; asset and liability management practices; information on foreign currency assetsand liabilities; interest rate sensitivity; and liquidity. In addition, commercial banks willbe required to make public statements about whether they are fully complying withprudential rules and whether the internal risk control is adequate. BSP has issued acircular pertaining to mark-to-market trading and equity portfolios and mark-to-marketaccounting procedures conforming to international norms which became effective inSeptember 1998. Finally. we intend to improve the quality of audits of financialinstitutions by placing external auditors under an affirmative obligation to inform BSP offactors that materially affect the soundness of a financial institution and by implementinga system of BSP accreditation of external auditors that may be hired by banks and quasi-banks.

21. We have developed formal policies with respect to concentrations of credit orinvestment in borrowers or borrower groups associated with a bank's owners. During thetransition toward consolidated supervision. all equity investments in affiliates andnonfinancial firms where the bank is the majority or controlling owner are to be deductedfrom bank capital in assessing a bank's capital adequacy, given the concern noted withrespect to the quality of capital.

(ii) Supervisory Effectiveness

22. The Monetary Board's role in the supervisory process is to be redefined to focuson the definition of broad policy goals and strategies and on improvement of BSP's legaland prudential standards, rather than on direct involvement in day-to-day supervisoryoperations. The Monetary Board also intends to better align the use of supervisory

ANNEX 1Page 7 of 14

resources with systemic concerns by developing a hierarchy-of-risk model thatestablishes priority for the allocation of resources.

23. Regulatory oversight has been strengthened by a shift away from a check-listdriven type of examination to a more analytical approach. which focuses on anassessment of the consolidated risk management practices of each bank and its affiliates.A revised "risk based" report of examination has been introduced and replaces theunnecessarily detailed examination report currently in use. Hence the examinationprocess will be reoriented to assess risk and the systems used by a bank to manage risk,including liquidity, interest rate. foreign exchange risks, and risks accruing fromderivatives and other off-balance sheet activities.

24. All examination activities will focus on the consolidated banking group. so thatno significant activity is permitted to escape supervision and the application of soundprudential rules and requirements. Staff training will facilitate a change from a largelymechanistic use of CAMEL and SLIM ratings to a more judgmental use, in order to moreaccurately portray the condition of a bank.

25. Greater flexibility will be permitted in the scheduling of examinations andexamination activities so that resources can be employed in areas of greatest risk andfollow-up corrective action can be taken in a timely manner. The BSP will use its specialexamination authority to define new types of examinations (e.g., visitations, targetedexaminations, etc.) to schedule examinations more frequently in banks exhibiting high-risk characteristics. In addition, we are preparing legislation for Congress that willeliminate the current restrictions on BSP's authority to examine banks, so that it mayschedule and conduct examinations at its own discretion whenever it determines the needto do so.

26. Another priority is to improve the timeliness of examination findings. Henceexamination reports will be submitted to banks on a more timely basis, facilitated byeliminating the vast amount of detail in the reports, and by introducing computers into theexamination process. All examination reports will be discussed directly with the bank'sboard of directors in the case of troubled banks. Communications will be improved byprioritizing the examination report's presentation of issues and criticisms so that bankmanagement and its board of directors can readily understand the relative importance ofthe various findings.

27. To strengthen off-site monitoring, the data collected through prudential reportingwill be presented in a comprehensive manner and logical format that provides animproved basis for analysis. Monitoring activities will focus not only on individualbanks, but also on systemic concerns such as the potential impact posed byconglomerates and major shareholders, industry concentrations, new instruments, anddependence on volatile sources of funding. To the extent allowed by law, the datacollected will be made accessible and shared between BSP and PDIC to eliminate

ANNEX 1Page 8 ofl4

duplication, increase supervisory efficiency, and reduce the burden placed on banks to theextent provided for under existing legislation.

B. Early Intervention and Resolution Strategy

28. We recognize that the underlying capitalization of the Philippine banking systemhas been weakened by macroeconomic events since mid-1997. And the uncertainregional situation implies the need for vigilance in monitoring potentially distressedinstitutions and enacting corrective actions. The BSP has therefore initiated a strategy foridentifying and dealing with the potential problem of insolvent or near-insolvent banks.as outlined below. Although this strategy will be strengthened by the enactment of newlegislation (Section E below), much can be done within the existing legislativeframework, and this is now being implemented.

(i) A crash-program of intensified monitoring of selected banks

29. The first element of the BSP^s strategy is an accelerated program of intensifiedmonitoring. A preliminary list of potential problem banks has been drawn up by the BSPwith a view to conducting a special program of supplementary on-site inspections. Thislist is now being augmented through use of additional early warning indicators (includingrapid growth in loan volumes or in reported past dues; concentration of lending in volatileeconomic sectors; large securities holdings not marked to market; exposure to foreigncurrency borrowings; deterioration in access to or cost of interbank or other depositfunds). Thus forward-looking as well as backward-looking indicators of stress are beingemployed.

30. The list is being arranged in order, with priority given to the institutions which areperceived as potentially posing the greatest systemic risks placed at the top. A revisedand augmented list will be kept under regular review. The World Bank will continue tobe informed on a periodic basis of the number of institutions on the list, the size range ofeach institution in order, and the sum of banking assets of the concerned banks.

31. The Monetary Board has given a blanket approval for supplementary on-siteinspections of commercial banks, thrift or rural banks that are or may be placed on the listby the BSP. thereby effectively over-riding the normal arrangement whereby inspectionshave been limited to once-a-year and allowing the BSP to move preemptively.

32. These special inspections are being conducted by special elite monitoring teams.Their focus is on a forward-looking and conservative assessment emphasizing assetquality as well as liquidity pressures. Particular attention is being paid to the potentialneed for provisioning in respect of loans that, though current, have been extended, and toliquidity risks associated with foreign borrowings.

ANNEX 1Page 9 of 14

33. The main preliminary findings of each inspection will be reported to the MonetaryBoard within one week from the end of the on-site inspection with the full reportavailable as soon as possible. The special inspection of at least the first two of theseinspections has been completed and corrective action has been proposed. CommencingAugust 1, 1998 and every two months thereafter, a further three banks will have beeninspected, and corrective action recommended.

(ii) Explicit procedures and rules establishing a graduated response to capitalshortfalls

34. As the second element in our early intervention and resolution strategy, we areformalizing the rules to deal with any capital deficiencies that are uncovered. InSeptember 1998, we issued a Circular (No. 176) that provides for a matrix of sanctionsaccording to the degree of capital deficiency, with sanctions differentiated by capitaldeficiencies ranging from up to 20 percent to more than 80 percent-including, for thelatter. the issuance by the authorities of a "cease and desist" order, which allows theMonetary Board to prevent the institution from doing business in the Philippines anddesignate the PDIC as receiver.

35. We recognize that Circular 176 needs to be complemented by a matrix of steps inthe area of corrective action to be issued shortly by the BSP. Such a matrix will clarify tothe banks the mandatory and discretionary actions they would face as the capitaladequacy ratio falls below the mandated level. An important objective of the correctiveactions would be to initiate earlier intervention in failing banks to minimize public lossesand facilitate options other than liquidation.

36. We intend to seek a market-based approach to resolution where possible, in orderto minimize the drain on public resources. Nevertheless, we stand ready to proposeemergency legislation and institutional arrangements to make available adequate budgetresources to deal with the failure of a large bank or widespread distress in smallerinstitutions if such distress were to constitute a threat to the health and stability of thefinancial system.

37. In order to be better prepared for the eventuality, however remote, that problemscould arise simultaneously at a large number of banks, the BSP has drafted contingencyplans for the resolution of systemic problems. We recognize the need to update theseplans as needed, obtain feedback from the DOF and PDIC. and will continue to consultthe World Bank in this exercise. In this regard, we recognize that dealing with theliquidity, management and ownership issues efficiently in such a circumstance willrequire an integrated approach and close cooperation between government agencies.

C. Strengthening Government-Owned/Controlled Banks

38. An essential element of our banking reform program is to strengthen PNB on asustainable basis. We are convinced that the most effective means of attaining this

ANNEX IPage 10 of 14

objective is to seek a strategic private investor that will have the ability and incentive toraise and maintain PNB's competitiveness. loan portfolio and capital adequacy up to thetop tier of banking industry standards. The Government has therefore initiated a processto transfer management and control of PNB to a strategic private investor. It isrecognized that given PNB's status as the second largest bank in the country. onlyrespected foreign and local banks will be included among those invited to bid for strategicownership.

39. To ensure that this process is conducted according to international best practice.we will contract the services of a reputable financial advisory firm to advise theDepartment of Finance (DOF) on all aspects of the sale (financial advisor terms ofreference are contained in Annex 3). To expedite preparation by the financial advisor ofthe information memorandum, the Government will provide the financial advisor allexisting information about the condition of the bank. BSP's special inspection of PNBwill also be updated by mid-November 1998 (using information as of September 30.1998) for this purpose. and to ensure that regulatory oversight of PNB continues toproceed on the basis of up-to-date information. In addition, it is expected that thefinancial advisor will need to conduct or commission a thorough audit of PNB in order toprepare the requisite information memorandum. The terms of reference for such an auditwill be made satisfactory to the World Bank. The Government will work with PNB'snew management and Board to fully cooperate with the financial advisor to realize ourobjective of selling government shares to a respected private investor through atransparent and internationally accepted bidding process satisfactory to the World Bank.

40. We further recognize the importance of maintaining strong standards ofgovernance over the government owned banks. In the context of proposed financialintermediation loans from the World Bank to the Development Bank of the Philippines(DBP) and the Land Bank of the Philippines (LB). which address our objective ofmaintaining credit access to SMEs. we intend to commission audits based oninternational best practices of DBP and LB. and to implement the recommendationsarising from these audits.

D. Reducing Regulatory Arbitrage and Intermediation Costs

41. We are fully aware of the potential for distortions in the financial system arisingout of costly regulations and certain aspects of taxation. In addition, the differentiatedtreatment of foreign currency and peso deposits, and of thrifts and commercial banks, hasled to a degree of regulatory arbitrage. Recent and ongoing reforms in prudentialsupervision practice being implemented should reduce the prudential risks associatedwith such arbitrage. but reduction of the underlying distortion is also desirable.

42. We have therefore lowered reserve requirements while containing unintendedliquidity side-effects. Through two stages in March and May 1998, reserve requirementson commercial banks were reduced from 13 to 8 percent, and reserve requirements for

ANNEX IPage 11 of 14

demand deposits, NOW accounts and deposit substitute liabilities in thrift and rural bankswere also reduced to 8 percent. Compensating increases in liquidity reserves wereenforced in March 1998. Reserve requirements were raised in October (to 10 percent forcommercial banks) to help stabilize the foreign exchange market. However. to minimizepressure on domestic interest rates. the interest rate paid by the BSP on 40 percent of thebanks' balances with the BSP was commensurately raised to 4.5 percent from 4 percent.

43. To further reduce differences in tax treatment between peso and foreign currencyintermediation, foreign currency deposits of residents were made subject to a 7.5 percentwithholding tax on interest income as of January 1998. Furthermore, the liquid assetcover requirement on foreign currency assets was raised to 30 percent in June 1998 (takenprimarily as a prudential measure). These measures have already reduced the share offoreign currency intermediation. If the latter were to resume growth at an unsustainablepace. the BSP stands ready to take further measures.

44. We intend to allow tax relief to be claimed by banks on specific loan lossprovisions to encourage better reserving practice leading to sounder bank managementdecisions. Legislation to this effect has been prepared. but since this measure wouldinvolve a significant initial cash flow cost to the budget. its implementation is beingdeferred. As part of a medium-term reform of the taxation of financial institutions, weintend to phase out the gross receipts tax (GRT) and documentary stamp tax (DST) onfinancial transactions, which would likely be replaced by a VAT-like charge based oneach bank's profits and salaries. The new charge would be at a rate calculated to bebroadly revenue neutral and would be applied to thrift and rural banks in addition tocommercial banks. Prior to implementation we however intend to study alternativeproposals to ensure that overall revenue is not sacrificed and efficiency is enhanced.

E. Legislative and Regulatory Agenda

45. The Government's legislative and regulatory agenda with respect to the bankingsector has three main objectives: first. to protect employees of the BSP and the PDICfrom suits arising out of their official conduct as well as to strengthen the ability of theBSP to close insolvent banks, second. to enhance the supervisory and enforcementpowers of the BSP and the PDIC; and third. to augment the legal authority of the BSP toclose insolvent banks and the PDIC to resolve closed banks promptly.

46. Our first objective is to protect employees of the BSP and PDIC from litigationarising from the performance of their responsibilities. It is essential that BSP and PDICofficials have the ability to perform their jobs, including the supervision of banks, and,when necessary. the ability to close insolvent banks, without the constant threat oflitigation. As a first measure. we will propose legislation that banks seeking emergencyloans reimburse the BSP for any losses incurred by the central bank from lawsuitscontesting the appointment of a conservator or receiver in the event that the bank iseventually closed. We will in addition cooperate with the World Bank in conducting a

ANNEX IPage 12 of 14

review to determine whether and to what extent additional measures are needed to fulfillour objective of providing adequate legal protection to the Monetary Board and BSP andPDIC personnel from institutions that they regulate. Upon completion of this review byJanuary 31, 1999, we will discuss the review's findings with the World Bank and agreewith the Bank on the nature and timing of measures that may be needed to fulfill theabove objective, including, if appropriate, additional legislation.

47. Our second objective is to enhance the supervisory and enforcement powers of theBSP and PDIC. We will do this in a number of ways. including legislative initiatives tosubstantially increase the civil and criminal penalties for violating the banking laws andto remove directors and officers who violate the law. and broadening the grounds onwhich a receiver may be appointed. New legislation has also been proposed to authorizeexaminations of banks as needed, without pre-approval by the Monetary Board.

48. We recognize the need to allow bank examiners to have access on a routine butstrictly confidential basis to the identities of individual depositors to better assess thestability of deposit sources, to determine the resources available for loan servicing, totrace loan proceeds and compliance with legal lending limits, to combat moneylaundering, and to expedite deposit payoffs in the event of bank failure. In view of thecurrent financial market volatility. however, we have adopted a phased approach toattaining this objective. Thus BSP issued a circular in August 1998 clarifying theconditions under which directors, officers and stockholders will be required to waive theirsecrecy rights as provided under current law. Furthermore, we intend to address anti-money laundering concerns in cooperation with international efforts.

49. Our third objective is to augment the legal authority of the BSP to close insolventbanks and the legal authority of the PDIC to resolve closed banks promptly. Tosupplement the regulatory measures described in paragraphs 34 and 35, we are proposinglegislation to place banks under receivership if their capital to risk assets ratio falls below2 percent. BSP and the PDIC will also adopt a new policy statement to spell out the rulesfor open bank assistance so that this process is significantly more transparent. Werecognize that rehabilitative efforts involving existing owners should be exercised beforea bank is closed. However. once closed. PDIC requires the flexibility to resolve thefailure promptly in a manner that minimizes government losses and enables depositors togain prompter access to their insured deposits. thus enhancing confidence in the ability ofthe authorities to manage the financial system. Therefore, we are expediting the processthrough which PDIC can dispose of assets once a bank has been closed by the MonetaryBoard to conserve assets of the bank under receivership, including proposing legislationthat allows PDIC to clean a failed bank's balance sheet once it is placed underreceivership. to facilitate its eventual sale or merger. PDIC may, but will not be obligedto entertain rehabilitation proposals from existing owners after a bank has been placedunder receivership. Finally. also we will propose legislative action, which will allowforeign banks to purchase 100 percent of the ownership of troubled Philippine banks (tobe reduced to 85 percent in five years and 70 percent in ten years), which will have anadditional benefit of increasing the number of potential bidders for failing banks.

ANNEX IPage 13 of 14

IV. Complementary Reforms Within the Financial and CorporateSectors

50. While strengthening the banking system is of the utmost priority, we recognizethat complementary reforms are needed to enhance the capacity to resolve corporatefinancial difficulties and bankruptcies, encourage capital market development. andincrease domestic saving and the efficiency of its allocation.

51. To prepare an appropriate response strategy to increased corporate stress, we haveinitiated a broad-based assessment of the health of the corporate sector. A special unit inthe BSP's Supervision Department has been established to assess the credit and exchangerisk of the 100 largest borrowers, and an initial credit analysis of these borrowers will becompleted by December 1998. A proposed Securities Act of 1998 addresses issuesrelating to registration, information disclosure, insider trading, anti-fraud provision andprudential regulation. We recognize that additional reforms are needed to make the SECan effective regulatory body. especially in its role of arbitrator in corporate debtrestructuring disputes, and given its authority to suspend debt payments of financiallydistressed firms. In this context. we have requested the Bank to assist the SEC to developnew policies and procedures for rehabilitating or liquidating distressed firms, and we willprovide the necessary resources to ensure that the SEC can carry out its duties effectively.

52. Over the medium term. the legal framework governing bankruptcy regulation alsoneeds to be strengthened in a comprehensive manner. It is therefore our intention toprepare a new bankruptcy law, in collaboration with the World Bank, which willincorporate the best features of existing legislation in Europe and North America. In thiscontext, we will consider transferring SEC's current responsibilities for supervisingsuspension of payments to the judicial system. thereby enabling the SEC to focus onregulatory matters and enforcement of prudential standards.

53. We recognize that developing a mature capital market that can effectivelyintermediate longer-term savings and investment is essential for reducing excessivedependence on foreign capital and the banking system. We will therefore analyze meansof promoting capital market development, inter alia. by leveling the playing field in termsof taxation across financing instruments and encouraging the development of crediblecredit rating agencies. As part of its Capital Market Development Program Loan, theAsian Development Bank (ADB) has proposed a comprehensive set of reform measuresto further develop equity and debt markets, for which we are in continuing dialogue withthe ADB.

54. Relatedly. and in consultation with the World Bank, we are examining the scopefor reforms within the contractual savings system and housing finance whose objectivesinclude: promoting long-term savings by strengthening private and public pension plans,

ANNEX IPage 14 of 14

life insurance agencies and pre-need plans; developing a more equitable, efficient andaffordable retirement income system; reforming housing finance policies to promote amore market-oriented and self-sustaining housing finance system: and reducinggovernment contingent liabilities associated with housing finance and contractual savingsinstitutions.

Signed

Gabriel C. Singson Edgardo B. EspirituGovernor Secretary of FinanceBangko Sentral ng Pilipinas Department of Finance

ANNEX 2Page 1 of 5

Policy Matrix-Objectives and Sequencing of ActionsAction Before Board date Second tranche Tlhird Tranche

Prudential Framework A Increase capital Timetable announcedB Ensure conservative valuations General and specific

loan loss provisioningschedule announced

C Tighter restrictions on bank licensing AdoptedD Disclosure and mark-to-market Circulars issued Circular issuedE Extend responsibility of auditors Objectives agreed Regulation issuedF New supervision methodologies Objectives and action

plan agreed andimplemented

G Consolidated supervision Objectives agreed Seven banks supervised Ten additional bankson consolidated basis supervised on

l ________________________ consolidated basisEarly Intervention and H Intensified monitoring Action plan agreed Supplementary on-siteResolution inspections com pieted

for 51 banksI Early Intervention and resolution Circular issued Circular issued

Contingency plandeveloped

Strategic Private J Actions complementary to strategic BSP inspection initiated Audit completed. Satisfactory progressInvestment in PNB investment Action plan initiated on action plan

K Transfer of management and control to Objective announced Due diligence, valuation Satisfactory biddingstrategic private investor Financial advisory firn process, information rules adopted for

appointed-Condition memorandum completed management/controlof Effectiveness transfer

Regulatory Arbitrage & L Reduce intermediation costs ImplementedIntermediation Costs M Reduce incentives for dollarization Objectives agreedLegislative Changes N Enhance protection for supervisors Action plan agreed Action plan

implementedO Limit appeals by bank owners Objectives agreed ImplementedP Increase supervisory authority of Objectives agreed ImplementedBSP/PDICQ Failure resolution Objectives agreed ImplementedR Additional receivership criterion Objectives agreed ImplementedS Liberalize foreign bank entry Objectives agreed Implemented

ANNEX 2Page 2 of 5

Summary Notes on Proposed Policy Actions

Prudential Framework

A Increase capitalIncreases in minimum capital requirements announced in March 1998 to become effective as ofDecember 1998 (Annex 4 provides schedule and extent of capital increases). Compliance withexisting capital adequacy standards is enforced. Exemptions to the 10 percent capital adequacyrequirement. which have been in effect for a small number of universal banks, are phased out byend 1998.

B Ensure conservative assessments of bank capitalIn March 1998. the schedule for meeting general loan loss provisions, first introduced in October1997, was accelerated. and a new schedule for adding specific loan loss provisions effective fromDecember 1998 was announced (Annex 4).

C Tighter restrictions on bcank licensingBSP issued a circular on July 13. 1998 putting into effect tighter licensing restrictions as describedin Annex 4.

D Disclosu -e and mark-to-mnarketThrough Circular 157. listed commercial banks will be obliged to disclose as of December 1998information on a quarterly basis relating to: NPLs; classified loans and other risk assets; generaland specific loan-loss reserves. BSP will agree with the World Bank on a schedule forimplementing additional disclosure requirements for listed and non-listed banks, and on theform, manner and frequency of such disclosures. The additional disclosure requirements areexpected to include the following: the individual bank's credit rating; its capital ratio; largeconcentrations of credit to specific sectors; aggregate exposure to directors, officers, shareholdersand their related interests; asset and liability management practices including dependence onforeign currency assets and liabilities; interest rate sensitivity; and liquidity. One or morecirculars will be passed. satisfactory to the World Bank, which would elaborate to what extentthe above items would be required to be disclosed by banks prior to the third tranche. Inaddition, banks will be required to make public statements about whether they are fullycomplying with prudential rules and whether the internal risk control is adequate. Regulationpertaining to mark-to-market trading and equity portfolios was issued in March 1998 (CircularNo. 161) and became effective as of end-September 1998.

E Extend r esponsibility of auditorsExternal auditors will be placed under an affirmative obligation to inform BSP of factors thatmaterially affect the soundness of a financial institution. Failure to comply by the auditor willresult in loss of BSP accreditation; the process of BSP accreditation of auditors is beingdeveloped.

ANNEX 2Page 3 of 5

F. New supervisory methodologiesImplement a broader qualitative assessment of banks, using a forward looking approach andprioritizing the issues and criticisms made. The supervision methodology will also emphasizeissues other than portfolio quality, such as risk management capacity, funding vulnerabilities(especially rollover risk for foreign exchange liabilities) etc.. as well as a review of the processesand systems that contributed to asset quality. Increase supervisory resources in banks and factorsthat pose systemic risks. Strengthen off-site procedures. Training program for BSP/PDIC staffinitiated.

G Consolidated supervisionImplement supervision of banking organizations on a consolidated basis in accord with the coreprinciples of the Basle Committee on Banking Supervision.

Early Intervention and Resolution of Problem Banks

H Intensified monitoringA priority list of problem banks on the basis of early warning indicators has been prepared.Special. critical. forward-looking on-site inspections of these banks to arrive at realisticvaluations of their capitalization in the current environment are being conducted. Completion ofinspection reports are being speeded up.

I Eariy intervention and resolutionCircular 176. issued in September 1998. provides for a matrix of sanctions according to thedegree of capital deficiency. An additional circular will be issued, satisfactory to the WorldBank. that clarifies to the banks the mandatory and discretionary corrective actions they wouldface depending on the degree of capital deficiency. Establish high-level committee to developand maintain a contingency plan for a "worst-case scenario".

Strategic Private Investment in Philippine National Bank

J Actions complemnentawy to stractegic investmentBSP will update its November 1997 inspection of PNB by mid-November 1998 based onSeptember 1998 data in order to monitor its financial condition, agree with PNB management onthe actions and timetable needed for strengthening financial performance, and provide up-to-dateinformation to the financial advisory firm (see item K). The advisory firm will conduct orcommission an audit of PNB; the terms of reference for such an audit should be satisfactory tothe World Bank. An action plan drawn up by the advisory firm will indicate the different stepsto be implemented by PNB management in order to strengthen the financial performance of PNBand arrive at a successful transfer of government shares to a strategic private investor.

K Transfer of management and control to strategic private investorThe Government has announced its intention to sell its shares in PNB to a strategic privateinvestor, implying the need to appoint an internationally recognized financial advisory firm(Annex 3 provides terms of reference for this appointment) and permitting the firm to haveaccess to pertinent information relating to PNB in order to prepare an adequate information

ANNEX 2Page 4 of 5

memorandum. The advisory firm will hence require access to existing and updated BSPinspection reports of PNB and existing recent audits of PNB. The sale of government shares inPNB to a strategic private investor will be conducted through a bidding process acceptable to theBank.

Reduce Regulatory Arbitrage and Intermediation Costs

L Reduice interniediation costsReserve requirements lowered on two occasions in 1998 (March and May) by a total of fivepercentage points to 8%. Liquidity requirements raised in March 1998. Reserve requirementsraised to 10% in October 1998. but interest paid on reserves held by banks increased.

M Redutce incentives for dollaria cionLiquid asset requirement on foreign currency intermediation increased to 30% in June 1998 andcost of peso reserve requirements lowered. Withholding tax on foreign currency interest forresidents enacted. Adopt additional measures if needed, to avoid unsustainable increases in theshare of foreign currency intermediation.

Legislative Changes

N Enhance protection for supervisorsBased upon a forthcoming review, adopt additional measures (if needed) to the satisfaction of theWorld Bank to provide adequate protection from civil lawsuits for members of the MonetaryBoard and BSP/PDIC staff in connection with actions carried out in their official capacity.Agreement on the content and timing of an action plan (if needed) to be agreed by secondtranche; legislative changes would be implemented (if needed) by third tranche.

0 Limit appeals bh hatnk ow nersEnactment of pertinent legislation to: (a) condition emergency assistance from the BSP on anindemnity from the assisted bank to prevent lawsuits in connection with the appointment of aconservator or receiver: and (b) provide that only money damages will be available to partieschallenging the closure of banks, so that equitable relief. such as re-opening the bank, will not bepossible.

P Increase supervisory authority of BSP/PDICEnactment of pertinent legislation to:

(i) Give BSP the power to suspend and remove bank directors, officers and employees that haveviolated banking laws from any further involvement in any bank;

(ii) Increase monetary penalties imposed by BSP and PDIC for banking law violations by afactor of at least 10;

(iii) Add new conditions in Section 30 to provide that banks may be closed if: they declare aholiday; or they remain open but do not pay depositors.

ANNEX 2Page 5 of 5

(iv) Allow bank exams at the discretion of the BSP Governor. Deputy Governor (SES) orManaging Director (SES).

Q Failure resolutionEnactment of legislation that enhances the powers of PDIC to dispose of assets of a bank as soonas it is placed in receivership by the Monetary Board.

R Additional receivership criter-ionEnactment of legislation to place banks under receivership if their capital to risk assets ratio fallsbelow 2 percent.

S Liberalize foreign bank entryEnactment of legislation to allow 100 percent foreign ownership of troubled domestic banks for aperiod of five years.

October 29, 1998

Annex 3Page 1 of 14

TERMS OF REFERENCE FOR THE FINANCIAL ADVISOR FOR PHILIPPINE NATIONAL BANK(DRAFT)

1. INTRODUCTION

The Department of Finance (DOF) of the Republic of the Philippines on behalf of theGovernment of the Philippines invites sealed bids from internationally experienced firmsand companies receiving these Terms of Reference to act as Financial Advisor to theGovernment of the Philippines for the sale of a strategic stake in Philippine NationalBank (PNB) along with management control to a strategic investor (or a group acting assingle strategic investor). The Financial Advisor, especially qualified in the bankingsector, will be responsible for performing all activities leading to the sale of a strategicstake and the transfer of management control to a strategic investor. The activities of theFinancial Advisor will involve a detailed review of the present operations of PNB makingrecommendations on what percentage of shares should form a strategic stake,identification of additional business opportunities, study of the banking sector of thePhilippines, financial valuations, structuring and promotion of the proposed sale,negotiation and execution of the transaction and appropriate post-sale activities. The bidsare required to cover the complete set of activities described under the scope of work ofthese Terms of Reference along with any additional work that the Advisor believes isnecessary to ensure that the overall objectives of the DOF for the sale of a strategic stakein PNB are met. The successful Financial Advisor will also be required to address andclose all legal and commercial issues of the transaction.

While the DOF would like to complete the privatisation process of PNB in an expeditiousmanner it does not intend to compromise on any of its key objectives. The DOF wouldtherefore be paying particular emphasis on the structural, marketing and implementationstrategies and project management approach of the bidders to demonstrate their ability tounderstand the scope of work, scheduling of activities and maximum allocation ofappropriate resources.

During the performance of its work, the Financial Advisor will be expected to interfacewith the various departments of the Government of the Philippines including theDepartment of Finance (DOF), Bangko Sentral ng Pilipinas (BSP), and Department ofJustice (DOJ).

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TERMS OF REFERENCE FOR THE FINANCIAL ADVISOR FOR PHILIPPINE NATIONAL BANK(DRAFT)

2. SELECTION OF THE FINANCIAL ADVISOR

The selection of the Financial Advisor will be based on a transparent and competitivebidding process for which the bidders are required to submit sealed bids in compliancewith these Terms of Reference (date to be confirmed).The selection will be made according to the following procedures:

The bids shall be comprised of two parts: The Technical Element and the FinancialElement. The Technical Element of the proposal shall contain the Firm's Experience(30% of Total), the detailed workplan (20%), proposed team structure (40%) andproposed set of deliverables (10%). Given the importance of the technical aspects of thistransaction and the role that is expected of the Financial Advisors, the Technical Elementshall account for 80% of the total markings. Price will only account for 20% of themarkings. Only those proposals scoring overall 80% points in the Technical Element willbe considered. Out of those firms scoring over this level the lowest priced proposal shallbecome the benchmark against which the rest shall be measured. The lowest price shallbe calculated as a result of adding the total success fee (retainer to be credited towardsthe success fee) plus the total reimbursable expenses.

The selected bidders are required to make a presentation to the DOF at the own expense.Presentation timing is to be confirmed. After the presentations are complete, evaluationswill be performed on the basis of the proposals and presentations.

3. PRIVATISATION OBJECTIVES

As a result of the sale of the Government's stake in PNB, the DOF is seeking the fulfillmentof the following objectives:

* To sell an equity stake and management control of PNB to a strategic investor thatwill bring the needed banking expertise, management, integrity, technology andcapital.

* Value enhancement

* Maximise proceeds from the sale of Government shares in the PNB.

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TERMS OF REFERENCE FOR THE FINANCIAL ADVISOR FOR PHILIPPINE NATIONAL BANK(DRAFT)

* To attract new capital.

* To promote capital formation and banking sector development within the nationaleconomy.

* Improve Governance and public interest

* Improve operational efficiency and overall performance of PNB without additionalresources from the Government of the Philippines.

* To mobilise investment funds both from domestic and foreign markets.

* Long term growth and expansion of the Bank.

* To upgrade staff skill through research and training.

* To upgrade and improve quality of services and infrastructure.

4. SCOPE OF WORK

In order to achieve the objectives of the DOF, the Financial Advisor appointed will takecomplete responsibility for all activities required for a successful sale of a strategic stakein PNB along with transfer of management control to a strategic investor. This section isdesigned to identify some of the activities that the DOF believes need to be mentionedhere and should not in any way be construed as the total activities required under anycontract resulting from these Terms of Reference. The bidders are required to provide aproposal that is not only compliant to the requirements of this section but alsodemonstrates the bidder's understanding of the overall scope of work.

The DOF expects the privatisation process to be an interactive one (i.e. regular interactionbetween the Financial Advisor, PNB and various departments of the Government) toenable efficient implementation of the assignment. The Financial Advisor will beexpected to study the financial markets in the Philippines and that of comparablecountries in order to draw implications of the privatisation of PNB to assist the

Annex 3Page 4 of 14

TERMS OF REFERENCE FOR THE FINANCIAL ADVISOR FOR PHILIPPINE NATIONAL BANK(DRAFT)

Government of the Philippines in better understanding the issues and enabling it to makequick and correct decisions. The Financial Advisor is also expected to interact with theBSP as well as other regulatory bodies in order to design a sale strategy which willcomply with the regulations applicable to PNB as well as other measures, such ascapitalisation and portfolio provisioning programmes, that are to be undertaken by thewinning bidder in order to insure the financial viability of the Bank and the rest of theBanking system of the Philippines.

The Financial Advisor will be required to provide and update the DOF with progressreports as reasonably requested by the DOF. The Financial Advisor will also be requiredto provide details of all assumptions/reasoning/valuations used to arrive at specificrecommendations (all such material should be provided not only in hard copies but oncomputer diskettes on any IBM - PC compatible software). The Financial Advisor will berequired to complete coordination and monitoring of all work related to this assignment.The Financial Advisor should make its bids in compliance with the scope of workprovided below in steps along with any additional requirements that are felt to benecessary in performing the obligations to meet the objectives of the transaction.

4.1 Review of Existing Operations / Due Diligence

4.1.1 General

* Study and evaluate the organisational, managerial and operational structure ofPNB

* Review and update work done to date.

* Review and update financial, fiscal, legal and legislative requirements.

* Assessment and design of a plan for the improvement of the performance andcompliance with regulatory requirements by PNB's domestic andinternational branches and affiliates.

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TERMS OF REFERENCE FOR THE FINANCIAL ADVISOR FOR PHILIPPINE NATIONAL BANK(DRAFT)

The Financial Adviser will commission a long form IAS Audit to aninternationally renowned audit firm. Terms of reference for the Audit will becleared with the World Bank.

4.1.2 Operational and Financial

* Review and assess in detail the books and related documentation andprocedures.

IDOF will arrange through PNB to give full and timely access to allinformation required by the Financial Adviser including but not limited toBSP inspection reports, SGV audits and special studies conducted for theManagement of PNB.

* Identify core and non-core business and its impact on the P & L account.

* Identify product lines and spreads.

4.1.3 Organisational

* Assessment and Recommendations for restructuring the Head Office

* Assessment and Recommendations for restructuring the Branch network

* Evaluate personnel skills

* Recommendations for employee related issues

4.1.4 Business Development

* Identification of new business lines and products.

* Assessment and design of a plan for the improvement of operational andmarketing aspects of PNB's domestic and international network of branchesand affiliates.

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TERMS OF REFERENCE FOR THE FINANCIAL ADVISOR FOR PHILIPPINE NATIONAL BANK(DRAFT)

4.2 Legal Amendments

The Financial Adviser shall advise whether the legal status needs to be changed andaccordingly engage in related work. He will employ a legal advisor for the privatizationprocess.

4.3 Valuation Process

Conduct a detailed evaluation of PNB's operations to assess its value based on historicperformance, future earning potential and goodwill. The valuation process should alsoextend to conduct the following:

4.3.1 Financial Valuation

Conduct a financial valuation of the company using techniques, such as the discountedcash flow technique and earnings multiple.

4.3.2 Assessment of PNB's Portfolio

Evaluate the loan portfolio of the company, quality of the assets,provisioning and recoverables.

4.3.3 Asset Valuation

Provide a valuation of the company based on the market value of its assets.

4.3.4 Assessment of Capital Adequacy

Evaluate the capital adequacy of the company. This should include an examination ofPNB's assets in order to develop a capitalisation program to be undertaken by thewinning bidder. This capitalisation program is to be agreed upon with the BSP Specialattention shall be paid to:

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TERMS OF REFERENCE FOR THE FINANCIAL ADVISOR FOR PHILIPPINE NATIONAL BANK(DRAFT)

* Adequate liquidity requirements

* Adequate capital structure

* Portfolio provisioning levels

4.4 Action Plan

On the basis of the Due Diligence and the Valuation Process the Financial Advisor will drawup an Action Plan. The Action Plan will indicate the different steps to arrive at a successfulprivatization and to be implemented by the Management. The Financial Advisor will workclosely with the DOF in developing and implementing a promotional strategy for the sale ofa strategic stake in PNB as well as conducting the appropriate marketing.

4.5 Preparation of Information / Documentation

This should incorporate a detailed history of PNB including historic financial information.industry study with comparative analysis, regulatory environment, opportunities andcompetitive edge for PNB.

Preparation of complete documentation including information memorandum, legaldocumentation bidding documents. evaluation criteria for bidders, sale agreements, etc.

4.6 Final Sale Process

4.6.1 Pre-qualification criteria for bidders

A detailed pre-qualification criteria will be prepared by the Financial Advisor incoordination with the DOF to develop a short-list of potential investors. Criteriashould include: experience in managing banks of comparable size and willingnessto invest new capital.

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TERMS OF REFERENCE FOR THE FINANCIAL ADVISOR FOR PHILIPPINE NATIONAL BANK(DRAFT)

4.6.2 Competitive Bidding Process

The Financial Advisor will render full assistance to the DOF to evaluate buyerbids leading to the selection of the strategic investor. He will ensure that acompetitive bidding process with the prospective buyers is conducted and that thebest sale price for the strategic stake in PNB is realised.

4.6.3 Sale of a strategic stake of shares

The Financial Advisor will assist the DOF in structuring the sale of strategicshareholding in PNB and timely closure of the transaction and negotiation. Theclosure documentation will include sale and purchase agreements and is toincorporate strategic investor's financial commitments, future business plansalong with any other obligations.

4.6.4 Transfer of Management Control

The Financial Advisor will assist the DOF in implementing the transfer ofmanagement control to the strategic investor along with preparation of thenecessary documentation.

4.7 Post Privatisation Support

The Financial Advisor should identify any possible issues from their experience inother privatisations that may arise once the sale process is complete and themanagement control has been handed over to the strategic investor. The FinancialAdvisor will be expected to assist the DOF for providing any related support postprivatisation of PNB.

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TERMS OF REFERENCE FOR THE FINANCIAL ADVISOR FOR PHILIPPINE NATIONAL BANK(DRAFT)

5. SCHEDULE OF ASSIGNMENT (TIMING)

The DOF would like to achieve the sale of strategic shareholding in PNB with the transfer ofmanagement control to a strategic investor as soon as possible after the date of actual awardof the mandate i.e. signing of the contract.

It is, however, the goal of the DOF to achieve this objective without sacrificing the quality ofwork required for completion of this assignment which is expected from the FinancialAdvisor of repute who will be appointed for this task.

6. PROJECT MANAGEMENT / COORDINATION

In order to meet the schedule. the bidders are required to provide a detailed projectmanagement schedule clearly identifying all the activities and their completion dates alongwith a list of the key people (e.g.. team leaders) involved in those activities. It is expectedthat the Financial Adviser will perform maximum number of activities in parallel, bydeploying several teams, so as to facilitate timely completion of the project.

An important aspect of the project management schedule would be to identify various targetsthat will need to be reviewed with the senior executives of the Government agencies involvedin this transaction.

The Financial Advisor will bid either independently or in a consortium and will becompletely responsible for all legal. accounting, technical, media, marketing and laborrelation matters. Collaboration of reputable local companies should be strongly considered.In addition, the bidder must demonstrate that appropriate expertise has been assigned toaddress media and labor relation issues possibly by engaging local expertise.

7. PROGRESS REVIEW / REPORTING

The Financial Advisor will be required to review its progress according to the projectmanagement schedule / critical time path with the DOF every week as well as prepare areport every two (2) weeks for the DOF summarising progress to-date and outlining thecritical issues. In addition, the Advisor will be expected to co-ordinate and attend meetings

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TERMS OF REFERENCE FOR THE FINANCIAL ADVISOR FOR PHILIPPINE NATIONAL BANK(DRAFT)

with the DOF and all concerned governmental agencies and others as and when required.This procedure is to be adopted to streamline hurdles before actually facing them and forobtaining timely decisions from the respective Government agencies.

8. REMUNERATION

The Financial Advisor will be remunerated on the basis of a combined compensationconsisting of a retainer, which will be paid upon completion of certain tasks which is tobe credited towards the success fee. The success fee will be calculated as a percentage ofthe deemed sale price (the actual proceeds received by the government as a result of thesale).

The Financial Advisor will be reimbursed for the expenses actually incurred. Items to beincluded under the heading of reimbursable expenses are only those directly associatedwith the performance of the services. These expenses are to be capped to a total fixedamount. Reimbursement of expenses will be made on the basis of actuals and without anyadministrative charge.

Breakdown of the out of pocket expense to be submitted (i.e. travel, communications,valuations, legal. technical. etc.). In the event of DOF not proceeding with theprivatisation transaction the Financial Advisor will be entitled to claim only thereimbursement of any expenditure related to the advisory work for the sale of strategicshareholding in PNB actually incurred. The Advisor will be required to submit originalreceipts / vouchers for actual expenses incurred along with any other details which willform the basis for reimbursement.

Payments made to other subcontractors or members of the bidding consortium of FAshall be clearly indicated and shall be considered fees.

In case an additional audit. special legal work or other activities have to be performed thefees should be detailed and separately mentioned.

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TERMS OF REFERENCE FOR THE FINANCIAL ADVISOR FOR PHILIPPINE NATIONAL BANK(DRAFT)

9. EXCLUSION AND PROHIBITION

The Financial Advisor will be prohibited from participation as a underwriter in any publicoffering of PNB shares, and from any involvement on buyers side in any private placement ofPNB's securities. This prohibition shall last for a period of two (2) years after the completionof this assignment.

10. CONFIDENTIALITY PROVISION

The Financial Advisor will be prohibited from divulging the results of any of its findingswithout the authorization of the DOF, except to PNB Executive Management and Board,BSP management involved with regulating PNB, and World Bank staff overseeing theBanking System Reform Loan.

11. SUPPLEMENTARY INFORMATION FOR THE FINANCIAL ADVISOR

Proposal should include the following information:

1. A brief description of the firm and an outline of its experience. (The informationon privatisation projects undertaken by your firm should follow the format givenin Form - A)

II. Any comments or suggestions of the financial advisor on the scope of work, and adescription of the manner in which the financial advisor would plan to execute the work.

III. The composition of the team of personnel which the Financial Advisor would proposeand the tasks which would be assigned to each team member.

IV. Curricula Vitae of the individual members of the Financial Advisor team to be assignedto the work and of the chief management contact in the home office (the curricula vitaeshould follow the format given in Form-B).

V. Estimate of the total time effort that would be provided for the services, supported by barchart diagrams showing the person-months for each member of the consultant team.

Annex 3

Page 12 of 14

TERMS OF REFERENCE FOR THE FINANCIAL ADVISOR FOR PHILIPPINE NATIONAL BANK(DRAFT)

VI. The consultant's comments, if any, on the data, services and facilities to be provided.

12. DELIVERABLES

The bidder will provide details of the deliverables for the project. All documentation will bedelivered in magnetic form (floppy disks) as well as hard copies.

Annex 3Page 13 of 14

TERMS OF REFERENCE FOR THE FINANCIAL ADVISOR FOR PHILIPPINE NATIONAL BANK(DRAFT)

FORM-A

FORMAT FOR INFORMATION ON PRIVATIZATION PROJECTSUNDERTAKEN BY YOUR FIRM DURING THE LAST FIVE YEARS

The following information should be provided for each reference project in the format indicatedbelow:

Firm's Name:

Project Name:

Country:

Professional Staff provided:

a) No. of staff and

b) No. of person-months:

Project details:

a) Name of Client:

b) Start and Completion Dates (month/year):

c) Approximate Value of Services:

d) Name of Associated Firm, if any:

e) No. of person-months of professional staff provided by associated firm:

f) Senior Staff involved and functions involved:

Narrative Description of Project and Services Provided:

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TERMS OF REFERENCE FOR THE FINANCIAL ADVISOR FOR PHILIPPINE NATIONAL BANK(DRAFT)

Name, Designation, Address including Telex or Fax number of responsible Client's staff towhom reference may be made:

FORM-B

FORMAT FOR CURRICULUM VITAE

Name Profession Yearswith firm Nationality Proposedposition on Team

Key Qualifications: (Under this heading, give outline of staff members' experience and trainingmost pertinent to assigned work on proposed team. Describe degree of responsibility held bystaff member on relevant previous assignments and give dates and location. Use up to half page).

Education: (Under this heading, summarise college/university and other specialised educationof staff member, giving names of schools, dates attended and degree obtained. Use up to quarterpage).

Experience: (Under this heading, list all positions held by staff since graduation, giving dates,names of employing organisation, title of positions held and location of assignments).

Language: (Indicate proficiency in speaking, reading and writing of each language by"excellent", "good", "fair", or "poor").

Signature of Staff Member Date

ANNEX 4Page 1 of 2

RECENT MEASURES TAKEN OR ANNOUNCED TO STRENGTHEN THEBANKING SYSTEM

1. All banks are required to raise their minimum capitalization in a three-stepprocess ending on December 31, 2000. The decision regarding the first stage wasannounced on October 1, 1997, while the decision regarding the latter two stages wasannounced in March 1998.

Minimum CapitalizationStage 1 2 3

Date on which effective Dec. 24, 1998 Dec. 31, 1999 Dec. 31, 2000

Million Pesos Further increase by Additional increase by

Universal Banks 4,500 10% 10%Commercial Banks 2,000 20% 20%Thrifts

Metro Manila 250 30% 30%Others 40 30% 30%

Rural banks 2-5 30% 30%

2. A general loan loss provision was introduced on October 1, 1997. This requiredbanks to provision for 1% by October 1, 1998; 1.5% by April 1, 1999 and 2% by October1, 2000. In March 1998, the loan loss provision of 2% was accelerated by one year andbrought forward to October 1, 1999.

3. Specific loan loss provisions were also announced in March 1998. Theprovisioning requirement will be on a staggered basis as follows:

Specific Loan Loss ProvisionsDate on which effective Dec. 31, 1998 April 15, 1999

Especially mentioned loans 2.5% 5%

Substandard loans 12.5% 25%(Collateralized)

4. New statutory reserve and liquidity reserve requirements became effective onMarch 31, 1998. For commercial banks the statutory reserves requirements were broughtdown from 13% to 10 % while the liquidity requirements were raised from 4% to 7%.Effective from May 29, 1998, commercial bank reserve requirements were furtherlowered to 8%, and the interest earning portion of bank reserves was raised from 25% to40%.

ANNEX 4Page 2 of 2

5. A Circular on "Basic Guidelines in Establishing Banks" dated July 13, 1998specified: minimum capital requirements consistent with the targeted levels as of end-2000; that a minimum of 25% of the total authorized capital stock be subscribed by thesubscribers of the proposed bank, and at least 25% of such subscription be paid-up; limitson cross-holdings with other corporations; stricter qualifications for directors and officersof the bank; and stricter requirements for the issuance of authority to operate.

6. A Circular (157) was issued in March 1998, to take effect as of December 1998,requiring all banks listed in the Philippine Stock Exchange to disclose the followinginformation on a quarterly basis:

* Amount of nonperforming loans and ratio to total loan portfolio* Amount of classified loans and other risk assets* General loan-loss reserve* Specific loan-loss reserve

A separate Circular (161) issued in March 1998, to take effect from September 1998,provides regulation specifying mark-to-market rules for trading and equity portfolios.

7. In April 1998, the Monetary Board decided to adopt the principle of consolidatedsupervision of banks and quasi-banks including their subsidiaries and affiliates engagedin allied activities, within the context of existing banking laws.

8. In July 1997, the BSP introduced stricter limits on banks' net open foreignexchange positions. Specifically, the limit on banks' overbought foreign exchangeposition was reduced from 20 percent to 5 percent while the oversold limit was raisedfrom 10 percent to 20 percent. From October 8, 1997 only forward contracts which aredelivered are allowed in computing banks' foreign exchange position.

9. In June 1997, the objective of improving the maturity profile of banks' foreigncurrency asset structure was announced: since December 1997, banks have had tomaintain a 15 percent foreign exchange liquid asset requirement on their FCDU holdings;this ratio was raised to 30 percent in June 1998.

10. In April 1997, the BSP adopted two measures to tighten regulations on real estatelending by banks: it lowered the ceiling on an individual bank's exposure to real estatefrom 30 to 20 percent of loan portfolio, giving banks one year to comply; and it loweredthe permissible ceiling on the loan-to-value ratio for real estate lending from 70 to 60percent of the market value of the property.

11. In April 1998, the Monetary Board adopted the principle of consolidatedsupervision of banks and quasi-banks including their subsidiaries and affiliates engagedin allied activities.

ANNEX 5page I of 6

Table 1: Selected Economic Indicators, 1993-99

1993 1994 1"5 1 199 1997 191b 1999/b

(percentage change)Growth and Inflation

Real GNP 2.1 5.3 55 6.9 5.3 0.1 3.5Real GDP 2.1 4.4 4.8 5 7 5.2 -0.6 3.2CPI (period average) 7.6 9.0 8.1 8.4 6.0 10.0 8.0CPI(endperiod) 8.4 7.1 10.9 5.2 7.3 10.8 6.1

Unemployment Rate (percent) 9.3 9.5 9 5 8.6 8.7

(in percent of GNP)Saving and Investment

National Saving 18.1 17.6 17.3 18.8 20.2 20.1 20.6Private 13 7 14.5 14.2 14 9 18.2 19.0 18.5Public 4.4 3.1 3.1 3.8 2.0 1.1 2.1

GrossInvestment 23.6 23.5 21.6 23.3 25.2 21.6 21.3Private 17.9 18.7 17.0 189 21.8 17.6 17.2Public 5 7 4.8 4.6 4.4 3.4 4.0 4.1

Public SectorNational Govemment

TaxRevenue 15.3 15.6 15.8 16.1 16.1 15.1 15.9Investment 2.5 1.9 2.7 2.5 3 1 2.3 2.2Balance /c -1.5 0.9 0.6 0.3 -0.1 -1.7 -1.0

Consolidated Public Sector Balance -2.2 -2.3 -1.4 -0.6 -1.4 -2.9 -2.0

Public Debt 127.4 1094 110.8 95.0 79.4 83.9National Govemment Debt 84 6 70 9 66.7 59.6 55.1 61.2 64.4

(end-year percentage change)Money and Credit

M3 246 265 25.3 15.8 20.9 17.0 170Credit to Private Sector 376 28.2 43.5 51.0 28.7 13.4 10.0Commercial Bank Loans 32.2 25 4 35.8 51.9 26 5

Balance of Payments(end-year percentage change: $ value)

Merchandise Exports 15.8 18.5 29.4 17,7 22.8 13.2 14.8Merchandise Imports 21.2 21.2 23.7 20.8 14.0 -7 7 8.8

(in percent of GNP)

TradeDeficit 112 11.9 11.7 13.0 129 7.3 5.1Current Account -5.5 -4.5 -4.3 -4.5 -5 0 -1.5 -0.7

International ReservesGross Official Reserves($billion)Id 5.9 7.1 7.8 11.7 8.8 10.5 12.5

(inmonthsofimports) 3.1 3.1 2.6 3.1 2.0 26 2.8

External Debt /eTotal ($ billion) 34 3 37.1 37.8 41.9 45.4In percent of GNP 62.0 56.4 49.6 48.1 52.2DebtServiceRatio(percent)/f 23.5 20.2 15.8 12.2 11 5 11.6 12.9

Exchange Rate (Pesos/$, period average) 27.1 26.4 25.7 26.2 29.5RealEffectiveExchangeRate(1990=100)fg 110.4 117.3 120.3 129.8 128.7

Sources: GOP: IMF. WB staff estimates.

a. Estimate.b. IMF program.c. Excluding central bank restructuring.d. Including gold.e. Extemal debt reported by BSPf. Before rescheduling. as a percentage of exports of goods and services.g. Increase indicates appreciation.

ANNEX 5

page 2 of 6

Table 2: Balance of Payments, 1992-98(in millions of US$)

1992 1993 1994 1995 1996 1997 1998Projected

Trade balance -4,695 -6,222 -7,850 -8,944 -11,342 -11,127 -4,985

(%ofGNP) (8.7) (11.2) (11.9) (11.7) (13.0) (12.9) (7.3)

Exports (fob) 9,824 11,375 13,483 17,447 20,543 25,228 29,678

Imports (fob) 14,519 17,597 21,333 26,391 31,885 36,355 37,500

Services (net) 3,020 2,507 3,964 4,765 6,839 5,744 5,296

Receipts 7,443 7,497 10,550 14,374 19,006 22,835 23,689

o/w Remittances/Private transfers 3,485 3,956 5,824 8,696 10,169 11,748 11,596

Payments 4,423 4,990 6,586 9,609 12,167 17,091 18,393

o/w Interest 1,703 1,513 1,579 2,179 2,167 2,519 3,185

Transfers (net) 817 699 936 882 589 1,080 335

Current Account Balance -858 -3,016 -2,950 -3,297 -3,914 -4,303 -2,191

(% of GNP) (1.6) (5.5) (4.5) (4.3) (4.5) (5.0) (3.1)

Foreign investment (net) 737 812 1,558 1,609 1,168 766 -14

Direct Invesment 675 864 1,289 1,361 1,338 1,117 1,088

Portfolio Investment 62 -52 269 248 -170 -351 -1,102

MLT borrowing (net) 666 2,105 1,313 1,276 2,690 4,688 2,794

Inflows 7,436 4,853 4,369 3,927 6,329 7,427 5,598

Outflows 6,770 2,748 3,056 2,651 3,639 2,739 2,804

Short-term Capital (net) 660 -148 1,002 -56 540 495 570

Change in Commercial Banks' NFA 459 -547 465 1,309 4,211 1,191 750

( - indicates increase)

Errors and Omissions -360 84 160 -291 -683 -5,524 -981

Others /a 188 544 254 81 -5

Changes in net reserves /b -1,492 166 -1,802 -631 -4,107 3,363 -928

( - indicates increase)

Source: BSP and IMF.

a. Includes monetization of gold, revaluation adjustments and $469 million purchase of collateral in 1992.

b. Includes net credit of IMF.

ANNEX 5

page 3 of 6Table 3: Selected Interest Rates (%)

BSPBSP O/N Interbank 1-month PHIBOR 91-day Prime

RRP O/N RRP 1-month T-bill Lending(average) (average) (average) (average) (average) (average)

Apr-97 10.0 10.1 10.1 9.7 10.1

May-97 14.8 14.8 10.6 11.2 10.9

Jun-97 14.4 14.4 10.6 11.5 10.6

Jul-97 26.0 25.8 15.6 21.4 13.0 24.3

Aug-97 16.0 16.2 13.0 18.8 14.3 22.6

Sep-97 12.0 15.8 14.5 18.1 16.0 22.2

Oct-97 12.1 34.2 15.5 26.0 17.7 25.4

Nov-97 12.0 16.0 15.5 23.4 15.9 24.1

Dec-97 11.4 12.4 15.3 25.9 17.7 23.4

Jan-98 12.2 13.5 16.9 24.1 19.1 24.5

Feb-98 13.2 13.5 16.6 21.1 17.8 23.9

Mar-98 13.0 13.2 16.5 18.7 16.4 20.5

Apr-98 13.0 13.2 15.0 17.8 15.1 17.8

May-98 13.4 13.6 15.1 17.2 14.4 17.0

Jun-98 13.1 13.3 14.8 16.4 14.2 16.6

Jul-98 13.1 13.2 14.7 15.5 14.5 17.2

Aug-98 15.9 16.1 14.6 16.8 14.1 16.7

Sep-98 16.0 16.1 14.6 16.4 13.8 16.3

Oct-98 14.1 14.2 14.5 14.8 13.6 16.3

Source: BSP and Bloomberg

ANNEX 5

page 4 of 6

Table 4: Philippines: External Debt, 1992-1997(in millions of US $)

March1992 1993 1994 1995 1996 1997 1998

External Debt

Shortterm 5,256 5.035 5,197 5.279 7,207 8.439 8.853o/w Commercial banks 1,422 383 1.156 1,800 3,273 3,658 3.529

Medium and longterm 25,650 29.188 32,387 33,274 34.263 36.105 35,981o/w Commercial banks 950 1.627 2.133 2.440 3,944 4,507 4.282

Total 32,089 35.535 38,723 39,367 41,875 45,416 45,662o/w Commercial banks 2,372 2.010 3.289 4.240 7.217 8,165 7,811

Monitored External Liabilities 1/

Short term . . .. 1521 11,853

o/w Commercial banks 6,740 6,529Medium and long term .. .. .. .. 38,321 38,481

o/w Commercial banks .. .. .. .. 5,803 5,482Total .. .. .. .. .. 50,714 51,162

o/w Commercial banks .. .. .. 12,543 12,011

Source: IMF

1. Monitored external liabilities are defined as external debt plus liabilities of foreign banks in the Philippinesto their headquarters, branches and agencies, some external debt not registered with the central bank,and private capital lease agreements.

ANNEX 5Page 5 of 6

Table 5: THE PHILIPPINE BANKING SYSTEMFINANCIAL INDICATORS

AS OF PERIODS INDICATEDOn Billion Pesos)

YEARS - ENDED Match1991 1 1992 113 1994 119 199 1 7 1998

iaources - 681.370 798.555 1,001.540 1 1,255.017 1,606.644 1 2,119.690 12,769.936 2,687.820Commercial Banks -' i 618.838 720.772 905.391 | 1,123.387i 1,429.711 1,888.34S j 2,509.133 2,428.501Thrift Banks 47.044 59.619 1 73.992 i 103.978 1 140.881 1 183.986 1 203.966 202.482

Rural Banks 15.488 18.164 22.157 27.652 36.052 47.359 56.o37 56.U37 a

loam (Net) | 332.281 400.606 552.695 707.446 963.682 1,356.166 I 1,713.634 1,653.355Commercial Banks i 293.901 354.355 493.220 625.184 852.628 1,206.614 1 1,538.371 1,484.681Thrift Banks 28.083 34.057 44.441 63.667 86.780 118.829 | 135.257 128.468

Rural Banks 10.297 12.194 15.034 18.5971 24.274 32.723 40.006 40.006 2t

Depos;bt1 425.324 503.102 1 649.254 807.124 1 1,016.647 1,293.331 1 1,674.365 1,626.915Commercial Banks 383.175 452.510 1 585.688 726.202 1 904.157 j 1,140.606 i1,502.221 | 1,460.219Thrift Banks 33.658 j 40.129 1 50.230 63.475 91.240 I 122.501 135.529 130.081Rural Banks 8.491 10.463 13.336 17.447 23.250 30.224 ! 36.615 36.6t52

Capital Accounts - 91.651 114.239 1 134.159 j 170.701 226.110 287.496 363.379 I 372.384

Commercial Banks ' 83.599 104.078 1 121.729 152.038 201.147 253.710 320.670 329.082Thrift Banks 5.378 j 6.952 i 8.537 14.087 1 19.352 26A96% 34.065 34.658

Rural Banks 2.674 3.209 1 3.a93 4.576 1 5.611 7.290 i 8.644 5 8.644 2

Net Income Before Tax 19.16S 19.820 19.810 25.524 33.322 45.173 46.023 13.762Commercial Banks i17.630 17.864 i 17.590 | 22.610 i 29.393 40.729 41.993 13.044 3t

Thrift Banks 1.205 1.583 ! 1.703 2.306 1 3.002 3.205 1 2.875 0.359 3

Rural Banks I 0.330 0.381 1 0.517 0.608 1 0.927 1.2391 1.155 0.359 4

Ratio of Capital to Reoources (%) -' 13.45 14.31 1 13.40 13.60 14.07 13.561 13.12 13.a5Commercial Banks ' 13.51 14.44 13.44 13.53 14.07 13.44 12.78 13.55Thrift Banks 11.43 11.66 11.54 | 13.55 1 13.74 14.40 j 16.70 17.12Rural Banks 17.26 i 17.67 17.57 16.55 15.56 15.39 1 15.21 15.21 2t

Ratio of Pas Due oan to I ILoan Portfolio 7.38 6.84 1 5.28 4.71 4.01 i 3.51 1 5.41 8.28

Commercial Banks 6.70 6.13 4.73 3.93 3.23 2.80 4.69 7.58Thrift Banks 7.61 7.93 6.02 1 8.36 8.16 7.74 ' 10.63 14.09

Rural Banks 26.33 24.43 21.33 18.17 16.07 14.14 15.37 15.37 zt

Share to total reowrces by industry:i 26.33Commercial Banks -' ! 90.82 90.26 90.40 89.51 88.99 89.09 1 90.59 90.35Thrift Banks 6.91 7,471 7.39 8.29 8.77 8.68 j 7.36 7.53Rural Banks 2.27 2.27 2.21 2.20 2.24 2.23 | 2.05 2.12

Totl! 100.00 100.00 100.00 100.00 100.00 100.00 100.00 100.00

Preliminary

Net of Due fromtto H. O./Branches/Other Agencies account of forei8n banks

For the 9 Month Period Ended September30, 1997

t As of December 31, 1997

For the Quarter-nderd March 30, 1998

For the Quarter-Ended September 30, 1997NOT£ Data for Commercial Banks includes Specialized covernment BanksSource: Supervisory Reports and Studies Office(SRSO), Bangko Sentral ng Pilipinas

ANNEX 5

page 6 of 6

Table 6. Nonperforming Loans in the Banking System

Total Loan Portfolio Nonperforming Loans (NPLs) Ratio of NPLs to Total Loans(in billion pesos) (in billion pesos) (in billion pesos)

Commercial Thrift Rural Total Commercial Thrift Rural Total Commercial Thrift Rural Totalbanks banks banks banks banks banks banks banks banks

1996

December 1221.8 122.1 33.4 1377.3 34.2 9.5 4.7 48.4 2.8 7.7 14.1 3.5

1997

March 1284.6 132.6 34.3 1451.5 42.3 9.9 5.1 57.3 3.3 7.4 14.9 3.9June 1419 145.8 36.9 1601.6 47.9 11.3 5.4 64.5 3.4 7.7 14.6 4.0September 1498.9 148 39.4 1686.3 59.4 14.9 5.9 80.2 4.0 10.1 15.0 4.8December 1573.2 139.6 40.8 1753.6 73.7 14.8 6.3 94.9 4.7 10.6 15.4 5.4

1998

March 1524.2 133.3 ... 1698.3 115.6 18.8 ... 140.6 7.6 14.1 ... 8.3June 1595.4 135.7 ... 1771.9 142.7 22.7 ... 171.7 8.9 16.7 ... 9.7

Source: Bangko Sentral ng Philipinas; and IMF

ANNEX 7Page 1 of 2

Philippines at a glance 9/15/98

East Lower-POVERTY and SOCIAL Asia & middle-

Philippines Pacific income Development diamond1997Population, mid-year (millions) 73 4 1.753 2,285 Life expectancyGNP per capita (Atlas method, US$) 1,220 970 1,230GNP (Atlas method, US$ billions) 89 6 1.707 2,818

Average annual growth, 199t-97

Population (%) 2 3 1 3 1 2Labor force () 2 7 1 4 1 3 GNP Gross

per primaryMost recent estimate (latest year available, 1991-97) capita < enrollment

Poverty (% of population below national poverty line) 54Urban population (% of total population) 56 32 42Life expectancy at birth (years) 66 69 69Infant mortality (per 1, 000 lve births) 36 38 36Child malnutrition I% of children under 5) 30 16 - Access to safe waterAccess to safe water (% of population) 85 84 84Illiteracy (% of population age 15+) 5 17 19Gross primary enrollment (% of school-age populabon) 116 115 il1 Philippines

Male 118 116 Lower-middle-income groupFemale .. 116 113

KEY ECONOMIC RATIOS and LONG-TERM TRENDS

1976 1986 1996 1997Economic ratios'

GDP (US$ billions) 17.2 298 82 8 82.2Gross domestic investmenVGDP 32 9 16 0 24 0 24 8Exports of goods and services/GDP 193 26 3 40.5 49.0 TradeGross domestic savings/GDP 269 199 15.2 145Gross national savings/GDP 27.7 19.3 193 18.8

Current account balancelGDP -6.4 3 2 -4 8 -5 2 I A \Interest payments/GDP 1 0 3 8 21 2.3 DomestcvTotal debtUGDP 351 94 5 49 7 . SavingsTotal debt service/exports 16 9 33 7 14.4Present value of debt/GDP .Present value of debVexports

Indebtedness1976-86 1987-97 1996 1997 1998-02

(average annual growth)GDP 1.8 3.2 5.7 5.3 . PhilippnesGNP per capita -0 8 1.4 4.5 3.3 Lower-middle-income groupExports of goods and services 6.0 9.5 154 175 ..

STRUCTURE of the ECONOMY1976 1986 1996 1997 Growth rates of output and Investment (%)

(% of GDP) 2Agriculture 293 23.9 20 6 18.7 0Industry 35 7 34 6 321 32 2

Manufacturmng 25.4 24 6 22.8 22 3 v

Services 35 1 41.5 47.3 49.2 .2 / 92 93 94 95 99 97.20

Private consumption 62.3 72.1 728 72.5 .30

General government consumption 10.8 8.0 11.9 130Imports of goods and services 25.2 22.4 49 3 59.4 GOi -GDP

(average annual growth) 1976-86 1987-97 1996 1997 Growth rates of exports and imports (%)(average annual growth)Agriculture 1.4 1 8 3 0 3.7 25

Industry 0.7 3 1 6.3 6.0 20Manufacturing 0 5 3.0 5.6 4 2 IS

Services 3.2 3.9 6.5 5.4 is

Private consumption 2.4 3.7 5.3 3.7 General govemment consumption -0.3 3.9 5 2 0.6 °Gross domestic investment -32 63 15.6 9.2 -5 92 93 94 95 9i 97

Imports of goods and services 2.1 113 16.7 14.4 -Exorts 0-importsGross national product 1 5 3.8 6.9 5.5

Note. 1997 data are preliminary estimates.

The diamonds show four key indicators in the country (in bold) compared with its income-group average. If data are missing, the diamond willbe incomplete.

ANNEX 7Page 2 of 2

Philippines

PRICES and GOVERNMENT FINANCE

Domestic prices 1976 1986 1996 1997 Inflation (%)

(% change) 20

Consumer prices 9.2 0.8 8.4 5.1 15

Implicit GDP deflator B.3 3.0 7 8 6.0 10

Govemment finance 5(% of GDP. includes current grants) cCurrent revenue 13.0 18 9 92 93 94 95 96 97

Current budget balance 1.4 -GDP denator a+CPIOverall surplus/deficit . -5.0 0 3

TRADE

(US$ millions) 1976 1986 1996 1997 Export and import levels (USS millions)

Total exports (fob) 4,842 20,543 25,228 40.000

Coconutoil 333 571 673 35000

Sugar . 103 136 83 30.000

Manufactures . 2,672 17,106 21,488 25.000

Total imports (cif) 5,044 31,885 36.355 20.00.

Food .. 193 1,578 1,435 15000Food 193 i~~~~~~~~~~~~~~~~~~~~~~000iFuel and energy . 869 3,008 3,074 59000

Capital goods . 839 10,472 14,369 0Export price index (1995=100) . 76 100 -Import price index (1995=100) . 61 101 . Exports ImportsTerms of trade (1995=100) . 124 99

BALANCE of PAYMENTS

(US$ mi//ions) 1976 1986 1996 1997 Current account balance to GDP ratio (%)

Exports of goods and services 3,262 7,702 27,627 34,359 0Imports of goods and services 4,381 5,868 41,371 50.477 91 92 93 94 9S 96 97

Resource balance -1,119 1,834 -13.744 -16,118-2

Net income -253 -1,321 9,202 10,735Netcurrenttransfers 268 441 589 1,080 3

Current account balance -1.105 954 -3,953 -4,303 4

Financing items (net) 1,051 184 8,060 7,666 -5

Changes in net reserves 54 -1,138 -4,107 -3,363 -6

Memo:Reserves including gold (US$ millions) . 11,745 8,768Conversion rate (DEC, localVUSS) 7.4 204 26.2 2985

EXTERNAL DEBT and RESOURCE FLOWS1976 1986 1996 1997

(US$ millions)Total debt outstanding and disbursed 6,039 28,204 41,214

IBRD 316 3,017 4,666 4,194IDA 27 92 193 195 Compositignoftotalde-FA6 JV9$ milions)

Total debt service 571 2.961 5,778 .t 7 96t9 c: I405

IBRD 35 406 766 636IDA 0 1 3 3 D 3,079

Composition of net resource flowsOfficial grants 61 401 246Official creditors 212 198 -310Private creditors 883 294 1,859 . F. 12,817 E12095

Foreign direct investment 132 127 1,408Portfolio equity 0 0 1.333

Worid Bank programCommitments 226 151 528 60 A - IBRD E -BlateralDisbursements 102 197 457 305 8 - IDA D - Other multilateral F - Private

Principal repayments 14 170 426 336 C - IMF G- Short-term

Net flows 88 27 31 -31Interest payments 20 238 343 303Nettransfers 68 -210 -312 -335

Development Economics 9/15/98