rising to the challenge in asia: a study of financial markets · rising to the challenge in asia: a...

Rising to the Challenge in Asia:A Study of Financial Markets

Asian Development Bank1999

Volume 10

Philippines

Asian Development Bank

P.O. Box 789

0980 Manila, Philippines

The views and opinions expressed in this publication are those of the individual authors

and do not necessarily represent the views of the Asian Development Bank.

Published by the Asian Development Bank

All rights reserved

Publication Stock No. 060799

ISBN 971-561-237-7

Foreword

The Asian currency and financial crisis has had far-reaching effects on the regional economies and theirtrading partners. These effects have threatened to wash away the region’s significant social and economicadvancement achieved during the preceding years of rapid growth. The crisis has also unveiled many intri-cate problems and challenges in macroeconomic management, banking and capital markets management,institutional capacity, and governance of the financial systems in the region.

Recognizing the urgency of addressing these problems and challenges, the Economics and DevelopmentResource Center of the Asian Development Bank (ADB) undertook a regional study of financial markets innine developing member countries: People’s Republic of China, India, Indonesia, Republic of Korea, Malay-sia, Pakistan, Philippines, Thailand, and Viet Nam. The objectives of the study were to analyze and deepenour understanding of the sources of the crisis in the currency and financial markets, to provide a useful basisfor designing and implementing preventive measures and refocused country strategies, and to help ADB andits member countries build robust and sustainable financial systems in the region.

The study was designed, supervised, and coordinated by S. Ghon Rhee, Resident Scholar, 1997–1999.A large number of ADB staff and renowned scholars and experts contributed to this study.

Regional policy issues and recommendations based on the findings of the study were discussed at theHigh-Level Workshop on the Asian Financial Crisis in Tokyo, on 25–26 March 1999. The workshop washosted by the ADB, the ADB Institute, and the Institute of Fiscal and Monetary Policy of the Ministry ofFinance of Japan.

The present series of publications seeks to bring the research findings to a much wider audience and hopesto contribute to a better understanding of the Asian financial crisis and how its recurrence can be preventedin the future.

Jungsoo LeeChief Economist

Preface

Rising to the Challenge in Asia: A Study of Financial Markets presents the findings of a study carried outunder Regional Technical Assistance 5770: Study of Financial Markets in Selected Member Coun-tries. Many Asian Development Bank staff members and outside experts contributed to the study’s success-ful completion.

The core members for the study were Ramesh Adhikari, David Edwards, Tobias Hoschka, Sudipto Mundle,Soo-Nam Oh, Pradumna Rana, Yutaka Shimomoto, Reza Siregar, Peggy Speck, Ramesh Subramaniam, andVo Van Cuong. The outside experts were Stephen Cheung (Hong Kong, China), Yoon Je Cho (Republic ofKorea), Jang-Bong Choi (Republic of Korea), Catherine Chou (Hong Kong, China), G.H. Deolalkar (India),Maria Socorro Gochoco-Bautista (Philippines), Akiyoshi Horiuchi (Japan), Masahiro Kawai (Japan),Mohammad Zubair Khan (Pakistan), Joseph Y. Lim (Philippines), Sang-Koo Nam (Republic of Korea),Anwar Nasution (Indonesia), Edward Ng (Singapore), Jaeha Park (Republic of Korea), Mohd. Haflah Piei(Malaysia), Ken-Ichi Takayasu (Japan), Khee Giap Tan (Singapore), S. K. Tsang (Hong Kong, China),Stephen Wells (United Kingdom), Richard Werner (Germany), Min-Teh Yu (Taipei,China), and BarentsGroup LLC (KPMG).

Thirty-seven reports are contained in a series of 12 volumes:

Volume 1: Regional Overview• Macroeconomic Policy Issues• Banking Policy Issues• Capital Market Policy Issues

Volume 2: Special Issues• Asset Management Entities• Deposit Protection Schemes

The volumes benefited extensively from constructive comments from the Bank interdepartmental workinggroup, and the ministries of finance, central banks, and securities and exchange commissions of the ninemember countries that participated in the regional technical assistance study program and in the High-LevelWorkshop on the Asian Financial Crisis in Tokyo, on 25–26 March 1999. Mitsuo Sato, former President ofthe Asian Development Bank; Bong-Suh Lee, former Vice-President (Region West); and Peter Sullivan,Vice-President (Region East) provided strong support and guidance throughout this project.

Soo-Nam Oh coordinated the research and publication activities. Wilhelmina Paz, Lagrimas Cuevas,Anthony Ygrubay, Ruben Mercado, Virginia Pineda, and Rosalie Postadan provided administrative andtechnical support. The volumes were edited by Gloria Argosino, Mary Ann Asico, Graham Dwyer, andMuriel Ordoñez. Typesetting, computer graphics, and conceptualization of the cover design were done bySegundo de la Cruz, Jr.

S. Ghon RheeK. J. Luke Chair of International Finance and BankingUniversity of HawaiiResident Scholar of the Asian Development Bank(June 1997–June 1999)

Volume 3: Sound Practices• Corporate Governance (Hong Kong, China)• Currency Board (Hong Kong, China)• Central Provident Fund (Singapore)• Dichotomized Financial System (Singapore)• Banking Sector (Taipei,China)

Volumes 4–12: Country Studies• Macroeconomic Policy Issues• Banking Policy Issues• Capital Market Policy Issues

THE CAPITAL MARKET IN THE SOCIALIST REPUBLIC OF VIET NAM v

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Contents

Foreword iii

Preface v

Acronyms and Abbreviations viii

Recent Issues in the Management of Macroeconomic Policiesin the Philippines 1

Anwar Nasution

INTRODUCTION 2

ECONOMIC GROWTH, STRUCTURAL CHANGES, EMPLOYMENT, AND INFLATION 3

Aggregate Demand and Sectoral Growth Rates 3

Sectoral Employment 5

Inflation Rates 6

DOMESTIC SAVINGS AND THE FINANCIAL SECTOR 7

Domestic Savings 7

Financial Sector Developments 8

MONETARY POLICY 12

External Reserves and Sterilization Operations 12

Exchange Rate Policy 14

Policy to Reduce Interest Rates 16

Lending Boom and Credit Policy 17

FISCAL POLICY 17

Government Revenues 18

Expenditures 18

EXTERNAL TRADE AND THE BALANCE OF PAYMENTS 19

External Trade 19

Worker Remittances 22

Capital Flows 22

External Debt 24

CONCLUSION 24

NOTES 26

REFERENCES 27

vi A STUDY OF FINANCIAL MARKETS

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The Past Performance of the Philippine Banking Sector andChallenges in the Postcrisis Period 29

Ma. Socorro Gochoco-Bautista

EXECUTIVE SUMMARY 30

INTRODUCTION 34

Structure of the Philippine Financial System 34

History of Reforms 35

THE ASIAN CRISIS AND THE STATE OF THE PHILIPPINE BANKING SYSTEM 41

Major Measures Taken to Strengthen the Banking System 51

Remaining Weaknesses and Vulnerability 55

RECOMMENDATIONS 68

Strengthen Banks to Meet the Increasing Requirements of Globalization 68

Strengthen Prudential Regulation and Supervision 69

Raise the Degree of Competition and Efficiency in the Banking Industry 70

Improve the Financial Infrastructure 70

Improve the Legal System 70

SUMMARY AND CONCLUSION 71

NOTES 74

REFERENCES 77

Solid Crust with Soft Center: A Problem of Enforcement in thePhilippine Capital Market 79

Stephen Wells

OVERVIEW 80

POLICY ISSUES 81

Equity Market 81

Bond Market 90

Investors 93

POLICY RECOMMENDATIONS 97

Equity Market 97

Bond Market 100

Investors 103

NOTES 105

THE CAPITAL MARKET IN THE SOCIALIST REPUBLIC OF VIET NAM vii

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Acronyms and Abbreviations

ABS asset-based securities

ADB Asian Development Bank

AGRI/AGRA agriculture/agrarian reform

ATM automated teller machine

BAP Bankers’ Association of the Philippines

BIS Bank for International Settlements

BOT build-operate-transfer

BSP Bangko Sentral ng Pilipinas

BTr Bureau of the Treasury

CAMEL capital adequacy, asset quality, management, earnings, and liquidity

CAMELS capital adequacy, asset quality, management, earnings, liquidity, and systems

CBCI central bank certificate of indebtedness

CBP Central Bank of the Philippines

CGT capital gains tax

CIBI Credit Information Bureau, Inc.

CP commercial paper

CRPP Currency Risk Protection Program

CTF common trust fund

DBP Development Bank of the Philippines

DOSRI directors, officers, stockholders, and related interests

DVP delivery vs payment

EDF exporters dollar facility

EKB expanded commercial bank

EMEAP Executive Meeting of East Asia and Pacific

FCDU foreign currency deposit unit

FDIC Federal Deposit Insurance Corporation

FRN floating-rate note

FSA Financial Supervision Authority (UK)

GDP gross domestic product

GNP gross national product

GSIS Government Service Insurance System

HDMF Home Development Mutual Fund

HIGC Home Insurance Guaranty Corporation

IFS International Financial Statistics

IMF International Monetary Fund

IPO initial public offering

KB domestic commercial bank

LDR loan/deposit ratio

LIBID London interbank daily rate

viii A STUDY OF FINANCIAL MARKETS

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MBS mortgage-based securities

NBFI nonbank financial intermediary/institution

NDF nondeliverable forward (facility)

NGO nongovernment organization

NOW negotiable order of withdrawal

NPC National Power Corporation

NPL nonperforming loan

NYSE New York Stock Exchange

OTC over-the-counter

PCA prompt corrective action

PCD Philippine Central Depository, Inc.

PCIB Philippine Commercial and Industrial Bank

(now Philippine Commercial and International Bank)

PDIC Philippine Deposit Insurance Company

PDS Philippine Dealing System

PNB Philippine National Bank

PRC People’s Republic of China

PSE Philippine Stock Exchange

RER real effective exchange rate

ROA return on assets

ROE return on equity

ROPOA real and other property owned and acquired assets

ROSS Registry of Scripless Securities

SCCP Securities Clearing Corporation of the Philippines

SEC Securities and Exchange Commission

SME small and medium-size enterprise

SRO self-regulatory organization

SRSO Supervisory Reports and Studies Office, Bangko Sentral ng Pilipinas

SSS Social Security System

STMY-GS short-term market yielding Government securities

UHLP Unified Home Lending Program

UK United Kingdom

US United States of America

VAT value-added tax

Recent Issues in theManagement of Macroeconomic

Policies in the Philippines

Anwar Nasution

Anwar Nasution is Senior Deputy Governor of Bank Indonesia; Dean, Facultyof Economics; and Professor of Economics, University of Indonesia.

2 A STUDY OF FINANCIAL MARKETS

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Introduction

The Philippines has managed to avoid the severe

fallout from the regional financial crisis partly be-

cause it has barely recovered from the past spend-

ing and investment binge and banking crisis of the

1970s and 1980s. The short-term stabilization pro-

gram and long-term economy-wide reform initiated

by the Aquino administration (1986–1991) have be-

gun to bear fruit. Trade, investment, and financial

sector policy reform and the privatization program

(more vigorously implemented during the adminis-

tration of President Fidel V. Ramos who came to

office in May 1992) have revived private sector in-

vestment because the reforms have significantly cut

the costs of doing business and raised productivity

and efficiency. The new public and private sector

investment helped ease the infrastructure constraints

in the economy, including the power crisis during

1992–1993. This and the restoration of peace and

order and political stability have improved the invest-

ment climate.1 The significant reduction of resources

required for security purposes raised their availabil-

ity for economic development. As a result, the

economy has been growing back to a respectable

level in terms of gross domestic product (GDP), av-

eraging at 4.2 percent per annum between 1992 and

1996. Inflation rates were suppressed from the

double-digit levels of 1981–1991 to single-digit levels

from 1992 to 1997. After having been in deficit con-

tinuously for two decades, the cash position of the

national Government has been in surplus since 1994.

In nominal dollar values, exports grew by 21 percent

annually between 1992 and 1997.

The completion of the full liberalization of foreign

exchange in 1992, combined with those encouraging

developments, has increased capital inflows to the

country to finance its wide current account deficit.

The current account deficit, as a percentage of GDP,

rose sharply from 1.6 percent in 1992 to 5.5 percent

in 1993 and stabilized at around 4.5 percent per an-

num from 1994 to 1997. Prior to the economy-wide

liberalization, the access of the private sector to in-

ternational capital markets was relatively limited. The

access became greater as the country was gradu-

ated from the International Monetary Fund (IMF)

Standby Arrangement in March 1993 and with the

conclusion of the Paris Club rescheduling negotia-

tions in 1994. To boost public confidence, including

that of international investors, the Philippines, how-

ever, chose to voluntarily sign up on 11 March 1998

for a two-year IMF Extended Fund Facility that will

give access to $1.37 billion in case of emergencies.

At the same time, the compulsory regular consulta-

tions with the IMF and other multilateral financial

institutions help shape the policies and improve coor-

dination among Government bureaucracy who draw

and implement the policies. The favorable market

response to the issue of Samurai bonds in July 1996

and the Brady Exchange Program in September later

that year signified significant improvements in the

international creditworthiness of the Philippines.

Having recovered from a serious banking crisis in

the 1980s, the banking system in the Philippines is in a

better shape compared with, say, those in Indonesia

and Thailand. To enhance the credibility of the mon-

etary authority and improve the effectiveness of the

monetary policy, the Philippines undertook a reform

of the financial system between 1986 and 1993. The

authorities toughened up prudential rules and regula-

tions, which include capital adequacy and provisions

for loan loss or doubtful accounts, compliance with

the minimum risk-asset ratio, legal lending limits, and

interlocking directorship (Lamberte and Llanto 1995,

Paderanga Jr. 1996, and Intal and Llanto 1998).

The reform includes major restructuring and re-

habilitation of the central bank, a number of State-

owned financial institutions, and the deposit insur-

ance corporation. To replace the old bankrupt Cen-

tral Bank of the Philippines (CBP), a better orga-

nized and well-funded brand new central bank,

Bangko Sentral ng Pilipinas (BSP), was estab-

lished in 1993 (Republic Act No. 7653). Restructur-

ing included transfer of the foreign liabilities of CBP

3ISSUES IN THE MANAGEMENT OF MACROECONOMIC POLICIES IN THE PHILIPPINES

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to the National Government and capital increase.

Between 1986 and 1990, the CBP suffered from

heavy losses as a result of successive currency de-

valuation, swap, forward cover and open market

operations, and granting of emergency loans to dis-

tressed financial institutions. The collapsed State-

owned banks, namely, Philippine National Bank

(PNB) and Development Bank of the Philippines

(DBP), were fully rehabilitated in 1986 by transfer-

ring their nonperforming assets to the National Gov-

ernment.2 Established in 1916, PNB is the principal

depository of Government funds. The reduction of

political intrusion in the financial system significantly

decreases the chronic moral hazard behavior and

principal-agent problems in this system.

Economic Growth,Structural Changes,Employment, and InflationAfter a decade of economy-wide structural reforms,

resolution of the power crisis during 1992–1993, and

improvements in political life and security, the

economy of the Philippines began to recover in 1994.

Since then, it has been growing at a rapid pace. Real

gross national product (GNP) rose by an annual av-

erage of 5.9 percent and real GDP by 5.2 percent

from 1994 to 1997 (Table 1). Because of the positive

net factor income from abroad, mainly workers’ re-

mittances, both the level and rate of growth of the

GNP of the Philippines are higher than that of the

GDP.3 These rates of growth of national income are

well above the average annual rate of population

growth of 2.3 percent per annum, thus allowing an

average annual increase in per capita income of

around 2.7 percent.

Aggregate Demand andSectoral Growth RatesUnlike in the past two decades, growth in the 1990s

has been driven by increased levels of private sector

investment, high export growth, and decreased role

of the public sector in the economy. Over one fifth

of the annual GNP of the Philippines is now plowed

back into physical investment. However, the buoy-

ant accumulation of capital goods during the first half

Table 1: Share and Rate of Growth—Real Gross National Product by Industrial Origin (percent)

Sharea Rate of Growth

Item 1985 1995 1990 1991 1992 1993 1994 1995 1996 1997

Gross National Product (GNP) 100.0 100.0 4.8 0.5 1.6 2.1 5.3 5.0 6.9 5.8

Gross Domestic Product (GDP) 103.8 97.3 3.0 (0.6) 0.3 2.1 4.4 4.8 5.7 5.1

Agriculture, Forestry, and Fishery 25.5 20.9 0.5 1.4 0.4 2.1 2.6 0.8 3.1 2.8

Industry Sector 36.5 34.5 2.6 (2.7) (0.5) 1.6 5.8 7.0 6.3 5.7

Mining and Quarrying 2.2 1.3 (2.6) (2.9) 6.7 0.7 (7.0) (0.8) (1.5) (3.2)

Manufacturing 26.1 24.6 2.7 (0.4) (1.7) 0.7 5.0 6.8 5.6 4.0

Construction 5.3 5.4 4.9 (15.7) 2.8 5.7 8.9 6.5 10.9 16.3

Electricity, Gas and Water Supply 2.9 3.2 (0.7) 4.7 0.7 2.9 13.9 13.0 7.5 4.1

Services Sector 41.8 41.9 4.9 0.2 1.0 2.5 4.2 5.0 6.5 5.6

Transportation, Communication, and Storage 5.7 5.7 2.3 0.4 1.4 2.6 4.2 5.8 7.4 7.9

Trade 15.0 15.0 4.6 0.5 1.6 2.5 4.0 5.6 5.5 4.2

Finance and Housing 8.9 9.4 5.8 (1.1) 0.6 2.0 4.0 4.9 8.3 7.7

Services 12.2 11.8 5.9 0.5 0.4 2.8 4.8 4.1 5.7 4.6

Net Factor Income (3.7) 2.7 75.3 198.1 237.1 2.5 54.9 12.8 52.2 23.0

Traded Sectorb 51.8 48.2 1.5 0.3 (0.5) 1.4 3.5 3.8 4.3 3.3

Nontraded Sectorc 48.1 51.8 4.6 (1.4) 1.2 2.8 5.2 5.6 7.0 6.7

a As percentage of GNP, except for traded and nontraded sectors, which are computed as percentage of GDP.b Comprising agriculture, forestry and fishery; mining; and quarrying; and manufacturing.c Comprising construction; electricity, gas and water supply; and services.Sources: Bangko Sentral ng Pilipinas (BSP), 1996 Annual Report; Statistical Bulletin. BSP, 1998. Selected Philippine Economic Indicators. February.


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of the 1990s was mainly concentrated in the

nontraded sector of the economy. This included the

much needed investment in durable equipment in

energy, transportation, and telecommunication to solve

the supply-side constraints. Major power projects of

the National Power Corporation (NPC) were com-

pleted in 1994 and modernization of water and air

transport peaked in 1993–1994. Deregulation of the

telecommunications industry has attracted substan-

tial private sector investment and introduced market

competition. These increased the number of tele-

phone connections, which more than tripled between

1990 and 1995, and reduced rates. The pace of in-

vestment in construction and real estate slowed down

with the BSP ruling on 5 June 1997 to cap the growth

of bank credit to the real estate sector to no more

than 20 percent of a bank’s total loan portfolio. In-

vestment in durable equipment grew strongly with

the surge in private sector investment, particularly in

the manufacturing industry.

The share of the agriculture sector (comprising

crops, poultry and livestock, fishery, and forestry) in

GNP slightly dropped from 25.5 percent in 1985 to

20.9 percent in 1995. During the same period, the

contribution of the industry sector was relatively stag-

nant at around 35 percent. Similarly, the share of

services in GNP was also stable at 42 percent. Manu-

facturing was the most important segment of the in-

dustry sector, contributing about 25 percent to the

annual GNP in 1985 and 1995. The construction in-

dustry produced 5.4 percent while other industries

(mining and quarrying and public utilities) generated

4.5 percent of GNP in 1995. The contribution of min-

ing and quarrying to annual GNP sharply dropped

from 2.2 percent in 1985 to 1.3 percent in 1995. In

the service sector, trade was the biggest generator

of GNP in 1995 (with 15 percent share), followed by

services (11.8 percent); finance and housing (9.4

percent); and transportation, communication and stor-

age (5.7 percent). As in other developing economies,

services include mainly labor-intensive and low-tech-

nology activities that produce low value added.

After increasing by an average of 4.6 percent per

annum during the height of the green revolution in

1965–1980, the growth rate of agricultural output

decelerated to an average of 1.0 percent per annum

in the 1980s and early 1990s. During the period 1980–

1993, rice, the nation’s staple food, grew by 2.9 per-

cent per annum compared with average annual growth

rates of the whole agriculture sector at 1.6 percent

and of all crops (comprising rice, corn, coconut, sug-

arcane, banana, and other crops) at 0.8 percent.

Other crops include fruits and vegetables, especially

nontraditional export crops such as coffee and pine-

apple. During the same period, poultry and livestock

grew by 7.7 percent per annum, and fishery by 1.6

percent. However, the forestry sector recorded a

negative growth rate of 30 percent per annum. Dur-

ing this period, sugarcane and banana also registered

negative annual growth rates of 3.1 and 0.5 percent,

respectively. In 1992, all crops accounted for over

59 percent of agriculture value added, poultry and

livestock for 24 percent, fishery for 16 percent, and

forestry for 0.8 percent. Rice was the most impor-

tant commodity in the group of crops as it consti-

tuted 16 percent of agriculture value added in 1992.

A number of factors contributed to the stagnation

of the agriculture sector until the mid-1980s

(Balisacan 1995). The insecurity and political insta-

bility slowed down the cultivation of new lands, while

the uncertainty concerning the implementation of the

Government’s Comprehensive Agrarian Reform Pro-

gram of June 1988 discouraged the flow of private

investments into agriculture and encouraged conver-

sion of agricultural lands into nonagricultural uses.

The fall of public investment in the agriculture sector

(especially on rural roads, irrigation, and research

and development and extension services) severely

affected production and productivity as well as pro-

cessing and marketing. Meanwhile, the rise in Gov-

ernment interventions (including price and quantita-

tive controls of agricultural inputs and products that

affected domestic production, processing, distribu-

tion, and international trade) has acted as explicit and


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implicit onerous taxation on agriculture. Moreover,

the exhaustion of forest resources because of rapid

deforestation in the 1960s and 1970s has deceler-

ated the growth rate of the forestry sector.

Most of the distorted Government interventions in

the agriculture sector were phased out starting re-

cently. Moreover, a combination of the restoration of

peace and order and political stability allowed the

cultivation of new lands while the increase in public

investment improved production, processing, and pro-

ductivity of this sector. However, mainly because of

a long drought, agricultural output stagnated in 1995

and grew by only 3.1 percent in 1996. The continu-

ing El Niño reduced the rate of growth of the agri-

culture sector further down to 2.8 percent in 1997.

The growth rate of the industry sector peaked at

7 percent in 1995, but declined to 6.3 percent in the

following year and to 5.7 percent in 1997. The ser-

vice sector grew by over 6 percent per annum from

1995 to 1997. In the industry sector, construction had

the highest growth rate from 1992 to 1997. Partly

because of the new investment in public utilities and

land-based industries, construction activities rose

from 2.8 percent in 1992 to 8.9 percent in 1994 to

further 10.9 percent in 1996 and 16.3 percent in

1997. Again, because of the new investment, the

rate of growth of the electricity, gas, and water sup-

ply subsector peaked in 1994 and 1995 at 13.9 and

13.0 percent, respectively. In the service sector, the

transportation, communication, and storage

subsector, and the finance and housing subsector

grew rapidly at an annual average rate of about 8

percent from 1995 to 1997.

Sectoral EmploymentFrom 1980 to 1994, the working age population, those

who are between 15 and 64 years old, grew by about

3 percent per annum. During this period, the labor

force increased by 3.4 percent annually, which meant

about 650,000 new entrants to the labor force every

year. Owing mainly to the increasing rate of female

labor force participation, the total labor force partici-

pation rate has been rising through time, from about

60 percent in the 1970s to roughly 63 percent in the

1980s and to around 66 percent in the 1990s. The

progrowth policies have raised employment rate dur-

ing the period 1980–1994 to sufficiently absorb new

entrants to the labor force. The accumulated labor

surplus was partly reduced by the increasing num-

ber of overseas contract workers (Esguerra 1995).

Nevertheless, the unemployment rate in the Philip-

pines is still relatively high at around 9 percent from

1993 to 1997. The underemployment rate is estimated

at 20–23 percent.

The agriculture sector absorbed nearly 46 per-

cent of the labor force in 1993 and 43 percent in

1996 (Table 2). The service sector (comprising

wholesale and retail trade, transportation, storage and

Table 2: Distribution of Employment by Major Industry (percent)

Industry 1970 1975 1980 1985 1990 1993 1995 1996

Agriculture, Forestry, and Fishery 53.7 53.5 51.4 49.0 44.9 45.7 43.4 42.6

Mining and Quarrying 0.4 0.4 0.6 0.6 0.6 0.6 0.4 0.4

Manufacturing 11.9 11.4 11.0 9.7 10.1 10.1 10.2 10.0

Electricity, Gas, and Water Supply 0.3 0.3 0.4 0.4 0.4 0.4 0.4 0.4

Construction 3.8 3.1 3.6 3.4 4.4 4.6 5.1 5.6

Wholesale and Retail Trade 7.4 11.2 10.1 13.2 14.2 13.9 14.7 14.8

Transportation, Storage, and Communication 4.4 3.4 4.4 4.7 4.9 5.3 5.8 6.0

Financing, Insurance, Real Estate, and Business Services na na 2.0 1.7 2.0 2.1 2.1 2.3

Community, Social, and Personal Services 16.4 16.4 16.4 17.2 18.5 17.4 17.9 17.9

Industry not Adequately Defined or Reported 1.6 0.3 0.0 na 0.1 0.1 0.0 0.0

na = not available.Sources: Reyes, Milan and Sanchez (1989) for 1970, 1975, 1980, and 1985; Bureau of Labor and Employment Statistics (BLES), Current Labor Statistics, for 1990 and1993; National Statistical Coordination Board, 1997 Philippine Statistical Yearbook, for 1995 and 1996.


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communication, financial sector, community, social

and personal services, and business services), which

employed 38.7 percent of the labor force in 1993

and 41.0 percent in 1996, has been the main recipi-

ent of the labor force moving out of agriculture. The

rapid growth of employment in this sector indicates

the fast growth of low-productivity and low-paying

jobs in the informal sector of the economy, which

mainly produces nontraded goods and services.

The economic reform has been designed to de-

velop an efficient industry sector, increase external

competitiveness, and promote employment. Measures

to achieve these objectives include creation of a

sound macroeconomic environment, modifications in

the tariff structure, dismantling of nontariff barri-

ers, removal of the capital bias in the system of

investment incentives, and promotion of cottage,

small, and medium industries. These policies have

changed the structure of the industry sector. But

the percentage share of employment absorbed by

industry has been hovering between 14 and 16.5

percent since the 1970s. The manufacturing sector

provided between 10 and 12 percent of total em-

ployment, but its share in more recent years has

been lower than in the 1970s.

Owing to their relatively large shares in employ-

ment, the agriculture and service sectors exert con-

siderable influence on the overall performance and

on the aggregate profile of poverty and income dis-

tribution.

Inflation RatesPrice inflation is generated by interactions between

domestic and international markets for goods and

services, labor markets, and financial (including for-

eign exchange) market. A combination of stabiliza-

tion policy to suppress aggregate demand, economy-

wide reforms in all three markets, and real peso ap-

preciation has helped control inflation rate. The re-

forms in the market for goods and services included

the phasing out of price and quantitative controls,

adoption of measures to improve domestic market

competition, and policies to reduce levels and vari-

ance of levies and taxes on domestic trade and ex-

ports. The trade policy reforms also liberalized im-

ports and cut the levels and variance of import tar-

iffs. Greater market competition decreased prices

further and improved productivity. Prices of imported

goods in the local market were reduced by trade lib-

eralization, tariff cuts, and real peso appreciation.

Table 3: Consumer Price Index (CPI) and Inflation Rate

Item 1990 1991 1992 1993 1994 1995 1996 1997

CPI (1988 = 100)

All Items 128.1 152.0 165.6 178.2 194.3 210.0 227.7 239.2

Food and Beverages 127.6 147.2 157.3 166.9 180.7 197.9 217.4 221.6

Clothing 120.3 140.6 155.7 167.3 175.3 181.2 187.6 194.7

Housing and Repair 132.8 159.6 187.6 211.3 238.9 264.4 289.6 317.8

Fuel, Light, and Water 136.0 173.3 183.7 197.1 210.7 217.0 231.3 252.0

Services 129.3 171.4 183.6 198.0 215.5 229.4 251.3 284.5

Miscellaneous 120.5 140.0 158.2 171.5 190.3 192.1 184.7 188.4

Inflation rate (%)

All Items 14.2 18.7 8.9 7.6 9.0 8.1 8.4 5.1

Food and Beverages 11.9 15.4 6.9 6.1 8.3 9.5 9.9 1.9

Clothing 10.0 16.9 10.7 7.5 4.8 3.4 3.5 3.8

Housing and Repair 16.9 20.2 17.5 12.6 13.1 10.7 9.5 9.7

Fuel, Light and Water 23.7 27.4 6.0 7.3 6.9 3.0 6.6 8.9

Services 22.0 32.6 7.1 7.8 8.8 6.5 9.5 13.2

Miscellaneous 11.7 16.2 13.0 8.4 11.0 0.9 (3.9) 2.0

Source: BSP. 1998. Selected Philippine Economic Indicators. February.


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The inflation rate has been suppressed from nearly

19 percent in 1991 to around 9 percent in 1992 and it

has remained at a single digit thereafter (Table 3).

The decline in the inflation rate of food and bever-

ages and clothing has been due mainly to import lib-

eralization. In the housing and repair sector, new con-

struction of housing and commercial buildings relaxed

the supply constraint and slowed the increase in rents.

Moreover, new investment in public utilities also miti-

gated price increases in this sector.

Domestic Savings andthe Financial SectorVolatile economic conditions, political instability, and

security problems have dampened public confidence,

and restrained savings and investment and growth

of the financial industry in the Philippines.

Domestic SavingsThe aggregate savings ratio in this country, ranging

between 16 and 20 percent of annual GDP during

1990–1996, was not only low by Asian (Associa-

tion of Southeast Asian Nations [ASEAN] and East

Asian) standard, but each sector of the economy—

households, corporations, and the Government—

saved considerably less than its counterpart in this

region.4 Considering that the gross national invest-

ment was between 20 and 24 percent of annual

GDP, the resource gap in the Philippines hovered

between 1 to 4 percent of annual GDP during 1990–

1996. To narrow the gap, the Philippines, in recent

years, has started to catch up with its neighbors by

maintaining sound and stable macroeconomic man-

agement and introducing a number of policies to

increase domestic savings. These included mea-

sures to control the inflation rate, raise positive real

interest rate, and policies to promote a fast growth

rate of household incomes as well as to affect the

age and employment structures of the population

by reducing the dependency ratio through a family

planning program.

Government employees in the Philippines are re-

quired to participate in the Government Service In-

surance System (GSIS) while private employees are

encouraged to become members of the Social Secu-

rity System (SSS). Both agencies are modeled after

the Employment Provident Fund (EPF) in Singapore

and Malaysia.

The corporate sector has been a net borrower in

the Philippines. The relatively high savings rates of

this sector are partly explained by the past repres-

sive financial policies and industrialization strategies.

The authorities in the Philippines, like their counter-

parts in other Asian countries, accepted the view

that highly diversified private conglomerates and

State-owned enterprises are to be the main instru-

ments for the rapid industrialization process. Thus,

the Government strengthened State-owned compa-

nies and supported private business by directing en-

try and exit of firms, and providing subsidized credit

and other funds from State-owned institutions. In-

dustrialization strategies included high rates of pro-

tection from imports, and special access to locally

produced inputs and to Government procurements.

A close relationship grew between the Government

and these enterprises. The result is a long history

and extensive record of State interventions, inward-

looking trade and investment regimes, financial re-

pression, patrimonialism, and cronyism.

For the first time after two decades of continued

deficit, the cash position of the central Government

recorded a surplus of nearly 1 percent of GDP in

1994. The consolidated public sector financial posi-

tion improved significantly in the 1990s, from a defi-

cit of close to 5 percent of GDP to a small surplus in

1996. The improvements, however, have been due

partly to large receipts from the privatization of State-

owned enterprises, particularly in 1994 and 1995. To

generate a Government budget surplus in 1997,

State-owned enterprises were required to remit a

$210 million dividend due in 1998. Selling public

sector assets is of course not a sustainable source

of Government revenues, and the advance payments


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distorted the fiscal picture. To raise sustainable rev-

enues from internal taxes, the Government imple-

mented the expanded value-added tax (VAT) in Janu-

ary 1996 and passed the Comprehensive Tax Re-

form Program in December 1997. Tax efforts and

revenue collections are expected to increase with

the program to strengthen tax administration. On the

expenditure side, the Government reduces nondebt

and nonpersonnel expenditures by, among others,

decreasing the demand for public investment through

privatization of State-owned enterprises. To make up

for the reduction of public sector investment in public

utilities, the Government attracts private sector invest-

ment through the build-operate-transfer (BOT)

scheme. The surplus in the public budget helps control

domestic aggregate demand, stabilizes public debt lev-

els, and controls and reduces real interest rates.

Financial Sector DevelopmentsSTRUCTURE OF THE FINANCIAL SYSTEM

As in many other developing countries, in terms of

total assets and number of offices, the banking sys-

tem is the core of the financial system in the Philip-

pines (Table 4). As of March 1998, there were 51

banks in the Philippines: 18 domestic expanded com-

mercial banks (EKBs), 15 domestic commercial

banks (KBs), 17 branch offices of foreign banks,

and 1 land bank.5 The list excludes DBP and also

the Al-Amanah Islamic Investment Bank of the Phil-

ippines, which operates based on risk-sharing accord-

ing to Shariah or Islamic laws. Both the EKBs and

KBs are allowed to deal in foreign exchange trans-

actions, but only the EKBs are licensed to exercise

the authority of an investment house. Operating li-

censes for 10 of these banks were issued between

October 1994 and December 1997.

The gradual financial sector reform, which started

in 1980, has enhanced competition in the banking

system through many avenues: first, the relaxation

of barriers to new entrants to the banking industry

rapidly increased the number of banks and their

branches. Some of these were foreign institutions as Tabl

e 4:

Str

uct

ure

of

the

Fin

anci

al S

yste

m a

nd

Sh

are

in A

sset

s, 1

990–

1997

Nu

mb

er o

f O

ffic

esS

har

e in

Ass

ets

(%)

Ass

et G

row

th (%

)

Fin

anci

al I

nst

itu

tio

n19

9019

9119

9219

9319

9419

9519

9619

97a

1992

1993

1994

1995

1996

1993

1994

1995

1996

1997

a

Cen

tral

Ban

k1

11

11

11

135

.027

.622

.619

.619

.0(1

1.6)

(7.4

)4.

623

.3na

Com

mer

cial

Ban

ksb

1,86

31,

989

2,36

12,

604

2,92

43,

221

3,64

73,

890

41.3

46.0

49.8

52.7

57.6

25.1

22.5

27.3

39.2

24.1

Thr

ift B

anks

653

663

718

780

821

925

1,17

11,

386

3.6

4.0

5.0

5.6

5.7

23.9

43.0

34.3

29.2

19.2

Sav

ings

Ban

ks27

028

531

633

434

736

742

650

02.

22.

43.

33.

53.

022

.154

.727

.611

.914

.3

Priv

ate

Dev

. B

anks

211

202

218

250

265

310

432

547

1.0

1.2

1.3

1.7

2.1

30.6

28.4

48.8

58.5

29.0

SS

LA

c17

217

618

419

620

924

831

333

90.

40.

40.

40.

50.

616

.917

.140

.452

.010

.0

Spe

cial

ized

Ban

ksd

7676

7777

7777

nana

2.5

3.1

2.8

2.7

0.0

36.7

4.9

13.3

na

Rur

al B

anks

1,04

51,

063

1,14

011

,195

1,27

41,

346

1,51

41,

650

1.1

1.2

1.3

1.4

1.5

22.0

24.2

29.8

31.1

12.1

Non

Ban

ks3,

849

4,06

94,

613

5,28

25,

977

6,87

19,

161

9,91

316

.518

.118

.417

.916

.323

.515

.116

.716

.14.

7

To

tal

7,48

77,

861

8,91

019

,939

11,0

7412

,441

15,4

9416

,840

100.

010

0.0

100.

010

0.0

100.

025

.021

.124

.728

.6n

a

na =

not

ava

ilabl

e.a

Pre

limin

ary

data

as

of S

epte

mbe

r 199

7.b

Incl

udes

Lan

d B

ank

of th

e P

hilip

pine

s, D

evel

opm

ent B

ank

of th

e P

hilip

pine

s st

artin

g F

ebru

ary

1996

, and

Al-A

man

ah Is

lam

ic In

vest

men

t Ban

k of

the

Phi

lippi

nes

star

ting

June

199

6.c

SS

LA =

Sto

ck S

avin

gs a

nd L

oans

Ass

ocia

tions

.d

Con

solid

ated

with

com

mer

cial

ban

ks in

199

6.S

ourc

e: B

SP.

199

8. S

elec

ted

Phi

lippi

ne E

cono

mic

Indi

cato

rs, F

ebru

ary.


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the reform allowed greater penetration of the do-

mestic market by foreign banks. Second, the removal

of the traditional functional specialization of financial

institutions raised competition between banks and

nonbank financial institutions (NBFIs) on both asset

and liability sides of their balance sheets. Third, lib-

eralization of the capital account permitted credit-

worthy companies to raise funds in international

markets. This also created market segmentation as

only the less reputable and probably more risky debt-

ors borrow from the domestic banks.

Banks are the main external source of corporate

financing. They mainly provide short-term loans

backed up by collateral. Too much dependence on

bank credit and, to some extent, on bonds, for fund-

ing makes the corporate sector in the Philippines

heavily indebted. The other sources of corporate fi-

nancing in the country include tax evasion and prof-

its generated internally from various forms of eco-

nomic rents.

DEVELOPMENT FUNCTION

Traditionally, banks and NBFIs in the Philippines bor-

row short and lend long at a high debt/equity ratio.

During the past financial repression, the State-owned

DBP provided medium-term and long-term credit

programs with subsidized interest rates and low risks

that can be easily rolled over. Following the financial

sector reform, banks and finance companies turned

to short-term, foreign currency-denominated borrow-

ing in the interbank market or foreign currency de-

posit units (FCDUs) to fund long-term bank loans or

investment projects. A significant portion of loans

provided by banks and finance companies has been

given to finance the real estate sector and consumer

credit. Because of a combination of poor auditing

and reporting, and cross guarantees within groups of

companies, there is no reliable information on the

levels of debt/equity ratio of the corporate sector in

this country.

It should be noted, however, that the banking sec-

tor reform has not eliminated Government-directed

lending. At present, a bank is required to channel at

least 25 percent of its credit to agriculture, including

agrarian reform. Between 1992 and 1995, 10 per-

cent of total bank loan portfolio was given to small-

scale firms. This was reduced to 5 percent in De-

cember 1996 and down to zero by the end of 1997.

To decrease the banks’ vulnerability, in April 1997,

BSP set a 20 percent ceiling on banks’ loan expo-

sure to the property sector, including loans to real-

estate builders and home buyers. Banks with expo-

sure higher than the limit were given one year to

comply with the rules. In addition, when property is

used as collateral for a loan, banks are not allowed

to lend more than 60 percent of the appraised value

of that property. Prior to this, banks were generally

prohibited from lending on a secured basis amounts

exceeding 70 percent of the appraised value of land

and buildings, and 60 percent of the appraised value

of unimproved land.

PRUDENTIAL RULES AND REGULATIONS

The Philippines has not formally adopted the mini-

mum standard of 8 percent risk-based capital-assets

ratio as recommended by the 1988 Basle Capital

Accord guidelines. However, banks have actually

calculated their capital (tier 1 plus tier 2)6 ratios based

on the guidelines. This practice and the rehabilitation

of PNB and DBP have strengthened banks’ capital

relative to the stock of nonperforming loans (NPLs)

and resulted in higher than the required capital stan-

dard at 10 percent of on-balance-sheet risks as set

by BSP. In 1989, the mandated minimum capital re-

quirements for EKBs and KBs were raised to P1

billion and to P500 million, respectively. Effective

November 1996, the capital requirements for EKBs

and KBs were increased to P4.5 billion and P2.0

billion, correspondingly.

Banks in the Philippines are required to build ad-

equate loan-loss provisions to complement capital in

providing a safeguard against risks and potential

losses. To calculate these, BSP classifies bank loans

into five categories, namely: pass (secured loans with


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no interest arrears and no reduction in principal);

special mention (secured loans with interest arrears

that do not exceed three months, without reduction

in capital); substandard; doubtful; and loss. For sub-

standard loans (secured loans with interest arrears

that do not exceed six months without reduction in

principal) banks are required to build provisions

amounting to 25 percent of the unsecured portion.

Doubtful loans (secured substandard for 12 months

without at least a 20 percent repayment) need an

extra minimum reserve requirement of 50 percent of

the amount of the loan. For loss loans (secured loans

classified as doubtful for 12 months) banks are re-

quired to build additional reserve amounting to 100

percent of the loans. The ratio of NPLs to total

loans of the banking system was reduced markedly

from 7.9 percent in 1990 to 5.3 percent in 1993 to 4

percent in 1995, but slightly increased to 4.7 per-

cent in September 1997 (Table 5).

When domestic interest rates are high, there is a

strong temptation for banks and their customers to

denominate debt in foreign currency. The Govern-

ment’s commitment to stabilize the peso makes the

risk of exchange loss appear small. Partly because

of this, a large portion of the external debt is unhedged.

This situation not only makes banks and their cus-

Table 5: Loans Outstanding of Commercial Banks, Classified by Economic Activitya, 1990–1997

Item 1990 1991 1992 1993 1994 1995 1996 1997

Total Loans (in P billion) 240.3 264.1 327.4 431.8 542.8 737.3 1,120.3 1,416.8

Share in total loans (%)

Agriculture, Fishery, A41 and Forestry 11.2 13.3 11.8 10.7 9.2 8.1 5.7 5.0Mining and Quarrying 2.6 2.1 2.1 2.5 1.0 1.2 0.9 1.1Manufacturing 38.5 34.0 34.4 33.1 34.9 34.4 32.3 29.9Electricity, Gas, and Water 1.3 1.3 1.2 2.4 2.4 2.2 2.8 3.0Construction 2.7 2.6 2.5 3.2 3.3 3.4 3.9 3.6Wholesale and Trade 14.5 16.8 16.3 15.7 17.5 17.7 16.1 16.3Transportation, Storage, and Communication 3.8 3.4 3.4 3.9 4.8 6.1 6.1 7.1Financial Inst., Real Estate, Business Services 16.9 18.3 20.1 16.7 18.3 16.8 21.8 24.6Community, Social and Personal Services 8.6 8.1 8.2 11.7 8.5 10.2 10.5 9.3Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Annual growth rate (%)

Agriculture, Fishery and Forestry 30.6 10.1 19.1 8.1 19.6 6.4 11.5Mining and Quarrying (10.5) 23.2 56.9 (48.1) 55.9 9.4 70.3Manufacturing (3.0) 25.6 26.9 32.5 33.9 42.5 17.3Electricity, Gas, and Water 10.6 15.4 159.5 25.7 24.7 90.6 34.0Construction 8.8 18.5 65.3 32.3 37.4 74.2 19.6Wholesale and Trade 27.7 19.9 27.8 39.9 37.3 38.1 28.0Transportation, Storage, and Communication 0.5 21.9 52.8 53.8 72.0 53.3 47.7Financial Inst., Real Estate, Business Services 19.2 36.1 10.1 37.4 24.8 97.2 42.6Community, Social, and Personal Services 3.4 25.4 88.4 (8.7) 61.8 57.6 11.4Total 9.9 24.0 31.9 25.7 35.8 51.9 26.5

Memo Items Percentb

Loan to Deposits Ratio 96.8 87.6 96.6 99.1 101.9 111.6 131.7 132.8LGR Minus GDPGRc 8.6 (9.6) 17.9 24.0 15.7 24.6 32.2 17.3NFL to TBLd (10.0) (10.7) (7.9) (7.6) (4.1) 0.0 10.8 12.9Nonperforming Loanse 7.9 7.3 6.8 5.3 4.7 4.0 3.5 4.746f

M2 Multiplier 3.2 3.2 3.2 3.4 4.0 4.3 4.6 5.4M2/Forex Reserves 1,417.9 497.5 442.5 479.7 526.2 574.6 448.6 513.6

a Peso and foreign accounts but excluding transactions of local banks’ foreign offices.b Except for M2 multiplier, in terms of ratio.c LGR = loan growth rate. GDPGR = GDP growth rate.d NFL = net foreign liabilities. TBL = total bank liabilities.e As percentage of total loans.f Preliminary data, as of end-September 1997.Source: BSP. 1998. Selected Philippine Economic Indicators. February.


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tal markets, they sell only a portion of the total equity

and retain control of the majority shares of the com-

panies. Business conglomerates in the Philippines,

as in many other Asian countries, are family owned

and controlled. These companies are run by the

founding families who take up the top management

positions rather than give them to professional man-

agers. The availability of low-cost and risk-free loans

during the past financial repression had reduced the

incentive for firms to go public. On the demand side,

market participants are confined to a limited number

of institutional investors made up of large banks, in-

surance companies, and State-controlled pension

funds. Through subsidiaries, the commercial banks

in the Philippines are allowed to engage in capital

market operations. BSP imposes a single limit of 25

percent of the unimpaired capital. In practice, how-

ever, such regulation of the legal lending limit is not

well implemented. The latest example of this is the

recent collapse of Orient Bank because of overlend-

ing to its sister company in the real estate business.

The swift transition to a market-based financial

system and open capital account has not been fol-

lowed by rapid progress in the implementation of pru-

dential rules and regulations. This is partly due to the

structural weaknesses in the legal and accounting

systems (Intal and Llanto 1998). Moreover, after a

long period of financial repression, bank supervisors

and managers often lack the experience and skills

required to supervise and examine the fast-growing

number of banks and rapidly expanding powers of

these institutions. The State-owned financial institu-

tions (e.g., PNB, Land Bank of the Philippines, and

DBP) suffered from erratic Government policies,

such as the shifting of public deposits from these

banks to BSP. After a long era of political intrusion

under the Marcos regime, there is a principal-agent

problem as regulators and supervisors may not be

operating in the public interest. Meanwhile, private

banks belong to business conglomerates and do not

act tough on affiliated companies since they can

expect financial assistance from BSP.

tomers more vulnerable; it also makes it harder for

them to deal with the banking crisis, rise in interest

rates, and sharp devaluation of the peso. The latter

results in deterioration of banks’ and firms’ balance

sheets because much of their debt is denominated in

foreign currencies. The substantial fall of the exter-

nal value of the peso in relation to foreign currencies

rapidly increases the cost of renewing or rolling over

the short-term floating rate of foreign borrowings in

real terms. The indebtedness of domestic banks and

firms rises and their net worth falls. This would be

the case, for example, if domestic banks extend for-

eign currency-denominated loans to local borrowers

for financing activities in the nontraded sector. The

surge in interest rates causes interest payment to

increase, resulting in the deterioration of the balance

sheets of the banks and their customers.

The risks of maturity mismatches are higher for

the unlisted banks, which cannot mobilize long-term

sources of funding (by selling bonds, shares, and other

types of securities) in stock markets. Selling equity

in stock markets can be a way to spread or share the

risks. Those who can issue local currency-denomi-

nated securities (such as stocks) can transfer the

foreign exchange risk to foreign investors. The risks

of maturity mismatches are higher as, again, most

companies in the Philippines rely excessively on bank

loans for financing, with land as the main collateral

for credit. The high loans-to-value ratio of banks to

companies such as property developers has exposed

Philippine banks to sharp declines in real estate prices.

This and the plunge in equity prices depress the mar-

ket value of the collateral and assets of the banks.

The liquidity problem becomes serious because there

is no securitization of mortgages nor a well-developed

secondary market for Government bonds.

The markets for equity and long-term debt instru-

ments are relatively narrow and shallow. On the sup-

ply side, the growth of the capital market is partly

hindered because of the reluctance of family-owned

firms to raise capital by floating equities or debts to

finance their expansion. If they are listed in the capi-


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At present, there is tax discrimination between

income from financial assets and that from real prop-

erty. A 20 percent final withholding tax on interest

income from bank deposits, treasury bills, and other

securities is imposed. In contrast, capital gains on

property accruing to individuals are subject to a tax

of 5 percent of the grossly outdated selling price of

the real property in the assessor’s schedule. For ad-

ministrative efficiency, the authorities in 1981 shifted

to a secular individual income taxation because of

the difficulty of taxing interest income on bank de-

posits and dividend income on a global basis.

Monetary PolicyMonetary policy has been utilized as the main tool to

pursue a short-run stabilization objective in the Phil-

ippines. The policy heavily relies on the use of two

principal instruments, namely: (i) sterilization inter-

vention in the foreign exchange market, and (ii)

change in the mandatory reserve requirement ratio.

Other policy tools include transfer of public sector

deposits between commercial banks and BSP. In

addition, BSP imposes ceilings on both the rate of

credit expansion and sectoral allocation of banks’

credit. This mix of tight monetary policy, despite

greater openness of the financial market and stable

nominal exchange rate, has raised domestic interest

rates higher than those in international markets. The

pressure for higher domestic interest rates has in-

creased further with the shift in Government policy

for financing of public sector deficit from foreign

sources to issuance of Government securities (trea-

sury bills or T-bills), which overcrowded the domes-

tic financial markets.

External Reserves andSterilization OperationsAside from financing a chronic current account defi-

cit, capital inflows to the Philippines have also been

used for accumulating foreign exchange reserves.

Using the balance of payment identity, this can be

written as:

K = CA + R (1)

where: stands for changes, K is capital

inflows, CA is current account deficit, and

R is foreign exchange reserves.

The Government’s commitment to stabilize the

peso exchange rate requires the piling up of foreign

reserves. In 1997, the country held foreign exchange

reserves to cover 2.3 months’ imports or 1.2 times

of its short-term debt. According to some economic

literature (Grilli and Roubini 1992), the need for ex-

ternal reserves increases in line with the rising levels

of national income, import and foreign debt, and with

closer integration of the national economy with the

rest of the world. The latter exposes the economy to

external shocks such as terms of trade changes, re-

alignment of major vehicle currencies in international

trade, contagious effects of currency crises in other

countries, and fluctuations in trade and capital ac-

counts that would cause variability in the balance of

payments. Realignment of major currencies since the

mid-1980s has encouraged the authorities in the Phil-

ippines to diversify the currency composition of its

holding of foreign exchange reserves so as to ease

the burden of rising imports and external debt repay-

ments. To strengthen or raise external liquidity, BSP

has also increased the stock of its standby commer-

cial loans and entered bilateral repurchase agree-

ments with other central banks in the Asia and Pa-

cific region.7

In their study on the Indonesian economy, Woo

and Nasution (1989) argued that the total stock of

the short-term external debt should be counted as

part of debt-service due each year. In their view,

this more inclusive definition provides a better indi-

cator of the short-term external liquidity of the

economy. In a normal case, however, it is unlikely

that the creditor would call in all short-term debt at

once. Calvo (1994) stresses the need to build ex-

ternal reserve to face financial vulnerability because

of financial deepening, particularly the rapid rise in

vulnerable dollar-denominated deposits at local com-


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In the early 1980s, CBP issued its own securities,

the central bank certificate of indebtedness (CBCI),

to reduce the excess liquidity created by the CBP

itself as it rescued a number of financially distressed

banks and NBFIs. Their problems originated from a

combination of events. In 1983 the peso was deval-

ued nearly 30 percent as the country’s international

reserves went down to an alarmingly low level. In

October of that year, the Government declared a

moratorium on debt repayment. The problems were

compounded by the flight in 1984 of Dewey Dee, a

Chinese businessman who was heavily indebted to

these financial institutions. All of these, together with

the political uncertainty and the coup attempts, caused

severe bank runs and capital flight. To accommo-

date the surge of withdrawal of deposits and capital

flight, CBP provided special credit facilities (in peso

and foreign exchange) to banks and NBFIs that faced

serious liquidity problems.

The CBCI was a flexible instrument for man-

agement of short-term liquidity as the central bank

itself determines the issuance, auction system,

counterparties, maturities, and settlement rules

(Chandravarkar 1996). The dual issue of the cen-

tral bank and Government securities posed prob-

lems of coordination, segmentation, and compres-

sion in the markets of these two competing finan-

cial assets. The heavy use of CBCI to reduce ex-

cess liquidity represents the expensive interest costs

of the instruments that contributed to CBP losses

in the 1980s. The financial losses not only eroded

the credibility of CBP but also undermined the ef-

fectiveness of monetary policy because of the dan-

ger of monetization of the losses.

The increasing use of Government securities as

an instrument for management of short-term liquid-

ity began in 1986. The restructuring of the central

bank and establishment of Bangko Sentral ng Pilipinas

in 1993 completely changed the use of financial in-

struments for sterilization operations. T-bills are now

the principal instrument for sterilization as BSP

stopped issuing CBCI and mainly used the T-bills it

mercial banks as shown by the rising ratio of M2/

GDP. In a world of fractional reserve banking sys-

tem and implicit deposit insurance, bank deposits

are contingent liabilities of the central bank and the

Government.

Nonsterilized capital inflows allow both nominal

and real peso appreciation to help reduce domestic

interest rates and inflation rates. On the other hand,

when capital inflows fell in July 1997, BSP resorted

to contractionary monetary policy and sold foreign

exchange of about $4 billion to finance the current

account deficit and defend the peso. Subsequently,

the running down of foreign exchange reserves re-

duced the monetary base and hence the money sup-

ply, and raised domestic interest rates and their dif-

ferentials with foreign rates. Formally, the identity of

the monetary base is

B = D + R (2)

where: stands for changes, B is monetary

base (currency plus commercial bank re-

serves at the central bank), D is domestic

credit of the central bank (to Government,

commercial banks, and business sector), and

R, again, is foreign exchange reserves.

Accumulation of external reserves is paid by

money created by the central bank. To keep the

monetary base constant, the monetary authorities can

reduce domestic credit or deposit money banks loans

by an equivalent amount. Such operation is called

sterilization as the central bank does not allow the

accumulation of the external reserves to be carried

over to the monetary base and money supply. The

operation changes only the balance between the do-

mestic credit component and reserve component of

the monetary base, keeping the supply of monetary

base or money supply constant. Thus, using identity

(2), if a ceiling on B is imposed, then an increase in

R is sterilized by decreasing D. D can be re-

duced if the public sector and commercial banks re-

duce their borrowings from the central bank or in-

crease their savings deposits in it.


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received from the Government. From its inception in

1993, BSP has obtained T-bills amounting to P10 bil-

lion as the first installment of its statutory capital of

P50 billion. The change in the principal instrument

for liquidity management has shifted the interest bur-

den of sterilization operations from the central bank

to the Government budget.

Central bank net credit to the national Government

dropped significantly from P49 billion in 1986 to P29.5

billion in 1989 (Manasan 1994). This decline was due

to the marked increase in the national Government’s

deposits in the central bank from P17.1 billion in 1986

to P79.2 billion in 1989 (Table 6). The rise in Govern-

ment savings in the central bank came mainly from

the increased issuance of T-bills to replace CBCIs as

the principal instrument for open market operations.

Exchange Rate PolicyThe exchange rate policy is the weakest element of

the macroeconomic policy in the Philippines. In

theory, the exchange rate is the single most impor-

tant relative price and one of the most significant

monetary transmission mechanisms in an open

economy. Monetary transmission operates through

exchange rate effects on net exports and interest

rate effects on financial portfolio. The exchange rate

policy,8 jointly with other policies, can be used to re-

move distortions in the domestic economy and to help

safeguard international competitiveness.9 Such an

active exchange rate policy is the principal instru-

ment of export-oriented policy in many Asian coun-

tries. Under this policy, the authorities avoided the

use of prolonged nominal and real exchange rate

overvaluation as a main instrument for generating

fiscal revenues and curbing domestic inflation and

interest rates. Of course, international competitive-

ness is not determined by weak currency alone.

Apart from the exchange rate, other factors affect-

ing competitiveness are productivity and costs. For a

given level of domestic productivity and costs, a

weaker national currency lowers the dollar cost of

producing in the country.

Figure 1 displays the movements of the real ef-

fective exchange rate (RER) indices of the peso

Table 6: Central Bank Assets and Liabilitiesa, 1985–1997 (in P billion, end of period)

Item 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997

AssetsForeign Assets 20.7 51.4 41.9 45.0 53.2 57.6 122.4 133.5 164.0 173.8 203.6 308.8 350.5Claims on Central

Government 33.3 58.7 45.7 40.9 40.0 39.8 32.1 76.2 293.5 233.9 227.9 240.3 235.8Claims on Local

Government na na na na na na na na na na na na naClaims on Nonfinancial

Public Enterprises 4.5 4.1 4.4 5.1 6.0 6.3 6.0 3.5 2.3 2.0 1.9 1.8 3.0Claims on Deposit Money

Banks (DMBs) 27.8 16.0 19.0 20.5 22.5 28.0 29.1 15.4 7.3 6.2 7.3 7.7 26.4Claims on Other

Financial Institutions 27.8 9.3 8.7 8.2 8.0 7.6 6.8 6.5 5.9 4.6 6.3 6.5 8.0LiabilitiesReserve Money 39.5 52.1 59.4 69.1 96.0 113.0 135.7 153.4 182.3 191.6 224.4 257.0 277.2

Of which: CurrencyOutside DMBs 24.0 29.3 35.4 40.6 52.9 61.9 69.4 74.3 84.1 95.7 110.9 123.0 143.6

Restricted Deposits 58.2 49.0 30.4 31.1 29.6 34.3 80.6 94.7 61.0 45.4 36.1 102.1 43.0Foreign Liabilities 138.7 184.7 174.1 166.6 161.5 198.2 191.0 141.2 107.3 82.0 85.3 76.1 138.6Central Government

Deposits 8.7 17.1 47.6 64.4 79.2 81.8 96.7 168.2 120.2 108.7 99.2 127.4 91.1Capital Accounts 3.1 3.6 4.2 4.1 4.3 6.6 6.6 6.6 21.1 26.5 30.0 30.1 40.3Other Items (net) (134.1) (167.1) (195.9) (215.6) (240.8) (294.4) (314.1) (329.1) (18.8) (33.7) (28.0) (27.7) 33.6

na = not available.a Beginning July 1993, data reflect the financial restructuring of the Central Bank of the Philippines. The Bangko Sentral ng Pilipinas was created to take over the monetary authority

functions of the former Central Bank of the Philippines.Source: IMF, International Financial Statistics, various issues.


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between 1990 and 1998. The RER calculation is

based on relative consumer prices as a measure of

domestic cost and price developments. Taken from

Emerging Markets Data Watch, a publication of the

Morgan Guaranty Trust Company, the indices are

standardized so that 100 represents the state of com-

petitiveness in 1990. Falling below 100 represents

depreciation or weakening or cheapening of the na-

tional currency and a gain in competitiveness. On

the other hand, rising above 100 indicates an erosion

in competitiveness as domestic goods become more

expensive relative to foreign products.

The International Financial Statistics (IFS) classi-

fies the exchange rate arrangement in the Philippines

under the category of independent floating system.

This, however, does not prevent BSP from actively

intervening in the foreign exchange market in order

to stabilize the nominal value of the peso. Part of the

capital inflows was sterilized. To defend the exchange

rate from speculative attack, BSP unloaded more

than $1 billion in the foreign exchange market in mid-

1997. As this did not ease the pressures, BSP floated

the peso on 11 July 1997 to defend its external re-

serves following the flotation of the Thai baht in the

preceding week. In terms of the RER, the peso ap-

preciated by 18 percent between 1990 and 1996. The

monthly average of the nominal peso-dollar exchange

rate, which reached P23.3 in 1990, had depreciated

to P27.5 in 1993 but appreciated a little to P25.7 in

1995 and depreciated again to P29.5 in 1997.

A too rapid depreciation of the peso could cause

significant adjustment costs in the short run. Although

it enables families with members working abroad and

people whose income is denominated in a foreign cur-

rency to maintain their purchasing power in terms of

the peso, it decreases the purchasing power of those

whose income is denominated in the local currency.

The cheaper peso increases the domestic prices

of imported and import-intensive goods and services.

This will result in a higher inflation rate and may erode

the competitiveness of exports that require imported

inputs. For example, the Philippines’ biggest ex-

ports—electronic and electrical equipment—have a

relatively high import content: more than 40 percent

of the import value share relative to the export value

in 1997. Thus, by increasing the cost of imported

inputs, depreciation of the exchange rate reduces

electronic goods production and their export and in-

creases the price of such goods.

The cheaper peso also raises the external debt

repayments of the corporate sector and banks, par-

ticularly those that have taken unhedged foreign cur-

rency loans. The balance sheets of banks and non-

bank companies deteriorate further if their invest-

ments are mostly in the nontraded sector. Measured

in foreign currencies, the peso depreciation also re-

duces the capital base of banks and nonbank com-

panies. The weaker peso also causes fiscal distress

because of the greater external debt-servicing ex-

penditure of the Government budget.

The issue in exchange depreciation is not only

the lower value of the exchange rate but also the

policy behind it. It is important for the Government

not to maintain an overvalued exchange rate for

long—it is illusory to consumers who may receive

a shock when the exchange rate suddenly de-

creases. The Government should also exercise cau-

tion in widely opening the capital account, as that is

one avenue of speculative attacks. In opening the

capital account, the Government must consider both

its foreign reserves and also its ability to thwart

speculative moves.

Figure 1: Real Effective Exchange Rate Index,January 1990–April 1998 (1990 = 100)

Source: J.P. Morgan, Emerging Markets Data Watch, various issues.

J A J O J A J O J A J O J A J O J A J O J A J O J A J O J A J O J A80

90

100

110

120

130

1990 1991 1992 1993 1994 1995 1996 1997 1998


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Policy to Reduce Interest RatesThe high interest rate policy was implemented dur-

ing the stabilization period in 1991–1992. The stabili-

zation program included sterilization of capital inflows.

This operation, however, entails high domestic inter-

est rates, thus driving a large wedge between do-

mestic and international interest rates, and subse-

quently creating an additional incentive for banks and

the corporate sector to borrow overseas. The float-

ing of the peso since July 1997 has also contributed

to the high domestic interest rates. To reduce the

interest rate differentials, in July 1997 BSP applied a

30 percent reserve requirement against the foreign

currency deposits of banks.

To bring down the intermediation cost of banks

and, ultimately, interest rates, BSP reduced the re-

serve requirement ratio seven times during 1993–

1997. The mandatory ratio for peso deposit liabilities

and deposit substitutes was lowered from 24 per-

cent in 1993 to 15 percent by May 1995, further down

to 14 percent effective from January 1997 and to 13

percent effective from 4 July 1997. On top of the

mandatory reserve ratio, the banks are also required

to maintain an additional 2 percent reserve in the

form of short-term market yielding Government se-

curities (STMY-GS). Effective 15 June 1995, the

common trust funds are subject to a 10 percent re-

serve ratio, excluding the required reserves that may

be maintained in the form of STMY-GS: 4 percent

effective 3 January 1997 and 3 percent beginning 4

July 1997. A minimum of 25 percent of the reserve

ratios for both peso deposit liabilities and common

trust funds has to be deposited with BSP, earning no

interest; the balance is held in vaults and as Govern-

ment securities.

The mix of fiscal and monetary policies has re-

duced the Government deficit, caused the exchange

rate to slightly appreciate, and lowered the inflation

rate. All of these decreased bank average lending

rates from 19 percent in 1992 to 14.6 percent in

1995. Having reached the bottom at 12.9 percent in

April 1997, the interest rates steadily rose back to

15.5 percent in August and to over 20 percent dur-

ing the fourth quarter of that year (Figure 2). This

raised the interest burden of domestic firms since

bank credit is their main source of external financ-

ing. As a result, NPLs of the banking system rose

from P30 billion in 1993 to P39 billion in 1995 and to

P80 billion in September 1997. As a ratio to total

loan, however, NPLs in the respective years de-

clined from 5.3 percent to 4 percent then slightly

increased to 4.7 percent.

The above policy mix, however, has not signifi-

cantly diminished the wide gap in interest differen-

tials between domestic and international rates, as well

as between economic sector, region, and class of

borrowers in the domestic economy. One key expla-

nation for these differentials might be domestic mar-

ket imperfections and the oligopolistic structure of both

the financial markets and the real sector of the

economy. These structural problems have led to asym-

metric information (Stiglitz and Weiss 1981). The dis-

tribution of bank lending is heavily skewed towards

large conglomerates that invested the funds mainly in

the nontraded sector of the economy and in export

industries that produce low value added. Moreover,

the reputable large domestic firms also have favored

access to lower interest rate loans from abroad while

funds for other domestic enterprises have to be ra-

tioned through high interest domestic loans.

Figure 2: Selected Domestic Interest Rates,1990–January 1998a

Lending = Bank Average Lending Rate; Interbank = Interbank Call Loan Rates;T-Bill = 91 days Treasury Bill Rates; MRR = 60 days Manila Reference Rates.a Annually weighted averages for 1990 to 1995, and monthly weighted averages for

1996 to 1998.Source: Bangko Sentral ng Pilipinas, 1998 Selected Philippine Economic Indicators,February.


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Lending Boom and Credit PolicyThe financial sector reform and capital account lib-

eralization precipitated a lending boom. Reduction in

the reserve requirement ratio expanded the capabil-

ity of banks to extend credit. Increases in financial

savings and surges in capital inflows intermediated

through the banking system raised their loanable

funds. Greater exposure of the banks to foreign ex-

change risk is shown by a steady rise in the ratio of

their foreign liabilities to total liabilities – from 10

percent in 1990 to 11 percent in 1996 and 13 percent

in 1997. Foreign currency liabilities of banks were

mainly in the form of foreign currency deposits held

by residents, particularly Filipino overseas workers.

The surge in bank lending has also been encour-

aged by other factors, including increasing market

competition, elimination of interest rate controls, and

scaled-down selective credit policy, which have

widely opened new opportunities as well as new prob-

lems and risks. The decline in credit rationing brought

about by the reform allows banks to lend to marginal

borrowers investing in riskier projects. Meanwhile,

the more severe competition and downward pres-

sure on franchise value may have induced banks to

lend to this class of riskier borrowers and investment

projects. Table 6 shows that the loans outstanding of

commercial banks have been growing at a rapid pace,

at an average of 34 percent per annum from 1992 to

1997. The overextension of the banking system is

indicated by the loan/deposit ratio (LDR) and loan

growth rate minus GDP growth rate. LDR in the

Philippines steadily rose from 97 percent in 1990 to

99 percent in 1993 to 112 percent in 1995 and further

to 133 percent in 1997. The gap between the loan

and GDP growth rates increased from 8.6 percent

in 1990 to 24 percent in 1993 to 25 percent in 1995

and then dropped to 17 percent in 1997.

Lifting the restrictions on bank lending immediately

expanded credit to land-based industry and investment

in infrastructure projects. The boom in commercial

bank lending and surges in private capital inflows

have driven up the prices of land and equity prices in

the nascent and newly liberalized capital market.

During the past financial repression, a directed credit

program and selective credit policy had been two of

the monetary transmission mechanisms in the Philip-

pines to achieve the economic targets set by the au-

thorities. In addition, the State-owned banks had also

been used to implement policies of directed and se-

lective credit.

Credit has boomed, but the internal capabilities of

banks to administer and monitor the use of credit is

inadequate. Reared in an earlier controlled environ-

ment, bank credit officers may not have the exper-

tise needed to evaluate market risk. When the

economy is booming, it is difficult to distinguish be-

tween good and bad credit risks because most bor-

rowers look profitable and liquid.

Fiscal PolicyThe pressure on monetary policy was eased by a sig-

nificant reduction in the consolidated public sector

deficit (measured as the excess of expenditures over

current revenues for the Government and State-owned

enterprises) and a shift toward noninflationary sources

of finance. The rise in Government revenues and re-

duction in budget expenditures have significantly de-

creased public sector budget deficits. Since 1994, the

cash position of the national Government has been in

surplus. This alleviates pressures on financing, stabi-

lizes public sector debt levels, helps reduce interest

rates, and increases confidence in private sector-led

growth strategy as it provides a greater flow of do-

mestic savings for non-State investment.

Just as important as the decline in the public sec-

tor deficit, there has been a marked shift in the fi-

nancing of the deficit from foreign sources and the

central bank to noninflationary sources in the domes-

tic economy. The latter include borrowing from com-

mercial banks and direct borrowing from the public

(using T-bills). One consequence of this shift will be

a pickup in the growth of Government debt and an

increase in interest payments in the Government bud-

get expenditures.


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Government RevenuesThe rise in Government revenues as a share of GDP

comes from four sources. First, the more rapid eco-

nomic growth has expanded the tax base. Second,

proceeds have come from the privatization of State-

owned enterprises. Third, the comprehensive tax

policy reform, first introduced in 1986, has broad-

ened the tax base further. Fourth, better tax adminis-

tration has led to improvement in compliance. The

tax reform concurrently helps eliminate distortions,

raises economic efficiency, and improves sectoral

allocation of economic resources.

The corporate and individual income taxes have

been the workhorse of the tax reform in the Philip-

pines, generating over 32 percent of revenue since

the early 1990s. Introduced in 1988, the VAT has

contributed to over 13 percent of total tax revenues

since 1991. The VAT rebates are increasing in line

with the export performance of the Philippines, par-

ticularly the processing trade, which is exempted from

the VAT. Concerned about the rising level of rebates,

the authorities have undertaken more thorough veri-

fication because of suspicion of widespread fraud.

To improve tax revenue collections, the recent tax

reform bills are widening the tax base by closing cer-

tain loopholes and improving compliance by strength-

ening tax administration and the credibility of Gov-

ernment to prosecute tax delinquents. Legislated in

1996 and 1997, the comprehensive tax reform cov-

ers domestic taxes, such as excise duties and corpo-

rate and individual income taxes. The increased rev-

enues generated from domestic taxes are expected

to replace the losses in custom revenues due to the

tariff reform program, which provides for a low uni-

form tariff rate of 5 percent by the year 2004. The

investment law of the Philippines, however, still of-

fers a variety of tax incentives for new investors,

such as import duty exemptions and tax holidays.

ExpendituresThe desire to reduce or eliminate the budget deficit,

amid the decline in revenue as a share of GDP, has

meant strong pressure to keep budgetary expendi-

tures under control. Subsidies to State-owned enter-

prises and demand for public investment have been

significantly reduced with the privatization of these

enterprises and the adoption of policies to attract pri-

vate investment in education, health, and public utili-

ties. However, mainly because of the existence of

externalities, the involvement of the private sector in

certain activities and sectors may be neither possible

nor desirable. Most rural infrastructure, including

roads, sanitation, basic education and extension ser-

vices, irrigation, and water supply fall under this cat-

egory. The Government will have to remain a key

investor in this sector to promote rural development

and channel the benefits of development to the poor.

Mainly because of the sharp increase in interest

payments, national Government expenditures, mea-

sured as a percentage of GNP, rose from 13.4 per-

cent in 1986 to 16.3 percent in 1987 and since then

stabilized at about 17 to 19 percent from 1990 to

1997 (Table 7). At present, interest rates, personnel,

and allotments to local government units account for

about two thirds of the budgetary expenditures of

the national Government. Personnel expenditures

have been stable at about 6 percent of GNP. In 1994,

these expenditures accounted for 35 percent of the

current expenditures and 29 percent of the total ex-

penditures of the central Government. The authori-

ties have drawn up a plan for a civil service reform

that will help contain the growth of personnel expen-

ditures in the Government budget.

A number of present Government programs will

potentially put pressure on its future expenditures.

Pressure will come from (i) the possibly large stock

and flow losses associated with housing loans under

various public programs of the Unified Home Lend-

ing Program (UHLP); (ii) implicit pension debt of

social security unless the authorities take corrective

measures to address the causes of decline in funding

levels to face the coming demographic transition;

(iii) the unfunded compulsory health care insurance

program, which covers a large segment of society;


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and (iv) spending commitments of Government-

owned corporations to complement private invest-

ment under BOT-type schemes.

External Trade and theBalance of PaymentsExternal TradePushed by vigorous domestic growth as well as by a

strong currency, a slowdown in world demand for

export products, and more severe competition from

low-cost producers such as the People’s Republic of

China (PRC) and countries in Indochina, the current

account in the Philippines moved deeper into deficit.

Measured as a percentage of annual GNP, the defi-

cit grew from below 2 percent in 1991 and 1992 to

5.5 percent in 1993 and hovered around 4.2 percent

per annum from 1994 to 1997 (Table 8). The widen-

ing current account deficit was financed by substan-

tial surges in worker remittances, private transfers,

and capital inflows. The latter began to soar in 1994,

after the country liberalized its capital account in 1992

and privatized State-owned enterprises and public

utilities in the following years. External reserves were

built up between 1994 and 1996 because the overall

balance of payment positions were in surplus, as the

capital inflows were higher than the current account

deficits.

Encouraged by the economy-wide liberalization,

large increase in the productive capacity of export-

oriented foreign direct investment, and strong de-

mand in international markets, exports have been

Table 7: National Government Financial Position, 1985–1997a

Item 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997b

P billion

Total Revenues 69.0 79.2 103.2 112.9 152.4 180.9 220.8 242.7 260.4 336.2 361.2 410.4 471.8

Tax Revenues 61.3 65.4 85.9 90.3 122.5 151.7 182.3 208.7 230.1 271.3 310.5 367.9 412.2Direct Taxes 18.7 19.1 21.8 27.4 37.6 49.4 61.1 70.1 74.5 91.9 111.2 na na

Indirect Taxes 42.6 46.3 64.1 62.9 84.9 102.3 121.2 138.6 155.6 179.4 199.4 na na

Nontax Revenues 7.7 13.8 17.3 22.5 29.9 29.2 38.5 34.0 30.2 64.9 50.7 42.6 59.7Total Expenditures 80.1 110.5 119.9 136.1 172.0 218.1 247.1 258.7 282.3 319.9 350.1 404.2 470.3

Current Operating

Expenditure 55.3 66.9 95.5 113.6 142.8 178.0 196.5 214.9 226.1 267.5 277.3 328.5 naPersonnel Services 22.5 25.0 32.5 40.8 51.4 62.2 72.4 74.3 78.7 92.7 109.1 135.4 na

Interest Payments 14.7 21.0 36.9 45.9 54.7 71.1 74.9 79.5 76.5 79.0 72.7 76.5 78.0

External Debt 4.2 5.8 12.6 13.7 13.7 17.5 18.6 16.4 20.3 19.2 21.1 17.5 19.6Domestic Debt 10.5 15.2 24.3 32.2 41.0 53.7 56.4 63.1 56.2 59.8 51.6 59.0 58.4

Other Current

Expenditure 18.1 20.9 26.1 26.9 36.7 44.7 49.2 61.1 70.9 95.8 95.5 116.5 naCapital Expenditures 8.8 11.7 12.9 15.2 20.9 29.1 37.6 46.1 37.8 33.6 52.7 57.5 na

Equity & Net Lending 16.0 27.5 10.9 7.2 5.8 6.8 7.7 (6.9) 9.9 9.0 8.4 3.2 3.6

Capital Transfer na 4.4 0.6 0.1 2.6 4.2 5.4 4.6 8.5 9.8 11.8 15.0 naSurplus/Deficit (11.1) (31.3) (16.7) (23.2) (19.6) (37.2) (26.3) (16.0) (21.9) 16.3 11.1 6.3 1.6

External Borrowing (net) (0.3) 3.6 6.8 4.2 8.2 4.1 6.9 14.4 12.9 (11.6) (13.3) (5.9) (6.8)

Domestic Borrowing (net) 11.5 27.7 9.9 19.0 11.4 33.1 19.4 1.6 9.0 (4.7) 2.3 (0.3) 5.3

Memo Items Percent of GNP

Total Revenues 12.5 13.5 15.5 14.4 16.8 16.9 17.6 17.7 17.4 19.4 18.4 18.0 18.4Tax Revenues 11.1 11.1 12.9 11.5 13.5 14.2 14.5 15.2 15.3 15.6 15.9 16.1 16.1

Total Current Expenditures 10.0 11.4 14.4 14.5 15.8 16.6 15.7 15.6 15.1 15.4 14.2 14.4 na

Total Capital Expenditures 1.6 2.0 1.9 1.9 2.3 2.7 3.0 3.4 2.5 1.9 2.7 2.5 naSurplus/Deficit (2.0) (5.3) (2.5) (3.0) (2.2) (3.5) (2.1) (1.2) (1.5) 0.9 0.6 0.3 0.1

na = not available.a Including central bank restructuring.b Preliminary data.Sources: BSP, 1996 Annual Report; Statistical Bulletin. BSP, Selected Philippine Economic Indicators, February.


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Table 8: Balance of Payments, 1990–1997 (in $ billion, unless otherwise indicated)

Item 1990 1991 1992 1993 1994 1995 1996 1997a

Current Account, Net (2.6) (0.9) (0.9) (3.0) (3.0) (3.3) (3.9) (3.2)

(As percent of GNP) (5.8) (1.9) (1.6) (5.5) (4.5) (4.3) (4.5) (4.7)

Trade, Net (3.3) (1.7) (1.7) (3.7) (3.9) (4.2) (4.5) (3.5)

(As percent of GNP) (7.4) (3.7) (3.1) (6.7) (5.9) (5.5) (5.2) (5.3)

Goods, Net (4.0) (3.2) (4.7) (6.2) (7.9) (8.9) (11.3) (8.3)

(As percent of GNP) (9.1) (7.0) (8.7) (11.2) (11.9) (11.7) (13.0) (12.4)

Exports 8.2 8.8 9.8 11.4 13.5 17.4 20.5 18.4

Imports 12.2 12.1 14.5 17.6 21.3 26.4 31.9 26.6

Services, Net 0.7 1.5 3.0 2.5 4.0 4.8 6.8 4.7

Receipts 4.8 5.6 7.4 7.5 10.6 14.4 19.0 17.0

Payments 4.1 4.1 4.4 5.0 6.6 9.6 12.2 12.3

Transfers, Net 0.7 0.8 0.8 0.7 0.9 0.9 0.6 0.4

Inflow 0.7 0.8 0.8 0.7 1.0 1.1 1.2 1.2

Outflow 0.0 0.0 0.0 0.0 0.1 0.3 0.6 0.8

Capital and Financial Account, Net 1.8 1.9 1.9 2.8 4.5 4.4 8.6 4.4

Medium- and Long-Term Loans, Net 0.7 0.8 0.6 2.5 1.3 1.3 2.7 3.3

Investments, Net 0.5 0.7 0.7 0.8 1.6 1.6 1.2 (2.3)

Nonresident Investments in the Philippines 0.5 0.7 0.9 2.1 2.5 2.9 3.6 0.8

Resident Investments Abroad 0.0 0.0 0.2 1.3 0.9 1.3 2.5 3.1

Change in the NFA of KBs 0.6 0.0 0.3 (0.3) 0.7 1.6 4.2 3.0

Purchase of Collateral na na (0.5) na na na na na

Short-Term Capital, Net 0.0 0.4 0.7 (0.1) 1.0 (0.1) 0.5 0.4

Others, Net 1.0 0.6 0.7 0.5 0.3 0.1 (0.0) (0.2)

Monetization of Gold 0.2 0.2 0.1 0.1 0.2 0.2 0.2 0.1

Revaluation Adjustmentsb 0.8 0.4 0.5 0.4 0.1 (0.1) (0.2) (0.2)

Net Unclassified Items (0.3) 0.5 (0.2) (0.5) (0.0) (0.6) (0.6) (2.2)

Overall BOP Position (0.1) 2.1 1.5 (0.2) 1.8 0.6 4.1 (1.2)

(As percent of GNP) (0.2) 4.6 2.8 (0.3) 2.7 0.8 4.7 na

GNP 44.1 45.7 53.9 55.3 65.7 76.2 87.1 87.0

na = not available, BOP = balance of payment, GNP = gross national product, KB = domestic bank, NFA = net foreign asset.a January–September 1997, very preliminary data.b Reflects changes in the exchange rate of the US dollar against Special Drawing Rights (SDR) and other third currencies which form part of the reserve assets and monetary

liabilities of the Central Bank and discounts arising from debt reduction schemes.Sources: ADB. 1997. Country Economic Review; Philippines. November. BSP. 1998. Selected Philippine Economic Indicators. February.

the driving force of the economic recovery since 1994.

In nominal dollar terms, merchandise exports grew

by over 18 percent in 1994 and by 29 percent in 1995

(Table 9). The rapid growth of export value, how-

ever, was driven by over 40 percent growth of ex-

ports of electronics, mainly semiconductor-type prod-

ucts, which contributed to about one half of the total

export value in 1996–1997. This sector has a rela-

tively high import content and, therefore, produces

low value added. With the weakening in external

demand, electronics export growth began to slow

down in August 1996 and reduced overall export

growth to nearly 18 percent in 1996.

The textiles and garments group, which also re-

quire high import content, is the second important

contributor to export earnings. Its contribution to to-

tal export peaked at 23 percent in 1992 and declined

to about 16 percent in 1995 and further to 11 percent

during the first three quarters of 1997. With an er-

ratic export growth rate ranging from 15 percent in

1992 to -3.7 percent in 1996, textiles and garments

did not participate in the export boom. The share of

machinery and transport equipment in total export

earnings has steadily increased from around 3 per-

cent in 1992 to 4.2 percent in 1995 and to over 10

percent during the first nine months of 1997. Exports


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of this group jumped by 61 percent in 1992, deceler-

ated in 1993 and 1994, but soared again by 57 per-

cent in 1995 and 76 percent in 1996. For the first

three quarters of 1997, its exports rose by only 15

percent relative to the same period in 1996 but for

the first time, its export share exceeded that of agri-

culture and forestry-based products.

The slowdown in exports of textiles and garments,

footwear, and handicrafts in recent years indicates

the negative effects of the real exchange rate ap-

preciation on labor-intensive products. The BSP

policy to float the peso in July 1997 and its depre-

ciation since then should help reverse these falling

trends, contain the foreign trade deficit, and push

the growth of the traded sector of the economy.

Semiconductor-type products, which face declining

international prices, require more fundamental mea-

sures. The international prices of these products have

Table 9: Exports by Commodity Group, 1990–1997

Item 1990 1991 1992 1993 1994 1995 1996 1997a

Value ($ billion)

Agriculture 1.39 1.48 1.56 1.58 1.68 2.10 1.86 1.38

Forest Products 0.10 0.07 0.06 0.05 0.03 0.04 0.04 0.03

Minerals Products 0.72 0.58 0.63 0.69 0.78 0.89 0.77 0.57

Manufactures 5.71 6.43 7.30 8.73 10.62 13.87 17.11 15.61

Electronics & Elec. Eqpt./Parts and Telecom. 1.96 2.29 2.75 3.55 4.98 7.41 9.99 9.35

Garments, Textile Yarns/Fabrics 1.87 1.96 2.26 2.39 2.55 2.78 2.68 2.01

Chemicals 0.26 0.30 0.27 0.26 0.31 0.34 0.35 0.28

Machinery and Transport Eqpt. 0.15 0.18 0.29 0.36 0.47 0.74 1.30 1.92

Petroleum Products 0.16 0.18 0.15 0.14 0.13 0.17 0.27 0.19

Othersb 0.11 0.10 0.13 0.20 0.26 0.38 0.49 0.58

Total Exports 8.19 8.84 9.82 11.38 13.48 17.45 20.54 18.36

Share in total exports (%)

Agriculture 17.0 16.7 15.8 13.9 12.4 12.0 9.1 7.5

Forest Products 1.2 0.8 0.6 0.4 0.2 0.2 0.2 0.2

Minerals Products 8.8 6.6 6.4 6.0 5.8 5.1 3.8 3.1

Manufactures 69.7 72.8 74.3 76.7 78.7 79.5 83.3 85.0


Garments, Textile Yarns/Fabrics 22.8 22.2 23.0 21.0 18.9 15.9 13.0 10.9

Chemicals 3.2 3.4 2.7 2.3 2.3 2.0 1.7 1.5


Petroleum Products 1.9 2.0 1.5 1.2 1.0 1.0 1.3 1.1

Othersb 1.4 1.1 1.3 1.8 1.9 2.2 2.4 3.1

Total Exports 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0


Agriculture (2.2) 6.2 5.2 1.3 6.3 25.1 (11.2) 2.3

Forest Products (51.8) (23.2) (21.9) (21.1) (42.2) 46.2 10.5 32.0

Minerals Products (12.8) (19.6) 9.0 8.4 13.7 14.5 (13.5) (5.0)

Manufactures 9.9 12.7 13.5 19.6 21.6 30.6 23.3 26.0


Garments, Textile Yarns/Fabrics 12.4 4.9 15.3 5.7 6.6 9.0 (3.7) 0.5

Chemicals (6.5) 16.5 (11.8) (2.2) 16.8 12.1 2.9 6.1


Petroleum Products 63.2 12.9 (14.3) (9.3) (2.9) 29.5 59.6 3.8

Othersb 37.3 (12.3) 30.0 56.2 25.6 49.4 28.3 54.2

Total Exports 4.7 8.0 11.1 15.8 18.5 29.4 17.7 23.0

a January–September1997. For growth, comparison is with the same period in 1996.b Special transactions and re-export activities.Sources: BSP, 1996 Annual Report; Statistical Bulletin. BSP. 1998.Selected Philippine Economic Indicators, February.


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been decreasing because of weak demand and

aggressive investment in many Asian countries

(particularly in the PRC; Hong Kong, China; Rep-

ublic of Korea; Malaysia; Philippines; Singapore;

Taipei,China; and Thailand) during 1995 and 1996.

International competitiveness can be improved by

adopting measures that reduce labor costs and raise

productivity.

Philippine total imports more than doubled during

1990–1996, with an annual average growth rate of

18 percent. Capital products and raw materials and

intermediate goods formed the bulk of imports, re-

flecting the robust growth of investment and produc-

tion in the domestic economy. On the other hand, the

share of consumer good imports has grown steadily

from around 8 percent in 1990–1992 to about 10 per-

cent since 1994 (Table 10). The slight appreciation

of the RER may have contributed to the rapid growth

of imports, particularly that of consumer goods, which

rose by an annual average of 22 percent in 1990–

1996.

Worker RemittancesReceipts from services and inflows of transfers rose

rapidly beginning in 1992 and 1994, respectively. The

surges may be due to increasing inflows of worker

remittances and a portfolio shift among nonresidents.

Significant improvements in the banking system also

restored confidence that resulted in greater use of

banks in intermediating remittances (World Bank,

1988).

Capital FlowsNet private capital inflows more than doubled during

1990–1994 and continued their rapid growth in 1995

and 1996 (Table 11). The sharp decrease in long-

term loans indicates the reduction in public sector

borrowing as a result of the privatization of State-

owned enterprises and public utilities. Privatization

and greater investor confidence in the Philippine

economy increased the inflows of foreign direct in-

vestment. Portfolio inflows started only quite recently

with a relatively small amount. Improvement in the

international creditworthiness of the Philippines is also

reflected by the first issue of Samurai bonds in 15

years in July 1996 and a Brady Exchange Program

in September of the same year. The dual issue of

five-and-a-half and seven-year yen bonds in Tokyo

allowed the Philippines to retire more expensive debts

and replace them with cheaper ones, and develop

benchmarks for future borrowings of economic

agents from the Philippines in Japanese financial

markets. Under the Brady program, the Philippines

was permitted to retire 39 percent of its outstanding

$1.6 billion of Brady bonds for uncollateralized 20-

year fixed rate bonds at 225 basis points over the 30-

year US Treasury bond rate. The collateral released

in the retirement of par bonds in such transaction

will make available $183 million in cash to the Philip-

pines. Meanwhile, the bond exchange component

reduced the debt stock by $84 million. In addition,

the transaction developed a benchmark for future

borrowings of the country’s economic units in inter-

national capital markets.

The Philippines has developed an FCDU market

as an offshore financial market in Manila by provid-

ing it with regulatory and tax advantages over the

domestic market. For example, foreign exchange

deposits in this market are not subject to the 5 per-

cent gross receipts tax and the 20 percent withhold-

ing tax on interest earnings of residents. Moreover,

prior to June 1997, the FCDUs were not subject to

reserve requirements. The FCDU market was origi-

nally intended as a regional financial center, to en-

able local financial institutions to provide clients in

nearby countries with financial services (“out-out

transactions”). In reality, however, it functions as a

vehicle to encourage worker remittances and for-

eign exchange deposits by Filipinos, and to service

creditworthy domestic firms (“out-in transactions”).

The recent foreign exchange liberalization permits

exporters to retain their earnings in foreign currency.

This and the rapid growth in worker remittances and

trade and investment flows have raised the ratio of


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Table 10: Imports by Commodity Group, 1990–1997

Items 1990 1991 1992 1993 1994 1995 1996 1997a

Value ($ billion)

Capital Goods 3.12 2.95 4.02 5.61 6.87 8.03 10.47 9.94

Power Generating and Specialized Machines 1.28 1.05 1.43 2.08 2.50 2.87 3.65 2.88

Telecommunication Eqpt. & Elect. Eqpt. na na 1.47 1.91 2.53 3.21 4.21 4.51

Raw Materials and Intermediate Goods 5.81 5.85 6.76 7.86 9.61 12.17 14.06 11.24

Unprocessed Raw Materials 0.86 0.84 0.95 0.98 1.28 1.56 1.72 1.26

Semiprocessed Raw Materials 4.95 5.01 5.81 6.87 8.33 10.61 12.34 9.97

Chemical na na 1.49 1.67 2.02 2.41 2.57 2.15

Manufactured Goods 1.79 1.71 2.14 2.59 2.89 3.57 3.95 3.16

Materials/Accessories for Manufacture

of Electrical Equipment 1.11 1.21 1.40 1.81 2.71 3.77 5.13 4.06

Mineral Fuels and Lubricant 1.84 1.78 2.05 2.02 2.04 2.46 3.01 2.27

Consumers Goods 1.06 0.99 1.24 1.59 2.11 2.78 3.33 2.38

Special Transactionsb 0.37 0.47 0.45 0.53 0.71 0.94 1.02 0.80

Total Imports 12.21 12.05 14.52 17.60 21.33 26.39 31.89 26.62

Share in total imports (%)

Capital Goods 25.6 24.5 27.7 31.9 32.2 30.4 32.8 37.3

Power Generating and Specialized Machines 10.5 8.7 9.9 11.8 11.7 10.9 11.4 10.8

Telecommunication and Electrical Equipment na na 10.1 10.9 11.9 12.2 13.2 16.9


Unprocessed Raw Materials 7.1 7.0 6.5 5.6 6.0 5.9 5.4 4.7


Chemical na na 10.3 9.5 9.5 9.1 8.1 8.1

Manufactured Goods 14.7 14.2 14.7 14.7 13.6 13.5 12.4 11.9


of Electrical Equipment 9.1 10.0 9.6 10.3 12.7 14.3 16.1 15.2

Mineral Fuels & Lubricant 15.1 14.8 14.1 11.5 9.6 9.3 9.4 8.5

Consumers Goods 8.7 8.2 8.5 9.0 9.9 10.5 10.4 8.9

Special Transactionsb 3.1 3.9 3.1 3.0 3.3 3.6 3.2 3.0

Total Imports 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0


Capital Goods 28.8 (5.4) 36.3 39.4 22.4 16.9 30.4 28.9

Power Generating and Specialized Machines 29.9 (18.3) 37.0 44.9 20.4 14.9 26.9 5.7

Telecommunication Eqpt. & Elect. Eqpt. na na na 30.1 32.2 26.9 31.1 48.0


Unprocessed Raw Materials 6.8 (2.4) 12.6 3.6 30.3 22.2 10.1 (2.5)


Chemical na na na 11.8 20.9 19.3 7.0 9.7

Manufactured Goods 0.4 (4.5) 24.8 21.1 11.7 23.5 10.5 4.4


of Electronic Equipment 25.0 9.2 16.0 29.1 49.9 39.1 36.0 9.5

Mineral Fuels and Lubricant 31.9 (3.1) 14.9 (1.7) 1.2 20.6 22.2 4.6

Consumers Goods 18.0 (6.7) 25.4 27.9 32.9 32.0 19.6 (6.8)

Special Transactionsb 19.9 27.1 (5.9) 18.6 34.2 32.8 7.7 9.4

Total Imports 17.2 (1.3) 20.5 21.2 21.2 23.7 20.8 12.4

na = not available.a January–September 1997. For growth, comparison is with the same period in 1996.b Including articles temporarily imported and exported.Sources: BSP. 1996. Annual Report; Statistical Bulletin. BSP. 1998.Selected Philippine Economic Indicators, Feb.


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foreign exchange deposits to peso deposits. The ratio is

particularly growing during a period of peso apprecia-

tion. Attracted by the preferential treatment, foreign

financial institutions channel much of their lending to

domestic firms through the FCDU. However, the rapid

growth of foreign currency deposits and lending through

the FCDU erode the ability of the central bank to influ-

ence monetary policy and bank credit expansion.

Part of the capital inflows has been used by the

authorities to accumulate external reserves.

External DebtThe mix of factors discussed above—fast growth of

exports and worker remittances and the increase in

nondebt private capital inflows—has significantly re-

duced the external debt burden of the Philippines.

The World Bank considers a debt/GNP ratio of less

than 48 percent as low risk and 40 to 80 percent as

medium risk. As of December 1995, the Philippines’

external debt stood at $37.8 billion, or 49 percent of

GNP. In terms of the ratio of total debt service to

exports, the World Bank considers 18 percent as the

‘warning’ threshold. The Philippines’ figure for 1995

was under 15 percent, reduced sharply from 27 per-

cent in 1990.

Short-term external debt stood at $5.3 billion in

1997. This figure, however, does not include the for-

eign exchange liabilities of banks.

For a number of reasons, the external debt expo-

sure of banks in the Philippines is, nevertheless, not

daunting. First, external borrowings of banks and their

customers in the Philippines are closely monitored

under the IMF programs. The Global Data Watch of

the Morgan Guaranty Trust Company (3 April 1998)

reported that the proportion of short-term debt to the

Bank for International Settlements (BIS) to external

reserves in the Philippines was only 69.4 percent in

mid-1997 compared with 195 percent in Indonesia

and 194.4 percent in Thailand. Second, having lived

with currency volatility in the 1970s and 1980s, the

corporate sector in the Philippines has hedged a good

fraction of its external obligations. Moreover, BSP

introduced in late December 1997 a hedging facility

through commercial banks so as to cover or limit the

risk of eligible borrowers with existing unhedged for-

eign exchange liabilities to FCDUs. Third, to slow

down the rate of growth of foreign exchange inter-

mediation by the banking sector, in June 1997, BSP

prescribed a 30 percent liquid cover on all foreign

exchange liabilities of FCDUs. Fourth, the pruden-

tial concern relating to exchange rate risks and ma-

turity mismatches faced by individual banks can be

minimized as long as the Philippines can maintain

rapid growth of the economy and exports.

ConclusionThe macroeconomic performance of the Philippines

has been strong in recent years as shown by respect-

able economic growth, rapid growth of exports, low

inflation rate, and improved financial condition of the

Table 11: Current Account Deficit and Capital Flowsa (percent of GDP)

Item 1991 1992 1993 1994 1995 1996 1997b

Current Account Deficit 2.3 1.6 5.5 4.6 4.4 4.7 4.5Total Capital Flows 5.0 3.9 4.9 5.7 5.9 10.1 1.4Net Private Capital Flowsc 1.7 2.0 2.6 4.9 4.5 9.9 0.6

Net Direct Investment 1.2 1.3 1.6 2.0 1.8 1.6 1.4Net Portfolio Investment 0.3 0.1 (0.1) 0.4 0.3 (0.2) (5.3)Other Net Investment 0.2 0.6 1.1 2.5 2.4 8.5 4.5

Net Official Flows 3.3 1.9 2.3 0.8 1.4 0.2 0.8Change In Reserved -2.3 -1.5 -1.1 -1.9 -0.9 -4.8 2.1

a Net capital flows comprise net direct investment, net portfolio investment, and other long- and short-term net investment flows, including official and private borrowing.b Preliminary data.c Because of data limitations, other net investment may include some official flows.d A minus sign indicates an increase in reserves (BOP surplus).Sources: IMF, World Economic Outlook, October 1997. IMF, World Economic Outlook; Interim Assessment, December 1997.


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banking system. These have enabled the country to

exit from the IMF program and to regain access to

the international financial markets. Its encouraging

economic performance, however, has also been ac-

companied by a number of disquieting developments.

The degree of overextension in the banking system

and exposure to foreign exchange risk are rising.

Probably because of market imperfections and the

oligopolistic structure of the financial markets, inter-

est rates are still persistently high. The fast-growing

bank loans are largely invested in the nontraded sec-

tor of the economy and in the traded sector compo-

nent that requires high imported inputs and produces

low value added. All of these indicate the need to

improve monitoring and supervision of the banking

system. Better implementation of the rules and regu-

lations governing the banking industry acts as a brake

to prevent banks from making excessive risky loans.

The ongoing economic crisis in the Asian region

has also affected external trade, labor remittances,

and capital inflow to the Philippines. The crisis re-

duced its exports to neighboring countries. Devalua-

tion of the currencies of its competitors and appre-

ciation of the peso decreased its competitiveness in

international markets. Economic difficulties dimin-

ished the capacity of neighboring countries to ab-

sorb workers from the Philippines. Moreover, the

drying up of private sector capital inflows from

Hong Kong, China; Japan; and the Republic of Korea

cannot be replaced by rising inflows from Singapore;

Taipei,China; and elsewhere. Aside from currency

devaluation, international competitiveness can also

be enhanced by increasing labor productivity, remov-

ing economic distortions, and eliminating antiexport

policies.

To improve economic management and restore

public confidence, the authorities have adopted a

short-run stabilization program. The program includes

measures to tighten fiscal and monetary policies, raise

interest rates, control inflation rate, and allow the peso

to float more freely. The experiences of other Asian

countries indicate that these policies should be done

carefully to allow the banking system and corporate

sector to adjust smoothly to the new environment,

particularly as they are highly leveraged and increas-

ingly dependent on foreign borrowings.

The short-run stabilization program has also been

supplemented with structural reform to remove dis-

tortions in the economy and to eradicate poverty. This

reform covers policies on trade and investment, taxes,

and the financial sector. The structure of Govern-

ment expenditures (such as for education and basic

health and rural infrastructure) also plays an impor-

tant role in eradicating poverty. In the long run, the

reform will extend further to legal and accounting

frameworks to improve the market infrastructure.

To further boost public confidence, including that of

international investors, these efforts have been sup-

ported by the voluntary standby arrangements with

the IMF.


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Notes

1The administration of President Corazon Aquino wasbesieged by coup attempts at least once a year between1987 and 1989. The most dangerous one occurred in De-cember 1989, led by a group of disappointed soldiers whoplayed an active role in toppling President FerdinandMarcos in 1986 .

2Between 1981 and 1987, 161 small financial institutions,holding 3.5 percent of total financial system assets, closed.Five private banks were nationalized in varying stages ofcentral bank supervision, and later privatized.

3As in any other developing country, it is difficult to esti-mate the national accounts in the Philippines partly be-cause of the relative difficulty of measuring the signifi-cant informal and nonmarketable economic activity andthe rapid growth of net factor income from abroad, mainlyworkers’ remittances (World Bank 1996).

4The main problem of most studies on savings in lessdeveloped countries, including the Philippines, is the un-reliable nature of the savings data. As pointed out earlier,this is partly due to the difficulty of measuring the na-tional accounts. Moreover, savings tends to be calcu-lated as a residual. As a result, it inherits all the statisticalproblems of other components of national income, par-ticularly investment.

5The 18 domestic EKBs are Allied Banking Corporation,Asian Bank Corporation, Banco de Oro, Bank of the Phil-ippine Islands, China Banking Corporation, EquitableBanking Corporation, Far East Bank and Trust Company,Metropolitan Bank and Trust Company, Philippine Bankof Communications, Philippine Commercial and IndustrialBank, PNB, Prudential Bank, Rizal Commercial BankingCorporation, Security Bank Corporation, Solid Bank Cor-poration, United Coconut Planters Bank, Union Bank ofthe Philippines, and Urban Bank. The 15 domestic com-mercial banks are Bank of Commerce, Bank of South EastAsia, East West Banking Corporation, Export and Indus-try Bank, Global Bank (joint venture with Tokai Bank ofJapan), International Exchange Bank, MayBank (formerlyPhilippine National Republic Bank; MayBank is classifiedas a domestic bank since it was incorporated in the Philip-pines but the major stockholder is Malaysian), Orient Bank,Philippine Banking Corporation, Philippine Trust Company,

Philippine Veterans Bank, Pilipinas Bank, Traders RoyalBank, TA Bank of the Philippines, Inc., and WestmontBank Philippines. The 16 foreign banks are Australia andNew Zealand Banking Group, Bank of America NT&SA,Bangkok Bank Public Company Limited (Bangkok), TheBank of Tokyo-Mitsubishi Limited, The Chase Manhat-tan Bank, China Trust Philippine Commercial Bank Corpo-ration, Citibank, NA, Dao Heng Bank, Development Bankof Singapore, Deutsche Bank AG, The Fuji Limited Bank,International Commercial Bank of China, ING Bank, KoreaExchange Bank, Banco Santander Philippines Incorpo-rated, and Standard Chartered Bank. The land bank is theState-owned Land Bank of the Philippines. PNB and UnionBank have Government shares.

6Tier 1 capital or “core” capital includes stock issues aswell as disclosed reserves without any limit. Tier 2 capitalor “supplementary” capital consists of perpetual securi-ties, “undisclosed reserves,” subordinated debt with ma-turity exceeding five years, and share redeemable at theoption of the issuers.

7The central banks include those of Australia; Hong Kong,China; Malaysia; Singapore; and Thailand under theExecutive Meeting of East Asia and Pacific (EMEAP).EMEAP was established in February 1991. Other mem-bers of the organization are People’s Republic of China,Republic of Korea, Japan, New Zealand, and the Philip-pines. In addition to cooperation in central bank facili-ties, the EMEAP has two other objectives, namely: fi-nancial market development and banking prudential su-pervision to improve the flow of information. The quickresponses from other central banks in extending finan-cial support to the Central Bank of Thailand for defend-ing the baht during the crisis in mid-May 1997 was thefirst test of the EMEAP. The financial resources, how-ever, were inadequate to solve the structural problems ofthe Thai economy: large current account deficit, low qual-ity of investment, fragile banking system, and rigid ex-change rate regime.

8The exchange rate policy includes devaluation, speed-ing up depreciation of the national currency, widening theintervention band in the band system, and raising trans-action costs in the foreign exchange markets.

9It should be pointed out, however, that it is relativelyeasy to define competitiveness at the level of firms, butextremely difficult at the level of countries or economies.


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Chandravarkar, Anand. 1996. Central Banking in Devel-oping Countries. New York: Macmillan Press, Ltd.

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The Past Performance of thePhilippine Banking Sector and

Challenges in the Postcrisis Period

Ma. Socorro Gochoco-Bautista

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


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Executive Summary

A look back at the history of Philippine banking re-

veals a developmental role assigned to the banking

system and a common pattern of frailty in the face

of adverse shocks. Ceilings on interest rates, inter-

est rate subsidies, and directed lending were intended

to enable the banking system to promote economic

growth by being the main source of development fi-

nance. While the system itself has displayed a flex-

ibility and willingness to undertake reforms, these

actions were often in response to, rather than pre-

ventive measures against, crises. Genuine reforms

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

transition from crisis to stability (and one regulatory

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

dence in financial markets was agonizingly slow. The

ensuing contraction in credit and intermediation has

usually dragged down the rest of the economy.

The occurrence of the Asian financial crisis has

led to a rethinking of how best to strengthen banking

systems so as to prevent banking crises, or to reduce

banking system vulnerability to crises. There is ap-

parently a greater appreciation for the idea that regu-

lation and supervision must now increasingly focus

on the less traditional and conventional methods.

This study examines the structure and current

state of the Philippine banking industry, reviews the

history of financial reforms, discusses the measures

taken by the authorities to strengthen the banking

sector prior to and after the Asian crisis, identifies

the remaining weaknesses and factors that contrib-

ute to the vulnerability of the Philippine banking in-

dustry, and makes some recommendations to ad-

dress them.

The original impetus for reform in the 1950s and

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

rapid growth and increasing fragmentation of the

banking system. The increasing diversity of financial

institutions and services challenged the ability of the

central bank to adequately regulate them. However,

prudential financial regulation at that stage was highly

undeveloped: capital adequacy standards for solvency

were relevant, but required very simple and rudimen-

tary implementation mechanisms; liquidity was man-

aged by imposing the reserve requirement; and su-

pervision and examination requirements were ad-

dressed through simple reporting systems.

In 1972–1973, a Joint International Monetary

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

mission recommended that several amendments be

made to the General Banking Act and the Central

Bank Act. These amendments were meant to (i)

realign regulation by function rather than by type of

bank; (ii) consolidate central bank authority over

banks and nonbanks (except insurance companies);

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

clude the promotion of economic growth; and (iv)

impose restrictions on entry into the banking system,

with concomitant efforts to improve the efficiency

of existing banks. Along with the increasing dyna-

mism of the financial sector and the need for more

responsive financial structures to address financing

needs, the moves toward rationalizing the central

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

creasing pressure to adopt more sophisticated pru-

dential regulatory mechanisms and structures. While

banking institutions remained the dominant financial

intermediaries, nonbank private and quasi-public fi-

nancial institutions emerged, constituting an alterna-

tive means of intermediation.

The process of reform suffered an adverse shock

in 1981 when businessman Dewey Dee, faced with

millions of pesos in debt owed to various financial

institutions, decided to abscond. The Dee incident

triggered a financial crisis, a rash of insolvencies in

investment houses and finance companies. This re-

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

out of these institutions and into large commercial

banks. The Aquino assassination in August 1983 pre-

cipitated an even bigger crisis, one that further eroded

domestic and international confidence in the entire

financial system. In response to the massive capital

flight and persistent current account deficits, the

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

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Government was forced to devalue the peso, impose

a moratorium on external debt payments, ration for-

eign exchange, and raise interest rates.

Years of protracted crisis took their toll on other

aspects of the financial system. Uncertainty and risks

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

ber of bank offices declined in absolute terms (as

several banks collapsed), and so did the total assets

of the banking system. Total lending by the banking

system fell and did not reach the 1980 levels until the

early 1990s. The rash of foreclosures followed the

deterioration in loan portfolios and led to an increase

in bank investments. To strengthen what remained

of the banking system, the central bank pursued a

rehabilitation program for weaker banks. Asset qual-

ity remained generally weak and, in the process,

banks invested a large portion of their funds in high-

yielding government securities.

The early 1990s saw a marked improvement in

the state of the financial system. Bank branching

was relaxed. The foreign exchange market was

deregulated in 1992 to enhance market efficiency

and achieve exchange rates more consistent with

economic growth. Restrictions on foreign exchange

transactions of banks were lifted and prudential

limits on foreign exchange positions of banks were

redefined.

Unfortunately, the boom in the financial sector also

planted the seeds for weakness and vulnerability in

the 1990s. The reentry of the Philippine Government

into the international capital markets encouraged

many domestic banks and firms to follow suit. As a

result, while relative indicators suggested that the

foreign indebtedness of the public nonbank sector

had been steadily declining, the foreign indebtedness

of the private banking and private nonbank sectors

steadily increased.

The Philippine banking system experienced many

of the symptoms that ultimately did in the banking

systems in the countries worse hit by the crisis. These

symptoms, which became particularly evident in the

aftermath of the crisis, included macroeconomic vola-

tility, high property exposure and asset inflation, large

amounts of foreign exchange liabilities, government-

directed lending and related-party lending, fragility in

the case of some banks, and weak supervision and

underregulation in some others. The response of the

monetary authorities to speculative pressure on the

peso beginning in July 1997 was to sell dollars ini-

tially and, subsequently, to tighten liquidity. The latter

resulted in raising interest rates on 91-day treasury

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

percent in January 1998. The central bank ultimately

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

ated by 15 percent on 11 July 1997.

These events adversely affected the corporate sec-

tor, the financial sector, and the rate of economic

growth. Bank profitability declined dramatically in 1998

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

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

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

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

1999, it had decreased further to 1.69 percent.

Nevertheless, most observers as well as Govern-

ment authorities themselves agree that the Philip-

pine banking system managed to survive the Asian

financial crisis relatively unscathed and that there is

no banking crisis in the Philippines. Over the last

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

the Philippines’ central bank, undertook measures to

strengthen its prudential framework over banks so

as to reduce system risks, strengthen regulatory over-

sight, and align domestic banking standards with in-

ternational best practices. The major measures in-

cluded the raising of capital requirements, tightening

of provisioning requirements, and stricter loan clas-

sification subject to loan-loss provisioning.

The BSP undertook a comprehensive reform pro-

gram whose elements included (i) strengthening the

prudential and supervisory systems, (ii) adopting an

early intervention system and a bank resolution strat-

egy to deal more effectively with problem banks

and to safeguard the soundness of the banking sys-

tem, (iii) undertaking special programs to strengthen


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and modernize government banks through

privatization, (iv) adopting measures to reduce the

intermediation costs of financial institutions, and (v)

improving the legal and regulatory framework through

legislation by Congress.

Bank closures in 1997 and 1998 were few and

the amount of total bank assets they represented was

small. Notwithstanding the Asian financial crisis, the

total resources and total operating network of the

Philippine banking system expanded slightly in 1998

compared with a year earlier. The total resources of

the banking system grew by close to 1 percent in

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

problem of Philippine banks is not about solvency as

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

and Thailand. In terms of portfolio loan quality, the

nonperforming loan (NPL) ratio of the entire bank-

ing system increased from 4.7 percent in December

1997 to 12.1 percent in January 1998.

The BSP continues to encourage mergers and

consolidation within the banking sector, principally

through increases in minimum capital requirements.

There have been substantial improvements toward

the prudential supervision of banks, including those

on asset quality norms such as the interest accrual

policy on past-due loans, the reversal of accrued

interest income on NPLs, and the high provisioning

requirements.

Nevertheless, there are remaining weaknesses and

vulnerabilities that must be addressed.

The Philippines continues to be plagued by cer-

tain macroeconomic weaknesses. Among the coun-

tries in Asia, the Philippines has the lowest savings

rate at 19 percent and it is second only to Indonesia

in having the largest ratio of public sector debt to

gross domestic product (GDP). Both these facts

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

to rely on foreign savings. GDP growth was nega-

tive in the last two quarters of 1998, but managed

to rise to 1.5 percent in the first quarter of 1999

largely due to improved agricultural growth. On the

inflation front, estimates of year-on-year average

inflation rate for 1999 are higher than those for

neighboring countries.

Some observers have associated the problem-

atic outcomes of the liberalization of financial mar-

kets with a deficient state of institutional arrange-

ments, such as good accounting systems and ad-

equate disclosure.

Several weaknesses in the prudential norms of

Philippine banks remain. First, banks accrue income

on restructured loans or immediately classify them

as performing loans so long as the loans are current

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

loan value up to 60 percent of the appraised value of

the real estate security and other qualified collateral.

While there have been notable improvements in dis-

closure with respect to NPLs, loan-loss provisioning,

and loan-loss reserves, as in many Asian banking

sectors loan-loss provisioning requirements are typi-

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

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

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

without formal legal foreclosure proceedings. In many

cases, these properties are actually unearned assets

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

other property owned and acquired accounts

(ROPOA) in bank balance sheets at realizable val-

ues. Philippine banks can directly foreclose pledged

collateral once the borrowers are proven unable to

service the interest or the principal or both. Third,

reserve coverage against such ROPOA assets are

not required until after five years from the time the

property is booked. Some banks could use this to

inflate collateral value since the property market is

illiquid. Fourth, loan-loss reserves are currently not

tax-deductible although the BSP has endorsed to

Congress a plan to make such reserves deductible.

Since this move involves tax revenues, it needs to

be legislated. In general, while attempts should be

made to lower financial intermediation costs and

enhance the profitability of banks, the important point

is that the industry must also become more con-

testable. Otherwise, such moves to reduce inter-


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mediation costs will simply strengthen an existing

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

termined in part by its effect on the capital position

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

write-offs is common and may materially overstate

the value of assets and capital.

The banking system continues to suffer from weak

implementation of prudential norms and international

supervisory standards. While the Bank for Interna-

tional Settlements (BIS) core principles for effective

bank supervision put much emphasis on estimating a

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

sors and examiners are implementing this is slow.

The approach to bank examination in the Philippines

focuses largely on borrower-related risks associated

with loans, while secondary or product-related risks

are not consistently taken into consideration. There

seems to be much regulatory forbearance. Bank su-

pervisors seem reluctant to effect the early closure

of failing institutions.

The credit culture is weak and inadequacies in

addressing the long-term developmental needs of the

economy have persisted. The Philippines has one of

the lowest degrees of financial intermediation in Asia,

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

mal credit system serves only a small portion of the

rural sector and other vital sectors.

The Bank Secrecy Law may partly be respon-

sible for bank examiners’ conservative approach to

examination. This law makes it impossible for the

BSP and Philippine Deposit Insurance Corporation

(PDIC) examiners to verify individual account (de-

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

aminers may not detect misstated deposit account

balances and could then become more conservative

in the other areas of their examination.

NPL resolution needs to be more closely aligned

with corporate governance and rehabilitation. A major

impediment to doing so is that corporate rehabilita-

tion is not defined anywhere. While it is a remedy

provided under Presidential Decree 902-A, the pro-

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

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

of remedies for ailing corporations, the Securities and

Exchange Commission (SEC) has exclusive jurisdic-

tion over corporate rehabilitation; thus, corporate re-

habilitation tends to be regulator-driven. However,

the SEC has not adopted formal rules to govern the

implementation of these remedies. Hence, it exer-

cises a lot of discretion and power in the granting of

these remedies, treating applications for the availment

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

overall capacity of the SEC to perform its roles as

corporate regulator and supervisor is being compro-

mised because it is overburdened with so many tasks.

The study makes the following recommendations

and proposes measures to address the remaining

weaknesses and vulnerabilities of the Philippine bank-

ing sector:

• Strengthen banks to meet the increasing require-

ments of globalization through the appropriate

conduct of macroeconomic policy. This will pro-

vide the correct system of incentives, and raise

the degree of efficient financial intermediation

while addressing the demands of long-term de-

velopment finance as well.

• Strengthen competition and efficiency in the

banking industry by promoting contestable mar-

kets and greater foreign entry while encourag-

ing bank mergers and acquisitions; undertaking

privatization; strengthening the public listing re-

quirements to improve corporate governance in

the banking industry; reducing or eliminating fi-

nancial intermediation taxes such as the gross

receipts tax, the documentary stamp tax, AGRI/

AGRA (agricultural/agrarian) requirement, Mag-

na Carta for small and medium-size enterprises

(SMEs); and eventually removing implicit finan-

cial intermediation taxes such as the liquidity re-

serve requirements.

• Strengthen prudential regulation and supervision

by adopting a formal framework and common

terminology for risk assessment and risk man-

agement systems in banks; improving financial


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reporting, disclosure, and transparency, includ-

ing repeal of the Bank Secrecy Law; implement-

ing prudential norms and supervisory standards

effectively; and reducing regulatory forbearance

by such methods as legislating the adoption of

preventive corrective action (PCA) measures.

• Improve the financial infrastructure by strength-

ening the legal/regulatory infrastructure on cor-

porate and financial restructuring and bankruptcy.

The SEC must improve corporate disclosure and

transparency rules, adopt formal rules for imple-

menting corporate rehabilitation, make the pro-

ceedings swift and time-bound, and creditor-

rather than regulator-driven. Concerning the

BSP’s role as supervisor and regulator of banks,

there should be a clearer legal interpretation of

its mandate in relation to mergers and acquisi-

tions in the banking industry and the extent of

the need for legislation for the industry to effect

such mergers and acquisitions.

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

Philippine banking system has survived the worst

effects of the Asian financial crisis, the goals of the

reform program that began in the early 1980s still

have not been completely met. The challenge is to

achieve those goals in a more volatile macroeco-

nomic environment that is more integrated with the

global economy.

IntroductionThroughout its history, the Philippine financial sys-

tem has displayed characteristics typical of a devel-

oping financial system: periods of moderate to ex-

treme financial repression followed by cycles of re-

form and deregulation; periods of strong domestic

credit growth and growing risks of moral hazard, fol-

lowed by severe crises and contraction in the supply

of credit often leading to recessions. In addition to

these difficulties, the performance of the Philippine

financial sector has also been regularly undermined

by inadequate regulation in the past and burdened by

poor macroeconomic conditions.

A look back at the history of Philippine banking

reveals a developmental role assigned to the bank-

ing system and a common pattern of frailty in the

face of adverse shocks. Ceilings on interest rates,

interest rate subsidies, and directed lending were

intended to enable the banking system to promote

economic growth by being the main source of de-

velopment finance. Early on, the shocks that hit the

system were mostly internal, arising from the inef-

ficiencies that the flawed system of regulation and

incentives engendered.

The occurrence of the Asian financial crisis has

led to a rethinking of how best to strengthen banking

systems so as to prevent banking crises or to reduce

banking system vulnerability to crises. There is ap-

parently a greater appreciation for the idea that regu-

lation and supervision must now increasingly focus

on the less traditional and conventional methods.

This study examines the structure and current state

of the Philippine banking industry, reviews the his-

tory of financial reforms, discusses the measures

taken by the authorities to strengthen the banking

sector prior to and after the Asian crisis, identifies

the remaining weaknesses and factors that contrib-

ute to the vulnerability of the Philippine banking in-

dustry, and makes some recommendations on how

to address them.

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

ries of institutions listed in Table 1.

The central bank1 is responsible for implement-

ing monetary policy and the prudential supervision

and regulation of the banking system. The Securi-

ties and Exchange Commission (SEC) oversees the

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

extent that banks and nonbank financial intermedi-

aries (NBFIs) participate in these markets, the SEC

works with the central bank in supervising and regu-

lating the activities of the latter institutions. Increas-

ing financial sophistication has led to greater diver-


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sification in the conduct of business in the financial

services sector. However, this has also called for

concomitant strengthening in the conduct of finan-

cial supervision and regulation, and administration

of a policy consistent with macroeconomic and fi-

nancial sector stability and efficiency in financial

intermediation. As the history of the Philippine bank-

ing system suggests, these needs have not always

been addressed in a timely and effective manner.

The result has been a system historically vulner-

able to shocks, with low domestic savings mobiliza-

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

for inefficiency.

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

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

growth and increasing fragmentation of the banking

system.2 The fragmentation of the banking system

was in part spurred by new legislation designed to

develop rural banks, encourage deposit secrecy, and

create new institutions, such as the Development

Bank of the Philippines (DBP) and the Philippine

Deposit Insurance Corporation (PDIC).3

The increasing diversity of financial institutions and

services challenged the ability of the central bank to

adequately regulate them. However, prudential fi-

nancial regulation at that stage was highly undevel-

oped: capital adequacy standards for solvency were

relevant but required very simple and rudimentary

implementation mechanisms, liquidity was managed

through the use of the reserve requirement, and su-

pervision and examination requirements were ad-

dressed through simple reporting systems.4

REFORMS IN THE 1970S

In 1972–1973, a Joint International Monetary Fund-

Central Bank (IMF-CB) Banking Survey Commis-

sion recommended that several amendments be made

to the General Banking Act and the Central Bank

Act. These amendments were meant to (i) realign

regulation by function rather than by type of bank;

(ii) consolidate central bank authority over banks and

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

fine the central bank’s responsibilities to exclude the

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

strictions on entry into the banking system, with con-

comitant efforts to improve the efficiency of the ex-

isting banks. Along with the increasing dynamism

of the financial sector and the need for more re-

sponsive financial structures to address financing

needs, the moves toward rationalizing the central

bank’s supervision over the banking sector led to

increasing pressure to adopt more sophisticated pru-

dential regulatory mechanisms and structures. While

banking institutions remained the dominant finan-

cial intermediaries, nonbank private and quasi-pub-

lic financial institutions emerged as an alternative

means of intermediation.

During this period, the central bank displayed a

marked shift toward a more interventionist monetary

and credit policy. Through its rediscounting window

and other facilities, it began to implement various

directed and selective developmental credit pro-

grams for Government, and also imposed ceilings on

domestic interest rates in support of this function.

Table 1: The Philippine Financial System

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

Type of Institution Components

Banking Institutions Universal banksCommercial banksThrift banksRural banksSpecialized government banks

Nonbank Financial Investment housesIntermediaries Financing companies

Securities dealersInvestment companiesFund managersLending investorsPawnshopsGovernment NBFIsa

Venture capital corporations

Nonbank Thrift Mutual building and loanInstitutions associations

Nonstock savings and loansassociations


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Liberal lending and use of rediscounting facilities to

support such policies, however, undermined the stabil-

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

sponse to the deterioration in asset quality associ-

ated with these programs, the Government tightened

access to the rediscounting window. Subsequently,

the ensuing efforts to address structural weaknesses

in the banking sector proved ineffective.

The late 1970s saw important institutional and policy

reforms being implemented in the banking system.

Following the World Bank’s recommendation, the

central bank adopted the universal banking system,

which enabled banks to undertake investment and

commercial banking functions as well as engage in

allied and nonallied financial activities. In 1980, in-

terest rates on several types of deposit liabilities as

well as on loans with maturity of over two years

were deregulated. Ceilings on the interest rate on

other loans were abolished in 1983. Table 2 enumer-

ates the significant reforms and events in the Philip-

pine financial system.

Deregulation efforts, however, were not matched

by enhancements to the system of financial inter-

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

the provisioning of reserves versus bad loans, and

examination of deposit by central bank examiners

continued to be either or both weak and inad-

equately enforced. The growing risks of moral haz-

ard in a system with poorly and loosely supervised

institutions were manifested in the actions of NBFIs,

whose nonrecourse transactions were not being

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

pared SEC. These risks surfaced to the fore during

the Dewey Dee scandal.

THE 1980S BANKING CRISIS

The process of reform suffered an adverse shock in

1981 when businessman Dewey Dee, faced with

millions of pesos in debt owed to various financial

institutions, absconded. The Dee incident triggered

a financial crisis, a rash of insolvencies in investment

houses and finance companies. This resulted in a

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

those institutions and into large commercial banks.

The central bank attempted to stabilize the system

by infusing additional liquidity through the Industrial

Rehabilitation Fund and Stock Financing Program.5

Moreover, prudential measures were taken to shore

up the quality of commercial papers and strengthen

regulations on the trust activities of commercial banks.

Among the other early manifestations of the im-

pending crisis in the financial sector was the tremen-

dous amount of dollar borrowing by domestic resi-

dents from foreign currency deposit units (FCDUs)

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

cumulation of foreign debt was encouraged by the

relaxation of capital controls and the negative real

interest rates on such credit in 1979–1980. With

mostly short-term foreign indebtedness, the Philip-

pines would later plunge into a debt crisis.

The Aquino assassination in August 1983 precipi-

tated an even bigger crisis, one that further eroded

domestic and international confidence in the entire

financial system. In response to the massive capital

flight and persistent current account deficits, the

Government was forced to devalue the peso, impose

a moratorium on external debt payments, ration for-

eign exchange, and raise interest rates.6 To control

liquidity in the financial system, the central bank in-

troduced its own debt instruments, the central bank

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

Another flight-to-quality ensued, as bank depositors

switched out of bank deposits and into the higher

yielding and safe CBCIs . A severe credit crunch

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

vate sector. This led to a sharp real contraction in

gross national product (GNP), in which real growth

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

the postwar history of the country.

Instead of strengthening the system of prudential

regulation to match the growing sophistication of the

banking sector, the central bank actually relaxed its

supervision in the early 1980s. After capital require-

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


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Table 2: Some Significant Events Affecting the Financial System

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

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

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

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

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

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

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

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

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

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

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

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

Continued next page


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

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

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

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

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

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

I. Strengthening of the Financial System

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

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

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

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

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

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

II. Rationalization of Foreign Exchange Trading

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

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

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


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

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

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

capital requirements was to enable banks to lend long-

term.8 After the Aquino assassination in 1983, the

external sector collapsed, resulting in a full-blown

liquidity crisis. The Government undertook various

rescue efforts, including the takeover of certain pri-

vate business enterprises and financial institutions. It

tried to rescue five commercial banks and eventu-

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

the existence of a severe crisis, the central bank opted

for some regulatory forbearance.

The central bank also relaxed its rules regarding

loans to directors, officers, stockholders, and related

interests (DOSRI). These developments combined

with weak enforcement of existing prudential rules

to tremendously raise the risk of moral hazard in bank

lending. Government financial institutions (GFIs) such

as the Philippine National Bank (PNB) and DBP

were declared technically insolvent after the quality

of their asset portfolio deteriorated because of ex-

cessive exposure to DOSRI loans. All of the two

institutions’ nonperforming assets had to be trans-

ferred to the national Government to strengthen other

firms with significant exposures in these two institu-

tions. Rehabilitation of banks of all types had to be

carried out over several years.

Monetary and financial indicators reflected the

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

cator of financial depth, plunged in 1984–1985 after

rising in the preceding years (Table 3).

Low real rates of returns on financial savings

share some of the blame for the decline in financial

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

the lack of competitiveness in the banking system.

The banking system experienced a term transfor-

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

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

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

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

sustained due to political instability.

The years of protracted crisis took their toll on the

other aspects of the financial system. Uncertainty

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

ket. The number of bank offices decreased in abso-

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

the total assets of the banking system. Total lending

by the banking system declined and did not reach the

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

closures followed the deterioration in loan portfo-

lios and led to an increase in bank investments. To

strengthen what remained of the banking system, the

central bank pursued a rehabilitation program for the

weaker banks. Asset quality remained generally poor;

in the rehabilitation process, banks invested a large

portion of their funds in high-yielding Government

securities. This was a natural consequence of the

precarious state of the economy and the existence

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

rioration in loan portfolios.

The sharp reduction in domestic credit in the 1980s

was aggravated by the debt crisis and the ensuing

international credit constraints on the Philippine Gov-

ernment and domestic firms. Following the debt

Table 3: Ratio of M3 to GNP

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

Year M3/GNP

1981 0.29

1982 0.31

1983 0.32

1984 0.24

1985 0.24

1986 0.25

1987 0.24

1988 0.25

1989 0.28

1990 0.28

1991 0.28

1992 0.28

1993 0.32

1994 0.35

1995 0.39

1996 0.39

1997 0.42

1998 0.41


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moratorium declared in 1983 and unable to tap do-

mestic and international capital markets, domestic

firms relied more on internal cash generation to fi-

nance investments.

To strengthen the banking system as a whole, the

central bank introduced a set of improved reporting

requirements for commercial banks, and guidelines

for asset valuation and loan-loss provisions. Mea-

sures to strengthen the rules on the single borrower

limit and DOSRI loans were likewise introduced,

as well as increases in minimum capital adequacy

standards. The measures aimed to tighten and stan-

dardize criteria for all banks, and help curb abuses

by insiders. The need for consolidation in the bank-

ing sector led the central bank to encourage mergers

as a way of meeting minimum capital requirements.

Entry into the banking sector was restricted until

1991. The policy of restricting entry came at the cost

of increasing concentration in the banking sector.

Between 1980 and 1990, the share in total deposits

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

The increased concentration and apparent lack of

competition in the banking sector to some extent miti-

gated the impact of interest rate deregulation. Banks

continued earning high spreads, supported by low

interest rates on deposits.

BANKING SYSTEM DEVELOPMENTS IN THE 1990S

The early 1990s saw a marked improvement in the

state of the financial system. Bank branching was

relaxed. In 1992 the foreign exchange market was

deregulated to enhance market efficiency and

achieve exchange rates more consistent with eco-

nomic growth. The restrictions on the foreign ex-

change transactions of banks were lifted and pru-

dential limits on the foreign exchange positions of

banks were redefined. In addition, rules governing

the remittance of export proceeds were relaxed, and

exporters were allowed to take out loans from

FCDUs. Moreover, restrictions on the repatriation

of foreign investment income were lifted, and the

Foreign Investments Act of 1991 simplified the reg-

istration process for investments. The system for

remittances was improved to facilitate payments, and

rules for automated teller machines (ATMs) were

loosened. In 1993, the new Central Bank Act was

approved. This law aimed at ensuring the indepen-

dence of the conduct of monetary policy from politi-

cal interference. It also provided for the recapital-

ization of the central bank and the transfer of over

P300 billion worth of losses of the old central bank to

a board of liquidators. The new central bank is now

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

1994, 10 foreign banks were allowed entry under

specified modes.

Monetary and financial variables have served

as good indicators of the health of the banking sys-

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

significantly from 1993 to 1996, reaching 38 per-

cent in 1996, reflecting a booming financial sec-

tor. The reliance of financial institutions on bor-

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

deposit liabilities rose. The capital adequacy ra-

tios of banks also improved. Freer entry and lib-

eralization of bank branching, as well as greater

reliance on improved technology spurred a sharp

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

1995. The improved atmosphere for competition led

banks to find niche markets, with thrift banks in-

creasingly tapping the retail markets and small de-

positors, and commercial banks increasingly ser-

vicing the more affluent clients. Growing competi-

tion also lowered bank spreads, at least with re-

spect to lending rates and time deposit rates. Fee-

based activity also rose, as banks turned increas-

ingly to off-balance-sheet financing.

Unfortunately, the boom in the financial sector also

planted the seeds for weakness and vulnerability in

the 1990s. The reentry of the Philippine Government

into the international capital markets encouraged

many domestic banks and firms to follow suit. As a

result, while foreign indebtedness of the public non-


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bank sector had been steadily declining, those of the

private banking and private nonbank sectors continu-

ously increased. The relatively smaller proportion of

public sector indebtedness following the Philippines’

reentry into the international capital markets is due

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

den declined from 8 percent of gross domestic prod-

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

because of the implementation of the Brady Plan,

which began in 1990;10

(ii) after a long period of

deficits, the national Government had a small surplus

equivalent to 0.94 percent of GNP in 1994, owing

largely to the receipts from its privatization program;11

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

cit also showed a modest surplus.

Interest rate differentials prompted the Govern-

ment to encourage exporters to tap FCDU credit

facilities to sustain competitiveness. Short-term for-

eign capital inflows rose dramatically in 1995–1996,

forcing the peso to appreciate and raising the

country’s vulnerability to sharp reversals. Heavy

short-term foreign portfolio flows translated into sharp

increases in the growth of domestic credit due to the

well-known limitations of the sterilization policy. First,

as liquidity was reduced, domestic interest rates rose,

attracting even more capital inflows. In the years

when capital inflows as a percentage of GDP peaked,

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

bill annual average rates were 16.02 percent, 12.71

percent, and 12.34 percent, respectively.12

The rise

in domestic interest rates likewise induced

recessionary tendencies in the economy. Second,

such a sterilization policy imposed a quasi-fiscal bur-

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

ing domestic assets for relatively lower yielding for-

eign assets. With the ineffectiveness of the steriliza-

tion policy and the growth in domestic credit, the

banking sector became increasingly exposed to the

real estate sector. A survey of the commercial bank-

ing sector found that combined loans and equity ex-

posure to this sector came to about 52 percent of

unimpaired capital.

The Asian Crisis andthe State of the PhilippineBanking System

The Philippine banking system experienced many of

the symptoms that ultimately led to the collapse of

the banking systems in the countries worse hit by the

crisis. The symptoms became particularly evident in

the aftermath of the crisis and included macroeco-

nomic volatility, high property exposure and asset in-

flation, large amounts of foreign exchange liabilities,

Government-directed lending and related-party lend-

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

supervision and underregulation of some banks. The

response of the monetary authorities to speculative

pressure on the peso beginning in July 1997 was to

sell dollars initially and, subsequently, to tighten li-

quidity. The latter resulted in raising interest rates on

91-day treasury bills from 10.5 percent in June 1997

to a high of 19.1 percent in January 1998.13

Ulti-

mately, the authorities gave up on their defense of

the peso, and the peso depreciated by 39 percent at

the height of the crisis, going from an average of

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

depreciation of the peso was prevented by the huge

inflow of dollar remittances by overseas workers and

of portfolio investments toward the end of 1998.

These events adversely affected the corporate

sector, the financial sector, and the rate of economic

growth. Nevertheless, most observers as well as

Government authorities themselves are in agreement

that the Philippine banking system managed to sur-

vive the Asian financial crisis relatively unscathed

and that there is no banking crisis in the Philippines.

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

sure of the extent of the banking crisis in five Asian

countries in June 1998 and May 1999.14

The Asian

financial crisis did not lead to the same kinds of

deleterious effects on the Philippine banking system

as it did in countries like Indonesia and Thailand. In

part, this was due to the reforms undertaken by the


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Government over the previous two decades, the rela-

tively short period of accelerating GDP growth in

the Philippines, and its relatively lower levels of fi-

nancial intermediation. Also, Philippine banks, like

Hong Kong and Singapore banks, had relatively strong

capital bases at the start of the crisis.

Bank closures in 1997 and 1998 were few and

the amount of total bank assets they represented was

small. Fourteen banks—1 thrift bank and 13 rural

banks—were closed in 1997.15

Bank closures in

1998 increased further to 22, involving 1 commercial

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

sures were only a small fraction of the total number

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

1997 and 1998, respectively. In terms of total assets

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

excluding rural banks, constituted about 0.01 and 0.04

percent in 1997 and 1998, correspondingly.

The BSP continues to encourage mergers and con-

solidation within the banking sector, principally

through increases in minimum capital requirements.

In addition to encouraging mergers and consolidation

among domestic banks, the BSP has endorsed re-

forms that would allow up to 100 percent foreign

ownership of banks compared with the current limit

of 60 percent foreign equity.16

This is seen as a way

to strengthen the domestic banking system but re-

quires legislation. While endorsing 100 percent for-

eign ownership, the BSP is asking Congress to stipu-

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

ing system remain in the hands of Filipinos in order

to have, in the words of the monetary authorities,

some “macroeconomic” protection for local banks.

Ostensibly, this simply reflects the protectionist sen-

timent that permeates the banking industry and other

vested interests in the Philippines. It is unclear

whether Congress will pass this amendment to the

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

ther domestic banks nor BSP has been lobbying Con-

gress for the passage of such an amendment. BSP

had earlier recommended 100 percent ownership

only in the case of distressed local banks, but the

Senate apparently would like 100 percent foreign

ownership to apply to newly created banks as well.

In contrast to the Philippines’ current ceiling of 60

percent foreign bank ownership of domestic banks

(30 percent limit on foreign nonbank ownership) and

the limitation to 10 foreign banks through four spe-

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

rea, and Thailand allow 100 percent foreign owner-

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

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

Republic of Korea, the permission of the monetary

authority is required.

Only the bank merger between the Bank of South-

east Asia and the Development Bank of Singapore

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

ers are under discussion. These are the mergers of

Prudential Bank and Pilipinas Bank, Asianbank and

the Standard Chartered Bank, and the Bank of Com-

merce and Traders Royal Bank.

Recently, Equitable Bank and its partners, includ-

ing Government financial institutions such as the

Government Service Insurance System and the So-

Table 4: Measuring the Banking Crisis—Then and Now

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

June 1998 Estimate May 1999 Estimate

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

Indonesia 60 23 82 64

Korea, Republic of 25 13 30 16

Malaysia 17 10 30 17

Philippines 10 4 20 9

Thailand 35 23 67 63


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cial Security System, bought the Lopez-Gokongwei

shares in the Philippine Commercial and Industrial

Bank (PCIB).17

Several banks, including Manila

Bank, have expressed interest in buying Prime Bank,

a savings bank that has been on bank holiday since 4

June 1999.

Notwithstanding the Asian financial crisis, the to-

tal resources and total operating network of the Phil-

ippine banking system expanded slightly in 1998. The

total resources of the banking system grew by close

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

Total network—head offices and branches—in-

creased by 645 offices between 1997 and 1998, even

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

996 in the same period.

Bank profitability declined dramatically in 1998

relative to the two previous years.19

Table 5 shows

the profitability trend for Philippine banks. The re-

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

tem declined from 16.34 percent in 1996 to 12.42

percent in 1997 and to a low but still positive 5.81

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

further to 1.79 percent.20

The return on assets

(ROA) before taxes decreased from 2.16 percent in

1996 to 1.66 percent in 1997, and further to 0.28

percent in March 1999.21

Nevertheless, in its as-

sessment, Goldman Sachs states that the underlying

profitability of Philippine banks is good, similar to that

of Singapore and Hong Kong banks. In the case of

the top six banks of the Philippines, preprovisioning

operating profits to assets ratio was 2.9 percent in

1998, a decline from 3.31 percent in 1997 and 3.41

percent in 1996. This was due to falling net interest

margins and loan growth. There was a 28 basis points

decline in net interest margin, from 5.11 percent in

1997 to 4.83 percent in 1998.22

This occurred, de-

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

ing nonearning assets. Gross loans declined by 7 per-

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

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

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

the lowest levels of financial intermediation in Asia.23

Other factors that tend to impact negatively on

bank profitability are described in Table 6. These

include (i) high capital adequacy requirements equi-

valent to 10 percent Tier 1 equity to total assets;

(ii) high reserve requirements, even though statu-

tory reserve requirements have been reduced to 9

percent and liquidity reserve requirements to 3 per-

cent, or a total of 12 percent compared with the

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

provisioning (all gross of collateral), in which banks

are required to maintain general loan-loss reserves

of 2 percent of outstanding loans in addition to spe-

cific reserves by October 1999 and loan-loss re-

serves of 5 percent against special mention/watchlist

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

small and medium-size enterprises (SMEs) and the

agriculture sector, which constitute 18 percent of

the total loanable funds of Philippine banks.24

The

AGRI/AGRA stipulates that 25 percent of the loan

portfolio be set aside for agriculture and agro-based

activities. Likewise, the Magna Carta for SMEs

requires the allocation of 6 and 2 percent of the

loan portfolio to small and medium-size enterprises,

respectively. Despite weak compliance with them,

these requirements give rise to distortions and di-

versions that impose a substantial cost to banks,

and raise intermediation costs and inefficiency in

the allocation of capital.

The BSP granted emergency loans to banks that

remained solvent but found themselves temporarily

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

gency loans and overdrafts to the banking system

from 15 July 1997 to 16 February 1999.25

This

amount is equivalent to less than 0.7 percent of the

1998 nominal GNP or 1.1 percent of total bank loans

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

lion or about 16 percent has been repaid.

The asset quality problem of Philippine banks is

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

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

portfolio loan quality, the nonperforming loan (NPL)

ratio of the entire banking system increased from

44A

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Table 5: Profitability and Capital Adequacy of Philippine Banks

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

Profitability

ROE (Total Asset/Capital) (%)

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

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

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

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

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

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




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

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

Capital Adequacyc




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

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

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

1998


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Table 6: Prudential Norms with Structural Impact on Profitability

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

Prudential Norms with StructuralPositive Impact on ROA and ROE

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

Korea, Republic ofLow reserve requirement (7%)

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

three months

PhilippinesInadequate provisioning on NPLs

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

Hong Kong, ChinaLow corporate tax rate (15%)

SingaporeNone noted

Prudential Norms with StructuralNegative Impact on ROA and ROE

None noted

1. Very strict provisioning requirements, gross ofcollaterals

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

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

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

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

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

ROE

None noted

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

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

4.7 percent in December 1997 to 12.1 percent in

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

percent in May 1999 before declining to 13.1 per-

cent in June 1999. While the ratio of structural NPL

to total NPLs indicates that most NPLs are not struc-

tural, the ratio appears to be high for the Philippines

compared with the other Asian economies (Table

8). Structural NPLs are not temporary and are not

likely to be resolved with an improvement in the

macroeconomic environment. Many of these struc-

tural NPLs relate to property bubble lending. Since

Philippine banks have a credit culture that tends to

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

ing of the property bubble gave rise to more struc-

tural NPLs. Some observers have pointed out that

Philippine banks were headed in the direction of Thai-

land and Malaysia as far as property lending, large

amounts of foreign currency borrowings, and exces-

sive lending were concerned, but that the Asian cri-

sis, specifically, the devaluation of the baht abruptly

halted the process.

There are several reasons for the rise in NPLs.

First, corporate sector performance deteriorated rap-

idly between 1997 and 1998. This is evidenced, for

example, by the number of firms that filed for debt

payment suspension with the SEC. In 1997, 20 firms

filed for suspension of debt payments, with total li-

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

cent of outstanding commercial bank loans.26

In 1998,

35 firms applied for a suspension of debt payments,

with total liabilities amounting to P96.1 billion or 6.2

percent of outstanding commercial bank loans.


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

(in million pesos as of dates indicated)

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

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

1983 22,851 189,284 12.072 2,512

1984 41,801 198,929 21.013 5,046

1985 37,726 166,660 22.637 5,753

1986 37,506 183,476 20.442 40,783

1987 19,047 138,885 13.714 11,160

1988 17,565 162,684 10.797 9,705

1989 17,135 208,042 8.236 11,284

1990 19,426 270,760 7.175 12,679

1991 20,245 306,171 6.612 12,270

1992 22,494 366,809 6.132 12,453

1993 23,840 506,425 4.708 13,311

1994 25,050 637,179 3.931 11,995

1995 28,008 866,330 3.233 13,781

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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A second reason was the BSP’s implementation

of a more stringent definition of past due loans. In

October 1997, the BSP strengthened its loan classi-

fication procedure with the release of Circular 143,

which identified specific criteria to minimize the sub-

jectivity of examinations.27

Regulations were modi-

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

review purposes if one or more of the following ap-

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

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

has missed the following number of payments de-

pending on the payment cycle: monthly, three months

in arrears; quarterly, one quarter in arrears;

semestrally, one semester in arrears; and annual, one

year in arrears. Installment loans constituted about

25 percent of total loans.28

The circular also states

that the total outstanding balance of a loan will be

considered past due regardless of the number of in-

stallments in arrears when the balance in arrears

reaches 20 percent of the total outstanding balance

of the loan receivable. The circular states that the

entire balance of a loan receivable is considered de-

linquent when the past due amount reaches 10 per-

cent of the outstanding loan balance for all modes of

payment other than those listed in this paragraph.

Another reason for the increase in the NPL ra-

tio for commercial banks was the decline in abso-

lute loans.29

As of the first quarter of 1999, loans

outstanding of commercial banks fell by 4.5 per-

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

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

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

banks expanding their loans in 1998.30

Both weak

demand for loans and the banks’ more conserva-

tive lending stance amidst the economic slowdown

have been cited as reasons for the decline in com-

mercial bank loans.

The NPL ratio briefly declined to 10.37 percent

by December 1998. Several factors tended to re-

duce the NPL ratio.

First, some attribute the decline to the waning ef-

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

loan restructuring, foreclosure, and loan-for-property

swaps among banks, ostensibly to avoid having these

problematic loans classified as NPLs, which carry

necessary specific loan-loss provisions that could hurt

earnings. Table 9 describes factors that materially

overstate or understate book value, while Table 10

describes factors that materially overstate or under-

state reported earnings. The foreclosed loans are

booked under real and other property owned and

acquired (ROPOA) accounts. Between December

1998 and May 1999, ROPOA increased by 25 per-

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

ROPOA increased by 158 percent.31

For the top 10

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

ROPOA from the first quarter of 1998 to the first

quarter of 1999 ranged from a low of 55.9 percent

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

nut Planters Bank, with all banks except PNB ex-

ceeding 100 percent.32

Monetary authorities pointed

out that if the measure of banks’ poor quality were

expanded beyond NPLs to include foreclosed assets

and restructured loans as a ratio to total loans, the

sum of NPLs, ROPOA, and restructured loans would

decline slightly to 17.4 percent or P299.3 billion in

December 1998 from 17.8 percent or P302.6 billion

in October 1998.33

In contrast to the official view, as

of May 1999, it is estimated that NPLs are already

close to 20 percent if restructured assets are included,

equivalent to 9 percent of GDP despite the official

NPL figure of 12 percent in April.34

If economic

activity and the real estate sector do not recover,

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

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

Economy Percent

Hong Kong, China 26.4

Korea, Republic of 34.8

Malaysiaa 27.0

Philippines 46.6

Singapore 13.9

Thailand 47.4


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Table 9: Assessment of Book Values

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

Factors Materially Overstating Book Value

Thailand1. Lenient provisioning norms on NPLs

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

guidelines leading to inadequateprovisioning

Philippines1. Appraised collateral value can be

overstated, lessens true provisioningneeds

2. Banks can avoid provisions throughloan for property swap agreements

3. Occasional loan refinancing to avoidNPL classification

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

overstated, lessens true provisioningneeds

3. Frequent loan refinancing to avoid NPLclassification

Malaysia1. Low provisioning norm (no

substandard loan provisioningrequirement)

2. Lenient interest accrual on NPLs to sixmonths

3. Potentially lenient collateral valuationguidelines, leading to inadequateprovisioning

Korea, Republic ofCost accounting for associates ratherthan equity accounting

Hong Kong, ChinaNone noted

SingaporeNone noted

United StatesNone noted

Factors Materially Understating Book Value

None noted

None noted

None noted

None noted

None noted

Cost accounting for associates ratherthan equity accounting

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

accounting. To be changed to equityaccounting from fiscal year 1999

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

Conclusion

Weak provisioning normsGenerally overstated bookvalues

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

Weak enforcement and banksupervision generally lead tooverstated book values.

Weak interest accrual andprovisioning norms generallyoverstated book values.

Book value fairly stated forthe most part

Book value fairly stated tomodestly understated forthe most part

Book value understated forthe most part

Book value fairly stated ormodestly understated forthe most part


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Table 10: Assessment of Reported Earnings

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

Factors Materially Overstating Reported Earnings

Thailand

1. Inadequate provisioning on NPLs

2. (phased in through 2000 year-end)

3. Nonrecurring items in other income

4. Loan provisions sometimes taken directly

against retained earnings

5. No reversal of accrued interest income on

NPLs (only required starting January 2000)

Philippines


2. Occasional loan refinancing to avoid

classifying as NPLs

Indonesia


2. Loan refinancing to avoid classifying as

NPLs

3. Loan provisions sometimes taken directly

against retained earnings

4. No reversal of accrued interest income on

NPLs

Malaysia


2. NPL interest accrual up to six months,

reversal from three months

Korea, Republic of

1. Nonrecurring items in other income

2. Cost accounting for associates rather than

equity accounting

Hong Kong, China

Nonrecurring items in other income

Singapore

Nonrecurring items in other income

United States

None noted: banks are quick to provide

against NPLs

Factors Materially Understating Reported Earnings

Nonrecurring expenses e.g., foreign exchange

losses

Extreme rule for the accrual of interest on NPLs

for noninstallment loans (75% of total loans);

interest accrual stopped after 1 day past due,

versus the 90-day rule used in the United States

Intergroup loans may be extended at below-

market rates

None noted

Nonrecurring expenses, e.g., foreign exchange

losses

Cost accounting for associates rather than

equity accounting

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

year

2. Associates at book rather than equity

accounting (to be changed to equity

accounting from fiscal year 1999)

None noted

Conclusion

Earnings overstated

for the most part

Earnings fairly stated

for the most part,

may be overstated

for banks with sharp

rises in NPLs

Earnings overstated

for most banks

Earnings overstated

for most banks


for the most part, but

focus on core

earnings


for the most part, but

focus on core

earnings


to modestly

overstated for the

most part, but focus

on core earnings


for the most part


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

sets on their books for some time to come, adversely

affecting bank profitability. Banks are not required

to disclose loan refinancing, although they may do so

on a voluntary basis.

Recently, the Bankers’ Association of the Philip-

pines (BAP) expressed support for the proposal of

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

nies experiencing cash flow problems, including

freezing interest rates on these loans. Some are of

the view that once a borrower turns for protection,

banks will be more prone to restructure loans, which

would then revert the loans to current status.35

How-

ever, freezing interest rates and other such measures

simply defer rather than address the main problem,

namely, ignoring the need for both corporate and fi-

nancial restructuring to take place in order for lend-

ing to resume. Improvements in the legal framework

are necessary for orderly corporate restructuring and

loan workouts, including strengthening of the bank-

ruptcy law and implementation procedures.

Third, the recent decline in interest rates will re-

duce the corporate sector’s borrowing costs and cash

flow strains and the banking sector’s carrying costs

of NPLs. It also decreases pressure on asset quality

and the risk of a systemic banking crisis. With the

further lowering of interest rates, as the BSP has

forecast, economic growth and loan growth are ex-

pected to be revived in the second quarter of 1999,

and stabilize if not further reduce NPLs. Goldman

Sachs has calculated the implied NPL ratios assum-

ing a decline in interest rates (Table 11).

The BSP imposed a ceiling on bank lending to the

real estate sector equal to 20 percent of total loans,

exclusive of loans to finance the acquisition or im-

provement of residential units amounting to no more

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

mercial banks fell from a peak level of 14.2 percent

in 1997 to 13.8 percent by September 1998.36

Mon-

etary authorities pointed out that this is way below

the 20 percent ceiling. They also noted that as of

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

e 11

:N

PL

Rat

ios

Imp

lied

by

Go

ldm

an a

nd

Sac

hs

Bo

tto

m-U

p E

BIT

DA

Mo

del

Ass

um

ed C

han

ge

in

Cu

rren

t

Rev

ised

Pri

or

Str

uct

ura

lS

urv

eyed

Deb

tB

orr

ow

ing

Co

sts

NP

L

Imp

lied

Imp

lied

NP

L R

atio

as %

of

Sh

ort

-ter

m I

nte

rban

k R

ates

(%

)19

99 O

ver

1998

(b

ps)

Rat

io

Est

imat

esE

stim

ates

Est

imat

es

Eco

no

my

Tota

l B

ank

Lo

anS

ep 1

998

No

v 19

98S

ep 1

998

Rep

ort

1999

1998

1999

1998

1999

1998

1999

Sin

gapo

re79

5.3

2.3

no c

hang

e(7

5)

6.2

c7.

26.

77.

710

.81.

01.

2

Hon

g K

ong,

Chi

na37

14.4

5.9

no c

hang

e(1

60

)4.

9d13

.09.

211

.614

.83.

43.

9

Mal

aysi

a53

9.3

6.6

(60

)(1

35

)10

.7d

16.6

18.5

16.6

19.6

4.5

13.5

Phi

lippi

nes

401

3.9

13

.4(1

30

)(2

00

)11

.0d

16.8

14.5

16.2

18.9

7.8

8.0

Kor

ea,

Rep

ublic

of

531

0.2

7.7

(20

0)

(30

0)

19.4

d,e

25.5

26.3

28.6

33.8

8.9

9.8

Tha

iland

227

0(2

90

)40

.0d

48.6

43.0

43.9

49.5

23.0

23.9

bps

= ba

sis

poin

ts, E

BIT

DA

= E

arni

ngs

befo

re in

tere

st, t

ax, d

epre

ciat

ion

and

amor

tizat

ion,

GS

= G

oldm

an a

nd S

achs

, NP

L =

nonp

erfo

rmin

g lo

an.

aP

erce

ntag

e of

sur

veye

d de

bt b

elon

ging

to c

ompa

nies

whe

re E

BIT

DA

falls

bel

ow in

tere

st e

xpen

se.

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erce

ntag

e of

sur

veye

d de

bt b

elon

ging

to c

ompa

nies

whe

re E

BIT

DA

is n

egat

ive.

cG

loba

l as

of A

ugus

t 199

8: 3

.9%

for S

inga

pore

loan

s on

ly a

s of

Jun

e.d

As

of S

epte

mbe

r 199

8.e

Exc

ludi

ng p

reca

utio

nary

loan

s. In

clud

es N

PLs

pur

chas

ed b

y K

orea

Ass

et M

anag

emen

t Com

pany

(KA

MC

O) t

otal

ing

12.3

% o

f all

loan

s.S

ourc

e: G

oldm

an S

achs

Inve

stm

ent R

esea

rch,

199

9a.

NP

L R

atio

aR

evis

ed C

aseb


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manufacturing sector (26.5 percent), financial insti-

tutions, real estate and business services (25.8 per-

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

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

have complied with the ceiling set on loan exposure

to the real estate sector.38

Banks’ loan exposure to the real estate sector

raises several issues. First, the classification of sec-

tor lending lumps real estate with financial institu-

tions and business services and thus makes it diffi-

cult to isolate bank exposure to the real estate sector

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

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

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

tate loans. Second, while the sector average is under

20 percent, some individual banks, including large

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

sures above 20 percent.39

In the March 1996 sur-

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

28.6 percent.40

Finally, funds are fungible. There-

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

sified as a manufacturer, there is no guarantee that

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

estate. This makes it difficult for the authorities to

ascertain whether the bank is truly complying with

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

appliance maker EYCO. Creditor banks lent EYCO

money ostensibly to finance the expansion of its ap-

pliance manufacturing business. Yet, like many other

companies, EYCO had a real estate development

subsidiary to which the funds were funneled. The

loan soured when the property market collapsed.

In terms of the Philippine banking system’s capi-

tal adequacy against probable risks, the capital ad-

equacy ratio stood at 17.65 percent at end-De-

cember 1998.41

It rose further to 17.91 percent as

of March 1999.42

This was higher than the statutory

ratio as well as the Bank for International Settle-

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

thorities noted that even as the BIS amended the

1988 Basle Accord to include market risk, and as-

suming amendments to the banking law to include

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

equacy is still higher than the suggested level of an

additional several percentage points above the BIS

standard of 8 percent.

The recent decline in the NPL ratio, from 14.40

percent in May 1999 to 13.10 percent in June 1999,

has been attributed in part to the slight increase in

the outstanding loans of the commercial banking sec-

tor, which rose by 0.3 percent in May 1999 after

months of contraction, and by 2.5 percent in June

1999.43

The modest growth in outstanding loans can

be ascribed partly to growth in the economy in the

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

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

some that the worst effects of the crisis are over

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

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

encourage lending by banks, has exempted loans

given out after March 1999 from the 2 percent gen-

eral loan-loss provisioning requirement. It is not clear

whether such regulatory forbearance is primarily

designed to help spur the economy, or simply win-

dow-dress the NPL ratio. It also sends confusing

signals about the need to strengthen prudential norms

versus giving banks some breathing space to recover

from the crisis.

Major Measures Taken toStrengthen the Banking System

44

Over the last three years, the BSP undertook mea-

sures to strengthen its prudential supervision over

banks in order to reduce system risks, improve regu-

latory oversight, and align domestic banking standards

with international best practices. The major measures

included raising the capital requirements, tightening

the provisioning requirements, and stricter loan clas-

sification subject to loan-loss provisioning.

The BSP implemented a comprehensive reform

program whose elements included (i) strengthening

the prudential and supervisory systems, (ii) adopting

an early intervention system and a bank resolution

strategy so as to deal more effectively with problem


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banks and to safeguard the soundness of the bank-

ing system, (iii) undertaking special programs to

strengthen and modernize government banks through

privatization, (iv) adopting measures to reduce the

intermediation costs of financial institutions, and

(v) improving the legal and regulatory framework

through legislation in Congress.

STRENGTHENING THE PRUDENTIAL

AND SUPERVISORY FRAMEWORK

Several measures are being implemented to

strengthen the prudential and supervisory framework:

• Hike in minimum capital requirements by 20–67

percent from the prescribed end-1998 levels, in

two equal rounds to be completed by end-De-

cember 2000, depending on the type of bank.

• Monetary and nonmonetary sanctions for non-

compliance with the minimum capital require-

ments.

• Requiring banks to set up a 2 percent general

loan-loss provision and an additional specific loan-

loss provision on loans and other risk assets on a

graduated basis as follows: 1 percent by 1 Octo-

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

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

loss reserve is 5 percent on especially mentioned

loans, 25 percent on substandard but secured

loans, 25 percent on substandard and unsecured

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

cent on loan losses. Relative to the previous loan-

loss provisioning requirements, the only differ-

ence is that the first two categories have provi-

sioning requirements now but none previously.

The NPL ratios and loan reserve coverage for

different types of banks are shown in Table 12.

• Sanctions on banks and quasi banks if they fail

to set up allowance for probable losses on loans

and other risk assets.

• Making the criteria for past due loans more strict

by reducing the period of arrears for loans to be

classified as NPLs: from six months to three

months for loans payable in monthly installments,

and from three quarters to one quarter for loans

payable in quarterly installments.

• Revising the guidelines on restructured loans of

banks and nonbanks with quasi-banking func-

tions by treating restructured loans as perform-

ing loans if they are in current status or are fully

secured by real estate.

• Enhancing transparency in several areas, such

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

banks to publish quantitative information on at

least the level of NPLs, classified assets, and

specific loan-loss provisions each quarter; (iii)

expanding the daily required report on lending

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

ternal auditors of banks under an affirmative

obligation to inform the BSP of factors that may

materially and adversely affect banks in order to

improve the quality of audits of financial institu-

tions; (v) implementing a system of accrediting

the external auditors of banks; and (vi) issuing

guidelines on mark-to-market trading and equity

portfolios and mark-to-market accounting pro-

cedures to raise the accounting and disclosure

standards to an international level.

• Issuing stricter qualification and competency

criteria for the grant of new bank licenses.

• Improving the quality of bank management by

requiring prior BSP approval for the appointment

of bank officers from the rank of senior vice

president, prescribing the duties and responsi-

bilities of the board of directors and officers of

banks, and designating a compliance officer in

each bank.

• Emphasizing a more analytical, risk-based ap-

proach of examination and consolidated super-

vision of banks and their subsidiaries and affili-

ates rather than the traditional checklist ap-

proach. Risk-based reporting of bank examina-

tion has been introduced and the examination

process has been reoriented to be able to assess

the risks and systems used by the banks to man-

age, identify, control, and monitor risk.

53TH

E PA

ST P

ER

FOR

MA

NC

E O

F THE

PH

ILIPP

INE

BA

NK

ING

SE

CTO

R A

ND

CH

ALLE

NG

ES

IN TH

E P

OS

TCR

ISIS

PE

RIO

D

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Table 12: NPL Ratios and Loan Reserve Coverage

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

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

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

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

Nonuniversal banks 4.4 5.5 7.1 9.6 15.7 17.6 19.5 19.2 20.1

Foreign banks 4.1 4.6 6.5 7.1 8.0 8.7 8.7 10.3 10.1

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

Savings and mortgage banks 6.0 7.4 9.1 10.0 10.7 11.3 10.0

Private development banks 2.6 4.0 5.6 7.7 7.0 7.4 6.6

Private loan associations 1.3 3.5 4.1 4.9 4.8 4.9 4.7

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

Total loans 1,696.8

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

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

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

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

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

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

Savings and mortgage banks 8.4 10.1 13.2 13.6 11.6 12.6

Private development banks 5.2 7.4 10.9 15.4 17.4 16.8

Private loan associations 11.3 26.9 32.4 40.5 42.0 40.1

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


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• Revising the bank rating system from capital ad-

equacy, asset quality, management, earnings, and

liquidity (CAMEL) to capital adequacy, asset

quality, management, earnings, liquidity, and sys-

tems (CAMELS).

• Intensifying off-site monitoring of banks.

• Adopting prudential measures such as imposing

a ceiling of 20 percent of total loans on bank

exposure to the real estate sector, reducing the

allowable loan value of real estate security from

70 to 60 percent of appraised value, and requir-

ing a 30 percent liquid cover on all foreign ex-

change liabilities of FCDUs.

• Training the BSP supervision staff on a continu-

ing basis.

ADOPTING AN EARLY INTERVENTION

MECHANISM AND A RESOLUTION

STRATEGY FOR PROBLEM BANKS

The BSP has adopted several measures to iden-

tify and deal with potential problems of solvent and

nearly solvent banks. These measures include the

following:

• A crash program of intensified monitoring of

selected banks using forward- and backward-

looking indicators to draw up a prioritized list of

potential problem banks with the intention of

conducting a special on-site examination on

them.

• Formalizing sanctions on capital-deficient banks

whose guidelines embody the principles of

prompt corrective action (PCA), including the

issuance of a memorandum of understanding.

Sanctions are based on the degree of capital

deficiency.

• Issuing guidelines for resolving problem bank is-

sues.

• Providing additional incentives to promote and

encourage mergers or consolidation of banks/

financial institutions.

• Developing a worst-case contingency plan for

institutional or system crises.

PROHIBITING BANK OWNERS FROM

BIDDING ON ANY RESTRUCTURED

FINANCIAL INSTITUTION FOR SALE

The BSP, in coordination with the Department of Fi-

nance, undertakes special programs to strengthen and

modernize banks that have full or substantial gov-

ernment share. The modalities include the sale of

government shares to private investors.

TAKING MEASURES TO REDUCE

INTERMEDIATION COSTS

OF FINANCIAL INSTITUTIONS

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

tory reserve requirements were lowered from 10 to

8 percent. Under Circular No. 188 dated 3 February

1999, liquidity reserves, on top of regular reserves,

against peso demand, savings, time deposits, and

deposit substitutes have been set at the following lev-

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

cial banks and NBFIs with quasi-banking functions,

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

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

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

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

1999) for current accounts, and 0 for savings and

time deposits.

IMPROVING THE LEGAL AND

REGULATORY FRAMEWORK

THROUGH LEGISLATION

The BSP has proposed major revisions to Republic

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

as amended. The proposals encompass both struc-

tural and prudential reforms.

The proposed structural reforms include updating

bank classifications to cover universal, Islamic, and

cooperative banks; liberalizing and rationalizing the

equity and citizenship structure of banks; rationaliz-

ing the powers of universal and commercial banks to

invest in allied and nonallied enterprises; and rede-

fining the functions, authority, and minimum capitali-

zation of trust entities.


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Among the proposed prudential reforms are adopt-

ing the Basle framework for measuring a bank’s

capital adequacy; strengthening the provisions against

overexposure of a bank to DOSRI; adopting mea-

sures against the concentration of credit to certain

borrowers; authorizing the Monetary Board to dis-

qualify, remove, or suspend unfit and improper di-

rectors and officers; granting the Monetary Board

the power to regulate compensation and other ben-

efits of bank directors and officers, if warranted;

providing guidelines and penalties for unsafe and

unsound banking practices; and requiring periodic

submission and publication of financial statements

for greater transparency.

The BSP has also proposed amendments to RA

7653, the New Central Bank Act. These include

empowering the BSP to examine banks once every

calendar year; granting the Monetary Board the au-

thority to impose administrative sanctions on subsid-

iaries and affiliates of banks and quasi banks and

their directors and officers; authorizing the issuance

of regulations requiring bank subsidiaries and affili-

ates to maintain a balanced position in their foreign

exchange transactions; giving the Monetary Board

the authority to grant loans for liquidity purposes to

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

could lead to illiquidity of the banking system; and

removing the five-day consecutive period during

which the deposit account of a bank with the BSP is

overdrawn before it can be excluded from clearing.

To summarize, there have been substantial im-

provements toward the prudential supervision of

banks, particularly in asset quality norms such as the

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

sal of accrued interest income on NPLs, and the high

provisioning requirements. Goldman Sachs recently

rated the overall banking system as fairly solid, with

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

is weakest.45

This represents an improvement from

its previous assessment of 14 for system fragility,

and is a rating similar to those for the Republic of

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

system fragility is shown by comparing the Goldman

Sachs assessment at end-1997 with its assessment

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

the Philippine banking system is fairly strong relative

to its regional counterparts is no reason to be com-

placent.

Remaining Weaknessesand VulnerabilityMACROECONOMIC POLICY

Transparency and incentives for prudent banking

are lacking while the degree of uncertainty increases

because of flawed macroeconomic policy. The in-

correct exchange rate policy created incentives for

foreign currency intermediation. The Asian crisis

demonstrates, for example, that a policy of main-

taining a fixed nominal exchange rate by keeping

domestic interest rates high skewed the incentive

system and encouraged overborrowing in foreign

currencies as it obscured the currency risk and re-

duced the drawdown of corporate cash reserves

by lowering interest payments. This move came at

the price of raising financial risk from a deprecia-

tion of the domestic currency. With underdeveloped

risk management systems and the inability of banks

to assess the consequences of currency deprecia-

tion on the borrowers’ ability to pay, the banking

system became more vulnerable to system fragility

and failure.

While the postcrisis exchange rate policy is seem-

ingly more market-determined, as the BSP has largely

remained on the sidelines at the Philippine Dealing

System and has also made a conscious effort to re-

duce interest rates by decreasing its own overnight

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

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

cent volatility that hit the peso allegedly due to exter-

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

depreciation of the baht, the BSP governor was

quoted as saying that the monetary authorities had

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

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

56A

ST

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Table 13: Assessment of Solidity of the Philippine Banking System

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

End-1997 End-1998

Macroeconomic volatility Some Yes Yes Yes Yes Stabilizing Some Yes

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

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

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

Financial liberalization destabilizing No Some Yes Some Some No Potentially Yes

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

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

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

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

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

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

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

Fragility scorea 8 20 22 15 14 10 7 22

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

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

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


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he was merely saying that the BSP would intervene

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

the highly interventionist and flawed exchange rate

policy in the past.

The tax of 7.5 percent on interest income on

FCDU accounts instituted in January 1999 is osten-

sibly meant to discourage holding assets in the form

of foreign currency to avoid putting pressure on the

peso, and therefore also serves as a disincentive to

foreign currency intermediation. Recently, there were

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

seems to have been shelved in view of the strong

opposition from the private sector, particularly banks.

As usual, several complex forces are at work here:

the perceived need to reduce pressure on the peso,

the need to generate more government revenues in

the face of sluggish growth and tax collections, the

need to raise efficiency in resource mobilization by

trying to align the returns on domestic and foreign

assets through the imposition of the tax, etc.46

The Philippines continues to be plagued by cer-

tain macroeconomic weaknesses. Among the coun-

tries in Asia, the Philippines has the lowest savings

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

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

second only to Indonesia. These imply that, in the

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

eign savings. Meanwhile, foreign bank lending to the

country dropped to $17.8 billion in June 1998 com-

pared with $19.7 billion in December 1997.47

In gen-

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

ippines is small relative to that of other Asian coun-

tries and is comparable with the level in India. All

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

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

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

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

Hong Kong, China 41 10 4.7

Indonesia 25 55 2.4

Korea, Republic of 29 19 5.5

Malaysia 35 7 3.2

Philippines 19 12 6

Singapore 53 10 6.3

Thailand 35 11 25.9

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

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

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

Crisis countries

Indonesia 69 83 82

Korea, Republic of 102 304 34

Malaysia 35 71 50

Thailand 28 110 25

Noncrisis economies

China, People’s Republic of 124 981 13

Hong Kong, China 3 167 2

Philippines 46 65 71

Taipei,China 84 258 32


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GDP growth was negative in the last two quar-

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

the first quarter of 1999 largely due to the improved

agricultural growth. On the inflation front, Deutsche

Bank estimates a 6.6 percent year-on-year average

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

mates for Thailand (0.3 percent), Republic of Korea

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

rent account as a percentage of GDP is estimated at

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

lowest in this group of countries.48

The BSP gradually reduced its overnight borrow-

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

to 12.25 percent and further to 9 percent currently.49

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

which are based on the 3-month London interbank

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

ever, while interest rates are currently falling, there

are no guarantees that they will continue in this di-

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

raises interest rates because of fears of an over-

heating economy or as a preemptive strike against

inflationary pressures, domestic interest rates may

rise. This would hamper the recovery in output growth

and loan demand.

LIBERALIZATION WHEN INSTITUTIONAL

FAILURES ARE PRESENT

The initial attempts at financial liberalization involved

removing interest rate ceilings and other measures

meant to avoid disintermediation. The banking sys-

tem was given a developmental role, particularly as

a source of finance for investment projects. In some

cases, there were successes, but there were also

large failures as many of the financed projects turned

out to be nonviable. Some analysts have associated

these outcomes with a deficient state of institutional

arrangements, such as weak accounting systems and

inadequate disclosure.50

Other institutional failings,

such as the lack of well-developed asset markets,

also hamper transparency, as market participants must

use internal company estimates of values rather than

those based on market-based observations. Interest-

ingly, one of the possible explanations for the contin-

ued tolerance for weak institutional structures is that

they provide a competitive advantage to domestic

financial institutions, particularly in their role as in-

termediaries between international markets and do-

mestic agents.51

The sequencing of liberalization and reforms is

also problematic. The pursuit of liberalization and

reforms in itself may be difficult, but when under-

taken in the absence of a strong supervisory and regu-

latory framework, a high degree of accountability

and transparency, and competent bank management,

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

trous. Attempts were made to increase the degree

of financial intermediation through the banking sec-

tor, even as the authorities continued to encourage

mergers and consolidations of banks. Unfortunately,

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

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

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

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

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

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

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

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

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

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

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

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


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there were no moves to sufficiently ease entry into

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

no new banks could be established until 1990 and

foreign banks could enter only starting in 1992 and in

a limited way.

Consequently, banks had some degree of monopoly

power. They enjoyed high profits despite high costs.

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

ippine banks was 2 percent while the average for

seven other economies was only 1.8 percent.52

The

resulting inefficiency in the banking sector is seen in

many ways. Philippine banks spend $3.75 for every

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

and Singapore spend $1.15, and Korean banks pay

$2.75 only.53

In fact, Philippine banks can afford to

be inefficient because their interest margins are

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

dent of Thomson BankWatch Asia.54

Even though

the average difference between deposit and lending

rates has fallen from over 5 percent in 1997 to 4.7

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

this differential is still higher than the 1997 averages

for countries in the region such as Indonesia (1.8

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

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

Overheads as a ratio of total assets were as high as

4.4 percent for Philippine banks in 1988–1995, while

the average for seven other Asian economies was

only 1.8 percent.56

These inefficiencies may persist

if no serious efforts are taken to open the industry,

particularly to foreign participation.

REMAINING WEAKNESSES

IN PRUDENTIAL NORMS

There are several weaknesses in the prudential norms

of Philippine banks.57

First, banks accrue income on

restructured loans or immediately classify them as

performing loans so long as the loans are current in

status or are fully secured by real estate with a loan

value up to 60 percent of the appraised value of the

real estate security and other qualified collateral.

Previously, banks could only restructure loans and

declassify these as NPLs if such loans were fully

current on interest payments. The change in norms

may provide a way for some banks to refinance non-

viable companies.

While there have been notable improvements in

disclosure with respect to NPLs, loan-loss provision-

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

ing sectors loan-loss provisioning requirements are

typically net of collateral, usually property. The Re-

public of Korea, Philippines, and Singapore all use

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

Indonesia, Malaysia, and Thailand use time-based

Table 17: NPL Definition and Loan-Loss Provisioning Policies

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

Economy NPL/Past Due Definition NPL Cassification Provisioning Requirements

Hong Kong, China Judgmental Judgmental Net of collateral

Usually > three months

Indonesia > three months Time based Net of collateral

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

Malaysia > three months Time based Net of collateral

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

> one day for non-installment loans

Singapore Discretionary Collateral based Net of collateral

Usually three months

Thailand > three months Time based Net of collateral

United States > three months Judgmental Net of collateral


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provisioning, while Hong Kong, China and the US

utilize a judgmental system, based on the perceived

risk and the likelihood of payment. Since Philippine

banks implement collateral-based lending, in which

the collateral is usually property, they are very sen-

sitive to declines in property values. When prop-

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

pines and Thailand, loan-loss provisioning may not

reflect real losses.58

Second, Philippine banks are active in loan-for-

property swaps. Such practice can take place with-

out formal legal foreclosure proceedings. In many

cases, the properties are actually unearned assets in

the form of raw land and are booked as ROPOA in

bank balance sheets at realizable values. Philippine

banks can directly foreclose pledged collateral once

borrowers are proven unable to pay either interest

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

to process foreclosure orders.59

The borrower is

given a one-year redemption period to pay off his

obligations and reclaim the loan.

Third, reserve coverage against such ROPOA

assets is not required until after five years from the

time the property is booked. Some banks could use

this to inflate collateral value since the property mar-

ket is illiquid.

Fourth, loan-loss reserves are currently not al-

lowed as tax deductions. BSP has already endorsed

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

deductible. Since this move involves tax revenues,

it needs to be legislated. In general, while attempts

should be made to lower financial intermediation

costs and enhance the profitability of banks, the

important point is that the industry must also be-

come more contestable. Otherwise, such measures

to reduce intermediation costs will simply strengthen

an existing oligopoly.

Fifth, the timing of loan write-offs is determined

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

the bank and on taxes.60

Deferring write-offs is com-

mon and may materially overstate the value of as-

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

loans is one of the indicators used by supervisory

authorities for off-site supervisory purposes. How-

ever, it is considered a reactive measure because

the authorities take action only after actual losses

have been incurred.

With respect to the proposal to amend the Gen-

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

framework for measuring a bank’s capital adequacy,

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

lents, the Philippines uses a stricter method than

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

asset ratio is 10 percent versus the current 13 per-

cent (17 percent using the BIS standard).61

There

seems to be little point in asking Congress to weaken

the bank capital adequacy measure especially be-

cause such strong capital requirements are regarded

as being largely responsible for the ability of Philip-

pine banks to weather the Asian crisis. Table 18 shows

the estimated recapitalization needs of the banking

system as calculated by Goldman Sachs. Note that

the Philippines and Malaysia are the only countries

with existing surplus capital, and the Philippines is

the only country that does not require new capital.

Among the proposed amendments to the General

Banking Act is the requirement that an enterprise

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

ject to BSP examination. Banks can own allied or

nonallied enterprises, meaning such enterprises that

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

these banks are majority owners of these enterprises,

they would be subject to BSP examination. While

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

that there seems to be an attempt to supervise on a

globally consolidated basis, possible implementation

problems may be large. First, the BSP is currently

pressed, in terms of time and expertise, to examine

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

law. Second, the proposal could result in supervisory

and regulatory overlap with the SEC, which is pri-

marily charged with the regulation of corporations.

Already, the BSP has proposed that the amendments

to the General Banking Act include the proviso that


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the BSP be consulted about intracorporate disputes

in banks, quasi banks, and trust entities that affect

bank operations and transactions with the banking

public. Presently, intracorporate disputes fall within

the original and exclusive jurisdiction of the SEC.

Perhaps the solution to global supervision is to have

a unified structure of supervision, similar to that in

the crisis-hit countries.

Another proposed amendment to the General

Banking Act is granting the Monetary Board the

power to regulate compensation and other benefits

of bank directors and officers, if warranted. This may

give rise to conflict of interest and affect the ability

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

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

the bank’s capability to pursue enhanced profitability

by infringing on its capacity to compensate bank of-

ficers and directors on the basis of performance.

WEAK IMPLEMENTATION OF

PRUDENTIAL NORMS AND INTERNATIONAL

STANDARDS OF SUPERVISION

The banking system continues to suffer from weak

implementation of prudential norms and international

supervisory standards. While the BIS core principles

for effective bank supervision put much emphasis

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

bank supervisors and examiners are implementing

this is very slow. The approach to bank examination

in the Philippines focuses largely on borrower-re-

lated risks associated with loans, while secondary or

product-related risks are not consistently taken into

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

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

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

People’sRepublic Republic

Item of China Indonesia of Korea Malaysia Philippines Thailanda

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

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

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

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

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


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consideration. Examiners focus on loans, equities,

fiduciary activity, foreign transactions and treasury

operations; check compliance with banking laws;

assess internal controls; and appraise management.

Loans are evaluated based on BSP standards and

while examiners profile the loans, they do not neces-

sarily focus on loans that are beginning to become

delinquent. Examiners do not develop risk profiles of

individual products or services, nor formally appraise

risk management systems, although they claim that

they are moving in that direction.62

There seems to be much regulatory forbearance.

Bank supervisors are reluctant to effect the early

closure of failing institutions. In recent years, the most

glaring examples are Orient Bank and, more recently,

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

portant for bank supervisors to close failing institu-

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

systemic risk as well as losses to the deposit insur-

ance fund.63

While the BSP has pursued attempts at

enhancing transparency with respect to DOSRI loans

and strengthened provisions against overexposure of

a bank to DOSRI, it remains to be seen whether

more Orient Bank-type experiences, in which 80

percent of the bank’s loans went to bank owners

despite the 15 percent ceiling on DOSRI loans, will

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

leged that the BSP knew about the DOSRI loan vio-

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

it even gave Orient Bank an emergency loan whose

amount has not been revealed publicly.64

Equally important in reducing the cost and fre-

quency of bank failures is the adoption of PCA mea-

sures. This involves early intervention of regulators

in problem banks. However, even as examiners pro-

file loans, they do not necessarily focus on loans that

are beginning to become delinquent.65

This would

seem to preclude the adoption of PCA measures.

The BSP recently issued Circular No. 181 that

specifies PCA measures to be taken based on the

severity of regulatory noncompliance by banks with

respect to capital adequacy. Table 19 shows the pen-

alty to be imposed on banks depending on the per-

centage of capital deficiency, while Table 20 lists the

PCA measures corresponding to the severity of

undercapitalization. However, while the BSP has

been actively pushing for all kinds of amendments to

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

tioning the term PCA in the banking act. Its officials

argue that they would rather deal with such matters

“administratively” because it is difficult to get Con-

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

circulars they issue have the force of law.

Although one may not want to necessarily debate

with the authorities on the legal basis of such circulars,

the point is that legislated mandatory intervention,

rather than regulatory discretion, is important in pro-

tecting the interests of the public.66

The problem does

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

cient power to implement PCA measures or to ef-

fect early closure of failing institutions; it is that when

there is regulatory discretion, the intervention usu-

ally does not take place.67

Under the current law,

Section 65 of the General Banking Act states that if

a bank does not comply with the prescribed mini-

mum (capital) ratio, the Monetary Board may limit

or prohibit the distribution of net profits by such bank

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

used to increase the capital accounts of the institu-

tion until the minimum requirement is met. It is vague

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

explicit with regard to sanctions related to specific

levels of capital inadequacy. In the United States

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

tory intervention in the Federal Deposit Insurance

Corporation (FDIC) Improvement Act instead of

allowing PCA measures to be implemented using

regulatory discretion.68

Among the proposed amendments to the New

Central Bank Act is empowering the central bank

to examine banks once every calendar year. This

proposal is surprising since it appears that the BSP

needs Congress to carry out its constitutionally man-

dated task of bank supervision. Worse, it seems to


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Table 19: Sanctions on Banks Violating Capital Adequacy Regulation

Capital Deficiency

Commercial BanksUp to 20%

Up to 40%

Up to 60%

Up to 80%

More than 80%

Thrift BanksUp to 20%

Up to 40%

Penalty

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

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

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

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

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

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

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

Continued next page


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

Capital Deficiency

Up to 60%

Up to 80%

More than 80%

Rural BanksUp to 20%

Up to 40%

Up to 60%

Up to 80%

More than 80%

Penalty

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

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


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

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

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

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


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


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Table 20: Capital Deficiency and Prompt Corrective Action

Capital Deficiency(under existing lawsand regulations)

UndercapitalizedUp to 20 %

SignificantlyUndercapitalized

Up to 60%

CriticallyUndercapitalized

More than 60%

Prompt Corrective Action

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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


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imply that better BSP supervision over banks has

been hampered by the existing law in terms of the

freedom to examine banks as frequently as possible

or as needed. It is also unclear why examiners would

want to examine banks only once a year or at least

once a year and why Congressional approval is

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

ask Congress to pass the implementing law with re-

gard to supervision, would it not make more sense to

ask for the authority to examine banks as frequently

as the authorities deem necessary? This seems to be

a relic from the past when bank supervision meant

on-site examination and is constrained by time and

availability of personnel. However, the emphasis at

present is on off-site examination that allows for

greater disclosure and frequency of examination. In

countries like Malaysia, such off-site examination

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

ippines, foreign exchange trading activities of banks

are monitored daily.

WEAK CREDIT CULTURE AND INADEQUACIES

IN ADDRESSING THE DEVELOPMENTAL NEEDS

OF THE ECONOMY

The country has a weak credit culture.69

As men-

tioned previously, the Philippines has one of the low-

est degrees of financial intermediation in Asia, with

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

of credit to vital sectors of the economy, such as

rural enterprise, private infrastructure, exports, SMEs,

and the efficiency with which such credit is provided

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

credit system provides only a small portion of the

financing requirements of the rural sector. Yet, un-

less the needs of this sector and other vital ones are

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

velopment will not advance.

Two legislated provisions mandate banks to set

aside a portion of their loan portfolio to agriculture

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

March 1997, banks provided a total of P117 billion in

credit to the entire agriculture sector. Commercial

banks provided P104 billion or 89 percent of the total

agriculture loans of the banking system, thrift banks

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

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

total bank loans were below the mandated loans to

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

ance ratio of only 17 percent versus the required

ratio of 25 percent.70

Nevertheless, the bulk of ac-

tual investments to SMEs has remained “net eligible

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

have been increasing at a higher rate than those of

the total loan portfolio. The compounded annual

growth rate of SME actual investment (loan) during

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

the total loan portfolio was 33 percent.71

There are concerns that funds to SMEs may not

have really reached the beneficiaries since they are

not actual investments, and that banks have found

ways to comply with the letter of the law by simply

putting funds in an ever-expanding list of allowable

funds for compliance.72

Apart from the usual emphasis on credit provision

to SMEs and the export sector, microfinance as a

new approach to development finance has led to a

more balanced view that low-income groups demand

other financial services as well. Microfinance institu-

tions in the Philippines are composed of rural banks,

cooperatives, cooperative banks, credit unions, and

credit-granting nongovernment organizations (NGOs).

The latter have demonstrated some success in reach-

ing poor clientele.73

However, microfinance institu-

tions need to mobilize more deposits (in the cases of

rural banks and cooperative banks), tap the commer-

cial loan market, and increase their equity so as to

sustain their financial capability. It is estimated that

some 2,362 microfinance institutions reach only

656,000 clients.74

There is some debate on whether

transforming credit NGOs into banks and subjecting

them to formal regulation and supervision will lead to

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


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In part, the conservative stance of banks and the

weak credit culture may be blamed on bank examin-

ers and regulators. There is widespread uncertainty

and concern about the expectations and requirements

of regulators and examiners. Bankers have consid-

erable discretion in granting loans, but examiners have

considerable discretion in evaluating the performance

of bankers. Uncertainty and concern about examin-

ers’ expectations discourage regulated institutions

from undertaking innovative credit policies such as

finding alternatives to collateral and formal financial

statements as basis for lending, and encourage bank-

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

jective judgments.75

This tends to make bankers ex-

tremely conservative in lending. Increased foreign

participation is seen as a way to provide greater com-

petition, and to improve the credit culture, manage-

ment practices, and borrower repayment culture for

Philippine banks.

BANK SECRECY LAW

The Bank Secrecy Law may be partly responsible

for bank examiners’ conservative approach to ex-

amination.76

This law makes it impossible for BSP

and PDIC examiners to verify individual account

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

aminers may not detect misstated deposit account

balances. They could then become more conserva-

tive in the other areas of their examination. PDIC

officials have long sought access to bank deposit

records before a bank is closed because it is difficult

to effect quick liquidation when attempting to verify

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

out the complete records of bank deposits before-

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

tampered with, especially during a time of imminent

bank liquidation.

Recently, the PDIC asked Congress to amend

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

posit records of banks that have had their insured

status terminated.77

Repealing the Bank Secrecy

Law will enhance system transparency and pre-

vent systemic risk by allowing a quick payoff of

depositors as soon as the bank is closed and pre-

serving confidence in the system. The examiner

must be able to trace accounting entries through

the deposit side of the balance sheet.78

LINKAGES BETWEEN NPL RESOLUTION,

AND CORPORATE GOVERNANCE AND

REHABILITATION

The deterioration in corporate sector performance

between 1997 and 1998, as evidenced by the increase

in the number of firms applying for debt suspension

with the SEC and whose total liabilities amounted to

6.2 percent of outstanding commercial loans in 1998,

points to the need to parallel corporate debt resolu-

tion and the resolution of bank NPLs. The health of

the banking system depends to a large extent on the

health and performance of the corporate sector.

Unfortunately the SEC, which is in charge of corpo-

rate sector supervision, is extremely burdened with

many different functions. Both the effectiveness of

existing corporate regulations, especially with regard

to disclosure and transparency, and the capacity of

the SEC to fulfill its corporate regulatory and super-

visory functions need to be addressed.

One of the major impediments to improving the

resolution of corporate debts and ultimately, of bank

NPLs, is the inadequacy of the existing law covering

corporate rehabilitation. Corporate rehabilitation is

not defined anywhere.79

While it is a remedy pro-

vided under Presidential Decree 902-A, neither the

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

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

forms of remedies for ailing corporations, the SEC

has exclusive jurisdiction over corporate rehabilita-

tion and, thus, corporate rehabilitation tends to be

regulator-driven. However, the SEC has not adopted

formal rules to govern the implementation of these

remedies. Hence, it exercises a lot of discretion and

power in granting them, treating applications for


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

questions, such as who will prepare the corporate re-

habilitation plan, who will manage the corporation dur-

ing the pendency of the petition, and can encumbered

assets be disposed of, remain unanswered.80

Unless

the law covering corporate rehabilitation is improved

to address all of these issues, banking sector reform

will remain standing on one leg.

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

policy appropriately. The previous macroeconomic

regime gave rise to an inappropriate system of in-

centives for market participants, particularly in the

area of recognizing and minimizing risks, which con-

tributed to the fragility of the banking sector. The

previous system of incentives, which attracted capi-

tal inflows for the wrong reasons and into the wrong

sectors, must be avoided. It is important to conduct

macroeconomic policy appropriately so that the

proper incentive system evolves, moral hazard is

avoided, with market participants aware of the need

to recognize and minimize risks, banks owners and

managers being accountable to depositors, and de-

positors willing to monitor the behavior of bank man-

agement. Such an incentive system would rely more

on market-based incentives rather than on strong

supervision by supervisory authorities.

Second, there must be serious improvements in

institutional arrangements and mechanisms that give

rise to greater transparency and flows of informa-

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

behaved asset markets so that corporate transpar-

ency is enhanced and valid financial information is

based on market observations. However, it is a fact

of life that inappropriate macroeconomic policy

such as government financing of a large and recur-

ring fiscal deficit either by borrowing through trea-

sury bill sales or through an inflation tax, or attempts

to fashion a floor price for the exchange rate by

keeping domestic interest rates high, will keep capi-

tal markets, both equity and debt markets, relatively

underdeveloped. High interest rates will also make

it difficult for borrowers to repay loans and will

therefore raise the degree of fragility of the bank-

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

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

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

ernment is financing this increased spending pri-

marily by borrowing from abroad to be able to keep

domestic interest rates down. Care must be exer-

cised, however, that the foreign borrowings do not

translate into a difficult external debt service bur-

den as they did in the early 1980s.

Third, the banking system must respond to the

developmental needs of the economy without com-

promising the banks’ commercial viability. Banks must

learn to mobilize savings efficiently so that they can

address the needs of specific sectors that have cru-

cial developmental and social impact, such as ex-

porters, SMEs, microfinance, etc. Transactions costs

are effectively high for banks handling mandated

credit programs because of an asymmetry of infor-

mation that impacts directly on the credit decision

and the credit risk between borrower and lender.

These costs must be reduced by introducing mar-

ket-based compliance mechanisms to minimize the

information gap between financial institutions and the

mandated credit program market.81

The PDIC can

also play a role in mobilizing savings in the poorer

rural areas by providing the confidence needed for

the rural depositor to place funds in local financial

institutions.

Under the national strategy for microfinance, is-

sues such as performance standards for microfinance

institutions, termination of subsidized directed credit

programs, adoption of market-determined interest rates,

and government support to capacity-building efforts

of microfinance institutions are being attended to.


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Strengthen Prudential Regulationand SupervisionThis entails strengthening prudential norms and ad-

dressing the remaining weaknesses identified, such

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

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

erty swaps in bank balance sheets and the need for

adequate and immediate provisioning, (iii) the tax

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

disadvantages of the current stricter definition of

capital adequacy relative to the BIS standard, (v)

the overemphasis on collateral as the basis for lend-

ing decisions, (vi) the scope of supervision beyond

banks to include allied and nonallied bank-owned

enterprises and the appropriate architecture of su-

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

sory authorities to regulate the compensation of bank

directors and officers.

In addressing these weaknesses, it is necessary

to have a formal framework and common terminol-

ogy for risk assessment and risk management sys-

tems in banks.82

The disadvantage of the current

system, which relies heavily on collateral when mak-

ing lending decisions, is that it tries to mitigate risk

more by avoiding rather than managing it. The adop-

tion of good risk management techniques permits

lenders to take on more risks, serve more borrow-

ers, and earn higher returns associated with greater

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

It must be pointed out that while the Basle Accord

focuses on capital measurement and the setting of

minimum capital adequacy standards, it does not

offer standards for banks’ efforts to identify, mea-

sure, monitor, and control material risks.83

This

means that the Basle Accord cannot be regarded

as a complete international prudential agreement

and that individual countries will have to find a way

to interpret and implement the spirit of the accord,

given their own levels of institutional and socioeco-

nomic development.

Another measure to strengthen prudential super-

vision is better implementation of prudential norms

and supervisory standards. It is important for bank

examiners and supervisors to gain expertise in de-

veloping risk profiles of individual products and

services and in being able to formally appraise risk

management systems.

Ways to improve the implementation of prudential

norms and supervisory standards include training of

bank supervisors and examiners in risk appraisal and

management techniques, enlargement of the pool of

competent bank examiners and supervisors by of-

fering competitive salaries to attract and retain ex-

perts from the private sector, and opening the do-

mestic banking industry to foreign participation to help

produce such experts in the private sector.

Another way is to emphasize transaction-based

banking, rather than relationship banking, and to re-

duce regulatory forbearance. In the Philippines, many

things are accomplished on the basis of relationships

or “connections,” whether one is talking about getting

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

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

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

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

pay rather than on whether there is collateral. Rela-

tionship banking makes it difficult to put a stop to the

abuses of related-party lending or to effect the early

closure of failing institutions. Here, all the prudential

standards and norms one can write into law will not

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

lect their clients, and in the seemingly cozy relation-

ship between the BSP as regulator and supervisor of

banks and the regulated banks themselves.84

Measures to reduce potential conflict-of-interest

situations must be adopted. One way to maintain an

arm’s-length relationship between the supervisor and

regulator of banks and the banks themselves is to

reduce regulatory discretion with respect to PCA

measures by legislating mandatory intervention. If

these measures are written into law, there will be

greater transparency and both supervisor and banks

will be accountable to entities other than themselves,

such as Congress.


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

able. This is accomplished primarily by removing

barriers to entry. While the BSP is raising capital

standards and encouraging mergers and acquisitions

among banks, it must also allow entry or raise the

threat of potential entry, particularly of foreign insti-

tutions. The dismal fact is that while raising capital

standards and encouraging mergers have made do-

mestic banks strong, there are no distinct signs that

financial intermediation has become more efficient.

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

tio and some of the highest interest rate spreads

among Asian countries. This has remained so de-

spite financial liberalization and reform moves since

the early 1980s. It appears that capital hikes and

voluntary mergers have acted as effective barriers

to entry. While 100 percent foreign ownership of

banks is being discussed, the BSP already has thought

of ways to provide macroeconomic protection to the

local banking industry by setting a ceiling on the per-

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

eign owned. It seems there are more benefits than

there are disadvantages from complete foreign own-

ership of banks as shown by the experiences of

Singapore and New Zealand.

Privatization is also seen as a way of raising effi-

ciency and competition in the industry. In this regard,

the clinching of the PCIBank sale by the Equitable

Group, with the participation of two government fi-

nancial institutions, sends the wrong signal to market

participants. The signal being given is that having the

Government on your side ensures the winning bid.

Worse, it could imply that the Government, because

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

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

problem of moral hazard, which led to large losses

and insolvency in government-owned corporations

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

ing systems in Asia during the crisis.

Public listing requirements must be strengthened

to improve corporate governance in the banking in-

dustry. Measures to raise overall system transpar-

ency to make information readily available must be

adopted so that each banking firm can compete on

an equal footing.

Financial intermediation taxes, such as gross re-

ceipts tax and documentary stamp tax, the AGRI/

AGRA requirement, and the Magna Carta for SMEs,

must be eliminated or reduced, and implicit financial

intermediation taxes, such as the liquidity reserve

requirements, must eventually be removed.

Currently, a World Bank Financial Sector Adjust-

ment Loan is being utilized to assist in improving the

banking sector’s health and efficiency.

Improve the Financial InfrastructureAccounting and disclosure systems have to be

strengthened so that the true financial condition of

banks, including their affiliates, is readily verifiable.

Without a credible disclosure system, it will be diffi-

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

tive of a crisis situation or a situation of increased

vulnerability. Better accounting and disclosure will

also allow better off-site monitoring of banks and

reduce the strain on personnel and time of conduct-

ing on-site inspections.

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

allow bank examiners access to deposit records be-

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

the PDIC to review deposit account balances be-

cause of the Bank Secrecy Law makes it virtually

impossible to protect the interests of depositors. To

enhance the PDIC’s role in bank examination, legal

impediments to the review of second-party verifica-

tion of deposit accounts must be lifted. The repeal of

the Bank Secrecy Law will also assist fiscal authori-

ties in tax mapping and tracking down tax evaders.

The linkages between NPL resolution and im-

proving corporate governance and rehabilitation


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must be recognized. Improvements are needed in

the legal framework for orderly corporate restruc-

turing and loan workouts, including strengthening

the bankruptcy law and implementation procedures.

Specifically, the SEC must adopt formal rules for

implementing corporate rehabilitation, and make the

proceedings swift and time bound, and creditor

rather than regulator driven.85

It is also necessary to have a clearer legal inter-

pretation of the BSP mandate as supervisor and

regulator of banks, and the extent of the legislation

required to carry out such mandate. The legal basis

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

the need for Congress to legislate measures to ef-

fect the adoption of the Basle core principles of ef-

fective supervision apparent. It is ambiguous where

BSP independence is at stake and where legislation

is needed to minimize regulatory forbearance.

Summary and ConclusionLike in many Asian countries, the Philippine banking

system until the early 1980s was primarily tasked

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

duit of credit to sectors deemed as high priority by

the State. Controls on interest rates, subsidies, and

directed lending were some of the ways this was

carried out. Financial repression was one of the re-

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

nance, and inefficiency in the system of financial in-

termediation were among the main problems that

emerged in the financial sector.

An IMF-Central Bank study of the financial sec-

tor in 1972–1973 made recommendations to address

those issues. Beginning in 1980, financial liberaliza-

tion and reforms were undertaken. Ceilings on inter-

est rates were lifted, bank consolidation and merg-

ers were encouraged, the liberal discounting policy

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

forms were implemented; however, bank entry was

not allowed and certain prudential norms were not

adopted. The 1980 reforms did not include rules on

the treatment of overdue loans, the provisioning of

debt, and examination of deposit transactions by cen-

tral bank examiners. In 1980, the capital adequacy

requirements were even reduced. Rules regarding

credit accommodation to DOSRI were relaxed. All

these set the stage for the banking crisis in 1981,

triggered by the collapse of the commercial paper

market. Meanwhile, excessive public borrowing in

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

decade, became an external debt burden in the 1980s

when the second oil shock dried up foreign capital

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

the Philippines had declared a moratorium on the

service of external debt, which effectively meant that

no new foreign inflows would be forthcoming for a

while. The country experienced negative rates of

growth for the first time in its postwar history in 1984

and 1985. The central bank raised domestic interest

rates by issuing high-yielding debt instruments of its

own called Jobo bills, and tamed inflation by inducing

tremendous slack in the economy.

Hence, although financial liberalization and re-

form measures were taken prior to the financial

crisis in 1981, the macroeconomy itself was in bad

shape, largely because of earlier excesses and the

loss of foreign inflows. It was difficult under such

circumstances to proceed with and deepen the fi-

nancial sector reforms. Nevertheless, since the re-

form process was necessary, it did continue. The

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

etary authorities to strengthen prudential regulations

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

The authorities strengthened regulations on single

borrower limits, limits on DOSRI loans and inter-

locking directorships, capital adequacy, compliance

with minimum risk-asset ratio, and provisions for

loan losses. The Government also undertook the

rehabilitation of the financial sector, particularly of

PNB and DBP, two government-owned financial

institutions that accounted for nearly 50 percent of

all banking assets and which had become insolvent

by 1985. The rural banking system, which experi-

enced large failures after its primary source of funds,


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namely the central bank’s discount window, aligned

its rate with market rates, was also rehabilitated

through a capital-buildup program.

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

eralized. In 1994, foreign bank entry was allowed

but was limited to 10 banks under specified modes

of entry. The foreign exchange market was also lib-

eralized during the early 1990s. By 1992, exporters

could retain 100 percent of their foreign exchange

earnings, restrictions on the purchase of foreign ex-

change were lifted, and the full and immediate repa-

triation of duly registered foreign investments was

allowed without prior BSP approval.

With the liberalization of the financial and capital

markets in the Philippines, foreign capital inflows

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

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

crisis in July 1997, the monetary authorities once

again strengthened certain prudential norms, includ-

ing setting a 20 percent cap on real estate lending

by banks, imposing a 30 percent liquid cover on all

foreign exchange liabilities of banks, and prescrib-

ing guidelines governing the responsibilities and du-

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

those measures helped prevent the collapse of the

banking system, they were insufficient to control

the dramatic increase in its NPL ratio from about 4

percent prior to the crisis to 13.1 percent as of June

1999. Although the Philippine banking system es-

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

nerability to the crisis increased. This can be blamed

on defective macroeconomic policy and premature

liberalization of the capital market prior to the insti-

tution of a strong supervisory and regulatory frame-

work for banks.

The flawed policy of maintaining a fixed nominal

exchange rate largely by keeping domestic interest

rates high encouraged overborrowing from abroad,

particularly in the last two years before the onset of

the Asian crisis. It created an inappropriate incen-

tive system, enabling domestic banks to borrow

cheaply from abroad and relend locally at very high

rates. Most of the borrowed funds flowed into the

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

large corporations that were able to borrow directly

from abroad, there were substantial interest cost sav-

ings. However, the ease with which foreign borrow-

ing could be effected made market participants less

than prudent in their borrowing and lending behavior.

The lack of effective bank supervision allowed such

situation to continue. Most of the borrowing was

unhedged. Fixed nominal exchange rates obscured

the currency risk, treating this as mere credit risk.

When the peso defense was abandoned on 11 July

1998, many of the loans soured and contributed to

the growing NPLs.

Since the crisis, the monetary authorities have fur-

ther strengthened prudential norms. They have re-

defined the criteria for past due loans by shortening

the period of installment arrears; mandated a 2 per-

cent general and specific loan-loss provision for

banks, to be accomplished in several stages; raised

capital requirements; and rationalized foreign ex-

change trading by introducing a dollar hedging facil-

ity to banks called the Currency Risk Protection Pro-

gram (CRPP)—which is also known as the

nondeliverable forward (NDF) facility—by prescrib-

ing prior BSP clearance for sales of NDF contracts

by banks, and adjusting the overbought/oversold for-

eign exchange position of banks.

This study identifies factors that contribute to the

remaining weaknesses and vulnerability of the Phil-

ippine banking system. They include structural weak-

nesses and difficulties in the conduct of macroeco-

nomic policy, the problem of pursuing liberalization

when institutional failures and deficiencies are

present, weaknesses in prudential norms, poor imple-

mentation of prudential norms and international stan-

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

pediments in the legal infrastructure such as the Bank

Secrecy Law and a weak legal framework for or-

derly corporate restructuring and loan workouts.

To address these problems, the study recommends

the following measures:


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• Strengthen banks to meet the increasing require-

ments of globalization through the appropriate

conduct of macroeconomic policy. This will pro-

vide a correct system of incentives, which is

necessary for improving financial intermediation

efficiency while addressing the demands of long-

term development finance as well.

• Foster competition and efficiency in the banking

industry through (i) promotion of contestable mar-

kets and encouragement of greater foreign en-

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

(iii) strengthening of public listing requirements

to improve corporate governance in the banking

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

nancial intermediation taxes (such as gross re-

ceipts tax, documentary stamp tax, AGRI/AGRA

requirement, Magna Carta for SMEs), and im-

plicit financial intermediation taxes (such as li-

quidity reserve requirements).

• Strengthen prudential regulation and supervi-

sion by (i) adoption of a formal framework and

common terminology for risk assessment and

risk management systems in banks; (ii) improve-

ment of financial reporting, disclosure, and

transparency, including the repeal of the Bank

Secrecy Law; (iii) better implementation of pru-

dential norms and supervisory standards; and

(iv) reduction of regulatory forbearance by such

methods as legislation of the adoption of PCA

measures.

• Improve the financial infrastructure by strength-

ening the legal and regulatory system for corpo-

rate governance, financial restructuring, and

bankruptcy. The SEC must upgrade standards

of corporate disclosure and transparency, adopt

formal rules for implementing corporate reha-

bilitation, make the proceedings swift and time-

bound, as well as creditor rather than regulator-

driven. There must be a clearer legal interpreta-

tion of the BSP’s mandate as supervisor and

regulator of banks and the extent of the legisla-

tion needed to carry this out.

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

Philippine banking system was spared from the worst

effects of the Asian financial crisis, the goals of the

reform program that began in the early 1980s still

have not been completely achieved. The challenge

is to accomplish these in a more volatile macroeco-

nomic environment that is more integrated with the

global economy.


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Notes

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

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

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

4Ibid.

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

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

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

8Valenzuela, 1989, p. 6.

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

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

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

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

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

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

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

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

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

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

18Guinigundo, 1999.

19Ibid.

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

21Ibid.

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

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

24Ibid., p.10.

25Guinigundo, 1999.

26Ibid.

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

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

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

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


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31Ibid.

32Ibid.

33Guinigundo, 1999.

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

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

36Guinigundo, 1999.

37Ibid.

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

39Deutsche Morgan Grenfell, 1998, p. 54.

40Intal and Llanto, 1998, p. 23.

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

42Bangko Sentral ng Pilipinas SRSO.

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

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

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

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

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

48Deutsche Bank, 1999, p.17.

49Guinigundo, 1999.

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

51Ibid., p. 220.

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

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

54Ibid., p. 30.

55ADB, 1998, p. 23.

56Ibid.

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

58Ibid., p. 8.

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

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

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

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

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

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

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

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

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


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

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

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

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

71Ibid. , p. 18.

72Ibid, , p. 17.

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

74Ibid., p. 4.


76Ibid., p.10.

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


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

80Ibid., pp. 16–19.

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

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

83Frankel, 1998, p. 218.

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

85Concepcion, 1999, p. 5.


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References

Aggarwal, Raj and Kevin T. Jacques. 1998. Assessing theImpact of PCA on Bank Capital and Risk. Federal Re-serve Bank of New York Economic Policy Review Oc-tober: 23–32.

Asian Development Bank. 1998. Philippines Country Eco-nomic Report. Manila.

Bangko Sentral ng Pilipinas. 1997. Proposed Revised Gen-eral Banking Act of 1997. December.

__________. Various issues. Selected Economic Indi-cators.

__________. Supervisory Reports and Studies Office.(Table on Selected Financial Ratios of the Philippine Bank-ing System and Table on Total Loans, NonperformingLoans and Loan-Loss Provisions—Commercial Banks)

Basilio, Robert JA Jr. 1999. Asia’s Banks Still on ShakyGround. Business World, 5 July: 30.

Bautista, Ernesto D. 1992. A Study on Philippine Monetaryand Banking Policies, Philippine Institute for DevelopmentStudies (PIDS). Working Paper Series No. 92-11, August.

Concepcion, Danilo L. 1999. Corporate Rehabilitation: ThePhilippine Experience. Paper presented at the EconomicPolicy Agenda Symposium Series, Mandaluyong City,25 June.

Demirguc-Kunt, Asli, and Enrica Detragiache. 1997. TheDeterminants of Banking Crises: Evidence from Devel-oped and Developing Countries, May. Unpublished.

Deutsche Bank. 1999. Is Asia’s Recovery Sustainable?Global Emerging Markets-Asia, May.

Deutsche Morgan Grenfell. 1998. Philippine Banks. March.

Dolor, Felicisimo A. Jr. 1999. Story Remains the Same:Banks’ Asset Quality Continues to Deteriorate in Q1.Business World, 17 May. p. 34.

Dumlao, Doris. 1999. Allied Seen Bidding for Prime Bank.Philippine Daily Inquirer, 14 June. p. B1.

__________. 1999. Banks’ Bad Loans Down to 13.5%.Philippine Daily Inquirer, 5 August. p. B2.

__________. 1999. BSP Moves to Ease Foreign Owner-ship Cap in Banks. Philippine Daily Inquirer, 31 May.p. B1.

Fitzgerald, Thomas M., Feliciano Miranda Jr., David S.Murphy, and Gerald C. Schulz. 1997. Regulatory Barri-ers to Innovative Lending Practices: Traditional Ap-proaches to Bank Supervision. IMCC Credit PolicyImprovement Program, October.

Frankel, Allen B. 1998. Issues in Financial Institution Capi-tal in Emerging Market Economies. Federal ReserveBank of New York Economic Policy Review, October1998: 213–223.

Gochoco-Bautista, Maria Socorro. 1998. Prudential Regu-lation and Supervision: Comments on the ProposedAmendments to the GBA. Unpublished.

Gochoco-Bautista, Maria Socorro, Soo-Nam Oh, and S.Ghon Rhee. 1999. In the Eye of the Asian FinancialMaelstrom: Banking Sector Reforms in the Asia-PacificRegion. Paper presented at the ADB-ADB Institute-Institute of Fiscal & Monetary Policy High-Level Re-gional Workshop on the Asian Financial Crisis, Tokyo,25–26 March.

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

__________. 1999b. Asia Banks 1999: Issues and Out-look, 5 January.

__________. 1999c. Asia Banks: Prudential Norms andCAMELOT II, 1 March.

__________. 1999d. Philippine Banks, 28 April.

Guinigundo, Diwa C. 1999. Current State of the PhilippineBanking System. Paper presented at the Annual Meet-ing of the Philippine Economic Society. Makati, 12March.

Intal, Ponciano S. Jr., and Gilberto M. Llanto. 1998.Financial Reform and Development in the Philip-pines, 1980–1997: Imperatives, Performance, andChallenges. PIDS Discussion Paper Series No. 98-02, January.

Lamberte, Mario. 1993. Assessment of the Financial Mar-ket Reforms in the Philippines, 1980–1992. Journal ofPhilippine Development. No. 37. 2(2): 231–259.


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Llanto, Gilberto M., Rosario G. Manasan, Mario B.Lamberte, and Jaime C. Laya. 1998. Local GovernmentUnits’ Access to the Private Capital Markets. Makati:Philippine Institute for Development Studies.

__________. 1998. Policy and Regulatory Issues FacingMicrofinance in the Philippines. Paper presented at theCoalition for Microfinance Standards National Summit,Asian Development Bank, Mandaluyong City, 20–21August.

Medalla, Felipe, and Johnny Noe Ravalo. 1998. Impact ofMandated Credit Programs. Credit Policy ImprovementProject Working Paper No. 8.

Paderanga, Cayetano. 1996. Philippine Financial Develop-ments: 1980–1995. In Raul V. Fabella and Kazuhisa Ito,eds. Financial Sector Issues in the Philippines. Insti-tute of Developing Economies, Tokyo. pp. 1–26.

PDIC Seeks Access to Deposit Records. 1999. PhilippineDaily Inquirer, 14 June, p. B2.

Philippines. Republic Act No. 337. An Act RegulatingBanks and Banking Institutions and for Other Purposes.First Congress.

Philippines. Republic Act No. 3591 (Original and Amend-ed). 1963. The Charter of the Philippine Deposit Insur-ance Corporation.

Philippines. Republic Act No. 7653. 1993. The New Cen-tral Bank Act.

Philippines. Senate Bill No. 589. 1997. An Act Providing forthe Regulation of the Organization and Operations ofBanks, Quasi Banks, Trust Entities and for other Purposes.Eleventh Congress of the Republic of the Philippines.

Rana, Pradumna B., Joseph Anthony Y. Lim. 1999. TheEast-Asian Financial Crisis—Issues in Designing andSequencing Macroeconomic Policies. Paper presentedat the ADB-ADB Institute-Institute of Fiscal & Mon-etary Policy High-Level Regional Workshop on theAsian Financial Crisis, Tokyo. 25–26 March.

Torrijos, Elena R., and Doris C. Dumlao. 1999. Banks Ex-pect Better Times Ahead. Philippine Daily Inquirer,10 May. p. D1.

Valenzuela, Carlota P. 1989. Bank Supervision and Exami-nation: 1948–1988—A Historical Sketch, Central BankReview 41(1): 4–8.

Solid Crust with Soft Center:A Problem of Enforcement inthe Philippine Capital Market

Stephen Wells

Stephen Wells is Senior Partner of Stephen Wells Consulting; Research Fellowof the Financial Markets Group, London School of Economics; and was former

Chief Economist (1989–1997) of the London Stock Exchange.


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Overview

The purpose of the study is to assess the effective-

ness of the Philippine capital markets in mobilizing

the savings of ordinary people to provide investment

capital for developing the Philippine economy and in

attracting sustainable flows of foreign capital for the

same purpose.

The broad conclusion is that the markets have not

been so successful in either aim even though evi-

dence suggests that there have been very substan-

tial improvements in recent years. The savings ratio

remains low by standards of the region. In part that

reflects the relatively low income per head in the

Philippines compared with other economies in the

region.

But that, in turn, is a comment on the capital mar-

kets—other countries have started from a low in-

come base and mobilized sufficient domestic and

foreign capital to permit more rapid income growth

and hence a higher level of savings. It is also true

that while average incomes in the Philippines remain

low, the developments of recent years have brought

comparatively higher wealth at least to a segment of

the population. The growth of shopping facilities in

Metro Manila is testament to this. These new high-

net-worth individuals who are avid consumers would

be expected to be making significant savings through

financial investments, but this has not been the case.

The reasons for this are many. There are detailed

issues in the operation of markets, but the main is-

sues are (i) the absence of savings vehicles, espe-

cially for middle and higher income groups; (ii) lim-

ited attractive investment (as opposed to specula-

tive) opportunities for foreign portfolio investors; and

(iii) the perception that capital markets are not fair,

open, and transparent.

The Philippines is not a rich country—indeed its

growth has fallen behind that of comparable coun-

tries in Asia. However, it has seen significant growth

and there is evidence— from the level of consump-

tion–of an emerging middle class of relatively pros-

perous individuals. Typically, such a middle class be-

comes interested in saving for eventualities (such as

education) and for their retirement. The result is a

demand for financial assets either directly to be held

by the individuals or to be held through collective

savings vehicles. The financial assets, which repre-

sent claims on real assets, are sold by the asset own-

ers to raise new capital to develop those real assets.

This transfer is facilitated by intermediaries, by mar-

kets and market infrastructures (regulation, secure

settlement, etc.), which offer comfort that users will

not be defrauded.

This has happened to only a limited extent in the

Philippines and the situation explains why the

country’s savings ratio is relatively low–there is just

nowhere to put the money. To summarize the cur-

rent situation:

• There are retail savings deposits, which gener-

ally offer a low return.

• There is a banking network, banks are very nu-

merous (and relatively well-capitalized as reserve

requirements are high), but they are usually part

of larger groups and their function is to raise fi-

nance for those groups.

• There is a stock market, but it is seen by many

as not entirely clean and is highly speculative.

• There is a bond market, but the corporate bond

market is small relative to the Government bond

market and has an almost exclusively floating

rate.

• There is an embryonic mutual fund business, but

its growth is slow and its investment opportuni-

ties are limited.

• There is a national funded pension scheme, but

its investments are constrained and there is no

framework for private schemes.

• There are other financial intermediaries such as

insurance companies, but again, their investment

opportunities are limited.

• There is foreign investor interest, but it tends to

be speculative because of the nature of the mar-

ket and lack of security of transfer.

81SOLID CRUST WITH SOFT CENTER: A PROBLEM OF ENFORCEMENT IN THE PHILIPPINE CAPITAL MARKET

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A generally unsatisfactory situation is caused by

weak infrastructure:

• There is no proper market for the determination

of interest rates. These are largely mandated

by Government policy and have been set artifi-

cially high.

• There is frequently a suspicion that those in au-

thority will abuse their position. To protect against

that eventuality, regulation tends to be overly pre-

scriptive, rigid, and slow to respond.

• Corporations tend to be dominated by tight,

founder groups of shareholders– even where

they are listed, which relatively few are. They

are generally highly cautious about releasing in-

formation and are subject to little shareholder

pressure.

• Accounting standards and disclosure are, in

theory, comparable with good international prac-

tice, but enforcement is weak.

• The stock exchange lacks authority and willpower

to act in the interest of the whole market rather

than just its members or indeed a powerful sub-

set of those members.

• The main regulator lacks resources, is overbur-

dened with inappropriate administrative tasks, and

is too much focused on prescription and hands-

on regulation rather than standard setting and

policy guidance.

• Banks dominate the retail savings market, and

the easy availability of cheaper bank credit—

usually from banking arms—has stultified the use

of public markets as sources of capital.

An examination of the detailed problems, issues,

and possible resolutions forms the rest of this report.

Policy Issues

Equity Market

MARKET INFRASTRUCTURE

Microstructure

The Philippine Stock Exchange (PSE) operates a

fairly standard electronic order book. However, there

are two important features. First, the ticker that dis-

plays trades to the market immediately as they are

made shows the code of the firms involved in the

trade.

All systems will show the firm IDs to the regula-

tors, but most do not publish them. This has two ef-

fects:

• It makes it easy for firms to have a very precise

measure of their market share and those of their

competitors. Since brokering is a network busi-

ness, market share is a critical competitive point.

Firms with larger market shares, since they see

more orders, can be assumed to be better in-

formed about the current state of the market.

Therefore, in most stock markets, firms are rather

secretive about their market share and prone to

exaggerate.

• It makes it easier for observers to judge where

the business is at any time. As a rule, there is a

limited number of orders – probably only one

sizeable order – in the market at any one time.

Knowing where that is assists other firms to cap-

ture part of the counterparty business to that or-

der. They will be more able to negotiate deals

away from the trading system by calling directly

to the firm working the order.

It is difficult to predict the effect of this on firms.

It probably benefits (i) larger firms by making ex-

plicit the firm with the most market share, but it also

benefits (ii) smaller firms by allowing them to spot

where the order flow is and to consummate trades

that otherwise would probably have been crossed by

the firm with the order. It could go either way, but

my sense is that (ii) dominates – small firms may

gain sight of order flow that they would otherwise

not be aware of. As part of a strategy to consolidate

and strengthen stock brokering firms, the PSE might

consider altering this feature.

The second feature is the special block trades of

the PSE. All markets have a way of handling large

orders, which is different from the way normal size

orders are handled. Without this, the market would


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not be able to offer institutional liquidity at acceptable

prices; the order would move the market by stimulat-

ing front-running behavior. In essence, what is offered

is a private negotiation possibility where the trade can

be constructed without alerting other traders. On the

New York Stock Exchange (NYSE) this is called up-

stairs trading; in London it is called protected trading

or worked principal agreements; on the PSE it is called

special block trading or put-throughs.

When doing a put-through, a broker finds a

counterparty among his own client base. One large

foreign broker estimated that most of his business

would be crossed within the firm (a “cross”) or with

another firm by telephone negotiation (a special

block). A price is agreed upon and the trade is re-

ported to the PSE (this makes it an on-exchange trade

and so is exempt from the capital gains tax [CGT]).

The price of crosses is constrained to no more than

two “fluctuations” (a fluctuation is between 1 and 2

percent) away from the previous trade provided the

cross price is within the best bid and offer. The price

of special blocks is not constrained. Each special

block requires approval of the Floor Trading and

Arbitration Committee; but given that there are, on

average, 20–30 special blocks per day, detailed ex-

amination is probably not possible or necessary.

It is often argued that a facility of this type allows

a two-tier market to develop, and many exchanges

(e.g., NYSE) have rules forcing upstairs trades to

interact with the public order book. However, others

(e.g., London, Amsterdam, Paris) do not and this trend

is growing. Arbitrage, it is argued, reduces the need

for formal interaction. But exchanges that adopt this

approach are concerned to ensure that a two-tier

market does not develop and so monitor the situa-

tion. There is no evidence that the PSE monitors this

in any formal and rigorous way and, given the gen-

eral quality of the market, it is likely that there is a

two-tier market.

A further feature is that trade-to-trade price

changes are limited to one ”fluctuation” except for

special blocks (Table 1). A fluctuation is approxi-

mately 1-2 percent of the price. This seems small

and may limit liquidity in the market. The notion may

be based on the NYSE tick rule where the “price

continuity rule” limits the trade-to-trade price changes

to a single tick. But the important difference is that

the NYSE has a specialist whose main function is to

ensure that this happens and to manage the trading

and price movement in single tick increments. The

PSE does not have this and there may be occasions

when order imbalances prevent the gradual price

change and so jam the market. The fact that this

does not seem to happen suggests that it is not a

problem or that the market has worked around it,

but it could be a barrier to liquidity.

Table 1: Daily Volume of Stocks in the Philippine Stock Market, February 1998

na = not available.PLDT = Philippine Long Distance Telephone.Source: Philippine Stock Exchange monthly report, February 1998.

Special Blocks Average Value

Stock Total Value (P million) Number Value (P million) % of Total Value Special Blocks Other Stocks

Manila Electric Company 5,480 19 3,081 56 162 114

PLDT 4,707 21 560 12 27 197

Ayala Land 3,606 16 657 18 41 140

Metro Bank 2,151 26 531 25 20 77

San Miguel 2,018 5 67 3 13 93

Belle 1,737 2 38 2 19 81

Ayala Corp. 1,732 2 46 3 23 80

SM Prime 1,668 4 772 46 193 43

Digitel Telecom 1,330 1 14 1 14 63

Metro Pacific 1,299 na na na na 62


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Transaction Cost and Liquidity

Cost and liquidity are important attributes of mar-

kets seeking to attract large traders such as foreign

institutions. Liquidity is the extent to which large

trades can be made without moving the market. A

number of practitioners suggested that in the top 10

stocks there was quite considerable liquidity; some

claimed that trades of up to $100,000 (P4 million)

could be accommodated (before the current crisis).

Trades above that size would be done as special

blocks. Major players will also cross business in-

house—one major firm claimed to cross 40 percent

of its volume in the top five stocks.

Table 1 shows the daily volumes for February 1998

for the top 10 most active stocks. It shows that, while

special blocks were important in some stocks, in most

stocks their role was relatively modest. The block

figure for Manila Electric was boosted by a single

trade for P2.8 billion that represented over 90 per-

cent of the special block value. The results suggest

that in these stocks there is reasonable liquidity for

institutional trading, and the special block facility of-

fers the opportunity to transact in larger size without

the “upstairs” market becoming too dominant.

Commission rates are negotiable, with a maximum

of 1.5 percent plus 10 percent value-added tax

(VAT). The imposition of VAT on commissions is

unusual but not of major significance. The view

among practitioners was that commissions remained

rather high— perhaps P75 billion for foreign inves-

tors, though negotiations down to P20 billion were

not unknown. In addition, transfer taxes are high: the

combination of the documentary stamp tax on the

buyer and stamp tax on the seller adds 1.25 percent

to the transaction costs. Settlement and other cen-

tral fees are low (0.00008 percent ad valorem and

certificate issue of P25) and are paid from the bro-

kers’ commissions.

Probably as a result of the high commissions and

taxes, the Philippines is a relatively high-cost market

by neighboring country standards. Table 2 shows the

results of the Elkins/McSherry analysis of transac-

tion costs for the fourth quarter of 1997. Elkins/

McSherry is a New York-based performance mea-

surement house. It has an institutional client base in

the United States (US).

Elkins/McSherry’s results show the Philippines as

having the second highest transaction costs among

comparable Asian equity markets. The main cause

is the high commissions, fees, and taxes (price im-

pact costs are actually rather low, probably because

of the prevalence of crosses for all larger business).

However, the figures also show that US investors

are able, on average across their trading in Philip-

pine stocks, to avoid the full imposts of the taxes and

commissions. It is not clear how they do this, but

trading in offshore centers would be one way of do-

ing that and is a rational response to high local charges.

Equity transaction costs are high largely because

of high taxes on transfers; high commissions also

contribute to the costs. The Government is, no doubt,

loath to give up the revenue, but two points need to

be considered.

Studies suggest that the elasticity of demand for

transaction services is very high. This is supported

Table 2: Global Transaction Costs, Fourth Quarter1997 (P billion)

a Market impact is measured by comparing the trade price with some measure ofthe “underlying price,” i.e., the price that would have prevailed had the trade nottaken place. It measures the skill of execution and liquidity of the market.Normally, the larger the trade, the more the impact. The methodological problemis to estimate the underlying price. In the absence of better data, Elkins/McSherry’s methodology uses an average of the high, low, open, close for the dayas the estimate.

Source: Elkins/McSherry Co., Inc.

Commission,Fees, and Market Total

Economy Taxes Impacta Cost

Hong Kong, China 46.45 9.46 55.91

India 20.70 49.53 70.23

Indonesia 77.90 23.38 101.28

Korea, Rep. of 60.77 158.81 219.58

Malaysia 71.36 16.36 87.72

Philippines 104.03 6.76 110.79

Singapore 55.32 16.64 71.96

Taipei,China 52.55 21.15 73.70

Thailand 66.79 20.66 87.45

Average 61.76 35.86 97.62

New York Stock Exchange 12.36 22.11 34.47

World 44.28 27.17 71.45


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by intuitive reasoning on exploitation of arbitrage op-

portunities: the narrower the arbitrage channel, the

more opportunities there are for profitable trades. Elas-

tic demand suggests that reductions in transfer taxes

may well increase revenue rather than reduce it as

the gain in volume offsets the lower charge. This is an

empirical question that should be researched.

In a global market, high-cost markets lose busi-

ness to low-cost ones. This works in two ways. First,

business in domestic stocks moves offshore. This is

not technically difficult to achieve and, given the im-

portance of offshore investors in the Philippine mar-

ket, would be difficult to control. Foreign investors

prefer to trade in the home market because they see

it as the lowest cost market; but if it is not, then they

will move. Secondly, the Philippines is not the only

economy offering Southeast Asian exposure. It com-

petes with others where trading is cheaper. Inves-

tors given a choice will go to the economies with

low-cost trading.

Settlement

The current system retains two significant risks:

• Since it is not true delivery versus payment

(DVP) and there is no electronic link between

the clearing and stock movement processes,

there is a serious risk that in a default situation

investors will be left without cash or stock.

• Certificated holdings to date only represent 17

percent of listed shares.

The first is precisely the sort of situation that DVP

is designed to avoid and it is the reason why G30

recommendations insist on it. There is a compensat-

ing scheme in these circumstances, but its total value

is limited to P100 million (approximately $2.5 million

at current rates) and P40,000 ($1,000) per claim in

the event of a default. Beyond that, there is a guar-

antee by the PSE, which can call upon the members

to make full compensation for any client losses. The

value of such a guarantee is, of course, critically de-

pendent on one’s view of the willingness and ability

of PSE members to meet this. In a crisis, one’s view

of this may become more bearish. It has to be said

that in the new environment of a much larger market

and larger players, reliance on a relatively small com-

pensation fund and an unspecified and possibly

unclaimable guarantee is not adequate regardless of

how well it may have served in the past.

In part, the second risk reflects the fact that many

shares are tightly held and the owners have no inten-

tion of selling, and so choose not to dematerialize.

But it also reflects the preference of many foreign

investors for certificates rather than dematerialized

holdings. It is not clear what lies behind this prefer-

ence, but it is likely to be related to the fact that the

holdings are in the name of the PSE broker, not the

beneficial owner. It may also be connected to the

fear that some local custodian banks were lending

stock without the knowledge or permission of ben-

eficial holders. Whatever the reason, most foreign

investors hold certificates. This means that they may

at any time have bought stock but did not receive a

certificate. If they wish to sell the stock, they have

no title of ownership. In this event then the broker

who did the original trade can issue a nontransfer-

able certificate of holding against the holding in the

Philippine Central Depository, Inc. (PCD) that is

awaiting a certificate. If the client wishes to trade

through another broker, then the first broker can trans-

mit the investor’s stock through PCD to the second

broker and the latter can issue the certificate of hold-

ing. This, in itself, is not the main risk, though there

are risks here. The main risk is that the certificate

will be issued and the certificate of ownership will

not immediately be cancelled, so the same stock ex-

ists twice (and can be sold twice). This apparently

does happen and occurrences of both certificates

being in existence at the same time are considered

as not at all uncommon.

Since short selling is not permitted on the PSE,

there is, in theory, no need for stock borrowing facili-

ties. However, the PSE imposes very severe penal-

ties for failure to deliver stock on T+4.1 The penalty

is a one-day suspension from trading plus a fine. In-


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evitably, errors occur that can cause delays, and an

informal stock borrowing system exists to cover these

eventualities. The PSE is considering permitting short

selling, subject to an uptick rule. This will require a

more formal stock borrowing system, as there are

risks in informal systems (and indeed in formal ones

as Maxwell demonstrated), if potential stock lenders

are to be reassured. If for no other reason, this will

make it very desirable for institutions to become

members of PCD.

Successful and timely introduction of the Securi-

ties Clearing Corporation of the Philippines (SCCP)

would address these risks and, by enabling frequent

monitoring of firms’ exposures, also lessen the pos-

sibility of default. The Securities and Exchange Com-

mission (SEC) had set a deadline of 1 April 1998 for

its introduction. There are no technical issues since

the SCCP system will run on PCD hardware and

PCD software already offers “shadow” clearing.2

The only issue is agreement on ownership and sur-

veillance between SEC and the PSE.

Recent conversations with a senior PSE official

suggest that an accommodation has been reached,

but at the time of writing, details are incomplete.

Equity Primary Market

There are two main questions about the primary

market:

• Why have relatively few companies obtained list-

ings? The PSE lists only some 200 companies

and less than 100 of the Philippines’ top 1,000

largest corporations have a listing.

• Is the primary market efficient?

Looking at the first question—why so few com-

panies—the answer is in the nature of the Philippine

industrial organization. In general, companies seek

listings for a number of reasons, among the most

important of which are the following:

• to raise new capital through equity issues,

• to allow owners to realize some of their shares,

• to enable companies to make acquisitions using

equity issues rather than cash,

• to gain tax privileges either directly or for their

shareholders,

• to get a regular valuation, and

• to attract investors who are prohibited from in-

vesting in unlisted assets.

The disincentive, of course, is loss of control.

None of the advantages really apply to the typical

Philippine company. Philippine companies, as noted

elsewhere, are tightly held and obtain most of their

capital needs from captive banks. They do not need

the valuation, the trading market to realize shares, or

the new investors. There is a tax privilege (CGT-

free trading on the PSE), but this is only valuable to

potential sellers—and most shareholders have no

such intention. There is no real market for corporate

control in the Philippines as there is no real pressure

from outside investors for better performance. Even

if there were, then the company would not be obliged

to take much notice. Corporations certainly change

hands, but usually in private deals rather than through

public takeovers and for reasons that seem specula-

tive or monopolistic rather than economic.

Looking at the second question—is the primary

market efficient? Unquestionably it was not efficient

in that the PSE’s rules enshrined a privilege that gave

member firms a guaranteed allocation of shares from

an initial public offering (IPO). When markets were

doing well and the supply of IPOs was limited, then

this privilege was rewarding for PSE members. Stud-

ies of other markets have shown that over the longer

term, new issues underperform in the market although

in most circumstances they tend to do well on the

first few days of trading. This is because underwrit-

ers generally underprice the IPO to ensure success

and to limit their risk. In fact, a small study in Eu-

rope has suggested that IPOs of family-dominated

firms will tend to be relatively more underpriced since

this allows the owners to ration the stock allocation

in a way that maintains their dominance—i.e., by not

allowing big blocks to be allocated.

It is likely that the original intention of the mem-

bers’ privilege was to allow wider distribution among


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their clients—as opposed to an auction or placing

process that might distribute the issue as a few large

blocks. However, its effect in recent years has been

to give PSE members a near automatic profit and it

was seen as an abuse. The allocation was equal

across firms; hence, large firms got an allocation that

was of no practical use and so had to go to the smaller

firms to bring up their allocation to an economically

useful holding.

The privilege was abolished in late 1997 at the

instigation of SEC. The new rules essentially pro-

hibit profitable proprietary trading by stock brokers

ahead of investor orders. The greater reliance on

book-building techniques should improve the pric-

ing of IPOs, especially as this allows foreign inves-

tors to participate in the price-formation process.

Investors and large securities firms see the new

system as an improvement. However, the absence

of any recent IPOs means that it remains untested.

It is, for example, not clear how SEC or the PSE

will police the new rules.

The overall impression is that the Philippine pri-

mary market is not hugely inefficient, even before

the recent reforms. Many other primary markets

have monopolistic elements but still thrive— the

market of the United Kingdom (UK), for example,

suffers from unnecessarily high underwriting fees

(effectively fixed at 2 percent). The problem is lack

of supply of new issues and lack of demand from

investors.


The Securities and Exchange Commission

SEC has got itself into a double bind: too much

work, too little resources. Its range of responsibili-

ties are enormous: in addition to the “normal” capi-

tal market functions of an SEC (rule monitoring, reg-

istration), it has responsibility for company registra-

tion, company disputes, and a sort of Chapter 113

role in insolvencies. It is believed to have realigned

its policy approach from merit to disclosure, but this

has not yet been tested.

To further increase the pressure on SEC, it takes

a very prescriptive line on regulation. It does not

lay down general principles and monitor the self-

regulatory organizations’ (SROs) adherence to

them. Rather the impression is that SEC is inti-

mately involved in the rule-making process of the

SROs. Its conflict with the PSE over governance

is a case in point. While it is perfectly right for

SEC to have views on the PSE’s rules, it might do

better to set about making the PSE’s position more

contestable rather than getting into public conflict

and brinkmanship. The US SEC and the UK’s Fi-

nancial Supervision Authority (FSA), as examples,

are moving to the stance that market rules are a

commercial decision for exchanges, but that there

will be free entry so that exchanges that have re-

pressive, unfair, or partial rules will tend to lose to

newcomers. The possibility of competition is a

more potent threat than the possibility of the long

policy discussions with SEC that most SROs love

to engage in.

On the resource side, SEC has a staff of 770 that

seems adequate, but they tend to be underskilled and

underpaid. SEC staff, like all Government employ-

ees, are bound by a pay scale (apparently this scale

covers all, up to the president who has a maximum

of P300,000). Typically skilled staff will earn more

working for investment banks, and it is impossible

for SEC to retain sufficient staff in the important

professional areas of law and accounting.

The problem is not unique to the Philippines—

even the US SEC only expects to keep good law-

yers for two to three years. However, the US SEC

has managed to make a virtue of this by position-

ing itself as the gateway to the industry: a stint at

the US SEC is the way to a good job on Wall Street.

So the US SEC has a constant supply of hungry,

young professionals wanting to prove themselves.

And they prove themselves to their prospective

future employers not by lying down when they deal

with them but by their aggression and assertiveness

in enforcement. Both the US SEC and UK FSA


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are outside the normal civil service pay and re-

cruitment systems.

Stock Exchange Governance

The PSE has been engaged in a long dispute with

SEC over external representation on the PSE board.

The PSE now has 3 external representatives—includ-

ing the president—in its board of 15. The problem has

been that the PSE was seen as member dominated and

unwilling or unable to accept the views of users. The

changes to date are to be welcomed, but three exter-

nal members are not many and SEC is pushing for more.

An issue of equal significance that has not fea-

tured is the question of voting rights. The current

situation gives each member firm a single vote, irre-

spective of size. This may seem democratic and pro-

tective of the rights of smaller firms, but experience

elsewhere has shown that this can be a drag on de-

velopment of the market. Typically, smaller firms have

less interest in change than do large firms. The former

see change as a threat—which it often is—to their

previously secure position. Exchanges that have had

to undergo radical change have generally had to al-

ter voting rights in order to achieve that—and every

conversation about change with exchange officials

almost anywhere in the world is hedged around by

“what is politically feasible with the smaller firms.”

London in 1986 (which led to voting changes) and

London International Financial Futures and Options

Exchange (LIFFE) in 1998 (which will result in vot-

ing changes) are examples of exactly that conflict.

Several exchanges have gone even further and,

realizing that even the interests of their larger, more

progressive, members may conflict with the long-

term development of the capital market, have moved

to become public companies rather than member

cooperatives. Examples are Australia, Stockholm, and

Amsterdam, with Paris soon to follow.

Everything about the PSE is symptomatic of such

conflicts between different interest groups—from the

struggle to allow the surveillance unit to inspect firms

on demand to the restrictive IPO distribution rules

(which existed in other markets also). In every case,

there is an argument to be made by PSE members

for retaining the status quo, but the users of the mar-

ket are almost unanimous in wanting change (for the

benefit of the market even if it does them no favors).

The feeling that the PSE is not operating in the

interests of the market but in the sectional interests

of its members (or some subset of them) is what lies

behind the persistent conflicts with SEC. It also ex-

plains SEC’s insistence on detailed involvement in

rule making and policy.

At the same time, the PSE seems to achieve the

worst of both worlds by allowing its governors a term

of only one year. While they can return for a second

term, that is the maximum, there are admittedly prob-

lems of continuity.

Surveillance and Enforcement

The nature of corporate ownership—many tightly

held corporations even among the top 30 compa-

nies—makes it difficult to catch insiders, and the

lack of any convictions should not in itself be taken

as a sign that enforcement is not being strenuously

pursued. But there is a feeling that the resource

and determination brought to bear are inadequate

to the task. To illustrate, Figure 1 shows the price

movements in C&P Homes on 17 March 1998.

There is clear evidence of something going on when

the price rose on the 17th, but no announcement

was forthcoming until 2 pm on the 19th. This is not

an isolated instance.

Figure 1: Price Movements of C & P Homes,17–19 March 1999

Source: PSE Monthly Report, February 1998.

M arch 17 M arch 18 M arch 19

4.2

4.0

3.8

3.6

3.4

3.2

3.0

Close 3.60Volume 22MBuyers 49Sellers 83

Close 3.95Volume 40.4MBuyers 81Sellers 92

Close 3.65Volume 44.1MBuyers 114Sellers 75


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The PSE also examines the data for signs of un-

usual volume. Aside from the usually dismissive re-

sponses from companies asked to explain, the tech-

niques themselves are not particularly powerful tools

of detection as they are applied here. Insiders and

manipulators are skillful and do not leave obvious

tracks. Detecting them requires a substantial invest-

ment in hardware, software, information, and plain

expertise. It seems likely that much information that

would be helpful is not being used fully or not at all.

The PSE has the trading data, SEC has the data on

directors/shareholders, the Credit Information Bu-

reau, Inc. (CIBI) has data on cross-holdings—not to

mention the Bangko Sentral ng Pilipinas (BSP) in-

formation on bank business. If that information were

marshalled properly—i.e., on linked databases—and

proper emphasis given to exploring it, then the work

of insider traders could be made very much harder.

But as things are, the PSE has a very small and

underresourced Surveillance Unit, SEC has practi-

cally no information technology expertise or capabil-

ity, CIBI is rarely brought into the picture, and BSP

is not involved.

The PSE does investigate unusual price jumps—

companies are asked if there is an explanation. Al-

most invariably, companies get their lawyers to write

back saying there is nothing unusual—and soon af-

terwards the announcement comes out or the rea-

son comes out in some other way.

SEC might consider that its interest would be bet-

ter served by working with the PSE to improve the

quality and the perception of quality of the market

rather than spending its limited resources on ultimately

futile, high-profile head-on encounters with the PSE.

At the same time, if the PSE were really interested in

raising the reputation of its market and attracting a

less speculative type of investor, then it would do well

to focus on some aggressive investigation instead of

seeming to drag its feet whenever a new initiative that

would enhance the information available is suggested.

A current example is the dispute between SEC and

the PSE over inspections of firms. Originally the PSE

rules required the PSE inspectors to give the firm to

be inspected advance notice of the inspection. On SEC

insistence this was changed, but now the inspectors

are required to notify the PSE president (who is inde-

pendent and also the chief executive officer). This, in

itself, may be harmless, but it appears that this comes

down to gaining approval from the president and in-

serts an automatic delay in an investigation. Naturally,

SEC is unhappy with this, and an acrimonious public

debate has ensued with the PSE appearing to defend

restrictions on the independence and freedom of ac-

tion of its inspectors.

Securities Firms

PSE membership requirements are not particu-

larly onerous. In particular the educational/profes-

sional qualifications of applicants or staff of corpo-

rate members are not stipulated (though a curricu-

lum vitae is required from individual applicants).

There is no formal minimum capital requirement. One

significant restriction – especially in the context of

the Philippines – is that individual members and nomi-

nees may not be connected with any other stock-

brokering firm. The charge for entry is P200,000.

The market is dominated by the large firms, in-

cluding 43 foreign members. Many of the domestic

brokers remain small - “mom and pop brokers.” Com-

ments suggest that many have no customer business

and are essentially “locals” trading on their own ac-

count. Until 1997 they also were able to profit from

the special IPO allocation to PSE members.

The capital adequacy requirements are low and,

while hard information has not been available, the

smaller firms are widely regarded as seriously un-

dercapitalized. Because the PSE has no ability to

monitor exposures of firms, there is significant risk

of default. The guarantee fund is very small and the

risks are compounded. The potential for risk is com-

pounded by the rules allowing margin trading, and

this will be further added to if the PSE allows short

selling. Larger firms monitor their exposures to smaller

firms and limit them accordingly.


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These have undoubtedly been achieved but need to

be maintained if the Philippines is to continue to grow

as a market for foreign investors.

Nonenforcement of disclosure standards creates

a vicious circle: if accounts do not give the true pic-

ture, then investment decisions come to be based on

rumor rather than fundamentals. An example of this

was a large company that entered the market through

an IPO. Of the 5,000 prospectuses ordered for cli-

ents, only 800 were taken up—though the issue was

very well subscribed—presumably because most in-

vestors relied on tips.

The SEC Accounting Standards Bureau is seen

as lacking teeth and being underresourced. Its staff

members are poorly paid and underskilled.

Corporate Governance

The quest for good corporate governance has rela-

tively little following in the Philippines. Almost all

companies, even in the small listed market, are tightly

held: more than 70 percent by the founding family is

the norm. This is normal in smaller companies, in

most markets, but ownership usually disperses as the

companies grow. There is some form of vicious circle

in the Philippines: there is no substantial body of in-

vestors to buy the stock away from the founding fami-

lies while at the same time there are apparently ad-

vantages in maintaining and expanding control with-

out the stimulus to seek external funding.

Companies also tend to be grouped into highly

complex conglomerates largely for reasons of finan-

cial economies–access to cheap bank finance–and

monopolistic power. This structure leads to a form

of corporate governance in which the insiders treat

the company as a private estate and minorities are

ignored.

There are no rules to protect minorities and they

are routinely disadvantaged. Rules to protect minori-

ties in the event of a takeover would at least force

companies to offer to buy out minorities and limit the

scope for pyramiding control based on less than total

ownership.

A shakeout is widely anticipated, with many of

the smallest firms expected to withdraw from the

market. The risk is that this will be a hard landing

rather than a gradual withdrawal, so complacency is

unacceptable.

Accounting Standards

Accounting standards are not much different from

international standards, but the problem is nonenforce-

ment. Enforcement of standards is the responsibility

of SEC. SEC’s policy thrust is toward full disclosure,

but that has not been attained yet.

Many companies, even large ones, are not enthu-

siastic about disclosure—for example, disclosure of

directors’ salaries or details of contracts—fearing

either union unrest or competitors. Reports and ac-

counts do not give the full details of cross-holdings

or connected parties. Also the complex conglomer-

ate structure of Philippine companies makes it easy

to move assets and liabilities between subsidiaries.

Most of this information is held by SEC, but is diffi-

cult/impossible to get hold of largely because the data

are stored in paper form with no easy retrieval. The

general feeling is that accounts are prepared to suit

a particular purpose—tax, share issue, etc.—and

rarely give a true and fair picture.

Accountancy firms, with reputations to protect,

will push for better enforcement but only if they

feel they will be backed up by regulators. How-

ever, neither local investors nor regulators (SEC)

seem too concerned. Accountancy firms expect the

SEC Accounting Bureau to enforce standards of

disclosure, but claim that it does not. The feeling is

that accountants who ask too many questions will

lose business and there seems to be little oppro-

brium attaching to firms who switch accountants to

get an easier ride.

There is pressure for change, but it comes from

foreign investors either as portfolio investors into the

Philippines or when stocks seek listings in North

America (as a few have indicated). Foreign inves-

tors have been the main forces for improvements.


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Bond Market

INTEREST RATES

Interest rates appear to be the result of collusion,

management, and deals rather than market forces.

This is, at first, surprising given the large number of

banks in the Philippines (12 universal, 50 commer-

cial), but the evidence is all too clear:

• BSP rates have been held high for years to sup-

port the currency–as was common across Asia.

This encouraged short-term borrowing and reli-

ance on foreign lenders. Furthermore, this set

the tenor for wholesale rates and for discount

rates for investment.

• It is clear that lending rates are set by the banks in

a cartel-like manner. The public discussions dur-

ing March 1998 under which BSP agreed with

the Bankers Association of the Philippines (BAP)

to reduce reserve requirements if the banks re-

duced their lending margins smack of rates that

are administered rather than competed for.

• Retail savings deposits pay very low rates—

negative real rates. All the banks offer similarly

low rates. There are no other competitive insti-

tutions for small retail deposits. Mutual funds

offer a different service in theory, though at least

one is offering a better rate for what are, in ef-

fect, higher retail deposit rates.

The large number of banks was a consequence of

the interest rates being administered and cartelized.

The interest rate situation encouraged conglomerates

to develop banking arms as a source of cheap finance.

Further, as BSP does not issue any long-term

bonds, there is no long-term, risk-free interest rate

as a price guide.

The overall effect of this has been low savings

and a stifled capital market.


Primary and Secondary Markets

The Philippines has a relatively more developed

bond market than some of its neighbors in the As-

sociation of Southeast Asian Nations (ASEAN). It

has shown a diversity of instruments and occasional

availability of long-term debt instruments. However,

it remains largely a market for floating rate instru-

ments and hence does not truly offer the advan-

tages of a true fixed-rate bond market. Its develop-

ment will be stifled by the immediate crisis, but there

is scope for the development of long-term debt in-

struments if a number of infrastructure failings are

addressed.

Table 3 shows the main classes of assets. In ad-

dition, there are municipal bonds and an embryonic

mortgage-backed securities (MBS) market.

The Philippines has a significant public bond mar-

ket stimulated by the need to fund chronic fiscal

deficits. Since mid-1998, the Government bond mar-

ket has been regulated by the Bureau of the Trea-

sury (BTr) rather than by the central bank, BSP.

The bulk of the issuance is at the short end though

there have been longer dated issues including some

fixed-rate issues. Currently the market is almost all

three-month T-bills. The sizeable issuance gener-

ates a liquid secondary market supported by a

scripless settlement system.

Government issues, through repos, form a basis

for interbank lending as well as the central bank’s

activities in the money market. The attraction of a

secure asset even if only short term, makes Gov-

ernment securities a popular investment vehicle for

pension funds and other institutions as well as for

wealthy individuals.

The municipal bond market remains small and lim-

ited to local investors.

The Philippine corporate bond market is relatively

small (very much smaller than the public bond mar-

ket) and is suffering in the current crisis. The corpo-

rate bond market is regulated by SEC, which regis-

ters bonds (BSP also approves bank issues on a case-

by-case basis). Prior to the crisis there had been some

growth, but the bond market was only open to the

largest companies and the main issuance was in float-

ing rate assets.


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cost and middle-class housing. In practice, the mort-

gages being securitized are guaranteed by the Home

Insurance Guaranty Corp. (HIGC), and the MBSs

are issued through a special purpose vehicle with the

same rating as Government debt. Because of this,

they are outside the jurisdiction of SEC and do not

require registration. For the same reason, they are

exempt from the 20 percent withholding tax. Recently

BSP has become concerned about the commitment

of banks in MBSs and SEC has become aware of its

lack of involvement in the market. New regulations

are in the process of being prepared though it is not

clear, at this stage, which will be the main regulator.

Overall the Philippines before the crisis did see

growth and development of its bond market, includ-

ing long-term debt. It was not a true bond market in

the sense that it was almost all floating rate debt.

Bond markets are attractive to issuers and investors

because of the certainty they bring. Companies gain

a secure source of finance with fixed redemption

and fixed cash outflows. Investors gain a long-term

asset with a certain cash flow that they can match to

the duration of their liabilities. Bonds are especially

The ratings agency CIBI covers only some 30

corporations and, while ratings are not mandatory,

the scope of rated companies matches the scope of

the market. All except four of the rated companies

have ratings of A or above and none is below B.

Issuance is almost exclusively in commercial pa-

per (CP) which, when market conditions will sup-

port it, can be long term: anything up to 10 years

although 5 is the norm. As mentioned, CPs have float-

ing rates and are renegotiated every quarter. There-

fore, while they essentially involve long-term com-

mitment of capital, they, like overdrafts, do not offer

the certainty of a conventional bond issue.

Large borrowers were often able to offer CPs at

rates below T-bill rates, reflecting the perceived high

credit quality of the issuers. In recent years, large

corporations have also tapped the international bond

markets.

The market has also seen the beginnings of an

asset-backed market for mortgage bonds. This origi-

nated in a project funded by social funds to support

low-cost housing. There are now a number of pri-

vate sector initiatives repackaging mortgages for low-

Table 3: Philippine Bond Market Assets

BTr = Bureau of Treasury. CP = commercial paper. GSIS = Government Service Insurance System. OTC = over the counter. PDC = Philippine Depository Corporation. ROSS =Registry of Scripless Securities. SEC = Securities and Exchange Commission. SSS = Social Security System.Source: Compilation by author.

Public Private

Item Short-Term T-Bills Long-Term T-Bonds Short-Term CP Long-Term CP

Term 91–364 days 1–20 years Up to 365 days Over 1 year—mostly 5 years

Interest Fixed Floating—reset quarterly Fixed Floating—reset quarterly

Issue Method Weekly auction by BTr Fortnightly auction by BTr Underwritten or private placement.

Underwriting fees P100 billion–150 billion)

Trading OTC—liquid OTC—illiquid

Settlement Scripless, electronic run by BTr Currently interoffice, paper-based. Proposal to

transfer to scripless using PDC or ROSS

Regulator BTr SEC—registration required

Investors Insurance companies, banks, mutual funds, wealthy individuals, state pension systems (SSS and GSIS),

which are required to invest heavily in government securities

Issuers Prime corporations from manufacturing, finance and

especially property/real estate sectors

Other Features CP requires no shareholder approval, in contrast to

bonds


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attractive to insurance companies and similar institu-

tions with distant but predictable liabilities. They are

attractive to companies that have long-term projects

since they offer longer term finance than is available

from banks but without the uncertainty or ownership

dilution of equities.

However, for this to work, there must be a high

level of certainty among issuers that (i) the bond will

be repaid, i.e., the issuer will not go bust, misuse

the money, or otherwise defraud the investor; and

(ii) the real rate of return will be what they expected.

(Companies are also concerned with the real rate,

as they do not want to be locked into a bond when

rates are falling.)

Where these requirements are not met, it is very

difficult for a bond market to evolve in the sense of a

market offering the certainty that issuers and inves-

tors want. The two requirements depend on differ-

ent conditions:

• The avoidance of default risk is a function of

information. Investors need to feel certain that

they have adequate information to judge the

issuer’s state and probity on a continuous basis.

For the largest companies, investors rely on pub-

lished information and ratings from public agen-

cies. For smaller companies, investors will do

their own due diligence and establish a close re-

lationship with the issuer (often including a board

seat so the ownership dilution benefit of bonds

over equity is less strong). Investors, in addition,

will usually demand covenants limiting the

issuer’s freedom of action and ensuring regular

reporting.

• The predictability of real returns is a result of

macroeconomic stability. Many countries have

experienced volatile interest rates either as a

result of volatile inflation or because of a com-

mitment to a stable exchange rate without the

necessary fiscal discipline. Both bond investors

and issuers will have experienced unpleasant

shocks in those situations—investors receiving

less than they could have received from alterna-

tive investments and issuers paying more than

they would have paid on alternative sources of

finance.

As a result, fixed-rate finance becomes hard to

obtain at acceptable rates and the lending market

relies increasingly on floating rate assets. These can

be either floating rate notes (FRNs) or bank over-

drafts, depending on the willingness of the banks to

make what amount to long-term loans and the atti-

tude of borrowers toward those banks. In practice,

the only issuer who can obtain fixed-rate finance is

the Government. Governments will borrow at what

seem to others to be penal rates because of their

powers to tax and to control the future real rate at

which they repay. This compounds the problem by

crowding out any other borrowers who do not have

those advantages.

The Philippines has or expects to have problems

on both the requirements. As anticipated, the bond

market is in retreat and the long-term finance avail-

able is at floating rates.

In practice, it is only in the US where investors

have the required skills in corporate risk analysis to

assess bonds for smaller companies. US insurance

companies, in particular, have developed the neces-

sary skills. The cost of the due diligence they carry

out is substantial, and they are deeply suspicious of

accounting standards and practices outside of the

US. Therefore the possibility of extending the bond

market beyond the prime companies in the Philip-

pines seems remote.

For larger companies there remain problems with

accounting standards, auditing practices, and the qual-

ity of company information. However, the fact that,

prior to the crisis, there had been growing willing-

ness to lend long-term to prime corporations indi-

cates that investors were more comfortable with the

data they were given. To some extent, the efforts of

the rating agency have helped. CIBI is not seen as

entirely independent or immune from improper pres-

sure, but its attempts to insulate itself through the

independent ratings board have helped its reputation.


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The planned tie-up with an international agency will

further strengthen its position.

Historically, the Philippines has experienced arti-

ficially high rates as the Government has sought to

manage the exchange rate at a level not justified by

the national economy. While this has not prevented

the emergence of a nascent fixed-interest market, it

has certainly stunted its growth. While prime private

sector borrowers were often able to borrow using

CP at rates below the managed central bank rates, it

must be true that the competition for funds kept CP

rates artificially high. The enthusiasm of Philippine

companies for international bond issues in recent

years supports this view.

The crisis saw sharp rises in local interest rates.

These remain high with little immediate prospects of

relief. Furthermore, the crisis is putting pressure on

the already frail fiscal stance of the Philippines, and

it would be rash not to expect significant volatility in

inflation and interest rates over the near term.

Settlement

The Government securities market is supported

by an electronic scripless settlement system oper-

ated by the BTr system Registry of Scripless Secu-

rities (ROSS).

Corporate bonds including CP are currently settled

interoffice in paper form. This is slow, costly, and

risky. The delays and costs arise because of lack of

electronic entry systems for trade details and lack of

an automatic trade matching system. The risks arise

from absence of DVP.


BTr has regulated the Government bond market since

mid-1998. Prior to that time, BSP was the regulator.

BTr arranges the regular auctions and intervenes in

the market.

BSP no longer has a role in overseeing the mar-

ket but, in its role as bank supervisor, it regulates

bond issuance by banks. In particular, it may have a

significant role in the development of the asset-

backed-securities (ABS) market, in which the banks

are heavily involved.

SEC is the regulator of the corporate bond, in-

cluding CP, market. It authorizes issues, requiring not

only registration but also compliance with certain fi-

nancial minimum ratios. It is also concerned with the

developing ABS market. SEC also regulates the au-

thorized securities firms that operate in the market.

InvestorsPENSION FUNDS

Emerging economies will experience longer life ex-

pectancies and a growing interest in provision for

old age. The Philippines has a young population,

but experience elsewhere shows that increasing

prosperity is associated with a declining birth rate

and consequently an ageing of the population. In

developed economies, the most important conduits

for mobilizing savings are those associated with

pension provision. These observations lead to the

conclusion that developing its pension infrastruc-

ture should be an important element of Philippine

financial development.

Both State schemes (Government Service Insur-

ance System [GSIS] and Social Security System

[SSS]) are funded, so the Philippines will not be

faced with the problems of an ageing population

depending upon pay-as-you-go contributions from

the working population. However, funding is only

of value if the contribution rates are adequate to

meet the actuarial needs of the accrued liabilities

of the schemes. The schemes are currently in sur-

plus—which is not surprising, given the growth of

the population, but contribution rates are not high

and benefits are quite generous. As the schemes

mature, contribution rates will need to increase to

cover a higher benefit-to-contribution ratio. Con-

tributions to GSIS were increased in 1997. It is

apparent that employees viewed their contributions

to the schemes not as investments but rather as a

tax. There may therefore be resistance to future

increases in contributions.


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In many countries, pension savings attract fiscal

privileges and these are significant in encouraging

individuals to make provisions for the future. This

brings five important benefits:

• It encourages a higher level of saving by altering

the relative cost of consumption.

• Because the administration of the tax relief re-

quires the savings to be pooled in some way, it

stimulates the development of collective invest-

ment schemes, which are important elements in

the development of capital markets.

• It takes pressure off State schemes which, how-

ever well constructed and funded, tend to be seen

as taxes and, as such, are resented. In contrast,

contributions to individual, tax-advantaged

schemes are seen as attractive ways of provi-

sioning for the future.

• Private pension schemes, as contractual arrange-

ments, give greater certainty than public

schemes. Public schemes, however well inten-

tioned, are always subject to political pressures

and future benefits may not live up to present

promises. Such uncertainties will make contribu-

tors less inclined to pay into State schemes.

• Private pension schemes can more easily ac-

commodate the self-employed. Developing

economies will, as their service sector expands

and as the certainties of employment become

less, experience an expansion of the self-em-

ployed sector.

The downside of granting fiscal privileges is the

impact on Government revenue. The tax exemption

on SSS/GSIS contributions was granted relatively

recently under the Comprehensive Tax Reform Pro-

gram and made a significant hole in revenues. A

careful calculation will have to be made comparing

the benefits for Government revenues from better

mobilization of savings and a larger, deeper domestic

financial sector as against the revenue forgone by

granting fiscal privileges for retirement savings.

The limits4 on portfolio allocation laid down in the

1997 Social Security Act may not be particularly

onerous at the moment since the funds were invested

almost entirely in bank deposits, housing loans, and

Government bonds. With interest rates as high as

they are currently, holding a substantial investment

in Government debt seems a sound investment strat-

egy. However, from a funding point of view it is, of

course, questionable whether a State fund that is

heavily invested in Government debt is really funded

at all: it represents future claims on Government rev-

enues just as a pay-as-you-go scheme would. In a

growing economy, the sound strategy for a pension

fund would involve substantial equity investment and

the limits would constrain this. The purpose of the

restrictions is not clear, and the managers may find

that the limitations conflict with the obligation im-

posed by the Act to “manage and invest with the

skill, care, prudence and diligence necessary under

the circumstances then prevailing that a prudent man

acting in a like capacity and familiar with such mat-

ters would exercise.”

It is likely that in changed circumstances in the

future, the managers might find the investment limi-

tations to be restrictive and feel they could better

serve their members if they were allowed to exceed

the limitations in the Act. In the future, they might

invest more than 45 percent in private securities and

reduce their investment in, for example, private loans

or Government debt.

There is no framework for private pension schemes

in the Philippines. A number of companies are said

to operate schemes using the common trust funds

(CTFs) of banks, but these are no different in their

tax treatment from other investments in CTFs. For

many reasons related to mobilization of savings, deep-

ening capital markets, and easing the future benefit

burden on Government, the emergence of private

pension funds will be beneficial. Where private pen-

sion funds have evolved, they have been helped by

having a clear legal framework, strong regulation,

and fiscal advantages.

There should be a legal and regulatory framework

for private pension schemes, probably including fis-


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cal benefits to encourage savings through this me-

dium (with safeguards and limits to prevent abuse).

The Philippines is restricted by its fiscal position, but

most governments see tax breaks for pension sav-

ings as a worthwhile investment since it cuts back

the obligations of State schemes. The Philippines has

the lowest percentage of population over 65 among

the Asian countries—and will continue to have the

lowest percentage in 2025. However, the proportion

over 65 will double by that year and proper provision

is required. This is a good time to move as the de-

pendency ratio is still low.

Private pension schemes are always funded and

it is important that there are assets to support that

funding. Transferring from a State scheme to a pri-

vate scheme invested in Government bonds does not

alter the Government’s long-term commitments.

Equally it is essential that funded schemes have the

freedom to invest so as to maximize benefits (or mini-

mize contributions). This suggests that the restric-

tions on the State schemes’ investments will not be

acceptable for private schemes (it is a fact that coun-

tries that have restricted the investment policies of

private schemes do not have successful private

schemes since savers avoid them). Of course, it is

likely that the State schemes will wither unless they

are able to invest on equal terms with private schemes.

In the near term, it would be appropriate for cur-

rent Philippine pension schemes (the two State

schemes SSS and GSIS) to move some of their assets

into equity if they were to be allowed to do so. But

bonds should continue to play an important part in their

portfolio, the more so as funds mature and start to

have a significant number of members approaching

retirement. Therefore pension funds—both current

public and future private—would benefit from a liquid

and sizeable bond market. From a fund’s point of view,

it makes little difference whether these are public or

private bonds (after appropriate allowance for differ-

ing risks). But, as noted above, funding pension

schemes through Government bonds is economically

the same as running a State pension scheme. The

fiscal burden is the same. It would be best, therefore,

if there were in the future a deep pool of private bonds

for pension funds to invest in. There is currently no

such pool, and infrastructure changes to support a pri-

vate bond market are required if one is to develop.

MUTUAL FUNDS

The obvious market for mutual funds would be the

high-net-worth individuals who also use the bank

CTFs. However, the relatively high rates on deposits

compared with stock market returns (and the recent

stock market setback) make it difficult to attract those

customers. The mutual funds have therefore targeted

the less sophisticated investors. These investors are

less return-conscious and their savings options are

otherwise limited to retail banking accounts offering

low nominal rates and negative real rates. Such in-

vestors are judged to be seeking safe homes for their

savings—which are usually for emergency provisions

or for schooling—rather than for returns. In pursuit

of these savers, one group—Kabuhayan—is offer-

ing to accumulate a minimum holding of P5,000 at

the rate of P200 per month. The contributions are

held in an interest-bearing account (paying 4.8 per-

cent as of March 1998, which is attractive in its own

right) until the minimum has been built up.

It remains to be seen whether this strategy will be

successful or it is better for these funds to be in-

vested in equities. Regulators may be expected to

raise questions about the suitability of risky invest-

ment for this sort of savings.

INSURANCE COMPANIES

Insurance companies provide life cover and pre-need

policies (especially education). Their investment strat-

egies are fairly adventurous and they are significant

players in the equity and Government bond market.

They are also investors in private equity, taking sig-

nificant stakes in unlisted companies where they usu-

ally demand a management role through a board seat.

Their stake is usually 10-25 percent with $5 million-

$10 million value. They can thus invest in relatively


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small companies as well as infrastructure projects

that cannot be listed.

For unlisted companies, the investors are obliged

to do very extensive due-diligence analysis since in-

formation about them and their quality are even

skimpier than for listed companies. (However, this is

not unusual. Insurance companies based in London

and investing in smaller UK and European corpora-

tions do similar levels of due-diligence work.)

The exit route from these private equity deals is

almost always through a listing. Tax rules impose 20

percent CGT on trades in unlisted companies, but

those listed are exempt.

COMMON TRUST FUNDS

CTFs are a major savings vehicle for the better-off.

Being run by banks, they tend to favor deposit in-

vestments, which, given the high rates available, are

sound investment anyway. A more worrying feature

is their apparent lack of transparency and lack of

regulatory control. CTFs are regulated by BSP, the

regulatory authority for banks, but, of course, CTFs

are investment vehicles and should be regulated as

such. In fact, BSP’s regulation quite naturally goes

no further than assessing the effect of CTFs on bank

solvency, with little interest in their investment fea-

tures. Given the retail nature of this product, it is

risky to regulate them in this way.

FOREIGN INVESTORS

Many recipients of foreign investment flows are

pleased to receive them as long as the foreign inves-

tors do not expect anything in return. Of course, a

negative perception of foreign investors is more likely

when foreign investors are inclined to dump a coun-

try when the going gets tough. It is therefore not

surprising when Filipinos say that they do not want

hot money.

But foreign portfolio investment is no more hot

than any other money. When foreign portfolio man-

agers think the market will go down, they sell just

like domestic investors. They may sell and buy in

larger blocks than domestic investors, but their moti-

vations are exactly the same. Foreign investors sold

in 1997, and so did domestic investors.

Foreign investors reduce their commitment to a

country when they perceive that they are discrimi-

nated against, not being told the whole story, or being

expected to face unreasonable risk of systemic fail-

ure. All three occur in the Philippines.

Foreign investors are excluded wholly or partially

from certain industries. It is difficult to see why for-

eign portfolio investors are prohibited from having

(aggregate) stakes exceeding 30 percent in adver-

tising or why they are totally banned from retailing.

If the issue is external control, then the regulations

are missing the target—foreign fund managers do

not want to have dominant control of companies

(though the idea of dominant control is by no means

alien to Philippine corporations). If the ban on for-

eign ownership of retail was motivated, as it has

been suggested, by other than commercial motives,

then again they are missing the target. It is not as if

these sectors were so well developed in the Philip-

pines that further investment would not be benefi-

cial. If, as is probably the case, the rules are largely

avoidable anyway, then it is another example—of

which there are many in the Philippines—where

rules whose point has been forgotten still clutter

the books, encouraging evasion and a culture that

accepts such regulatory evasion as necessary and

acceptable. It is difficult to imagine Jardine Fleming

or Liberty Life, to pick two names at random, being

interested in owning biological warfare plants, so

why does the Philippines feel the need to have a

rule that prohibits it?

Foreign investors, in the main, see the Philippine

markets as dominated by insiders. The perception

is widespread and is encouraged by the lack of trans-

parency over ownership and accounting details; even

when figures are collected by regulators, such as

those relating to dominant shareholdings, they are

not available to inquirers. This makes investors won-

der if there is something to hide.


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Foreign investors are yet to be convinced of the

integrity of the central depository and settlement sys-

tems. However secure the system looks in prin-

ciple, the system is not yet DVP. Therefore inves-

tors will have delivered stock and not yet been paid

or they will have paid and not yet received their stock.

A default at such a time would expose investors to a

loss. Investors, especially foreign investors, are very

fearful of such risks.

Policy Recommendations

Equity Market


Microstructure

The PSE should set up a monitoring unit with the

objective of analyzing the effect of its rules on mar-

ket quality. Specifically, it should first turn its atten-

tion to

• the effect of special blocks in possibly creating a

two-tier market;

• the impact of publishing firm details on the ticker

in maintaining fragmentation of stock-brokering;

• a longer trading day. The trading day of the PSE

is abnormally short.5 Typically as exchanges

move toward electronic trading, they are able to

extend their trading day. Such extension stimu-

lates more local business as well as creates an

overlap with other time zones and thus increases

arbitrage trading. Longer hours and arbitrage

have been shown to raise overall liquidity wher-

ever studies have been carried out. The oppos-

ing arguments are linked to the need for a long

period to settle business. This is not entirely plau-

sible and should vanish when fully electronic

settlement is introduced.

Transaction Cost and Liquidity

Taxes on transactions are high and are almost

certainly restricting volume and liquidity. Low liquid-

ity reduces the attraction of a stock market for in-

vestors and issuers. However, accepting that the

Philippines is in a tight fiscal situation, the tax au-

thorities should study the likely impact of reducing

transaction taxes on overall volume and on tax rev-

enue. Experience elsewhere suggests that cutting

very high transaction taxes leads to substantial in-

creases in trading and tax revenue.

Commissions are negotiable but remain, in the view

of practitioners, rather high. It is difficult to address

this and anyway the evidence to support the allega-

tion is lacking and so the claim may not be true

(though the Elkins/McSherry results are supportive).

The PSE could usefully add to its range of publica-

tions some information on the “going rate” for com-

missions. This would help either to disprove the alle-

gation or highlight the excessive levels and lead to

more intense negotiation. (Reducing commission rev-

enue might seriously damage some firms, but the

unsustainability of many firms will need to be ad-

dressed anyway on grounds of settlement risk and

capital adequacy.)

The assessment work on special blocks and other

microstructure issues proposed above should focus

attention on the impact of PSE rules on market qual-

ity. It may, for example, be appropriate to liberalize

the special block and crossing rules by removing the

price constraint on crosses and the need for special

blocks to gain specific approval. Lighter regulation

here could and should be accompanied by stricter

monitoring of the market.

Settlement

Security of transfer is too important to get held up

in a regulatory war. If they have not already done so,

the issue of ownership should be resolved. The idea

of the settlement function being jointly owned by

market participants is not unusual.

The use of the depository is very low at 17 percent.

In part, this reflects the tight ownership structure, but

it also suggests that many institutions (including for-

eign) are opting to hold certificates. The charging struc-

ture allows the option of certificates at a very low,

possibly uneconomic price. For example, the cost of


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uplifting a certificate for a holding is P25 (plus the

normal ad valorem PCD fee of 0.0000834 percent).

But the low usage also suggests that significant in-

vestors are not convinced of the security of the sys-

tem. Their fears should be addressed as a matter of

urgency.

The settlement guarantee fund with a maximum

payout of P40,000 is far too small and should be re-

viewed. Its funding (i.e., relying on members as the

ultimate source) is also unsatisfactory, especially given

the lack of monitoring of member firms’ exposures.

Equity Primary Market

Companies would be more inclined to use public

markets if there were a cheaper and easy access to

bank finance. A legislative separation of banks from

conglomerates would be difficult to effect and even

more difficult to enforce, especially given the preva-

lence of influence through interlocking directorships.

As usual, the competitive solution is better. More

competition for the saver’s dollar together with lib-

eralized interest rate would mean that savers would

receive something closer to the market cost of capi-

tal. Captive banks would be unable to compete (their

cost base is seen as excessively high) and so corpo-

rations would be forced to look elsewhere for fund-

ing. Competition for funding would put pressure on

conglomerates to offer genuine shareholder value

rather than insider-only benefits.

The emergence of domestic investment institu-

tions also creates a demand for assets, especially

equity assets. More demand means a premium and

companies would be more attracted to stock issues

if there were a solid and predictable institutional de-

mand. The overall need is for a more substantial body

of institutional investors—mutual funds, pension funds,

and insurance companies—than what exists today.

Finally privatization offers an opportunity to build

up the primary market and improve its quality.

Privatization also offers a boost to Government rev-

enues that would be welcome, and the new presi-

dent is making positive noises about selling state as-

sets. Inevitably, the privatized companies would ap-

peal to foreign investors and so should be able to start

life without the usual tight shareholder structure. The

Government should set new standards of corporate

governance. The privatized companies should be con-

stituted in such a way as to follow best practice in

governance and treatment of shareholders. Their ex-

ample, combined with their competition for funds, will

provide an incentive for others to follow.


The Securities and Exchange Commission

SEC should release its responsibilities in noncapital

market regulatory areas, particularly, its role in com-

pany registration. This would allow it to focus on its

proper role as a policy guide, standard setter, and

licenser of SROs.

SEC should adopt a less prescriptive approach,

but look at ways of weakening rather than strength-

ening the PSE’s monopoly. Current tax laws give the

PSE an advantage in that on-exchange trades are

exempt from CGT. Making this concession more

widely available (there is also a case for extending

relief to unlisted companies to encourage venture

capitalists) would enable competitors to threaten the

PSE’s secure position (even if they never actually

go off the ground, the threat will stimulate the PSE).

SEC should become an independent agency with

its own staffing policies and salary scale. This would

enable it to compete more effectively for staff. But

in the short term, there could be gains from

secondments to SEC from securities firms and oth-

ers in the industry. This would give the SEC access

to staff who were not career civil servants and who

might adopt a more diligent and aggressive approach

to enforcement.

Stock Exchange Governance

The PSE should examine its governance with a

radical eye. At the very least, it should change vot-

ing structures to give larger representation to its larg-

est members. It could achieve this by a fudge: es-


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sentially allocating different voting rights to the two

types of member– corporate and individual—with

votes for corporate members being allocated on some

measure of size. But the better move would be to-

ward corporate membership entirely and allocating

votes according to business levels.

To gain more stability, the PSE should extend the

terms of board members (they are already consider-

ing a rolling three-year system).

Management independence should be enshrined

in the terms of employment. At present, the staff

report to the members’ representatives on a day-to-

day basis including notifying (or seeking approval)

before acting. This is not the way to develop an ef-

fective surveillance and enforcement program. The

staff should answer to the chief executive officer

who is answerable in retrospect to the board on a

regular, but not continuous basis.

But for a real chance of successful development

as a market operator and regulator, the PSE should

look toward becoming a public company with

shareholding open to all. Its motivation would then

be to provide a market that attracts the maximum

amount of business rather than being driven by the

need to protect the membership. There is a local

model in Australia.

Surveillance and Enforcement

There is little confidence in the current enforce-

ment procedures. They are seen as not impartial nor

rigorously pursued as well as being poorly resourced.

Additionally it is really not clear where responsibility

lies—in SEC or the PSE. Indeed the two organiza-

tions seem to conflict rather than cooperate in catch-

ing wrongdoers.

Credibility would be aided by firm steps to

strengthen enforcement procedures.

There is need for a clear statement of the division

of responsibilities for enforcement. Ideally the PSE

should have the responsibility for frontline detection

and enquiry since it has authority over its members,

with SEC in reserve if more data are required.

The PSE’s Surveillance Unit should be able to

operate independently without a requirement to seek

authority or give advance notice. However sensible

the reasons for the current requirement to give no-

tice to the chairman of the PSE (who is an inde-

pendent), it gives a bad smell and causes users to

question the robustness and independence of inves-

tigations.

Surveillance should be adequately supported and

given access to the latest data management and pro-

cessing techniques. It is pointless chasing insiders

with paper-based records systems and simple algo-

rithms; they don’t work. Even the most sophisticated

systems have a hard job spotting insider trading, but

at least they have a chance. The resource allocation

of the PSE should reflect the fact that poor enforce-

ment (or a perception of poor enforcement) is much

more damaging to a market than other things they

might choose to spend money on, such as new trad-

ing systems. The techniques are sophisticated—they

are rocket science—but they have already been de-

veloped by other markets and it is a certainty that

they could be shared to the benefit of all. The PSE

should seek assistance and training in sophisticated

trading analyses from other stock exchanges. The

Federation Internationale des Bourses de Valeurs

might be a forum to turn to for assistance.

The PSE should be more aggressive with com-

panies that fail to adhere to the spirit of the listing

rules and so bring the market into disrepute. Like

other stock exchanges, its sanctions are limited to

suspension/delisting or censure. Suspension harms

the shareholders as much as the company, and ex-

changes, rightly, avoid using it whenever possible.

However, more disclosure and censure would have

an effect. Companies do not enjoy public censure

and investors, particularly foreign investors, are de-

terred from investing. A fund manager who holds

stock in a company facing stock exchange censure

is in a risky position if something goes wrong as his

trustees could argue that the censure should have

served as a warning. The example of C&P Homes


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cited earlier should have brought a censure from

the exchange—at the very least criticizing the com-

pany and its advisors for allowing information to

leak. In fact, the price movement should have been

spotted immediately and the PSE should have de-

manded a statement from the company. This is the

strength of self-regulation—regulators can comment

and act on the balance of probability rather than

requiring the absolute certainty—beyond reason-

able doubt—of the criminal justice system. The PSE

should flex its self-regulatory muscles and throw

its weight about more.

Securities Firms

There are too many weak and undercapitalized

firms. They weaken the image of the market and,

collectively, constitute a barrier to reform. The PSE

needs to show that it is monitoring the solvency of its

members. The proposed settlement system will pro-

vide a method of monitoring exposures. The PSE

should seize this opportunity to enforce an adequate

level of capital adequacy, which should reflect the

risk being carried rather than merely following arbi-

trary requirements. The likely result will be a reduc-

tion in the number of firms.

Accounting Standards

The main issue is failure to enforce. To improve

enforcement, the following measures are recom-

mended:

• SEC’s Accounting Standards Bureau should be

given proper resources and authority. It should

be able to set standards, including standards of

disclosure of cross-holdings, and insist that com-

panies disclose their adherence to these stan-

dards.

• SEC should also strengthen its data management

capabilities so that the information it collects on

shareholdings—which is of public value and

should be in the public domain—is available. Al-

ternatively, it could open its files to an outside

organization that could manage the data.

In practice, it is difficult to mandate change, espe-

cially if investors are not particularly interested. How-

ever, the likelihood is that foreign investors, having

been burned by nondisclosure will be more cautious

in the future. They are likely to insist on audits by

reputable firms underwritten by commitments from

those firms to stand by their work. They will dis-

count heavily the stock of companies where opaque

structures seem to be obscuring the view or where

international standards are not followed.

Corporate Governance

Promotion of competition for investment and en-

couragement for the emergence of larger, more pow-

erful institutions will push companies into better gov-

ernance practices over time. However, specific mea-

sures to accompany that process should include rules

enforced by the PSE to protect minorities and force

bidders to offer them the same terms in takeover

situations.

The PSE should introduce a code of governance.

There are several such codes around the world and they

usually cover things like separation of functions, remu-

neration decisions, and appointment of independent,

nonexecutive directors. The latter would be difficult in

the Philippines since there are relatively few suitable

appointees, but the demand for their services would bring

forth a supply. Such a model code does not have to be

mandatory—as it could be unreasonably burdensome

on smaller companies—but companies should be re-

quired to state the extent of their compliance. Investors,

especially foreign investors, would favor companies that

aim for better governance practices.

The privatization program should aim for best gov-

ernance practice in the privatized entities and this

should be enshrined in their internal procedures and

articles.

Bond MarketINTEREST RATES

The interest rate policy should be market determined

rather than administered. BSP does hold auctions,


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but the sense is that these are managed by BSP and

do not reflect the supply of and demand for funds.

146. The Government should encourage a more

competitive market for retail deposits. There are

currently very few sensible ways for average Filipi-

nos to save, so it is small wonder that savings are

low. Other countries have successful national sav-

ings schemes for small savers and, given the margin

between base rates and current retail rates, there

should be enthusiastic takers.

BSP should set reserve requirements (which are

currently very high) to meet the perceived risks fac-

ing the banking system, rather than as part of a deal

to manage interest rates down.

As an approach to weakening the banks’ domi-

nance over capital markets and money raising, the

reserve requirements should also focus more on large

exposures. As Philippine banks are captives of con-

glomerates, it is likely that their lending is highly con-

centrated, which is risky. Forcing them to lend more

widely would increase banking competition, reduce

intermediation costs, and bring about a better deal

for retail depositors. Development of the equity mar-

ket and bond market as alternative sources of funds

will force banks to reduce commercial lending rates.

Since the markets will tend to punish conglomerates

with banking subsidiaries, a more developed market

will reduce the number of bank subsidiaries.


Primary and Secondary Markets

With the uncertainty over interest rates and the

question remaining as to whether or not the experi-

ence of the recent crisis showing the weakness of

corporate information will have a long-term deter-

rent effect on investors, the near-term prospects for

the development of a fixed-rate bond market are not

encouraging. The situation has been further biased

by the differing shareholder approval requirements

for bonds and CP: bonds require approval of two

thirds of shareholders, while CP does not. Never-

theless, given the structure of most Philippine com-

panies, this may not be too much of a barrier in prac-

tice. However, the reemergence of the floating rate

CP market is to be expected and this could form the

basis for a movement toward more fixed-rate offer-

ings as macroeconomic stability improves. But for

the longer term development, there are some infra-

structure issues that need to be addressed. The risk

is that if the infrastructure questions are not addressed

then, when conditions are better, the market will re-

emerge and develop but in an offshore location.

Market users do not have to tolerate poor infrastruc-

ture or high costs in the domestic market; they can

issue overseas.

The issuing costs in the market are high. Under-

writing fees of P100 billion to P150 billion are more

the level one would expect in the equity market. To

some extent, the levels reflect the higher risks on

bonds in the Philippines, but it is hard to accept that

such high rates are the outcome of a free and com-

petitive market. However, there seem to be no obvi-

ous barriers to entry to underwriting. It is rare for

companies, except the most sophisticated, to chal-

lenge issuance fees (the fear of a failed issue tends

to outweigh the pain of high costs). The alternative

of making a private placement is generally more ex-

pensive because of the negotiating and information

provision costs when dealing with individual institu-

tional investors.

SEC should initiate a thorough investigation to find

out why costs are so high and address any monopoly

issues that are unearthed.

The high taxation of corporate bond trading and

traders impairs the secondary market. The second-

ary market for private bonds is very illiquid, partly

also because of settlement uncertainties/complexi-

ties. For example, bond intermediaries are subject to

the documentary stamp tax on transactions. Liquid

secondary markets assist primary markets by reduc-

ing risk and so reducing yields. Fixed-income instru-

ments tend to trade on very fine margins and so are

especially vulnerable to the dampening effect of trans-

action taxes on the secondary market.


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The Tax Reform Act of 1997 left the financial

sector largely untouched, so market players continue

to face high taxation and a high level of uncertainty.

There are plans, yet to be developed, to rationalize

capital taxes under the Comprehensive Tax Reform

Program. These plans should progress more rapidly,

with particular attention given to the effect of re-

duced transaction taxes on liquidity and tax revenues.

The importance of high-quality, reliable corporate

information for the bond market has been noted. There

are a number of issues connected to accounting qual-

ity and the willingness of companies to divulge infor-

mation that can restrict bond markets and force con-

tinued reliance on bank finance (banks are better placed

than other debt investors since they see and control

corporate cash flows). These points have been made

under the equity market section of this paper.

Greater credibility of the ratings agency through

the proposed joint venture will help. An international

agency is less likely to be fobbed off by companies

concealing information (it has a reputation and is

not short of customers anyway). This is not to im-

ply that CIBI was lax, but it is a matter of percep-

tion as much as fact.

There is no formal system for allowing intermedi-

aries to borrow stock/money to cover short/long po-

sitions. Such a facility would assist dealers in pro-

viding liquidity. Repos and reverse repos are pos-

sible, but taxation of interest earned and imposition

of reserve requirements on repo transactions have

stifled their use in liquidity support. A possible way

forward would involve offering exemptions for li-

quidity-supporting transactions by specified deal-

ers. This in practice would mean all their transac-

tions, but this would require ring-fencing of the se-

curities business of banks.

There is no benchmark yield curve because of

the absence of long-term fixed-rate issues. It is diffi-

cult to suggest a policy response since the answer is

to issue long-term fixed-rate bonds, which would be

very difficult in the current circumstances. Naturally,

when conditions permit, the Government should be

encouraged to lengthen the maturity of its debt, as it

was doing before the crisis.

In the short term, there are possibilities for using

the nascent MBS as the basis for a benchmark. This

is being developed elsewhere with assistance from

the Asian Development Bank (ADB), and it can be

explored in the Philippines. However, for the Gov-

ernment guarantee (which would be required for the

MBS to form the basis of a risk-free yield curve), a

fixed-rate debt against floating rate assets (mort-

gages) would entail very significant risks.

For the benchmark yield curve to benefit the bond

market, practitioners would need to have confidence

that the long-term yield curve is a more useful bench-

mark than the T-bill rate that is currently used in

pricing all maturities, even those beyond the T-bill

durations. This requires it to be a true risk-free rate

(or at least equivalent to sovereign risk).

Investors in MBSs would need to be confident of

the guarantee and the risk-management systems put

in place by the Government to hedge this risk. This,

in itself, would be difficult to achieve given the risk,

and might involve a substantial risk premium in the

MBS rates. Further study of the mechanics of MBS

issuance under current conditions is required.

Settlement

There are two possibilities for the future corpo-

rate bond settlement system: the ROSS system run

by BTr for Government securities and PCD that

settles for the equity market. The decision is yet to

be taken. ADB’s technical assessment suggests

PCD is superior. This view is taken on the basis of

greater security and easier (electronic) access to the

system.

Naturally the greatest economies (and risk reduc-

tion) would arise from combining ROSS and PCD,

and the ADB assessment proposes a migration path

to achieve this. A speedy decision is required, based

on a rational assessment of relative costs and ben-

efits of the two systems. So far, the PCD seems the

likely winner.


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There is regulatory uncertainty and confusion. The

bond market has multiple regulators. Government

bonds are currently the responsibility of BTr, and other

bonds (but excluding ABS) are governed by SEC. It

is natural that the Government should have a domi-

nant role in the Government market, but an appear-

ance of rivalry, which comes to a head in the settle-

ment system debate, is damaging. The long-term re-

sponsibilities should be made very clear so that

progress can be made on the settlement system.

Similar issues involve BSP, which is trying to take

a role in the ABS market apparently in competition

with SEC. Again, it is natural that BSP should be

concerned about bond issues involving banks, but the

regulatory responsibility for the investment products

(as opposed to the banks’ solvency) should clearly

rest with SEC. The current uncertainty over regula-

tion is not helping the ABS market and is almost cer-

tainly adding to issue costs as issuers have to create

special vehicles to avoid possible regulatory changes.

SEC’s role in approving bonds seems to go be-

yond that of a listing or issuing authority. Specifically,

it requires issuers to satisfy certain ratios before au-

thorizing a CP issue. The requirements are well meant

in that they aim to ensure the solvency of the issuer.

But that should not be the job of SEC (any more than

it should judge the merit of equity IPOs); it should be

the task of investors, perhaps assisted by ratings agen-

cies, basing their judgment on the information pro-

vided by the issuer. SEC’s task is to set standards

for information disclosure and ensure they are en-

forced. SEC claims to have abandoned the merit-

based approach to regulating equity IPOs. It should

follow this in its regulation of bond and CP issues by

removing its ratio requirements but strengthening the

enforcement of information provision.

There is no regulation of secondary market trad-

ing. Bond secondary markets tend to be professional

markets and therefore need less regulation than eq-

uity markets. However, even professional bond mar-

kets can be improved by greater transparency and a

minimal level of regulation. SEC should consider

mandating the basic regulatory framework, in par-

ticular, the reporting of transactions and prices.

InvestorsPENSION FUNDS

A legal and fiscal framework for private pension

schemes should be developed to facilitate their emer-

gence and growth. The framework should offer in-

centives to savings through such schemes and not

limit their investment policies nor discriminate in fa-

vor of or against bond or equity investment. Ideally it

should also permit sensible diversification into over-

seas assets as well.

Restrictions on the investment policies of State

schemes should be removed if they are to compete

effectively with private schemes and not be seen as

a second choice for the less rich.

For pension schemes to develop sound investment

portfolios, there is need for changes to enhance the capi-

tal markets and increase the supply of financial assets.

MUTUAL FUNDS

As other investment institutions, mutual funds find it

hard to compete with banks for deposits from bet-

ter-off investors. Their strategy of targeting the less

well-off seems misconceived and likely to lead to

problems—it is not clear that investors’ portfolios of

$100 should be invested in equities. The rules relat-

ing to suitability of investments should be tightened

(and properly enforced) to ensure that the funds tar-

get those investors who can afford to take the risks

associated with the equity market.

However, it would be a shame to restrain a new

competitor for retail deposits. If mutual funds have

the infrastructure for handling smaller deposits, then

they should be encouraged to do this but without the

need to convert the savings portfolio into equity.

The quality of the equity and bond markets and

the number of issues should be improved so that

mutual funds can have an adequate range of invest-

ment possibilities.


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INSURANCE COMPANIES

The rules on the CGT mean that insurance compa-

nies, which can and do act as venture capital com-

panies elsewhere, are restricted in their private eq-

uity investments to more substantial companies, i.e.,

those likely to seek and gain a listing within the insur-

ance companies’ investment horizon. They are de-

terred from a true venture capital role of investing in

start-up enterprises. The effect of the CGT on smaller

company investment should be examined. It seems

unlikely that the yield is high, but its effect is to stul-

tify a valuable source of development capital.

Even more than pension funds, life assurance com-

panies need access to liquid bond markets where they

can match the duration of their liabilities with appro-

priate, secure assets. Policy changes to provide a bond

market infrastructure, as described, would benefit in-

surance companies and facilitate the provision of life

cover. In the absence of a domestic market, insur-

ance companies will have little alternative but to move

money offshore into foreign bond markets, thus de-

priving the country of a valuable investment source.

COMMON TRUST FUNDS

CTFs are important retail savings channels and could

become an important element in a private pension sys-

tem. As such it is inappropriate for them to be regu-

lated by a regulator with little interest or expertise in

the regulation of savings products. Their regulatory

reporting line should be reviewed. More generally, this

sort of problem becomes more acute as markets be-

come more sophisticated and institutional boundaries

begin to blur. An eventual shift toward a function-based

rather than institution-based regulatory structure is likely

to be the best long-term solution.

FOREIGN INVESTORS

Restrictions on foreign ownership should be removed;

they are largely without purpose and create a nega-

tive impression of a restricted and overcontrolled

market. They also deny foreign capital to important

sectors. However, there is a problem in removing

such restrictions too precipitately. While such a move

would be to the long-term benefit of foreign inves-

tors, foreign funds that have bought at a premium in

the restricted market will experience losses if a uni-

fication of the market leads to a fall in the value of

their holdings – as it very likely will. Two possible

approaches are (i) the death of a thousand cuts, i.e.,

gradually remove restrictions so the pain is spread;

or (ii) a one-time move that is timed to coincide with

a low point in the premium.

Enforcement should be improved. Foreign inves-

tors were most critical of the enforcement efforts of

SEC and the PSE. In short, they felt there was no

enforcement worthy of the name. Foreign investors

will continue to regard the Philippines as a “cow-

boy” market (i.e., no effective laws, regulations, or

enforcement) unless there is convincing action. The

consequence is that foreign investors will only look

at more speculative investments and will get out at a

hint of trouble.

Settlement security should also be improved. For-

eign fund managers are rarely fired for picking the

wrong stocks, but they are fired for letting stock or

money get lost in settlement. If the Philippines would

continue to have a shaky settlement system, for-

eign fund managers would put the country toward

the bottom of their market lists and only look there

when other, more secure, opportunities have been

exhausted.


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Notes

1T+4 means that settlement of a trade occurs on the fourthbusiness day after the trade, e.g., a Monday trade getssettled on Friday.

2Shadow clearing produces reports that are not actuallyused—a sort of parallel running.

3Under US Laws, an insolvent company can apply forChapter 11 protection. Essentially, this gives the companyprotection from creditors who may wish to force it intoreceivership. Such protection enables the company tocontinue operating, instead of closing, and using its pro-ceeds to meet creditors’ claims.

4Maximum percentage limits on investment of social se-curity funds are as follows:

Bonds issued and guaranteed by the Philippine Government No limitPhilippine Government or State agency bonds to fund

infrastructure and guaranteed by the Government 30Bonds of Government financial institutions or corporations 30Bonds or deposits of good quality banks operating in the

Philippines 40Bonds issued by housing corporations (including

Government corporations) 35Bonds of educational and medical institutions 10Real estate and stocks of real estate companies 25Bonds and securities of prime corporations 30Common stock of listed companies 30Domestic mutual funds 20Foreign mutual funds 7.5Foreign currency deposits or foreign currency

denominated assets 7.5

Loans secured by collateral of Government debt orsimilar instruments 30

5The PSE trades from 9:30 a.m. to 12:30 p.m.

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