Philippines - Aspects of the financial sector

A WORLD BANK COUNTRY STUDY PU B-2546 THE PHILIPPINES Aspects of the Financial Sector A Joint World Bank/IMF Study Ma' 1980   THE PHILIPPINES Aspects of the Financial Sector A Joint World Bank/IMF Study This report is the result of a joint World Bank/IMF mission which visited the Philippines in March 1979. Both the IMF and the World Bank maintain an ongoing interest in the financial sector in the course of their operations. From time to time a review is carried out of sectoral issues of concern to the authorities. The present report looks at the situation of the financial sector in the light of the need to increase the flow of long-term credit. At the request of the Government particular attention was paid to the possibilities of changing the functions carried out by financial institutions, notably by commer- cial banks. A draft of the report was discussed with the Government on a second visit in August 1979. The mission members were: Edward K. Hawkins, Chief of Mission Madhusudan S. Joshi Farida N. Khambata Klaus W. Riechel Katrine W. Saito Hans 0. Horch, Consultant In carrying out its work the mission drew heavily upon earlier studies of the financial systems done by the staff of the Philippine Government, the Central Banking Department of the IMF and the World Bank. The mission wishes to acknowledge the extensive assistance provided by the staff of the Central Bank, the Ministry of Finance, NEDA, SEC, GSIS and SSS. Members of the financial community also gave freely of their time in discussions and provided much valuable information. The mission is alsoe grateful for the advice and assistance of colleagues in the Bank, IFC and the Fund concerned with operations in the Philippines. East Asia and Pacific Regional Office The World Bank Washington, D.C., U.S.A.  The World Bank issues country economic studies in two series. This report is a working docu- ment and is, as such, part of an informal series based wholly on materials originally prepared for restricted use within the Bank The text is not meant to be definitive, but is offered so as to make some results of internal research widely available to scholars and practitioners throughout the world A second, more formal series entitled World Bank Country Economic Reports is pub- lished for the Bank by The Johns Hopkins University Press, Baltimore and London. Titles of these and all other bank publications may be found in the Catalog of Publications, which is available free of charge from World Bank, Publications Unit, 1818 H Street, N.W , Washington, D.C 204&3., USA This report is a free publication A small charge may be made if airmail postage is required The views and interpretations in this report are the authors' and should not be attributed to the World Bank, to its affiliated organizations, or to any individual acting in their behalf. Copyright - 1980 The International Bank for Reconstruction and Development/The World Bank The World Bank enjoys copyright under Protocol 2 of the Universal Copyright Convention Nevertheless, permission for reproduction of any part of this report is hereby granted provided that full citation is made  CURRENCY EQUIVALENTS US$1.00 = Pesos (P) 7.4 X 1 .00 = JS$0.135 FISCAL YEAR January 1 - Oececmlier 31  I  THE PHILIPPINES ASPECTS OF THE FINANCIAL SECTOR TABLE OF CONTENTS Page No. INTRODUCTION SUMMARY AND CONCLUSIONS ... . . . . ..... . . . . . . i-ix 1. STRUCTURE OF THE FINANCIAL SYSTEM . . . . . . . . . . . 1 2. COMMERCIAL BANKING . . . . . . . . . . . . . . . . . . . 8 3. FINANCIAL MARKETS ... . . . . . . . . . . . . . . . . 22 4. FINANCE FOR INDUSTRY ... . . . . . . . . . . . . . . . 31 5. LONG-TERM FINANCE AND FINANCIAL INTERMEDIARIES . . . . . 37 6. REGULATORY POLICIES . . . . . . . . . . . . . . . . . . 50 7. FINANCIAL POLICIES ... . . . . . . . . . . . . . . . . 54 8. ISSUES IN THE DEVELOPMENT OF THE FINANCIAL SYSTEM . . 70 Appendix 1 - Laws and Regulations Governing Financial Institutions ... . . . . . . . . . . . . . 84 Appendix 2 - Calculation of the Contribution of the Proximate Determinants to the Growth of Money Supply ... . . . . 95 Appendix 3 - Deposit Growth, Stability and Stable Core ................ 98  TABLES IN TEXT Table No. Page No. 1 Total Assets of the Philippine Financial System . . . . . . . 3 2 Number of Financial Institutions in Operation, 1975-78 . . . 4 3 Private Domestic Banks: Ranking by Major Accounts . . . . . 10 4 Assets and Liabilities of Commercial Banks . . . . . . . . . 13 5 Structure of Deposits of Commercial Banks . . . . . . . . . . 15 6 Structure of Credits Granted by Commercial Banks - By Maturity .... . . . . . . . . . . . . . . . . . . . . . 17 7 Credits Granted by Commercial Banks - By Interest Rates . . . 19 8 Credits Granted by Commercial Banks - By Industry . . . . . . 20 9 Investment Houses Underwriting Volume, 1976-78 . . . . . . . 23 10 Sources of Deposit Substitutes by Issuer, 1973-78 . . . . . . 27 11 Commercial Banks: Deposits and Deposit Substitutes, 1974-78. 27 12 Deposit Substitutes Outstanding - Commercial Banks - By Maturities .... . . . . . . . . . . . . . . . . . . . 28 13 Money Market Rates, 1974-78 . . . . . . . . . . . . . . . . . 28 14 Investment Houses Balance Sheet Summary, 1977-78 . . . . . . 30 15 Percent Distribution of GDP by Sectoral Origin, Current Prices ... . . . . . . . . . . . . . . . . . . . 31 16 Long-Term Financing for Industry . . . . . . . . . . . . . . 33 17 Long-Term Local and Foreign Exchange Financing for Industry 34 18 Total Loans Granted by Institutional Groups, 1970-77 . . . 38 19 Percentage Distribution of Credits Granted by Purpose by Domestic Financial Institutions, 1960-77 . . . . . . . . . 39 20 Credits Granted by Banking Institutions by Maturity, 1973-77. 41 21 Outstanding Loans of NBFIs by Maturity . . . . . . . . . . . 42 22 Credits Outstanding by Financial Institutions by Maturity . . 43 23 Outstanding Loans of DBP by Maturity . . . . . . . . . . . . 44 24 Percentage Distribution of Loan Disbursements of DBP . . . 45 25 Loans and Investments of GSIS, 1974-78 . . . . . . . . . . . 46 26 GSIS Holdings of Stocks and Bonds . . . . . . . . . . . . . . 47 27 Loans and Investments of SSS, 1974-78 . . . . . . . . . . . 48 28 Loans and Investments of Private Insurance Companies, 1973-77 49 29 The Stability of Selected Economic Variables . . . . . . . . 55 30 Changes in the Money Supply and the Contribution of its Proximate Determinants to Those Changes . . . . . . . . . . 56 31 Inflation, Interest Rates and Real Interest Rates . . . . . . 60 32 Deposits and Deposit Substitutes, Short vs. Longer-Term Financial Savings . . . . . . . . . . . . . . . . . . . . . 61 33 Interest Rates on Time Deposits and Growth of Long-Term Deposits and Deposit Substitutes . . . . . . . . . . . . . 64 34 Interest Margin Between Central Bank Rediscount Rates and Lending Rates of Banks ... . . . . . . . . . . . . . . . 67 35 Maximum Maturities of Discounts and Advances . . . . . . . . 68 36 Deposit Growth, Stability and Stable Core, Quarterly Date: 1970 (I) - 1978 (IV) ................. .. . 73  THE PHILIPPINES ASPECTS OF THE FINANCIAL SECTOR SUMMARY AND CONCLUSIONS Introduction 1. A joint IMF/World Bank mission visited the Philippines in March 1979 to review certain aspects of the financial sector. In particular, the mission looked at the present situation of the sector in light of the need to increase the flow of longer-term savings and make such flows available for priority uses. There was concern about the shortage of medium and longer-term finance, especially for industry. The authorities requested that the mission pay special attention to the possibilities and consequences of changing the range of functions performed by financial institutions and the impact this might have upon the supply of finance. The main change suggested was that commercial banks be encouraged to increase their term lending and be given powers to invest in equities and engage in underwriting. 2. The mission focused on the background and implications of proposals which would move the banking system towards more universal banking. Qualified approval is given to these suggestions. However, it is felt that the manner in which they are implemented will need to take account of important features of the financial sector and the environment in which it now operates. There is a justification, at the present stage of the country's development, for a less rigidly specialized financial system. Any one change, by itself, may not produce a radical change in the supply of longer and medium-term lending. Other factors in the environment in which the system has to operate will also need to be taken into account. 3. Gross domestic savings have been relatively high in the Philippines in the recent past, but will need to expand from 25% to 30% of GNP over the next ten years. While all sectors are expected to increase their rate of savings, the household sector share is expected to go from 9% of GNP in 1978 to over 11% in ten years. This implies a marked increase in the savings effort in a sector which is already shouldering the task of financing the greater part of the country's investment requirements. For the years 1974-78, the contribution of households to gross domestic savings averaged 40%. The growth of private savings will depend ultimately on the continued rise in per capita incomes, but the mobilization of such savings in a form which can be tapped for the financing of investment depends upon a responsive and appropriate financial system. 4. In general, the financial system has served the country well in recent years. The external creditworthiness of the Philippines has been firmly established, starting from a precarious and difficult balance of  - ii - payments position in the early 1970s. The shock of the sharp and extended deterioration in the terms of trade (following the oil and other price increases of 1973-74) was weathered without disturbance to the monetary system. The banking system was strengthened by increases in capitalization, a sophisticated money market developed and a basis was laid for linkages with the international banking system. The banking system evolved in the direction of a more professionally managed group of institutions. 5. The rapid evolution of the financial system does indicate some response to the needs of the economy for the mobilization of savings in a financial form. Total assets of the financial sector grew by 11% p.a. (in real terms) between 1974 and 1978, while real GNP grew at 7%. The range of financial assets increased and there was a clear response on the part of savers to keep a larger proportion of savings in financial forms. In relation to the demand for finance, there was clearly a shortage of savings. Effective interest rates were high, constantly tending to exceed the controlled rates of interest, and smaller and less well-established enterprises found it difficult to obtain finance at any interest rate. 6. The requirements for financing set out in the Five-Year Development Plan indicate that the demand will increase even more in the future. There is general agreement that it would also be desirable to increase the supply of finance available on longer terms. Long-term peso funds have been particularly scarce in the past and the main criticism of the financial system is that it has failed to provide adequate long-term finance. As the country continues to industrialize the needs of industry for such longer-term finance will be particularly important, although other sectors, such as agriculture, mining, government, and housing will also require such financing. Reform of the Financial System 7. The framework of legislative and regulatory control of the financial sector is the most important determinant of the environment in which financial institutions have to operate. In the Philippines the basic philosophy behind it calls for a strong guiding and regulatory role for the Central Bank, com- bined with the idea of specialization of function between financial institu- tions. The commitment to specialization of function is an old theme, leading to the creation of new institutions as the need for them was perceived. The impulse towards specialization was often carried as far as to specify the operating limits beyond which institutions could not go (e.g. restrictions on rural banks as to borrowers and the purposes for which credits are made). 8. The tendency to specialization was reinforced by the implementation of the recommendations of the joint IMF/Central Bank Survey Commission of 1972, which reaffirmed the separation of regular banking activities - the task of commercial banks - from investment banking activities, notably the underwriting of security issues. Commercial banks were prohibited from the  - iii - acquisition of equities, other than in "allied undertakings." Specialization has led to considerable fragmentation among institutions and has reduced competition and the responsiveness of the system to changing needs and demands. It also appears to have done nothing to lengthen maturities or promote longer-term lending and borrowing. Measures to ensure active competition are at the core of any consideration of a possible reorganization of the financial sector in the Philippines. It should be stressed that such measures are desirable regardless of change in the functions of institutions. 9. The objectives of any reforms should be twofold - to increase the total flow of savings intermediated through the system and to increase the proportion made available to borrowers on medium and longer terms. At this stage of the country's development the investment needs of industry are particularly important; in this case it is not simply the lengthening of the terms of borrowing that is important, but providing access to finance for new and possibly small enterprises that are not established customers of the banking system. Lengthening the maturity of credits needs to be accompanied by new forms of lending. 10. However, this need not involve setting up of new specialized financial institutions. The pursuit of specialization of function in the past has introduced a degree of fragmentation into the system and probably led to too many institutions, often too small to be fully effective. As the most important mobilizers of savings, the size and number of the commercial banks particularly invite review; it may well be that the country has too many com- mercial banks at too small an average size to be able to exploit the potential economies of scale, and to be able to deal with the somewhat larger institutions operating in the international field. The openness of the economy makes it necessary for commercial banks to develop international links. 11. There are strong historical reasons for the existence of a large number of banks in the Philippines. The fact that many of them are family controlled enterprises, and that the practice of employing professional management emerged only recently, tended to limit their size. However, the limitation of function to classical banking activities may also have inhibited the expansion of individual banks. 12. The possibility of increasing the flow of medium and longer-term credit will require a greater degree of term transformation - the use of shorter-term liabilities as the basis for longer-term assets. There has been some encouraging growth in long-term deposits and everything should be done to encourage it further. However, given the present state of savers' expectations about the future, it is doubtful whether there will be a marked shift to longer-term liabilities. Term transformation will need to be more actively practiced, therefore, if longer-term lending is to be increased.  - iv - 13. The crucial question is the extent to which it can be safely and prudently practiced, either by one institution, or by the system as a whole. The general basis for term transformation, both for individual banks and for the system, should be the ability to lend at medium or longer term some percentage of the permanent core of deposits that form the greater part of the liabilities of commercial banks. Some guidance as to the proportion of deposits that can be considered as permanently available to the banks can be obtained from a study of past experience. The period 1970-78 in the Philippines included rapid structural change, and severe external shocks for the economy. Nevertheless, that period showed a rate of growth for all deposits (and deposit substitutes) of such a pattern as to suggest that a surprisingly high percentage of the total (about 90%) can be considered to be a stable part of the permanent core of deposits. This suggests that the common belief that the term structure of deposit liabilities should be the decisive factor for the term structure of intermediaries' assets requires revision. There would appear to be little ground for concern about the maturity structure of liabilities. Instead the focus should be more on what is needed to encourage banks to move to longer maturities on the assets side. 14. The risks for individual institutions depend upon the degree of term transformation and the access to liquidity should the owners of short- term liabilities withdraw their funds. The first line of defense for an institution faced with a loss of liquidity would be the interbank market, which is already well-developed in the Philippines, especially since the establishment of Overseas Banking Units. The second line of defense would be access to the facilities of the Central Bank. At the present time these facilities are provided in the form of rediscounts for particular approved instruments, and the rediscount mechanism is used to encourage the flow of credit to specific purposes. The practice of more extensive term transfor- mation by the banks would require that Central Bank rediscounting facilities be more assured and more general in scope, consistent with overall monetary policy. 15. For the financial system as a whole, the risks of more extensive term transformation depend upon the extent to which all institutions might come under pressure at the same time. The impact would then fall upon the Central Bank since the interbank market would be of little help. Such a state of affairs would be that of a general crisis of confidence and panic, an extreme situation that is likely to be a rare event, calling for special measures. A prudent expansion of term transformation does not need to be limited by the remote possibility of a general panic. 16. There is a spectrum of possibilities through which commercial banks could undertake more medium and longer-term lending. (a) In the first place, they could immediately lengthen their maturities within the present legal and regulatory system. There is some evidence that interest in such lending is increasing, but there is still a marked preference for short-term lending by the banks and for short-term borrowing by prime customers.  (b) A second way to extend longer-term loans would be for banks to take up more corporate bonds. An expansion of lending would also be achieved indirectly by banks subscribing to the obliga- tions of development banks. They could also expand the practice of syndicating loans. (c) A third possibility would require a major change in law and practice. This would be to permit banks to make equity invest- ments in nonallied undertakings. If prudently carried out, such a change offers the possibility of increasing the flow of longer- term finance available, especially where equity can be combined with other kinds of finance. 17. Banks could also engage indirectly in equity finance through underwriting. A stronger secondary market would be essential to successful equity investment by banks because of the need for assured liquidity so that equities can be disposed of. The banks' participation in equities and under- writing would lend institutional support to the presently thin securities market. A less specialized banking system, able to engage in more active trading of bonds and equities and to underwrite issues, would support the development of the securities market, increase competition and enhance the efficiency of markets. 18. Steps would need to be taken to guard against the potential dangers of banks participating in underwriting and equity investments. These dangers are the possibility of increased concentration of market power, and potential conflicts of interest. Concentration in the financial sector tends to create excessive market power for a few institutions. If the banks were free to invest in equities and hold them on their own account, there would clearly be a danger of them obtaining a controlling interest in other corporations. These dangers could be met by provisions designed to ensure that banks do not acquire controlling interests, and steps are taken to promote competition. It may also be desirable to require that banks divest themselves of equities after an agreed time. 19. The arguments in favor of less specialized financial institutions have been made in terms of more freedom of action for commercial banks. Consideration also needs to be given to permitting other institutions more freedom to carry out other functions and thus to remain competitive. Those that are presently quasi banks might be given the option of providing banking services, especially the right to solicit deposits. There are other possible changes in the financial system which would help to open it up and strengthen it. They are: further increases in the capitalization of the commercial banks, further mergers, broadening the ownership base of banks and more freedom of action for other financial institutions to further reduce the extent of specialization in the present system. 20. Further increases in the capitalization of the commercial banks would increase their resources and their potential for term lending and equity finance. Relative to the size of the economy, the average size of  - vi - private banks is smaller than in other comparable developing countries and there may be a case for larger institutions. They could take advantage of economies of scale and would be able to operate in the newer areas of activity such as international banking. Another objective of increased capitalization would be to broaden the ownership base of the banks. The powers of banks to engage in equity financing might be linked to the obligation to broaden their capital base and open up closely held businesses to broader ownership and listing on the exchanges. 21. The philosophy behind the above recommendations is that the financial system should be permitted to respond to the financial needs of the economy and that such responses are likely to be more accurately gauged by institutions that are free to provide services that they calculate can be profitable. The implications for the financial system would be far reaching in that a new divi'sion of labor will emerge on the basis of comparative advantage. While it is unlikely that the changes will be swift and dramatic, some institutions may well change their character, or disappear over time. These changes are bound to cause some unhappiness to those who have interests in the present system. From the authorities' point of view the criterion of change should be whether it contributes to the long run efficiency of the system, consistent with the maintenance of a stable monetary system. 22. The above points may perhaps be illustrated by considering the situation of investment houses. They are the prime examples of legislated specialization, having come into existence as a result of the Investment Houses Law of 1973, in which underwriting activities were reserved exclu- sively to investment houses. At present there are 12 investment houses, of which one is inactive. Two or three are involved in underwriting but the majority found that money market operations were significantly more profitable as the main activity and principal source of income. One of the investment houses is more concerned with development banking and does not engage very actively in either underwriting or money market activities. In these circumstances it is difficult to see that much would be lost by permitting commercial banks to carry out underwriting, provided they satisfied the legal requirements, because the investment houses' contribution to long-term finance has been marginal. If in return, investment houses were also permitted to assume a broader range of functions, the more efficient investment houses would undoubtedly survive, but that would be determined on the grounds of efficiency, comparative advantage and the ability to offer special skills. 23. The case of the development banks is that they offer, in principle, long-term banking skills, based on an ability to appraise projects. This requires an organization and kind of staff which has not been built up in the commercial banks. Development banks are likely to retain this comparative advantage at least until commercial banks can establish the same capability. Their weakness has been on the sourcing side, and they would be strengthened if they were able to mobilize more deposits and practice a prudent amount of term transformation. They would also need access to refinancing or liquidity facilities. In this case they would be competing with commercial banks for deposits.  - vii - 24. Broad geographical coverage is the main advantage of the rural banks which now have over 1,000 branches. The rural banks are unit banks, special- ized by law to serve agriculture and the rural areas. As such, they are often the main banking facility available in some areas. They enjoy access to low- cost refinancing facilities at the Central Bank. The right to accept demand deposits would make many rural banks more attractive institutions and less dependent upon subsidized funds channeled through the Central Bank. Greater use might then be made of such local financial institutions to support regional development. Commercial banking, despite its branch network, is essentially controlled and dominated by metropolitan institutions. 25. Both development banks and rural banks could be strengthened and supported by access to expertise and technical assistance. One way to provide it would be through regional institutions or associations, along the lines of those set up in other countries. They could be owned by groups of banks and would provide services on a larger scale than is possible for any one indivi- dual unit bank. 26. An important aspect of the general environment concerns certain institutional features which need to be taken into account when evaluating the impact of possible changes. The commercial banks have developed in a certain tradition and acquired habits and a style of operation which may not imme- diately welcome change. However, as a group they are far from homogeneous and the more progressive may be willing to adopt new techniques including, in particular, those required for project lending, and to take advantage of new opportunities. They should not be held back by the more conservative members of a community which does not, by tradition, welcome competition. 27. There is one feature of the financial system which is particularly important for the initiation of the above proposals. While the operation of the system is left largely to private enterprise, the authorities have con- siderable influence over it through public ownership of the largest commercial bank - PNB, and the largest development bank -'DBP. In addition, the Govern- ment can influence the disposition of the substantial funds flowing into GSIS and SSS. In the future the newly created housing finance institutions will also be under public control. Proposals for liberalizing the banking system and promoting more competition will depend upon the right pattern of incentives. Government influence through the above-mentioned institutions will need to be exercised in a way that supports the objectives of reform. For example, the reactions of the PNB to such possibilities as more term transformation, more longer-term lending and investments in equity may be crucial for the wider adoption of such practices. As the largest commercial bank, it could be expected to give a lead in the pursuit of the above objectives. The role of DBP is equally important. It enjoys privileged access to concessional long-term funds, including overseas borrowing. In its lending practices and policies, it can influence the operations of other institutions. If it sets long-term lending rates at a low level which does not reflect the costs and risks of other financial institutions, it can inhibit the overall growth of longer-term lending.  - viii - 28. The above proposals are all aimed at mobilizing more savings in a financial form, and making it possible to utilize a larger proportion of those savings for medium and longer-term lending. While the central proposal made - that there should be a less specialized banking system - will make it possible to move towards those objectives, it will not guarantee success. A number of other complementary factors need to be taken into account. 29. These factors are a dominant part of the general economic environ- ment in which the financial system has to operate. Greater mobilization of savings and a more adequate supply of medium and longer-term finance depends upon the right kinds of incentives for lending and borrowing. These incen- tives are influenced by the pattern of monetary policy, the structure of interest rates and the tax regime. 30. The monetary policy in the past has not always been conducive to encouraging financial institutions to engage in longer-term commitments. Both individual monetary policy measures and the comprehensive and growing body of instructions and regulations have created a feeling of uncertainty in the financial community and shortened its planning horizon. In addition, assured "lender-of-last-resort" facilities are practically nonexistent. Both factors severely reduce the preparedness of financial institutions to engage in longer-term commitments. A major element of financial environment relates to the level and structure of interest rates. The reforms of 1976 resulted in a significant increase in the longer-term deposits, but had very little impact on the assets side in terms of extending the maturities of loans. This could be explained on the grounds of profitability, liquidity and risk. Unless the effective differentials between the short and long-term lending rates reflect sufficiently the difference in perceived risks, and expectations of long-term rates are reasonably stable, it would be difficult to expect a rapid development of term lending. Another major determinant of economic behavior is the taxation regime. There is first of all the tax system's general impact upon incomes, savings and investments, which determines the pattern of behavior of lenders and borrowers. Secondly, specific taxation measures have been used to influence the form in which finance is made available, as in the case of the 35% tax on money market instruments. Fiscal incentives could be devised to provide more attractive after-tax yields for lenders and lower effective rates for borrowers. However, their benefits need to be weighed against the loss of revenues involved. 31. The full implementations of the above topics were not explored in detail. Given their significance for the achievement of the Government's aims, further studies are clearly required. 32. Changes along the lines sketched out above would have an impact upon the money and credit supply. While for efficiency reasons it appears desirable to remove a fair amount of legislated specialization in the finan- cial system and to open it up to a greater array of opportunities, it should  - ix - be borne in mind that monetary stability remains a goal of overriding importance. Furthermore, it should be recognized that the country will continue to be subject to constraints imposed by its foreign exchange position. 33. Monetary theory and quantitative evidence on the Philippines and other countries suggest that the above recommendations about the reorganiza- tion of the financial system should not have any serious adverse implications for monetary control. While no serious problems for monetary control should be expected from movements in the money and credit multipliers, the author- ities should be aware of certain repercussions from a liberalization of financial sector activities on the control of the monetary base. Any opening up of the financial system will have to be accompanied by appropriate supporting monetary and fiscal policy measures in order to strengthen the effects of an increased responsivenes of the financial system on the effi- ciency of financial intermediation. This applies, in particular, to the assurance of short-term accommodation in cases of deficiencies of financial resources; more specifically, it applies to the "lender-of-last-resort" function of the Central Bank. Such an approach to Central Bank policy will make the control of at least one part of the monetary base more difficult, namely, the size of loans granted as a result of the discounts and advances policy. As this instrument is allowed to respond more flexibly to the demand of financial institutions, it becomes at least partly passive. By reducing the allocative element of its rediscount policy, which carries an expansionary bias, by setting appropriate discount rates and by adjusting rediscount quotas as warranted by the overall monetary situation, the Central Bank will, how- ever, maintain a strong influence over the borrowing of financial institu- tions. Furthermore, policy instruments such as required reserve ratios and open-market operations by use of CBCIs or similar liabilities of the Central Bank can be used more actively to ensure that the longer-run behavior of the credit and money supply, while adjusting more flexibly to short-term swings in demand, remain firmly under the control of the monetary authorities.   1. STRUCTURE OF THE FINANCIAL SYSTEM Overview 1.01 The financial system of the Philippines is relatively well-developed and in recent years has become increasingly sophisticated, responding to opportunities in the field of intermediation in a particularly innovative way. The kingpin of the whole system is the commercial banking sector, consisting of both domestic and foreign banks. In addition, an array of other institu- tions has emerged at various stages to perform specialized functions. There is a well-developed and very active short-term money market. Foreign currency operations have grown rapidly in recent years following the establishment of Offshore Banking Units (OBUs) and expanded Foreign Currency Deposit Units (FCDUs). As a result, Manila has developed into a regional financial center of growing importance and the system which has developed is thus complex, with much overlapping of functions and considerable interlinking between institutions. 1.02 The system, however, does have its shortcomings. Perhaps the most significant drawback is the relatively undeveloped state of the long-term capital market. Despite the existence of three stock exchanges, their ac- tivity revolves mostly around relatively few and speculative issues. The institutions which have the largest volume of resources at their disposal, i.e., the commercial banks, have overwhelmingly been involved in short-term credit, and some of the institutions set up to specialize in long-term credit, for example, investment houses, have succumbed to the temptation of high short-term rates and have been dealing mostly with the short-term end of the market. Total Resources of the Financial System 1.03 Total resources of the financial system have expanded as the institutions involved in financial intermediation have evolved. As a percentage of GNP, they have grown from 48% in 1960 to 95% by 1978. The first half of the 1960s witnessed a rapid growth in total financial resources of the system as new commercial banks, development banks and rural banks were established. The emergence of new nonbank financial intermediaries together with a marked growth in the capitalization of commercial banks contributed to a more rapid real rate of growth in the resources of the financial system during the 1970s (14%). The growth of the nonbanking sector was particularly significant,/l and was assisted by two /1 Its total resources grew by 17% p.a. between 1970 and 1976 compared to a 12% growth in the banking sector.  - 2 - factors: the expansion of money market activities and the wide variety of new services offered by the nonbank financial intermediaries. As a result, by the mid-1970s the nonbank financial intermediaries had become an important component in the system (Table 1). Expansion in Facilities 1.04 As the total resources of the system have grown, so have the facilities which these institutions provide. Total number of banking and nonbanking financial offices has expanded from 2,285 in 1970 to 4,206 in 1978 (Table 2). This is an impressive network, comprising around 11,000 population per office./l The most rapid expansion in bank and nonbank offices over the last five years has been with the savings and mortgage banks and with the stock savings and loan associations, both of which have more than doubled their number of offices over these years. The total number of rural bank offices is now only slightly less than that of commercial banks' total offices, the latter having been rather slow in setting up branches and being heavily concentrated in the Metro-Manila region./2 Institutions in the Financial System 1.05 The banking system comprises commercial banks, rural banks, thrift banks and specialized government-owned banks. Because of their great relative importance, the operations of commercial banks will be given special attention in Chapter 2, while all other financial institutions will be briefly discussed below. 1.06 The rural banks are unit banks with the main function of extending credit to the small-scale farmers and enterprises of the rural sector. They receive considerable government assistance and have grown in number to more than 1,000, with wide geographical dispersion. Despite their number, total assets of rural banks comprised only 2% of the financial system's total in 1978, although they did provide 16% of all institutional agricultural credit. Of the three categories of thrift banks, the stock savings and loan associa- tions extend credit with less than one year's maturity. In terms of total assets, by far the largest of these three categories of thrift banks is the savings and mortgage banks which invest depositors' savings in bonds or loans for housing. The private development banks (PDBs) provide medium and long-term credit mostly to the small and medium-scale sector. They obtain financial assistance from DBP and also collect time and savings deposits. /1 The corresponding figure for India, for example, is 30,000 and for Kenya, 107,000. /2 As at the end of 1977, about 44% of the total bank offices were in Metro-Manila, 27% in Luzon, 16% in Visayas and 12% in Mindanao.  Table 1: TOTAL ASSETS OF THE PHILIPPINE FINANCIAL SYSTEM Amount (million pesos: end-of-year figures) As percent of total 1974 1975 1976 1977 1978 1974 1975 1976 1977 1978 Banking Institutions 54,142.8 69,840.3 79,989.7 95,151.3 121,164.8 72.3 71.6 69.6 72.7 74.5 Commercial Banks 42,424.8 53,172.8 58,730.9 68,676.5 89,798.6 56.7 54.5 51.1 52-5 55.2 Thrift Banks 1,666.9 2,126.5 3,024.5 4,080.0 5,602.9 2.2 2.2 2.6 3.1 3.4 PDBs 296.3 381.9 482.1 595.5 759.7 0.4 0.4 0.4 0.5 0.5 savings & mortgage banks 1,159.9 1,421.9 2,043.1 2,180.4 3,896.8 1.6 1.5 1.8 2.2 2.4 Stock SLAs 210.7 322.7 499.3 674.1 946.3 0.3 0.3 0.4 0.5 0.6 Rural Banks 2,110.7 2,749.3 3,017.7 3,327.5 4,037.0 2.8 2.8 2.6 2.5 2.5 Specialized Banks 7,940.4 11,791.7 15,216.6 19,067.3 21,726.3 10.6 12.1 13.2 14.6 13.4 DBP 6,758.0 9,644.2 12,779.8 15,805.7 18,209.7 9.0 9.9 11.1 12.1 11.2 Land Bank 1,182.4 2,095.5 2,384.4 3,193.9 3,446.1 1.6 2.2 2.1 2.4 2.1 Philippine Ananah Bank - 52.0 52.4 67.7 70.5 - 0.1 0.1 0.0 - Nonbank Financial Institutions 20,714.2 27,695.5 34,923.6 35,666.8 41,553.6 27.7 28.4 30.4 27.3 25.5 Investment houses 3,839.9 4,774.0 4,824.7 4,746.7 4,762.5 5.1 4.9 4.2 3.6 2.9 Finance companies 2,306.7 3,467.3 4,644.6 5,852.3 7,365.7 3.1 3.6 4.0 4.5 4.5 Investment companies 689.0 1,988.9 3,751.4 3,922.3 4,651.1 0.9 2.0 3.3 3.0 2.9 Securities dealers/brokers 882.1 1,067.1 1,091.8 978.4 1,119.8 1.2 1.1 1.0 0.8 0.7 Pawnshops 100.8 89.6 149.0 177.8 192.3 0.1 0.1 0.1 0.1 0.1 Fund managers 1,951.5 2,609.8 3,302.0 552.4 834.4 2.6 2.7 2.9 0.4 0.5 Lending investors 24.9 60.9 16.9 16.2 18.5 - 0.1 - - - Nonstock savings & loan associations 71.2 86.2 112.1 143.5 191.8 0.1 0.1 0.1 0.1 0.1 Mutual building & loan associations 24.7 25.9 23.5 23.2 21.4 - - - - - Private insurance companies 3,468.0 4,244.5 5,230.1 6,168.0 7,273.9/a 4.6 4.4 4.6 4.7 4.5 Specialized Nonbank 7,355.4 9,281.3 11,777.5 13,086.0 15,122.2 9.8 9.5 10.3 10.0 9.3 GSIS 4,144.5 4,689.6 6,303.6 6,751.4 7,833.3 5.5 4.8 5.5 5.2 4.8 SSS 2,388.9 2,997.1 3,841.4 4,941.5 5,499.4 3.2 3.1 3.3 3.8 3.4 ACA 451.5 698.0 709.9 421.1 751.3 0.6 0.7 0.6 0.3 0.5 NIDC 370.5 896.6 922.6 972.0 1,038.2 0.5 0.9 0.8 0.7 0.6 Total 748570 97,535.8 114,913.3 130,818.1 162,718.4 100.0 100.0 100.0 100.0 100.0 /a Extrapolated from 1977 figure assuming same annual growth rate as in 1977. Source: Data provided by the authorities.  Table 2: U1UMBER OF FINANCIAL INSTITUTIONS IN OPERATION, 1975-78 (As nf December 31) Percentage change 1975 1976 1977 1978 1975-78 Total Of which Total Of which Total Of which Total Of which Total Head offices head offices offices head offices offices head offices offices head offices offices offices Baaking Institutions 2.156 892 2,459 934 2,674 998 2L904 1,092 34.7 22.4 Commercial banks 996 33 1,107 31 1,208 32 1,287 32 29.2 -2.9 Thrift banks 259 88 392 95 447 113 509 126 96.5 43.2 Private development banks 86 33 98 33 109 34 117 36 36.1 9.1 Savings & mortgage banks 92 11 162 10 184 10 207 10 125.0 -9.0 Stock SLAs 81 44 132 52 154 69 185 80 128.4 81.8 Rural banks 834 768 887 805 938 850 1,024 931 22.8 21.2 Specialized government banks 67 3 73 3 81 3 84 3 25.4 - Nonbank Financial Institutions 1,267 1.232 1,334 1,279 1.246 1,158 1,302 1.201 2.8 -2.5 Investment houses 40 13 43 12 56 12 56 12 40.0 -7.7 Finance companies 319 194 348 219 338 244 419 263 31.4 35.6 Investment companies 117 23 59 59 59 59 58 58 152.2 152.2 Securities dealers/brokers 23 117 126 126 128 128 130 130 11.1 11.1 Fund managers 194 194 178 178 9 9 9 9 - - Lending investors 38 38 31 30 34 33 40 39 5.3 2.6 Pawnshops 462 428 472 430 492 447 508 460 10.0 7.5 Money brokers - - 2 2 3 3 4 4 - - Nonstock SLAs 67 67 68 68 70 70 71 71 6.0 6.0 Mutual BLAs 7 7 7 7 7 7 7 7 6.0 6.0 Private insurance companies /a n.a. 149 n.a. 146 n.a. 144 n.a. 146 n.a. -2.0 GSIS /a and SSS n.a. 2 n.a. 2 n.a. 2 n.a. 2 n.a. - Total 3.423 2.124 3.793 2.213 3.920 2.156 4.206 2,293 22.9 8.0 la Refers to fiscal year ending June 30. Source: Data provided by Central Bank.  1.07 The specialized banks are government-owned institutions set up with quite specific functions; they consist of the Development Bank of the Philippines (DBP), the Land Bank, and the Philippine Amanah Bank. DBP is the principal source of long-term credit in the Philippines. DBP obtains its funds from government equity, deposits (mostly government), sale of bonds, borrowings from the Central Bank, and foreign borrowings guaranteed by the Government. DBP securities have had relatively low rates, but special features such as tax exemption and eligibility for reserve requirements have enhanced their attractiveness. The Land Bank was set up mainly to finance the acquisition of landed estates by the Government as part of its land reform program. The Philippine Amanah Bank provides credit to the Muslim communities of Mindanao. 1.08 The nonbanking sector has a wide diversity of institutions. In- vestment houses engage primarily in the underwriting of corporate securi- ties. They also provide various other financial services, ranging from portfolio management to stockbroking. Alongside these activities, all the 12 investment houses are simultaneously involved in quasi-banking functions./l The largest in terms of assets is the Private Development Corporation of the Philippines (PDCP). PDCP is second to DBP as a provider of long-term finance, although its outstanding loans and investments are only around 13% of the DBP's. PDCP's main business is the provision of long-term loans, but it also makes equity investments, provides guarantees, under- writing and placement of equity and debt instruments and syndicates loans. PDCP's main sources of finance are World Bank and Asian Development Bank loans (86%) and equity contributions (9%). 1.09 Of the other nonbank financial intermediaries, the most important in terms of asset size are those involved in the provision of social security. These are the private insurance companies, the Government Service Insurance System (GSIS), and the Social Security System (SSS). Total assets of these three comprised almost 13% of the total assets of the financial system in 1978. The GSIS and SSS are both government-owned, the former providing benefits for government employees and the latter for private sector employees. The benefits which they provide differ, as do their portfolios. Both institutions extend loans to policyholders, but the GSIS is more involved in the direct purchase of stocks and bonds of both private and government institutions. It is phasing out its housing loans and plans to expand its business loans and its holdings of stocks and bonds. By contrast, SSS has invested 60% of its portfolio in notes receivable, which /1 Quasi-banking functions consist of the borrowing of funds for the borrower's own account through the issuance, endorsement, or acceptance of debt instruments of any kind, other than deposits, such as (a) accep- tances; (b) promissory notes; (c) participations; (d) certificates of assignment of similar instruments with recourses; (e) trust certifi- cates; (f) repurchase agreements; (g) such other instruments as the Monetary Board may determine. (See Central Bank Circular No. 387 of November 19, 1973).  - 6 - are mostly issued by PNB and DBP; the balance of its investments are housing loans (22%) and other loans (8%) to policyholders. 1.10 Finance companies are stock corporations which extend credit to both enterprises and consumers usually by discounting commercial papers on accounts receivable. They also engage in leasing. Fund managers administer funds on behalf of others. The funds involved are mostly pension or trust funds, and employee welfare funds. Investment companies deal in securities, and are of two distinct types, open-ended and closed-ended. The former have no fixed amount of paid-in capital, and will usually sell their shares on a day-to-day basis. Moreover, their shares are redeemable on demand. The closed-end company cannot redeem shares on a day-to-day basis, and has a relatively fixed amount of capital outstanding. Security dealers and brokers are also engaged in transactions in securities on behalf of others, which earn them commissions. They do not, however, act as a principal. The Agricultural Credit Administration (ACA) and National Industrial Development Corporation (NIDC), have quite specialized functions. The ACA was set up to promote agricultural production through the provision of credit to farmers and to agricultural projects. The NIDC was established to promote a wide variety of industrial, agricultural and commercial enterprises. It is a subsidiary of PNB, which extends long-term credit and invests in stocks and bonds of new enterprises. It also acts as a holding company. 1.11 Foreign financial institutions have played an important role in the Philippines financial system. Until recently, 13 foreign banks had equity participation in 10 domestic banks. The 12 investment houses, many of which were established during 1972-74, also had foreign equity participation. Three major finance companies, covering about 85% of the total assets, have foreign collaborators./I In addition, recently offshore banking units (OBUs) developed which authorized a branch, subsidiary or affiliate of a foreign banking corporation to conduct banking activities in foreign currencies./2 Such transactions involve the receipt of funds, mostly from external sources, and the subsequent transfer of these funds to borrowers inside or outside the country. There are no restrictions on the withdrawal of such funds, including interest by owners. These operations are mostly offshore, although offshore-to-onshore transactions are permitted if licensed by the Central Bank. A significant incentive to encourage foreign banks to set up OBUs is the exemption from all forms of local licenses, fees, dues or other local taxes. The functions of foreign currency deposit units (FCDUs) /1 Industrial Finance Corporation (Fidelity International Bank), Investors' Finance Inc. (FNCB Finance), and Filinvest Credit Corporation (Chase Manhattan Bank). /2 Sixteen OBUs started their operations in 1977-78.  were also expanded at the same time. FCDUs were exempted from the foreign exchange reserve requirement /1 and were permitted to extend foreign currency loans to any enterprise up to the amount of foreign currency deposits. As with OBUs a tax of 5% is imposed on offshore income, and for onshore income, a tax of 10% is imposed. Both OBUs and FCDUs were established with the objective of transforming the Metro-Manila area into a regional financial center, particularly for the ASEAN group of countries. To some extent, this has been achieved; as of December 31, 1978, 17 foreign banks have been authorized to operate OBUs, and 4 foreign branches of foreign banks and 13 domestic commercial banks were authorized as expanded FCDUs. Gross resources of OBUs amounted to $1,987 million and of FCDUs to $2,382 million. The growth of the offshore banking system is particularly remarkable, since at the end of 1977, the system's total resources amounted to only $757 million. The Foreign Currency Deposit System has also expanded rapidly, particularly after the granting of the tax privileges in 1976, with total resources almost doubling from $1,209 million at the end of 1977 to $2,382 million one year later. /1 Fifteen percent reserve requirement to be held in the form of foreign exchange deposits with the Central Bank.  - 8 - 2. COMMERCIAL BANKING 2.01 With about a half of the total financial resources and three fourths of the resources of the banking system, commercial banks play a dominant role in the financial sector. They are the primary mobilizers of funds although their allocation of these resources is mostly geared towards the short term, and the issue of the role of commercial banks as one of the oldest, well developed and most regulated financial institutions acquires prominence in this context. Since other specialized financial institutions like development banks, investment companies, insurance institutions and securities markets play only a limited role in providing long-term domest L1: reoRnrces to productive sectors especially the industrial sector, the major problem is how to reorient the operations of commercial banks so that they are more supportive of long-term development aims. 2.02 Information on other countries suggests that commercial banks' role in providing developmnent finance varies greatly from country-to-country. On the one hand, banks have traditionally restricted themselves to providing short-term credit for trade and industry as in the United Kingdom, while, in contrast, the German banks have involved themselves in providing all types of credits, equity finance and other services to the industrial sector. The Philippines banking system has been based on the United States model with legislated separation of commercial and investment banking. Background 2.03 Only four domestic banks and four foreign banks existed (li-[l World War II. A large number of banks were established after the War, many of them during the 1955-65 decade, as a response both to the rehabilitation and development program of the Government and substantially increased business activity of the private sector. With the liberal Central Bank regulations, such as no requirement of minimum capital, it was easy and convenient for family business groups to establish their own banks. A large majority of the banks today, perhaps over two-thirds, are closely related to family groups and their businesses, although there are some five joint ventures and two product specialized banks, such as Republic Plantars (Sugar) Bank and the UTnited Coconut Planters Bank. Only three banks have their stocks listed on the stock market. Growth and Structure 2.04 As at the end of 1978, there were 26 private domestic banks, 2 government or semi-government banks, and 4 branches of foreign banks./l Total bank assets have grown by about 16% a year in real terms since 1970 and in 1978 they were equal to about 54% of GNP. The government-owned Philippine National Bank (PNB), by far the largest bank with 180 branches, held more than /1 Two of the private domestic banks, Republic Planters Bank and the United Coconut Planters Bank have acquired a status of quasi-government banks.  - 9 - one-fourth of all bank assets of over P 91 billion in 1978. The second largest bank in terms of total assets was a foreign bank, Citibank N.A., holding about 8% of the assets. The top ten private domestic banks together held more than a half of the remaining banking assets. These ten banks each held assets of over P 2.5 billion ranging from the highest of F 4.4 billion of the Bank of the Philippines Islands (BPI) to P 2.5 billion of the Consolidated Bank and Trust Corporations (Solidbank). In contrast, there are six small banks whose total assets are less than P 1 billion each, ranging from P 0.56 billion of Philippine Trust to P 0.98 billion of Interbank. 2.05 The great diversity of commercial banks is reflected in many other aspects, such as, capital accounts, deposits and loans (Table 3)./1 The banks' capital accounts do reflect significant variations in size which are not systematically related to the ownership pattern. Despite the minimum capital requirement of P 100 million introduced by the Central Bank a few years back, two banks (J and V), apparently family-oriented, fall short of this level. On the other hand, the ten big banks, mentioned above, each has capital accounts of over P 200 million. It appears, moreover, that family- oriented banks are not necessarily small banks nor are they lagging behind joint venture banks in degree of modernization. 2.06 In general, banks with low levels of capital accounts also have lower levels of deposit base and hence small size of total assets. About ten banks have a deposit base of less than P 1 billion, ranging from as low as P 0.25 billion. These banks have to rely on borrowings, which is reflected in their high ratios of loans to deposits. At the same time, some big banks, with a deposit base of about P 2 billion and which are also growing fast, have low ratios of loans to deposits, which partly reflects their position as lenders in the inter-bank market and partly suggests their underutilized capacity to make direct loans. These banks include both traditional family banks as well as modernized banks. The diversity in the banks' annual rates of growth partly reflects their different stages of development, and the relatively short span and changing pattern of banking development. The changing pattern includes a series of mergers necessitated by the recent requirement of capital increase, closures and reinstatements of banks. /1 Since the existence of a very large government bank and a foreign bank distorts the picture of the commercial banking sector, Table 3 and the following analysis will concentrate on private domestic banks.  - 10 - Characteristics of Banks' Operations 2.07 The performance of commercial banks can be evaluated in many different, albeit rough ways; with respect to adequacy of capital, proportti-oi of risk assets or default loans to the capital account, level of liquidity of assets, ratios of loans to deposits, degree oF t:erm transformation, trans- action costs and concentration of loans. Information on concentration of loans is not readily available, but it is particularly relevant in the context of small family-oriented banks and the Central Bank could un(der-tak&> a study of this aspect of bank operations. Similarly, there ls no comparative study available on the costs of banking operations. A limited exercise suggests Table 3: PRIVATE DOMESTIC BANKS: RANKING BY MAJOR ACCOUNTS (As at end of 1978) Ratio of Annual rate of Total Capital loans to growth of total Bank assets accounts Deposits Loans deposits assets 1973-78 A 20 21 20 20 8 13 B 3 4 7 3 9 3 C 1 1 1 2 24 8 D 8 3 11 4 6 19 E 22 23 22 22 4 7 F 13 14 14 14 19 15 G 10 9 6 8 21 20 H 11 5 9 11 16 21 I 6 6 5 6 17 5 J 24 26 21 25 18 24 K 15 10 17 12 7 11 L 21 24 26 21 1 25 M 12 12 13 9 10 22 N 2 8 3 1 22 4 O 9 16 10 10 15 14 P 14 18 16 15 11 12 Q 18 13 19 17 2 16 R 5 7 4 5 23 26 S 26 20 24 26 13 10 T 25 22 25 24 3 9 U 17 15 15 16 20 23 V 23 25 23 23 5 6 W 7 11 8 7 12 18 X 19 17 18 19 14 17 Y 16 19 12 18 25 2 Z 4 2 2 13 26 1 Source: Data provided by the authorities.  - 11 - that transaction costs of commercial banks in the Philippines in 1976 for loans to medium and large industries were 2.7% of total loans, which compares favorably with costs of lending to medium industry in Korea and Colombia but ,l)i- Iridia./I Since detailed and unambiguous data are not available on most of these aspects only the following select issues are examined for individual banks. 2.08 The ratio of capital accounts to total assets for all banks has con- centrated around 10% during the last five years, although it shows a notice- able decline for some banks which presumably include small family banks./2 These ratios are generally considered respectable in the banking field. Most of the banks exceed the required minimum level of P 100 million capitaliza- tion. A lower ratio in certain cases only indicates an aggr(-s3ive banking style and not necessarily an inadequacy of capital. Another way of judging the adequacy of capital is through the ratio of capital accounts to risk assets./3 The minimum capital-to-risk asset ratio required by the Central Bank of each commercial bank is 10%. Most of the banks3, er.e)t the two marginal and apparently temporary cases, seem to satisfy this condition by a comfortable margin. 2.09 As regards the level of liquidity, banks seem to be increasingly pittting their assets in liquid forms as the ratio of liquid assets to total assets for all banks has increased from 28% in 1974 to 34% in 1978./4 Even the ratio of primary liquidity to total assets is high at 15% in 1978. Most of the remaining liquid assets are in the form of public bonds, which partly satisfy the requirements under different Central Bank regulations. These regulations in a way divert private bank funds to the public sector. Considering the increasing demand for funds from the private sector and in the light of the possible suggestions mentioned later to increase the flow of long-term funds to the industrial sector, this level of liquidtty and diversion of funds to the public sector appear to need ro-exa.nination. /1 See: IBRD: Domestic Finance Studies, No. 47, "Interest Rate, Trans- action Costs and Innovations" by V.V. Bhatt, January 1978. /2 Individual cases show great variations. The decline in ratios of capital accounts to total assets during the period 1974-78 for some banks was: 18%-12%, 15%-9%, 40%-24%, and 25%-8%. /3 Risk assets, as defined by the Central Bank, refer to a bank's total assets minus the sum of a long list of assets including cash, dues from Central Bank, loans to Government, bank premises, furniture and equipment, loans covered by holdout on deposits and marginal deposits, and some dues from foreign banks. /4 The ratio has greatly varied in the case of individual banks from the lowest of 16% to the highest of 59% in 1978.  - 1 2 - The decline in the ratios of loans to deposits from 146% in 1974 to 100% in 1978 /L indicates a general slowdown in lending activity for all banks and provides further support to the arguments mentioned above. This has been true for all types of banks, family-oriented as well as joint ventures, although the decline is somewhat steeper in the former case. Nevertheless, loan deposit ratios in general are quite reasonable except in few cases. Finally, the return on net worth, which could also be considered as a measure of effLclenit use of bank capital, reflects a respectable figure of 16% for all private domestic banks for 1978. Term Transformation 2.10 Yet another way of measuring the performance of banks as financial intermediaries is to ascertain the extent to which they perform term trans- formation /2 in an economy where savers have a high liquidity preference and there exists a dearth of long-term funds for investment. This seems to be a controversial issue both because of difficulties in exact measurement of maturities of assets as well as liabilities and because of the established view of requiring matching of maturities. In what follows, we will attempt to assess the overall situation and examine the potential for term transformation by commercial banks./3 2.11 Assuming capital and reserves and savings and Lime deposits are of a medium-term maturity, Table 4 suggests that about 45% of the total liabili- ties in 1978 are potentially available for some medium-term lending. Over the last decade, this proportion has remained more or less constant except for a decline in the period 1973-76 when there was a considerable shift to the booming money market operations through deposit substitutes. In fact, if we consider the last five years, the medium-term resources have increased. However, it can be argued that a part of the savings deposits From business organizations is the equivalent of demand deposits instantly withdrawable when needed. On the other hand, it could also be shown that part of these savings deposits as well as a part of demand deposits are of a stable nature and thus need not be excluded from the potential for medium-term uises. For the sake of argument, even if we look at capital and reserves, and time deposits, they indicate an increase from 18% in 1974 to 27% in 1978. /1 Here again there have been wide variations in the case of individual banks from the lowest of 42% to the highest of 256% in 1978. /2 The use of shorter term liabilities as the basis for longer term assets. /3 Statistics in the following section refer to all commercial banks, since separate data for private domestic banks are not available.  Table 4: ASSETS AND LIABILITIES OF COMERCIAL BANKS (% of total) 1969 1970 1971 1972 1973 1974 1975 1976 1977 1978/d Assets 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 Cash & other cash items 4.1 4.6 4.6 3.4 4.8 4.3 3.8 3.7 3.1 2.5 Due from CB & other banks 10.2 9.6 9.2 12.8 14.1 13.6 13.6 11.5 9.0 10.5 Loans & discounts 65.0 65.4 66.1 64.8 58.7 62.9 61.3 64.0 64.9 62.7 Investments 13.6 12.5 11.7 10.1 15.0 11.9 11.6 12.2 13.3 15.2 Other assets /a 7.1 7.8 8.3 8.9 7.4 6.3 9.6 8.6 9.6 9.1 Liabilities Capital & reserves 10.7 10.4 10.4 9.9 9.8 8.9 9.7 9.8 10.2 8.2 Demand deposits 19.7 17.5 18.2 18.7 17.8 14.3 12.5 12.6 13.2 10.5 Savings deposits 25.9 26.7 27.5 23.3 23.2 19.5 16.8 18.7 19.3 18.9 Time deposits 10.4 10.4 11.8 12.8 10.3 9.5 9.6 12.8 16.7 18.3 Bills payable /b 16.5 13.8 13.9 15.4 19.7 28.9 34.2 30.2 23.8 25.3 Other liabilities /c 16.6 21.0 18.3 19.8 19.1 18.9 17.0 16.1 16.8 18.8 Source: Data provided by the authorities. /a Includes premises, furniture, equipment and other real property. /b Includes deposit substitutes. /c Includes dues to banks and officers' and managers' checks. /d Preliminary estimates.  - 14 - 2.12 Further support to the banks' increasing medium-term liabilities can be obtained from Table 5 which shows the changing structure of bank deposits. Over the past decade, demand and time deposits have reversed their proportions and the medium-term deposit resources has increased from about two-thirds to over three-fourths of the total deposits. Furthermore, the proportion of time deposits with over two years' maturity has increased as a proportion of total time deposits from 10% in 1975 to 27% in 1978. This growth follows the increase in interest rates on longer-term deposits and supports the argument of the interest elasticity of time deposits. Similarly, the relative annual growth rates of different types of deposits over the past decade also support the above argument; demand deposits 16.8%, savings deposits 20.9%, and time deposits 33.3%. 2.13 On the asset side, there seems to be a steady pattern with about two-thirds of the total going to loans and discounts, most of which tend to have a short-term maturity. There is nothing in the rules and regulations governing commercial banks which prevents them from lending for medium and long-term purposes. There seem to be several other reasons explaining the reluctance of commercial banks towards lending other than short term. First, and most important, short-term lending appears to be more profitable than long-term lending. The maximum effective rate that can be charged on loans up to two years is 16% while the maximum effective rate on loans over two years is 19%. In addition, while the Central Bank is willing, under certain circumstances, to discount short-term paper it is not willing to do so for instruments with a maturity of over a year. Further, by lending long term the commercial bank locks itself into a lending rate without knowing how deposit rates or lending rates are going to move. Finally, most commercial banks have not traditionally involved their staff in project appraisals. 2.14 Instead of long-term lending, the practice followed by the commer- cial banks, as in many other countries, is to book a loan as short-term with the understanding that the loan will be rolled over. It is difficult to estimate the exact proportion of rolled-over credits and their maturities; the rough estimates suggest that about 50% of loans booked as short term are likely to be rolled over for at least another year and 30% for 1-3 years. The process of rolling over is profitable for the bank owing to the service fees and other charges involved. This additional income further reduces the effective differential between short and long-term lending rates and may even turn short-term lending into the more profitable type of operation. The common prevalence of this practice is further strengthened by the close ties between banks and industries. These roll-overs are mainly related to banks' prime customers, who are assured of credit when needed. There is a reluctance on their part to obtain a medium-term credit to start with, even if the banks are willing to extend medium-term credit. Banks thus find it difficult to make term loans to established customers. On the other hand, banks are  - 15 - Table 5: STRUCTURE OF DEPOSITS OF COMMERCIAL BANKS (Million Pesos) Demand Savings Time Total End of year deposits deposits deposits deposits 1969 2,372 3,128 1,259 6,759 (35.1) (46.3) (18.6) (100.0) 1970 2,459 3,757 1,470 7,686 (32.0) (48.9) (19.1) (100.0) 1971 2,916 4,410 1,890 9,216 (31.6) (47.9) (20.5) (100.0) 1972 3,735 4,670 2,559 10,964 (34.1) (42.6) (23.3) (100.0) 1973 5,276 6,865 3,044 15,185 (34.7) (45.2) (20.1) (100.0) 1974 6,062 8,281 4,032 18,375 (33.0) (45.1) (21.9) (100.0) 1975 6,665 8,951 5,131 20,747 (32.1) (43.1) (24.7) (100.0) 1976 7,482 11,022 7,558 26,062 (28.7) (42.3) (29.0) (100.0) 1977 9,045 13,263 11,470 33,778 (26.8) (39.3) (33.9) (100.0) 1978 9,602 17,314 16,737 43,653 (22.0) (39.7) (38.3) (100.0) Source: Data provided by the authorities. Note: Figures in parentheses indicate percentages of the total.  - 16 - generally unwilling to extend term loans to new customers. The practice of roll-over creates an environment of uncertainty in the event of liquidity crisis and default risks, and hence roll-over credits cannot be considered as a good substitute for term lending. 2.15 Roll-over arrangements have two disadvantages for the borrower: first, at the given relative interest rates, they are likely to be more expensive than straight long-term loans, (primarily as a result of recurrent charges) and, second, there is no guarantee that the loan will, indeed, be rolled over. The latter creates severely adverse conditions for long-term investments. The problem with the widespread use of roll-over credit is that it is inefficient from the point of view of the allocation of resources. It is biased in favor of borrowers in the larger, well-established businesses and not available to newer and usually smaller enterprises. There is also a question of structure and practice involved. The rolling over of credits is often associated with lending on the basis of collateral. Longer-term lending may well involve the appraisal and monitoring of investment projects. This is a desirable development from the point of view of the economy, but it does involve additional costs for the banks, and possibly also different staff and organization. On balance, therefore, relative to short-term roll-over credit, the present returns on long-term loans do not appear to be sufficient to compensate the banks for the greater project risk, the uncertainty of possible future changes in interest rates and the reduced liquidity of such lending. 2.16 Since banks' other assets are essentially of a short-term nature, banks do not seem to be involved to any significant extent in term trans- formation. On the contrary, considering at least the dominance of short-term assets as declared by the banks, it might be argued that banks are involved in a form of reverse term transformation. Moreover, external term transformation through acquisition of the assets of other intermediaries takes place only to a small extent and thus internal term transformation by commercial banks, the dominant group of intermediaries, acquires critical importance for the efficient functioning of the financial system. Credit Allocation - By Maturity and Interest Rates 2.17 Information on credit allocation by maturity, presented in Table 6, further establishes the point that practically all bank credit is of a short- term nature with a maturity of less than a year./l While all other statis- tical information suggests only a marginal existence of term lending, Table 7 implicitly indicates a contradictory situation of increasing amounts of lending at interest rates of over 14%, which presumably imply lending for more /1 Although commercial banks' medium and long-term credit to industry is miniscule at less than 2% of their total credit, they provide about one-fourth of the medium and long-term institutional domestic resources that go to industry.  - 17 - Table 6: STRUCTURE OF CREDITS GRANTED BY COMMERCIAL BANKS - BY MATURITY (Million Pesos) During Short Intermediate Long the year Demand term term term Total 1969 3,494 12,730 111 55 16,390 (21.3) (77.7) (0.7) (0.3) (100.0) 1970 4,701 16,929 248 74 21,952 (21.4) (77.1) (1.1) (0.3) (100.0) 1971 5,692 22,446 530 153 28,821 (19.7) (77.9) (1.8) (0.5) (100.0) 1972 6,867 24,720 757 345 32,689 (21.0) (75.6) (2.3) (1.1) (100.0) 1973 9,089 35,457 827 1,312 46,685 (19.5) (75.9) (1.8) (2.8) (100.0) 1974 22,077 54,849 2,373 3,004 82,303 (26.8) (66.6) (2.9) (3.6) (100.0) 1975 41,010 71,607 1,058 691 114,366 (35.9) (62.6) (0.9) (0.6) (100.0) 1976 39,025 90,435 918 1,346 131,724 (29.6) (68.6) (0.7) (1.0) (100.0) 1977/a 39,775 62,678 1,093 679 104,225 (38.2) (60.1) (1.0) (0.7) (100.0) /a January-August. Source: Data provided by the authorities. Note: Figures in parentheses indicate percentages of the total.  - 18 - than two years' maturity./I The interest rate ceilings on bank loans with over two years' maturity were raised to 19% since January 1976, and Table 7 shows doubling of these loans in two years reaching P 11.4 billion or 11% of the total credits granted by banks in the first eight months of 1977. This is also partly corroborated by some interviews with individual banks, which seem to have taken advantage of the higher ceilings and made some medium-term loans. If this evidence is considered, there appears to be some movement in recent years in the right direction both because of the incentives provided by the policy changes and the initiative taken by banks. Credit Allocation - By Industry 2.18 Since the Central Bank uses various allocative devices such as special rediscounting facilities and minimum required proportion of credits in certain sectors like agriculture, it is of interest to examine the compo- sition of credit granted by banks over the last decade. From the data presented in Table 8, this allocative mechanism does not seem to have worked very satisfactorily. Data on credit outstanding by sectors are not available on a continuing basis, however, they do reflect certain major divergences as mentioned below. 2.19 The major structural changes in credits granted are a substantial increase in loans to financial institutions accompanied by a declining share of credits to the trade and agricultural sectors. The phenomenal growth of credits to the financial institutions from 10% to over one-third in a decade indicates the growth of the financial sector, increasing financial layering and stronger interconnections between the financial intermediaries. This growth has particularly taken place during 1975-77 when money market activities were booming. However, on an outstanding basis, these credits form a small proportion of the total (only 6% at the end of December 1977), which indicates their short-term nature and high turnover. While the relative proportion of manufacturing credits has only slightly increased during the decade, that of trade credits has sharply declined since 1975. Although this industry-wise classification is quite often confused by the banks, the declining share of the total of manufacturing and trade also appears significant. The declining trade credits could be partly explained by lower volume of trade and alternative direct sources of trade financing among the nonfinancial business organizations, including suppliers' credits. On an outstanding credit basis, trade still accounted for 29% of the total at the end of December 1977. Despite the Government's efforts and Central Bank's regulations, the share of agricultural credit has declined during the last decade. This might have been partly offset by credit from other financial /1 The focus here is upon credits granted, because this gives a better indi- cation of the maturity pattern of bank practices. However, it should be recognized that such a series is biased towards short-term loans, which, in a given period receive a larger weight in the total. Loans outstanding data avoid this by giving a maturity pattern at one point in time.  Table 7: CREDITS GRANTED BY COMMFRCIAL BANKS - BY INTEREST RATES (Million Pesos) Year 0 - 4-1/2 5 6 7 8 9 10 11 12 13 14 Over 14 Total 1969 58.4 23.4 125.7 1,087.2 526.0 1,267.3 3,757.6 3,405.2 2,410.4 493.5 440.4 - 13,595.1 (0.4) (0.1) (1.0) (8.0) (3.9) (9.3) (27.6) (25.0) (17.7) - (3.6) (3.2) (100.0) 1970 64.4 47.4 128.5 260.4 303.8 1,668.4 2,239.5 5,228.6 4,520.4 1,300.4 1,064.9 - 16,827.0 (0.4) (0.3) (0.8) (1.5) (1.8) (9.9) (13.3) (31.1) (26.9) (7.7) (6.3) (100.0) 1971 62.2 28.3 92.8 82.8 218.7 984.5 2,051.3 6,660.2 6,995.8 2,482.2 3,158.4 - 22,817.2 (0.3) (0.1) (0.4) (0.4) (1.0) (4.3) (9.0) (2Q.2) (30.7) (10.9) (13.8) (100.0) 1972 235.3 52.2 256.4 223.3 338.9 875.4 2,290.5 6,855.1 7,798.0 2,368.5 5,654.5 - 26,948.1 (1.0) (0.2) (1.0) (0.8) (1.3) (3.2) (8.5) (25.4) (28.9) (8.8) (21.0) (100.0) 1973 2,698.4 444.4 521.0 690.7 699.3 1,114.8 1,944.8 9,901.6 9,895.4 2,477.5 6,847.1 - 37,226.0 (7.2) (1.2) (1.4) (1.8) (1.9) (3.0) (5.2) (26.6) (26.6) (6.6) (18.4) (100.0) 1974 3,423.7 424.8 544.6 319.7 572.3 1,005.8 2,408.1 19,513.8 16,610.1 4,204.3 22,525.6 - 71,552.8 (4.8) (0.6) (0.8) (0.4) (0.8) (1.4) (3.4) (27.3) (23.2) (5.9) (31.5) (100.0) 1975 11,326.5 1,643.2 3,074.5 2,424.8 3,659.6 2,863.1 3,862.0 4,924.6 24,588.0 4,327.2 45,800.3 5,872.3 114,366.1 (9.9) (1.4) (2.7) (2.1) (3.2) (2.5) (3.4) (4.3) (21.5) (3.8) (40.0) (5.1) (100.6) 1976 14,232.0 1,575.3 1,806.6 1,724.1 3,839.7 2,274.5 3,228.7 3,857.8 26,254.2 5,440.3 57,925.1 9,565.2 131,723.5 (10.8) (1.2) (1.4) (1.3) (2.9) (1.7) (2.4) (2.9) (19.9) (4.1) (44.0) (7.3) (100.0) 1977/a 11,798.6 1,983.2 2,593.8 1,822.5 3,054.5 2,494.2 2,493.5 2,317.6 14,424.3 5,864.6 43,935.4 11,443.2 104,225.4 (11.3) (1.9) (2.5) (1.7) (2.9) (2.4) (2.4) (2.2) (13.8) (5.6) (42.1) (11.0) (100.0) /a January-August. Note: Figures in parentheses indicate percentages of the total.  Table 8: CREDITS GRANTED BY COMMERCIAL BANKS - BY INDUSTEY (Million Pesos) Agri- Manu- Con- Public Financial Real Con- Public culture Mining facturing struction utilities Services Trade institutions estate sumption sector Total 1969 1,772 93 3,656 224 172 264 7,130 1,717 248 325 788 16,390 (10.8) (0.6) (22.3) (1.4) (1.0) (1.6) (43.S) (10.5) (1.5) (2.0) (4.8) (100.0) 1970 2,195 96 4,056 186 277 366 9,795 2,775 410 868 929 21,952 (10.0) (0.4) (18.5) (0.8) (1.3) (1.7) (44.6) (12.6) (1.9) (3.9) (4.2) (IDO.0) 1971 2,514 322 5,966 227 464 498 12,001 4,830 503 1,160 339 28,820 (8.7) (1.1) (20.7) (0.8) (1.6) (1.7) (41.6) (16.7) (1.7) (4.0) (1.2) (100.0) 1972 2,551 563 7,391 365 815 550 13,873 4,693 514 870 505 32,698 (7.8) (1.7) (22.6) (1.1) (2.5) (1.7) (4?.4) (14.4) (1.6) (2.7) (1.5) (100.0) 1973 2,828 835 10,359 368 855 590 22,380 5,776 796 971 927 46,685 (6.1) (t.8) (22.2) (0.8) (1.8) (1.3) (47.9) (12.4) (1.7) (2.1) (2.0) (100.0) 1974 6,070 2,388 22,535 481 830 1,178 31,680 12,473 1,144 1,499 2,025 82,303 (7.4) (2.9) (27.4) (0.6) (0.1) (0.1) (38.5) (15.1) (0.1) (1.8) (2.5) (100.(0) 1975 9,756 4,109 30,610 851 1,478 2,506 23,506 32,275 1,772 2,44S 5,055 114,366 (8.5) (3.6) (26.8) (1.0) (0.7) (2.2) (20.5) (28.2) (1.5) (2.1) (4.4) (100.0) 1976 9,140 4,357 35,142 1,592 2,236 2,968 29,247 41,560 1,680 3,188 613 131,7?'4 (6.9) (3.3) (26.7) (1.2) (1.7) (2.2) (22.2) (31.5) (1.3) (2.4) (0.5) (100.0) 1977/a 5,517 2,109 26,636 1,258 1,715 1,626 21,944 39,760 1,114 1,645 902 104,225 (5.3) (2.0) (25.5) (1.2) (1.6) (1.6) (21.0) (38.1) (1.0) (1.6) (0.9) (100.0) la January-Augju,r. Note: Figure-s in parentheses indicntu percenitages of the total.  - 21 - institutions to the agricultural sector. Here again, although the credits granted relatively declined over the decade, on an outstanding basis, they were about 13% of the total at the end of December 1977. In other words, the ballooning effect of credits to financial institutions has partly distorted the composition of credit granted by banks. Furthermore, the specific allocative mechanism through regulations in the case of agricultural credit does not seem to have worked very well as the credits to that sector have not relatively increased, both in terms of credits granted as well as credits outstanding. As regards the allocative mechanism related to credits to exports and small industries, although there are no statistics available on the matter, it seems that there is only a marginal improvement.  - 22 - 3. FINANCIAL MARKETS Capital Market 3.01 The capital market in the Philippines is not a significant source of medium and long-term finance. Nevertheless it remains government policy to promote the development of the capital market in the hope that it will play a bigger role in the future financing of development. This chapter reviews the main features of recent developments in the market that are relevant to any proposals to increase and broaden the flow of long-term finance. 3.02 Public sector securities in the capital market comprised a volume of issues amounting to P 12.3 billion in 1978, compared to P 8.8 billion in 1975. National government issues account for 59%, and Central Bank Certificates of Indebtedness (CBCIs) for 39%, with government enterprises accounting for the remaining 2%. 'National Government Treasury Bills are the only short-term securities issued. The majority of national government (medium and long-term) issues carry interest rates significantly below the market rate and thus are restricted to captive markets. 3.03 The Central Bank issues CBCIs monthly, in the order of P 200 mil- lion. In 1974 it extended the maturity of new issues from three to five years and then, in June 1977, extended the maturity again to seven years. From September 1978 subsequent issues carry a 9% taxable coupon and are sold by auction. These auctions have resulted in yields ranging from 10% to 14.4%. All CBCI regular series qualify as substitutes for the agricultural and agra- rian reform credit requirements of commercial banks./l As of January 31, 1979 approximately P 2,750 million were held by commercial banks and P 536 million by other financial institutions for these purposes. In view of the CBCIs' advantages to the commercial banks for deposit reserves, for agrocredit obligations, and their high liquidity under repurchase agreements, they remain the banks' favored investment. As a result the rate on CBCIs sets the level for short-term interest rates. 3.04 The supply of private sector corporate securities is fundamentally determined by the capital requirements of the business sector which cannot be met from retained earnings or loan funds. Long-term peso bank credit is clearly insufficient in the Philippines. The existence of markets capable of absorbing securities issues will ultimately determine whether securities financing is feasible and whether debt or equity instruments are the right choice. Debt equity ratios may limit the potential for bond issues, although the higher ratios found in the Philippines may result from an overdependence on short-term borrowing. Tax considerations favor the issue of debt instruments, since all costs are tax deductible expenses, while equities do not provide any meaningful tax incentives for the issuer, shareholder or for future subscribers to shares. /1 15% and 10%, respectively, of the increment of loanable funds over their May 1975 levels.  - 23 - 3.05 The limited extent to which the capital market serves as a source of long-term capital can be illustrated by the small number of public offerings in the primary market. The number of corporations registered with the SEC over the last ten years is 36,842, with approximately 5,000 being added each year. In contrast the number of public issues of equity authorized ranged from 55 in 1975 to 20 in 1977. In addition, there were a handful of bond issues. Even those small numbers include a number of noncorporate entities and several of the bond issues did not involve actual placements; they were bonds issued as collateral for loans from other sources. Thus the actual number of authorizations really intended as public offerings of corporate securities did not exceed, on average, 30 a year. The amounts raised have been insignificant in terms of resource mobilization. Such limited activity would seem to be insufficient to occupy the 12 investment houses which are the only institutions currently allowed to perform firm underwriting. However, the underwriting volume handled by investment houses does not coincide with SEC public offer registration. The major portion of that volume involved securities not listed on the exchange and bond issues that were privately placed. Total underwriting volume handled by investment houses has expanded considerably, although admittedly from low levels (Table 9) but this expansion took place in the bond sector. In comparison it can be noted that the net worth of the 1,000 largest corporations has grown by P 17.4 billion between 1972 and 1977, or an average of P 3.5 billion per year. Assuming a 50% payout of profits averaging P 3 billion, these corporations had an annual inflow of resources, including reinvested profits, in the form of equity of about P 2 billion per year. Table 9: INVESTMENT HOUSES UNDERWRITING VOLUME, 1976-78 (Million Pesos) 1976 1977 1978 Equities 384 188 276 Bonds 423 1,897 2,858 Total 807 2,085 3,134 Equities as % of total 48% 9% 9% Source: Central Bank. 3.06 The demand for corporate securities is determined by considera- tions of after-tax yield, risk and liquidity. For equities the chances of capital appreciation supplement yield expectations. In the corporate bond market in the Philippines liquidity is a more important concern than risk.  - 24 - Only one bond issue is listed on the exchange, albeit almost without being traded. For a limited number of other issues the principal underwriters post offers and bids in the over-the-counter market. The net yield on bonds obviously depends upon the tax bracket of the bondholder. It is likely that taxation will be at or higher than the 35% transactions tax on money market investments, and thus aftertax yield would not even reach 12% at a coupon rate of 16%. The bond market demand could be strengthened by fiscal arrangements which favor long-term investments, such as reduced levels of a final withhold- ing tax in lieu of a progressive income tax. The demand for equities may be more difficult to improve. Cash dividends are subject to income taxation, following prepayment of a 10% tax at source. There are no tax incentives to acquire shares, nor is there any significant distinction in tax treatment for shareholders of closely or publicly held corporations to encourage the broadening of the equity ownership base. Liquidity of equities outside the approximately 200 listed securities is practically nonexistent. Serious liquidity constraints affect a number of less speculative issues even for the listed securities. 3.07 Institutional investors are not big participants in the market. Within the banking system, the commercial banks predominate in the total investment portfolio, accounting for almost 70% of the P 18.4 billion total (January 1979). However, 95% of that share is accounted for by government bonds, public sector equities and CBCIs. The restrictions placed on commercial banks' investments in equities fully account for these low percentages, the banks being limited to the equities of "allied enterprises." 3.08 The development banks, dominated by DBP, are the only group of institutions with a significant and expanding private sector participation in their investment portfolio. The total development banks portfolio rose from P 1.5 billion in 1975 to P 3.5 billion in 1978, with the share of private sector securities increasing sharply from 19% to 42%. Insurance companies are another group of potentially important investors in equities, but present regulations place restrictions on their activities in this field. Equities account for P 553 million, or 15% of the portfolio, and have not expanded for four years, so that they are declining in importance. Another 4% of the portfolio consists of private sector bonds. The government institu- tions are not major investors in the capital market. The Social Security System (SSS) has stopped providing direct finance for the private sector and holds only 2% of its portfolio of p 5.8 billion in equities and bonds. The greater part of its funds go to placements with DBP and PNB which enable those institutions to expand their loan operations. The Government Service Insurance System (GSIS) has 21% of its portfolio in bonds and equities and it is expanding its capital market involvement. 3.09 The unimportance of public issues in the securities market as a source of long-term finance is matched by the lack of vigorous development in the secondary market for stocks and shares. The market is narrow partly  - 25 - for institutional reasons. The number of listed securities is small, currently 196, including one bond issue. This number is approximately representative of 0.5% of all the corporations registered with the SEC in the last decade. Only 58 of the 1,000 largest corporations are listed on the exchanges, and 20% of all listed issues were not traded at all in 1978. The limited trading that takes place tends to be concentrated in the stocks of a small number of corporations. There is also a concentration of trading volume in more speculative stocks, particularly oil and minerals, which prejudices market growth of the industrial sector. 3.10 While there has been some growth in the significance of capital markets, it has not been enough to make such markets an important force in the flow of funds for investment. Further growth in the market, both in number and size of new issues is highly desirable in pursuit of several objectives, such as a wider distributton of equity ownership. Such growth cannot be expected to occur quickly, and it is therefore unlikely that capital markets will rapidly become the predominant intermediary for long-term flows of funds into private industry and trade. Nevertheless, policies, practices and institutional development can be altered to encourage the growth of efficient capital markets. That growth will depend ultimately on the evolution of a general climate of confidence in the institutions and expectations appropriate to the commitment of savings to such financial instruments as stocks and bonds. 3.11 The most important elements of an environment conducive to capfta, wA,-ket development are the regulatory framework and the tax regime. The former is the responsibility of the SEC, whose activities have expanded since it became a body reporting directly to the President (1976). It has absolute jurisdiction, supervision and control over all entities operating under government franchises, licenses and permits. It also has overlapping functions with the Central Bank in supervising the issues of money market instruments and installment sales finance companies. Under the proposed reform of the Corporate Law prior SEC approval will be required for the crea- tioai of any new public corporation. The agency would also be empowered to limit group ownership in closely held corporations, or require corporations to go public where the public interest requires it. Such powers, if approved, would give the SEC enhanced authority to influence the breadth and activity of the capital market. However, the agency still has to develop a meaningful concept of public ownership. The present definition of a "public offering" as a sale to a very small number of outside shareholders (15-20) is ineffective in broadening the base of ownership. The number is also too small to permit trading on a scale large enough to provide liquidity for the shares. The same definition is used in the corporate tax laws which levy an additional 5% development tax on closely held corporations. This differential is not sufficient to induce controlling shareholders to go public. The tax treatment of corporate income, interest and dividends n-eds to be reviewed for consistency in their total impact upon investors' decisions, while encouraging a genuine public equity ownership base.  - 26 - Money Market 3.12 In contrast with the marginal role of the long-term capital market described above, the short-term money market operations have played an important role in the Philippines financial markets in the first half of the 1970s. In fact, the money market became a prominefit -;(trce of funds in the years 1974-75 when deposit substitutes increased to the equivalent of about 80% of the total of savings and time deposits. Effective money market rates rose to over 30% a year in comparison with the time deposit rates of 8-11%. The financial reforms of 1976-77 were introduced to reduce and stabi- lize the money market rates and provide a base for the development of long- term markets. These reforms covered a wide range of policy changes including higher interest rates on deposits, interest rate ceilings on deposit substi- tutes, increases in reserve requirements for deposit substitutes, minimum lot requirements for money market operations, and imposition of a transaction tax of 35% on money market operations. The major impact of these reforms is highlighted by a sharp decline in the growth rate of deposit su'b-;itutes and a significant reduction in the money market rates, accompanied by less volatile fluctuations. Deposit Substitt-; 3.13 Deposit substitutes, which grew rapidly at an annual rate of 50% during 1974-75, increased by only 5% a year thereafter. In relative terms, they were equivalent to about 43% of the total of time and savings deposits by 1978, a decline from 80% in 1974./i Thus, the policy measures were quite effective in arresting the high growth rates of deposit substitutes. Most of these funds are likely to have been channeled to medium-term resources in the form of time and savings deposit which continued to grow at an average annual rate of about 30% in 1977-78. 3.14 Commercial banks have played an important role in deposit substitute operations with their share as issuers of the total obligations increasing from 54% in 1973 to 59% in 1978 (Table 10). Despite this increasing share, the banks' activities in this area have declined relatively as reflected in the reduced proportion of the deposit substitutes to the total of deposits and deposit substitutes from 41% in 1974 to 21% in 1978 (Table 11). The main reason for the earlier high growth of deposit substitutes was the unregulated money market rates. To the extent that the banks could attract funds from the informal sector into the formal sector because of the high yields on deposit substitutes, they helped the integration of the financial system. Similarly, to the extent that there has been a shift from the deposit substitutes to medium-term deposits as suggested above, it has increased the potential for long-term channeling of resources and for improving financial efficiency. /1 For data see Table 32.  - 27 - Table 10: SOURCES OF DEPOSIT SUBSTITUTES BY ISSUER, 1973-78 (%) Commercial DBP & Total Investment Other Total banks other banks /a banks houses NBFIs NBFI Total 1973 54.1 0.6 54.7 32.1 13.2 45.3 100.0 1974 58.9 0.2 59.1 27.8 13.1 40.9 100.0 1975 59.3 4.2 63.5 25.1 11.4 36.5 100.0 1976 62.3 4.6 66.9 19.4 13.7 33.1 100.0 1977 62.8 5.3 68.1 17.4 14.5 31.9 100.0 1978 59.4 5.8 65.2 17.5 17.3 34.8 100.0 /a Mbstly DBP. Source: Data provided by the authorities. Table 11: COMMERCIAL BANKS: DEPOSITS AND DEPOSIT SUBSTITUTES, 1974-78 (Million Pesos) Deposit Deposits substitutes Total 1974 18,375 7,470 25,845 1975 20,747 9,632 30,379 1976 26,061 10,873 36,934 1977 33,777 11,400 45,177 1978 43,653 11,494 55,147 Source: Data provided by the authorities. 3.15 The recent measures have not yet produced a noticeable effect on extension of terms in money market borrowing, at least not beyond the two- year limit. Money market instruments with a maturity of over two years have been only marginal at about 0.2% of the total reported volume. While matur- ities of 45 days or less generally account for 85% of all transactions, the instruments with shorter maturities have increased their relative trading share in the latter half of 1978. Transaction volume in money market instru- ments has expanded somewhat faster in recent years than the value and con- sequently it might be argued that there has been either a shortening of maturities issued or a more intensive trading in the shorter end thereof, or both. However, because of the pyramiding effects of trading volume statistics on short-term rates, these conclusions could be misleading. At the same  - 28 - time the evidence provided by data on deposit substitutes outstanding in the case of commercial banks show a definite decline for maturities of over one year (Table 12). Table 12: DEPOSIT SUBSTITUTES OUTSTANDING - COMMERCIAL BANKS - BY MATURITIES (%) End Less than 61-120 121-240 241-360 Over year Demand 60 days days days days 360 days 1975 41.6 36.3 9.7 1.8 7.7 2.9 1976 29.2 44.0 12.7 2.8 10.3 1.0 1977 31.7 41.0 17.9 2.1 5.4 1.8 1978 29.5 40.8 21.3 4.6 3.4 0.3 Source: Data provided by the authorities. Money Market Rates and Transactions 3.16 The weighted average money market rates have steadily declined from 17.6% in 1974 to 10.7% in 1978 (Table 13). Throughout the period from 1975 to the first half of 1977, the majority of the money market transactions were carried out at posted interest levels in excess of 14%. A transaction tax of 35% was introduced in June 1977. Since then, volume at high rates declined through mid-1978 when almost half of the transaction volume carried interest of less than 10%. During the second half of 1978, however, rates began to increase again, possibly in connection with rapid expansion of borrowings by the nonbank financial sector. The current rates are higher, as the 15% ceiling potentially becomes the "normal" rate. The reversal in trends is also visible in data on deposit substitutes outstanding for commercial banks (see Table 10 above). Interbank call loan rates also advanced during 1978 from 8% in the first quarter to 12% in the last quarter. Table 13: MONEY MARKET RATES, 1974-78 (%) Interbank 30-day deposit Weighted average call loan substitute all paper 1974 14.0 13.6 17.6 1975 11.1 12.1 15.0 1976 11.4 11.0 12.9 1977 12.0 13.3 12.6 1978 10.4 10.4 10.7 Source: Data provided by the authorities.  - 29 - 3.17 No aggregate financial data are available which would permit the identification of all holders of money market instruments./l Available data only permit comparisons of the transaction volume of specific groups as borrowers and lenders. The total transaction volume in the first quarter of 1978 was P 113 million, with an average maturity of 29 days. The comparison of institutional transaction volumes reveals that banks claimed not only the largest borrowing intensity but also the largest lending element in trading volume. An analysis of sources and uses of funds in the money market for the first quarter of 1978 indicates the following major borrowers and lenders by percentage share of the total: borrowers - commercial banks 65%, investment houses 23% and finance companies 10%; lenders - commercial banks 40%, private corporations 18% and individuals 17%. Thus commercial banks and investment houses are the largest net absorbers of funds generated through the money markets while private corporations and individuals are the largest net suppliers. Individuals played a significant role as lenders especially considering that over three-fourths of the transactions are in placements of more than one million pesos. Investment Houses 3.18 Money market and deposit substitutes have been closely associated with investment houses because of their excessive reliance on money market operations which provided 60-70% of their annual incomes during the recent boom. The majority of investment houses found the money market operations with their recurrent spreads, commissions and trading gains significantly more profitable than the underwriting business. Thus, the investment houses have been transformed from the original concept of providers of long-term funds to intermediaries in the short end of the money market. Over the last two years, there has been some improvement in this respect, but virtually only two to three investment houses are active and, even so, a significant share of placements is handled on a best-effort basis for which other existing channels could be utilized. The main activity and principal source of income still continues to center on the money market operations. 3.19 At present, one investment house is inactive. Another entity, PDCP, although licensed as an investment house, is a development bank. Its opera- tions coincide only marginally with those of investment houses inasmuch as it does not engage very actively in either underwriting or in money market activ- ities. Table 14 reflects the impact of PDCP on the aggregate financial data. Its elimination would drastically change the term composition of investment house borrowings at the end of 1978, as long-term borrowings would decline from 17% of total borrowings to less than 2% and thus would contradict the impression gained normally from aggregate statements of investment houses that their long-term sourcing ratio is more favorable than that of other types of financial institutions such as commercial banks. PDCP's main /1 Promissory notes continue to be the favored instrument accounting for over 60% of all transactions.  - 30 - Table 14: INVESTMENT HOUSES BALANCE SHEET SUMMARY 1977/78 (Million Pesos) 1977 1978 All invest. Inv. houses All invest. Inv. houses houses PDCP excl. PDCP houses PDCP excl. PDCP Assets 4,338.6 909.8 3,428.8 4,762.5 1,006.3 3,756.2 Cash & banks 351.2 22.4 328.8 446.1 14.4 431.7 Loan portfolio 3,419.7 728.0 2,691.7 3,622.9 741.8 2,881.1 Investments 220.7 73.7 147.0 315.8 136.5 179.3 Other assets 347.0 85.4 261.6 377.7 113.5 264.2 Liabilities 3,767.0 775.3 2,991.7 4,122.0 859.2 3,262.8 Borrowings 3,435.0 759.5 2,675.5 3,867.5 828.2 3,039.3 Short-term 2,760.3 157.7 2,602.6 3,224.6 236.3 2,988.3 Long-term 674.7 591.8 82.9 642.9 591.9 51.0 Other liabilities 332.0 25.8 306.2 254.5 31.0 223.5 Net Worth 571.6 134.4 437.2 640.5 147.0 499.5 Paid-in capital 390.1 73.4 316.7 417.7 73.4 344.3 Retained earnings 181.5 61.0 120.5 222.8 73.6 149.2 Note: Data excludes Philcapital (nonoperating) Source: Data provided by the authorities. business is the provision of long-term loans which comprise more than 80% of its total assets. Its contribution to capital formation is indicated by its P 1,733 million participation in the P 4,760 million investments of the 631 projects assisted as of December 1977. Of this financial assistance, 65% was in the form of long-term loans, and the remainder were project guarantees, equity investments, underwriting and syndication. Its operations have been mostly to assist the private manufacturing sector.  - 31 - 4. FINANCE FOR INDUSTRY 4.01 Over the period 1970-77, the Philippine economy grew at an average annual real rate of 6.5% which was an acceleration over the 5.5% growth regis- tered in the 1960s. The contribution of the industrial sector /1 to gross domestic product (GDP) rose from 30% in 1970 to 35% in 1977 (see Table 15). The manufacturing sector in 1977 accounted for 25% of GDP, about 30% of fixed investment and 10% of total employment. The mining sector was relatively stagnant over the period 1973-77 and contributed only about 2% to GDP in 1977, owing to the low price of copper. The construction sector experienced a rapid growth in 1974-76 as a result of extensive public in- vestment; however, the growth in this sector appears to be leveling off. Investment Requirements 4.02 Over the period 1974-78 gross domestic capital formation (GDCF) in current terms grew at an annual average rate of about 21%. Since the Gross National Product (GNP) grew at a slower rate, the proportion of GDCF to GNP rose slightly to 28% in 1978. Fixed capital formation in durable equipment accounted for around 40% of GDCF with the balance being accounted for by Table 15: PERCENT DISTRIBUTION OF GDP BY SECTORAL ORIGIN, CURRENT PRICES 1970 1973 1977 Agriculture, fishery & forestry 27.8 29.3 28.1 Industry Mining and quarrying 2.8 3.4 1.7 Manufacturing 22.5 24.7 24.6 Construction 3.6 3.8 7.4 Electricity, gas and water 0.7 0.8 0.9 Total Industry 29.6 32.7 34.7 Services 42.6 38.0 37.2 GDP at market prices 100.0 100.0 100.0 Source: NEDA. /1 The industrial sector includes mining, manufacturing, construction and utilities.  - 32 - construction expenditures. It has been estimated that the manufacturing sector accounted for 30-40% of gross domestic capital formation in durable equipment for the period 1970-78 while investment in construction and mining accounted for 7-11% of total investment for the same period. 4.03 With increasing levels of industrialization, the recent trends in industrial capital formation will need to be sustained and reinforced if development targets are to be attained. Fixed capital formation in durable equipment is projected under the five-year development plan 1978-1982 to account for an increasing share of GDCF in view of the proposed industrial program and the projected decline in construction activity. In current prices, the volume of investment in capital equipment is expected to increase from P 18 billion in 1978 to P 43 billion in 1982, a rate of increase of 24% p.a. The financing requirements to meet these investment needs are likely to be substantial. As government investment in GDCF is expected to account for only 19%, the bulk of the investment will have to be carried out by the private sector. Sources of Financing 4.04 The identified long-term institutional sources of finance going to manufacturing, mining and construction are given in Table 16. The total volume of identifiable long-term financing going to these sectors rose from P 4,615 million in 1974 to P 8,341 million in 1978, or a growth rate of 16% p.a./1 The proportion of foreign currency financing has increased sharply from 42% in 1974, to 72% in 1978 (see Table 17). Data on Board of Investments (BOI) registered projects shows that they were funded more through foreign exchange than local currency financing. This was true not only in the aggregate, but for each of the sectors for each of the years, with one exception. Foreign exchange resources have been increasingly used to finance industry, in part owing to the scarcity of domestic long-term resources and their high costs when available. In general, foreign exchange resources have been much more easily available for long-term finance since the bulk of them came from official sources and often had prescribed maturities. /1 The data base used in deriving the volume of medium and long term resources going to industry is not satisfactory. In the past, the Central Bank of the Philippines collected data on the volume of credit disbursed by type of institution. This series was discontinued in 1976. Since then only data on loans outstanding have been collected. Data on loans outstanding by type of institution were not available for 1978. As the CB does not collect data on repayments it is not possible to derive the volume of credit granted by type of institution for 1977 or 1978, and assumptions have been made in deriving the data for those years. Owing to the limitations of the data base, the tables are not precise; however, they probably reflect the orders of magnitude involved.  - 33 - Table 16: LONG-TERM FINANCING /a FOR INDUSTRY (Million Pesos) 1974 1975 1976 1977 1978 Amount Y Amount x Amount % Anount x Amount x Banks 1,667.6 36.1 549.3 13.1 712.6 9.4 568.3 6.1 842.8 10.1 Commercial banks 1,658.9 35.9 540.7 12.8 702.6 9.3 545.9/b 5.8 -/c - Savings banks 4.0 0.1 6.6 0.2 6.2 0.1 -/c - -/c - Stock savings & loan associations 4.7 0.1 2.0 0.1 3.8 - 15.4 0.2 12.5 0.1 Offshore banking units -/d - -/d - 7.0 0.1 830.3 10.0 Nonbank Financial Intermediaries 489.1 10.6 1,180.2 28.0 1,963.1 26.0 2,462.1 26.4 3.878.7 46.5 DBP 147.6/e 3.2 742.7 17.6 1,506.4 19.9 2,123.5 22.8 3,575.8 42.9 PDCP 104.3/f 2.2 93.1/f 2.2 45.6/f 0.6 69.6/f 0.8 77.8/f 0.9 BANCOM 198.8 4.3 73.3 1.F 274.1 3.6 161.5 1.7 173.7 2.1 IIIDC 7.5 0.2 194.0 4.6 75.4 1.0 40.2 0.4 38.3 0.5 PISO -a - -/g - 10.5 0.2 8.8/h 0.1 2.4/h - Private insurance companies /i 30.9 0.7 75.5 1.8 49.5 0.7 58.2 0.6 9.9 0.1 Nonstock savings & loan associations -/c - 1.6 - 1.6 - 0.3 - 0.P 8 - Other 1.301.6 28.2 1,222.8 29.0 3,050.7 40.3 3,396.1 36.5 2.619.9 31.4 Suppliers credit 651.8 14.1 299.5 7.1 984.1 13.0 335.7 3.6 7.4/k 0.1 Cash loans 649.8 14.1 923.3 21.9 2,066.6 27.3 2,480.9 26.7 1,258.3/k 15.1 Swaps agreenents -/c - 0/c - -/c - 579.5 6.2 1,354.2 16.2 Securities 1.156.5 25.1 1,259.0 29.9 1,837.0 24.3 2,885.6 31.0 999.6 12.0 Equity issues 768.3 16.7 1,102.2 26.2 1,263.3 16.7 1,604.7 17.2 533.6/1 6.4 Bond issues 181.8 3.9 8.5 0.2 - - 157.5 1.7 100.0 1.2 Direct public sector borrowings 206.4 4.5 148.3 3.5 573.7 7.6 1,123.4 12.1 366.0 4.4 Total 4,614.8 100.0 4,211.3 100.0 7,563.4 100.0 9,312.1 100.0 8,341.0 100.0 /a Gross disbtursements by financial instttutions. /b January to August only. /c Not a-ailable. Id Offshore banking units started operations in 1977. /e Domestic currency financing refers to FY74 (July 1 to June 30). /f Of the total domestic cuirrency lending, the volume of resource going to small loaTns is: 1974 - P 1.8 million, 1975 - P 2.1 million, 1976 - P 2.0 million, 1977 - P 10.7 million, 1973 - P 18.8 nillion. PISO started operation in 1974 but wenit in for mediulm- and long-term lending in 1976. /h Of the total domestic currency lending, the amounts going to IGLF-funded projects were: 1977 - P 1.0 million, 1978 - P 2.0 million. /i Comprises the lending of the four Ayala Group Insujrance Companies and Philan Life Insurance Company. __ January to September only. /k Januiary to October only. /1 Foreign currency lending only. Sources: Central Bank of the Philippines, D0P, PDCP, PISO and NIDC.  - 34 - Table 17: LONG-TERM LOCAL AND FOREIGN EXCHANGE FINANCING FOR INDUSTRY (Pesos million) (x) Local Foreign Total Local Foreign Total Year financing financing financing financing financing financing 1974 2,668.1 1,946.7 4,614.8 57.8 42.2 100.0 1975 1,928.3 2,283.0 4,211.3 45.8 54.2 100.0 1976 2,658.7 4,904.7 7,563.4 35.2 64.8 100.0 1977 3,097.2 6,214.9 9,312.1 33.3 66.7 100.0 1978 2,367.7 5,973.3 8,341.0 28.4 71.6 100.0 Source: Data provided by the authorities and mission estimates. 4.05 A study conducted by the Ministry of Industry (MOI) also showed that foreign loans were significantly cheaper than domestic borrowing. Export-oriented and BOI-registered projects have found it relatively easy to get permission from the Central Bank to borrow from abroad, the most favored form of borrowing for industry being cash loans and swap agreements./l Assuming a borrowing rate a few percentage points above LIBOR and an annual guarantee fee of 3%,/2 the cost of foreign borrowing, excluding the foreign exchange risks, would amount to about 13%, while the cost of domestic currency resources would be nearer 19%. Exporting firms, whether mining or manufacturing, are able to discount the foreign exchange risk as they have a built-in hedge in terms of their exported output. Nonexporting firms have to impute a cost for the foreign exchange risk. However, the foreign exchange risk on dollar denominated loans has been relatively insignificant as the peso has been linked to the dollar and the rate between the two has remained remarkably stable over the period 1975 to 1978. Despite this there are indications that some of the nonexporting firms would prefer borrowing in pesos and be completely free of any foreign exchange risk. However, many of these firms have been unable to acquire the needed peso resources, resorting to swap agreements to overcome these constraints. Swap agree- ments,/3 increased from $78 million in 1977 to $183 million in 1978. In addition, the Government has recently been borrowing abroad on behalf of the private sector; direct public sector borrowings have increased from $30 million in 1974 to $151 million in 1977./4 /1 The cost of dollar borrowings has generally been directly linked to the London Interbank Offered Rate (LIBOR). In the recent past LIBOR has been as low as 7-1/2%. /2 DBP charges 3% on guarantees availed of and outstanding. /3 In a swap agreement, a firm borrows from abroad and deposits the borrowing, which is nominated in a foreign currency, with a bank which in its turn releases the equivalent peso resources. Consequently, the foreign exchange risk for the firm is minimal. /4 By going in for "Jumbo" loans, the Government has been able to get a better rate.  - 35 - 4.06 The total volume of identifiable resources going to manufacturing has increased from P 3,236 million in 1974 to P 5,647 million in 1977 or an annual average rate of growth of about 30%. The proportion of domestic currency resources going to manufacturing declined from 68% in 1974 to 37% in 1977 while the foreign exchange component rose correspondingly. The major sources of foreign currency finance were DBP, cash loans and foreign equity which together accounted for 75% of all foreign exchange resources going to manufacturing. The major domestic sources were DBP, commercial banks and equity. Privately owned development banks and investment houses which might have been expected to play a major role contributed very little. 4.07 The total volume of identifiable resources going to mining rose from P 989 million in 1974 to P 2,516 million in 1978. The proportion of foreign currency financing has remained relatively constant at around 67% of the total financing from 1974 to 1978. In 1974, suppliers credit and cash loans together accounted for 82% of all foreign currency financing going to the mininig sector, but for subsequent years the major source of financing has been DBP. DBP has also been the major source of local currency financing for the mining sector. Factors Inhibiting the Flow of Domestic Resources to Industry 4.08 The proportion of domestic resources in the total long-term finan- cing for industry has been declining. Commercial banks might have been expected to do significantly more medium and long-term lending for industry than they appear to be doing. The reasons for their limited present role were discussed in Chapter 2. In many countries, insurance companies are a major source of long-term finance for industry, but their role in the Philippines is minimal. Finally, one raison d'etre of development banks is the mobilization of long-term domestic and foreign currency resources for onlending. While DBP has played a major role, the volume of long-term domestic resources going to industry from institutions such as the Private Development Corporation of the Philippines (PDCP) or Philippines Investment Systems Organization (PISO) has been insignificant. Some of the possible reasons preventing these institutions from lending to industries are discussed below. 4.09 Insurance company loans to industry must be completely secured by real estate or by iron clad commercial bank or parent company guarantees. Consequently, insurance company loans tend to go to prime industrial companies. The smaller insurance companies make almost no loans to industry. The resources of the GSIS and SSS, which are almost double those of the private insurance companies, were not channeled directly into industry, but some GSIS and SSS resources were placed with DBP and might have been used by DBP to finance industry.  - 36 - 4.10 The major source of DBP's funds are its equity and retained earnings (33%) and bonds and notes (54%). The SSS, under Government instruction, deposits a significant volume of its resources with DBP at a lower than market rate. This was also true with respect to deposits from the GSIS. However, since 1975 the outflow of GSIS resources has been greater than the inflow. Both the DBP bonds and the DBP Progress Bonds are being withdrawn and are being replaced by the DBP countryside bills, which were first issued in June 1974. To date, there have been four issues of such bills. As of March 30, 1979, out of a total authorized issue of countryside bills of P 2 billion, P 1.6 billion had been sold. All the countryside bills issued have a term of five years and offer an interest of 9%, payable semi- annually. The first three issues were exempt from taxation with respect to both principal and interest. In addition, they could be used by financial institutions to meet their reserve requirements with respect to agricultural credit financing and deposit substitutes. Consequently, DBP was able to mobilize resources on the basis of privileged terms accorded its instruments. In the fourth issue, the Government removed both the tax exempt and reserve eligibility features. The first auction of the fourth issue for P 100 million occurred in January 1979 and the selling price varied between 80.160/hundred and 82.445/hundred, resulting in an average cost to DBP of 14.69%. Given that the weighted average rate of return on DBP loans is 15.5%, the gross spread that would accrue to DBP would be minimal making it unprofitable to onlend these resources at the current lending rates. The current picture is thus very similar to that faced by the private sector in its attempts to raise long-term peso resources for onlending. 4.11 Privately owned development banks, like PDCP, were established with the objective of raising resources which would be onlent to both agri- culture and industry. While they have been able to mobilize foreign exchange resources for onlending they have been less successful with local currency resources. Given the very small volume of domestic currency resources onlent by them to industry it is clear that they are unable to fulfill this aspect of their role. At present these institutions, together with PDCP, are not allowed to accept deposits. Consequently, the only way they can raise resources for onlending is either by borrowing them from other institutions or by issuing their own bonds.  - 37 - 5. LONG-TERM FINANCE AND FINANCIAL INTERMEDIARIES The Loans Market 5.01 The commercial banks have long dominated the loans market in the Philippines; they were responsible for an annual average of 92% of total loans granted through financial institutions between 1970 and 1977, a share which has remained remarkably stable over the years despite the influx of new institutions (Table 18). Second in importance are the government nonbank financial institutions, among which the Social Security System (SSS) and the Government Service Insurance System (GSIS) are by far the major lenders. During the years 1973 to 1975 credit granted by private NBFIs grew rapidly. With some curtailment of money market activity in 1976, the volume of credit granted by this group dropped sharply, and in 1977 accounted for less than 1% of all institutional credit granted. 5.02 The sectoral allocation of credit has changed markedly over the years. There has been a substantial shift away from lending to agriculture, which in the period 1960-64 absorbed 17% of credit granted compared to only 8% in the years 1975-77 (Table 19). Industry, particularly manufacturing has also received a smaller share, although recently the share has grown. In the early 1970s the trading sector received the major portion of credit granted (40%); recently, however, the share has declined. The most striking development in the pattern of credit allocation is the rapid growth in the credit granted to financial institutions since 1975. 5.03 The loans market is dominated by short-term credit. This is particularly true of bank credit, more than 90% of which is short-term (Table 20). The NBFIs have a rather better maturity balance, with 38% of /1 Major data deficiencies consist of the lack of consistent information on the maturity structure of credit granted, often data on outstanding credit of many NBFIs had to replace the more useful information on credits granted. Also differences occur in the classification of short, medium and long-term. To the extent possible, the following definitions are adhered to in this section: short-term: up to 1 year, medium-term 1 to 5 years; long-term 5 or more years. An additional problem is that the exact data on loans granted cannot be obtained since the statistics available include credits granted through money market operations. These limitations do not, however, affect the broad observations of this section.  Table 18: TOTAL LOANS GRANTED BY INSTITUTIONAL GROUPS, 1970-77 (Million Pesos) Average annual shares (X) 1970 1971 1972 1973 1974 1975 1976 1977 1960-64 1965-69 1970-77 Commercial banks 21,951.7 28,820.4 32,689.4 46,684.6 82,302.8 114,366.1 131,723.5 156,338.1/a (As % of total) (90.9) (91.4) (93-0) (90.4) (91.1) (91.0) (92-7) (92.8) (90-1) (87.0) (91.7) Savings banks & stock savings & loan associations 115.0 263.8 215.6 301.7 556.8 733.0 1,320.3 1,673.9/b (As % of total) (0.5) (0.8) (0.6) (0.6) (0.6) (0.6) (0-9) (1.0) (0.6) (9.8) (0.7) Rural banks 558.8 678.7 785.2 1,073.6 1,824.5 2,491.9 1,881.4 2,065.7 (As Z of total) (2.3) (2.2) (2.2) (2.1) (2.0) (2.0) (1-3) (1.2) (2.5) (2.8) (1.9) Development banks /c 162.0 116.6 181.1 326.3 854.3 2,822.5 2,608.3 3,019.3 (As % of total) (0-7) (0.4) (0.5) (0.6) (1.0) (2-3) (1.8) (1.8) (2.8) (2.8) (1.1) Private nonbank financial institu- tions /d 540.2 465.7 243.4 2,226.4 3,144.6 3,790.5 1,968.8 1,409.6 (As % of total) (2.2) (1.5) (0.7) (4.3) (3.5) (3.0) (1-4) (0.8) (0.04) (2.2) (2.2) Government nonbank financial insti- tutions /e 812.2 1,195.4 1,032.3 1,059.4 1,620.7 1,460.6 2,639.7 3,932.8 (As Z of total) (3-4) (3.8) (2.9) (2.1) (1-7) (1.2) (1.9) (2-3) (4-0) (4-3) (2.4) Total 24,139.9 31,540.6 35.147.0 51,672.0 90,303.7 125,664.6 142,142.0 168,439.4 (100.0) (100.0) (100.0) Source: Data provided by the autilorities. /a Estimated from January - August 1977 data. /b Based on actual loans granted by stock savings and loan associations plus loans granted by savings banks estimated from change in outstanding loans and average repayment. /c Development Bank of the Philippines and private development banks. Td PDCP, BANCOM, mutual building and loan associations and nonstock savings and loan associations. Le ACA, GSIS, SSS and NIbC.  - 39 - Table 19: PERCENTAGE DISTRIBUTION OF CREDITS GRANTED BY PURPOSE BY DOMESTIC FINANCIAL INSTITUTIONS, 1960-77 (Average annual percentage shares) 1960-64 1965-70 1970-74 1975-77 Agriculture /a 17.1 15.3 7.0 8.3 Industry /b 33.4 27.2 23.1 29.0 Trade 33.6 35.5 40.0 19.0 Public utilities 2.4 2.0 1.7 1.7 Real estate 3.2 4.3 3.1 2.4 Banks and other financial institutions 4.0 8.2 13.0 30.1 Consumption 4.6 4.4 4.3 2.6 Other 1.7 3.1 5.0 6.0 Total 100.0 100.0 100.0 100.0 Source: Data provided by the authorities. /a Includes fisheries and forestry. /b Manufacturing, construction, mining and quarrying. the total outstanding loans being short-term in 1977, an improvement over the position five years earlier when 53% were short-term (Table 21). The social security institutions and the private life insurance companies also have the major portion of their outstanding loans in intermediate and long-term credit, although the maturities have been shortening in recent years, with 31% of their total outstanding loans in short-term credit, compared to 15% five years earlier. 5.04 The major long-term lending institution is DBP, which provided almost half of total outstanding long-term credit in 1977 (Table 22). Second in importance was the GSIS, accounting for a further 16%./1 In terms of intermediate maturity, the commercial banks and financing companies together accounted for almost 60% of the total with DBP providing 15%. The overall maturity distribution of outstanding loans of all financial institu- tions is heavily weighted at the shorter end of the market, with short-term loans comprising 59%, intermediate-term 18% and long-term 23%. Three factors need to be borne in mind in interpreting these findings: one is that this /1 As explained in the section on GSIS, the picture is likely to be quite different in terms of credit granted, since GSIS housing loans (50% of their portfolio) were extended several years ago. In terms of credit granted (for which data for all institutions are not available), PDCP would rank second in importance to DBP.  - 40 - refers to credit outstanding and the picture in terms of credit granted may be different. For example, long-term credit granted by commercial banks in 1977 was less than 1% of total credit granted, compared to 4% of their outstanding portfolio. The second factor is that Table 19 refers only to loans and not to investments. If the latter are taken into account, then the importance of such institutions as investment houses, GSIS, SSS and private insurance companies as suppliers of long-term finance would be considerably greater. Finally, external financing has become increasingly significant in the Philippines, particularly medium and long-term credits which comprise the major portion. Since the role of commercial banks and PDCP in long-term finance has been already discussed in earlier chapters, the contribution of other financial institutions is discussed below. Savings and Mortgage Banks and Stock Savings and Loan Associations. 5.05 The loan portfolios of both savings banks and stock S&L associations have a higher share of long-term credits than commercial banks, reflecting the purpose of their lending as well as the composition of their liabilities. Both lend predominantly for real estate purposes and savings and time deposits comprise between 80 to 90% of their total liabilities. Savings banks are by far the larger in asset size, and long-term loans granted by savings banks comprised 53% of their total loans granted in 1976; if intermediate-loans are included the share rises to 65%. This is a marked increase over corresponding shares of the early 1970s (26% and 35% respec- tively). The total volume of loans by savings banks and S&L associations, however, is relatively small, comprising only 1% of total loans granted by the financial system in 1977. This, together with the preponderance of their loans for real estate purposes, has meant that their credit has had a minimal impact on funding productive investment directly. Private Development Banks (PDBs) 5.06 The PDBs extend a small portion of total credit of the financial system (0.2%),/1 but they are potentially institutions in the long-term credit market for two reasons: first, in 1978, 76% of their credit granted was intermediate and long term,/2 and second, their funds are used primarily for productive investment. In 1978, for example, 39% of credit went directly to industry and a further 37% to agriculture. This credit is important for the small-to-medium-scale enterprise. PDBs are also allocating a growing share of their portfolio for investment in stocks and bonds./3 /1 The capacity of PDBs to grant a larger volume of loans is constrained by the limits set on their capital base. /2 They are required by law to invest 75% of loanable funds in medium and long-term loans for economic development purposes. /3 Around 25% of total assets in 1976.  - 41- Table 20: CREDITS GRANTED BY BANKING INSTITUTIONS BY MATURITY, 1973-77 (Million Pesos) Commercial Savings Rural As % of banks banks PDBs banks /a DBP Total total 1973 Short term 44,546.2 39.1 17.2 966.2 930.0 46,498.8 90.3 Intermediate term 826.9 32.7 48.1 107.4 981.5 1,996.6 3.9 Long term 1,311.5 80.2 15.8 - 1,604.0 3,011.5 5.9 1974 Short term 76,925.3 186.9 28.7 1,642.0 761.9 79,544.8 90.6 Intermediate term 2,393.2 26.2 47.7 182.5 1,007.3 3,656.9 4.2 Long term 3,004.3 121.7 23.6 - 1,474.8 4,624.4 5.3 1975 Short term 112,617.2 193.0 25.3 2,242.7 1,216.0 116,294.2 95.3 Intermediate term 1,057.9 4.6 53.7 249.2 1,158.6 2,524.0 2.1 Long term 691.0 143.5 21.0 - 2,342.5 3,198.0 2.6 1976 Short term 129,460.2 251.2 26.2 1,693.3 1,215.4 132,646.3 93.3 Intermediate term 917.7 80.8 53.7 188.1 1,554.4 2,794.7 2.0 Long term 1,345.6 379.6 20.2 - 5,055.0 6,800.4 4.8 1977 Short term 153,680.2/b n.a. 28.4 1,859.1 563.9 156,131.6 92.8 Intermediate term 1,639.5/b n.a. 53.0 206.6 1,794.9 3,694.0 2.2 Long term 1,018.9/b n.a. 18.6 - 7,356.0 8,393.5 5.0 Source: Data provided by the authorities. /a Maturity breakdown estimated from 1976 and 1977 actual figures. /b Estimated from January to August actual figures for 1977.  - 42 - Table 21: OUTSTANDING LOANS OF NBFIs BY MATURITY /a (Million Pesos) Securities Investment Financing Investment dealers/ As % of houses companies companies brokers Total total 1973 Short term 285.3 450.7 164.8 39.3 940.1 52.8 Intermediate term 88.1 505.8 6.9 0.6 601.4 33.8 Long term 198.5 7.8 28.8 3.7 238.8 13.4 1974 Short term 328.4 715.2 137.3 134.7 1,315.6 45.4 Intermediate term 99.8 919.3 37.5 2.1 1,058.7 36.5 Long term 451.1 13.8 47.8 12.7 525.4 18.1 1975 Short term 446.7 1,089.3 186.8 430.4 2,153.2 44.7 Intermediate term 260.1 1,320.2 119.8 6.7 1,706.8 35.4 Long term 623.7 26.0 269.0 40.5 959.2 19.9 1976 Short term 660.5 1,442.8 198.6 179.6 2,481.5 41.5 Intermediate term 323.2 1,985.1 157.2 3.6 2,469.1 41.3 Long term 729.8 23.9 272.8 8.3 1,034.8 17.4 1977 Short term 414.6 1,553.8 280.0 450.7 2,699.1 38.1 Intermediate term 378.9 2,660.7 256.5 9.1 3,305.2 46.6 Long term 733.1 16.6 313.1 20.7 1,083.5 15.3 Source: Data provided by the authorities. /a Excluding fund managers, lending investors, pawnshops, non.tock SLAs and mutual building and loan associations due to lack of data. These institutions comprised only 3% of total loans outstanding of all private NBFIs in 1977.  - 43 - Table 22: CREDITS OUTSTANDING BY FINANCIAL INSTITUTIONS BY MATURITY AS OF DECEMBER 31, 1977 (Million Pesos) Intermediate Short term term Long term % of % of % of Amount total Amount total Amount total Commercial banks 34,256.7 87.1 4,233.6 35.1 1,682.6 10.8 Savings banks 485.7 1.2 650.3 5.4 586.7 3.8 Stock S&L associations 389.6 1.0 48.7 0.4 33.0 0.2 LBP and PAB /a 482.6 1.2 88.5 0.7 501.4 3.2 DBP 563.9 1.4 1,794.9 14.9 7,356.0 47.0 PDBs 76.6 0.2 234.8 1.9 122.8 0.8 Investment houses 414.6 1.1 378.9 3.1 733.1 4.7 Financing companies 1,553.8 4.0 2,660.7 22.1 16.6 0.1 Investment companies 280.0 0.7 256.5 2.1 313.1 2.0 Securities dealers 450.0 1.1 9.1 0.1 20.7 0.1 GSIS - - 917.2 7.6 2,477.7 15.8 SSS 369.9 0.9 66.9 0.6 972.4 6.2 Private insurance companies - - 707.5 5.9 823.5 5.3 Total 39,323.4 100.0 12,047.6 100.0 15,639.6 100.0 Percentage of Total: Short term 58.7 Intermediate term 18.0 Long term 23.3 Source: Central Bank, Statistical Bulletin, and data provided by Central Bank, DBP, GSIS, SSS and Insurance Commissions. /a Land Bank of Philippines and Philippine Amanah Bank.  - 44 - Development Bank of the Philippines (DBP) 5.07 Loan disbursements by DBP over the period FY74-78 have amounted to P 10 billion, of which 22% has been intermediate term. In fact, of this long- term lending, 21% has had a maturity of over 10 years (Table 23). In addition, DBP has approved equity investments amounting to P 13 billion over these five years. In total, therefore, DBP's operations have amounted to P 23 billion over the period FY74-78, and in 1977 was responsible for finan- cing 12.5% of gross fixed capital formation. Most of DBP's activities are in industry (71% of loan disbursements in 1978 - Table 24); especially public utilities (19%), textiles (13%) and metal industries (12%). The sheer volume of DBP's operations, together with the predominantly long-term nature of its operations and the wide diversity of its activities make DBP an extremely important institUtion. Table 23: OUTSTANDING LOANS OF DBP BY MATURITY (Million Pesos) 1973 1974 1975 1976 1977 1978 As of June 30 ------- As of December 31 -------- Up to 2 years 930.0 761.9 1,216.0 1,215.4 563.9 1,819.9 Over 2 & up to 5 years 981.5 1,007.3 1,158.6 1,554.4 1,794.9 1,832.6 Over 5 & up to 10 years 1,422.9 1,326.9 1,591.2 2,695.0 4,708.2 4,291.9 Over 10 years 181.1 147.9 751.3 2,360.0 2,647.8 2,954.7 Total 3,515.5 3,244.0 4,717.1 7,824.8 9,714.8 10,899.1 As Percent of Total Up to 2 years 26.5 23.5 25.8 15.5 5.8 16.5 Over 2 & up to 5 years 27.9 31.1 24.6 19.9 18.5 16.7 Over 5 & up to 10 years 40.5 40.9 33.7 34.4 48.5 39.0 Over 10 years 5.2 4.6 15.9 30.2 27.3 26.8 Total 100.1 100.1 100.0 100.0 100.1 99.0 Source: Data provided by DBP.  - 45 - Table 24: PERCENTAGE DISTRIBUTION OF LOAN DISBURSEMENTS OF DBP 1973/a 1974/a 1975 1976 1977 1978 Agriculture 27.5 44.6 38.5 25.8 19.8 13.0 Industry 59.7 36.8 32.4 35.9 64.9 71.2 Real estate 9.1 10.6 25.1 35.2 10.5 10.7 Government and landed estate 0.3 3.4 1.7 1.6 2.9 2.8 Other 3.3 4.6 2.2 1.5 2.1 2.2 Total 100.0 100.0 100.0 100.0 100.0 100.0 Source: DBP. /a Fiscal years ending June 30; thereafter on calendar year basis. GSIS, SSS and Private Insurance Companies 5.08 The GSIS, SSS and private insurance companies are important institutional sources of long-term finance, both in the form of loans, and particularly in the form of equity participation and bond purchases. In terms of outstanding credit, the GSIS ranks second only to DBP in the volume of long-term credit provided. This picture is somewhat misleading, since much of GSIS long-term loans were housing loans to members which were granted several years ago./I Indeed, GSIS is no longer making housing loans and plans to gradually phase them out. GSIS already holds 21% of its portfolio in stocks and bonds, and plans to increase this share as it is phasing out its housing loans. GSIS holdings of stocks and bonds as of July 31, 1978 were mostly private issues (82%), particularly common stocks (Table 26). Investments have been mostly in transportation, particularly in Philippine Air Lines which is now 92% owned by GSIS,/2 and hotels. These two sectors accounted for 50% of GSIS stocks and bonds portfolio, with the balance in manufacturing, mining and government stock. Future plans are to increase the share of holdings of stocks and bonds to 46% of the total portfolio by 1983. If this materializes, then GSIS will be one of the major institu- tutional investors on the capital market. /1 They constitute a declining share in outstanding portfolio: 60.6% in 1976, 51.3% in 1978 (Table 25). Housing loans were for 10-25 years. /2 In 1977 GSIS subscribed to the entire increase of PAL capitalization from P 25 million to P 225 million, increasing its percentage of PAL ownership from 14.5% to 92%.  Table 25: LOANS AND INVES'1N4ENTS OF GS0S, 1974-78 (Million Pesos) Percentage of total 1974 1975 1976 1977 1978 1974 1975 1976 1977 1978 Policy loans 263.9 295.5 332.8 365.6 414.3 9.3 9.6 8.6 8.5 8.5 Salary loans 381.4 406.8 500.3 546.7 647.7 13.5 13.2 13.0 12.6 13.3 Real estate loans 1,669.8 1,806.6 2,335.4 2,477.7 2,496.2 58.9 58.6 60.6 57.3 51.3 Investment Incentive loans 10.0 0.2 0.2 0.3 3.8 0.4 - - - 0.1 Treasury & promissory notes - 61.7 42.0 63.3 248.3 - 2.0 1.1 1.5 5.1 Stocks & bonds 373.9 468.9 596.4 827.0 1,028.2 13.2 15.2 15.5 19.1 21.1 Accounts & notes receivable 106.1 1.9 1.9 - - 3.7 0.1 0.1 - - Backpay certificates - 1.7 1.7 1.7 0.5 - - - - - Educational assistance loans - - 1.9 4.6 8.3 - - 0.1 0.1 0.2 Miscellaneous investments 28.1 40.9 39.0 37.9 21.1 1.0 1.3 1.0 0.9 0.4 Total 2,833.2 3,084.2 3,851.6 4,324.8 4,868.4 100.0 100.0 100.0 100.0 100.0 Source: GSIS, Financial Statements.  - 47 - Table 26: GSIS HOLDINGS OF STOCKS AND BONDS (as of July 31, 1978; Million Pesos) Amount % of total Private issues: 824.5 82.0 Common stocks 701.9 69.8 Preferred stocks 69.9 7.0 Debenture bonds/mortgage 47.7 4.7 Promissory notes 5.0 0.5 Government issues: 181.0 18.0 CPP 5.0 0.5 Land Bank bond 0.1 - DBP refunding issue 107.4 10.7 Promissory and Treasury 0.3 _ PNB bills 50.5 5.0 Notes 17.6 1.8 Total 1,005.4 100.0 Source: Data provided by GSIS. 5.09 GSIS also extends business loans to entrepreneurs to help finance projects. These loans have a maturity of 10-15 years, and are secured by mortgages. As of July 31, 1978, business loans comprised 23% of total portfolio, but were heavily concentrated in the hotel industry. An interesting feature of GSIS portfolio is their "acquired assets" which are assets which the GSIS acquired through foreclosure of mortgage properties. As of July 31, 1978, acquired assets amounted to P 2 billion, or 47% of total loans and investments. This is a particularly high proportion, and can in part be explained by the fact that four hotels are included in the acquired assets. Total GSIS investment in hotels is estimated to be P 1,186 million, or 24% of the investment portfolio. 5.10 Although both are government institutions, there are fundamental differences in portfolios of the GSIS and SSS (Table 27). The SSS is much less involved in direct investments than GSIS, preferring instead to invest in DBP and PNB. SSS also offers a wider variety of loans to policy- holders, and in terms of credit granted, lends more to policyholders than GSIS. Unlike GSIS, SSS has the major portion of its funds in short-term loans and investments (54% as of December 31, 1978 compared to only 7% for GSIS). This is because SSS has invested heavily in one-year PNB notes (41% of portfolio), yielding 12-14%. Most of the investments of medium or long-term are in the form of DBP notes, which are generally 3-year notes with a yield of 11-12%. 5.11 The private insurance companies are important institutional in- vestors on the securities market because of the regulation stipulating that domestic insurance firms must use 50% of their minimum paid-up capital in government securities. The total loan and investment portfolio of private insurance companies stood at P 3.6 billion in 1977, and was invested in almost equal shares between loans to policyholders (32%) and stocks and bonds (38%) (Table 28).  Table 27: LOANS AND INVESTMENTS OF SSS, 1974-78 (Million Pesos) Percentage of shares 1974 1975 1976 1977 1978 1974 1975 1976 1977 1978 Loans to Members 793.1 893.4 1,102.6 1,342.3 1,608.3 33.8 30.6 30.7 30.9 30.5 Salary/education 209.1 240.5 309.0 369.9 427.9 8.9 8.2 8.6 8.5 8.1 Student assistance - - 2.3 5.9 10.0 - - 0.1 0.1 0.2 Housing 583.1 652.0 790.5 966.2 1,170.2 24.8 22.4 22.0 22.2 22.2 Other 0.9 0.9 0.8 0.3 0.2 - - - - - Commercial & industrial loans 73.3 67.2 71.6 66.9 63.0 3.1 2.3 2.0 1.5 1.2 Corporate notes & bonds 52.4 51.7 51.6 50.9 53.7 2.2 1.8 1.4 1.2 1.0 Stocks 64.1 63.5 63.5 71.2 77.3 2.7 2.2 1.8 1.6 1.5 Government Debt 1,345.5 1,816.1 2,285.5 2,792.3 3,445.4 57.3 62.3 63.5 64.2 65.3 Notes 827.3 1,097.2 1,732.7 2,445.0 3,175.0 35.2 37.6 48.2 56.2 60.2 DBP 462.5 502.5 698.0 890.3 1,000.3 19.7 17.2 19.4 20.5 19.0 PNB 362.8 594.7 1,034.7 1,554.7 2,174.7 15.4 20.4 28.8 35.8 41.2 Treasury notes/bills 421.6 617.4 537.8 332.3 255.4 17.9 21.2 15.0 7.6 4.8 Government bonds 96.6 101.5 15.0 15.0 15.0 4.2 3.5 0.4 0.3 0.3 Other 17.8 18.7 21.2 24.5 29.0 0.8 0.6 0.6 0.6 0.5 Total 2,348.8 2,915.5 3,597.0 4,348.1 5,276.7 100.0 100.0 100.0 100.0 100.0 Source: SSS, Financial Statements.  Table 28: LOANS AND INVESTMENTS OF PRIVATE INSURANCE COMPANIES, 1973-77 (Million Pesos) Percentage of total 1973 1974 1975 1976 1977 1973 1974. 1975 1976 1977 Policy loans 411.2 461.8 530.0 612.6 707.5 18.4 18.4 19.2 18.4 19.6 Collateral loans 9.8 19.2 66.3 97.3 122.4 0.4 0.8 2.4 2.9 3.4 Mortgage loans 167.0 213.3 271.2 288.3 311.2 7.5 8.5 9.8 8.7 8.6 Real estate 359.2 326.1 306.3 323.6 389.9 16.1 13.0 11.1 9.7 10.8 Bonds 374.6 495.7 609.5 788.8 826.0 16.7 19.8 22.1 23.7 22.9 Stocks 545.8 453.7 461.7 636.1 553.1 24.4 18.1 16.7 19.1 15.3 Fixed deposits 21.7 24.0 22.4 34.5 53.9 1.0 1.0 0.8 1.0 1.5 Other 348.3 501.0 489.2 549.0 649.7 15.6 20.0 17.7 16.5 18.0 Total 2,237.6 2,494.8 2,756.6 3,330.2 3,613.7 100.1 99.6 99.8 100.0 100.1 Source: Insurance Commissioner, Annual Reports.  - 50 - 6. REGULATORY POLICIES 6.01 The surprising breadth of the present financial system witnesses to a conscious effort on the part of the authorities, especially since the 1950s, to support and strengthen the process of financial intermediation in the country. Generally speaking, however, the authorities' approach to this task has been fairly eclectic. When it was observed that commercial banks made little effort to penetrate the countryside and to supply financial services to its residents, a system of rural banks was set up (1952). When a rising demand for medium and long-term development finance was felt in the early years after World War II, development institutions such as the Development Bank of the Philippines (1947) and a number of private development banks (1959) were created or encouraged. Recognition of the unfulfilled credit needs of small-scale industries led to the creation of the National Cottage Industries Bank (1963). The perceived shortage of financial services in the Muslim provinces of Mindanao prompted the establishment of the Amanah Bank (1963). More often than not new financial institutions were "tailor-made" in the sense that the legal framework within which they operated reflected fairly rigidly the need--as perceived by the legislators--for additional financial services of particular types of potential customers. This approach to the organization of the financial sector has essentially pre- vailed to date./I 6.02 Various laws guiding the activities of financial institutions as well as the host of regulations in the form of Presidential Decrees and Letters of Instruction attest to the authorities' continued attempt to assign specific roles to each type of institution. As a result of the fairly high degree of legislated specialization in the financial system, some financial institutions were initially and are still constrained to provide a rather narrow range of financial services to a selected group of customers./2 Rural banks, for example, are essentially confined to supplying financial services to "small" investors and borrowers, where the term small is meticulously defined in terms of the number of hectares of land owned or cultivated by a farmer, or the size of the capital investment of a merchant or business enterprise. They may extend loans only against well-specified collateral, mostly real estate; customers with a satisfactory savings record but no collateral do not generally qualify for a loan, whether for consumption, home building or productive purposes. 6.03 Restrictions on rural banks' allocation of their loan portfolio attest to the authorities' intention to limit their activities to those areas where the greatest need for finance and specialized financial services /1 The establishment of a Home Mortgage Finance Corporation and Letter of Instruction 618 (1977) - creating a committee to study ways and means to establish a bank for cooperatives to finance their credit requirements - appear to be evidence of this proposition. /2 For a summary of present laws guiding individual types of financial institutions see Appendix 1.  - 51 - was perceived. Rural banks have to apply fixed shares of their credit to agrarian reform projects and to agriculture in general. These shares are still quite meaningful and cause no problem of compliance in the predominantly rural areas. They begin to constitute a severe constraint for rural banks in the Manila metropolitan area and in other areas where agriculture has been taken over by various types of industries as the main source of income of the population. Other regulations such as the fixed amount ceiling on capital investment (P 50,000) of a small business enterprise are easily overtaken by inflation and natural growth of enterprises. Such regulations hence imply that after the passing of the legal threshold the rural bank is prohibited by law from serving certain customers with whom it has built up a close business relationship. 6.04 Fairly rigid limitations on the type of operations and on the clientele exist not only for rural banks but also for the Veterans Bank, the National Cottage Industries Bank, the Amanah Bank, the private development banks, and savings and mortgage banks. The loan operations of most of those institutions are strictly defined in terms of purpose, collateral and maturity. Detailed legal regulations to that effect exist for such narrowly defined lending activities as: (a) loans secured by their own savings, etc., (b) loans to encourage breeding, raising and production of cattle, carabao and other livestock, (c) equipment loans, (d) loans for the acquisition of agricultural inputs, (e) mortgage loans, (f) real estate mortgage loans, and (g) loans secured by the pledge to the corporation of gold or silver bullion. The same regulations as above apply in principle to private development banks, some of which are already now additionally constrained by the obligation to apply 75% of their loanable funds to medium and long-term loans for economic development purposes and the remainder to short-term, essentially commercial banking activities. Various types of special regulations, some similar to those of other financial institutions, some of a rather different nature, guide the Veterans Bank, the National Cottage Industries Bank and the Amanah Bank. All these special regulations contribute to the high degree of fragmentation in the financial system. 6.05 Commercial banks are essentially exempt from the fairly strict assignment of functions to financial institutions. At the time the General Banking Act was promulgated commercial banks had grown into some sort of "department stores of banking" covering a wide range of financial services. While establishing detailed regulations for their maturities, the General Banking Act of 1948 left the already assumed range of functions of commercial banks essentially intact. Since the Act included no specific mention of certain financial activities for which demand was only gradually evolving, commercial banks were not explicitly prohibited from moving into new areas of banking services. 6.06 This situation changed in 1973 when the recommendations of the joint "IMF-CBP Banking Survey Commission of the Philippine Financial System" (September 1972) began to be reflected in the laws and regulations guiding the financial system. The most significant change introduced by a comprehen- sive package of measures consisted of the strict separation of "investment banking activities", which include above all the underwriting of government  - 52 - and corporate securities from "regular banking activities". With the promulgation of the so-called "Investment Houses Law" on February 15, 1973 underwriting activities as well as other related financial activities such as stockbroking and buying and selling of securities were now explicitly limited to investment houses. The purchase and sale of equities on their own account by institutions other than investment houses /1 was henceforth limited to a narrowly defined spectrum of allied undertakings such as (a) warehousing, leasing, storage and safe deposit companies, (b) companies engaged in the management of mutual funds themselves, (c) banks other than rural banks, and (d) such other similar activities as the Monetary Board may from time to time declare appropriate. All financial institutions other than investment houses were thus by law excluded from a type of business for which they themselves and their customers gradually developed a demand. An exception to the generally enforced separation of investment from regular banking is to date the Land Bank, the charter for which, as part of the Code of Agrarian Reforms, permits this financial intermediary to carry out simultaneously both regular banking activities and the full range of investment banking activities./2 6.07 A further major change in the focus and scope of the existing types of financial intermediaries resulted from the implicit definition of "icommercial banking functions" contained in the recommendations of the Joint Commission. The Commission suggested that demand or checking accounts were primarily a commercial banking function and should be strictly limited to commercial banks "which are functionally suited and geared to managing these funds for optimum use."/3 This recommendation led to corresponding changes in the General Banking Act when it was revised in 1973./4 Henceforth, only commercial banks and a few rural banks which had already, previous to the introduction of the new regulations, acquired the permission to accept demand deposits were permitted to offer this type of financial service./5 /1 The examples below apply to commercial banks only but are similar for other financial intermediaries. /2 See Sec. 75 (8) of the Code of Agrarian Reforms which gives the Land Bank the power to underwrite, hold, own, purchase, acquire, sell, mort- gage, dispose or otherwise invest or reinvest in stocks, bonds, deben- tures, securities and other evidences of indebtedness of other corporations and of the Government, which are issued for or in connection with any project or enterprise. /3 Recommendation 67. /4 Presidential Decree No. 71. /5 A revision of this rule took place in 1978 when permission to accept demand deposits and open checking accounts was given to thrift banks, but not to rural banks.  - 53 - A further implicit delimitation of "commercial banking business" resulted from Recommendation 76 of the Joint IMF-CBP Commission which advised in essence that savings and mortgage banks be restricted to dealings with small savers and borrowers since "These banks are essentially household oriented and foster the virtues of thrift, industry and frugality among the people. Therefore "invariably, they should basically service the needs of households for savings facilities, consumption credits, and long-term credits for home building and improvement". Savings and mortgage banks were thus not thought to compete with commercial banks for larger commercial and industrial customers. 6.08 The above and a number of other recommendations which prompted changes in financial sector laws either cemented existing specialization of financial institutions or created additional specialization through narrowing the range of customers an intermediary could serve, and of financial services it could provide. They also tended to reduce the scope for portfolio diversification of financial intermediaries. Judged against the already quite diversified and sophisticated demand for financial services, in the country, it appears that the reliance of the authorities on a high degree of speciali- zation in the financial system has already resulted in a formidable barrier to some institutions' ability to respond flexibly and dynamically to their customers' demands. 6.09 As the economy develops and the familiarity with and trust in financial institutions grows, changes in the type and the structure of demand must be expected from genuine changes in preferences, from cyclical and structural shifts in the economy, and from adjustments in the composi- tion of customers as a result of demographic changes. A low degree of responsiveness of financial institutions implies costs to both suppliers of financial resources (savers) and to the ultimate users of funds (borrowers/ investors). This, in turn, will tend to reduce the overall level of finan- cial savings and their useful and efficient employment for investment pur- poses. A narrowly focused specialization of financial institutions is thus prone to inhibit the economic development of a country in the long run. 6.10 The same holds principally true for a particular type of legislated specialization, namely the prohibition of investment banking activities by commercial banks. Commercial banks in the Philippines have the most extended and closest financial relationships with actual and prospective customers of investment banking services. If by law commercial banks are excluded from this type of financial activity they will be unable to respond to potential demand on the part of these customers for such services. They will, consequently, have to refer their customers, whose economic and financial status they know intimately and with whom they have built a close business relationship, to other institutions specially created for carrying out these investment banking activities. Such an enforced switch of financial inter- mediaries may involve friction and economic costs and can result in negative consequences for the economy. Legislated specialization in general, and an exclusion of commercial banks from investment banking activities in particu- lar, has to be justified on grounds other than the optimal responsiveness of institutions to customer demands.  - 54 - 7. FINANCIAL POLICIES 7.01 Financial intermediaries are strongly affected in their behavior by the implications of discretionary policy measures carried out by the authorities. The impact of these policy measures can influence the term structure of financial operations, as can a great number of other factors. Uncertainty is a constituent element of financial behavior. The more diffi- cult expectations formation, the greater the uncertainty and the smaller the preparedness of economic agents to enter into long-term financial commitments. A number of relevant economic variables considered to be of particular importance for the financial institutions and savers are presented in Table 29. They are money supply, domestic credit, prices (both domestic and foreign), interest rates and the exchange rate. The table shows the growth rates or levels of the variables, on a quarterly basis, over the period 1970-78. The coefficient of variation given at the bottom of the table is a measure of the stability of the growth rate for each of the items. These coefficients suggest that a comparatively high degree of uncertainty origi- nates abroad; the behavior of import and export prices, in particular, displays a high degree of instability. This constitutes a considerable risk for importers and exporting industries and creates adverse conditions for any long-term commitments, financial or other, on their part. In contrast to the erratic behavior of traded goods' prices, the authorities succeeded in keeping the exchange rate firmly under control. Though it depreciated by almost 40% over the period under review, this depreciation took place in a rather stable and predictable fashion and thus did not create too much uncertainty. By contrast the domestic money supply and though to a lesser extent - the credit supply, displayed a fair amount of variability as did consumer prices. In toto the data suggest that expectations formation was in aggregate not easy for economic agents in the Philippines. 7.02 As a result of its paramount importance for expectations formation in the financial sector the behavior of the money supply has been examined in more detail. Table 30 reports the results of an investigation into the growth, stability, and the contribution to changes in the money supply of all those factors which determine its behavior. For this investigation the supply of money is explained by the multiplier framework./l The multiplier and its components describe essentially the responses of the nonbank public and the financial sector to changes in preferences and to outside influences. The monetary base and its components, on the other hand, depict the influence of independently determined foreign and domestic policy factors on the money supply. The contribution of each of the components (the so-called "proximate determinants" of the money supply) is calculated for each individual quarter. The long-run contribution of a component over any period ("Absolute contribution: Mean" in Table 30) is simply the quarterly contribution added up over the whole period and then divided by the number of quarters in the period. The long-run relative contribution of a component (Percentage con- tribution: Mean) is obtained by dividing the mean of the individual quarters' /1 The method of calculation of the various entries in Table 30 is explained in Appendix 2.  - 55 - Table 29: THE STABILITY OF SELECTED ECONOMIC VARIABLES/ Money Domestic Consumer Export Import Exchange /b Period supply credit prices prices prices rate WAIR - 1970 I -3.21 2.02 4.56 35.24 38.42 5.27 n.a II 3.42 0.65 5.46 16.94 11.23 6.21 n.a III -0.08 3.11 3.93 4.18 -3.76 6.34 n.a IV 7.27 6.20 3.58 1.60 -3.50 6.44 n.a 1971 I 3.83 1.69 3.46 -5.53 5.76 6.44 n.a II 1.79 3.27 0.74 2.23 0.00 6.44 n.a III -0.02 1.13 6.81 10.90 -3.02 6.44 n.a IV 10.04 5.39 2.07 0.00 -2.50 6.44 n.a 1972 I -0.34 2.57 2.70 -5.16 4.69 6.44 n.a II 1.38 2.23 -0.16 12.69 0.82 6.78 n.a III 9.36 4.80 6.43 -1.15 -3.84 6.79 n.a IV 16.85 4.73 -3.57 -0.70 -5.67 6.79 n.a 1973 I 3.62 0.72 0.32 17.56 19.38 6.78 n.a II 0.12 0.52 4.97 2.79 25.93 6.77 n.a III 3.22 5.60 8.84 5.62 13.04 6.75 n.a IV 4.89 5.67 7.00 13.21 9.96 6.75 n.a 1974 I 5.12 11.33 9.82 20.91 18.12 6.73 15.06 II 6.17 5.02 7.27 25.07 22.00 6.73 19.65 III 6.04 10.77 8.11 0.54 -2.56 6.71 16.40 IV 4.74 8.28 1.95 5.01 12.14 7.01 22.07 1975 I 3.77 5.81 0.10 -2.54 -5.68 7.05 14.55 II 2.77 -1.78 -0.30 4.17 -14.85 7.03 10.40 III -2.21 11.22 1.62 0.90 -16.59 7.52 15.03 IV 9.79 13.64 0.40 2.08 -11.41 7.51 18.57 1976 I 1.78 8.17 2.28 -1.65 2.17 7.47 12.37 II 2.06 3.90 2.13 -0.69 10.74 7.44 11.85 III 2.86 1.90 2.18 1.39 3.83 7.44 13.11 IV 9.56 8.15 0.00 0.00 5.43 7.44 15.03 1977 I 4.63 1.34 3.15 5.00 -10.61 7.42 13.97 II 4.04 0.30 1.08 7.10 15.90 7.41 11.26 III -1.32 9.59 3.23 -1.31 -11.03 7.40 11.81 IV 15.18 8.93 1.90 -0.97 -4.36 7.39 12.74 1978 I 1.51 2.16 0.85 3.12 14.84 7.38 10.01 II -3.36 7.29 0.84 -2.08 -0.81 7.37 9.86 III 1.95 5.77 3.66 -0.71 -1.13 7.37 n.a IV 13.43 6.80 3.05 6.94 19.19 7.37 n.a Mean 4.18 4.97 3.07 4.23 5.08 6.92 14.10 Standard deviation 4.79 3.70 2.94 12.31 8.87 0.50 3.39 Coefficient of varia- tion 1.15 0.74 0.96 2.91 1.75 0.07 0.24 Source: International Financial StatTstics, IMF. /a Data on exchange rate and WAIR are levels all others are growth rates. No adjust- ments are made for seasonal influences. /b Weighted average interest rate of money Tnarket transactions. n.a = not available.  Table 30: CHANGES TN TIIE MONEY SUPPLY AND THE CONTRIBUTION OF ITS PROXIMATE DETERMINANTS TO THOSE CHANGES (Quarterly data: 1970 1 - 1978 IV; in per cent) Contribution of components of the multiplier Contribution of the components of the base AM/M C D ER RR Am/m NFA NCG COE CCB COF CBCI )NA ABS/BS I. Absolute contribution Mean 4.02 -0.41 1.99 -0.02 -1.90 -0.34 3.06 -0.03 0.03 0.98 0.86 -3.80 3.25 4.36 Standard deviation 4.64 -0.78 2.63 3 22 1.52 22.87 7.71 0.72 6.98 2-35 3.43 2'.28 Coeflici tot of variation 1.15 1.90 1.32 161.0 0.80 7.47 257.0 24.0 7.12 2.73 0.90 ".47 TI. Percentage-contribution M'ear /b 100 -10.2 49.5 -0.5 -47.3 -8.5 76.1 -0.7 0.7 24.4 21.4 -94.5 E).8 108.5 Average per ouarter influence /c l00 12.9 161.0 +10.8 -131.2 53.5 882.6 -357.2 -9.5 -52.8 48.9 -378.2 -87.1 46.5 o0 /a The money suipply definition examined here is narrow money, i.e., M = C + D. Due to rounding results may not add up exactly, /b The :Percentage contribution: Mean' is equal to the mean value of the respective components' weighted percentage change per qLuarter divi led by the corresponding oean value of M. It measures the contribution of the respective component to the growth of the money supply over the total )eriod ea. i ned. /c The Percentage contribution: Average per quarter influence" is the mean value of the individual quarter's ratio of the weighted percentige change in the respective component to the percentage change in the money supply. (See Appendix 2 for the calculation of the discrete time approximation ) Explanation or variables: M = money supply NFA = net foreign assets ONA = other net assets C = currenc. NCG = net credit to government BS = base money/reserve money. D = demand deposits COE = credit to other official entities ER = excess leserves CCB = credit to commercial banks RR = required reserves COF = credit to other financial institution5; m = money multiplier CBCI = Central Bank Certificates of Indebtedness Soulrce: Central Bank.  - 57 - contribution by the mean of the rate of growth of the money supply M/M over the entire period being examined./l 7.03 The average short-run (i.e., within the quarter) contribution of a component is calculated by first dividing its percentage change in each individual quarter by the percentage change in M in each of the same quarters, and then averaging the results for the whole period being analyzed. This figure, called the "average per quarter influence" indicates, by its size, the average thrust of this influence. As an example of the difference between this information and the mean percentage contribution, Table 30 shows that credits to commercial banks (CCB) accounted for 24.4% of the growth of the money supply over the period 1970 (I) to 1978 (IV), yet its average per quarter influence was -52.8%, indicating that on average over this period this component of the base moved in the opposite direction of the money supply within a given quarter. This implies that it had an offsetting effect on quarter-to-quarter changes in the money supply. Both the mean of the absolute contribution and that of the percentage contribution indicate that the behavior of the money supply is clearly dominated by changes in reserve money (BS). In fact, the contribution of the money multiplier to the growth of the money supply is negative. This is primarily due to the inclusion of required reserves in the multiplier rather than in the base./2 Changes in required reserves ratio and in the percentage to be held with the Central Bank as well as shifts in deposits with different legal ratios accounted for this negative influence. 7.04 Judged by the coefficient of variation, the most important sources of instability are (a) net foreign assets, thus supporting the above view that the foreign sector is an important source of instability in the financial sector, (b) central bank credit to commercial banks, and (c) its net other assets, a conglomerate of various entries not officially disclosed disclosed. Considerable instability is also observed for credit to other financial institutions. It appears, therefore, that the conduct of the Central Bank's lending policy is a major source of uncertainty in the financial sector. This only reflects the fact that, while open in principle, many discount windows are often partly closed for the purpose of monetary management and as a result of rearrangements of credit priorities. The former fact is clearly supported by the significant negative "average per quarter influence" observed for CCB. In contrast to the lending policy of the Central Bank its handling of certi- ficates of indebtedness displays a rather stable behavior. Over the period under the review the selling of CBCIs proved to be the most contractionary instrument and a fairly stable component of monetary policy. /1 The standard deviations and the coefficients of variation of the com- ponents' absolute quarterly contributions provide information about the relative stability of each component's average influence on the money supply. /2 This device was prompted by the inability, due to a lack of data, to distinguish between endogenous changes in total required reserves and those originating from official changes in reserve requirements.  - 58 - 7.05 The strongly allocative element inherent in the Central Bank's discount and advances policy constitutes in itself a formidable problem for portfolio management by financial institutions. In addition to its allocative task this policy is a major instrument of stabilization policy, a fact which results in frequent discretionary policy measures. This double function generates extreme uncertainty and creates almost insurmount- able problems for financial institutions. As a result the perceived risk of long-term commitments is high and the preparedness to engage in such activi- ties low. The implications for the term structure of lending are obvious. 7.06 Given the desire of the authorities to lengthen the term structure of lending, the above observations suggest that a rethinking of the conduct of monetary policy may be warranted. It could be asked, for instance, whether that part of Central Bank lending which is clearly allocative in thrust should not be entirely divorced from its presently simultaneous stabilization func- tion./l This would enhance the trust of ultimate borrowers in the availabil- ity of funds for priority projects. It would also facilitate expectations formation and portfolio management on the part of financial institutions. Uncertainty and risk on the part of financial institutions could be further reduced if the Central Bank engaged in a more active, nonallocative redis- count policy of the "lender-of-last-resort" type. The prior knowledge of the availablity of a limited but sufficient amount of short-term funds in cases of temporary liquidity shortages will enhance the preparedness of financial institutions to enter long-term commitments. Such a reorientation of the discounts and advances policy will necessarily reduce the short-run controllability of Central Bank lending under this scheme. By setting appropriate discount rates and rediscount quotas, the longer-run control- lability should, however, remain unaffected. In addition, a more flexible use of open-market operations via CBCIs or other types of financial instruments suitable for that purpose should greatly enhance the chances for effective monetary control even in the short run. As to the more important longer-run growth of monetary aggregates, other policy instruments such as required reserves ratios will remain a powerful tool of monetary policy. Whichever approach to the use of monetary policy instruments is adopted, it is crucial for improved expectations formation that the rationale of central bank monetary management becomes more clearly understandable and more predic- table. 7.07 The information contained in Tables 29 and 30 covers only a selected number of those policy measures which are of immediate quantitative impact. It gives an incomplete picture of the influence of the qualitative /1 If the sole or predominant purpose of the preferential rediscounting of a productive sector's liabilities is to subsidize its operations it might be preferable and more efficient to achieve this goal via fiscal policy measures. If on the other hand the predominant purpose is to guarantee this sector's access to financial resources the relative efficiency of prescribed lending ratios may occasionally have to be weighted against a discount policy as a viable alternative.  - 59 - policy measures on expectations formation. These qualitative measures are in the form of a host of Letters of Instruction and Central Bank Circulars. As far as they concern the type and scope of financial institutions' operations the proliferation of such Letters and Circulars lends support to the suggestion that some revision and consolidation of financial sector laws would permit a more dynamic and smooth operation of the financial sector in the future. 7.08 Relative returns on financial assets are, after taking account of uncertainty and risk, the primary determinants of the term structure of economic agents' portfolios of financial assets. Apart from differences in the real productivities of investments financed, relative effective returns on financial assets are predominantly influenced by various types of monetary policy peasures, such as prescribed minimum and/or maximum interest rates, reserve requirements, and credit controls. Furthermore, the relative tax incidence has an important influence on the term structure of portfolios. Legislative and regulatory measures which prescribe ratios and/or upper limits for financial assets by type of maturity, or which restrict the degree of term transformation by financial intermediaries may also be an important determinant of the term structure of lending. The total impact of monetary and fiscal policies has to be taken into account in assessing the impact of official intervention on the term structure of savings and lending. The response of individual decision-making units - savers, financial inter- mediaries and borrowers - to discretionary economic policy measures is discussed below. 7.09 Any lengthening of the term structure of lending for an increased level of capital investment would be expedited by a lengthening of the term structure of savings. To induce savers to invest their savings in longer term financial instruments the generally greater risk of such instruments has to be compensated by an appropriate term structure of effective returns. The authorities have attempted to use various policy instruments to achieve a more satisfactory term structure of savers' portfolios. The most important and frequently used tool was interest rate policy. Interest rates on savings and time deposits were periodically adjusted in order to raise the overall level of financial savings. Such adjustments have been exclusively in the upward direction since 1956. Despite this effort, the real return on finan- cial savings - measured by the difference between the nominal interest rate and the rate of inflation - was more often than not negative during the last 20 years (compare Table 31). Investment of financial surpluses in tangible assets appears to have remained a viable alternative to channeling funds through the financial system. Nevertheless, the ratio of domestic financial savings to nominal GDP has increased from about 7.2% in 1970 to about 13.8% in 1977. This growth in overall financial resources translates into an increased scope for long-term lending, the more so if accompanied by a shift of savings towards longer maturities. 7.10 Table 32 reports the development of various types of deposits and of deposit substitutes. Somewhat arbitrarily demand deposits and deposit substitutes have been aggregated as "short-term savings" while savings and  - 60 - Table 31: INFLATION, INTEREST RATES AND REAL INTEREST RATES (M) Savings deposits Time deposits Rate of Interest Real rate of Interest rate /b Real interest Year inflation /a rate /b return /c (360 days) rate /c 1959 -0.9 3.0 3.9 3.5 4.4 1960 4.2 3.0 -1.2 3.5 -0.7 1961 1.6 3.0 1.4 3.5 1.9 1962 5.8 3.0 -2.8 3.5 -2.3 1963 5.6 3.5 -2.1 4.5 -1.1 1964 8.2 3.5 -4.7 4.5 -3.7 1965 2.6 4.0 1.4 5.0 2.4 1966 5.4 5.75 0.35 6.5 1.1 1967 6.3 5.75 -0.55 6.5 0.2 1968 2.4 5.75 3.35 6.5 4.1 1969 2.0 6.0 4.0 7.0 5.0 1970 14.3 6.0 -8.3 7.0 -7.3 1971 14.7 6.0 -8.7 7.0 -7.7 1972 10.3 6.0 -4.3 7.0 -3.3 1973 11.0 6.0 -5.0 7.0 -4.0 1974 34.5 6.0 -28.5 9.5 -25.0 1975 8.2 6.0 -2.2 9.5 1.3 1976 6.1 7.0 0.9 10.0 3.9 1977 7.9 7.0 -0.9 10.0 2.1 1978 7.6 7.0 -0.6 10.0 2.4 Sources International Financial Statistics, International Monetary Fund and data provided by the Central Bank of the Philippines. /a Measured by changes in the consumer price index. /b Rates offered by commercial banks, rates by other financial institutions were generally 0.5% higher since July 29, 1974. /c The real interest rate is defined as the nominal interest rate minus the rate of inflation.  - 61 - Table 32: DEPOSITS AND DEPOSIT SUBSTITUTES, SHORT VERSUS LONGER-TEPJ4 FINANCIAL SAVINGS (Million Pesos, end-of-year data, 1969-1978) Short-term savings Longer-term savings Demand Deposit Savings Time deposits substitutes Total deposits deposits Total 1969 2,377.8 -- 2,377.8 3,769.2 1,575.3 5,344.5 1970 2,466.6 -- 2,466.6 4,587.9 1,808.1 6,396.0 1971 2,924.4 -- 2,924.4 5,455.0 2,307.8 7,762.8 1972 3,744.7 -- 3,744.7 5,752.1 3,150.3 8,902.4 1973 5,290.6 7,471.0 12,761.6 8,586.8 3,634.0 12,220.8 1974 6,078.9 12,681.1 18,760.0 10,715.1 5,086.2 15,801.3 1975 6,685.6 16,247.6 22,933.2 14,062.9 6,819.7 20,882.6 1976 7,500.6 17,453.8 24,954.4 16,133.6 10,247.1 26,380.7 1977 9,064.8 18,155.1 27,219.9 18,989.6 14,748.3 33,737.9 1978 9,768.2 19,363.0 29,131.2 24,539.1 20,676.1 45,215.2 Compound growth rates: (%) 1969-1978 17.0 n.a 31.6 23.1 33.1 26.8 1969-1975 18.8 29.0 /a 45.9 24.5 27.7 25.5 1975-1978 13.5 6.0 8.3 20.4 44.7 29.4 Source: Central Bank. "a For period 1973-75. n.a.= not available.  - 62 - time deposits are referred to as "longer-term savings"./I The data suggest that over the last ten years (1969-1978) short-term savings have grown faster (31.6%) than their longer-term counterpart (26.8%). This result is primarily due to the rapid growth--especially up to 1975--of deposit substitutes, a financial instrument which came into existence as late as 1973. For the earlier subperiod (1969-1975) demand deposits, the other component of short-term savings, grew at a somewhat slower pace (18.8%) than deposit substitutes. 7.11 Table 32 indicates that an important shift in the term structure of these major forms of financial savings took place after 1975. While between 1969 and 1975 longer-term savings grew at an annual rate of only 25.5%, com- pared with 45.9% of short-term savings, their rate stands at 29.4% for 1975 to 1978 while, over the same period the growth of short-term savings declined to 8.3%. This important shift can be attribittzl i A package of economic policy measures--the so-called seven circulars--introduced in early 1976. Circulars No. 492 and No. 493 of January 2, 1976 raised interest rates on savings deposits to 7% and rates on time deposits to 8.5-12%. At the same time Circular No. 493 introduced an interest ceiling of 17% for deposit subsitutes with a maturity of 730 days or less. Furthermore, effecttire kXpril 1, 1976, the minimum size of a single deposit substitute transaction was set at P 100,000 for maturities of 730 days or less and at P 50,000 for maturities of more than 730 days. Effective July 1, 1976 the respective minimum sizes were P 200,000 and P 100,000./2 Additional measures introduced reserve requirements on deposit substitutes of commercial banks at a level of 20% and raised those on deposit substitutes of nonbank financial intermediaries from 5 to 20%./3 7.12 Taken together these measures drastically reduced the attractive- ness of deposit substitutes and raised the attractiveness of time deposits. The increase in interest ceilings on time deposits and the i-mposition of an interest ceiling on deposit substitutes implied that, given their quarterly compounding of interest rates, especially longer-term time deposits, yielded a higher return than deposit substitutes with the same maturity. The increase in the minimum size of deposit substitutes made them a much more I)ilky savings instrument and excluded many small lenders - as -well as 1rcrowers from their use. The new reserve requirement regulation increa.?. ol`e cost of deposit substitutes to financial institutions to an amount equal /I The choice can perhaps be justified on the grounds that between 1975 and 1978 on average less than 0.5% of deposit substitutes of commercial banks had a maturity of 730 days and more while for time deposits the figure was about 10%. /2 See Circular No. 495 of January 2, 1976. /3 See Circular No. 495 and 497 respectively, both of January 2, 1976.  - 63 - to that of time deposits. In 1977 an additional policy measure, the imposition of a 35% transactions tax /1 on interest derived from commercial paper issued in primary markets, further reduced the attractive- ness of deposit substitutes. The tax compares with a 15% tax on interest derived fom savings and time deposits. The fact that during the period 1975-78 the growth of the sum of deposit substitutes and time deposits (20.2%) kept pace with that of savings deposits (20.4%) and exceeded by a substantial margin that of demand deposits (13.5%) indicates that the measures did not simply result in a substitution of time deposits for deposit substitutes but raised the overall level of longer-term financial savings./2 Table 31 suggests that this may be the result not only of the increase in interest rates on time deposits but its concurrence with a decline in the rates of inflation after their surge in 1973 and 1974: real returns on time deposits with a maturity of 180 days and longer became modestly positivze again in 1975. 7.13 Apart from raising the general level of interest rates the authori- ties also changed their structure in order to give an incentive to longerterm placements of savings. Table 33 indicates that the first major step in that direction was undertaken in 1974 when alongside a major increase in rates on time deposits a simultaneous increase in the spread between the rates for 90 days deposits and 360 days and longer deposits was introduced. This change in rates was followed by a further adjustment in 1976. The two policy measures resulted in a noticeable lengthening of the term structure of time deposits and deposit substitute liabilities of financial institutions, as can be seen from the data in the last column of Table 33. Separate data on the term structure of time deposits of commercial banks show that between 1975 and 1978 time deposits with a maturity of more than two years grew at a compound growth rate of about 65 percent annually while time deposits with a maturity of two years and below grew at a rate of about 21% only. The data thus suggest that economic agents in the Philippines are rather responsive to changes in both the level and the structure of interest rates. /1 Revenue Regulation 7-77 of June 3, 1977. /2 Substitution was important, however. It had its most serious repercus- sions for the quasi-banking activities of investment houses. Unlike commercial banks, for which the net effect of the substitution was prac- tically nil, the substitution implied a vast decline in their financial resources. Their share in financial assets declined from around 5% in 1974 to about 3% in 1978. The rather narrow sources base of investment houses' funds turned out to be a danger for their stability and viability in the face of a policy-induced shock.  - 64 - Table 33: INTEREST RATES ON TIME DEPOSITS AND GROWTH OF LONG-TERM DEPOSITS AND DEPOSIT SUBSTITUTES Deposits and deposit sub- stitutes (over 730 days) Interest rates on time deposits/La as a percentage of total Year 90 days 180 days 360 days 540 days 730 days deposit liabilities 1969 5.75 6.5 7.0 n.s. n.s. n.a 1970 5.75 6.5 7.0 8.0 n.s. n.a 1971 5.75 6.5 7.0 8.0 n.s. n.a 1972 5.75 6.5 7.0 8.0 n.s. n.a 1973 5.75 6.5 7.0 8.0 n.s. n.a 1974 8.00 8.5 9.5 n.s. 11.0 n.a 1975 8.00 8.5 9.5 n.s. 11.0 3.1 1976 8.50 9.0 10.0 11.0 12.0 3.8 1977 8.50 9.0 10.0 11.0 12.0 5.8e 1978 8.50 9.0 10.0 11.0 12.0 9.7e Source: Central Bank. /a For commercial hanks. As of July 29, 1974 rates for other financial institutions were generally 0.5% higher. As of the same date there was no legal limit on deposits with a maturity of more than 730 days. n.s. = not specified, generally equal to rate of next lower maturity. n.a. = not available. e = estimate.  - 65 - 7.14 The cost of deposit liabilities of financial institutions is essen- tially determined by legally prescribed interest rates. Financial institu- tions can only vary service or other nonprice measures to influence the term structure of their deposit liabilities. Differences in services offered and sometimes even the exercise of suasion on the part of financial institutions has had some influence on the structure of deposits. Differences in required reserves on deposits (and deposit substitues) also influence the behavior of institutions since, like interest rates, the required reserves ratio influences the effective costs of deposit liabilities. Initially demand deposits were subject to the highest required reserves ratio, thus making them the most costly type of deposits if viewed solely from the costs due to required reserves. Banks thus had an incentive to sell longer-term savings and time deposits rather than demand deposits. In 1965, and again as of 1968 to date, the incentive to seek other longer-term deposits instead of demand deposits has been taken away from commercial banks: all types of deposits are now subject to a uniform required reserves ratio. For rural banks this incentive still exists. As to the reserves ratio of time deposits in comparison to that of savings deposits their required reserves ratio has been the same for rural banks since 1975 and for thrift banks since the very beginning. At times, time deposits of commercial and rural banks had a lower ratio than savings deposits. On balance it appears that considerations other than the implied relative cost to financial institutions and the related incentives for achieving a desired term structure of deposits dominated both the level and the structure of required reserves ratios. 7.15 While financial institutions can only modestly influence the term structure of their deposit liabilities the situation is different for other liabilities such as borrowings fom the nonbank public, from other financial institutions and from the Central Bank. For this type of financial inter- mediaries' liabilities relative interest rates have an important bearing on the term structure. As to borrowings from the nonbank public and from other financial institutions, a major impact on the relative costs of such funds resulted in 1976 from the seven circulars mentioned above and in 1977 from the introduction of the 35% transactions tax. Since the overall level of effec- tive interest rates on short-term money market papers declined drastically, the investment of surplus funds for short periods of time with the intention of rolling them over became relatively less profitable in relation to an immediate longer-term placement. As a result a certain substitution of longer-term placement for short-term roll-overs took place: the term structure of money market transactions lengthened moderately in 1976 after the introduction of the above-mentioned policy package. The share of demand transactions, for instance, declined from 51% to 34% and the share of transactions of over 30 days increased from 27% to 31%. Equally, for the first time transactions with a maturity of more than 730 days were carried out, though on a very modest scale. 7.16 The term structure of borrowing from the Central Bank is primarily affected by the provision about maximum maturities for discounts and ad- vances and by the structure of interest rates charged. In the Philippines, however, an additional element plays an important role. Discounts and  - 66 - advances policy in the Philippines is predominantly allocative in nature. In order to assure priority sectors' access to credit at preferential rates, the Central Bank not only sets the rate at which financial institutions can acquire funds from the Central Bank but also fixes maximum rates at which these funds can be onlent. As a result it is not simply the discounts and advances rate which matters for the structure of lending but primarily the spread between the borrowing rate and the prescribed maximum lending rate. Table 34 gives an impression of the relative profitability of certain types of loans. To the extent that relatively profitable loans are also those with the longest maturity there will be an incentive to lend for longer-term rather than for shorter-term projects. Table 35 indicates that there are only two types of loans by the Central Bank which have a maturity of more than one year: IGLF-related loans and loans to long-term financing institutions against the pledge or assignment of payment, installments or amortization of their borrowers. The interest margin on these loans is fairly high by all standards but does not compare favorably with that on certain shorter-term papers/loans, especially if recurrent charges and commissions are added to the maximum base rate of return. Some moderate advantage is given for productive credits but in general it appears fair to say that no strong incentive to lend longer-term exists in the design of the Central Bank's discounts and advances policy. This policy instrument has been primarily used to influence the sectoral distribution of credit rather than the distribution by term of the loan extended to the ultimate borrower. 7.17 The data presented in Table 32 suggest that during the period 1975-78 longer-term deposits grew faster than shorter-term deposits and deposit substitutes. Taking deposit and other liabilities together it is apparent that the term structure of intermediaries' total liabilities clearly lengthened. As a result the ability to supply longer-term funds to borrowers without incurring liquidity problems was strengthened. However, evidence presented in Chapter 4 suggests that this fact was not reflected to any significant extent in the term structure of lending by commercial and savings banks, i.e., those financial institutions that benefited most from the restructuring of savers' portfolio after the introduction of the policy package in early 1976. On the other hand the seven circulars appear to have initiated a more important reorganization of the loan portfolio of nonbank financial intermediaries towards longer maturities./l 7.18 Given the paucity of detailed information on the term structure of banks' lending after early 1976 only a cursory interpretation of the data is possible. Two not unrelated major factors may account for the disappointing response of commercial and savings banks' lending structure to the lengthening of the maturity of, notably, their deposit liabilities. First, as has been discussed earlier, short-term lending appears to have remained more profitable than medium and long-term lending. Furthermore, /1 See Chapter 5, Tables 20 and 21. Since data on commercial and savings banks are on credits granted while those on nonbank financial inter- mediaries are on loans outstanding, no direct comparison of the actual behavior of these two types of institutions is possible. The choice of different sets of data was necessitated by the fact that corresponding data were not available for the respective other type of institutions.  - 67 - Table 34: INTEREST MARGIN BETWEEN CENTRAL BANIK REDISCOUNT RATES AND LENDING RATES OF BANKS* Maximum Discount lending Interest Type of paper/loan rate rate margin 1. Masagana 99 and Agrarian Reform a. Supervised l/a 12 11 b. Non-supervised 5 12 7 2. Gold and copper 4 6 2 3. Export activities a. Small scale 4 9 5 b. Other 5 9 4 4. >WDA and BOI/DOI listed small scale industries 5 12 7 5. Basic Group A 6 17-19 /b 11-131b Group B 7 17-19 /b 10-12/b Group C 8 17-19 /b 9-11/b 6. Emergency /c /b /c 7. CB/IBRD (6)9/d 12 (6)3/d 8. IGLF loans 7 12 5 9. Long-term financing /e /e institutions 6 12-14 6-8L- Source: Central Bank. /a For unsecured loans without guarantee coverage the rate is 5%. /b No administrative ceiling, but under Circular 494 interest rate p.a. shall not exceed 17% for loans with maturity of 730 days or less and 19% for loans with maturities of over 730 days. No administrative ceiling exists for the purchase of receivables with maturities of longer than 730 days. /c Rate is determined on the case-by-case basis. /d Rural banks obtain loans at 6%, other banks at 9%. /e Rate for secured papers is 12% and for unsecured papers 14%. * Note: Not all of the above listed categories are quantitatively equally important. The most important categories are items 1 and 3.  - 68 - Table 35: MAXIMUM MATURITIES OF DISCOUNTS AND ADVANCES Commercial Thrift banks banks OtherL-. 1. Production credits/b 360 days 360 days 2. Commercial credits 180 days 180 days 3. Advances against eligible government securities other than Treasury Bills 180 days 180 days 4. Advances against Treasury Bills 60 days 60 days 5. Export credits 180 days 6. Negotiated sight or time export bills 30 days 7. IGLF loans a. For working capital 3 years 3 years 3 years b. For fixed assets 5-10 years 5-10 years 5-10 years 8. Credit extended by long-term financing institutions 3 years Source: Central Bank. /a Nonbank financial intermediaries and other long-term financing institutions. /b Industrial and agricultural credits.  - 69 - short-term lending reduces the risk for the lending institution, especially since only short-term papers qualify for rediscounts while longer-term assets with an equal remaining maturity do not. 7.19 The behavior of the banks may reflect both the lack of competition especially among the group of commercial banks and the related high degree of power of individual financial institutions over borrowing customers, who are more often than not small in relation to banks. Lack of active competi- tion could then be said to be the second factor for the unsatisfactory term structure of lending. Short of imposing a minimum share of lending which has to be medium and long term, a policy-induced shift in relative profitability of lending, and measures to strengthen competition among institutions can be expected to achieve a more satisfactory term structure of lending. As to the level and structure of lending rates, it is obvious that - unlike the deposit rate policy - past lending rate policy has not succeeded in lengthening the term structure of lending. The above analysis indicates that a more important change in effective relative rates of return is necessary to compensate for the higher perceived risk of long-term commitments by financial institutions and to achieve a rate structure more closely geared to a lengthening of the term structure of lending. 7.20 As to nonbank financial intermediaries the lengthening in the term structure of loans outstanding can be fully attributed to the strong impact of the seven circulars on the structure of their liabilities. Since the ability to mobilize funds through the sale of deposit substitutes was reduced to an extent that threatened the viability of several institutions they had to give renewed and increased emphasis to their initial purpose: the mobilization and allocation of longer-term funds. The shift in the term structure of loans outstanding was most significant for investment houses, i.e. those institutions that had come to rely more on their quasi-banking business than on their primary purpose, namely the conduct of investment banking. 7.21 Not unlike the discounts and advances and the selective credit control policy, exchange controls have primarily aimed at influencing the sectoral allocation of funds rather than their allocation by maturity. The term structure of operations of financial institutions has remained little affected by such controls.  - 70 - 8. ISSUES IN THE DEVELOPMENT OF THE FINANCIAL SYSTEM General Objectives for the System 8.01 The financial system of the Philippines has shown remarkable growth in the 1970s and has reached a high level of maturity and sophis- tication. In general the system has served the country well. In the years 1970 to 1978 the country experienced a relatively rapid rate of growth while also experiencing adverse international developments. The evolving financial system helped to ensure that the financial implications of these developments were handled effectively. Perhaps the most striking aspect has been the way in which the money and banking system is adapting to the openness of the economy to international influences. Starting from a difficult balance of payments position in the early 1970s the external creditworthiness of the country was firmly established, and it was possible to increase net borrowing from abroad, both official and private. This increase in external borrowing established linkages between the financial system and the international banking network, itself developing rapidly during this period. 8.02 The rapid evolution of the financial system indicates a responsive- ness on the part of its component institutions to the intermediation needs of the economy. The system has mobilized a growing proportion of the country's savings in a financial form. It appears, however, that financial savings were still insufficient relative to the credit needs of the country. A conspicuous feature of the financial system was its failure to provide sufficient medium and long-term finance. As is quite common in developing countries, savers in the Philippines still have a pronounced preference for shorter-term, liquid forns of savings instrument. Recent policy measures have, however, indicated that savers are quite responsive to incentives which make longer-term savings instruments more attractive; the term structure of savings lengthened considerably. This change in the term structure of financial resources of the financial system was not reflected in a lengthening of the term structure of its assets, short-term lending continued to predominate. The lack of long-term finance presents the most important obstacle for a financially sound development of the economy in the future. The present reliance on short-term finance not only creates a climate of uncertainty for investors, and thus reduces capital formation, it also favors misallocation of existing financial resources, and thus reduces the efficiency of financial intermediation. 8.03 In considering the kinds of legal or institutional changes that might be undertaken it is necessary to postulate the objectives that are to be pursued. It should be clear from the above that there are two such principal objectives - to increase the total flow of financial savings intermediated through the system, and to increase the proportion made available on longer term. These objectives must be pursued in the light of a caveat, which is that any changes should also make the system more responsive to the changing development situation. A high degree of responsiveness to changing needs and demands is a key requirement for the  - 71 - contribution of individual financial institutions and the financial system as a whole to the economic development of the country. The present system of specialized institutions has led to a certain degree of fragmentation which tends to reduce the responsiveness of the system. 8.04 Since the early 1970s the financial system has been guided by the concept of specialization of function under the strong regulatory control of the Central Bank. Commercial banks in particular, are essentially limited to providing orthodox banking functions. Other functions were to be carried out by specialized institutions and the tendency has been to create new institutions as new needs were identified. 8.05 It is this concept of specialization that is now being challenged with the suggestion that the failure of the system to generate longer-term funds indicates the need to reconsider the philosophy behind enforced specialization. In particular the case for new specialized institutions requires special justification. Efficiency of Financial Institutions 8.06 One such justification would be if it were true that specialized institutions were more efficient than universal, all-purpose institutions. Broadly speaking, the efficiency of financial institutions can be said to depend on the existence of economies of scale in their operations and on the degree of financial stability. The former relates to some measurement of costs and output over a given period of time. The latter aspect deals with the proneness of types of financial institutions to variations in their liquidity, costs, earnings and output. It thus incorporates a strong dynamic element and bears upon such intangible characteristics of efficiency as the security of assets entrusted with a financial institution and the trust of the general public in the stability of such institutions. 8.07 Economies of scale in financial activities arise primarily from the indivisibility in financial assets, from cost reductions as a result of port- folio diversification and management, and from the presence of transactions costs. Scale economies are observed in individual types of transactions as well as in the overall size of the institution. An important characteristic is that they are not independent of a country's stage of development. If, for example, a country's demand for a given type of financial service is still very modest, a specialized institution is more likely to exploit potentially existing economies of scale in this particular type of service than an all-purpose institution which attracts only a minor share of the business. A high level of information about projects and customers is an indispensable input into the operations of financial intermediaries, since it crucially affects the risk of their activities. Information costs are thus an important aspect of economies of scale in financial intermediation. It appears that a broadly gauged institution which supplies a varied range of services to individual customers acquires, on a continuous basis and at a very low cost, a substantial amount of information on the financial position  - 72 - of its customers. Consequently it will rarely need to make additional in-depth investigations into the soundness of lending to customers who approach the institution for new, additional services. This represents a cost advantage of multipurpose institutions that translates into an advan- tage for the economy as a whole. 8.08 The financial system in the Philippines has reached a degree of overall size and sophistication which does not warrant legislated specia- lization in search of possible advantages from economies of scale. It seems furthermore that the exploitation of existing scale economies is missed as a result of too many institutions in the field./l 8.09 Financial stability, the second measure of the efficiency of finan- cial institutions, is primarily a function of risk of operations in which a financial intermediary is engaged. Risk, in turn, is a critical fuction of the level and the flow of information. Full information and perfect fore- sight would eliminate uncertainty and risk, but neither exists. 8.10 Abstracting from differences in the level and flow of information the exposure to risk of different financial institutions also depends upon the degree of term transformation, the degree of portfolio diversification, the efficiency of financial markets and the approach of the monetary authori- ties to accommodate financial institutions with temporary liquidity problems. 8.11 Term transformation involves the transformation of short-term lia- bilities of financial institutions into longer-term assets. A risk arises from the possibility that the owners of short-term liabilities may unex- pectedly decide to withdraw, or not to renew their financial position with internediaries. If financial institutions have extended longer-term loans on the basis of incorrect expectations, if furthermore, they have no sufficient primary or secondary reserves, and if, finally, the central bank is not prepared to accommodate them, they will be unable to meet the demand for a withdrawal of short-term funds. Similar problems of illiquidity can arise if loans are not repaid on time. The risk involved in term trans- formation will also generally increase with the degree of term transformation, e.g. short into medium, or short into long term, and with the percentage of short-term funds that is transformed into longer-term lending. 8.12 Some amount of term transformation is obviously possible with- out endangering the liquidity of a financial institution because, although funds are invested only for short periods of time, a core of these funds - mostly deposits of all types - remains permanently available for investment by financial intermediaries. The percentage of total short-term resources which /1 No empirical research could be carried out to support this contention. Most data needed for such an exercise are available to the research department of the Central Bank who should be encouraged to carry out the studies.  - 73 - forms the core of such resources may vary from country to country. It depends primarily on the growth rate of these funds and on the stability of the growth path. In order to investigate this question for the Philippines some simple econometric research on demand, savings and time deposits as well as deposit substitutes was carried out and is reported in Table 36./1 The results suggest that of all types of financial instruments included in the analysis time deposits grew the fastest and deposit substitutes the slowest. The growth path was most stable for savings deposit, (as witnessed by the highest t-value) followed closely by demand deposits. The percentages reported in column 3 of Table 36 will be indicative of the percentage of the respective financial instrument that will, despite its short-term nature, still be available to financial intermediaries in the next period. A surprisingly high percentage of such short-term funds as demand and savings deposits can be relied on to be available over more than one period. As expected the percentage core is even higher for the average measure of future periods, as given in column 4 of Table 36. Table 36: DEPOSIT GROWTH, STABILITY AND STABLE CORE, QUARTERLY DATE: 1970 (I) - 1978 (IV) Estimated percentage core of deposits /a Quarterly rate First period Average for of growth outside the future Rate t-value sample periods Demand deposits 4.33 35.2 87.2 95.8 Savings deposits 4.13 41.2 89.4 96.6 Time deposits /b 6.57 10.6 50.2 80.6 (14.20) (22.2) (81.0) (94.3) Deposit substitutes 3.47 9.3 84.2 94.8 "Short-term deposits" /c 6.15 24.8 75.9 91.7 /a Results are based on one tailed calculation of 95% confidence interval. /b Data in brackets cover the period 1975 (I) to 1978 (IV) to take account of the fact that the total period saw two distinct subperiods with a different behavior of time deposits. This fact was not appropriately taken account of by the linear regression applied to the total period estimate. Ic "Short-term deposits" is the sum of demand and savings deposits and deposit substitutes. Source: Central Bank. /1 See Appendix 3 for the method of calculation.  - 74 - 8.13 On balance the results of Table 36 suggest that a relatively fast- growing core of short-term sources of funds exists in the Philippines, that this core is fairly stable, and that, consequently, an important percentage of these funds could be used for longer-term lending without endangering the liquidity of the financial system. However, the results apply to the financial system as a whole and not to individual financial institutions. Some of them may well be subject to slower and less stable growth of deposits and deposit substitutes. Furthermore, the investigation takes a look at only one side that may cause liquidity crunches, namely the funding side. Arrears in loan repayments may cause additional, and possibly simultaneous, problems from the uses side./_ Both factors will tend to reduce the extent of term transformation that is possible for individual financial institutions without endangering their liquidity. On the other hand, the existence of an active interbank loan market or other money and capital markets which allow for the flexible transfer of funds from institutions with excess liquidity to those with deficiencies makes the aggregate figures reported in the table, the more important ones for policy formulation. Also, to the extent that the Central Bank stands ready to finance short-term deficiencies in the system as a whole, the more relevant results are those reporting the average percentages. Central Bank policy is thus crucial for the degree of safe transformation. 8.14 Differences among financial institutions in the exposure to risk exist not only as a result of their differential degree of term transformation but also as a result of differences in the degree of portfolio diversification and the range of liabilities undertaken. Such diversification can reduce total portfolio risk and, although a specialized institution will have some scope for diversification, this is bound to be smaller than that of a broader based institution. The overall risk of a multipurpose institution will, therefore, generally be significantly lower and the earnings performance tends to be more stable. 8.15 This finding has a bearing on the question of whether investment banking activities and commercial banking should be kept separate. There exists, as a result of their substitutability, a frequent movement in opposite directions of security and equity business, on the one hand, and loan business on the other. This provides an argument in favor of combining commercial and investment banking under one roof, because such an arrangement stands to increase the stability of earnings and asset values of financial institutions and tends to reduce the risk of bank failures. Commercial Banks and the Development of Financial Markets 8.16 Financial markets complement the activities of financial interme- diaries. Through raising the liquidity of assets and lowering the risk of their acquisition they increase the efficiency of institutions and the use of /1 Quantitative information on repayment performance which could have allowed for further empirical research was not available to the mission.  - 75 - financial resources. Financial markets also act as catalysts of financial intermediation for the economy as a whole. 8.17 While money markets are well-developed in the Philippines this is not true for capital markets, which are still fairly undeveloped. One of the reasons why longer-term commitments on the part of economic agents are of so little importance is that the capital markets are not operating well enough to reduce the risk of such commitments. This question is relevant to the proposals being discussed to permit commercial banks to invest in equities, or to engage in investment banking activities. Support for these proposals stems from the observation that it may not be possible to develop capital markets in the Philippines further without giving a direct stake in them to commercial banks, which command the overwhelming share of all financial assets of the financial system. 8.18 The development of financial markets depends crucially on the demand for the services they offer. Different kinds of financial institu- tions are likely to have a different need for such services, in particular for the markets' contribution to reducing the risks of illiquidity. For example, the risk of extensive term transformation--including the acquisi- tion of long-term securities and of equities on the basis of essentially short-term liabilities--declines with the ability to liquidate such assets when necessary. The ease with which such operations can take place and the costs involved depend crucially on the efficiency of the relevant markets. Given these observations it appears natural that financial institutions which engage heavily in term transformation will have a great need for, and thus a fundamental interest in, well-developed capital markets. 8.19 A further point of importance for the development of capital markets is the accessibility--direct or indirect--of markets to savers and investors. Accessibility is partly a question of the breadth of the network of institutions directly involved in transactions in these markets. At present economic agents who are financially strong enough and possess the necessary sophistication to invest their financial savings in securities and equities are heavily concentrated in the urban areas of the Philippines and can thus be reached by the few outlets of investment houses, brokers, etc. However, as the country develops, more savers will reach the stage at which such investments are a realistic alternative to time and savings deposits. In order to fully tap these savings and thereby lengthen the term structure of resources a large network of branches is necessary. This will also be supportive of a wider ownership pattern of securities. 8.20 In spite of the above arguments, it is often doubted that commercial banks would get involved in investment banking. However, if relative effective returns are favorable, there is no a priori reason to assume that commercial banks would not be interested in investment banking activities. It appears also to be in their own interest as lenders to ensure that their customer's debt-equity ratio is financially sound. As a result they may even want to urge certain of their borrowing customers to go public or to extend their capital base by floating new issues of shares. The fact that a  - 76 - number of commercial banks have acquired sizable trust departments and already have some experience with capital markets should help them to reach a sufficient level of expertise within a short time. 8.21 In summary there is no reason to believe that a less specialized banking system would neglect the development of capital markets in the Philippines. In fact there are good arguments to support the contention that allowing commercial banks to compete with investment houses, brokers, etc. would increase competition and thereby step up the development of securities and equities market and enhance their efficiency. Concentration, Market Power, and Conflicts of Interest 8.22 Although the financial sector is characterized by a very large number of participants it does not automatically follow that the financial system is highly competitive. A large number of institutions in itself does not guarantee competition, and in particular, it does not guarantee that institutions compete on even grounds. Concentration in the financial sector tends to create excessive market power for a few institutions. Market power, in turn, will reduce the economic efficiency of the financial sector as a whole, because credit will tend to be misallocated and extended at a high cost. Also the range of financial instruments offered to savers will generally be narrower and not be supplied on the best possible terms. The size distribution of financial institutions is, therefore, of some importance. Since, however, financial institutions frequently do not com- pete with each other over the entire spectrum of financial services, it is often more important for active competition to ensure that individual institutions do not achieve a dominating influence in any one activity. This suggests that the absolute size of a financial institution does not necessarily imply that it possesses excessive market power, nor does it imply that an institution which is small cannot possess such power in any single market. 8.23 The prospects of increased concentration of market power and of conflicts of interest are most frequently mentioned as objections to commercial bank participation in equity, beyond their present powers to do so. While the possibility of this happening requires guarding against, the net effects upon the concentration of economic power may well be small. There are already close informal links between banks, business groups and other financial institutions. Such informal links might well tend to become formal and thus more visible and controllable. 8.24 Conflict of interest situations may develop when banks obtain more immediate access to the internal information of a company in the course of their normal business. If, in addition, the bank acquires equity in the company, conflicts might arise through the bank having access to information not available to other shareholders. The closer association of banks and industries need present little conflict of interest in principle, because growth and profitability of banks and industries would be of mutual interest  - 77 - to both groups. However, much will depend on the conditions under which banks are permitted to invest in equities and whether they will be permitted to hold a controlling share of the stock of corporations. 8.25 Emphasis should be placed on the importance of active competition in the financial sector, as a means of reducing excessive market power and conflicts of interest. The case for competition is strengthened by the general observation that it is primarily competition which is the driving force behind innovation. Measures to ensure active competition are at the core of any consideration of a possible reorganization of the financial sector in the Philippines. The present specialized and, therefore, frag- mented system is an obstacle to the promotion of further active competition. The Implications for Monetary Control 8.26 If a particular financial system makes monetary control by the authorities difficult or even impossible, this would be a strong argument against it, despite any advantages it might otherwise have. It is necessary to see whether additional problems of monetary control would arise if it were decided to reduce the degree of specialization and to move towards a more universal banking system. 8.27 Monetary theory and quantitative evidence on the Philippines and other countries suggest that the above recommendations about the reorgan- ization of the financial system should not have any serious implications for monetary control. Both the growth of the money and the credit supply are dominated by movements in the monetary base (reserve money). The money and credit multipliers are observed to be stable in the medium and long run. In the short run, they do, however, display a certain degree of variabilli-y reflecting adjustments to outside shocks and shifts in preferences. These adjustments are due to attempts on the part of the nonbank public and financial institutions to reduce the costs associated with immediate and full adjustment to such shocks. In fact, as shown by econometric studies, the more flexible adjustments in the multiplier, the less severe is the impact of outside shocks on ultimate goal variables, such as GDP, prices and foreign exchange. An increased degree of responsivenes of the financial system can thus through its influence on the multiplier be expected to enhance the stability of major ultimate goal variables of economic policy. As to shocks arising from monetary policy measures, it is apparent from a number of econometric studies that the response of the money and credit multipliers to the use of various types of monetary policy instruments is rather stable and predictable. The net impact of such measures caa thus be estimated quite accurately. 8.28 While no serious problems for monetary control should be expected from movements in the money and credit multipliers, the authorities should be aware of certain repercussions from a liberalization of financial sector activities on the control of the monetary base. Any opening up of the financial system will have to be accompanied by appropriate supporting monetary and fiscal policy measures in order to strengthen the effects of an  - 78 - increased responsiveness of the financial system on the efficiency of finan- cial intermediation. Apart from such important policy variables as the level and structure of interest rates, special attention has to be given to a more demand-oriented central bank policy. This applies in particular to the assurance of short-term accommodation in cases of deficiencies of financial resources; more specifically, it applies to the "lender-of-last-resort" function of the Central Bank. The assurance of such credit reduces the short-term liquidity risk, facilitates portfolio management and lengthens the time horizon of financial institutions. It would, thus, be conducive to longer-term commitments on the part of financial intermediaries. At the same time, however, such an approach to Central Bank policy will make the short-run control of at least one part of the monetary base more difficult, namely, the size of loans granted as a result of the discounts and advances policy. As this instrument is allowed to respond more flexibly to the demand of financial institutions, it becomes at least partly passive. By reducing the allocative element of its rediscount policy, which carries an expansionary bias, by setting appropriate discount rates and by adjusting rediscount quotas as warranted by the overall monetary situation, the Central Bank will, however, maintain a strong influence over the borrowing of financial institutions. Furthermore, policy instruments such as required reserve ratios and open- market operations by use of CBCIs or similar liabilities of the Central Bank can be used more actively to assure that the longer-run behavior of the credit and money supply, while adjusting more flexibly to short-term swings in demand, remain firmly under the control of the monetary authorities. The compatibility of such policies with the objective of internal and external stability can be assured as long as the Central Bank remains committed to controlling the monetary base in line with the requirements of these objectives. 8.29 Apart from the overall macro-economic control a change in the set up of the financial system may conceivably increase the problems of bank super- vision. The combination in an all-purpose banking system of a spectrum of financial services under one roof and the accompanying increase in the scope for extensive portfolio management does make bank supervision more difficult. However, problems will arise only if the degree of sophistication of bank supervisors does not keep step with that of bank managers. Furthermore, special requirements for the presentation of information, e.g., a separation of data on commercial and on investment banking business, will facilitate the task of supervisors. The Scope for Action 8.30 The scarcity of long-term domestic savings being made available for investment has been identified as a key problem in development finance. At the same time it is apparent that the specialized institutions set up to raise such funds have not been successful, while the commercial banks have emerged as the prime mobilizers of financial savings. The question arises, therefore, whether some prudent proportion of these deposits with the commercial banks could not be tapped for medium or long-term investments. Whether this coulld hk done without changes in the legal and institutional framework depends  - 79 - upon the extent of the changes envisaged. A spectrum of possibilities is reviewed below, beginning with greater incentives for longer-term borrowing and lending within the existing framework. In any case the emphasis should be on improving the intermediation process. The unique position of the commercial banks leads to the expectation that they have a leading, catal,ytic role to play. 8.31 Creating the correct environment through an appropriate regulatory framework and policies would be the first step in the direction of bringing about the required changes. Different regulations and laws will not, by themselves bring about desirable changes in financial operations, but the thrust of financial policies aimed at some liberalization of restrictive regulations can encourage institutions to move in the right direction. Similarly, appropriate changes in monetary and fiscal policies along the lines suggested above, would encourage banks to play a bigger role in channeling funds into long-term uses. 8.32 The criterion for any such changes must be their impact upon the relative profitability of bank activities. Banks have, in the past, found it more profitable to lend short term, preserving at the same time a maximum flexibility regarding lending rates and resource availability. The renewal, or roll-over, of long-term loans documented as short-term credit generated additional and recurrent fee and commission revenues. The situation will not change easily or quickly until long-term lending becomes relatively more profitable. 8.33 A direct increase in the amount of medium and long-term lending by the commercial banks would be the simplest way to increase the flow of longer- term financing, and would not require any change in the laws and regulations. Term lending is not a totally new practice for Philippine banks and, although the statistical picture is not clear, there is impressionistic evidence suggesting an increasing interest in such lending. The more dynamic banks successfully made a few term loans after the interest rate reforms of January 1976. Further progress will be slow, since it requires a change in the time horizon of the borrowers, as well as the bankers. Given the appropriate structure of interest rates and the right encouragement from the Central Bank the practice could grow. For the banks to step up their role they would either have to expand their long-term funding base, or become more active in term transformation. While there has been some encouraging growth in long-term deposits, a reliance on growth through the matching of maturities would only permit a rather gradual expansion of longer term lending. 8.34 Term transformation would allow a more immediate impact on long- term lending, drawing on the significant volume of "core" deposits which normally would not present any major liquidity risk if lent out for long or medium term. In the past the Central Bank has at times closely monitored the matching of maturities between the deposit base and the loan portfolios of the banks, having occasionally issued specific instructions requiring the matching of maturities. More extensive long-term lending through term  - 80 - transformation need not be hindered by such regulations, which do not appear to be enforced at present. Rather a wider application of term transformation could be actively encouraged and is possible without changes in the law. For the reasons discussed earlier term transformation should be closely monitored by both banks and the Central Bank and should be kept within prudent limits. 8.35 Another direct way in which banks could extend more longer-term lending would be by expanding their portfolio of corporate bonds. The holdings of bonds by commercial banks are currently limited to 20% of total bank deposits, for bonds with a remaining maturity of more than three years. However, this could be waived without legal change, because the Monetary Board is authorized to grant exemptions from this limitation. Indirectly, commercial banks could subscribe to the bonds of development banks and make more funds available to them for long-term financing. Other indirect ways of extending longer-term credit are possible, such as the practice that commercial banks have entered into in recent years of syndicating loans. 8.36 One idea which has been discussed is that a portion of the required reserves of a bank in the Central Bank should be released for term lending purposes. This would not be desirable, because it vitiates the purpose of a reserve requirement, which is to control credit and the general level of liquidity and to safeguard the solvency of the monetary system. What could be considered is an application of the alternative principle of using reserve requirements for allocative purposes. The long-term debt instruments of financial institutions could be exempted from reserve requirements (as is already done in the case of time deposits with maturities of two years or more). These instruments could take the form of debentures, certificates of deposit or capital notes. For example, long-term certificates of deposit, if made negotiable, could have liquidity and marketability, with yields streamlined according to the terms. Similarly, if capital notes are subordinated, they would have a quasi-equity characteristic and would help strengthen the banks' capital base through a convertibility feature. 8.37 As with bonds, so with equities: the banks would be able to extend longer term finance, if they were able to take up equities beyond the present restrictions which virtually debar them from all but investments in "allied undertakings." This possibility would require a change in the present laws. It is clear that direct equity investments by banks presents quite different features compared with other forms of assets. The most obvious are that there is no definite maturity, and there is no guarantee of a yield in the form of a dividend; as with bonds, there are possibilities of both capital loss or gains. 8.38 Banks could also engage indirectly in equity finance through underwriting, thus performing the functions of an investment house. This would place commercial banks in direct competition with the existing investment houses, although this is perhaps less a conflict than it appears, when it is recalled that the present investment houses have close links with the banks and are also actively involved in the money markets.  - 81 - 8.39 Banks' participation in equity finance and underwriting would lend institutional support to the thin securities market and help broaden the ownership of corporate enterprise by attracting other potential investors. The scope for individual investors in the Philippines is still largely limited to deposits and insurance as the main outlet for their savings; banksupported securities might be linked to and made conditional upon other requirements and restrictions aimed at other public holdings of equities and the opening up of closely held corporations. The conditions under which the commercial banks could invest in equities need to be carefully considered so as to ensure that the banks would have an interest in the size and strength of secondary markets, which would be their firstline source of liquidity. 8.40 There are other possible changes in the financial system which would help to open it up and strengthen it. They are: further increases in the capitalization of the commercial banks; further mergers of commercial banks; broadening the ownership base of banks and the integration of banks and other related financial intermediaries. 8.41 Further increases in the capitalization of the commercial banks would increase their long-term resources and their potential for term lending and equity financing. There has been a rapid growth in the capital accounts of the private banks in the last five years and, although part of this growth was due to inflation, in general the banks seem to have accepted the need to change their standards as the economy grows and develops. The average size of private banks in the Philippines is smaller than that of banks in other comparable developing countries and increases in size and possible mergers should be encouraged. Larger institutions could take advantage of economies of scale and would be able to operate more effectively in some of the newer fields such as international banking. 8.42 Another objective behind the requirements on the banks to increase their minimum capital was to broaden the ownership base. It is difficult to obtain information about the ownership pattern of banks, but impressionistic evidence suggests that perhaps the only diffusion that has taken place has been through family members and friends, especially in smaller, family- oriented banks. The general explanations for the present weakness of the securities market and the lack of a wider public ownership apply equally to banks participation in the stock market. One way to encourage a bigger par- ticipation might be to link the right of banks to carry out equity financing to those that are prepared to broaden their capital base and list their stocks. 8.43 The above discussion has been largely concerned with the commercial banks as the most important institutions in the financial system. The suggestions made would give them freedom of action to carry out more extensive long-term lending, in an environment in which they would find such investments profitable. The other institutions in the financial system would necessarily regard these freedoms as encroaching upon their activities, currently reserved  - 82 - to them, in some cases, by legislated specialization. To preserve the balance and to ensure that the system, as a whole becomes more competitive, considera- tion should be given to permitting more freedom for other institutions to engage in activities which have up to now been reserved to commercial banks. For example, the right to accept demand deposits, now limited to commercial banks and thrift banks, could be extended to rural banks and the general right to acept deposits to other quasi banks, subject to the appropriate reserve requirements. 8.44 It is not expected that any such changes will immediately result in rural and private development banks reaching a size where they would compete individually with commercial banks. As mostly unit banks, with limited local importance, they nevertheless perform functions which have not been carried out by commercial banks. As regional development proceeds in the Philippines, the importance of local financial institutions will increase, while the branch network of the commercial banks will grow as well. Greater use, at lower cost, could be made of the rural bank network already serving the regions. In order to enable them to make more use of their human and financial resources and to react flexibly to their customers' needs they should not be overly constrained in their activities. At the same time, they often have only a modest degree of expertise and need assistance to expand activities. One way to provide greater strength for both the rural development banks and the small development banks would be to establish regional institutions or associations of such banks to provide common services on a larger scale. An alternative approach, if the creation of regional associated institutions is not possible or acceptable, would be to establish a relationship with an existing national organization in the same field. An obvious possibility for the rural banks would be the Land Bank and for private development banks the Development Bank of the Philippines. 8.45 The above recommendations will eventually necessitate substantial changes in the legislative framework guiding financial institutions. Given the complicated structure and complexity of present laws, a general review and consolidation of the legislative framework appears to be desirable in any case. The above proposals are all aimed at mobilizing more savings in a financial form, and making it possible to utilize a larger proportion of those savings for medium and longer-term lending. While the central proposal made - that there should be a less specialized banking system - will make it possible to move towards those objectives, it will not guarantee success. A number of other complementary factors need to be taken into account, notably monetary policy, interest rates and fiscal measures./l 8.46 The conduct of monetary policy is obviously a major determinant of financial sector behavior. In the past it has not always been conducive to encouraging financial intitutions to engage in longer-term commitments. Both individual monetary policy measures and the comprehensive and growing body of instructions and regulations have created a feeling of uncertainty in the /1 It lies outside the scope of this report to examine any of these problems in detail. Such an examination requires special in-depth studies. Some more general observations are, however, made below.  - 83 - financial community and shortened its planning horizon. In particular, the simultaneous discretionary use of the discount and advances policy as an allocative instrument and a stabilization policy instrument has not only generated a formidable pro7olem for portfolio management but also raised the risks for longer-term commitments on the part of financial institutions, and has possibly discouraged such commitments. In addition, assured "lender-of- last-resort" facilities are practically nonexistent. Both factors severely reduce the preparedness of financial institutions to engage in longer-term commitments. Apart from the risk factor described above, relative profitability is of foremost importance for financial sector behavior. 8.47 A major element of the financial environment relates to the level and structure of interest rates. The reforms of 1977 had an important impact on the term structure of interest rates when both the deposit and lending rates for longer-term maturities were increased compared with the rates for short-term maturities. While on the liabilities side, this resulted in a significant increase in the longer-term deposits, it had very little impact on the assets side in terms of extending the maturities of loans. This could be explained on the grounds of profitability, liquidity and risk. The practice of putting on additional charges on short-term loans made these loans more profitable for the banks. The banks could always maintain their liquidity profile by lending on short terms. Similarly, banks still prefer a collateral-based and less risky short-term lending compared to a project- oriented lending which involves higher costs and carries higher risks especially for those institutions not geared to this form of lending. At the same time, borrowers may continue to have a preference for short-term loans because of the changing expectations of policy measures and economic environment including inflation. Unless the effective differentials between the short and long-term lending rates reflect sufficiently the difference in perceived risks, and expectations of loong-term rates are reasonably stable, it would be difficult to expect a rapid development of term lending. 8.48 Another major determinant of economic behavior is the taxation regime. There is first of all the tax system's general impact upon incomes, savings and investments, which determines the pattern of behavior of lenders and borrowers. Secondly, specific taxation measures have been used to influence the form in which finance is made availabe, as in the case of the 35% tax on money market instruments. Given the fact that participants in the financial system tend to belong to the richer groups in the economy, they are likey to be more heavily affected by taxation, at the margin, and thus more sensitive to its impact. There may be conflicts, therefore, between the general aims of the tax system, especially in terms of its incidence and the use of taxes to encourage particular patterns of response by borrowers and lenders. Fiscal incentives could be devised to provide more attractive after-tax yields for lenders and lower effective rates for borrowers. However, their benefits need to be weighed against the loss of revenues involved and consistency with other broader fiscal objectives.  - 84 - Appendix 1 Laws and Regulations Governing Financial Institutions A. Commercial banks 1. Activities permitted by law-/ (1) Accepting demand, savings, and time deposits (2) Accepting drafts (3) Issuing letters of credit (4) Discounting and negotiating promissory notes, drafts, bills of exchange and other evidence of indebtedness (5) Buying and selling foreign exchange, gold and silver (6) Lending money against personal security or first mortgages on improved real estate and the insured improvements thereon (7) Buying and selling of high-grade bonds and other evidences of indebtedness (8) Receive in custody funds, documents and valuable objects, and rent safety deposit boxes for the safeguarding of such effects (9) Act as financial agent and buy and sell, by order of and for the account of customers, shares, evidences of indebtedness and all types of securities (10) Make transfer payments (11) Invest in equities of allied undertakings (warehousing com- panies, leasing companies, storage companies, safe deposit box companies, companies engaged in management of mutual funds, banks other than rural banks and other institutions permitted by the Monetary Board) (12) Purchasing, holding and conveying real estate for specified purposes (13) Issuing deposit substitutes (14) Administering trust funds/engaging in the trust business (15) Accept foreign currency deposits and accept such deposits as collateral for loans (16) Enter into SWAP/RP arrangements with the Central Bank of the Philippines 2. Restrictions imposed on size of operations (1) Loans on real estate security of over one-year maturity for real estate, personal, and commercial purposes, or for the refinancing of such loans, shall not exceed fifty per cent (50%) of the total savings and time deposits of the bank (Sec. 21) 1/ Services (l)-(7) derived from Section 21, (8)-(10) derived from Section 72, (11) from Section 21A, (12) from Section 25, (14) from Section 57, all from the General Banking Act, and (15) from R.A. 6426/P.D. 1035.  Appendix 1 - 85 - A. 2. (2) Investments in securities having maturities greater than three years from date of acquisition are limited to twenty per cent (20%) of total deposits (Sec. 21) (3) Total investment in equities of allied undertakings shall not exceed twenty-five per cent (25%) of the net worth of the bank (Sec. 21A) (4) The equity investment in any one enterprise shall not exceed fifteen per cent (15%) of the net worth of a bank (Sec. 21A) (5) The total equity investment in any single enterprise shall remain a minority holding in that enterprise except where the enterprise is not a financial intermediary (Sec. 21A) (6) The combined capital accounts shall not be less than ten per cent (10%) of its risk assets (defined in same Sec. 22) (7) Total liabilities of any person, company, corporation or firm to a commercial bank shall not exceed fifteen per cent (15%) of the unimpaired capital and surplus of such bank (Sec. 23, certain exclusions exist, a further 15% is possible if liability adequately and appropriately secured) (8) Investment in real estate for its immediate accommodation in the transaction of its business shall not exceed fifty per cent (50%) of bank's net worth (Sec. 25) (9) Commercial banks are subject to reserve requirements (Sec. 26) (10) Loans against real estate security shall not exceed seventy per cent (70%) of the appraised value of the real estate security, plus 70% of the appraised value of the insured improvements (Sec. 78) (11) Loans on the security of chattels shall not exceed fifty per cent (50%) of the appraised value of the security (Sec. 78) (12) The outstanding credit accommodations which a bank may extend to each of its stockholders owning two per cent (2%) or more of the subscribed capital stock, its directors, or its offi- cers, shall not exceed an amount equivalent to the respective outstanding deposits and book value of the paid-in capital contribution in the bank (Sec. 83) (13) At least twenty-five per cent (25%) of loanable funds shall be set aside of which not less than ten per cent (10%) shall be made available for agrarian reform credit and the balance shall be made available for agricultural credit in general (P.D. 717) Note: Commercial bank branches in particular regions (i.e., outside Greater Manila Area) have to invest 75 per cent of deposits in the region where the deposits accumulated. Furthermore, at least 60 per cent of said 75 per cent have to be invested in agricultural and export industries, but can be invested in any government financial institution if compliance is difficult (Memorandum of Central Bank, March 1973).  Appendix 1 - 36 - 3. Restrictions imposed on maturity of lending (1) Loans on the security of real estate have maximum maturity of fifteen years, except loans for home building which have maximum maturity of twenty years (Sec. 21) (2) Investment in securities with remaining maturity of more than three years are subject to limit (see A.2.(2) above) (Sec. 21) B. Savings and mortgage banks 1. Activities permitted by laW / (1) Accepting demand deposits (2) Accepting time and savings deposits (3) Investing in bonds (4) Investing in loans secured by bonds, real estate, and other forms of security (as provided in Chapter V of the General Banking Act) (5) Investing in loans for personal finance (6) Investing in long-term financing for home building and home development (7) Investing in drafts, bills of exchange, acceptances, or notes arising out of current commercial transactions (8) Investment in equities of allied undertakings (9) Administering trust funds/engaging in trust business (10) Receive in custody funds, documents and valuable objects, and rent safety deposit boxes for the safeguarding of such effects (11) Act as financial agent and buy and sell by order of and for the account of customers, shares, evidence of indebtedness and all types of securities (12) Make transfer payments (13) Issue mortgage and chattel mortgage certificates, buy and sell them for its own account or for the account of others, or accept them in payment or as amortization of its loans (14) Purchasing, holding and conveying of real estate 2. Restrictions imposed on size of operations (1) Combined capital accounts shall not be less than ten per cent (10%) of its risk assets (defined in same Sec. 30) (2) Loans for personal and household finance secured by real estate or chattel mortgage shall not exceed ten per cent (10%) of the total assets of the bank (Sec. 31a) 1/ Service (1) derived from Sec. 72-A; Services (2)-(6) derived from Sec. 29; (7) from Sec. 31(f); (8) from Sec. 31(j); (9) from Sec. 57; (10)-(12) from Sec. 72; (13) from Sec. 33, and (14) from Sec. 34.  Appendix 1 - 87 - B. 2. (3) Loans secured by livestock shall not exceed fifty per cent (50%) of commercial value of the animals (Sec. 31b(l)) (4) Value of drafts, bills of exchange, acceptances, or notes arising out of current commercial transaction shall not exceed ten per cent (10%) of the total assets of the bank (Sec. 31f) (5) Loans secured by the pledge of gold or silver bullion shall not exceed ninety per cent (90%) of the value of the pledge (Sec. 31h) (6) For allied undertakings, same as in (3) to (5) for commercial banks (Sec. 31j) (7) Savings and mortgage banks are subject to reserve requirements (Sec. 37) (8) For investments in real estate, same as (8) for commercial banks (Sec. 34) (9) Total liabilities of any person, company, corporation or firm to a commercial bank shall not exceed fifteen per cent (15%) of the unimpaired capital and surplus of such bank (Sec. 32, certain exclusions exist, a further 15% is possible if lia- bility is for the purpose of subdivision or housing development) (10) Loans against real estate security shall not exceed seventy per cent (70%) of the appraised value of the real estate security, plus 70% of the appraised value of the insured improvements (Sec. 78) (11) Loans on the security of chattels shall not exceed fifty per cent (50%) of the appraised value of the security (Sec. 78) (12) The outstanding credit accommodations which a bank may extend to each of its stockholders owning two per cent (2%) or more of the subscribed capital stock, its directors, or its offi- cers, shall not exceed an amount equivalent to the respective outstanding deposits and book value of the paid-in capital contribution in the bank (Sec. 83) (13) At least twenty-five per cent (25%) of loanable funds shall be set aside of which not less than ten per cent (10%) shall be made available for agrarian reform credit and the balance shall be made available for agricultural credit in general (P.D. 717) 3. Restrictions imposed on maturity of lending (1) Loans to encourage breeding, raising and production of livestock is limited to three years (exceptions may be granted by monetary board) (Sec. 31b (1)) (2) Equipment loans are limited to five years (3) Mortgage loans for conservation, enlargement or improvement of productive properties are limited to ten years (4) Real estate mortgage loans are limited to twenty years  Appendix 1 - 8s - C. Building and loan associations (mutual) 1. Activities petmitted by law-/ (1) Accepting savings deposits of stockholders ("primarily households") (2) Loaning its funds, and funds borrowed for that purpose, to stockholders on the security of unencumbered real estate and with the pledge of shares of the capital stock owned by such stockholders as collateral security (3) Investing in bonds and obligations of the Republic of the Philippines or its parastatals (4) Borrowing money for temporary purposes and uses (5) Purchasing, holding and conveying real estate 2. Restrictions imposed on size of operations (1) No member may borrow upon security of real estate in excess of ten per cent (10%) of total assets of associations with assets of one hundred thousand pesos and more, nor more than ten thousand pesos from associations with assets less than - 100,000) (Sec. 41) (2) Short-term borrowing is limited to fifty per cent (50%) of capital stock actually paid in (limit excludes indebtedness to Central Bank) (Sec. 48) (3) As in (8) for commercial banks (Sec. 53) (4) Investment in real estate for subdivision into residential lots is limited to twenty-five per cent (25%) of paid-in capital and surplus (Sec. 53) 3. Restrictions imposed on maturity of lending No explicit limitations D. Trust corporations 1. Activities permitted by law-/ (1) Acting as trustee on any mortgage or bond issue by any municipality, corporation, or any body politic (2) Accepting any other municipal or corporate trust not inconsistent with law (3) Acting as trustee, guardian, receiver or depository under court order for specified persons (4) Acting as executor of any last will or testament (5) Acting as administrator under court order of estate of deceased person when there is no will 1/ (1)-(3) derived from Section 39, (4) from Section 48, (5) from Section 53. 2/ (1)-(5) derived from Section 58, (6) from Section 57.  Appendix 1 _ 39 _ D. 1. (6) Do commercial banking business (with the approval of Monetary Board, such business must be kept separate and distinct from the trust business and is guided by the regulations laid down in the General Banking Act for commercial banks) 2. Restrictions imposed on size of operations (1) Lending or investment of deposits or moneys received by trust company is subject to limitations (3)-(6) for savings and mortgage banks (Sec. 63) (2) If engaged in commercial banking business, investments of funds other than trust funds are subject to same limitations as apply for commercial banks (Sec. 64) (3) Trust companies are not subject to explicit reserve requirements (for their trust business) but are required to deposit with the Central Bank of the Philippines equal to no less than two hundred and fifty thousand pesos; this amount may be raised, from time to time, whenever in the judgment of the Monetary Board the growth of the trust business warrants it (Sec. 65) 3. Restrictions imposed on maturity of lending (1) For lending out of trust business, limitations for savings and and mortgage banks apply (2) For lending out of commercial banking business, limitations for commercial banks apply E. Rural banks 1. Activities permitted by law-/ (1) Accepting savings and time deposits (2) Accepting current or checking accounts (only with special permission of Central Bank) (3) Acting as a correspondent for other financial institutions (4) Acting as a collection agent (5) Acting as trustee over estates or properties of small farmers and small merchants (6) Acting as official depository of municipal, city or provincial funds in some instances when authorized by the Monetary Board (7) Rediscount paper with the PNB, DBP or other banks, including Central Bank of the Philippines (8) Extending loans and advances primarily for the purpose of meeting the normal credit needs of any small farmer, of cooperatives, small merchants, and small enterprises (9) Investing in equities of allied undertakings (except banks) as approved by the Monetary Board 1/ (l)-(7) derived from Sec. lla to llf of R.A, No. 720, as amended; (8) from Secs. 5 and 6; (9) from Sec.ll-A of R.A. No. 720, as amended.  Appendix 1 - 90 - E. 2. Restrictions imposed on size of operations (1) Single borrower loan limit shall not exceed fifteen per cent (15%) of unimpaired capital and surplus (2) Agrarian reform credit shall be no less than ten per cent (10%) of loanable funds (3) Agricultural credit in general shall be no less than fifteen per cent (15%) of loanable funds (4) Total outstanding direct credit accommodations to each of bank's directors (D), officers (0), and stockholders (S) shall not exceed the outstanding deposits and book value of paid-in capital contribution of such DOS (5) Total direct/indirect borrowings of DOS shall not exceed fifteen per cent (15%) of the bank's total loan portfolio or one hundred per cent (100%) of combined capital accounts net of valuation reserves (a more restrictive implementation of item (4) (6) Total combined equity investments in allied or related under- takings shall not exceed twenty-five per cent (25%) of net worth. While total equity investments in any single enter- prise shall not exceed 15% of net worth (7) Limitations on investments in fixed assets: (a) Bank building and lot - thirty-five per cent (35%) of private paid-up capital and surplus (b) Furniture, fixtures and equipment, motor vehicle - fifteen per cent (15%) of private paid-up capital and surplus Aggregate investment ceiling in such assets shall not exceed fifty per cent (50%) of paid-up capital and surplus (8) Capital account shall be no less than ten per cent (10%) of risk assets 3. Restrictions imposed on maturity of lending No explicit limitations given in Act, but regulations imposed by the Department of Rural Banks and Savings and Loan Associations of the Central Bank (regulations not available) F. Development Bank of the Philippines 1. Activities permitted by law-/ (1) Accepting time/savings deposits (2) Granting loans for home building or home financing and for the rehabilitation, the establishment or development of any agricultural and/or industrial enterprise 1/ (1)-(10) derived from Sec. 2, (11) from Secs. 11 and 12 of R.A. No. 85, as amended; (12)-(16) from P.D. 1467.  Appendix 1 - 91 - F. 1. (3) Purchasing preferred redeemable shares of stock, securities other than shares of stock, and obligations of, and to grant loans to, any agricultural and industrial enterprise (4) Granting loans to provincial, city and municipal government and parastatals for investment finance (5) Granting loans to cooperative associations to facilitate production, the marketing of crops, and the acquisition of essential commodities (6) Granting loans to individual employees in government-owned or controlled corporations or private enterprises engaged in development/expansion of agriculture or industry, for the purpose of buying shares of stock of these enterprises (7) Underwriting, purchasing, owning, selling, mortgaging of stocks, bonds, debentures, securities and other evidences of indebtedness of enterprises engaged in development (8) Issuing bonds, debentures, securities, collaterals and other obligations-1 (9) Subscribing out of its funds to the capital stock of private provincial and city development banks (10) Rediscounting of intermediate and long-term notes, loans and/or mortgages of the Philippine National Bank (11) Establishing a trust fund for the purpose of aiding the establishment of provincial and city private development banks through subscription to their stock and rediscounting (12) Accepting and managing trust funds and properties and carrying on the business of a trust corporation (13) Organizing and establishing/operating subsidiary corporations whenever necessary (14) Guaranteeing acceptance credit loans, transactions or obligations of any person, co-partnership, association or corporation, whether foreign or domestic (15) Issuing performance bonds or guarantee to secure performance of contracts funded for foreign currency by international financial institutions provided the contractors are domestic enterprises/ corporations,majority of the capital of which are owned by citizens of the Philippines (16) Granting of loans on the security of real estate without torrens title if the real estate has been declared for purposes of taxation continuously for at least ten years and the applicant for loan and his predecessors have been in continuous and uninterrupted possession in the concept of owner for at least ten (10) years. l/ Government Service Insurance System and Social Security System are obliged to invest twenty-five per cent (25%) in DBP.  Appendix 1 - 92 - F. 2. Restrictions imposed on the size of operations (1) No more than forty-five per cent (45%) of authorized capital stock shall be available for industrial loans, not more than thirty-five per cent (35%) for agricultural loans, and not more than twenty-five per cent (25%) for miscellaneous loans (incl. home building) (2) Not more than twenty per cent (20%) of total amount available for agricultural loans shall be available for any simple crop and of that not more than five per cent (5%) shall be loaned to any individual, association or corporation (3) No loan granted to a single person for house building shall be in excess of thirty (30) thousand pesos (4) Total liabilities of any person/company/corporation or firm or political subdivision of the government shall, exclusive of guarantees, at no time exceed thirty per cent (30%) of the paid-in capital and surplus of the bank (5) Subject to other restrictions similar to commercial banks on loans/risk assets, etc. 3. Restrictions imposed on maturities No explicit restrictions exist in the Charter. G. Private Development Banks 1. Activities permitted by law-/ (1) Accepting savings and time deposits (2) Acting as correspondent for other financial institutions and as collection agent (3) Rediscounting paper with the Central Bank, Philippine National Bank or other banks (4) Perform all functions and assume all obligations of mortgage banks as laid down in Chapter V of General Banking Act. 2. Restrictions imposed on size of operations (1) Seventy-five per cent (75%) for medium and long-term loans and twenty-five per cent (25%) for short-term loans (2) Other restrictions imposed similar to Savings and Mortgage Banks 3. Restrictions imposed on maturities (1) Seventy-five per cent (75%) of loanable funds shall be invested in medium and long-term loans for economic development purposes and 25% of loanable funds shall be invested in short-term loans for miscellaneous purposes 1/ (1)-(3) derived from Sec. 7 of PDB Act, (4) from Sec. 3 of Charter of DBP.  Appendix 1 H. Land Bank 1. Activities permitted by law (1) Accepting demand, savings and time deposits (2) Granting of short, medium, and long-term bonds against security of real estate or other acceptable assets (3) Financing or guaranteeing the acquisition of form lots transferred to tenant-farmers (4) Underwrite, purchase or sell stocks or bonds of other corporations and of the government (5) Guaranteeing acceptances or loans of any person or corporation in favor of any financing or banking institution (6) Borrowing from or rediscounting commercial papers with the Central Bank (7) Acting as trustee (8) Issuing own bonds, debentures, securities and other evidences of indebtedness 2. Restrictions on the size of operations (1) The value of own bonds, debentures, securities and other evidences of indebtedness issued must not exceed, at any one time, ten times its paid-in capital and surplus (2) Other restrictions similar to those on commercial banks 3. Restrictions imposed on maturities No information available I. Investment Houses 1. Activities permitted by law (Investment Houses Act)-/ (1) Underwriting securities (2) Participating in a syndicate undertaking to purchase and selling securities of other corporations and of the Government or its instrumentalities (3) Participating in tender offers, block sales, or exchange offer- ing of securities, and dealing in options, rights or warrants relating to securities (4) Promoting, sponsoring, or otherwise assisting and implementing ventures, projects and programs that contribute to the development of the economy 1/ With the approval of the Monetary Board Investment Houses may also perform quasi-banking functions (defined in Circular 387, November 1973). In this case various restrictions similar to those for commercial banks on size and maturities of activities apply.  Appendix 1 - 94 - I. 1. (5) Acting as financial consultant, investment adviser, or broker, also as portfolio manager, and/or financial agent, but not as a trustee of a trust fund or trust property (6) Providing assistance or participation in the formation, merger, consolidation and reorganization of productive enter- prises in the form of debt or equity financing or through the extension of financial or technical advice or service 2. Restrictions on the size of operations No information available, subject to Central Bank regulations 3. Restrictions on maturities No information available, subject to Central Bank regulations J. Finance cumpanies 1. Activities permitted by law (Financing Company Act) (1) Extending credit by discounting or factoring commercial papers or accounts receivable (2) Buying and selling contracts, leases, chattel mortgages or other evidences of indebtedness (3) Leasing motor vehicles, heavy equipment, office equipment, etc. 2. Restrictions on the size of operations No information available 3. Restrictions imposed on maturities No information available  Appendix 2 _ 95 _ Calculation of the contribution of the proximate determinants to the growth of the money supply 1/ The exact percentage change of the components of the money multiplier (m) and the monetary base 'BS), and their contribution to each individual period's growth of the money supply as well as their long-run contribution can be found by expressing the definition of the money supply.2/ (1) M = mBS or, written in full (2) M C +ER+RR (NFA + NCG + COE + CCB + COF - CBCI + O0NA) in terms of natural logarithms and differentiating the equation with res)ect to time. This gives: (1') lnM = lnm + lnBS and (1") dlnM dlrm + dlnBS dt dt dt Since the differentiation of a variable expressed in logarithmic form with respect to time yields the percentage change in the variable (growth rate) equation (1") can be written as (1"') 1 dM 1 dm +1 dBS Mdt m dt BS dt Applying the same method to equation (2) yields (2') 1 dm 1 dC + Rn dD + am dER am dRR M dtm a dt D dt MER dt 3BR dt) 1/ This note is pertinent to Table 30 in Chapter 7 eii6 the eceoi,a.;ying text. 2/ For an explanation of the syrbols see the notes to Table 30.  Appendix 2 - 96 - I UBS dNFA +BS dNCG +BS dCOE +BS dCCB -_ + _+ +_ BS 3NFA dt 3NCO dt KCOE dt DCCB dt +BS dCOF + 3BS dCBCI +S dONA \ cCOE dt XBCI dt DNA dt J Data was available and analyzed in discrete time periods, therefore a discrete time approximation of the above continuous time formulation was used. After solving the partial derivatives in equation (1') a discrete time approximation of the growth in the money supply is given by 1/ (2") AM/m =1-- AC + -U AD DAER - DEN ARR (iuk EN NUM DEN DEN + BS ANFA + BS ANCG + BS ACOE + BS ACCB BS BS BS BS + I ACOF - B ACBCI + BS AONA where NUM = C + D DEN = C + ER + RR The contribution of each variable on the right-hand side of (2") to the growth in the money supply of each individual quarter is found by inserting the appropriate quarterly values into the respective component term. The long-run percentage change of a component is derived by calculating the mean value of its composite term.2/ The long-run relative contribution of a component is obtained by dividing this mean value by the mean of AM/M. 1/ Notice that for the calculation of the above expressions, all level magnitudes are lagged values, e.g., AM stands for (Mt - Mt_l)/Mt_l and /TlNUM) - (l/DEN)t AC stands for /(l/NUMt-l) - (l/DENt-J)7*(Ct - Ct-l). 2/ "Long-run" refers to the result obtained for the entire period under investigation.  Appendix 2 - 97 - The standard deviations of the component terms' absolute contribution provides information about the relative stability of the variables' in- fluence on the money supply. The average short-run contribution of a variable is calculated by dividing for each individual period (month, quarter, etc.) the composite term of that variable by AM/M.  Appendix 3 - 98 - Deposit growth, stability and stable core In order to calculate the information contained in Table 36 of Chapter 3 on the growth of various types of deposits and deposit substitutes, their stability and their stable core the following econometric and statis- tical calculations were carried out. The first step of the investigation involved the regression of demand, saving and time deposits as well as of deposit substitutes against time in order to determine their past growth and its stability. The equation esti- mated for each type of deposit is given by: (1) lnXi = a + bt where In is the natural logarithm, Xi is the financial instrument i, and t is time. Quarterly data from 1970(1) to 1978(IV) were employed. The co- efficient b gives the quarterly rate of growth and its t-statistics allows for inferences about the stability of the growth path. The second step involved (a) the forecast--on the basis of the regres- sion of equation (1)--of the first out-of-sample value for each financial instrument, (b) the calculation of the lower-end value at a one-tailed 95 per cent confidence interval, and (c) the expression of the lower-end value as a percentage of the estimated out-of-sample value. A further calculation was carried out in order to determine the per- centage of the selected range of short-term financial instruments that would on average remain available to financial institutions over future periods. The confidence intervals are calculated in the following way: The confidence interval for the first out-of-sample period estimate is given by, (2) (a + Vb) - k* SEE* 1 +1 + (t)  Appendix 3 - 99 - where V is the value of the explanatory variable (here: time) in the next period, i.e., V - n + 1 - 37, n is the number of observations in the sample, k is the value of the student-t distribution for a one-tailed 95 per cent confidence interval, SEE is the error of the estimate of equation (1), and t is the average value of the explanatory variable, i.e. of time. The formula for the calculation of the average percentage is the same as for the first period calculation with the exception that the root value is given by, 1 + (V - i.e. withd n o (f _)2n i.e. without the addition of 1.    The World Bank Headquarters European Office Tokyo Office H 1818 H Street, N.W. 66, avenue d'Iena Kokusai Building Washington, D.C. 20433, U.S.A. 75116 Paris, France 1-1 Marunouchi 3-chome Telephone (202) 477-1234 Chiyoda-ku, Tokyo 100, Japan Cable Address INTBAFRAI) WASIIINCTONDC: