Philippines - Financial sector study (Vol. 1 of 3) : Main report

Report No. 7177-PH Philippines Financial Sector Study (In Three Volumes) Volume l: The Main Report August 23,1988 Industry and Energy Operations Division Country Department II Asia Region FOR OFFICIAL USE ONLY H~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~~ Document of the World Bank This report has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  CURRENCY EQUIVALENTS US$1.00 = Pesos (P) 20.90 P 1.00 = US$0.47 FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS ACPB - Agriculture Credit Policy Council ADB - Asian Development Bank AIC - Average intermediation cost AITTP - Agro-Industrial Technology Transfer Program ALF - Agriculture Loan Fund Apex - Apex Development Finance Unit APT - Asset Privatization Trust ASC - Accounting Standards Council BBP - Bakahang Barangay Program BDP - Biyayang Dagat Program BSKP - Bagong Kilusang Kaunlaran at Kabuhayan CALF - Comprehensive Agriculture Loan Fund CBP - Central Bank of the Philippines CDLF - Cooperative Development Loan Fund CFI - Court of first instance CFP - Cotton Financing Program CHM - Chattel mortgage CIB - Credit Bureau of Investigation CIGLF - Cottage Industry Guarantee Loan Fund CPA - Certified Public Accountant DA - Department of Agriculture DBP - Development Bank of the Philippines DLC - Department of Loans and Credit DOSRI - Directcrs, officers, stockholders and related interests DTI - Department of Trade and Industry ECP - Expanded Corn Program EIMP - Export Industry Modernization Program GAAP - Generally accepted accounting principles GDP - Gross domestic product GEM - Gross earnings margin GFSME - Guarantee Fund for Small and Medium Enterprises GIM - Gross interest margin GRT - Gross receipts tax GSIS - Government Service Insurance System HYV - High yield variety ICI - Intermediation cost index IGLF - Industrial Guarantee and Loan Fund ILFP - Industrial Loan Fund Program  FOR OMCIAL USE ONLY IRPP - Intensified Rice Production Program LBP - Land Bank of the Philippines LIBOR - London interbank offered rate MB - Monetary Board MRR - Manila Reference Rate M-99 - Masagana 99 NEDA - National Economic Development Authority OECF - Overseas Economic Cooperation lund PCIC - Philippine Crop Insurance Corporation PDIC - Philippine Deposit Insurance Corporation PFI - Participating financial institution PNB - Philippine National Bank QGFB - Quedan Guarantee Fund Board REM - Real estate mortgage SEC - Securities and Exchange Commission SES - Supervision and Examination Sector SME - Small and medium enterprises SMI - Small and medium industry STD - Special time deposit TLRC - Technology and Livelihood Resource Center TRP - Textile Rehabilitation Program T-bills - Treasury Bills ULFP - Urban Livelihood Financing Program Unibanks - Universal banks USAID - United States Agency for International Development USUCC - U.S. Uniform Comercial Code This document has a restricted distribution and may be used by rcipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  ACKNOWLEDGEMENT During our field work for this report in Manila during October- November 1987, the World Bank mission benefitted from discussions with a large number of senior officials from both the Government and private institutions. Their help is gratefully acknowledged. We would, however, like to particularly thank Mr. Jose B. Fernandez, Jr., Governor, Central Bank of the Philippines, Mr. Vicente Jayme, Secretary, Department of Finance, and Mr. Manuel Morales, President, the Bankers' Association of the Philippines for their active help and support. We wish also to thank Mr. Arnulfo Aurellano and Mrs. Armida San Jose for their help in data collection. Despite the help that we received from others, the mission alone is responsible for the views expressed in the report. Zamir Hasan  PHILIPPINES FINANCIAL SECTOR STUDY VOLUME I Table of Contents Page No. EXECUTIVE SUMMARY............... . ............ i I* INTRODUCTION.o.o1..........oo.. o.....ee. oo. eo...ooo... I Terms of Reference... oo.... e... o....o....o..o.... 1 Organization of the Report..e.p.o r...... o.. o.oo...o.. oos. 2 II. THE PHILIPPINE FINANCIAL SYSTEMY........oo ....o.o..o...o.. 2 A. Major Reforms in the Financial System up to 1980....... 3 The IMF/CBP Banking Survey Commission of 1972....72.*.. 3 The IMF/IBRD Financial Sector Study of 19797....o...... 3 B. Major Economic and Financial Events of the 1980s s.o. 5 1980-83: Growth, Deficits and the Money Market 1983-85: Economic Contraction and the External Financing Shoock ... ..0..0.. ............... 6. 1986-87 and Beyond: The Economic Pick-up.o.o.....up... 12 Interest Rate P o l i cy.o.. e.. o.o.. eo. ..... e.. o..o...o 13 Rehabilitation of PNB and DBP....oo....o......o......o. 16 Impact on the Financial Sy9tem....o.o.......oe*.. o..o. 17 C. The Present Financial Systemyoo.o.... .o.o....o...o.. 19 The Central Bank of the Philippines................... 20 Commercial Bansa..0n00ks090400000000 21 Thrift Banksaoonkoos.....o..e...e.... .oe...o......o e. 21 Rural Banks 22 Specialized Government Institutions.0tutions0. ... ... 23 Nonbank and Capital Market Institutions..00*0000000.... 24  Page No. III. CONMERCIAL BANK OPERATIONS AND FINANCIAL CONDITION .......... 30 A. Historical Perspective....... oooee.o.... ............e. 30 B. The Present Commercial Banking Sector..c t or.........." 31 Scope..O.... *........................*...*..*...*.*.... 31 Overall Performanceo.o... . ....oo. .o.. . 6e...oo....sso 33 C. Commercial Bank Performance, 1984-86...................0 35 Liability Management. ................................... 36 Asset Management ....................................... 41 Geographic Distribution of Branches and Credit......... 51 Capital Adequacy and Portfolio Qualityo....0........... 52 Profitability, Operating Costs and Productivity.....o. 60 Intermediation Margins*... ............. * *. *............ 66 u SRI L ons ... ...... .. .... 74 Trust Funsuondoesooooe*eeoooo.o*. 74 Competition/Concentration......... 76 Consolidation of the Banking Sectoroto.r.........9..e 79 IV. SUPERVISION AND REGULATION OF THE FINANCIAL SYSTEN.ooo..ooo. 81 A. Supervision and Regulation of Commercial Banks koos.os 81 The Legal Framework a m. w or....... ..... ....0 ... . ... 81 Organizational and Staffing Arrangements....oooooo.o 83 Prudential Restrictions..oo..oo....oo..o.....o.....o. 83 Penalties and Sanctions..................... * ......... 87 Supervisory Procedures........... ee.o....eo............ 87 Supervision Follow-Up...... o..o...o.........o.o.o..o 90 Evaluation of Bank Supervision and Regulation..o.... 91 B. Supervision and Regulation of Securities Markets....... 97 ,ecurities and Exchange Commission..oo .....*.&0600G499 97 Evaluation of Supervision and Regulation of Securities Market Institutions...o.o...o......... 100 Recom mendations.o.o... ooo.. ****o *eo**..... 101 V. LEGAL ISSUES AFFECTING BANK SUPERVISION AND DEBT COLLECTIONL L ET I O ?...... ..*0. .... .. 0 0 .. 103 A. Legal Issues Involving CBP in Relation to Commercial Banks.. ....... ...... ..... ..0. 0.0.... 104 Procedures to Deal with a Failing Bank.a nk............. 104 Enhanced Role of the PDIC.... DIC....................... 106  - lli - Page No. Detecting and Countering Insider Abuse................. 107 Cease and Desist Orders. ..........e..e......e............. 108 Institution of Civii Suits .............................. 108 Insurance and Fidelity Bonds..........................* 109 Need for a Special Court to Try Banking'Cases.......... 109 Vulnerability of CBP Staff to Personal Legal Suits..... 109 B. Lagal Issues Involved in Debt Recovery and Insolvency.. 11 Foreclosures of Real Estate Mortgages. ................. 111 Revision of Laws Governing Foreclosures*..*............ 112 Reform of the Insolvency Lav............b.............. 115 Other Legal Issues.......................... *........ .. 116 VI. THE ROLE OF THE GOVERNMENT/CBP IN CREDIT ALLOCATION ......... 119 A. Agricultural Credit and Guarantee Programs............. 120 The Programs........................................... 120 Guarantee Programs ....... 124 New Directions in Agricultural Lending Programs........ 125 B. Credit and Guarantee Programs for Industry............. 126 The ............................ ............. ......... 126 C. Central Bank Rediscount Window......................... 131 D. Evaluation of Government-Directed Credit Programs...... 134 Recommendations........................................ 137 VII. GAPS IN FINANCING AGRICULTURAL, EXPORT AND INDUSTRIAL SECTORS 140 Agricultural Credit...... .. .... .. ...................... 140 Export Finance ......... 143 Industrial Credit ...................................... 145 Bridging the Gap Between Supply and Demand for Term 149 Foreign Exchange Risk and Cover .......................- 152 VIII. SUMMARY OF CONCLUSIONS AND RECOMMEWDATIONS .................. 155  - iv - Page No. TABLES IN TEXT 2.1 Domestic Credit 1980-86........ ........... ...... * 9 2.2 Treasury Bill and Private Sector Loan Rates, 1980-86..... 10 2.3 Bank Failures, 198O-87.............. .. .... ee 18 2.4 Total Assets of the Financial System, 1980-86.*9e.*e**.*. 19 2.5 Central Bank Assets as a Percentage of GNP, 19854000*0*.. 20 2.6 Assets of the Specialized Banks, 19d4-86.0000..6......... 23 2.7 Structure of the insurance Industry, 1982-86.*9%9****,9* 25 2.8 Number of Listed Companies and Market Capitatization, 28 2.9 Volume and Value Turnover of Manila and Makati Stock E x c h a n g e ~~~~~~~~~~~29 3.1 The Largest and Smallest Philippine Banks, September 30, 32 3.2 Relative Sizes of the Largest Banks in Selected Asian Countries, 1986... **@**s^9*se**s* 33 3.3 Commercial Banks: Selected Balance Sheet Items, 1980-86.o.* ... .... .eo.*.*. **..oo*.. o.e. 34 3.4 Structure of Core Deposits, 1980-86 .............*...0... 36 3.5 Nominal Rate Structure of Core deposits, 1980-86.......o. 38 3.6 Deposit Maturity Premia, 1980-86................... 38 3.7 Interbank Money Market Rates, 1980-86....**.*$4&0....***0 39 3.8 Deposit Substitutes and Trust Funds, 1984-86.*00*00.e.e. 40 3.9 Liquidity Measurements, 1980-86... 0 ......**&.***...*.*. 41 3.10 Loans Outstanding, 1980-86*.e..o&..........*.s...... .s 41 3.11 Distribution of Credit Outstanding by Purpose, 1980-86... 42 3.12 Maturity Distribution of Outstanding Credits, 1980-86.... 44 3.13 Maturity Transfo!mation, 1980-86 ................... 47 3.14 Maturity Premia on Secured Loans Outstanding, 1980-86.... 49 3.15 Geographic Distribution of Branches, 1980-86.o .....*0*** 51 3.16 Geographic Distribution of Credit, 1980-86 ..... 0....*.. 51 3.17 Capital Adequacy, 1980-86oss......o.*..*.*.*.e.*.*.*..... 52 3.18 Recent Evolution of Past Due Loans, 1984-86#o*e...*9o*... 53 3.19 Estimated Potential Loan Losses as of Year-end 1986....*. 53 3.20 Capital Adequacy by Group, 1984-86...0..*4000*..0*00.... 55 3.21 Adjusted Capital Adequacy by Group, 1984-86***e**.o***... * 56 3.22 Performance Indicators of the Weak Banks, 1984-86........ 57 3.23 Performance Indicators of the Marginal Banks, 1984-86.... 57 3.24 Performance Indicators of the Sound Domestic Banks, 58 3.25 Performance Indicators of Foreign Banks, 1984-86......... 59 3.26 Commercial Banks' Earnings, 1980-86................... 60 3.27 Operational Performance of 29 Banks (System Less PNB).... 61 3.28 Non-Interest Income, 1984-86 ...................... 62 3.29 Sources of Noninterest Income, 1984-86 ....... *6.0009000 63 3.30 Components of Operating Expenses, 1984-86**..e.**..*e99*0 64 3.31 Measures of Productivity, 1984-86....99900 **06609996*Gw*. 65  v Page No. 3.32 Components of the Average Intermediation Cost (AIC), 3.33 Estimated Impact of Reserve Requirements on Inter- mediation Cost Index, 1982-87 ........ 70 3.34 Computed Intermediation Cost Indices*..*.**........s.... 71 3.35 Comparative Bank Margins (Percentage of Total Assets). 72 3.36 Trust Activity of All Banks, 1984-86..8 48... 74 3.37 Concentration Ratios Based on Total Assets, 1986....86... 76 6.1 Central Bank - Applicable Rediscount Rates, 1979 to Presert 174 6.2 Central Bank Rediscounting, 1980-87.80.- 87........ ...... 175 7.1 Sources of Outstanding Credit to Agriculture..cu.ltur..* 139 7.2 Sources of Outstanding Credit to Manufacturing.***.*n.... 144 7.3 Composition of Investment Portfolio of Insurance Industry, 196. 148 LIST OF FIGUrRES 2.1 Philippines: Price and Exchange Rate Movements....en.ts. 8 2.2 Domestic Credit, 19 8 2 - 8 7 11 2.3 Treasury Bill Rates, 1982-86 8 2 - 86..................... 14 3.1 Interest Rates, 1 -8 2 - 8 7 37 3.2 Commercial Bank Distribution of Lending by Purpose and by Sector, 1980 and 1936 43 3.3 Commercial Banks Maturity Transformation....o..s..-o. 46 3.4 Components of Average Intermediation Costs, 1983-86...6.. 68 4.1 Supervision and Examination Sector Organizational Chart.. 84 4.2 SES Department I Organization Chart..h a rt............*. 85 7.1 Sources of Credit to Manufacturing and Agriculture.o..... 141 7.2 Exchange Rates, 1974-87.9...8.... 153 APPENDIX LIST OF ANNEXES 1. National Accounts and Balance of Payments, 1975, 1980-86 2. Sectoral Output, 1979-86 3. Interest Rates, 1970-87 4. Assets of the Financial System 5. Percentage Distribution of Assets of the Financial System 6. Number of Thrift and Rural Banks 7. Savings and Mortgage Banks' Summarized Consalidated Balance Sheets, as of December 31, 1984-86  - vi - 8. Savings and Mortgage Banks' Summarized Consolidated Income Statements, for the Years Ended December 31, 1984-86 9. Private Development Banks' Summarized Consolidated Balance Sheets, as of December 31, 1984-86 10. Private Development Banks' Summarized Consolidated Income Statements, for the Years Ended December 31, 1984-86 11. Stock Savings and Loan Associations' Summarized Consolidated Balance Sheets, as of December 31, 1984-86 12. Stock Savings and Loan Associations' Summarized Consolidated Income Statements, for the Years Ended December 31, 1984-86 13. Rural Banks' Summarized Consolidated Balance Sheets, as of December 31, 1984-86 14. Rural Banks' Summarized Consolidated Income Statements, for the Years Ended December 31, 1984-86 15. Specialized Government Banks' Summarized Consolidated Balance Sheets, as of December 31, 1984-86 16. Specialized Government Banks' Summarized Consolidated Income Statements, for the Years Ended December 31, 1984-86 17. Profile of the Insurance Industry, 1982-86 18. The Social Security System 19. The Government Service Insurance System: Corporate Balance Sheet, 1985/86 20. Ranking and Selected Balance Sheet Accounts of Individual Banks as of September 30, 1987 21. Commercial Banks' Summarized Consolidated Balance Sheets, as of December 31, 1970, 1975, 1980-86 22. Commercial Banks' Summarized Consolidated Income Statements, for the Years Ended December 31, 1970, 1975, 1980-86 23. Analysis of Commercial Banks' Sources and Uses of Funds, 1Q80-86 24. Performance Ratios of the Commercial Banking System 25. Consolidated Balance Sheets of the Commercial Banking Less PNB 26. Consolidated Income Statements of the Commercial Banking System Less PNB, 1984-86 27. Performance Ratios of the Commercial Banking System Less PNB, 1984-86 28. Analysis of Deposit Structure of Commercial Banks 29. Distribution of Outstanding Loans by Purpose, 1980-86 30. Distribution of Outstanding Loans by Security 31. Distribution of Outstanding Loans by Maturity 32. Commercial Bank Branches by Region, 1976-86 33. Analysis of the Cost of Intermediation, 1983-86 34. Commercial Banks: Analysis of Arrears, December 31, 1986 35. Government-Supervised/Directed Credits: Agriculture 36. Financial Performance of Selected Credit Programs by Year 37. Government-Supervised/Directed Credits: Industry 38. Government-Directed Credit Programs in Agriculture-Subsidization 39. Movements of Exchange Rates, 1982-87  PHILIPPINES FINANCIAL SECTOE. STUDY Executive Summary Introduction 1. This Study of the Philippine financial sector has been undertaken with the endorsement of the Government and more specifically of Xhe Central Bank of the Philippines (CBP). The need for the Study was felt due to concerns about the performance of commercial banks, the problems they face, ar.d questions about the effectiveness of supervision and regulation of not enly the commercial banks but also of the securities market institutions. Concerns were also prompted by a spate of legal suits against CBP and its personnel, a perceived shortage of long-term capital in the country, and extreme volatility in interest rates, inflation and exchange rates which have made the private sector so reluctant to assume exchange risks that available foreign exchange resources are being underutilized. These concerns are shared by the World Bank. 2. The Study's focus is on commercial banks: their operations, financial condition, competitiveness/concentration, and supervision and regulation, including the legal aspects involved. It Also evaluates the government-directed credit programs and CBP's role-therein, and suggests a new institutionai framework to deal with the gap identified in the financial bystem: the provision of long-term credit. Related policy issues and implications have also been discussed and operationally-oriented recommenda- tions made to deal with them. The Present Status of Commercial Banking 3. Philippine commercial banking has a long history dating back to the Spanish era in the early nineteenth century. In modern times, the period between the end of World War II and 1970, when 27 new banks were created, was one of unrestricted and haphazard growth; in a reaction, licensing of new banks was stopped in the early seventies and the moratorium still continues. In more recent years, since 1980, the banking sector has undergone a very substantial contraction in real terms. This was the result of political turmoil and the many economic shocks experienced by the country since 1981. During 1980-86, the total assets of the banking system contracted by 44% in real terms; loans to the private sector contracted even more sharply, by 63%. Between 1980 and mid-1987, three commercial banks, 147 rural banks and 32 thrift institutions failed, involving total assets of P 14 billion or about 2% of system wide assets at the end of this period. In addition, the biggest commercial bank, the Philippine National Bank (PNB), and the Development Bank of the Philippines (DBP), both government-owned, became de facto insolvent and were bailed out in 1986 by a transfer of their nonperforming assets, amounting to 59% and 90% respectively of their tctal assets, to the Asset Privatization Trust. After the failure of one commercial bank in early 1987, there are now  - ii - 29 banks, of which four are foreign and one (PNB, still the biggest) is government-owned. Seven banks are licensed as universe. banks which means that they may engage in many near-banking activities; :o qualify as a "unibank," banks are required to have capital of at least P 500 million. 4. The size of individual commercial banks in the Philippines is much smaller than that in other Asian countries; the two largest Philippine banks, i.e., PNB and the orivately-owned Bank of the Philippine Islands, rank 82nd and 99th in a recent survey of the 200 biggest banks in Asia. Thus, the largest banks in the Philippines are, relatively, not very big; conversely, the simallest banks are very small indeed, e.g., the average size of total assets and capital of the three smallest banks was US$92.0 million and US'7.4 mellion equivalent, respectively, as of September 30, 1987. The five- bank and three-bank concentration ratios were 52.0% and 41.1%, respectively, as of December 31, 1986. These ratios declined substantially in 1987 after the restructuring of PNB. In sum, the number of banks and the relatively small size of the biggest banks suggests that concentration in the banking industry is not a problem. The Herfindahl Index which quantifies the degree of concentration was a relatively low 0.10 as of December 31, 1986. As of the same date, the five smallest banks accounted for only 4.3% of total banking sector assets. The Philippines has too many small banks, with relatively high operating costs because of their size; some are also in poor condition. This Study concludes that CBP should, as a matter of policy, consider to effect a cor.soLidation of the banking industry with the objective of strcngthening the overall banking system. Caution should be taken to avoid in the process of consolidationt, creating monopolistic situations in specific market segments. 5. The banking system as a whole has emerged stronger after the wrenching experience of the first hali of the decade. Although the total capital of the banking sector declined by about 18Z in real terms between 1980 and 1986, it showed a significant improvement in terms of the ratios of capital to assets and to loans, the traditional measures of capital adequacy, because assets and loans declined even more steeply than did capital. At the end of 1986, the capital/assets and capital/loans ratios were 11.4Z and 27.71, respectively, significantly higher than international norms. It should be recognized, however, that these ratios are based on the book values of capital and assets, which are probably overstated. Based on an analysis of arrears and the assumption that losses of 52 to 75Z of the amounts in different arrearage categories would be realized, the Study estimates that the commercial banking sector might need to write off a total of some P 13 billion in loan losses. After offsetting this loss against provisions already made, the banking sector would still need to write down its capital by about P 4 billion or less than 15Z of commercial banks' net worth at the end of 1986. Even after making this adjustment, the capital base of the system as a whole appears adequate to support growth in lending in the foreseeable future. 6. The foregoing does not mean that all banks are adequately capital- ized. Using the yardsticks of return on risk assets, return on total assets, past due loans and provisions therefor, potential loan losses, and adjusted capital/total assets, there are still a few banks which can only be classified as financially weak and marginal (excluding the Manila Bank, closed in early 1987, PNB and five other banks under rehabilitation). It should be noted,  - iii - however, that the total assets of these marginal ane.d weak banks, together, amounted to lust over 1% of the assets of all banks as of December 31, 1986. It is recommended that CBP should not sustain all weak and marginal banks Undefinitel; instead, it should aim to effect consolidation through mergers/acqu;sition. Coaercial Banks' Profitability and Productivity 7. Data on the profitability of the banking sector as a whole are dis- torted by the massive write-offs/losses of PNB (amounting to P 1.1 billion, P 7.2 billion and P 5.5 billion in 1984, 1985 and 1986, respectively). Excluding PNB, the profitability of the commercial banking segment steadily improved until 1986, when it stagnated. But even in 1986, the margins widened since almost the same amount was earned as in 1985 although the earning assets base was smaller. In the three years 1984-86, the annual net profit before tax of the banking sector (excluding PNB) amounted to P 2.3 billion, 2.6 bil- lion and P 2.5 billion, respectively. These profit levels represented returns on total assets of 1.07Z, 1.27X and 1.26%, and on equity of 7.46%, 9.36% and 9.35Z, respectively, for the three years. The sectorwide figures, of course, mask the wide range for individual banks. For the banks that the Study classifies as weak, the average return on total assets was -0.37%, -0.61% and -0.41% for 1984, 1985 and 1986, respectively, within a range of -11.85% to 1.04%. 8. The improvement in the profitability of the commercial banking sector during 1984-86, was due to a higher bank margin in total intermediation costs; in 1986 the margin amounted to 5.82 of total assets (on a pre-tax basis), considerably higher than for banks in a sample of other countries. The bank margin may be broken down into a cost component and a profit (pre- tax) comdponent. The profit component alone averaged 1.9% for the 1984-86 period. Excluding foreign, weak and marginal banks, the profit margin of the strong domestic banks increased to 2.4% for the same three-year period, considerably higher than the 0.7% for banks in the sample of foreign countries considered by the Study. The high profit margin was the result of continued tolerance of small and weak banks with high operating costs in the system; the more efficient ban's priced their products and services with reference to the cost structure of t}.e smaller banks, a practice which effectively enabled them to capture higher profits. It should be noted that during the period under consideration, banks' portfolios were under pressure and loan losses were high. A beneficial result of high profits was, therefore, that it allowed the banking system to make the needed provisions for bad and doubtful loans. 9. Productivity as measured by the ratio of staffing expenses to various balance sheet and income statement items has shown a generally improving trend, but a deterioration in 1985 and 1986. This was to be expected given the sharp contraction in the system's assets while staffing costs continued to increase. Although the rising trend of staffing expenses as a percentage of assets is fully explained by the substantial drop in the total assets of the banking system, it should be a cause for concern, particularly if delayed adjustment to redress the loss of real income puts upward pressure on compensation levels without commensurate control over staffing levels.  - iv - Interest Rates, Spreads and Intermediation Costs 10. As a result of a recommendation made in the 1979 Joint IMF/World Bank Financial Sector Study, the Government started dismantling controls over interest rates in 1980. By 1983, all interest rates, for deposits as well as for loans, had been deregulated. This brought considerable transparency to the financial system in that the various add-ons to circumvent rate ceilings gradually disappeared. Rates are now variable and determined by the inter- action of supply and demand. 11. The key interest rate in the system is that on Treasury bills (T- bills). The rate on T-bills influences all other rates because of the sheer volume of T-bills involved. In order to attract large deposits, banks must offer rates competitive with the T-bill rate; T-bills have thus come to be the bridge between banks and nonbanks. The T-bill rates are themselves determined in a competitive manner. As a result, the T-bill rate, and with it a whole range of other rates, are market-determined. 12. The T-bill rate, like other domestic interest rates, is strongly influenced by external factors. Foreign exchange controls have gradually been liberalized since 1983, and banks are no longer subject to any restrictions on their holdings of foreign exchange. Although capital movements are not entirely free in a formal sense, funds can be moved out of the Philippines relatively easily. Given the de facto openness of the capital account of the balance of payments, domestic interest rates cannot be held below what the free market would determine. 13. The influence of the external factors on domestic interest rates can be seen in the actual levels of interest rates in recent years, which have responded fully to devaluations so that variable rates have become the norm. Until 1983, dollar borrowings were not advantageous, but since 1984, borrowings in dollars would have been more economical than borrowings in pesos. (A strong aversion to assuming the exchange risk nevertheless remains, see paras. 64-65.) Interest rates have also responded well to inflation, with rates for deposits as well as for loans remaining positive except in 1984 when inflation rose very rapidly. 14. Given the market determination of interest rates and the apparent competitive environment of the banking industry, why are the average intermediation margins as wide as 7Z to 10Z, the actual range during 1983- 86? The answer lies in fiscal impositions on the banking industry in the form of taxes and reserve requirements as well as high bank profit margins (para. 8). 15. There are two taxes imposed on the banking industry. First, the Gross Receipts Tax (GRT) is levied on all bank receipts (including both interest and capital gains). It is imposed at a sliding rate, with a lower rate on income from instruments of longer-term maturity; the maximum 5% is imposed on by far the most common maturity of less than two years. Since GRT is directly related to interest income, it is higher when nominal rates are high and lower when rates are low; it is thus not a stable source of income. Revenue from CRT amounted to P 0.75 billion in 1985, P 1.2 billion in 1986 and  P 1.0 billion or about 1.5X of total government revenues in the first ten months of 1987. The imposition of GRT has also caused some distortions in the financial system, e.g., it is suspected that the steep increase in amounts in trust accounts results from an attempt to undertake normal banking activities on an off-balance sheet basis (para. 25). During 1983-86, GRT added between 73 and 99 basis points to average intermediation costs. It is therefore recommended that GRT be eliminated at an early date. 16. In addition to GRT, there is a 20% withholding tax on deposit interest income from all but interbank deposits of under seven days. This tax is a credit against income tax, but is not refundable if the computed income tax falls short of the amount withheld. This causes some distortion relative to an efficient income tax because, it is understood, banks are often in the position where their computed income tax liability falls below the amount of their withholding tax. This may be corrected by allowing a refund of tax withheld to corporations whose tax returns are found satisfactory otherwise. A more limited and recommended measure would be to relieve all interbank interest payments from the withholding tax. This would also eliminate another undesirable practice among banks: since the tax is applicable to interbank deposits of more than seven days, banks prefer to invest their excess funds in short-term deposits of under seven days, on a rollover basis, regardless of what their actual liquidity needs are. This practice makes monitoring of the banking system difficult to the extent that it might lead to ovetstatement of actual liquidity of the system. 17. Intermediation cost is also high because the reserve requirements are high (21% on short-term deposits and 5X on deposits of two years or more and 1X on interbank deposits) on which interest is paid at the rate of 4% only. The below-market interest paid on reserves is, in effect, a tax on financial intermediation. The current fixed arrangement also causes large swings in the size of the implicit tax with fluctation in market interest rates. Although it is recognized that the primary aim of reserve requirements is to control liquidity, the conduct of monetary policy should also aim to minimize and eventually eliminate the implicit tax on financial intermediation and its volatility. The option of lowering the reserve requirements is not considered here because it would have immediate and significant monetary policy implications. Instead the approach suggested is to relate the interest paid on the required cash reserves to market rates. However, interest earning reserves should first be separated from those cash reserves that banks would hold anyway even in the absence of reserve requirements; there is no need to pay any interest on this portion of reserves. It is recommended that initially CBP should compensate banks for what it costs them to raise the reserves. This formula would result in interest payments to commercial banks at a rate which is less than their opportunity cost but at least defrays thei: cost of mobilizing deposits against reserve requirements. (It is estimated that at the end of 1987, the weighted average interest cost of reserves to the commercial banks was abcut 4.4%). Such a formula would also eliminate the large swings in the implicit tax on reserves. As a medium term goal, CBP could move in steps towards a rate that better reflects the opportunity cost to banks such as MRR. Also in the medium to long run, CBP could consider replacing a part (say 30%-402) of the cash reserve requirement with a second- ary reserve requirement consisting of T-bills. This would reduce considerably  - vi - the interest cost to CBP and would enable the rate paid on cash reserves to be increased toward MRR to better reflect the opportunity cost to banks. This change in the composition of reserves would, however, have to be implemented carefullv to avoid unintended monetary effects. 18. At the same time that the interest paid on reserves is increased to market rates, it is recommended that the preferential reserve requirement on deposits of more than two years be eliminated. These longer-term deposits are usually allowed to be withdrawn before maturing without a penalty, and the lower reserve requirement now represents an abuse. Increasing the reserve requirement in longer-term deposits by introducing a uniform rate for all deposits would also partially offset the higher cost of compensating reserves at market rates. Fostering Competition Among Banks 19. In an environment where the strong domestic banks are earning high profit margins, CBP should be particularly concerned with impediments to competition. It has already been noted (para. 8) that because the system is protecting small and weak banks with high operating costs, the sound banks have high profitability. Therefore when the shield from the weaker banks is removed following the recommendations made in paras. 4 and 6, the effective competition between the remaining banks should increase. Since the aim of policy is to ensure effective competition among banks, the policy to allow no new bank to be licensed needs to be reviewed. Because there are already too many small banks (para. 4), an indiscriminate policy of allowing new banks is not recommended. As noted earlier (para. 4), the most appropriate policy stance would be to encourage the establishment of new banks through takeovers/mergers of presently small and weak banks. The Government may wish To consider providing incentives to achieve this policy objective. If private domestic investors cannot be found, consideration should be given to allowing new foreign banks to enter this market; some international banks with off- shore operations are known to be interested in obtaining full banking licenses. The aim is that the strong domestic banks should not feel forever insulated from competition. 20. In addition, the current policy with respect to branching, which is very restrictive, should be reviewed. In most parts of the country, the purchase of special five-year securities is required, thus discouraging the establishment of branches. The CBP should consider substantially easing the establishment of new branches. It is recommended that in rural areas all restrictions on opening new branches should be removed, but at the same time positive incentives should be offered to commercial banks to open new branches by taking over weak rural banks. The result over time would be to improve banking services in rural areas and reduce the burden on the Government of bailing out failing rural banks. In urban and particularly metropolitan areas, CBP should retain its discretionary policy on branching, but allow a bank to open a new branch so long as the bank's market share in that area would not increase to near monopolistic level. The decision on branch opening should in principle be left to the banking industry; CBP should not concern itself with the validity of underlying business considerations, and its approval role should be restricted to verification of good standing of the  - vii - applicant bank. If the bank wishing to open new branches is already in weak financial condition, CBP should, however, take into account possible adverse effects of an increase in its overhead which the new branches would entail. The present requirement to purchase special five-year securities should be eliminated. Supervision and Regulation of Commercial Banks 21. Although there is scope for improvements, as discussed below, the prevailing system of l.ows and regulations governing supervision and regulation of banks is, in general, satisfactory. Issues relating to failing banks can be identified well before they reach a critical stage. What seems problematic is the reluctance to act firmly and to apply the available sanctions force- fully. In the enforcement of regulations, particularly those leading to closure of banks, the Monetary Board (MB, essentially the board of directors of CBP) has consistently followed a remedial approach, with prolonged negotia- tions over corrective measures and sustaining the weak banks over long periods. While CBP's ability to enforce corrective measures on the government-owned PNB and DBP was perhaps limited, MB certainly had more flex- ibility in dealing with private banks. The past reluctance to act firmly and quickly may, however, have been due to the inadequate legal framework governing CBP's relationship with the commercial banks and the insufficiency of the regulatory instruments svailable. Recommendations have consequently been made in this report (paras. 34-43) which address both deficiencies and should improve the situation considerably. It is therefore recommended that in the future CBP should consider adopting a firmer approach in dealing with banks which violate its rules and regulations, including the prescribed prudential guidelines. If, as a result of this approach, some weak banks are liquidated, the result would be a healthy consolidation and a stronger overall banking sector. The recommendation should not be taken to mean that a bank is closed abruptly and suddenly without allowing corrective measures reasonable time to show results. But the process snould not be allowed to drag on for years. 22. Along with the recommended change in its approach to, and philosophy governing, supervision and regulation, CBP should also consider the specific measures discussed below which would further improve the effectiveness of its already largely satisfactory supervision effort. 23. Reporting Requirements and On-Site Inspections. The system of reports that banks are required to submit to CBP (annual, quarterly and daily) seems to be comprehensive and adequate for supervisory needs. Whether all of the data and information thus received is effectively utilized is not certain, however. The data as collected are not easily manipulated electronically and thus limit CBP's analytical capabilities. It is thus recommended that CBP undertake, in cooperation with the Bankers' Association of the Philippines (BAP), a comprehensive review of reporting requirements. The principal aims of the review should be to standardize all reports as much as possible and enhance electronic manipulation of data both when being prepared by the banks and after receipt by CBP. Once reporting requirements have been streamlined and their usability and timeliness enhanced, greater reliance for supervision and regulation should be placed on continuous off-site monitoring through  - viii - reports. It is also recommended that CBP supplement the data collected by its own Corporate Advisory Services Department with that provided by the Credit Information Bureau of the Philippines, whose pe-formance in corporate intelligence gathering has been good. 24. Pro4isioning for Loan Losses. Although CBP's Manual of Examination Procedures contains guidelines on loan and other risk asset classification, there are no firm rules for banks to make loan loss provisions, and in the past CBP staff have had to rely on their own assessment of the quality of a bank's assets in judging the adequacy of provisions. This is time consuming, has at times led to disagreements between CBP staff and bank managements, and also has the potential for lack of uniformity in the application of standards. More recently, CBP has asked all banks to establish formal systems for asset evaluations and loan provisioning, certainly a step in the right direction. It is recommended that the underlying principles for asset valuation and loan provisioning, including definitions, be standardized and required to be applied uniformly by all banks. 25. Treatment of Trust Accounts. Trust accounts have increased substan- tially in recent years, totaling P 32.3 billion or more than 23X of total deposits as of December 31, 1986. While some of this increase may represent a genuine growth of trust business, there is evidence that several banks have gone beyond the traditional and proper fiduciary role of assisting clients to invest and manage their long-term savings. Indications are that trust accounts are being used to engage in normal bAnking activities on an off- balance sheet basis, with serious tax and reserve requirement implications. This not only leads to a loss of government revenue but, more seriously, distorts performance indicators, thus affecting supervision of the banking system. It is recommended that CBP undertake a detailed study of trust account management practices and devise a set of measures to prevent abuse. 26. Transparency and Consistency in Financial Reporting. The generally accepted accounting principles (GAAP) recently proposed by the Accounting Standards Council in cooperation with CBP represent considerable progress towards improving consistency and transparency in financial reporting. There is scope for considerable further improvement, however. It is recommended that GAAP should be revised further, concentrating on the definition of materiality; the definition, classification and reporting of renegotiated and past due loans; the treatment of trust accounts; and the definition, treatment and reporting of specific as well as general provisions for loan losses. The proposed revision should preferably be undertaken as a joint exercise between the Accounting Standards Council and CBP in close consultation with BAP. Alternatively, CBP should complement GAAP by issuing more vigorous require- ments as a CBP regulation. Supervision and Regulation of Securities Market Institutions 27. The principal supervisory agency for securities markets is the Securities and Exchange Commission (SEC) which was established in 1936. In addition to acting as the watchdog agency for the securities industry, SEC also acts as the Registrar of Companies, judicial body for settlement of intra corporate disputes and has a role in the rehabilitation of insolvent firms.  - ix - Corporate securities issues and market trading activities are governed principally by the Revised Securities Act of 1981 (the Act) and, to a lesser extent, by the Corporation Code of 1980. The SEC's regulatory function is solely for "investor protection," as the laws it administers make clear. It is not involved in general policy formulation in other areas that may affect the development of the securities market. 28. There are two mutually inconsistent threads in the current philosophy of corporate securities market regulation in the Philippines. The first is that of "self-regulation" and "self-policing", whereby the Act assumes that its requirements will be complied with by market participants and that if they are not complied with, harmed investors will sue for damages. This philosophy applies particularly to the stock exchanges which are required to be self- regulators. However, another strand runs through the Act and the Corporation Code which is inconsistent with the seli-regulatory approach: SEC applies considerable direct influence through an "approval" requirement. This approach allows SEC to approve or disapprove significant corporate activities, specifically those relating to the issuance of securities. It is this approach which seems to have set the philosophy under which SEC currently operates. 29. Zegulatory procedures under the Act are based on four major premises for investor protection. It is assumed that investors will be protected if (a) they have assured access to information on which they can base their investment decisions; (b) stock brokers are qualified and generally regulated; (c) the stock exchanges are registered with SEC and meet certain substantive standards, and (d) certain types of transactions and activities are prohibited. 30. Questions have arisen about the effectiveness of supervision and regulation of the securities industry because of a general dissatisfaction with the record of the stock exchanges. Four major factors would appear to be responsible for problems in this area: (a) there is an exclusive focus, in a philosophical sense, on investor protection; (b) under a regulatory scheme which made the stock exchanges responsible for self-regulation, the exchanges tended to interpret self-regulation as less or no regulation, with the result that SEC had to use its rule-making power directly, and effectively ceased to exercise its "oversight" function; (c) the laws governing supervision and regulation patterned after the US laws do not sufficiently take into account conditions in the Philippines and some laws have become antiquated and need to be revised; and (d) SEC may have been burdened with too many diversified functions. 31. It is recommended that the Government establish a Securities Market Development Commission to identify and remove impediments to, &nd encourage, securities market development so that the securities industry is able to play its legitimate developmental role of providing longer-term finance to enterprises. The Government may consider including the already existing joint government-private sector i&,r4tal Markets Development Task Force into the proposed commission. It would be preferable to have a majority of members from the private sector, but all relevant government departments should also be represented on the proposed commission so that all aspects of the market, legal, fiscal, etc., are considered. The proposed commission should also  examine whether the supervision and regulation of the securities industry is at present too fragmented. In addition, it should review all laws, rules, and regulations from the point of view of establishing a balance between market development and investor protection. The commission as proposed would not replace SEC and would not have a perpetual life. 32. The commission reccmmended above may also be asked to review the present functions and responsibilities of SEC to determine whether these, taken together, are too diversified to be effectively handled by a single agency. The SEC's judicial functions should specifically be reviewed in this regard. This review should also identify ways of strengthening SEC so that it may effectively handle the responsibilities and functions recommended for it by thge proposed commission. 33. The principle of self-regulation should be reiterated and fully enforced. The present mechanisms available to the stock exchanges for self- regulation should be reviewed to determine their adequacy and strengthened as necessary. Once this has been accomplished, SEC should limit its role to an oversight function but should be firmer in using its enforcement authority if the exchanges are subsequently found wanting in regulating themselves and their members. In pursuance to limiting its role to an oversight function, SEC should reconsider its "approval" powers. It is further recommended that SEC's current focus on full disclosure for new issues should be shifted to "rc-ontinuing disclosure" through periodic reports and ad hoc announcements. In addition to the content of disclosure, emphasis should be placed on its timing to deter potential misuse of inside information. Finally, it is recommended that a detailed review be undertaken of the Revised Securities Act of 1981 and Presidential Decree 902-A. The aim should be to bring a balance between developmental and investor protection objectives and to make these laws more responsive to the country's present and, more important, future needs. Legal Issues Affecting CBP-Commercial Bank Relationship 34. In the wake of a rash of bank failures, at least a dozen suits have been filed against CBP and its personnel. This litigation, which has been long and tedious, ha, 'ocused attention on the legal framework that governs the relationship between CBP and commercial banks. Questions have been raised particularly about the efficacy of the laws and procedures that govern bank failures and closures, and detection and prevention of insider abuse. The CBP staff also feel personally vulnerable to suits brought against them for their official acts, and this is now affectinging their performance. The following paragraphs examine these and related issues and make recommendations which, if implemented, are expected to reduce the incidence of litigation brought against bank supervisory authorities and to increase the chances of CBP's successful prosecution of wrongful acts by bank officials. Particular care has been taken that the recommendations do not dilute the doctrine of due process. * 35. Guidelines for Extending Emergency Loans to Banks in Distress. The current procedures relating to emergency loans to banks in distress appear to lack consistent application. This has led to allegations of CBP's arbitrariness and bad faith. Revised guidelines to govern emergency loans to  - xi - banks in distress should, therefore, be formulated and made public to ensure consistency in application and predictability for the affected banks. There should, first, be a general guideline on the maximum amount that CBP would advance to a bank in distress. The maximum amount might, for example, be equal to 50% of the amount of the bank's total deposits and deposit substi- tutes. Second, it is recommended that the emergency advance be disbursed in two tranches. The first tranche, to be disbursed shortly after a bank requests this assistance, should be equal to the value of good and easily verifiable collateral (as defined by CBP) offered by the bank or 25% of its total deposits and deposit substitutes,|whichever is less. The decision to release the second tranche, if needed, should take into account progress on the implementation of selected measures for performance improvements already agreed; it should be disbursed against the security of (a) lower quality assets that the bank may possess plus, (b) the personal assets of the principal shareholders of the bank, and (c) after the principal shareholders have agreed to hold any conservator appointed by MB harmless from legal suits which might be brought against him by any depositors, creditors or personnel of the bank. The amount and type of collateral to be furnished by the principal shareholders would be specified by MB. The requirement that the principal shareholders pledge their own assets would evidence their belief that the bank can be salvaged and signify their stake and commitment in effecting that goal. If the principal shareholders refuse to pledge their assets or refuse to hold the conservator harmless in case he is sued, CBP would take that fact into account in deciding on the disbursement of the second tranche. The CBP may also decide in that case to telescope the process leading to the appointment of a receiver. 36. Criteria for Declaring Bank Insolvent. The criteria currently used by MB in deciding whether or not to declare a bank insolvent are whether (a) the liabilities cf the bank exceed the realizable value of its assets, and (b) the bank's continuance in business would involve probable loss to the deposi- tors. The Study has concluded that these criteria may not be flexible enough to permit timely action by MB under all circumstances. Therefore, in order to give MB more flexibility, consideration should be given to adopting two additional criteria for declaring a bank insolvent: whether the bank is able to meet its obligations as they mature, and whether there is a willful viola- tion of a cease and desist order which has become final. 37. Banking laws and regulations in the Philippines do not currently provide bank supervisory authorities with powers to issue fully developed cease and desist orders. The CBP is thus deprived of a regulatory instrument which has proved very helpful in many other countries. It may prove of particular use to counter insider abuse (see the following paragraph) before the latter causes irreversible damage to a bank that leads to its failures. It is recommended that CBP adopt cease and desist orders as an additional regulatory and enforcement instrument to be used in a process of graduated response well before it becomes necessary to invoke maximal means such as commencing liquidation proceedings. Adoption and appropriate use of cease and desist orders would also tend to shield CBP against the occassional accusation that its actions are too harsh.  - xii - 38. Detecting and Countering Insider Abuse. It is generally believed in the Philippines that malpracticas associated with loans to bank directors, officers, stockholders and related interests (DOSRI loans), or insider abuses, are responsible for many bank failures. Bank supervisors find it almost impossible to detect these abuses in a simely fashion because of a law which tccords almost absolute secrecy to depositors. While in many countries, including the United States, no comparable secrecy is accorded to deposit transactions, it is not recommended to abolish the present law on deposit secrecy because, given the strongly entrenched feelings in the Philippines in its favor, it is feared that abolition of the law would harm the financial system by damaging investor confidence. It is recognized, however, that blanket secrecy makes the task of bank supervisors unnecessarily and unduly difficult. In order to curb insider abuses, a more focused approach is suggested: CBP should consider requiring all bank directors and senior officials to waive the secrecy accorded their own bank deposits wherever held, as a condition for their taking office. The legal authority to prescribe such a condition seems already to exist. The risk that such a condition might dissuade competent persons from becoming directors/officers seems minimal. Consideration could also be given to extending the proposed waiver requirement to borrowers whose loans exceed a threshold amount. 39. Insurance and Fidelity Bonds. There is no requirement for Philippine banks to carry insurance against loss arising from insider abuse. It is recommended that CBP and the Philippine Deposit Insurance Corporation (PDIC) consider possibility of requiring all banks to carry adequate insurance against loss arising from insider abuse. Recovery from such insurance in case of actual loss would help PDIC offset its payouts to insured depositors and other expenditures. 40. Institu .ion of Civil Suits. Bank directors, officials, and others accused of wrongdoing are subject to criminal suits, which are protracted and difficult to prosecute. It is recommended that the law should also expressly empower CBP to institute civil suits in such cases and that CBP should not hesitate to bring them whenever appropriate. Since the standard of proof required in civil suits is less stringent than for criminal suits, the chances of successful prosecution would be enhanced. The threat of civil suits would be an additional disincentive for wrong doing. 41. Decreasing the Threat of Litigation against CBP Staff. The CBP staff, particularly in the Bank Supervision Department, feel vulnerable to suits brought against them for actions taken in the performance of their duties. They fear that they might be held personally liable for damage if successfully prosecuted. Such fears are now affecting their performance. The suits can be brought by the Tanodbayan (the Ombudsman) and/or by private parties. The Tanodbayan is empowered to investigate and prosecute all public officials. If convicted, the public officer loses all retirement and gratuity benefits and must satisfy the criminal penalties to which he may be subject. Since the authority of Tanodbayan extends to all public officials, an exception for CBP staff is not considered feasible and not recommended. However, as regards suits brought by private parties, reassurances could be provided to CBP staff. It is recommended that CBP should examine, in consultation with the Department of Justice, the feasibility and desirability  - xiii - of Government's adopting a doctrine whereby only CBP as its instrumentality could be sued and not its staff. In the meantime, CBP should consider more limited measures to protect its staff such as the purchase of liability insurance on behalf of its staff, provision of free legal counsel, and payment from public funds for judgements obtained against them. These measures would at least reduce if not eliminate completely the burden of potential judgements against CBP staff and should prove reassuring to them. Enlarged Role of the Philippine Deposit Insurance Corporation 42. Currently, CBP staff act as the conservators, receivers and liquida- tors of failing banks. This practice gives rise to questions of conflict of interest and also places a heavy burden on CBP that adversely affects its normal supervisory and regulatory role. On the other hand, it deprives PDIC of any say in the affairs of a failing bank even though PDIC is responsible to pay depositors after a bank has been closed. The Study concludes that the solution to this problem may lie in a substantially enlarged role for PDIC. It is recommc;nded therefore that, by law, PDIC not only be authorized to serve as, but be required to be appointed as the receiver in all cases. This means that CBP s role would cease as soon as a determination has been made by MB that the condition of a bank has deteriorated to an extent that a receiver should be appointed; all subsequent decisions (i.e., whether to extend more loans for rehabilitation, or pay out depositors and liquidate the bank, or arrange for its sale to another institution) would, in accordance with this recommendation, be made by PDIC. For its expanded role, PDIC would need to be substantially strengthened financially as well as in terms of management and staff. 43. Since PDIC's authorized capital has not all been paid in, it has had to rely on large borrowings from CBP. In 1986, the interest paid by PDIC on CBP borrowings was more than its total premia income. It has consequently been unable to pay insured depositors in a timely fashion. There is thus an urgent need to augment PDIC's capital resources. 44. In view of the recommendation to enlarge the role of PDIC and to have a clear demarcation of functions between CBP and PDIC, it is also recommended that the Governor of CBP should not be the Chairman of PDIC. In fact a bill amending the PDIC Act currently before the Congress proposes that the Secretary, Department of Finance should be ex-officio Chairman of PDIC. This is a step in the right direction. Legal Issues Involved in Debt Recovery and Insolvencies 45. Debt Recovery. Under current law and procedures, it is extremely time consuming to foreclose a real estate mortgage (REM). A harmful result of the present law and procedures has been to make banks reluctant to engage in long-term secured lending. Instead, banks prefer to lend on a renewable short-term basis, preferring to have the assured right of not renewing a loan rather than the security of a mortgage which may be difficult to foreclose. Changes are needed in the law and procedures to make their application more efficient and less time-consuming.  - xiv - 46. Under the present law, foreclosure of REMs may be either judicial or extrajudicial. Since the judicial foreclosures take a long time, most foreclosures are extrajudicial. However, even extrajudicial foreclosures often become subject to judicial proceedings initiated by a mortgagor or other interested party. Extrajudicial foreclosure also has the disadvantage that it is subject to a one-year redemption period during which the mortgagor may buy back the property; mortgagees complain that the redemption period is in fact often used to strip the assets mortgaged. In the case of banks and other financial institutions, the one-year redemption period is allowed even after judicial foreclosures. In all cases, the law requires that the mortgaged property must be sold upon foreclosure. While it is not recommended to eliminate the requirement of sale in foreclosure, because it would be incon- sistent with the strong Philippine policy against pactum commissorium, other improvements are possible. First, it is recommended that the redemption period should be reduced from twelve months at present to six months, to reduce the risk of substantial deterioration in the value of the foreclosed assets. The law should also authorize arbitration or a summary procedure to permit expeditious determination of issues during negotiations for redemp- tion. Second, the differentiation between bank and nonbank mortgagees in the case of judicial foreclosure should be eliminated, i.e., no redemption period should be allowed after a judicial foreclosure even if the mortgagee is a bank. The assumption that the judicial process safeguards the rights and interests of a mortgagor should remain valid when the mortgagee is a bank. Third, the access to courts after an extrajudicial foreclosure, too easily available now, should be tightened. 47. Reform of the Insolvency Law. Given the imperatives of the present economic situation in the Philippines, insolvency and reorganizatitn laws should operate to safeguard the going concern value of the affected enter- prises while also protecting the rights of creditors. The current insolvency law in the Philippines is antiquated. First, the legislation is not explicit and there are no clear guidelines and standards for rehabilitation. Secondly, doubts exist about the powers of SEC, the agency responsible for appointing a receiver to prepare a reorganization plan for SEC's approval. Finally, the courts' authority to affect the rights of secured creditors is uncertain. To remedy this situation, the current law might be extensively revised, but it would be easier to make a fresh start. Enactment of new legislation is therefore recommended, with the following objectives: (a) the process of reorganization should be accorded adequate protection from subversion by seizure of assets by creditors, (b) the courts should be given explicit administrative authority to enable the debtor enterprises to continue opera- tions while the reorganization proceeds, and (c) the SEC or another agency should unambiguously have the power to appoir" a trustee (the SEC or other agency should not assume the trusteb role, to avoid a conflict of interest). The overriding consideration should be to reduce substantially the total time involved, if the reorganization and restructuring of an enterprise is to be successfully completed. 48. Other Legal Issues Involved in Debt Recovery. Three other legal issues relating to debt recovery are also problematic; these relate to fore- closure of a chattel mortgage, priorities of claims in distribution, and perfection of security interests. Regarding the foreclosure of a chattel  - xv - mortgage, the present procedures are similar to real estate mortgage fore- closure except that extrajudicial foreclosure in the case of a chattel mort- gaget if agreed between the parties concerned, may be effected through a private sale without notice or advertisement. It is recommended that to safeguard the mortgagor's rights, the secured creditor should be allowed to retain collateral without sale only if the mortgagor has waived his ri8ht to have a foreclosure sale. As regards the priorities o -caims in distribution, it is recommended that the number of preferences should be reduced from the present 14 categories and a maximum placed on the preferences retained. Finally, the law governing creation aud perfection of security interests should be reviewed and Amended to simplify it and enable better enforcement. Proposal to Set up Special Courts for Banking and Insolvency Cases 49. In view of the inordinate delays in resolving banking-related liti- gation and in foreclosure proceedings, it has been repeatedly proposed that jurisdiction of both kinds of litigation should be given to special tribunals with the expertise to make rulings and disposition expeditiously and competently. The Study recommends against setting up special tribunals or courts. The special courts ma7 not have enough business to keep them fully engaged and, therefore, would be expensive. Secondly, the grant of special cases runs the risk of developing a bias or corrupting the relationship between the court and the parties that appear before it. Third, a strongly theoretical argument against a special court for banking and insolvency cases is that other industries could then also make a case for special courts. These factors against setting up special tribunals outweigh potential advantages. Instead, it is recommended that panels of judges might be selected from courts of first instance to whom all cases would be referred that involve bankruptcies and reorganizations, including bank reorganiza- tion. The initial selection of the panels should take into account the judges' qualifications and past experience in the field. Over time, it can be expected that the judges would develop the specialized knowledge sought by those proposing a special court. Government/CBP-Directed Credit Programs 50. The Government/CBP role in credit allocation has taken two forms. First, commercial banks are required to lend up to 15X of their total loanable funds for general agricultural loans (the Agri requirement) and an additional lOZ to the beneficiaries of agrarian reform (the Agra requirement). The eligibility criteria for Agri lending are so broadly defined that even large multinational corporations qualify, and the banks have had no problem in meeting this requirement. On the other hand, it has been vezy difficult to find borrowers eligible under Agra criteria and banks have routinely, and legally, purchased special securities to meet the shortfall. It is recommended that both Agri and Agra requirements should be dropped because they do not serve any useful purpose; the Agri requirement is redundant as the scope for profitable agribusiness lending is substantial and the quota is not needed, and the Agra requirement is unrealistic and in any case does not result in increased lending for agrarian reform beneficiaries.  - xvi - 51. The second form of the Government/CBP role in credit allocation is more direct: the Government designs credit programs and subsequently assumes responsibility for their implementation and funding. These programs cover both agriculture and industry, although the former accounts for about 7O0 of the total amount outstanding for all directed credit programs (excluding Agri/ Agra). While an accurate accounting and quantification of these programs is not possible for lack of data, it is estimated that they accounted for about 52 to 72 of total banking sector loans outstanding as of the end of 1986. 52. In the agricultural sector, there are currently 49 financing and loan guarantee programs; the total resources devoted to these programs amounted to almost P 9 billion up to June 30, 1987, of which P 4.2 billion were still available for commitment. Domestic government resources account for almost 90% and foreign borrowings for the remaining 10% of total funding requirements for these programs. Most of the agricultural sector programs have quite specific objectives; only some are of a comprehensive type with broader sectoral objectives. Most of the loans made under these programs are short-term and unsecured, carrying subsidized rates of interest to both the participating financial institutions (PFIs) and the end users. 53. In the industrial sector, there are ten programs for providing loans, one for guarantees and one for providing both loans and guarantees (the Industrial Guarantee and Loan Fund, IGLF). Target clients are industries of all sizes, but particularly small-scale industries and export-oriented enterprises. Unlike the agricultural sector loan programs, a majority of industrial sector programs are funded by borrowings from foreign sources, including the World Baak, the Asian Development Bank and the Overseas Economic Cooperation Fund. Loans are short- as well as long-term. Interest rates have tended in recent years to be market-oriented but are still subsidized for a few programs. In the past, utilization of loans for some larger projects was affected by fixed interest rates which tell out of line with rapidly fluctuating variable rates. 54. As is clear from the foregoing, directed lending has been more per- vasive in the agricultural than the industrial sector. Overall, the results of government-directed credit programs can at best be described as mixed. In the agricultural sector, the objective of most of the programs were defined in such a way that cost considerations and the creation of efficient projects became of secondary importance. As a result, the programs became very expen- sive, particularly in terms of defaults. It is estimated that the subsidy provided to the endusers of funds under 13 major agricultural sector credit programs for which data are available amounted to at least P 3.4 billion during 1981-86 in the form of interest rate subsidies and uncollected loans. As a percentage of annual budget deficit during this period, the subsidies on these 13 programs ranged between a low of 2% in 1986 to a high of 8% in 1983. In the industrial sector, direct subsidies have been much smaller. The recent trend for both sectors has been a move away frcm subsidies; for all major programs (ALF, IGLF, Apex), the on-lending rates are now market oriented. 55. Despite recent efforts to consolidate government-directed credit programs (22 programs have been consolidated under the Comprehensive Agricul-  - xvii - ture Loan Fund, CALF), fragmentation of both the programs and implementing agencies continues. This results in inconsistencies in lending criteria, and makes performance monitoring difficult. The proliferation of uncoordinated programs has been accompanied by a wide range of on-lending rates charged to the final borrowers. In many cases, these rates reflect neither the cost of funds in the economy nor the stated priorities of the Government. 56. The Study notes that the basic nature of many of the programs, particularly the three major programs (ALF, ICLF, Apex), is changing so that while they still reflect broad government objectives, decisions on lending to individual borrowers and the credit risks involved are now being left to the banking system. The Study recommends the Government should continue in the direction it has already started in ski-:ply reducing its directed credit activities. More specifically it is recsmmended that the Government should: (a) phase out completely the relativelL small subsidized industrial sector programs which are currently being cd i istered by the Department of Trade and Industry; (b) sponsor programs only for clear areas of market failure and even there provide incentives and assistance for the financial sector to eventually fill these gaps; the study identifies two areas for Government action in the industrial sector, see paras. 60-62); (c) ensure that it does not assume credit risk and that lending decisions are left to PFIs; and (d) accelerate the move towards market determined lending terms for the agriculture sector programs. The CBP has already taken up the subject of market oriented lending rates with the Department of Agriculture. 57. As regards the terms and conditions for what should in the future be more appropriately called government sponsored credit programs, it is recom- mended that lending rates should be market-oriented: the lending rates to PFI should approximate the cost of similar funds in the market, and the rates to end users should be determined by PFIs based solely on commercial considera- tions. It is expected that both rates will be variable. In no case should the cost of funds to the Government (whether budgetary allocations or domestic/foreign borrowings) be the determining factor for setting rates either to PFIs or the end users. The Government should also ensure that the credit risk is assumed by PFIs. 58. As regards the organizational arrangements for managing these programs, it is noted that since mid-1986, CBP has relinquished the responsi- bility for policy decisions in respect of a number of agricultural programs; this responsibility now rests with CALF. This reduction of CBP's role in administering credit programs should be pursued further. It is recommended that, as early as practicable, Government should make alternative arrangements so that CBP's role in the long term is reduced to managing only its discount window. For agriculture sector programs, it is recommended that CALF should prepare itself to assume total responsibility for all remaining programs. For industrial sector programs, it is recommended that the administration responsibility is assigned to a revamped DBP (see paras. 62-63). 59. As an interim measure, the responsibility for managing these credit programs currently diffused in three CBP departments (the Department of Loans and Credit (DLC), the Supervision and Examination Sector III (SES III), and the Apex Unit) should be consolidated into DLC. SES III, which is responsible  - xviii - for supervision and regulation of rural banks, should not as a matter of principle also manage credit programs; its some 200 staff members involved in 27 credit allocation programs should be transferred to DLC. This functional consolidation should also be used to streamline the organization and maximize economies; it may be necessary to offer incentives to reduce staff substan- tially along lines already used for PNB/DBP. If the transfer of agricultural sector programs to CALF can be accomnlished quickly, it may not be necessary to merge the 27 credit programs currently under SES III into DLC as an interim measure. Gaps in Financing Selected Real Sectors 60. While the banking system has been able to meet most short-term credit needs of both agriculture and industry, the provision of export financing and of long-term credit has not been adequate. As for credit to exporters, the Government operates various schemes in its support. The most important export finance scheme is the rediscount of short-term working capital export loans by CBP, but these have been rapidly declining. As an indicator of this decline, the ratio of loans outstanding to export value has fallen from 14% in 1982 to 2X-4Z in 1984-86. In an effort to remedy this situation, a new refinance mechanism was recently established within IGLF. This is clearly a step in the right direction because it is independent of the overall liquidity management. This in itself is not expected to be sufficient, however. It is important that the credit intermediaries are provided a measure of comfort if their export loans, particularly to small exporters, are to increase appreciably. It is recommended therefore that the Government should consider establishing an effective guarantee mechanism which should cover both pre- and post shipment finance. The premia charged should, over time, cover the costs of risk insured. The Government is currently carrying out a study to determine the future course of PhilGuarantee's activities; it is important that as part of that study, the need to establish an effective guarantee mechanism for export finance be given carefuL attention. 61. The major gap in the current financing system is in the provision of long-term credit, particularly for the industrial secto-. This is expected to worsen as the demand for investment credit increases with the growth of the overall economy. If this expected increased demand for long-term credit is to be adequately met, satisfactory arrangements need to be made regarding credit, interest rate and liquidity risks. The credit risk in long-term lending in itself is substantial, and commercial banks' reluctance to assume it can realistically be reduced only if arrangements are made to relieve them of the liquidity risk, i.e., commercial banks cannot be expected to assume the liquidity risk in addition to the credit risk. Given the liquidity crises of the past, banks are simply unwilling to assume the liquidity risk inherent in term transformation, and the present liability maturities are not, nor are they expected in the foreseeable future to be, long enougn to enable the banks to lend long-term. Ironically, long-term resources are in 'act available in the system from institutional savers like insurance companies (including the Social Security System (SSS) and the Government Service Insurance System (GSIS)) and pension funds. These institutions are also willing to invest long-term in the private sector if suitable opportunities are identified,  - xix - i.e., they are willing to assume the maturity risk. As for the interest rate risk, the end users have already shown their willingness to assume it b7 borrowing on a var;able rate basis. What is needed is to develop a finan- cially viable institutional arrangement to bring all parties together. It would be inadvisable for institutions like SSS to start lending directly to end users for they would in that case need to develop their own project appraisal and supervision capabilities. 62. It is recommended that the task of developing a market in long-term paper should be assigned to a specific financial institution; for this purpose it may maintain a pool of its own resources by issuing bonds thus helping domestic securities market development or otherwise borrow in domestic and foreign markets. The designated institution may act strictly as a market maker, with the paper issued by banks immediately sold to institutions like SSS, Armed Forces Pension Fund, etc. The institution should be prepared to sell to long-term investors paper held in its own inventory but it should not assume the credit risk at any time, i.e., the paper should always be sold without recourse. The institution should also not assume the interest rate risk because rates should be as arranged between the banks and end users; they are expected to be variable so that the interest rate risk would be borne by the borrowers. In addition t' developing a market in long-term paper, such an institution should have two additional functions: it should be designated by the Government to be the manager of all official foreign borrowings the proceeds of which are used by the private sector, and the Government/CBP should transfer to it responsibility for the management and administration of all remaining industrial sector credit programs which were sponsored by the Government but which are now envisaged to be run on market terms with PFIs assuming the credit risk. The ultimate aim is an institution which mobilizes an increasing proportion of its resources domestically or on its own internationally. 63. It is recommended that the role of performing the functions mentioned above should be given to DBP. This would offer the advantage of using DBP's accumulated experience in term lending to provide guidance on project financing to the retail lending conduits. Given its past problems, however, DBP's lack of credibility as an inscitution run on business principles would severely hamper its ability to be viewed as being fully responsive to market forces. If DBP is to fulfill the envisaged role effec- tively it would be essential that steps are taken to give it a private sector orientation; the aim should be to convert it into a joint venture between the public and private sectors, with adequate private sector representation on its Board and complete autonomy in its decision-making. It would also be essen- tial to reduce DBP's retail lending operations sdbstantially, to eliminate direct competition with other lending conduits. Acting both as a retail and wholesale bank would also create competing demands for funds as well as staff resources, lead to possible conflicts of interest, and arouse the suspicion of the retailing intermediaries which, for fear of losing their clients to DBP as a direct retail lender, would be loathe to entrust it, in its capacity as a wholesale bank, with information on their borrowers. The nature and extent to which DBP should divest its retail lending operations would require careful analysis. Transformed as recommended, DBP would also be able to pay competi- tive salaries and to attract first-rate staff.  - xx - 64. As noted earlier (para. 61), the major gap in the system is in the provision of long-term finance. In the past, the Government attempted to fill this gap through foreign borrowings, recognizing that domestic savings were inadequate to meet investment requirements. To the extent foreign savings were obtained by the Covernment and passed on to the private sector, the Government followed principally two alternatives to manage the exchange risk involved: (a) it passed on the risk directly to the private enterprises; or (b) the Government assumed the risk for a pre-determined fee, which was not necessarily uniform in all cases. As for the on-lending rates, when the exchange risk was passed on to the end users they paid the rate charged by the foreign creditor; when the Government assumed the risk, the on-lending rates were determined by adding a fixed fee to the rate charged by the foreign creditor and were not uniform as a consequence. The results of these past practices have not been satisfactory. Where the end users assumed the exchange risk, they suffered heavy losses because of massive and sudden devaluations, often resulting in massive defaults which in turn contributed to insolvency of the intermediaries or necessitated their bail out by the Government. This experience has caused the private sector to become extremely risk averse to accepting open-ended foreign exchange liabilities. In the other case, when the Government assumed the exchange risk, the fixed premia rarely covered the actual subsequent losses; moreover, the fixed fees added to the borrowing cost which itself varied significantly depending on the currency involved, resulted in widely differing effective cost of foreign exchange to the end users. 65. This experience has led the Government to adopt recently a different approach for the two major current programs funded by official foreign borrowings (ALF and IGLF). Under this approach funds are passed on to intermediaries in Pesos at prevailing variable domestic interest rates. Given the need to import capital to finance the level of private investment necessary to maintain growth momentum, and the continued reluctance of enterprises to assume the foreign exchange risk, it is recommended that the Government on-lend in domestic currency at market rates the proceeds of official foreign borrowings which are to be channelled to the private sector. However, for this recommendation to remain valid it is essential that the overall policy environment continues to be such that interest rates are market determined and remain responsive to external factcrs, and that the proceeds of foreign borrowings are always onlent at market rates. Adoption of the recommendation should not preclude private sector borrowers (e.g. exporters) that are willing and able to borrow in foreign currency from bearing the risk. Concluding Remarks 66. The Philippines has gone through major political and economic upheavals during the first half of the eighties. It is unrealistic to believe that the banking sector could have escaped unscathed, and it did not. Between 1979 and 1985 considerable damage was done to the banking system. However, some ground has been recouped during the last two years and in fact the synltem as a whole has emerged stronger and in better health than it was in 1980.  - xxi - 67. But there are still weaknesses in the system and now that the most wrenching adjustments have been completed, it is an appropriate time to institute changes to make the system more resilient, efficient and responsive to the needs of the real sectors. Changes are needed in the policies that affe-t the financial system, in the ways in which the banking system operates, in its supervision and regulation by CBP, and in the relevant legal frame- woTk. This Study has made operationally-criented recommendations which address these concerns. It is expected that, as a result of implementing the proposed recommendations, the system would develop greater competitiveness and efficiency, reflected in the provision of better and more comprehensive services at lower cost to the real sectors, thus not only sustaining but giving an impetus to overall economic development and growth. Moreover, it is expected that bank supervision and regulation would become more effective and that less time would be wasted in litigation.  PHILIPPINES FINANCIAL SECTOR STUDY I. INTRODUCTION 1.1 This Study of the Philippine financial sector, with particular reference to commercial banking, has been undertaken with the endorsement of the Government and more specifically of the Central Bank of the Philippines (CBP). The need for the study was felt because of concevns about the commercial banks' performance, the problems they face, and the supervision and regulation of the commercial banks as well as the financial system as a whole. The health and performance of the banking sector is also of immediate importance to the World Bank not only because efficient financial intermediation is a sine qua non for the country's overall economic development and growth but also because the Bank employs as channels various credit intermediaries which participate in many of its lending operations. The Government's concerns, shared by the Bank, have arisen in response to the failure of several financial institutions in recent years, which raises questions not only about the health of the banking system but also about the effectiveness and timeliness of the supervision and regulation of the finan- cial system. Concerns were also prompted by a spate of legal suits against CBP and its personnel, a perceived shortage of long-term capital in the country, and extreme volatility in interest rates, inflation and exchange rates which have made the private sector so reluctant to assume exchange risks that available foreign exchange resources are being underutilized. 1.2 The concept of this Study was discussed with the Government during the summer of 1987 and terms of reference were finalized in the fall of that year. A Bank mission, which visited the Philippines in November 1987, included Messrs. Zamir Hasan (mission chief), ViLod Busjeet, Ahmed Jehani, Patrick Honohan, Alan Gelb and Mrs. Rebecca Sekse from the Bank; Robert Effros and Carl Lindgren from IMF; Lawrence Clarke from IFC; and Frederick Dahl, Christopher Barltrop, Frank Kennedy, Terrence Reilly and George Uy-Tioco as consultants. Terms of Reference 1.3 The terms of reference (TOR) focused the Study on the coumercial banking segment of the financial system as it existed at the end of 1986. The commercial banking sector was to be examined in detail, covering all aspects of its op2rations and financial condition, concluding with a statement on its health and the need and scope for restructuring. The Study was to review the supervision and regulation of the financial system with particular emphasis on commercial banks and the securities market. The TOR called particularly for an analysis of the legal aspects involved in CBP supervision in view of the legal suits brought against CBP and its personnel, as well as the legal aspects involved in debt recovery by commercial banks in view of the perceived poor quality of their portfolio. 1.4 The TOR also called for the identification of gaps in financing arrangements for the more important real sectors or market segments and particularly the need for long-term credit. In this context, the TOR also called for an examination of the role of CBP in credit allocation programs.  - 2 - While the first aspect was to be treated qualitatively and not like a sector finance study, the examination of CBP's role in credit allocation was to be detailed and include an assessment of the costs involved and consideration of possible alternatives. 1.5 Finally, the TOR asked for an examination of selected financial sector policies--those relating to interest rates, assumptions of exchange risk, lending conditions, and the relationship between CBP and commercial banks. 1.6 The scope of the Study excluded a detailed examination of (a) thrifts and rural banks, (b) the Social Security System and Government Services Insurance System,, and (c) the Philippine Deposit Insurance Corporation, which was to be briefly reviewed where relevant. Organization of the Report 1.7 The topics covered in the report, its focus and approach are, there- fore, those agreed in the terms of reference for the Study. The report itself is in three volumes: the main report including an executive summary, legal annexes and statistical annexes, respectively. The main report given here continues with an overview of the country's financial system, including a discussion of the economic and financial policies and events that have impacted and shaped it. Chapter III gives details of the commercial banking sector, followed in Chapters IV and V by an examination of the supervision and regulation of the financial system and the legal aspects involved. Chapter VI deals with the Government's directed credit programs and CBP's role in those programs. Chapter VII identifies the financing gaps constraining selected real sectors and suggests an institutional arrangement for meeting long-term credit needs. Each chapter is self contained in that analyses are followed immediately by evaluation, conclusions and recommendations. The final Chapter VIII provides overall concluding remarks and summarizes all recommendations. II. THE PHILIPPINE FINANCIAL SYSTEM 2.1 This chapter provides an overview of the Philippine financial system as background to the subsequent examination of the commercial banking sector, which is the focus of this study. The chapter first briefly recapitulates the recommendations of two important earlier studies, the 1972 International Monetary Fund (IMF)/CBP Banking Survey and the 1979 IMF/IBRD financial sector study, both of which have strongly influenced the present structure of the Philippine financial system. It then discusses selected policies and economic events since 1980 that have directly impacted and shaped the financial system, ending with an analysis of the financial system, in terms of its major components, as it stood at the end of 1986.  - 3 - A. Major Reforms in the Financial System up to 1980 The IMF/CBP Banking Survey Commission of 1972 I/ 2.2 After the end of World War II, the Philippine financial system grew rapidly. By 1970, a strong feeling had grown that the system had become unnecessarily complicated and fragmented. Morever, the rise of new forms of financial intermediation challenged the effectiveness of CBP's supervision and regulation of the system. The Joint IMF/CBP Banking Survey Commission was created in 1971 to review the overall system and recommend changes in its structure and operations to guide future growth. Based on commission findings and recommendations, amendments were made to the General Banking Act and the Central Bank Act in 1972-73. The more important changes were as follows: (a) the classification of banking institutions was simplified and reduced from five to three: commercial, thrifts and rural banks; (b) "banks," "banking institutions" and "nonbank financial institutions" were redefined to indicate the extent to which each type was subject to CBP regulation; (c) the system's rules, regulations, restrictions and incentives were geared more to the types of activities carried out than to the type of institution involved; (d) CBP authority was expanded to cover the entire credit system (except insurance companies); (e) CBP's responsibilities were redefined to exclude promotion of economic growth, which was to rest primarily with the government planning agencies; and (f) no new banks were allowed to enter the system and an effort was made to improve the efficiency of banks already in existence. Since that time, no new commercial banks have been established. The IMF/IBRD Financial Sector Study of 1979 2/ 2.3 The IMF/IBRD financial sector study of 1979 found that the Philippine financial system was technically well developed for the Philippines' stage of development, but was still highly concentrated in the capital, Manila, which accounted for some 432 of commercial bank branches and 962 of commercial bank loans. The system was patterned after the U.S. banking system which featured functional specialization and legal separation between comiercial, savings, development, and investment banking and capital market activities. The banking system, excluding CBP, accounted for 60% of the assets of the financial system, and was fragmented into (a) 27 private commercial banks (with 27Z of system assets), one government commercial bank (11M), and four foreign commercial banks (6Z), all of which performed full service deposit taking, lending, and trade financing transaction banking; (b) 114 thrift banks (3x) engaged in gathering savings deposits but not demand deposits; (c) 985 rural banks (2Z) engaged in agricultural lending, predomi- nantly using funds provided by the Government under agricultural development programs; and (d) three specialized government banks (11Z)--the Development 1/ The Joint IMF/CBP Banking Survey Commission on the Philippine financial system was headed jointly by Messrs. Armand Fabella and San Lin. Mr. Jose B. Fernandez, one of the four commission members, is now the Governor of CBP. 2/ The Philippines: Aspects of the Financial Sector, IMF/World Bank Report, No. 2546-PU, October 1, 1979.  -4- Bank of the Philippines (DBP), the Land Bank of the Philippines (LBP) and the Philippine Amanah Bank. The CBP accounted for 21Z of the financial system's assets, while other nonbank financial intermediaries (insurance companies, pension funds and trust managers) accounted for the remaining 19%. While the late 1970s had shown a rapid expansion in bank credit, a disproportionate amount was concentrated in short-term lending, leaving medium- and long-term debt and equity needs partially unfulfilled. 2.4 Two major recommendations came out of the 1979 study: (a) deregula- tion of interest rates and (b) introduction of a "universal" banking system to reduce the fragmentation of financial intermediation and to encourage broader access to financial resources. Implementation of these recommendations was initiated in March 1980, when the country's banking laws were amended to permit the adoption of a universal banking system patterned on the German model. In July 1980, CBP issued guidelines for implementation of various changes. The objectives of these reforms were to increase the flow of savings through the system, to increase the proportion of funds made available to medium- and long-term borrowers, and to increase competitive conditions and economies of scale to produce greater efficiency within the financial system. 2.5 The minimum capital requirement for commercial banks was raised to P 100 million. Commercial banks that achieved a capital lyel of P 500 mil- lion could apply to CBP to become universal or "unibanks" 1' and, upon approval, were authorized to expand their activities to include near-banking activities such as those associated with investment houses, leasing companies and finance companies that had not previously been open to commercial banks. Unibanks were also permitted to make equity investments in allied and non- allied enterprises and were authorized to issue credit guarantees. Capital adequacy was graduated to require a 10% capital-to-risk asset ratio for banks capitalized at less than P 500 million, an 81 ratio for banks capitalized at P 500 million but less than P 700 million, and a 6% ratio for banks capitalized at P 700 million or more, effectively increasing the lending ceilings for unibanks. Thrift banks, which included savings and loan associa- tions, mortgage banks and private development banks, were permitted to provide full domestic commercial banking services including (with prior CBP authoriza- tion based on the applicant thrift bank's good standing) acceptance of demand deposits. 2.6 Banks that became unibanks were required to broaden their ownership base so that no one family or business group could retain control. No single domestic owner or group of owners within three levels of consanguinity were permitted to have more than 20% of the voting stock, while ownership by foreign interests was limited to 40%. At least 10% of the stock had to be offered to the general public and listed on the stock exchange. Ownership concentrations that existed prior to the new laws could continue until reduced voluntarily, but could not be increased above the new limits. Investments in 3/ Nine commercial banks converted to unibanks, of which one (Manila Bank) is no longer functioning. Current unibanks are Allied Bank, Bank of the Philippine Islands, City Trust, Far East Bank, Metropolitan Bank, Philippine Commercial and International Bank, Philippine National Bank and Uniced Coconut Planters Bank.  non-allied enterprises by unibanks as well as ordinary commercial banks were restricted to 35% of voting stock. In practice, however, all but one of the private commercial banks are still closely allied with one or more of the leading families; indirect ownership through companies where no visible connection is evident is difficult to detect. 2.7 The other major recommendation of the 1979 study was to deregulate interest rates. This was implemented in several steps, and interest rates are now market-determined. A detailed discussion of interest rates is undertaken later in paras 2.28-2.36. B. Major Economic and Financial Events of the 1980s 2.8 The financial system in the Philippines has been strongly influenced by the country's disturbed and fluctuating economic situation during the current decade. Since 1980, the Philippine economy has gone through three main phases. First, a period of growth extending until 1983 and accompanied by an increasing imbalance in international payments, a period also marked by a money market crisis in 1981. The second phase was the period of economic contraction from 1983 until at least the end of 1985, during which time inflation surged and then abated. This phase was characterized by an active monetary and exchange rate policy, with large devaluations and extremely high nominal interest rates. The most recent phase, which is continuing, is one of gradual economic recovery. 1980-83: Growth, Deficits and the Money Market Crisis 2.9 Following the 1970s when growth rates averaged over 6% per annum and despite the adverse impact of the second round of oil price increases, the Philippine economy continued to expand into 1983, with growth rates averaging over 4% in 1980 and 1981. This growth was, however, fueled by expansionary domestic policies (especially in 1981 and 1982), and was achieved at the cost of increasing pressures on tbe balance of payments, with the current account deficit totalling US$10 billion in the four years, 1980-83. The longer-term threat that this posed to the economy iid not fully manifest itself until 1983. 2.10 Nevertheless, the early 1980s were not without their problems. In 1981, a textile magnate, Dewey Dee, slipped out of the country, leaving behind debts running into hundreds of millions of pesos. Although these debts (only some of which were secured) accounted for only a small percentage of the total assets of the financial system, the default triggered a widespread crisis. This was partly because it followed a series of investment frauds and stockbroker failures which had already increased the fragility of the system. The Dewey Dee crisis and the insolvencies it caused (particularly in investment houses and finance companies which had significant credit exposures to Dee) reverberated throughout the economy, creating liquidity shortages even for nonfinancial firms not direc.ly connected with the crisis. 2.11 The Dewey Dee crisis was contained--at some cost to CBP--and did not result in a recession, but it did have an adverse impact on investor confi- dence. It exposed the weakness of the commercial paper market which prompted the authorities to tighten criteria for the registration of commercial paper, introduce credit ratings and establish a network of authorized government  securities dealers, among other measures. At the same time, the major commer- cial banks benefited from the crisis by a tendency on the part of depositors to shift their funds to what they perceived as safer havens. Private nonbank financial institutions experienced a withdrawal of some P 2 billion, or about one fifth of deposit substitutes, and this liquidity squeeze had to be met by emergency advances from CIP of a comparable magnitude. Some of the weaker nonbank financial institutions were merged with commercial banks. 1983-85: Economic Contraction and the External Financing Shock 2.12 The contraction of 1983-85 was by far the most severe in the Philippines since the Second World War. A gradual loss of confidence in the Philippine economy accelerated with the political events of the autumn of 1983, resulting in a serious outflow of funds, and particularly a withdrawal of suppliers' credits. Faced with this situation, in October 1983, the Government introduced a rationing system for foreign exchange and a moratorium on capital repayments abroad. The practical consequence of these events was that for the next two years the economy was not in a position to avail of foreign capital. From a deficit of US$2.8 billion, equivalent to over 4Z of GNP in 1983, the current account of the balance of payments contracted sharply to a deficit of less than US$0.1 billion, equivalent to 0.3X of CNP in 1985, and moved into a surplus of just over US$1 billion, equivalent to 3.4Z of CNP in 1986. As the export sector remained weak, this implied a very sharp fall in total imports, achieved partly by a contraction in overall domestic expenditure (which resulted in a fall in overall economic activity) and partly by a tightening of import restrictions. 2.13 Economic activity did not contract uniformly across economic sectors from its peak in 1983 to #-he trough in 1985. Between these two years, real GDP fell by just 10Z, but the fall was disproportionately felt in the con- struction sector (which continued to decline into 1986), and in the finance and housing branches of the services sector. Manufacturing also contributed a relatively large share of the fall in activity while some other sectors, notably agriculture, continusd to grow. 2.14 The decline in output of the banking subsector alone amounted to about one quarter of the decline in GDP. The recession had exposed the poor quality of a large part of the loan portfolio of financial institutions, and part of the fall in financial sector output reflected write-offs and provisions. When the banks' losses are subtracted from the remainder of their value-added in 1985, the result is a zero contribution to GNP in that year compared to almost 2.5% of CNP in 1983. 2.15 Despite the fall in national income, real consumption spending is estimated to have been virtually unchanged from 1983 to 1985, with a small decline in real government consumption being more than offset by a small increase in personal consumption (the latter reflecting the fact that real personal income remained stable through the recession). The fall in domestic expenditure was thus concentrated in capital formation which fell by more than a half in real terms, with sharp declines in all categories: construction, equipment and stocks; private and public. Personal savings already reached a very low level by 1983--little more than 1% of personal disposable income-- and, despite high real rates of interest, did not recover until 1986, when it approached 6%. The collapse in corporate income after 1983 had the result  - 7 - that corporate savings were negative for the first time. Details of national accounts and balance of payments as well as sectoral output are given in Annexes 1 and 2. 2.16 The process of adjustment over the two year period 1983-85 involved considerable financial turbulence. The external financing difficulties forced a decline in the external value of the peso, notably in the large devaluations of October 1983 and June 1984. The depreciation resulted in serious inflationary pressures, which were met by a policy of monetary contraction and high interest rates. A striking feature of this period is the degree to which domestic inflation adjusted rapidly and fully to exchange rate depreciation, as shown in Figure 2.1. The time lag seems to have been only a few months in the case of the two largest devaluations, so that the devalxtions had only a very transitory impact on the real effective exchange rate.- 4/ As Figure 2.1 shows, the response of domestic prices to the sharp depreciations of 1983 and 1984 was rapid. Consumer Price Index (CPI) inflation peaked two months after the major devaluation of 1983, and only one month after the major devaluation of 1984. This makes it impossible to represent the process in a simple regression equation. A reasonably good relationship was obtained with the following error correction model: P = 0.125 E + 0.274 E(-l) - 22.6 K(-2)*3 - 0.0940 K(-3) (5.3) (10.9) (8.4) (3.9) Method: Cochran-Orcutt, rho-0.521 (4.9) RSQ = 0,853 SEE = 0.00353 DW = 1.97 Sample 1983:3-1987:10 Monthly (t-statistics in parentheses) where P and E are logarithmic changes in Philippine CPI and in the peso/$ exchange rate; K is the log ratio of the CPI and the exchange rate. K can be interpreted as the deviation from purchasing power prrity, as it differs from zero when prices have not changed in proportion to the exchange rate. Thus the equation predicts that deviations from purchasing power parity will give rise to a subsequent tendency to correct this deviation. Price response to large depreciations is more rapid than to small ones, as suggested by the term in K cubed (K*3). This equation gives a rapid theoretical response of price to exchange rate changes, with some estimated difference in the response of inflation to large and small depreciations. For example, one month after a month in which a 1OZ depreciation has occurred, domestic prices are estimated to respond 4.0X; after three and six months the response totals 6.8Z and 8.42 respectively. A 15Z devaluation sees prices rise by 14.02 after only three months, reaching 15.0X after four .)nLha (and overshooting slightly to 15.4Z after six months). The precise speed of response is very sensitive to the exact specification of the equation in this kind of analysis; this should be borne in mind in applying the equation outside of the historical experience.  FIGURE 2.1 PHILIPPINES: PRICE AND EXCHANGE RATE MOVEMENTS (Logarithmic monthly change) : J 20% 10 20z A.......... ._ . .. ... ... . . ... . .....- _,,, .., f. .. - 198P 1984 1985 19P6 19B7 -PRlCS ....... PEso/oss  2.17 Though the events of late 1983 substantially increased reserve money, this was not reflected in any easing of nominal money market rates. An aggressive policy of monetary contraction was initiated in early 1984. This policy was effected through the sale of a new instrument, central bank bills (CB bills), at very high discounts. By November 1984, CB bill rates were between 392 and 44X, and other money market rates also rose, though they did not quite reach the same level. The available data indicated a sharp fall between 1983 and 1986 in bank credit to the private sector, even in nominal terms; the fall in real terms was much steeper, as shown in Table 2.1: Table 2.1: DOMESTIC CREDIT 1980-86 (billion pesos) 1980 1981 1982 1983 1984 1985 1986 1987 (June) Government 5.2 9.6 16.9 15.7 13.3 14.3 11.9 -20.7 Other Public Sector 2.5 2.0 4.1 11.0 14.5 17.8 13.3 11.5 Private Sector 86.1 103.7 118.1 144.1 138.3 124.6 97.3 108.8 Total 93.8 115.3 139.1 170.8 166.1 156.7 122.5 99.6 2 GNP Government 3.0 3.2 5.0 4.1 2.6 2.4 1.9 -3.1 Other Public Sector 0.9 0.7 1.2 2.9 2.7 3.0 2.2 1.7 Private Sector 32.5 34.2 35.2 38.1 26.2 21.0 15.8 16.1 Total 35.4 38.1 41.5 45.4 31.5 26.4 19.9 14.7 1980-Pesos (billion) Government 5.2 5.6 8.9 7.6 5.8 4.1 2.9 -5.0 Other Public Sector 2.5 1.2 2.2 5.3 6.3 5.2 3.3 2.8 Private Sector 86.1 60.4 62.3 69.9 60.0 36.1 23.9 26.3 Total 93.8 67.2 73.4 82.8 72.1 45.4 30.1 24.1 2.18 The monetary contraction halted the spiral of inflation and exchange rate depreciation, and contributed to the decline in capital formation. By 1986, the price level had stabilized following a two-year period in which it had increased by over 90Z. 2.19 The sharp fall in credit to the private sector between 1983 and 1986, as shown by the above table and in Figure 2.2, is generally attributed to a lack of demand from business, as political uncertainty--anAd high interest rates-discouraged investment. Another factor, namely increased caution on the part of banks, probably also contributed (as evidenced by the somewhat shorter loan maturities and greater requirements for security prevailing since  DOMESTIC CREDIT) 1982-87 Figure 2.2 180 - 170 - 160 - 150 - 140 - 130- w 120 ~,110 __100 s o - 70- 60- 50 - 40 -- 30- 20 101 _ 1982 1983 1984 1985 1986 1987 (June) YEARS tl Nominal + Real  - 11 - 1984). Bank lending rates increased, but not as much as money-market rates, and the rates on CB bills and Treasury bills (T-bills) (see Table 2.2). This suggests that the banks were unable to find borrowers willing and able to pay higher interest rates. Table 2.2: TREASURY BILL AND PRIVATE SECTOR LOAN RATES, 1980-86 1980 1981 1982 1983 1984 1985 1986 T-Bills 3 Month 12.1 12.6 13.8 14.2 40.9 26.2 16.3 6 Month 12.5 13.1 14.5 14.8 30.5 24.8 14.4 12 Month 12.8 13.2 15.0 14.9 41.5 35.2 13.2 Max "Safe" Return /a 10.2 10.6 12.0 11.9 33.2 28.2 13.0 Real "Safe" Return -0.3 2.2 0.0 -37.9 15.5 26.4 8.0 Loan Rates /b 12.8 14.4 14.5 16.2 18.9 17.0 14.2 Differential 2.6 3.8 2.5 4.3 -14.3 -11.2 1.0 /a The higher of the 3, 6 or 12 month T-bill average nominal rate less the 20Z Final Tax. /b Weighted average loan rates less the 5% Cross Receipts Tax. 2.20 Because of their high yield and freedom from credit risk, bills were a very attractive investment for banks during this period, and by September 1985 commercial banks held P 11.5 billion in bills, or over one fifth of the combined CB bill and T-bili issues. Nevertheless, the bulk of bills were held outside the banking system, and the banks saw their deposit resources decline. During 1986, bill yields fell sharply, and declined below bank lending rates. 2.21 The large sales of T-bills outside the banking system had the effect of limiting the Government's needs for borrowing from the banking system. In fact since 1982, the Government has received less than 10% of credit extended by the domestic banking system and by the end of 1986 5he public sector share in total outstanding credit was reduced to about 20pbt 2.22 The financing of the deficit outside the banking system, as stated above, resulted in a notable degree of disintermediation. This caused the liquidity to decline rather sharply since 1983 when measured in terms of M3 5/ The monetary policy operations in the first half of 1987, whereby retiring CB-bills were replaced, on their maturity, by new issues of T-bills have resulted in a situation where the Government has become a net creditor of the monetary system (June 30, 1987).  - 12 - (the precentage of M3/CNP declined from 282-29% during 1982-83 to about 202 at the end of June 1987). However, if T-bills and CB-bills are added to M3, the percentage to GNP remains stable (from 29% and 31% at the end of 1982 and 1983 respectively, it actually increased to 33% at the end of June 1987. 2.23 It would be possible to argue that the attractiveness of bills caused the banks to restrict credit, but a simpler explanation is that, even though bank lending rates were lower than bill rates, they were still suffi- ciently high to discourage many potential borrowers, in addition to those who had cancelled investment and stocking plans because of the recession and economic uncertainty. Indeed, the fall in capital formation was propor- tionately steeper than the fall in private domestic credit. Stock decumula- tion was also very pronounced during 1984 and 1985, when the fall in the value of stocks was equivalent to two thirds of the fall in domestic credit. 2.24 To summarize, although it is difficult to prove, credit rationing by the banks seems to have played a comparatively small role in the decline in bank credit, which instead appears largely attributable to a decline in the demand for credit at all interest rates, compounded by an increase in bank lending rates. 1986-87 and Beyond: the Economic Pick-up 2.25 A modest resumption of external funding, together with a reversal of capital flight and renewed confidence in the economy resulted in an economic recovery, beginning during 1986. In 1987, GNP growth was about 5%, the highest since 1980. Nevertheless, this growth rate was below the authorities' objective, and with population still growing at almost 2.5% p.a., it would take six or seven more years of real growth at 1987 rates to restore the level of per capita income reached in the early 1980s. 2.26 Overall economic recovery is expected to continue in 1988, with low inflation and stable interest and exchange rates. The yield curve on deposits has re-established positive maturity premia, but loan demand is still weak and liquidity high, with a continued relatively small maturity premium of less than 2% on loans in excess of one year, as compared to the pre-1982 figure of 5%. Concerns with economic and political stability have continued to be reig7 forced by attemyed coups, the continuing insurgency problems and union-led -/ worker strikes,- particularly against export-related and foreign-owned industry. 6/ Unions range from relatively quiescent house unions to militant unions intent on disruption of the economy. Almost all commercial banks are unionized. 7/ Sympathy strikes in support of workers at other companies within the same area are particularly troublesome, and are blamed for discouraging investment from Japan and particularly Taiwan.  - 13 - 2.27 Inflation resumed during 1987, but has remained in single digits. Nominal interest rates eased after the middle of 1986, and though there was some hardening of rates in the last quarter of 1987, it cannot be compared to the earlier period of monetary contraction. Real rates have remained positive since 1984 and moved in tandem with nominal rates. The peso's value in terms of the US dollar has remained comparatively steady. Because exchange rates of the ASEAN competitor countries have also tended to decline with the dollar, the exchange rate of the peso against the weighted average of ASEAN currencies has not shown any declining trend. As had been projected, the trade balance and current account have deteriorated from 1986. Interest Rate Policy 2.28 Change in Policy. The events of the 1980s have wrought substantial changes in the way interest rates are determined. There has been a gradual move away from a regime of close control over interest rates combined with restrictions on international payments, current as well as capital, to a system which in practice is open to international flows and characterized by market-determined interest rates. Starting in 1980, ceilings on various categories of bank lending and deposit rates were eased and then progressively removed. The last deposit rate ceiling (on deposits with maturity of two years or less) was removed in mid-1981, and the last lending rate ceiling (on short-term loans) on January 1, 1983. Before the deregulation of interest rates, the banks had been circumventing the ceiling through a proliferation of additional charges and fees. The change thus brought greater transparency to the system. 2.29 Interest rate movements since deregulation are summarized in Annex 3 which shows the rapid increase in most rates in 1984, and the gradual decline since then. The movements in 12-month T-bill rates as shown in Figure 2.3 illustrate this point. As the increased magnitude of interest rate fluctuations made long-term fixed interest lending unattractive to the banks, variable rate lending became standard. As shown in Annex 3, real interest rates in the Philippines have remained substantially positive for deposits as well as lending, except in 1983, when inflation suddenly flared up. 2.30 Interest Rate Determination. In the absence of regulation, interest rates in the Philippines are now determined by the interaction of supply and demand. As in most countries where a market interest rate system applies, interest rates on different instruments are interlinked by the possibility of substitution both on the part of borrowers and of lenders. In the Philippines, the T-bill auction has become a key influence on market interest rates, largely because of the amount of funds involved. As already mentioned (paras. 2.20-2.21) holdings of T-bills outside the banking system have grown rapidly in recent years, reaching P 85 billion in June 1987. This may be compared with about P 140 billion for M3 as of the same date. In order to attract or retain large deposits, banks must offer rates which are suffi- ciently competitive with T-bills. Because of the size of the T-bill issue, all rates are inevitabLy driven by current and prospective T-bill rates. 2.31 Civen the influence of the T-bill rate on other market interest rates, the latter are freely determined only if the T-bill rate is determined  TREASURY BILL RATES, 1982-86 Flgure 2.3 50 - 40 - 30- 20- 10~~~~~~~~~~~~~~~0 0- -10 -20 - -30- 1982 1983 1984 1985 1986 YEARS [ZZ1 Nominal T-Bills IeJ Real T-Bills  - 15 - in a truly competitive market. This would not be the case if there were collusion among the authorized dealers at the auction which would be mani- fested by a gap between auction and secondary market prices; if occurring among a subset of dealers, it should be detectable from the pattern of bids. The CBP is aware of the risks in this area, and has taken steps such as authorizing as dealers only a set of firms which are not interrelated, whether through officers or equity. 2.32 The Government's practice of sometimes adjusting the quantity of bills sold does not call itto question the degree to which interest rates are truly market determined. The practice of sometimes witholding a part of an issue is very different from imposing an interest rate ceiling and forbidding transactions above that ceiling. The difference lies in the fact that with a binding interest rate ceiling, the market will not clear, whereas the rate determined by a variable amount of bills sold is the market clearing rate. In attempting to influence interest rates in this way, CBP is al3o heavily constrained by the need to finance the fiscal deficit and by its monetary program. 2.33 Overall, therefore, the T-bill rate, and with it a whole range of other interest rates, appears to be truly market-determined, and thus subject to forces beyond the direct control of the authorities. As explained below, among all factors, external influences now seem to be the most important determinants of market interest rates. 2.34 External Influences.