Phlippines - Financial Sector Adjustment Loan

Document of The World Bank FOR OFFICIAL USE ONLY Report No. 14524 PROJECT COMPLETION REPORT PHILIPPINES FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN 3049-PH) MAY 19, 1995 Country Operations 1 Country Department I East Asia and Pacific Regional Office This docurnent 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 EOUIVALENTS Average 1993-US$1.0 = P27.7 Average 1992-US$1.0 = P25.1 Average 1991-US$1.0 = P26.7 Average 1990-US$1.0 = P24.7 Average 1989-US$1.0 = P21.7 Average 1988-US$1.0 = P21.1 Average 1987-US$1.0 = P20.6 Average 1986-US$1.0 = P20.4 Fiscal Year January 1 to December 31 ACRONYMS and ABBREVIATIONS BSP - Bangko Sentral ng Pilipinas CBP - Central Bank of the Philippines CMA - Central Monetary Authority CMS - Capital Market Study COA - Commission on Audit DBP - Development Bank of the Philippines DOA - Department of Agriculture DOF - Department of Finance DOSRI - Borrowing by Insiders (Directors, Officers, Stock Holders, etc.) EFF - Extended Fund Facility (IMF) ERL - Economic Recovery Program Loan FSAL - Financial Sector Adjustment Loan FSS - Financial Sector Study GAAP - Generally Accepted Accounting Principles GCs - Government Corporation GDP - Gross Domestic Product GFIs - Government Financial Institutions GNP - Gross National Product GOP - Government of the Philippines GRT - Gross Receipts Tax IGLF - Industrial Guarantee and Loan Fund IMF - International Monetary Fund JEXIM - Japan Export-Import Bank MB - Monetary Board NG - National Government OECF - Overseas Economic Cooperation Fund (Japan) PCR - Project Completion Report PDIC - Philippine Deposit Insurance Corporation PNB - Philippine National Bank  FOR OFFICIAL USE ONLY THE WORLD BANK Washington, D.C. 20433 U.S.A. Office of Director-General Operations Evaluation May 19, 1995 MEMORANDUM TO THE EXECUTIVE DIRECTORS AND THE PRESIDENT SUBJECT: Project Completion Report on Philippines Financial Sector Adjustment Loan (Loan 3049-PH) Attached is the Project Completion Report (PCR) for the Philippines Financial Sector Adjustment Loan (Loan 3049-PH) prepared by the East Asia and Pacific Regional Office. Part II, contributed by the Borrower, discusses project implementation and lessons learned. The objectives of the project were to: (a) strengthen the supervision and the regulatory framework for banks; (b) increase depositor protection; (c) reduce intermediation costs; (d) improve mobilization and delivery of long term credit and (e) restructure financially the Central Bank. The project also included cofinancing and technical assistance from Japan. In general, implementation was satisfactory whenever reforms fell exclusively within Government purview. They lagged behind schedule, however, when legislative action was required. The major accomplishments of the adjustment program were the passage of a bill restructuring the Central Bank into an independent and financially viable institution, the strengthening of the deposit insurance corporation, the improvement of supervision procedures, and the enactment of four important amendments to the Central Banking Act to improve financial sector soundness. Government sponsored credit programs were also transferred from the Central Bank to appropriate institutions. During supervision, Bank staff discovered that the problems facing the Central Bank were much more serious than anticipated and reflected in the loan's original conditionality. Fortunately, these problems were acted upon by extending the closing date and agreeing on new conditionality for second tranche release. A main lesson from this experience is that the sector studies undertaken to provide a basis for designing an adjustment program should be timely, comprehensive and in-depth in order to head off surprises. A complex operation like this one requires highly skilled multidisciplinary Bank and Borrower counterpart teams. It is also necessary to ensure that the Government has the administrative capability and the commitment to fully implement the program. Close collaboration with IMF is indispensable. All of these conditions were met. The project outcome is rated as highly satisfactory, its sustainability as likely, and its institutional development impact as substantial. The PCR is of good quality. It provides extensive information on the implementation of the adjustment program. The PCR, however, does not assess the direct effect of the reforms on financial sector performance, except for mentioning a short term decline in real interest rates. An audit is planned. Robert Picciotto by Francisco Aguirre-Sacasa Attachrment This document 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.   FOR OFFICIAL USE ONLY PHILIPPINES FINANCLIL SECTOR ADJUSTMENT LOAN (LOAN 3049-PH) PROJECT CONMPLETION REPORT Table of Contents Preface . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . I . . . . . . . . i Evaluation Summary. ii I. PROJECT REVIEW FROM BANK'S PERSPECTIVE ............... I 1. Project Identity ....................................... 1 2. Project Background ..................................... 1 A. The Macroeconomic Setting .......................... 1 B. The Financial Sector Context ......................... 2 3. The Financial Sector Adjustment Program ..... .......... . 4 A. Objectives and Scope of the Program .................... 4 B. Justification of the Program .......................... 5 4. Bank's Role in Structural Adjustment and Reform .................. 5 A. The Historical Perspective ........................... 5 B. The Financial Sector Adjustment Loan (FSAL) .... .......... 7 C. The Technical Assistance ............................ 8 5. Project Implementation and Tranche Release ..................... 9 6. Accomplishments of the Reform Program ..11 7. Sustainability.. 14 8. Bank/Borrower Performance ..14 9. Main Lessons Learned ...... ........... .................. 16 II. PROJECT REVIEW FROM BORROWER'S PERSPECTIVE .... ...... 18 1. Introduction ......................................... 18 2. The Financial Sector Adjustment Program: Description and Objectives . 18 3. Performance with Respect to Specific Policy Commitments under the Loan Macroeconomic Policies .19 4. Specific Conditionalities .20 5. Lessons Learned During the Evolution and Implementation of the Program . . 23 6. Conclusion .24 This document 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. l  III. STATISTICAL INFORMATION ............................. 25 1. Related Bank Loans .................................... 25 2. Project Timetable ...................................... 26 3. Cumulative Estimated and Actual Disbursements ...... .. .......... 26 4. Use of Bank Resources .................................. 27 A. Staff Inputs .................................... 27 B. Missions ...................................... 27 ANNEXES L.A Government's Statement of Policy on Financial Sector Adjustment (April 3, 1989) 28 11.B Government's Request for Extension of Closing Date (December 14, 1992) .... 37 2 Tranche Release Conditions (April 1989/December 1992) ............... 38  - i - PROJECT COMPLETION REPORT PHILIPPINES FINANCIAL SECTOR ADJUST\,E,NT LOAN (LOAN 3049-PmR PREFACE 1. This is the Project Completion Report (PCR) for the Financial Sector Adjustment Loan (FSAL) to the Philippines, (Loan 3049-PH) which was approved by the Board on May 4, 1989 in the amount of US$300.0 million equivalent . The Loan supported the Government of the Philippines' Financial Sector Adjustment Program, articulated in its "Statement of Policy on Financial Sector Adjustment" dated April 3, 1989 (Annex 1A). The Loan involved a close and active working relationship with the International Monetary Fund (IMF). 2. The proceeds of the Loan were withdrawn from the Loan Account for eligible expenditures made in respect of the reasonable cost of goods required during the execution of the program in two equal installments. The first tranche of US$150.0 million was made available for disbursement as the Loan became effective on July 18, 1989, and was fully disbursed on October 4, 1989. The second tranche, also of US$150.0 million, was released after completion of the agreed actions (Annex 2). Since there were delays in completion of these actions, the original loan closing date (December 31, 1991) was extended four times to allow the Government to fulfill all the mutually agreed conditions (including a new major condition, agreed prior to the second extension). The Loan was closed on December 20, 1993, and the Loan Account was closed on December 22, 1993 when the second tranche was fully disbursed. 3. The PCR (Preface, Evaluation Summnary, Parts I and III) was prepared by the (then) Industry and Energy Operations Division of Country Department 1, East Asia and Pacific Regional Office. The implementing agency of the program, Bangko Sentral ng Pilipinas (BSP), formerly the Central Bank of the Philippines (CBP), provided Part II. Preparation of this PCR is based, among other sources, on the Initiating Memorandum, President's Report (April 16, 1989) and Memorandum (December 22, 1993), and other Reports of the President; Loan Agreement, Government Policy Letter, Country Economic Memorandum, Capital Market Study (Report No. 10053-PH); IMF Staff Reports; Bank supervision reports; correspondence between the Bank and BSP and the national government and its institutions; audit report's; Board discussion of the Loan and other internal Bank documents, supplemented by staff interviews. 4. Japan's Eximbank (JEXIM) and Overseas Economic Cooperation Fund (OECF) supported the Adjustment Program, each with co-financing of US$300.0 million equivalent, which was disbursed in complete concordance with the Bank tranche release. In addition, a technical assistance grant fund (No. TF 026180) of Yen 607.5 billion (approximately US$4.7 million equivalent) was provided by the Government of Japan to help the Philippines to upgrade the staff and systems capabilities of the key institutions. This fund, administered by the Bank, was also fully disbursed.   - ii - PHILIPPINES FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN 3049-PH) PROJECT COMPLETION REPORT EVALUATION SUMMARY 1. Obiectives and Scone of the Program. The Bank worked closely with the Central Bank of the Philippines (CBP) and the Department of Finance (DOF), first to conduct a major study of the financial sector and, based on its findings, to develop a program of financial sector adjustment. The program was articulated by the Government of the Philippines (GOP) in its "Statement of Policy on Financial Sector Adjustment" (Annex 1A). The adjustment program was supported by the Bank under the Financial Sector Adjustment Loan (FSAL) for US$300.0 million equivalent to be released in two tranches of US$150.0 million each. The FSAL was cofinanced with Japan's Eximbank (JEXIM) and Overseas Economic Cooperation Fund (OECF), which also funded US$300.0 million equivalent each. This cofinancing mirrored the Bank Loan completely, and its tranching was fully tied-in with Bank tranching arrangments (para. 3.1). 2. The broad objective of the adjustment program was to strengthen the financial system, particularly the commercial banking system. The program aimed to: (a) strengthen the supervision and regulatory framework for commercial banks; (b) improve the institutional arrangement for depositor protection; (c) reduce the intermediation costs in the banking system; and (d) improve the institutional framework for the mobilization and delivery of long-term credit. The program involved implementation of specific actions to help accomplish these objectives - some of which were to be accomplished through administrative measures, while others required legislative actions. While the program was under implementation, the Bank completed the Capital Market Study which discovered that the CBP was insolvent, and would require a major financial restructuring. As a result, the program's objectives and scope were expanded to include a major additional condition regarding the CBP's financial restructuring (paras. 3.2 and 3.3). 3. Project Implementation and Tranche Release. The first tranche of the Loan was released on the date of loan effectiveness because the GOP had already either completed certain actions or had made significant progress towards their completion. These included actions in the areas of supervision and regulations, institutional arrangements for depositor protection, fund mobilization, delivery of term funds, and the phasing out of the CBP's role in credit allocation (para. 5.1). 4. The release of the second tranche required completion of the proposed reform program and involved specific legislative actions, completion of studies and actions based thereon, institutional strengthening of the Philippine Deposit Insurance Corporation (PDIC), transformation of the Development Bank of the Philippines (DBP) into a wholesale institution, and termination of CBP's role in management of government sponsored credit programs (para. 5.2). 5. A Bank review of the progress made in implementing the reform program indicated that the overall performance was encouraging, but mixed. In general, the GOP had made satisfactory progress  - iii - wherever executive orders were sufficient, but it seriously lagged behind the schedule wherever legislative actions were required. The Bank, therefore, agreed to the GOP's request for a one year extension of the closing to December 31, 1992. The Bank mounted a special review mission just prior to the new closing date. The GOP agreed with the Bank's assessment that the problems faced by CBP were far more fundamental than those to be addressed through the proposed amendments to the CBP Act, and thus agreed to include an additional major condition regarding the financial restructuring of the CBP for the tranche release (Annex IB) (paras. 5.4 - 5.6). 6. The Bank again reviewed the progress made by the GOP in meeting the tranche release conditions and concluded that, without the personal intervention of the President of the Philippines, all the remaining conditions were unlikely to be satisfied by the stipulated closing date and, as a result, cancellation of the second tranche became a real possibility. However, after concerted efforts by the GOP, a Central Monetary Authority (CMA) Bill satisfactory to the Bank was passed by the Congress on June 10, 1993, which the President signed into Law on the same day. The CMA Law provided a framework for restructuring the CBP, but left it to a committee to complete these transactions. More time was therefore required and so the closing date was extended to December 20, 1993. Finally, all 10 conditions of the second tranche release (including the newly added completion of the CBP's financial restructuring, i.e., actual completion of the transactions involved in the restructuring) were fulfilled on December 22, 1993 (Annex 2) (para. 5.7). 7. Accomplishments of the Reform Program. The financial sector adjustment reforms have been successfully completed by the GOP due to its strong commitment, decisive actions and exemplary leadership, albeit, with significant financial as well as technical support from the Bank. As recognized by the GOP, the Bank's Board and others, the FSAL may be considered to be one of the most successful operations of the Bank in the Philippines. Its developmental impact on the Philippine economy is going to be profound in the long run, which has already started showing unmistakable signs of recovery and strength. A unique feature of the reform program is the passage of a bill creating a new central bank, CMA that would be independent and financially viable, and thus capable of conducting effective monetary and exchange rate policies (paras. 6.1 and 6.2). 8. The major accomplishments of the adjustment program are: (a) Financial Restructurine of the CBP. The insolvency of CBP was a major macroeconomic distortion in the Philippines and was the main cause of high intermediation cost and financial disintermediation. The new CMA Act, which became law on July 3, 1993, satisfied key objectives of the restructuring, which were to: (i) make the central bank financially solvent with a positive net worth; (ii) enable the central bank to operate as an independent institution; (iii) facilitate the effective conduct of monetary policy without resorting to monetary instruments that distort financial intermediation; (iv) reduce the financial intermediation cost over time; and (v) have a financial structure that would ensure that the central bank will not have to depend on the GOP for budgetary support; (b) Enactment of the Amendments to the Central Banking Act. Four important amendments incorporated into the new CMA Bill were: (i) guidelines for emergency loans to banks in distress; (ii) adoption of transparent criteria for issuing cease and desist orders; (iii) for borrowings by insiders (DOSRI) above a certain size, borrowers would waive secrecy rights; and (iv) authorization of the CBP to indemnify or purchase liability insurance for staff to protect them from civil litigation; (c) Transfer of Government Sponsored Credit Programs from the CBP to Appropriate Institutions. During the 1980s, the CBP was heavily involved in providing directed credits to the private sector at below market rates, which contributed to CBP's operating losses. The directed credit program of the CBP is now limited to the operations of export finance; (d) Improvement in Supervision and Regulatorv Procedures. The CBP has undertaken a comprehensive review of a bank's reporting requirements, loan loss provisions, trust accounts, and of the Generally Accepted Accounting Principles  - Iv - (GAAP); (e) Strengthening of PDIC. The new PDIC Act was passed in February 1992 and, subsequently, appropriate steps have been taken to further augment PDIC's capital to the Bank's satisfaction; and (f) Economic Impact of Follow-up Actions. The accomplishments of the central bank restructuring and other financial sector reforms associated with the FSAL have led to the creation of a macroeconomic environment that is conducive to sustainable, healthy economic growth. In particular, the financial sector reforms have enabled the GOP to pursue effective and prudent macroeconomic policies as reflected in its Medium-Term Macroeconomic Framework, and the agreement under the IMF's Extended Fund Facility signed in May 1994. Further, the central bank restructuring would enable the GOP to take additional steps to make further improvements in the government securities market, contractual savings sector, taxation of financial instruments, and stock market (paras. 6.3 - 6.8). 9. Sustainability. The prospects of a sustainable development impact by the financial sector reform program are very promising, and the conclusions support the GOP's efforts to further deregulate the financial markets as a means to achieving a higher level of economic growth. The revenue generating capacity of the GOP has been enhanced through the enactment of several legislative measures, which will enhance the effectiveness of the reform program. The GOP as well as the private sector are convinced about the potential of these reforms and have taken many steps in this direction. While the GOP's recent macroeconomic management has been reassuring, and the Philippine economy is bouncing back, major impediments to a higher level of sustainable growth still remain, due largely to the underlying financial weakness of the public sector (paras. 7.1 and 7.2). The GOP will need to continue to address this constraint to ensure sustainable growth. 10. Main Lessons Learned The main lessons that may be relevant for the Bank and the Borrower alike in designing and implementing other similar projects may be summarized as: (a) A comprehensive and complex reform program, in order to be effective and successful, requires significant input of multidisciplinary teams (at the Bank and the counterparts in the NG), intensive interactive dialogue and negotiations, strong Bank support during implementation and, above all, political will and a full commitment to the program by the government; (b) While designing the project, the Bank together with the NG should carefully evaluate that the existing and expected macroeconomic framework is conducive to and that the institutional infrastructure is capable of undertaking and completing the reform program; (c) The sector study that is necessary to provide a basis for designing an adjustment program should be both comprehensive and in-depth; the weaknesses of key institutions (e.g., CBP) and their macroeconomic implications should be fully addressed, even at the risk of revealing a startling disclosure; (d) Since legislative action may not be within the purview of an NG's executive authorities which are responsible for project implementation, the Bank should carefully weigh its options and their trade-offs in designing the project (particularly, the loan conditionalities); (e) If passage of new law(s) or amendments to existing laws are considered necessary for a reform program to be effective and purposeful, the project should proceed only upon passage of such legislation; (f) While it may be appropriate and necessary in a reform program to keep its momentum and hence to have a tight time schedule, due allowance should also be given to political realities, administrative capabilities and external exigencies that may change govermnent priorities or deflect its attention from the program implementation; (g) A fundamental reform like the major financial restructuring of a central bank requires highly skilled and experienced staff, consensus building, innovative design, interactive dialogue and unwavering commitment from the Bank management and close collaboration with the IMF as well as NG's full conviction and firm commitment; and (h) A major reform program should be complemented by cofinancing and technical assistance, as they provide an additional incentive (i.e., a larger pool of funds) to follow the arduous and painstaking path of adjustment, and strengthen the institutions in order to carry forward the program with effectiveness and efficiency (para. 8.4).   PHILIPPINES FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN 3049-PH) PROJECT COMPLETION REPORT PART I: PROJECT REVIEW FROM BANK'S PERSPECTIVE 1. Proiect Identitd Project Name: Financial Sector Adjustment Loan (FSAL) Loan No: 3049-PH RVP Unit: East Asia & Pacific Country: Philippines Sector: Financial Subsector: Commercial Banking 2. Project Background A. The Macroeconomic Setting 2.1 Since the Philippines achieved independence in 1946, its economy has experienced a pattern of relatively high growth (especially till the 1970s) interrupted by a series of crises, which led to in an ever increasing debt (both external and domestic) burden. Exacerbated by the political crises in 1983, the impact of these crises had become too severe during the 1980s-primarily owing to national government's (NG's) continued strategy of borrowing its way out of the external payments burden instead of addressing the underlying causes. The willingness of the NG to borrow internationally during the 1970s and early 1980s, coupled with an easy access to external fmancing, led to accumulation of large amount of external debt, which, in turn, enabled the Philippines to postpone necessary structural and sectoral adjustments. It was only when the external debt burden completely dried up external finances (especially from conmmercial sources) that the Philippines initiated implementation of a comprehensive structural adjustment program.' 2.2 The Philippine strategy of financing growth through external borrowing is reflected in the inadequacy of domestic savings to finance the domestic investment over a long period of time. Specifically, the public sector remained a dissever till end-1980s and it tapped private savings to finance The first World Bank Structural Adjustment Loan (SAL) to the Philippines wS made in 1980, followed by the second in 1983. Since then several sectoral adjustment loans have been made by the Bank. In addition, the Philippines has been in the midst of almost an uninterrupted series of the International Monetary Fund (IMF) programs since 1970. (See Part 111, Table 1 for the Dank's adjustment operations.)  its investment. It deprived the private sector from productive investments, and its competition for investable funds led to higher real interest rates. The Government of the Philippines (GOP) thus had accumulated substantial amounts of external and domestic debt till end-1980s. This debt would not have been burdensome if the funds were invested in financially sound and economically viable projects. Apparently, these investments had little positive impact on the economy; otherwise the GOP should have been able to capture a significant portion from the increased tax revenues. The excessive external borrowing by the GOP till early 1980s enabled it to sustain a reasonable level of domestic investment and finance the gap between domestic investment and savings. Unfortunately, this sizeable investment had produced only negligible output growth since it was used inefficiently, resulting in unsustainable debt accumulation and debt serving-difficulties in the early and mid-1980s.2 The 1983, political crises (assassination of Benigno Aquino) preceded by exogenous factors, such as the second oil shock in 1979 and the global external debt problem in 1982, hurt the fragile Philippine economy, and led to its sharp contraction and loss of confidence in its financial system. 2.3 By end-1983 several measures were undertaken by the GOP to regain confidence in the financial system: the exchange rate was devalued by 55%, a moratorium on principal repayments on foreign debt was announced (although interest payments were maintained current), and imports were curtailed through the introduction of a strict licensing regime. The external payments crises resulted in an unprecedented recession: between 1983 and 1985 the real gross domestic product (GDP) experienced a decline of 14%, prices increased by 80% and employment fell by 12%. The dramatic adjustment in the economy was driven by a sudden inversion of the course of fiscal and monetary policy, and led the GOP to embark on a major stabilization effort with the support of the International Monetary Fund (IMF) and the Bank. Overall, the objectives of the stabilization programs were met or surpassed: the inflation was brought under control with the consumer price index registering an increase of 8.8% in 1988 and 3.8% in 1987, compared to 50.0% in 1984 and 23.0% in 1985; GDP growth was positive in 1986 and accelerated to 4.8% in 1987 and 6.3% in 1988; the current account balance (before official transfers) swung from a deficit equal to 4.8% of gross national product (GNP) in 1984 to a surplus equal to 3.0% of GNP in 1986 and showed only slight deficits in 1987 (1.3%) and 1988 (1.0%); and the economy was substantially more open and distortions were also reduced. The performance of the Philippine economy was thus commendable among the highly indebted countries in combining strong growth with low inflation; and a challenge that the NG faced then was: how to sustain the economic growth without accumulating unreasonable level of public debt. B. The Financial Sector Context 2.4 The dimension of the financial crises was in fact even more dramatic than that of the overall macroeconomic crises. The value added by the financial sector declined by 25% during 1983-85, due mainly to write-offs of non-performing assets. Domestic liquidity decreased by almost seven percentage points of GDP and banking credit to the private sector by almost 20 percentage points of GDP (from its peak of 33% of GDP in 1983 to less than 14% in 1986). Further, the two most important results of the 1983 financial crises were a shift in public deficit financing from external to domestic sources, and a sharp deterioration in the financial condition of the Central Bank of the Philippines (CBP). The drying up of external financing, the inability of the Government to reduce the public sector deficit to sustainable 2 The rising government debt led to a rapidly increasing ratio of interest payments to Government's revenue: from 11.0% in 1983 to 42.2% in 1988.  levels, and the inability of CBP to monetize these deficits required large sterilization operations which resulted in a large increase in public domestic debt: the public debt outstanding increased from Pesos 61 billion at end-1983 to Pesos 144 billion at end-1986, to Pesos 207 billion at end-1988. The increase in domestic public debt led to an increase in both the level and volatility of domestic real interest rates, and to a shift in composition of private sector portfolios away from the deposits into the government securities. The increase in the level of financial assets and in the share of government securities required, in turn, a marked increase in real interest rates. The interest rates on savings and time deposits had been negative, in real terms, for most of the post-war period until the 1980 rate liberalization. In the aftermath of the 1983 crises, nominal interest rates increased rapidly, but real ex-post interest rates initially remained negative. Since 1986, with the sharp increase in public debt and the decline in inflation rates, real interest rates turned positive and high: between 1985 and 1989 as the public debt outstanding increased from 19 to 25 percentage points of GDP, the real ex-post interest rate on Treasury bills increased from 3% to 12%. 2.5 The financial problers of the CBP had exerted direct repercussions on the financial market because of the constrains they impose on the choice of monetary policy instruments. Because of the negative foreign exchange position of the CBP, the exchange rate management during the 1980s was geared more toward reducing CBP's losses rather than real sector considerations. The autonomy of the CBP had been severely undermined by the inappropriate fiscal policies and financial transactions which it was obliged to conduct on behalf of the NG. During 1986, the CBP was asked to assume the foreign currency liabilities of certain public and private enterprises. The CBP also advanced the payment of moratorium interest on maturing obligations of certain public corporations guaranteed by the GOP. These liabilities led to large realized and unrealized losses. As a result, the CBP had been de facto financing the fiscal deficit which should have been assumed by the GOP. CBP's independence in monetary management had also been affected by transactions such as providing forward cover to oil companies to enable them to maintain oil price suppor'ts. The CBP did not have adequate foreign exchange reserves to actually support such transactions and it had to enter into swap arrangements to maintain the two-tier exchange rate system which was not sustainable. The structure of its liabilities and these transactions led to huge losses during 1986-90, and CBP's losses accounted (on average) for about 55% of the consolidated public sector deficit. The CBP's losses were not properly financed by the NG and the CBP had to resort to the banking system to cover the losses through very high reserve requirements (25%) on which it paid only four percent interest compared with the market rate of about 20%. 2.6 Commercial Banking System. As expected, the banking system was the most important segment of the Philippine financial system and commercial banks were a dominant force in the banking and financial sector. There were 30 commercial banks with a network of 1,812 branches at the end of 1990: 27 domestic banks including the Philippines National Bank (PNB)-(the largest commercial bank sharing 13%-16% of the assets, loans, deposits, and capital of the conmercial banking system), which was restructured and partially privatized; 2 specialized government-owned banks, Development Bank of the Philippines (DBP) and Land Bank of the Philippines (LBP); and the Philippines Ananah Bank (PAB). Out of these 30 banks, 12 were "universal banks" that were authorized to carry out investment banking functions. The 5 largest "universal banks" accounted for about 53% of the assets, 50% of the loans, 57% of deposits, and 41 % of the capital of the commercial banking system. Several other important developments had occurred in the commercial banking system during the 1980s. First, the direct role of the GOP in commnercial banking had declined with the shrinkage of the PNB. Second, the commercial banking system had survived the crises of the mid-1980s, it had adapted well to the changes in macroeconomic policy, and had emerged as a much stronger industry (e.g. in terns of profitability and retained earnings), although it had incurred sharp losses during 1985 and 1986 because of the contraction  - 4 - of the economy and massive devaluations. Third, although the loan/deposit ratio had declined from 107% in 1980 to 68% in 1990, actual credit available to the private sector was higher since 58% of trust operations (an off-balance sheet activity) were dedicated to corporate sector loans. Fourth, the role of foreign currency deposits in commercial bank liabilities had sharply increased and had helped to reduce the weighted average cost of funds. Finally, because of the structural changes in the mix of assets and liabilities, interest income as a source of revenue had declined from 91 % in 1980 to 81 % in 1990. Fee based income and income from trading activities (especially in foreign exchange trading) had shown a marked increase to 18% of total revenue. 3. The Financial Sector Adjustment Program A. Objectives and Scope of the Program 3.1 The Bank worked closely with the CBP and the Department of Finance (DOF), first to conduct a major study of the financial sector, and based on its fundings then to develop a program of financial sector adjustment. The program as articulated by the GOP in its "Statement of Policy on Financial Sector Adjustment" is provided in the letter dated April 3, 1989, addressed to the Bank President (Annex IA). In the context of this program, the Bank had also worked closely with the IMF. The GOP programn was supported by the Bank under the FSAL for US$300.0 million equivalent to be released in two tranches of US$ 150.0 rnillion each. The FSAL was cofinanced with Japan's Eximbank (JEXIM) and Overseas Economic Cooperation Fund (OECF); which also funded US$300.0 million equivalent each. The cofinancing was a complete mirror of the Bank Loan with its tranching fully tied in with the Bank tranching. In addition, to help the GOP implement the program, a technical assistance grant fund (TF) for Yen 607.5 billion equivalent (approximately US$5.0 million) was provided by the Government of Japan, especially to upgrade the staff and systems capabilities of the CBP, DBP, and the Philippines Deposit Insurance Corporation (PDIC). 3.2 The broad objective of the adjustment program was to strengthen the financial system, particularly the commercial banking segment. Specifically, the reform program aimed to:(a) strengthen the supervision and regulatory framework for commercial banks; (b) improve the institutional arrangement for depositor protection; (c) reduce the intermediation costs in the banking system; and (d) improve the institutional framework for the mobilization and delivery of long-term credit. It was expected that as a result there would be enhanced confidence in the financial system. 3.3 The program involved implementation of specific actions to help accomplish these objectives; of which some were to be accomplished through administrative measures, while others required changes in law and, therefore, legislative action, an outlined below: (a) Bank supervision and regulation were to be improved by: (i) strengthening the legal and supervisory framework so as to empower CBP to take corrective actions in a timely fashion with respect to problem banks and, if necessary, to affect bank closures; (ii) improving the supervisory and regulatory procedures; and (iii) separating the supervisory and regulatory function from receivership-liquidation; (b) Arrangements for depositor protection were to be strengthened by enlarging the role of the PDIC to empower it to act as receiver-liquidator of failing banks and strengthening it  financially and institutionally to enable it to play that role effectively; (c) Intermediation costs were to be reduced through promotion of more effective competition, reduction and elimination of certain fiscal impositions as well as improvement of laws governing debt recovery and insolvencies; and (d) Fund mobilization and medium-and long-term credit delivery were to be enhanced through actions involving a revamping of the DBP to enable it to act essentially as a wholesaler of long-term funds, and the elimination of the CBP's role in credit allocation. B. Justification of the Program 3.4 The main benefit from the Program was to be the creation of a healthier and more efficient financial sector, required to not only sustain but give an impetus to overall economic development of the Philippines. In particular, the strengthened bank supervision and regulatory framework for commercial banks, the improved institutional arrangements for depositor protection, the reduced intermediation costs in the banking system, and the improved institutional framework for the mobilization and delivery of medium-and long-term credit were to contribute towards a more competitive and effective banking system, enhance confidence in the financial system, benefit the investors and savers alike. These reforms and measures were to reduce time-consuming and wasteful unnecessary litigation which was a problem in the past, lead to a better savings performance in the future, and lower the cost of the banking services provided to real sectors. The Program had risks also, which were mostly associated with possible delays and/or inadequate implementation. The principal concem in this regard was that the legislative action could either be unduly delayed or prove to be deficient when completed. Although, most legal amendments (except revision of the bankruptcy/insolvency Act) were already drafted and agreed with the Bank, these agreed amendments were already presented to the legislature for approval. Yet notwithstanding government commitment to carry out the needed reforms, considerable delay occurred in the passage of key legislation and consequently in the release of the second tranche, which, in turn, also led to the financial restructuring of the CBP (as discussed in paras 5.4-5.7). 4. Bank's Role in Structural Adjustment and Reform A. The Historical Perspective 4.1 The Philippines was one of the first nations to pursue structural adjustment, starting with the first Structural Adjustment Loan (SAL-1) from the Bank in 1980. Since then it has imnplemented reforms in a broad range of areas: agricultural pricing and marketing, trade policy, energy policy, investment incentives, the financial system, the tax system, public corporations, and foreign-exchange management.(See Part 111, Table 1 for the Bank supported adjustment programs.) The Bank had completed its first study of the Philippine financial sector in 1979/80, and beginning in 1980 the GOP implemented its main recommendations aimed at the deepening and liberalization of the financial system. In particular, the interest rates were deregulated, capital requirements for banks were increased, and "universal banks" were introduced - all in an effort to increase savings mobilization by the financial system and to curb its fragmentation. However, these institutional improvements were undermined by the government measures instituted to combat effect of external factors, which led to a gradual weakening  - 6 - of the financial system. Specifically, the counter-cyclical fiscal policy implemented subsequent to the 1979 oil crises was accompanied by liberal lending on the part of the banking system-particularly by the two largest government-owned banks, the PNB and the DBP. In 1981, the default of textile entrepreneur Dewey Dee triggered a series of bankruptcies, which exposed the weakness of investment and broker houses, and contributed towards an overall weakening of the banking system and eroding the confidence of foreign lenders. 4.2 At the end of 1984, IMF Standby Arrangement and Bank SAL-II led to the resumption of external capital flows, and supported country's stabilization and reform program. The rescheduling of agreements with commercial and bilateral creditors, together with the securing of new loans, substantially improved the external financing outlook for the Philippines. The change in NG in 1986 further increased confidence (both domestically and internationally) in the ability of the Philippines to undertake the necessary adjustments in order to resume economic growth with stability. The stabilization program which was supported by IMF Standing Arrangement (October 1986) centered on the fiscal consolidation, monetary control and accumulation of an adequate level of international reserves. This program was complemented by comprehensive structural reform. The reforms of the financial system were consolidated with the restructuring and partial privatization of government owned banks; trade liberalization was pushed forward by the elimination of most quantitative restrictions; direct and indirect taxation were reformed to increase buoyancy and equity; public investment priorities were restructured; and a privatization program for public corporations was initiated. 4.3 The above-mentioned program of the Philippines was supported by the Bank in the context of its economic and sector policy dialogue through a US$300.0 million Economic Recovery Program Loan (ERL, Loan 2787-PH), approved in March 1987 and cofinanced with US$540.0 million from JEXIM and OECF. ERL supported a major reform program for the government financial institutions (GFIs), which included rehabilitation of the two largest GFIs (PNB and DBP) - the two largest GFIs that were insolvent and causing a serious drain on the government budget. This rehabilitation program included privatization (though only partial) of the PNB, and financial restructuring, cost reduction and institutional strengthening of the DBP. The Bank further approved in June 1988 a US$200.0 million policy-based loan: Reform Program for Government Corporations (Loan 2956-PH). This loan also was cofinanced by Japan's OECF (US$200.0 million) and supported by a technical assistance grants from the USAID, UNDP, ADB and Japanese Grant Facility. These two loans aimed to establish a policy and institutional framework to reduce, limit and rationalize government activities using the corporate form, and to institute improvements in the efficiency and effectiveness of retained financial and non-financial government corporations (GCs). 4.4 Subsequent to the approval of FSAL in May 1989, the Bank approved in January 1991 the Industrial Restructuring Project (Loan 3287-PH), wherein a loan of US$175.0 million was given to the DBP to support the Government's objectives of accelerating industrialization and restructuring major industries, besides strengthening the DBP's capabilities to act as a wholesale bank and play a more active role in the capital market development. As a part of its country assistance strategy for the Philippines, the Bank approved a loan of US$200.0 million in December 1992 (Loan 3539-PH) to support the Philippines' Economic Integration Program, focusing on enhancement of the macroeconomic management and appropriate energy pricing policies. The reform program was expected to improve the environment for private investment through implementation of the new Foreign Investment Code, trade and transport liberalization and the liberalization of the foreign currency market. The GOP successfully completed IMF Standby Arrangement in March 1993, IMF reached an agreement with the Government in May 1994 for EFF, and the Philippines also had healthy level of foreign exchange reserves.  - 7 - B. The Financial Sector Adjustment Loan (FSAL) 4.5 Bank's sustained close collaboration with the GOP and the IMF in the context of its policy based lending operations, as reflected above (para.4. 1-4.3), led to an environment conducive to concentrate on the reforms of the financial system. Hence, FSAL was designed to address most pressing problems of the banking system. These problems, in turn, were identified as a result of the financial sector study (FSS) conducted by the Bank in 1987/88, with the endorsement and active support of the Government.3 This study had concentrated on the commercial banking segment and identified four critical problem areas: (a) supervision and regulation, including government legal framework; (b) institutional arrangements for the protection of insured depositors; (c) high intermediation costs and lack of effective competition; and (d) institutional arrangements for the mobilization and delivery of long-term credit. Besides focusing on these problem areas of the financial system, FSAL addressed the extremely important issue of the insolvency of the CBP by adding a new condition requiring CBP's financial restructuring as discussed in paras. 2.5, 4.7, 5.6, 6.3 and 8.1 (b). 4.6 In the context of the FSAL, the Bank made significant contribution towards articulation of policy options; evaluation of proposals for action; redirection of priorities; and more generally, towards formulation and implementation of the adjustment program. This support was based on the above- mentioned financial sector study, which was preceded by the Government Financial Institutions Study. The FSAL operation, however, represented the first time when the Bank provided major legal services to a country in reviewing the entire financial sector. In that regard, a mission consisting of a Bank lawyer, a Fund lawyer and a professor from a law school had reviewed the laws and regulations related to the Philippine financial system and discussed with the GOP what should be done. The GOP in turn, was very satisfied with this approach. Moreover, the Bank assisted the GOP in drafting the Statement of Policy on Financial Sector Reformn by providing detailed comments. Furthermore, the Bank staff (and often the management) maintained effective dialogue with the Philippine authorities and other officials throughout the project cycle, particularly in the context of the second tranche release. The dialogue included (but not limited to) finalization of the terms of reference for several studies, amendments to the Central Banking Act, financial restructuring of CBP, new PDIC Act, Resolutions of the Monetary Board on consolidation of the banking industry, Institutional Development Plan and Policy Statement of the DBP. 4.7 The Loan was made to the Republic of the Philippines and the CBP was designated as the Executing Agency. The Loan was for a 20 year term (including five year grace) and carried interest at the Bank's standard variable rate. It was disbursed in two tranches. Tranching was determined in relation to the Adjustment Program, which was designed so that the Program becomes irreversible by the time the Loan was considered by the Board. Most of the legislative actions required to implement the Program had been not only drafted and agreed with the Bank, but had already been actually introduced in the Philippine Congress. Where only administrative actions were required to implement the Program, they were to be taken before the Board's consideration of the Loan. The first tranche of US$150.0 million was therefore released as soon as the Loan became effective, with no particular conditions set for the loan effectiveness because significant up front actions were already taken by the GOP. The second tranche (also of US$150.0 million) was to be released upon completion of the nine actions, satisfactory to the Bank, listed in Schedule 4 of the Loan Agreement. The tranche release was delayed due to 3 Philippines: Financial Sector Study, Report No. 7177-PH (August 1988).  noncompliance of some of these actions. In the meantime, as a result of the Bank's Capital Market Study (CMS) that was completed in February 1992, CBP's financial problems became public knowledge and a consensus emerged between GOP and the Bank that this problem needs to be given highest priority.4 The Bank's, therefore, requested the GOP to include an additional covenant of fundamental importance that required restructuring of CBP's finapces.(Attach 2) Other key covenants were: (a) enactment of the amendments to the Central Banking Act; (b) enactment of the amendments to the PDIC Act; (c) increase of the PDIC's paid-in capital; (d) completion and satisfactory progress towards implementation of recommendations arising from the four studies concerning commercial banks; (e) transfer of the management of all government sponsored credit programs out of CBP; and (f) achievement of interim performance targets by the DBP. The fulfillment of the conditions thus involved arnendments to the existing legislation or enactment of new legislation on which the executive authorities, who signed the Loan, had no control. 4.8 Both private and public sector imports were eligible for financing under the Loan. All import contracts costing US$5.0 million or more were subject to simplified international competitive bidding. Contracts for lesser value were subject to GOP's standard procurement procedures or normal commercial practices. The loan proceeds were to be disbursed against general inputs not contained in a "negative list". The "negative list" included goods and services for military and paramilitary purposes and for luxury consumption. The accounts of the expenditure to be incurred under the Loan were to be audited by the Commission on Audit of the Philippine Government (COA). 4.9 The Loan was appropriate from the considerations of balance of payments and resource gaps. The program implementation had substantial budgetary consequences, because of the required increase in PDIC's capital by Pesos 3 billion (US$150.0 million approximately) during its planned two year period. Further, the expected elimination of the 5% Gross Receipt Tax (GRT) and the 20% withholding tax on interbank deposits in order to reduce the financial intermediation cost, envisaged under the reform program, had an impact on the budgetary situation as the GOP had to find some other sources of revenue to offset the impact of the proposed reduction in financial intermediation taxes. The Loan was therefore, to help support the budget during the program implementation period when it would have been under pressure as a result of the GOP implementing the agreed adjustment program. Moreover, the Loan was designed in concurrence with IMF EFF, and provided the Philippines a base for debt and debt service reduction instruments. C. The Technical Assistance 4.10 Technical assistance was necessary to implement the government adjustment program, which was provided by the Government of Japan as a grant fund (TF) amounting to Yen 607.5 billion (US$4.7 million equivalent) from its cofinancing facility available with the Bank. The fund was used to finance: (a) purchase of computer equipment and develop software systems for the CBP, DBP, and PDIC for improving their ability to process and analyze data in a timely fashion; (b) conducting the technical studies to review and recommend improvements in the debt recovery and bankruptcy laws, depositor insurance, long-term resource mobilization, and financial instruments; and (c) training of the CBP, DBP and PDIC staff to fulfill their functions more effectively. 4 The pressing need for the financial restructuring of CBP was highlighted by the Capital Market Study (Report No. 10053-PH), February 1992.  - 9 - 5. Project Implementation and Tranche Release 5.1 The degree of commitment by the GOP to implement the reform program supported by the FSAL was very high. The GOP had actively participated in conducting the FSS; it had taken initiative in developing the adjustment measures, and was keen to start implementation of the program. The Loan was released in two tranches of equal amount; the first tranche was released on the date of loan effectiveness, because the GOP had already either completed certain actions or had made significant progress towards their completion. These actions include: (a) In the Area of Supervision and Regulations. (i) arnendments to banking status regarding emergency loans, cease and desist orders, appointment of receivers, insider abuse, and protection of the CBP staff against legal suits; (ii) the Monetary Board (MB) had adopted policies in respect of granting new bank licenses, opening new branches, and closing weak banks; and (iii) CBP had already initiated five studies to review and revise: commercial banks' reporting requirements; guidelines for asset valuation, loan loss provision and trust accounts; generally accepted accounting principles (GAAP) governing the preparation of the banks' annual accounts; and debt collection and insolvency laws. (b) In the Area of Institutional Arrangements for Depositor Protection. (i) PDIC's new President was appointed; (ii) draft PDIC Act had been submitted to the Congress for legislative approval; and (iii) PDIC's institutional strengthening plan had formally approved by its Board. (c) In the Area of Fund Mobilization. Delivery of Term Funds. and Phasing Out of CBP's Role in Credit Allocation. (i) a bill to eliminate Agri/Agra lending requirement had been introduced in the Congress and had CBP Support; (ii) the Governor of CBP had either signed the executive order to transfer all agricultural credit programs or the negotiations between CBP and Department of Agriculture (DOA) were in progress; (iii) detailed plan to transfer the Industrial Guarantee and Loan Fund (IGLF) and Apex programs to the DBP had been completed; and (iv) DBPs' revised Policy Statement reflecting the change in the orientation of its operations had been formally approved by its Board. 5.2 The release of the second tranche required completion of the proposed reform program, which was event bound rather than time bound, and involved the following: (a) Legislative Action. The Congress was expected to approve the draft amendments to the Central Banking Act and the new draft PDIC Act. (b) Completion of Studies and Actions Based Thereon. All study teams had to complete their respective tasks and their recommendations had to be acted upon. (c) Institutional Strengthening of PDIC. PDIC was expected to have a new Act to provide it a satisfactory legal framework, and its financial resources had to be augmented by a gradual increase in its paid in capital from Pesos 2 billion to Pesos 5 billion. Further, PDIC's fee income had to be increased. FSAL had recognized that PDIC's institutional rebuilding would require a longer period, but key steps had to be taken and necessary resources (both  - 10 - financial as well as managerial) had to be put in place before the second tranche release. (d) Transformation of DBP into a Wholesale Institution. Since full transformation of DBP was expected to require about four years, interim performance targets had to be achieved. (e) Termination of CBP's Role in Management of Government Sponsored Credit Programs. The process had already started, and was expected to be completed by June 30, 1990. 5.3 Based on the GOP's Policy Letter (Annex IA), the Bank prepared a detailed policy matrix to monitor the implementation schedule of the reform program. Prior to the release of the second tranche, the Bank had to be satisfied that all conditions specified in Schedule 4 of the Loan Agreement (including its amended version), reflecting completion of all the above-mentioned actions, were taken (Annex 2). Although no specific time was agreed for completion of the various actions, it was expected that all conditions would be met "around July - August 1990" or at the latest "by mid-1991". However, December 31, 1991 was the formally agreed closing date for the Loan so that the GOP had enough time to complete the required actions and extensions of the closing date could be avoided. As discussed before, even this deadline tumed out to be too ambitious and the closing date had to be extended on three occasions by a total of almost two years. 5.4 Bank review of the progress made in implementation of the reform program indicated that the overall perfomiance was encouraging but mixed. In general, implementation made satisfactory progress wherever executive orders were sufficient, but it seriously lagged behind the schedule wherever legislative actions were required. Bank review in November 1991, only one month before the original closing date, identified significant delays as follows: (a) The amendments to the Central Bank Act were not approved by the Congress as agreed. These amendments related to: (i) emergency loans to banks; (ii) criteria for appointing a receiver for troubled banks; (iii) cease and desist orders; (iv) loans to insiders and secrecy of depositors; and (v) protection of CBP staff against personal legal suits. (b) PDIC Act was not amended as agreed, and hence, PDIC could not play the expanded role as envisaged under the agreed reform measures. (c) PDIC's paid in capital had not been increased from Pesos 2 billion to Pesos 5 billion as agreed; above amendment to the PDIC Act was a prerequisite for the increase in capital and, in turn, for a Congressional appropriation of the budget for this purpose. (d) The taxation on financial intermediation had not been reduced as agreed. 5.5 Since considerable progress had been made in the implementation of the reform measures except those involving legislation, the Bank readily agreed to the GOP's request for one year extension of the closing date from December 31, 1991 to December 31, 1992. Bank's mid-year review in July 1992, however, concluded that two conditions - the passage of the amendments to the CBP Act or of an acceptable new Central Monetary Authority (CMA) Bill, and action on reducing taxes on financial intermediation - were unlikely to be complied with by December 31, 1992. Moreover, CBP had recognized that it would be easier to pass a new CMA bill rather than to amend the existing Act and also it would be desirable to ir.clude the financial restructuring of CBP in the CMA Bill then rather than  - 11 - address the problem later. This review also revealed that the proposed sale of some of DBP's retail branches to the Private Development Corporation of the Philippines (PDCP) had been shelved due to the valuation problem by the COA. DBP, however, had technically met the Bank covenant in terms of meeting its interim target of the share of wholesale loans to the total loan portfolio: at least 34%. This was due to the rapid disbursements of the Bank's Industrial Investment Credit Project, and Industrial Restructuring Project, and the credit lines from the JEXIM. 5.6 Just before the new closing date of December 31, 1992, the Bank mounted a special review mission, which was joined by the representatives of the IMF, OECF and JEXIM. The mission found that the four reforms (described in para 5.4) were not likely to be completed even by this closing date. More importantly, the GOP agreed with the Bank's assessment under the Capital Market Study that the problems faced by CBP were far more fundamental than those to be addressed through the proposed amnendments to the CBP Act. ilecognizing this, the GOP, with the assistance of and the Bank (and the IMF), drafted a comprehensive CMA Bill. This Bill was intended to make CBP a strong and independent entity capable of evolving and overseeing monetary policy. Further, passage of this Bill would have: (i) made the removal of GRT and capital infusion for PDIC moot; (ii) transferred CBP's accumulated foreign exchange liabilities to the GOP (or a shell corporation); (iii) increased CBP's net worth by sufficient amount, and (iv) barred CBP in the future from undertaking quasi-fiscal activities which had resulted with the current financial crises. Based on GOP's agreement for the tranche release to include an additional condition regarding financial restructuring of CBP, the Bank agreed to GOP's request dated December 14, 1992 to extend the closing date by six months to June 30, 1993 (Annex IB). 5.7 The Bank again reviewed the progress made by the GOP in meeting the tranche release conditions in April 1993, and concluded that without personal intervention of the President of the Philippines all the conditions were unlikely to be satisfied by the stipulated closing date; as a result, cancellation of,the second tranche (in the amount of US$450.0 million from the Bank and the cofinanciers of the loan) became a real possibility.5 Although the Bank had worked closely with CBP and DOF on CBP's financial restructuring, yet as many as four versions of CBP's restructuring were under consideration for possible legislative action and each of these versions required significant modifications to achieve the loan objectives. GOP's positive response to the Bank's above message, however, yielded encouraging results; two (final) versions of the bill (one Senate and one House) soon became available for the Bank review, and the Congress passed the CMA Bill, satisfactory to the Bank, on June 10, 1993 and the President signed it on the same day. The CMA Act became effective on July 6, 1993. Another extension of 150 days was requested and agreed on June 25, 1993 to enable the formation of the new Monetary Board (MB) and the completion of CBP's financial restructuring by the MB's committee. Finally, the Bank also agreed to GOP's request for another extension of 20 days to enable it to fulfill all 10 conditions of the second tranche release (including the newly added: completion of CBP's financial restructuring, i.e., actual completion of the transactions involved in the restructuring). Thus, the Loan was closed on December 20, 1993 when all conditions of the release of the second tranche, as notified by the Bank President in his menmo dated December 22, 1993, were fulfilled. 6. Accomplishments of the Reform Program 6.1 The financial sector adjustment reforms have been very successfully completed by the GOP due to its strong commitment, decisive actions and exemplary leadership, albeit, with significant financial The amount had increased to $480 million due to appreciation of Japanese Yen.  - 12 - as well as technical support of the Bank.6 As recognized by the GOP, the Bank's Board and others, FSAL may be considered to be one of the most successful operations of the Bank in the Philippines. Its developmental impact on the Philippine economy is going to be profound in the long run, which has already started showing unmistakable signs of recovery and strength. For instance, the latest official estimate of growth of real GNP of 3.5% in 1994 seems conservative when compared with the private estimate of 5.5 to 6.0%. Having thus satisfied with the overall macroeconomic management, which has been feasible only upon effective completion of these reforms (including restructuring of CBP), the IMF reached an agreement with the GOP in May 1994 for a three-year arrangement under the EFF (in an amount equivalent to SDR 474.5 million, or 75% of quota). 6.2 A unique feature of the reform program is the passage of a bill creating a new CMA that would be independent and financially viable and thus capable of effectively conducting appropriate monetary and exchange rate policies. Thus, the non-performing assets and liabilities of the (old) CBP have been transferred effectively to the NG to give the (new) BSP a positive net worth, and the liquid financial resources needed to conduct appropriate open market operations and earn positive net income even at much lower levels of reserve requirements have been provided. Other major accomplishments of the adjustment program include transfer of all government sponsored credit programs from CBP to appropriate financial institutions, reduction in taxes on financial intermediation, improvements in bank supervision and regulatory procedures, substantial enlargement of the financial base and role of the PDIC, and the transformation by DBP from a retail institution to a wholesale lending institution. These accomplishments are highlighted below. 6.3 Financial Restructuring of the CBP. The insolvency of CBP was a major macroeconomic distortion in the Philippines and was the main cause of high intermediation cost and financial disintermediation. During 1986-92, CBP had incurred losses at an average annual rate of Peso 18 billion (about U.S. one billion dollars), since it was engaged in quasi-fiscal activities, improper currency forward and swap arrangements and open market operations without adequate portfolio of domestic securities. The financial restructuring of CBP required new legislation to handle the past losses and establish a viable and independent central bank. The new CMA Act, which became law on July 3, 1993, envisaged a two step restructuring. The first step involved creation of a restructuring committee to assist the Monetary Board in the transfer of assets and liabilities from the (old) CBP to the (new) BSP and CBP-Board of Liquidators to give BSP a positive net worth of Peso 10 billion. The MB and the Secretary of Finance were empowered to implement the second stage of restructuring through innovative financial engineering.7 This plan, as implemented, satisfied key objectives of the restructuring, which were to: (a) make the central bank financially solvent with a positive net worth; (b) enable the central bank to operate as an independent institution (without incurring constant operating losses); (c) facilitate effective monetary policy operations (including appropriate open market operations) without resorting to monetary instruments that distort financial intermediation; (d) reduce the financial intermediation cost over time; and (e) have a financial structure that would ensure that the central bank will not have to depend on the GOP for budgetary support. 6 The Bank staff also presented analysis on several occasions to the Philippines legislatures to reinforce GOP's position. 7 The innovative features of the plan and some other details about FSAL's accomplishments are provided in President Memo: FSAL-Release of the Second Tranche (Sec. M93-1302), December 22, 1993.  - 13 - 6.4 Enactment of the Amendments to the Central Banking Act. When the FSAL was made in May 1989, a bill to amend the Central Banking Act was already in the Congress. As required by FSAL, four important amendments were incorporated into the new CMA Bill. These amendments were: (a) guidelines for emergency loans to banks in distress which would ensure consistency in application and predictability; (b) adoption of transparent criteria for issuing cease and desist orders to enhance the CBP's ability to act in a fair and decisive fashion; (c) for DOSRI loans above a certain size, borrowers would waive secrecy rights which would prevent insider abuses and make supervision easier; and (d) authorization of the CBP to indemnify or purchase liability insurance for staff to protect them from civil litigation. 6.5 Transfer of Government Sponsored Credit Programs from CBP to Appropriate Institutions. During the 1980s, the CBP was heavily involved in providing directed credits to the private sector at below market rates. This complicated monetary policy management and contributed to CBP's operating losses. Therefore, it was agreed under the FSAL that all directed crecits would be transferred out of the CBP. The directed credit program of the CBP is now limited to the operations of export finance. The APEX operation(s) and the Industrial Guarantee Loan Fund (IGLF) managed by the CBP were transferred to the DBP in 1990. The Agricultural Loan Fund Program of the CBP was transferred to the Land Bank of the Philippines in 1991. 6.6 Improvement in Supervising and Reeulatory Procedures. Other reforms to improve and strengthen supervisory and regulatory procedures required the CBP to undertake a comprehensive review of a bank's reporting requirements, loan loss provisions, trust accounts, and a revision of the Generally Accepted Accounting Principles (GAAP). All these have been achieved and the new BSP will be in much better position to enforce these prudential requirements. 6.7 Strengthening of PDIC. FSAL's objective was to assign by law the receivership and liquidation functions for failed financial institutions to the PDIC, as these were being performed by CBP staff who were also acting as supervisors and regulators of the banking system. This was to be achieved in three ways: (a) the enactment of the amendments to the PDIC Act substantially as introduced to the Legislature; (b) the institutional strengthening of the PDIC: and (c) a satisfactory increase of the PDIC's paid-in capital. The PDIC Act was passed in February 1992, but the authorized capital was increased from Peso 1 billion to Peso 3 billion (of which Peso 2 billion was paid-in). At the time of CBP's restructuring and subsequent to it, however, appropriate steps have been taken by the MB and NG to further augment PDIC's capital to the Bank satisfaction. PDIC's expansion and development have thus progressed in a satisfactory manner, and it will have adequate capital and reserves to perform its function satisfactorily. While the size of the staff has been growing, systematic training programs have helped in staff assimilation and improvements. Further, measures to increase efficiency like computerization and systems improvements have also been implemented. 6.8 Economic Impact of Follow-uR Actions. The accomplishments of the central bank restructuring and other financial sector reforms associated with the FSAL, complemented by the reduction in "debt overhang", trade and foreign investment liberalization, and improvement in the efficiency of public investment (particularly in the power sector) have led to the creation of macroeconomic environment that is conducive to sustainable, healthy economic growth. In particular, the financial sector reforms have enabled the GOP to pursue effective and prudent fiscal and monetary policies as reflected in its Medium-Term Macroeconomic Framework prepared in May 1994. The impact of a strong CMA is already bearing fruits: the real interest rates in the Philippines have consistently declined from 10% in 1992-93 to 4% in June 1994. The response of both the domestic and the foreign investors also has  - 14 - been very favorable to the establishment of the new central bank, BSP. In May 1994, the central bank restructuring also led to the passage of a law liberalizing the entry of foreign banks, replacing the previous regulations in place since 1948. The new regime will allow entry of 10 new foreign banks and unrestricted number of foreign banks by purchasing 60% of domestic banks or by establishing locally incorporated subsidiaries. This regime will promote competition, should reduce intermediation costs and help attract foreign investment. Further, the central bank restructuring would enable the GOP to take additional steps to make further improvements in the government securities market, contractual savings sector, taxation of financial instruments, and stock (securities) market. The Bank is planning for FY1996 a Capital Market Development Project to support these additional reforms. 7. Sustainabilitv 7.1 The prospects of a sustainable development impact of the financial sector reform program are very promising, and stakes are high for the Philippines to allow any relaxation in taking advantage of the impetus towards achieving and sustaining a high level of economic growth. The NG - both the executive and legislative branches, have worked very hard over an extended period of time to accomplish the objectives of the reform program, culminating in the establishment of new CMA and BSP. As a result of their joint efforts, the revenue generating capacity of the GOP has been enhanced through the enactment of several legislative measures, which will enhance the effectiveness of the reform program. The GOP as well as the private sector were convinced about the potential of these reforms; they have already taken many steps and many more are expected to follow in the near future, as follow-up measures to realize the potential benefits accrued to them. Among others, the International Finance Corporation (IFC) has been focusing on institution building in the financial sector and support of the industrial sector through venture capital funds. Also the Philippine Congress ratified the Multilateral Investment Guarantee Agency (MIGA's) Convention in November 1993. Both these measures will contribute towards enhancement and sustainability of economic impact of the reform program. 7.2 Policy reforms which seek improvement in the financial system's allocative efficiency and resource mobilization, however, work best in fairly stable economic environment. While the GOP's recent macroeconomic management has been reassuring and the Philippine economy is bouncing back, major impediments to a higher sustainable growth remain, largely due to the underlying financial weakness of the public sector. Moreover, financial weakness were reflected in a renewed deterioration of the overall balance of payments and acceleration in the inflation rate in 1993. The risk of such factors must not be undermined. While the Bank will continue to watch them in the context of its continued policy dialogue with the NG, they will be formally and more regularly monitored under the IMF EFF, whose agreement was signed in May 1994. 8. Bank/Borrower Performance 8.1 The Bank's role in the design and implementation of the GOP's financial sector reform program was crucial: Bank's involvement started with the discussions during preparation and review of the FSS report, conducted by the Bank in close collaboration and active participation with the CBP, DOF and other institutions. The report provided a basis for a comprehensive dialogue between the NG and the Bank, and also led to specific proposals for implementation. As a result, the FSAL was appraised within six months of the preparatory mission. In retrospect, however, following comments seem  - 15 - pertinent: (a) FSAL's original objectives did not include financial restructuring of the CBP, which later on turned out to be of critical importance in the context of the reform program. The Bank had become cognizant of the CBPs' financial problem, but its strategic importance and seriousness was not fully comprehended until the Capital Market Study was completed in February 1992. (b) In the absence of financial restructuring of CBP, the ongoing financial reform program would not have yielded the expected results and its developmental impact through macroeconomic linkages of CBP operations would have been minimal. Moreover, postponement of CBP restructuring would have delayed the Philippine economic recovery and growth. The Bank, therefore, prudently attempted to build consensus in the NG (DOF, CBP, Congress, etc.) about the urgency and appropriateness of CBP restructuring and it succeeded in its efforts. As a result, through mutual agreement, an exceptional step of incorporating an additional covenant into the existing Loan Agreement (requiring CBP's financial restructuring) was taken. In this context, the Bank also assisted the NG in developing an innovative restructuring plan and legislation required for the financial restructuring of CBP. (c) Leaving aside the above development, the original FSAL required fulfillment of nine specific conditions, of which at least two required legislative action. Project implementation was thus contingent upon the passage of laws on which the NG's executive authorities, who had signed the Loan Agreement, had no control (especially under the presidential system of a government). Hence, not only the executive authorities but even the Bank had to confer with the congressional leadership and persuade them to pass the laws, satisfactory to the Bank, as required under the loan conditionalities. (d) In retrospect, the Bank should not have proceeded with the FSAL on the GOP's promise to get the required legislation approved by the Congress since it had no control over it; the Bank should have discussed the necessity of requisite laws and proceeded with the loan only upon their passage. (e) Irrespective of the legislative requirements, with a hindsight, it seems that the expected time frame for project completion was overly ambitious in the light of technical complexities and intricate administrative measures. In particular, in a democratic society (such as the Philippine), priorities of the government may change or deflect due to a number of domestic considerations and/or external events that are beyond its control. It would have been better to allow adequate time for such exigencies. 8.2 The project implementation was helped by intensive Bank supervision and continuity of task managers, two in all (with considerable overlap), between project identification and completion. The quality of advice provided to the NG was highly professional and the speed of turnaround time was very fast. Since the first extension of the closing date (from December 31, 1991 to December 31, 1992) till the actual closing date (December 20, 1993), the implementation required extraordinary effort by the Bank staff and senior management (including the Resident Mission), as well as by the NG (including CBP, DOF and the Congress).  - 16 - 8.3 FSAL's successful completion has been commended by the Board Chairman and Executive Directors as well as the NG's authorities. The program implementation, particularly the restructuring of CBP, was indeed full of challenges and complexities; it had to pass through a difficult terrain and arduous path. The implementation challenged the patience, perseverance, and innovative skills on both sides - the NG and the Bank. It required deep understanding, full confidence and mutual respect for each others' concerns among all key participants. Above all, it is the Philippine political leadership, Congress and government officials who worked extremely hard to meet the time frame without compromising the quality of their achievements; together they did a commendable job in paving the way leading to the notable achievement.8 9. Main Lessons Learned 8.4 FSAL was one of the most successful lending operation in the area of financial sector adjustment in the Bank. Completion of the adjustment program took considerable more time than originally expected, because of the complexity and immensity of the tasks involved. The successful closing of FSAL was made possible due to concerted efforts by the GOP and the Philippine legislatures in making certain landmark decisions to restructure the CBP. It was creditable for the Bank to have succeeded in creating a virtual consensus in the NG to take technically very complex and politically risky decisions and implement them with utmost urgency and full determination. The main lessons of experience that may be relevant for the Bank and the Borrower alike in designing and implementing other similar projects may be summnarized as follows: (a) The comprehensive and complex reform programn, in order to be effective and successful, requires significant input of multidisciplinary teams (at the Bank and the counterparts in the NG), intensive interactive dialogue and negotiations, strong Bank support during implementation and above all political will, high priority and ownership of the program by the Government. (b) While designing the project, the Bank together with the NG should carefully evaluate that the existing and expected macroeconomic framework is conducive and the institutional infrastructure is capable to undertake and complete thereafter the reform program. (c) The sector study that is necessary to provide a basis for designing an adjustment program should be both comprehensive and in-depth; weaknesses of key institutions (eg. CBP) and their macroeconomnic implications should be fully addressed even at the risk of a startling disclosure. (d) Since legislative action may not be within the purview of NG's executive authorities that are responsible for project implementation, the Bank should carefully weigh its options and their trade offs in designing the project (particularly, the loan conditionalities). (e) If passage of new law(s) or amendments to existing laws are considered necessary for a reform program to be effective and purposeful, the project should proceed only upon The session of the Philippine Congress was extended in June 1993 to pass the bill creating a new central monetary authority, and the President signed the bill the day it was passed by the Congress.  - 17 - passage of such legislation. (f) While it may be appropriate and necessary in a reform program to keep its momentum and hence to have a tight time schedule, due allowance should also be given to political realities, administrative capabilities and external exigencies that may change government priorities or deflect its attention from the program implementation. (g) A fundamental reform like the financial restructuring of a central bank requires highly skilled and experienced staff, consensus building, innovative design, interactive dialogue and an unwavering commitment from the Bank's management and IMF's collaboration as well as the NG's full conviction and firm commitment. (h) A major reform program should be complemented by cofinancing and technical assistance; they provide an additional incentive (i.e., a larger pool of funds) to follow the arduous and painstaking path of adjustment, and strengthen the institutions to carry forward the program with effectiveness and efficiency.  - 18 - PHILIPPINES FINANCLIL SECTOR ADJUSTMENT PROGRAM (Loan No. 3049-PH) PROJECT COMPLETION REPORT PART II: PROJECT REVIEW FROM THE BORROWER'S PERSPECTIVE 1. Introduction 1.1 This report is an effort on the part of the borrower, the Govermment of the Philippines (GOP), to take stock of the accomplishments and shortcomings, lessons learned as well as the reasons thereof, of the reforms connected with the Financial Sector Adjustment Loan (FSAL). 1.2 This report is divided into four parts: The Philippine Financial Sector Adjustment Program: Description and Objectives; Performance with Respect to Macroeconomic and Specific Policy Commitments Under the Loan; Lessons Leamed During the Evolution and Implementation of the Program; and Conclusion. 2. The Financial Sector Adjustment Program: Description and Objectives Project Identity Project Name : Financial Sector Adjustment Program Loan Number: 3049-PH Borrower : Republic of the Philippines Loan Amount : US$300 million Terms : 20 year maturity, including 5 years of grace, at the standard variable interest rate Agreement Date : May 31, 1989 Effectivity Date : July 31, 1989 Closing Date : December 20, 1993 2.1 The loan was intended as a further step in the direction of reforming the financial sector, a task already begun by the completion of the Economic Recovery Loan (ERL) of 1986-87 and the Debt Management Program (DMP) of 1989-92 . While ERL's main focus was on the adjustment and stabilization of the overall economy, it also dealt with the most pressing of the financial sector problemns at that time: the rehabilitation of the two largest financial institutions in the country - the Philippine National Bank (PNB) and the Development Bank of the Philippines (DBP). With the completion of the rehabilitation of these two financial institutions, the stage was set for tackling the problems of the single largest segment of the financial system - the commercial banking sector. The DMP solved part of the problems of commercial banks by helping finance the debt buyback component of the 1989 commercial banking package which substantially reduced the outstanding stock of debt to commercial bank creditors. Complementary to the Debt Management Loan (DML), the principal objective of the  - 19 - FSAL was to strengthen the financial system, particularly the commercial bank segment. More specifically, the adjustment program was intended to: (a) strengthen the supervisory and regulatory framework for commercial banks; (b) improve the institutional arrangements for depositor protection; (c) reduce intermediation costs in the banking system; and (d) improve the institutional framework for the mobilization and delivery of long-term credit. 2.2 To help in the achievement of the fundamental goals underlying the program, release conditions for the second tranche were correspondingly outlined. These are discussed in detail in Section 3. 2.3 The loan of US$300 million equivalent was released in two tranches of US$150 million each. The first tranche was released in October 1989 with no particular conditions set. The proceeds were utilized to support the balance of payment and budgetary requirements of the country. The release of the second and final tranche was made on December 20, 1993 after an overall assessment of the compliance to the conditions discussed in Section 3. 2.4 Similar to the DML, the loan was co-financed in equivalent amounts by certain bilateral sources, specifically the Japan Ex-Imbank (JEXIM) and the Overseas Economic Cooperation Fund (OECF). 3. Performance with Respect to Specific Policv Commitments under the Loan Macroeconomic Policies 3.1 In its policy letter to the World Bank dated April 3, 1989, the GOP committed to further strengthen the macro economic framework by reducing the public sector deficit, containing inflation, maintaining a competitive exchange rate, and raising savings and investment levels so that an overall GNP growth of 6.5 percent will be achieved in the medium term. 3.2 These policy commitments were not immediately achieved in 1990, mainly because of unanticipated external factors and basic weaknesses in the economy which emerged in the second half of the year. On the external front, the Gulf crisis and the slowdown in the world economy, coupled by a succession of natural calamities, required additional public expenditures and at the same time reduced productive capacity and employment opportunities. Policy slippages during the year brought about serious stabilization problems. As a result, the public sector deficit rose to 5 percent of GNP, inflation accelerated to 14.2 percent and the current account deficit widened to 6.1 percent of GNP from 3.5 percent in 1989. 3.3 To reduce inflation and fiscal and trade deficits, a tighter fiscal program was adopted in 1991 together with additional revenue raising measures. As a result, the consolidated public sector deficit was reduced to 2.0 percent of GNP but inflation continued to accelerate at an average of 18.7 percent, even as monetary authorities limited liquidity expansion within program levels. Imbalances in the external accounts were, however, narrowed down with the current account reduced to 2.3 percent of GNP mainly as a result of a lower trade gap and higher net service inflows. 3.4 Efforts to rein in the public sector deficit and inflation were continued in 1992.  - 20 - Electricity rates were increased by 23 centavos per kwh early in the year to reduce the losses of the National Power Corporation (NPC), which contributed a large part to the consolidated public sector deficit. Monetary authorities continued to limit liquidity expansion within prudential levels. The year saw the initial dismantling of foreign exchange regulations. The completion of a Brady-type debt agreement in December 1992 also helped greatly in ensuring a viable balance of payments position through reduced external interest and principal obligations and the restoration of the country's direct access to international capital markets. This set of measures, complemented by the stabilizing effect of a new political administration, resulted in positive gains to the economy. The 1992 consolidated public sector deficit was reduced to 1.9 percent of GNP from 2.0 percent in 1991, and inflation was contained at 8.1 percent from 18.7 percent. The current account deficit fell to 1.8 percent of GNP while gross international reserves rose to US$5.2 billion, or the equivalent of 3.3 months of imports of goods and services. Real GNP, however, managed to grow by only 1.6 percent as severe power shortages continued to plague the economy. 3.5 In 1993, the substantial progress achieved in addressing the power problem generated improved business optimism and boosted investments. The continued increase in remittances of overseas contract workers, a recovery in agricuilture and an overall decline in interest rates contributed to more favorable growth prospects. In the area of financial reforms, the completion of the financial restructuring of the Central Bank of the Philippines (CBP) toward the end of the year eliminated a major distortion in the financial system and paved the way to a more effective management of the monetary system. 3.6 As a result, GNP growth doubled to 2.4 percent in 1993 from 1.6 percent in 1992, and inflation was held at 7.6 percent from 8.9 percent. Reflective of an increase in business confidence, the stock market exhibited general bullishness particularly in the second half of the year, while the peso improved its international competitiveniess. However, the need for a stronger fiscal position to help preserve the economic gains already achieved, raised the consolidated public sector deficit to 2.7 percent of GNP from 1.9 percent in 1992. 3.7 In summary, the period 1990 to 1993 may be seen as a time of fiscal realignment to soften the negative effects on the economy of certain adyerse external shocks. Given the adjustment and reforms already implemented so far, the economy may be said to have achieved enhanced capacity to shift to a higher and more sustainable growth path in the medium-term. The approval of a new arrangement with the International Monetary Fund (IMF), and the strong 4.8 percent GNP growth in the first quarter, could make 1994 a challenging and a banner year for the economy. 4. Specific Conditionalities 4.1 The fulfillment of the following conditionalities have done much to improve the stabilization of the financial system, deregulate and improve competition in credit markets, reduce disintermediation, and improve the regulation of financial institutions: 4.2 Condition 1. Enactment of the amendments to the Central Banking Act substantially as introduced to the Legislature. The Feforms were designed to address problems  - 21 - associated with (a) emergency loans to banks; (b) criteria for appointing a receiver; (c) cease and desist orders; (d) DOSRI loans and secrecy of deposits; and (e) protection of CBP staff against personal suits. In 1989, a bill was filed in Congress to introduce amnendments in the then existing CBP charter to address the above problems. These amendments were substantially incorporated in the New Central Bank Act of 1993. 4.3 Condition 2. Enactment of the amendments to PDIC Act substantially as introduced to the Legislature. A susbtantially enlarged role for the PDIC was envisaged under the reform measures. The objective was to assign by law the receivership and liquidation functions for failed financial institutions to the PDIC, as these were being performed by CBP staff who were also acting as supervisors and regulators of the banking system. In this connection, institutional strengthening was another objective of the measures. PDIC's expansion and development have progressed both in size and quality during the review period. 4.4 Condition 3. Satisfactory increase of PDIC's paid-in capital. The PDIC Act was passed last February 1992, but the authorized capital was only increased from P1 billion to P3 billion (of Which P2 billion has been subsequently paid-in) instead of the expected P5 billion. At the time of the financial restructuring of the CBP, it was decided to transfer P1.0 billion of CBP's loans to PDIC of P2.5 billion to the Central Bank Board of Liquidators (CB-BOL). To augment PDIC's capital, the National Government (NG) decided to increase PDIC's capital by P1.0 billion in 1995 by converting the loan of P1.0 billion in the books of CB-BOL. PDIC will not be required to pay any interest until the conversion takes place. In addition, the remaining P1.5 billion CBP loan transferted to the Bangko Sentral ng Pilipinas (BSP) will be restructured into a 20-year loan with an interest rate of 8.5 percent per annum. 4.5 Condition 4. Completion of. and satisfactory progress towards the implementation of recommendations. agreed with the Bank, arising from the following studies: (a) a comprehensive review of commercial bank reporting requirements to CBP: (b) study of the principles and practices eoverning loan loss provisions of commercial banks in the Philippines: (c) study of trust account mahagement practices of commercial banks in the Philippines: and (d) review and revision of accounting principles governing Rreparation and reporting of banks' financial conditions and results. The above reforms to improve and strengthen supervisory and regulatory procedures required the CBP to undertake a comprehensive review of a bank's reporting requirements, loan loss provisions, trust accounts and review, and a revision of generally accepted accounting principles . All these had been achieved and the new BSP will be in a much better position to enforce these prudential requirements, most of which had also been incorporated in the New Central Bank Act of 1993. 4.6 Condition 5. 'Satisfactory draft legislation for real estate mortgage and insolvency/reorganization shall have been submitted to the Legislature. Satisfactory draft legislation to improve a bank's ability to reorganize itself and to collect under- mortgaged securities had been introduced to Congress. Complementary provisions had also been incorporated in the New Central Bank Act of 1993. 4.7 Conditions 6 & 7. APEX and IGLF programs shall have been transferred to the Development Bank of the Philippines. All agricultute credit programs had been transferred to the appropriate financial institution as agreed with the Bank. The APEX operation and the IGLF managed by the CBP was transferred to DBP in 1990 while the Agricultural Loan  - 22 - Fund Program (ALF) was transferred to the Land Bank of the Philippines in 1991. 4.8 Condition 8. In its transformation from retail to predominantly wholesale financial institution. DBP shall have achieved agreed interim performance targets. This was to be achieved through the privatization of DBP's retail branches and an increase in its wholesale operations. Due to the limitations of its charter and the Commission on Audit's (COA's) objections to the validity of the transaction, the privatization of DBP's retail operations was not carried out. However, in December 31, 1992, the percentage share of DBP's wholesale loans to the total loan portfolio was 38 percent against the 34 percent target, due to the rapid disbursements of the wholesale lending operations funded by bilateral and multilateral sources. This trend continued and the share of wholesale loans as of February 1993 had increased further to 53 percent. DBP has also been successful in mobilizing resources both domestically and from abroad. 4.9 Condition 9. Satisfactory action on reducing taxes on financial intermediation shall have begun. The Government was to abolish the gross receipts tax (GRT) and the 20% withholding tax on inter-bank deposits over time. These taxes were not abolished due to the recognition that these were not crucial components of the intermediation cost and the removal of GRT will have a major fiscal impact. In a capital market study made by the World Bank, it was documented that the high intermediation cost was mainly caused by the CBP. The CBP has been financing a major part of its losses with high reserve requirement (25 percent for commercial banks in 1992) on which it paid a minimal interest rate (4 percent), thus effectively imposing an additional implicit major tax on the financial system. The financial restructuring of the CBP included a programmed reduction in the RR which was expected to lead to a lower intermediation cost. The RR for commercial banks had been reduced from 25 percent in 1992 to 22 percent at end-1993 and is programmed to be reduced further to 12 percent in 1998. Therefore the objective of this condition had been achieved through the restructuring of the CBP. 4.10 In addition to taking measures to lower the RR, the CBP also attempted to increase competition in the banking industry in order to lower margins, thus benefiting depositors and borrowers. By changing its policy regarding branching in 1989 (a moratorium on the establishment of new banks was implemented during 1971 to 1989), the CBP was able to dilute the concentration of large banks. The immediate impact of this change in policy was witnessed when 75 and 73 new branches were allowed to be established in 1990 and 1991, respectively. In May 1994, legislation liberalizing the entry of foreign banks in the country had been passed by Congress. 4.11 Condition 10. Financial restructuring of the CBP to the Bank's satisfaction. This was implemented in two phases. The first phase was intended to handle the past losses of the CBP by creating a restructuring committee that will oversee the transfer of assets and liabilities from the former CBP to the new BSP and the CB-BOL. The transfer effectively gave the BSP an initial networth of PIO billion and retained the non-performing assets and the bulk of the foreign liabilities of the former CBP with the CB-BOL. The transfer was finalized in November 1993 but was retroactive July 1993. 4.12 The second phase of the financial restructuring was completed on December 20, 1993 and was intended to further strengthen the financial position of the BSP and give it wider  - 23 - room in its open market operations. This phase involved the following mechanics: (a) issuance of P220 billion in government securities at market rates by the NG to the BSP, P50 billion of which were long-term securities; (b) placement of the proceeds of said securities by the NG in special deposit accounts with the BSP, of which P50 billion was in core deposit with maturity of no less than 10 years. The balance of P170 billion was earmarked for reimbursing BSP for advances it had extended to NG/CB-BOL during the interim period when the transfer provisions were being finalized and for future payments on selected liabilities retained with CB-BOL; (c) BSP will remit 75 percent of its net income to a sinking fund, or to the NG as dividend. Any net income over one percent of BSP assets on the date of dividend declaration will be treated as interest rebates to NG; (d) the NG undertakes to service all BSP advances to the NG at market rates. 5. Lessons Learned During the Evolution and Implementation of the Program 5.1 The Bank through its Financial Sector Adjustment Program for the Philippines (FSAP) was able to identify the needs of the country's financial sector very early on which enabled it to formulate a clear and precise adjustment assistance program for the Philippines. The Philippines was able to avail itself of the FSAL through the sustained efforts of the Bank and the GOP. Aside from studies and policy advice provided by the BaiLk, intensive coordination was also undertaken to ensure overall consistency and firmness in the program implementation. The first lesson to be drawn, then, is that this process to be successful requires an active participation and decisiveness on the part of the parties involved. 5.2 The Bank's lending strategy is specifically designed to support the process of structural adjustment. The second lesson that can be drawn is that the sequencing of the loan by tranche is critical to the overall success of the adjustment program. The fulfillment of all conditionalities as a prerequisite for the release of the final tranche commits the borrower to continue to pursue sound macroeconomic policies that will foster economic stability. 5.3 A key requirement of the program was the financial restructuring of the CBP. Experience demonstrated that to a large extent, the quasi-fiscal activities of the CBP and its consequent deficits restricted it from discharging monetary policy effectively. With this important experience completely behind it, and with its strong financial position, the new BSP is expected to be profitable in its operations and well equipped to undertake monetary policy management. 5.4 In strengthening the supervision and regulation of commercial banks, the Financial Sector Study (FSS) for the Philippines done by the Bank generated results that led to the timely identification of the problems hampering supervision and regulation. The results of the FSS helped hasten CBP's rationalization efforts mainly because a substantial portion of the recommendations agreed with the Bank arose from CBP's own studies. The lesson that can be drawn here is that borrower participation and initiative could greatly enhance the success of the program. 5.5 In contrast, the required transformation of DBP from a retail into a predominantly wholesale financial institution which was to be achieved through the privatization of its retail branches, was not exactly carried out as recommended due to the limitations in its charter and  - 24 - the objections of the COA on the validity of the transaction. However, DBP's share of wholesale loans as a percentage of its total loan portfolio increased due to the rapid disbursements of its wholesale lending operations. Since the relevant condition of the performance criteria refer only to DBP's transformation into a predominantly wholesale bank, this development was considered as compliance with the FSAL condition. This points to some lessons for future programs: the need for flexibility on the part of the Bank in determining essential compliance with its conditionalities; and the possibility of longer time horizons for the borrower to comply with requirements that require legislation or diversion from existing legal frameworks. 5.6 In the implementation of the required reforms of the Program, a two-way link was apparent between financial reform and macroeconomic management. One could not be implemented successfully without corresponding progress being achieved in the other. For programs of this nature, therefore, another factor that can ensure success, in addition to the close cooperation between the Bank and the borrower is the collaboration between the Bank and the IMF. 6. Conclusion The FSAL accomplished its objectives in supporting the Philippine Government's program toward improving and strengthening the country's financial system. Institutional reforms were introduced under the FSAL as intended, with exception of some slippages and delays in the implementation of certain measures, particularly those that required legislative action. Actions in all areas were, however, subsequently and substantially undertaken as agreed, both in the letter and in the spirit of the program. However, it is imperative that Government pursue the full completion of institutional reforms and build on the progress already made.  - 25 - Part III Table 1 PHILIPPINES FINANCIAL SECTOR ADJUSTMENT LOAN (LOAN 3049-PH) PROJECT COMPLETION REPORT PART Im. STATISTICAL INFORMATION Related Bank Loans Loan Project Description Amount Year of Status No. (US$ Million) Approval 1903 Structural Adjustment Loan (SAL-I) 200.00 1980 Closed 2266 2nd Structural Adjustment Loan (SAL-II) 302.25 1983 Closed 2787 Economic Recovery Program Loan (ERL) 300.00 1987 Closed 2956 Reform Program for Government Corporations 200.00 1988 Closed 3149 Debt Management Program 200.00 1989 Closed 3287 Industrial Restructuring Project (IRP) 175.00 1991 Active 3539 Economic Integration Program Loan (EIL) 200.00 1992 Active - Capital Market Development Loan Under Preparation  - 26 - Part III Table 2 and Table 3 2. Prkct lEmetable Item Planned Date Actual Date Initiating Memorandum 11/88 11/09/88 Appraisal 11/88 12/1-14/88 Negotiations 03189 03/13-17/89 Letter of Development Policy 02/89 04/03/89 Board Approval 04-05/8 05/04/89 Loan Signing - 05/31/89 Effectiveness 06/15/89, 08/29/89 07/18/89 Second Tranche Release 08/90, 12/90, 08/91' 12/20/93 Closing Date 12/91, 12/92, 06/93, 11/93 12/20/93 Account Closed 12/31/91 12/22/93 3. Cumulative Estimated and Actual Disbursements (USS million? FY90 FY91 FY92 FY93 FY91 (i) Estimated 150.0 300.0 - - (ii) Actual 150.0 150.0 150.0 150.0 310D (iii) (ii) as % of (i) 100.0 50.0 50.0 50.0 DD Final Disbursement Date: December 22, 1993 Tranche release was event bound rather than date bound; these dates represent the Bank staff expectations. 2 In addition, the Bak disbursed technical assistance grant funds (TF) amounting to Yen 607.5 billion (US$4.7 million).  - 27 - Part III Table 4 4. Use of Bank Resources A. Staff InDt (staffweeks) Task Pre FY89 FY90 FY91 FY92 FY93 FY94 Total FY 88__ _ _ _ _ _ __ _ _ __ _ _ Lending Development 0.7 2.8 - - - - - 3.5 Preappraisal 12.3 44.8 - - - - - 57.1 Appraisal - 22.6 - - - - - 22.6 Negotiations - 11.9 - - - 11.9 Supervision - 0.4 9.9 8.4 7.3 7.7 6.6 40.3 TF Supervision - - 3.6 7.0 1.0 - 11.6 PCR - - - - 5.4 5.4 Total 13.0 82.5 9.9 12.0 14.3 8.7 12.0 152.4 B. Missions /1 Days in No. of Report Task Date Field Persons Expertise Date Preparation 06/88 20 n 4 / Fa; Bkg; Leg 06/88 Preappraisal 09/88 20 2 Fa; Bkg; 11/88 Appraisal 12/88 14 5 Fa; Bkg; Leg 12/88 Supervision 1 05/89 7 1 Fa 06/89 Supervision II 03/90 17 3 Fa; Bkg; Leg 03/90 Supervision III 03/91 8 2 Fa 03/91 Supervision IV 11/91 11 1 Fa 12/91 Supervision V 07/92 10 /4 1 Fa 07/92 Supervision VI 12/92 7 32L5 Fa; Bkg; Leg 12/92 Supervision VII 04/93 9 5' Fa; Bkg; Leg 05/93 Supervision VIII 08/93 7 41315 Fa; Bkg; Leg 08/93 Supervision IX 11/93 4 1 Fa 11/93 Notes: FA = Financial Expert; Bkg = Banking Expert; Leg = Legal Expert. /I The loan was more intensively supervised than reflected through this table especially during 1992 and 1993, when the Task Manager made brief stops in the country as and when he was in the East Asia Region. In addition, the supervision involved constant dialogue among all the parties in the Philippines and the Bank (Headquarters and Resident Office in Manila), and often involved the IMF staff and representatives of cofinancies as well. /2 Includes the time required for the discussion of the Financial Sector Study Report, which provided a basis for proposing the FSAL. /3 Includes the IMF Staff (Legal or Financial Expert). /4 Includes the time required for starting preparation of the proposed Capital Market Development Loan. /5 In addition, representatives of the cofinanciers-JEXIM and OECF - also participated in the mission.  -28- Annex 1A Page 1 of9 PHILIPPINES FINANCIAL SECTOR ADJUSTMENT LOAN REPUBLIC OF THE PHILIPPINES MINISTRY OF FINANCE MANILA April 3, 1989 Mr. Barber Conable President World Bank Washington, D.C. Dear Mr. Conable: Re: Statement of Policy on Financial Sector Adjustment As indicated in our letter of January 2, 1987, the Government of the Republic of the Philippines has since carried out a number of reforms in the areas of trade policy, public investment, taxation and restructuring of government financial institutions. The Government has also followed, in the context of standby arrangements with the International Monetary Fund (IMF), appropriate policies regarding monetary base growth, public sector credit expansion and short term external debt. As a result of following these and other appropriate macro economic policies more generally, the Philippine economy was able to achieve a GNP growth rate of 5.9 per cent in 1987 and 6.7 per cent in 1988, without producing inordinate inflationary pressures and exchange rate instability. It is the intention of the Government to further strengthen the macro economic framework by reducing the public sector deficit, containing inflation, maintaining a competitive exchange rate, and raising savings and investment levels so that an overall GNP growth of 6.5 per cent is achieved in the medium term. The Government recognizes that the financial sector, particularly the commercial banking segment which is the largest component of the sector, must play a major role in efficient resource mobilization and allocation to help the economy achieve overall growth objectives. The Government also recognizes that reforms are needed in the financial system to enable it to play its due role. The Government is, therefore, undertaking a financial sector adjustment program, and is requesting the World Bank to make available to the Philippines a quick disbursing policy based loan in the amount of $300 million equivalent in support of the adjustment program. The broad objective is to strengthen and improve the financial system, particularly the commercial banking segment. More specifically, the adjustment program is intended to: (i) strengthen the supervisory and regulatory framework for commercial banks,  Annex IA - 29 - Page 2 of 9 (ii) improve the institutional arrangements for depositor protection, (iii) reduce intermediation costs in the banking system by improving competitive conditions and efficiency, and (iv) improve the institutional framework for the mobilization and delivery of long-term credit. 1. Bank Supervision and Regulation a. Commercial Bank Reporting Requirements. Although the system of reports that commercial banks are required to submit to the Central Bank of the Philippines is adequate for supervisory needs, it is recognized that all of the data and information thus received may not be fully and effectively utilized. Accordingly, the Central Bank has initiated, in cooperation with the Bankers Association of the Philippines (BAP), a comprehensive review of commercial banks' reporting to the Central Bank with a view to standardizing reports and enhancing electronic evaluation of data. Revised reporting requirements will be prescribed when the review, now in progress, has been completed. It is our intention to streamline and place greater reliance for supervision and regulation on continuous offsite monitoring through analysis of these reports. b. Guidelines for Asset Valuation and Loan Loss Provisions. Although the Central Bank has formulated guidelines on loan loss and other risk classification, the rules for banks to make loan loss provisions have not been uniform in their application. The Central Bank is, therefore, developing underlying standardized principles for asset valuation and loan provisioning and intends to require that these be applied uniformly by all banks. c. Guidelines for Treatment of Trust Accounts. Trust accounts have increased substantially in recent years. While part of this increase represents a genuine growth of trust business, we believe that in some cases trust accounts are being used to undertake normal banking activities on an off balance sheet basis, with serious tax and reserve requirement implications. We believe that the practices involved in trust account management need to be investigated in order to devise a set of measures to prevent abuse. Accordingly, a joint Central Bank/Bureau of Internal Revenue team has been set up to review guidelines for the treatment of trust accounts by commercial banks. Revised guidelines will be issued after completion of the review currently in progress. d. Guidelines for Financial Reporting. The Central Bank dialogues with the Accounting Standards Council (ASC) on the Generally Accepted Accounting Principles (GAAP) for banks and the Regulatory Accounting Principles (RAP) for the purpose of reconciling them among other things. Recently the Central Bank, ASC and BAP concluded the GAAP for the banking industry. In order to improve consistency and transparency in financial reporting, it is intended that RAP and GAAP for banks be reviewed further and revised if there is need, 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 review exercise in consultation with ASC and BAP has already started. e. Guidelines Governing Emergency Loans to Banks in Distress. The guidelines to cover emergency loans by the Central Bank to commercial banks in  Annex 1A -30 - Page 3 of 9 distress will be revised in order to ensure consistency in their application. The revised guidelines will provide that the maximum amount that the Central Bank can advance to a bank in distress will not exceed 50 percent of the amount of a bank's total deposits and deposit substitutes. The revised guidelines will also provide that the emergency advance be disbursed in two tranches. The Monetary Board has the authority substantially to implement the measures indicated in (a) to (e) above. The measures indicated under items (a) to (d) will be implemented when the reviews now underway have been completed. We expect that new regulations to give effect to these measures will be issued in due course. Measures (f) to (j) discussed below, require amendments to the Central Bank Act and the PDIC Act. These amendments have been incorporated in bills which have already been introduced into the Legislature, and the Government intends to pursue vigorously for the passage of these bills. f. Cease and Desist Orders. A new instrument of bank regulation is being developed for use in a process of graduated response before it becomes necessary to invoke maximal means such as commercial liquidation proceedings against a bank. It is believed that the instrument may be particularly useful in efforts to counter insider abuse before the latter causes irreversible damage to a bank that may lead to its failure. g. New Criteria for Appointment of Receivers for Distressed Banks. The criteria currently used by the Monetary Board in deciding whether or not to appoint a receiver for a distressed bank include its determination (i) that the liabilities of the bank exceed the realizable value of its assets, or (ii) that the bank's continuance in business would involve probable loss to the depositors. Since these criteria may not be flexible enough to permit timely action by the Monetary Board under all circumstances, it is proposed therefore to add two additional criteria for appointing a receiver; (iii) that the bank is unable to meet its obligations as they mature or (iv) that there is a willful violation of a cease and desist order that has become final. h. Curbing Insider Abuse (DOSRI Loans). It has been determined that, as a consequence of the current law on depositor secrecy, bank supervisors have been handicapped in their efforts to detect insider loan abuses in a timely fashion. Such loans have frequently been associated with bank failures. In order to curb abuses stemming from these loans, the Government intends to seek an amendment to the current banking law so that all bank directors, officers, or stockholders, together with their related interests as defined in the law, will be deemed to have waived the secrecy accorded to their bank deposits wherever held in the Philippines when their borrowings from any of their banks exceed P5 million or 5Z of the bank's net worth or the maximum amount permitted by law, whichever is lower. i. Empowering Banking Supervising Authorities to Institute Civil Suits against Bank Directors and Officials Accused of Wrongdoing. Bank directors, bank officials and others accused of wrongdoing are currently subject to criminal suits which are protracted and difficult to prosecute. The revised PDIC Act seeks that both the law and the practice in this regard will be changed to authorize PDIC to institute civil suits. Civil suits will serve as an additional disincentive against wrongdoing. Since the standard of proof required in civil suits is less stringent than for criminal suits, the chance of a successful outcome will also be enhanced.  - 31 - Annex IA Page 4 of 9 j. Protection of the Staff of the Banking Supervisory Authorities from personal losses resulting from suits brought against them for action taken in performance of their duty. Civil suits have been brought against members of the staff of the Central Bank for actions taken by them in the performance of their duties. In order to protect the staff of the Central Bank from such suits, the government is seeking to amend the Central Bank Act so that the Central Bank is authorized to establish reserves and make expenditures for: (a) the provision of legal services; and (b) the purchase of liability insurance or the provision of self insurance or coinsurance for its personnel in connection with legal case arising from the performance of their duties and functions. A protection against suit is also being proposed for the staff of PDIC on actions-done by them in good faith in the exercise of their functions, through an amendment to the PDIC Act. 2. Arrangements for Depositor Protection Currently, the Central Bank staff acts as the conservators, receivers and liquidators of failing banks. This practice gives rise to questions of conflict of interest and also places a heavy burden on the Central Bank 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. We believe that the solution to its problem lies in a substantially enlarged role for PDIC. Accordingly, the Government is seeking amendments to the PDIC Act and the Central Bank Act so that PDIC will not only be authorized to serve, but will be required to be appointed, as the receiver in all cases. This means that the Central Bank's role would cease as soon as a determination has been made by the Monetary Board that the condition of a bank has deteriorated to an extent that the bank has to be closed and a receiver should be appointed. All subsequent decisions would, in accordance with the revised PDIC Act, be made by PDIC. The measure discussed in the prior paragraph would result in a greatly expanded role for PDIC. In addition, the role may be expected to expand further in the future since the financial responsibility of PDIC is also being increased inasmuch as the maximum amount of deposits insured is proposed to be raised from P 40,000 to possibly P 60,000. Accordingly, it is recognized that the PDIC must be substantially strengthened financially as well as in terms of management and staff. The PDIC has prepared and adopted an Institutional Strengthening Plan. It is the intention of the Government to fully support PDIC in implementing the Plan. In order to increase the role of PDIC in dealing with failed banks and to enable it to implement the Plan, amendments to the PDIC Act and the Central Bank Act have been incorporated into draft legislation. The bills have already been introduced in the legislature, and the government shall pursue vigorously the passage of these bills so that on or before the release of the second tranche of the proposed loan, these bills would have been enacted into laws substantially as already agreed with the World Bank. To further strengthen PDIC, its paid-in capital needs to be increased. The Government has assessed the resource requirements of PDIC to perform its role effectively, taking into account the current obligations and  -32- Annex 1A Page 5 of 9 resources of PDIC. The Government is seeking from Congress an increase in the authorized capital of PDIC from its present P 2.0 billion to P 5.0 billion. To effect this increase, the Government will request Congress to approve budgetary allocations increasing the capital of PDIC by P 1.5 billion in 1990, P 1.5 billion in 1991, and P 0.5 billion in 1992, in addition to the present paid-in capital of P 1.0 billion and the P 0.5 billion already programmed for 1989. 3. Intermediation Costs The Government realizes that the financial intermediation costs in the country are high and need to be reduced. The intermediation costs are high because (a) there is lack of effective competition resulting in high profit margins; (b) there are taxes on financial intermediation; (c) the debt collection and insolvency laws and procedures entail inordinate delays and therefore add to costs. In addition, the Central Bank's policy governing compensation on reserves has also been revised. Steps have been taken in each of these areas, as discussed below. a. Increasing Effective Competition. As provided in its Charter, it is the responsibility of the Central Bank to administer the monetary, banking and credit system of the country. Accordingly, the health and performance of the commercial banking sector, among other financial sectors, is one of the Central Bank's major concerns knowing that the efficiency of financial intermediation will help ensure the attainment of the country's overall economic development program. Towards this end, it is the policy of the Government to enhance and maintain conditions conducive to effective competition in the banking industry. The Monetary Board has accordingly adopted the following policies for the purpose and will be disseminated in the form of a circular. (i) Consolidation of the Banking Industry. The elimination of weak banks with high operating costs and the development of larger and stronger commercial banks is expected to create healthy competition and to bring about better services at lower costs and a stronger financial system. The Central Bank shall therefore refrain from sustaining weak banks except in times of general financial emergency or when specific banks face problems of liquidity rather than of solvency. The Central Bank shall continue to encourage weak banks to merge with, or consolidate into, stronger institutions as an option to strengthen the weaker units as well as consider closing them in accordance with the law. In the consolidation process, the Central Bank shall continue to observe the principle of diffusion of equity in commercial banks to prevent the concentration of ownership in the financial system among a few. (ii) Licensing of New Banks and Branches. The Central Bank shall continue to review its policies on the licensing of new banks and the opening of new branches to make them responsive to a growing economy and to enhance and maintain effective competition in the industry. There is no bar to granting new bank licenses and, accordingly, the establishment of new banks in the future shall be allowed, with the Central Bank  - 33 - Annex 1A Page 6 of 9 determining the qualifications, both qualitative and quantitative which shall be made public, such as but not limited to compliance with all requirements of existing laws, capitalization, direction and administration as well as the integrity and the responsibility of the organizers and administrators to reasonably assure the safety of the interest which the public may entrust them. A new bank may also be allowed to be established as a result of merger or consolidation of weak and marginal banks. On the opening of new branches, the Central Bank's objectives are to increase availability of branches in the rural areas and to increase competition in the banking industry generally. Toward that end, the Central Bank has lifted the requirement to purchase special five-year government securities as a condition to open new branches. In rural areas, all restrictions on opening new branches have been removed. The Central Bank may also consider providing positive incentives to strong commercial banks to open new branches by taking over weak banks. In urban and particularly metropolitan areas, the Central Bank shall 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 create any market concentration problems. While the Central Bank would not concern itself with the bank's underlying business considerations, it will take into account both in the case of rural and urban areas the bank's track record of viability and prudential operations and take into consideration the adverse effects of the costs that the new branch could have on the bank's financial condition in the short run. (iii) Uniformity of treatment. The Central Bank shall continue to apply its rules and regulations uniformly and without discrimination upon all commercial banks and other financial institutions, whether government or private. (iv) Maintenance of Conditions of Competition. The Central Bank shall continue to maintain condition of competition among the commercial banks and the whole financial system, encouraging price competition and market-determined interest rates and intermediation costs. At the end of the year and annually thereafter, the Monetary Board will review the impact of the above-mentioned measures, and will consider such additional measures as may be necessary to achieve the stated objectives on increasing effective competition. b. Reducing Taxes on Financial Intermediation. While it is the government's intention to phase out in due time the 5 per cent gross receipts tax and the 20 per cent withholding tax on inter-bank deposits, this is not possible at this time because of adverse budget implications. The phase out would therefore be determined by the progress made towards attaining the tax revenue objectives and improvement  34 Annex IA Page 7 of 9 in tax administration. The following tax revenue targets will be used as a measure for these purposes: 1989 1990 1991 1992 Tax revenue to GNP ratio 12.4 13.5 13.8 14.2 Should the target be met for any given year, the Government will seek the elimination of the withholding tax on interbank deposits, and the reduction of the gross receipt tax by one percentage point. Each subsequent year that the target is met, the Government will seek to further reduce the GRT by one additional percentage point. c. Improving Debt Collection and Insolvency Law and Procedures. (i) Amend laws and procedures governing debt recovery and real estate mortgages. Under current law and procedures, it is extremely time consuming to foreclose a real estate mortgage. A harmful result of the present law and procedures has been to make banks reluctant to engage in long term secured lending. Instead, banks 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. We recognize that measures are needed to streamline the law and practice in this area. It is intended that the redemption period under judicial foreclosures will be reduced from the current 12 months to 6 months. In order to reduce the risk of substantial deterioration in the value of the foreclosed assets and in order to permit expeditious determination of issues during negotiations for redemption, arbitration and a summary procedure will be proposed. The differentiation between bank and nonbank mortgages in the case of bank foreclosures will be proposed for elimination so that no redemption period will be allowed following a judicial foreclosure even though the mortgagee is a bank. In addition, access to courts after an extrajudicial foreclosure will be limited. (ii) Amendment to bankruptcy laws. We believe that there are a number of deficiencies in the current insolvency and reorganization laws. The Government, therefore, intends to pursue revision in the appropriate legislation in order to accomplish the following objectives: (a) the process of reorganization will be accorded adequate protection from subversion by seizure of assets by creditors, (b) the courts will be given explicit administrative authority to enable the debtor enterprises to continue operations while the reorganization proceeds, and (c) the Securities and Exchange Commission or another agency will unambiguously have the power to appoint a trustee.  35 Annex IA Page 8 of 9 A special task force to undertake the work indicated in (i) and (ii) above has been constituted with instructions to complete its assignment by December 31, 1989. d. Required Reserves and Interest Paid Thereon. The policy of the Central Bank governing interest paid on reserves is being reviewed within the broader perspective of monetary policy needs and the level of required reserves. The Central Bank will share with the World Bank the results of such a review before the end of 1989. In this connection, the Monetary Board has agreed to consider increasing, over a period of time, the present rate of interest being paid on the cash portion of required reserves actually kept in deposit with the Central Bank. 4. Institutional Framework for Mobilization and Delivery of Term Credit. (a) The Central Bank's Role in Credit Allocation Programs. In the past, the Central Bank has in certain cases been directly involved in managing credit allocation programs and has accordingly borrowed and lent funds in its own name. We have concluded that the Central Bank should be phased out of credit allocation programs. Accordingly, an agreement between the Central Bank and the Department of Agriculture has already been concluded to transfer all agricultural credit programs (except ALF) currently under Central Bank management to the Consolidated Agricultural Loan Fund. As for the transfer of ALF, the Government is considering the Land Bank or another appropriate financial institution except DEP. As far as the industrial sector programs are concerned (Apex and IGLF), our intention is to transfer them to the Development Bank of the Philippines (DBP). The Monetary Board and the Board of Directors of DBP have passed formal resolutions approving the transfer of Apex and IGLF programs to DBP. Steps necessary to effect the transfer of the Apex program have already been started. For the transfer of the IGLF program, a committee constituted by the Central Bank (including a representative of DBP) is working out the details. The transfer is envisioned to take place in a phased fashion. (b) Onlending Rates. The Government recognizes that for efficient resource allocation, interest rates need to be left to be determined by the markets. Accordingly, the Government has in recent years moved to market- oriented onlending rates in respect of government sponsored or supported credit programs. The Government affirms that onlending rates will continue to be market-oriented for all credit programs for which funds are obtained in the first instance by the Government or with the support or guarantee of the Government, irrespective of the source of funds or their cost.  -36- Annex 1A Page 9 of 9 (c) Reorientation of DBP. In order to reform the institutional framework for the mobilization and delivery of term credit, the operational orientation of DBP will be significantly changed from being a retail lending institution to a predominantly wholesale bank. Towards this end, DBP will be the main conduit for onlending of official funds obtained by the Government for the private sector, and such funds will be made available for onlending by DBP on a wholesale basis. The Board of Directors of DBP is favorably considering a Policy Statement which spells out this new operational orientation, and it is expected that the Policy Statement will be subsequently approved by the Department of Finance and the Monetary Board. A more detailed Institutional Development Plan has also been drawn up by DBP and approved by its Board, which Plan spells out how the operational objectives stated in the Policy Statement are to be achieved. We expect the Plan to be diligently and expeditiously implemented. In consideration of the financial sector adjustment measures that have already been initiated and those that are expected to be implemented in the near future, as discussed above, the Government of the Republic of the Philippines would appreciate it if the World Bank would give favorable consideration to this request for a US$300 million Financial Sector Adjustment Loan. We will continue close consultations with the World Bank as the reforms are implemented as we did when the reform package was being designed. Yours sincerely, Sd/- Sd/- VICENTE R. JAYME JOSE B. FERNANDEZ, JR. Secretary Governor Department of Finance Central Bank of the Philippines.  Republic of the Philippines DEPARTMENT OF FINANCE Annex 1B \ ,/..z/ N Manila Page I of 1 24 December 1993 Mr. Calixto Madavo Director The World Bank Washington D.C., U.S.A. Dear Director Madavo: We are pleased to acknowledge receipt of disbursement on the last tranche of the Financial Sector Adjustment Loan. This will now enable Japan Export Import Bank and the Overseas Economic Development Cooperation to likewise disburse their respective component of co-financing shortly. This could not have been possible without your understanding of the tasks involved to carry out the necessary actions and the support of your colleagues in securing approval of Management and the Executive Board. With Bangko Sentral ng Pilipinas (BSP) financially ,trengthened and administered properly, monetary policy can now be putrsued with greater effectiveness in attaining macro economic equilibrium essential for sustained growth of the Philippine Economy. Resource enhancement of the Philippine Deposit Insurance Corporation (PDIC) will not only reinforce its capacity to protect small depositors but its role in promulgating a sound banking system. The heavy cost for strengthening BSP and PDIC borne by Government can only be justified by economic benefits arising from enhanced capacity to pursue sound monetary policies and imprcvement of our financial system. Government is committed to these objectives. We wish to express appreciation to the World Bank for sLtpporting reforms in these areas and look forward to continued assistance in our effort to address the fiscal consequences of this undertaking in the coming years. Yours very truly, ERNEST LEUNG Acting Secretary cc President Fidel V. Ramos Governor Gabriel Singson  - 38 - Annex 2 Page 1 of I SCHEDULE 4 Actions Referred in Paragraph 3 (b) of Schedule 1 to this Agreement 1. Enactment of the amendments to the Central Banking Act substantially as introduced to the Legislature. 2. Enactment of the amendments to PDIC Act substantially as introduced to the Legislature. 3. Satisfactory increase of PDIC's paid-in capital. 4. Completion of, and satisfactory progress towards the implementation of recommendations, agreed with the Bank, arising from, the following studies: (i) a comprehensive review of commercial bank reporting requirements to CBP; (ii) study of the principles and practices governing loan loss provisions of commercial banks in the Philippines; (iii) study of trust account management practices of commercial banks in the Philippines; and (iv) review and revision of accounting principles governing preparation and reporting of banks' financial conditions and operating results. 5. Satisfactory draft legislation for real estate mortgage and insolvency/reorganization shall have been submitted to the Legislature. 6. Apex and IGLF programs shall have been transferred to DBP. 7. All agricultural credit programs shall have been transferred to appropriate financial institution as agreed with the Bank. 8. In its transformation from retail to predominantly wholesale financial institution, DBP shall have achieved agreed interim performance targets. 9. Satisfactory action on reducing taxes on financial intermediation shall have begun. 10. The finances of the CBP will be restructured to the World Bank's satisfaction before November 30, 1993.   IMAGING Report No: 14524 Type: PCR