Philippines - Banking System Reform Project

Document of The World Bank FOR OFFICIAL USE ONL,Y Report No. P-7235-PH REPORT AND RECOMEMENDATION OF THE P]RESIDENT OF THE INTERNATIONAL BANK FOR RECONSTRUCTION AND DEVELOPMENT TO THE E,XECUTIVE DIRECTORS ON A PROPOSED LOAN IN THE AMOUNT OF US$ 300 MILLION TO THE REPUBL IC OF THE PHILIPPINES 1FOR BANKING SYSTEM REFORM\/ November 4, 1998 This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.j  CURRENCY EQUIVALENTS (As of November 4, 1998) Currency Unit = Peso $1.00 = 39.40 pesos 1.00 peso = $0.025 FISCAL YEAR January 1 - December 31 ABBREVIATIONS AND ACRONYMS APT - Asset Privatization Trust BAP - Bankers Association of the Philippines BSP - Bangko Sentral Ng Pilipinas CAMEL - Capital, Asset Quality, Management, Earnings and Liquidity CAS - Country Assistance Strategy CPSD - Consolidated Public Sector Deficit DBP - Development Bank of the Philippines DOF - Department of Finance DST - Documentary Stamp Tax EFF - Extended Financing Facility FCDU - Foreign Currency Deposit Units GFI - Govermment-Owned Financial Institution GDP - Gross Domestic Product GNP - Gross National Product GRT - Gross Receipts Tax IFAC - Effects of Non-Application NPL - Nonperforming Loan PDIC - Philippines Deposit Insurance Corporation PNB - Philippine National Bank SCL - Single Currency Loan SEC - Securities and Exchange Commission SLIM - Solvency, Liquidity, Income and Management SME - Small and Medium Enterprise TA - Technical Assistance VAT - Value-Added Tax Vice-President: Jean-Michel Severino, EAPVP Country Director: Vinay Bhargava, EACPF Sector Manager: Jacques Loubert, EASFS Task Manager: Sanjay Dhar, EASPR  FOR OFFICIAL USE ONLY REPUBLIC OF THE PHILIPPINES BANKING SYSTEM REFORM LOAN TABLE OF CONTENTS Page No. LOAN AND PROGRAM SUMMARY ............................................................ i I. THE ECONOMIC CONTEXT .......................... .................................. I A. Impact of the Regional Economic Crisis ............................................................ I II. THE BANKING SYSTEM: PAST PROGRESS AND CURRENT CONCERNS ............................................................ 5 A. Past Financial Reforms: An Overview ............................................................ 5 B. The Current Banking Environment ....................................... ..................... 6 C. The Corporate Sector ............................................................ 11 1II. REFORM AGENDA FOR THE BANKING SYSTEM .............................. 12 A. Strengthening the Prudential Framework ............................................................ 13 B. Refining the Intervention and Resolution Strategy ........................ .................... 15 C. Strengthening Government Owned or Controlled Banks ................................... 18 D. Reducing Regulatory Arbitrage and Intermediation Costs .............. ................... 19 E. Legislative and Regulatory Agenda ............................................................ 20 IV. THE PROPOSED LOAN ............................................................ 22 A. Background and Rationale .................. .......................................... 22 B. Loan Objectives ............................................................ 23 C. Loan Description, Conditions and Tranching .................................................... 24 D. Loan Administration ............................................................ 26 E. Benefits and Risks ............................................................ 26 V. RECOMMENDATION ............................................................ 27 This loan was prepared by a team led by Sanjay Dhar and includes contributions from McDonald Benjamin, Carlos Escudero. Patrick Honohan, Niels Minners. Vincent Polizatto, Owen Camey (banking consultant) and Ross Delston (legal consultant). David Bisbee provided research assistance and Hedwig Abbey assisted with document processing. 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.  ANNEXES Annex 1: Letter of Development Policy Annex 2: Policy Matrix-Objectives and Sequencing of Actions Summary Notes on Proposed Policy Actions Annex 3: Terms of Reference for the Financial Advisor to the Department of Finance for PNB Annex 4: Recent Measures Taken or Announced to Strengthen the Banking System Annex 5: Statistics Table 1: Selected Economic Indicators. 1993-99 Table 2: Balance of Payments, 1992-98 Table 3: Selected Interest Rates Table 4: External Debt, 1992-97 Table 5: The Philippine Banking System Table 6: Nonperforming Loans in the Banking System Annex 6: Status of Bank Group Operations in Philippines Operations Portfolio Annex 7: Philippines at a Glance  REPUBLIC OF PHILIPPINES BANKING SYSTEM REFORM LOAN LOAN AND PROGRAM SUMMARY Borrower: Republic of Philippines Amount and terms: $300 million floating rate single currency loan in US Dollars for 20 years including 5 years grace at the Bank's standard amortization terms, grace period and interest rate for floating rate US dollar loans with an expected disbursement period of less than three years will apply. Objective: The purpose of the loan is to support the Borrower's banking reform program. whose goal is to strengthen the banking system and enable it to better withstand current difficulties and future shocks. Description: Reforms to strengthen the banking system include policies to: improve the prudential framework and supervisory effectiveness; enhance market discipline and owner incentives; reduce regulatory arbitrage and intermediation costs; refine the intervention and resolution framework for troubled banks; and initiate a program to strengthen state-owned/controlled banks. Legislative changes are essential to the success of the program. A fast disbursing loan is proposed. The loan would disburse in three equal tranches in accordance with conditions noted in the Policy Matrix and supporting summary notes (Annex 2). Benefits and risks: Associating the Bank with policy advice and lending for banking reform can strengthen the quality of the reform program and improve confidence in the banking system, which has been weakened with the onset of the regional crisis. Maintaining a sustained effort to strengthen the banking system will remain essential in the medium term. Even assuming a rapid return to normalcy within the region, the banking system would benefit from the enhanced prudential framework envisaged under the reform program, in order to exercise the appropriate degree of restraint in intermediating potentially large private capital flows. The Philippine economy remains vulnerable to a sustained deterioration in the regional environment, which would exert added  - 11 - pressure onto a fragile external position and adversely impact financial markets. Even without unanticipated macroeconomic deterioration, the banking system faces a period of increased stress from a slowdown in growth, high interest rates. peso depreciation and weaker real estate prices that have strained corporate balance sheets. A number of banks could fall short of capital adequacy requirements as the burden of nonperforming loans grows. and individual institutions remain subject to sudden deposit withdrawals that can render the entire system more vulnerable. While economic and banking risks are significant. the Bank can mitigate these by improving the quality of the banking reform program and also enhance investor confidence. thereby improving its prospects of succeeding. Macroeconomic risks are being addressed within the context of a two year IMF stand-by program approved on March 27. 1998. Poverty category: Not applicable Estimated disbursements: The loan would be disbursed in three equal amounts. Disbursements would be conditioned upon satisfactory macroeconomic performance and financial sector policies as described in the Letter of Development Policy. Schedule of Disbursements: US$ million US$ million Bank FY 1999 2000 Annual 100 200 Cumulative 100 300 Project ID Number: PH-56524  REPUBLIC OF THE PHILIPPINES BANKING SYSTEM REFORM LOAN 1. I submit for your approval the following report and recommendation on a proposed adjustment loan of U.S. $300 million to the Republic of the Philippines to strengthen the banking system and enable it to cope more effectively with the increased financial market volatility since mid-1997. I. THE ECONOMIC CONTEXT A. Impact of the Regional Economic Crisis 2. The Philippine economy was among the first in the region to be adversely impacted by the Thai crisis. Yet the cumulative impact of the subsequent region-wide crisis on the economy and financial sector. although substantial, has been less severe than in most neighboring economies: there has been no need thus far for the Government to recapitalize private banks and the majority of large corporations remain current on their domestic and foreign obligations. This may be attributed to several factors: the experience gained by bankers and foreign creditors during the crises of the 1980s and early 1990s led to a more cautious approach to credit use; hence external debt build up by the private sector was slower; corporations are less highly leveraged; and banking problems stemming from the 1980s stimulated reforms which, prior to the onset of the current regional crisis, had produced a stronger banking regulatory and supervisory environment than that prevailing in some of the Philippines' neighbors. Nevertheless, slowing economic activity and continued instability in financial markets has increased stress on the banking and corporate sectors, with smaller banks and enterprises on average impacted more severely. 3. Impact on Financial Markets. In early 1997. financial markets began to exhibit increased anxiety over the Philippines' rising trade deficit, rapid pace of credit expansion, and the impact of a possible correction in property prices on banks and real estate developers-key economic indicators are provided in Table 1. The impact of such concern was first felt in the stock market which reached a record high in early February 1997. but had fallen to a 6 year low by early September 1998. As of November 4, stock prices had recovered strongly-by 58 percent-from their low on September 11, 1998, but were still 50 percent below their previous high on February 3. 1997. 4. Faced with a sustained attack on the peso, particularly after the Thai devaluation on July 2. 1997 the central bank (BSP) substantially reduced its intervention in the foreign exchange market as of July 11, after which the peso fell to a low of P46/US$ in early January 1998. The peso has recovered during the course of 1998 while being subjected to ongoing bouts of regional instability. As of November 3, 1998, the peso had strengthened beyond P40/US$, again consistent with the recent trend towards  -2- strengthening in regional currencies. After building reserves over a number of years (in the process of intervening to prevent a more rapid market-driven real exchange rate appreciation), the BSP's reserve loss in 1997 amounted to $3.4 billion, with much of this occurring in the nine days between the floating of the Thai baht and Philippine peso. At end-1997, adjusted gross reserves had fallen to $7.6 billion, equivalent to 1.7 months of imports and 28 percent of broad money. As of October 9. 1998. adjusted gross reserves had however recovered to $9.1 billion, or about 2.3 months of import cover. reflecting an import decline and shift towards current account balance during the year. 5. Net inflows of foreign capital fell from some $8 billion in 1996 to less than $1 billion in 1997. The initial shift in investor sentiment was driven by foreign capital, but subsequent pressure on the exchange rate was also domestic-driven. in part by the desire to hedge against foreign currency obligations.' 6. The BSP has used temporary increases in its overnight rates to defend the currency during periods of heightened speculation-its overnight borrowing rate rose to a high of 32 percent in July 1997-but has also been cognizant of the impact of sustained increases in overnight rates on corporate and government borrowing costs. Market interest rates therefore peaked in late 1997 and early 1998 but have declined since then: the benchmark 91-day Treasury bill rate had fallen to below 14 percent by August 1998 from a peak of nearly 20 percent in January; and prime lending rates have stabilized recently at 16-17 percent from a high of over 25 percent in late 1997 (inflation is currently at 10 percent). The initially higher interest rate structure relative to pre-crisis levels reflected several factors: an increased risk premium on the peso; increased perceptions of risk and preference for liquidity among bankers; and the increased cost of maintaining the deposit base particularly among smaller banks, some of which have been subjected to deposit withdrawals. Since early 1998, a reduction in financial intermediation costs through adjustments in reserve requirements and an informal agreement coordinated by the Bankers Association of the Philippines (BAP) to limit commercial lending rates have brought down real interest rates to approximately pre- crisis levels. though credit access for non-prime borrowers has deteriorated. 7. Economic Impact. The impact of financial market turbulence on economic activity was restrained in 1997 but has become more severe in 1998. Real GDP growth slowed to 5.4 percent in 1997 but export growth accelerated to 23 percent, and the increase in inflation was modest. During the first half of 1998, real GDP growth was practically flat-seasonally adjusted GDP growth is estimated at about -1.4 percent- notwithstanding maintenance of robust export growth. Agricultural production fell by 7.5 percent in the first half of 1998 reflecting the severe drought, while industrial production also declined as credit conditions tightened and private investment fell. The Total foreign currency exposure of banks and corporations (including foreign currency deposits) is estimated at $30 billion as of March 1998. Corporations owed about $23 billion in foreign currency, of which about $11 billion was owed to domestic banks. Banks foreign currency liabilities totaled $18.6 billion (covered by position limits).  -3- Government's revised targets under the IMF's stand-by program include GDP growth of I percent in 1998, average inflation of 9.5 percent. public sector and current account deficits of 2.9 percent and 1.5 percent of GNP, respectively, but with improvements in each of these variables projected for 1999 (Table 1). Attainment of the 1998 growth target would require a significant recovery during the second half of the year. 8. Social Impact. 2 The Philippines has made notable gains against poverty in recent years: preliminary data indicate a decline in poverty incidence to 32.1 percent in 1997 from 35.5 percent in 1994. The repercussions of the financial turbulence include: reduced affordability and access to credit for the poor and informal sectors; lower real incomes (due primarily to the drought); reduced government services; and increased risk of layoffs. These stresses have occurred as the drought-induced crop damage from El Nino intensified through mid-1998. particularly in Mindanao. Unemployment in April 1998 had risen sharply relative to April 1997, but as of July 1998 it was up only marginally (to 8.9 percent versus 8.7 percent in July 1997). The relatively stable unemployment figure for July however reflects reductions in both the labor force as well as employment relative to 1997, which appears to indicate a decline in new job opportunities. 9. External Financing Environment. The volume of capital flows will clearly impact the economic outturn. Yet the nature of private capital flows in the near term is particularly difficult to predict in view of the prohibitive increase in recent months in the cost of capital in international markets for emerging markets including the Philippines and the uncertain evolution of the regional crisis.3 10. The scenario outlined below envisages a current account deficit that falls from 5 percent of GNP in 1997 to below one percent by 1999-00 reflecting export growth averaging 14 percent and a recovery of imports following their decline in 1998. While short-term debt is assumed to be rolled over on a regular basis, the build up of reserves is assumed to remain constrained by the private capital flow uncertainties and the intermittent pressure still felt on the exchange rate. The projections for foreign investment are driven primarily by direct investment flows as portfolio flows are assumed to be approximately flat in net terms. Debt finance is projected to fall relative to pre- crisis levels, and its composition to shift towards official and multilateral resources, reflecting the deterioration in access and terms to private capital. 2 Through its social impact assessment and review of social expenditures, the Bank is developing a common understanding with the Government of the social impact of the financial crisis and a strategy to address the consequences. The interest rate spread for Philippine long-term dollar-denominated paper had declined to below 600 basis points at end October 1998 from a peak of 987 basis points on September 1, 1998.  -4- Philippines: External Financing Requirements and Sources, 1998-00 ($ Billion) 1998 1999 2000 Requirements 4.7 5.4 6.2 Current account deficit 1.0 0.5 0.4 Amortization 2.6 3.5 3.7 Net Reserve Increase 1.1 1.4 2.1 (excludes ST debt rollover) Sources 4.7 5.4 6.2 Foreign Investment 0.7 0.8 0.9 MLT Loans and Bonds 5.9 6.6 6.8 ST, Comm. Banks, E&O -1.9 -2.0 -1.5 Source: IMF 11. Economic Policy Responses to the Regional Crisis'. The policy response to the difficult environment since mid-1997 has been positive overall. The conduct of monetary policy has on balance been appropriate when evaluated against: the periodic pressures on the peso emanating in large part from regional repercussions; the limited resources available for intervention by the central bank; and the need to balance the negative impact of depreciation on foreign currency debtors with the damage from higher interest rates on corporations, banks and economic activity. 12. The consolidated public sector deficit (CPSD) is projected to rise by about two percentage points of GNP to nearly 3 percent in 1998 reflecting slower growth, weaker corporate profits. and the adverse impact of interest and exchange rate trends on debt service. Although the Government has mandated additional restraints on public expenditure in anticipation of fiscal pressure, efforts to protect real expenditure on vital social services and effective safety net programs are also ongoing. For 1999, the CPSD is targeted to decline to about 2 percent of GNP assuming the resumption of growth of about 3.5 percent. 13. Following the peso float in July 1997, the government immediately negotiated an extension and augmentation of its existing Extended Financing Facility (EFF) with the IMF, which was successfully completed on March 27, 1998. On the same date, the IMF Board approved a new two year SDR 1,021 million precautionary stand-by program, which recognizes the need for a cyclical increase in public deficits but also envisages 4 Reforms within banking are described in the following sections.  -5- adjustments to improve medium-term fiscal sustainability.5 At the Government's request, the IMF has activated its program following a Board meeting on October 30. 1998, making available SDR 197.4 million. 11. THE BANKING SYSTEM: PAST PROGRESS AND CURRENT CONCERNS A. Past Financial Reforms: An Overview 14. The Philippine financial sector has undergone significant reform over the past decade in response to the economic and financial crises of the mid 1980s. The two largest development banks at the time-the Philippine National Bank (PNB) and the Development Bank of the Philippines (DBP) underwent substantial restructuring in 1987 that included: transfer of nonperforming loans (NPLs) to a separate public agency (the Asset Privatization Trust (APT): branch closings, approval and implementation of revised charters and rehabilitation programs, strengthened internal governance: etc. Through most of the subsequent decade, these banks remained profitable and financially sound; and PNB was formally incorporated as a private commercial bank in May 1996 following the Government's reduction of its ownership stake to 45.5 percent. 15. The central bank, which had become technically insolvent on account of the losses accumulated over the past decade. was restructured and recapitalized in 1993 and acquired substantial independence from other branches of government through constitutional change. Since this major reform, the new BSP has been able to focus more effectively on the conduct of monetary policy and supervision and regulation of banks. 16. Complementary reforms in the early 1990s included: strengthening supervisory and regulatory systems for commercial banks: transferring directed credit programs from government departments to the restructured DBP: and reducing the proportion of loans commercial banks were required to allocate to agrarian reform, agricultural credit, and small and medium enterprises (SMEs):6 and a recapitalization of the Philippines Deposit Insurance Corporation (PDIC). The PDIC is charged with rehabilitating or liquidating banks closed and placed under receivership by the Monetary Board, and insures deposits of up to P100.000-in contrast to the experience in other regional economies, there has been no need to offer unlimited deposit insurance during the current crisis. 17. In 1994. the maximum foreign equity participation in domestic banks was raised from 40 to 60 percent: and in 1995. licenses were granted to 10 new foreign banks, As described in Section IV. there has been significant coordination between the Bank and Fund in developing with the authorities a banking reform agenda. The IMF stand-by includes measures to strengthen the banking system within its structural benchmarks. 6 These requirements are not unduly burdensome since they can be satisfied by placing resources instead in government securities and corporations involved with agriculture.  -6- bringing the total number to 14, and providing the impetus for domestic banks to improve efficiency and to modernize. Together with increases in minimum capital requirements announced in 1995, 1997 and most recently in March 1998, the entry of foreign banks has led to a number of bank mergers and is expected to accelerate the process of consolidation within the banking system. 18. A series of measures were taken in response to heightened concerns about banks' vulnerability to real estate exposure, credit expansion and foreign exchange risk during 1996-97. In April 1997, the BSP adopted two measures to tighten regulations on real estate lending by banks: it lowered the ceiling on an individual bank's exposure to real estate from 30 to 20 percent of loan portfolio, giving banks one year to comply; and it lowered the permissible ceiling on the loan-to-value ratio for real estate lending from 70 to 60 percent of the market value of the property. In June 1997, the objective of improving the maturity profile of banks' foreign currency asset structure was announced: since December 1997, banks have had to maintain a 15 percent foreign exchange liquid asset requirement on their FCDU holdings; this ratio was raised to 30 percent in June 1998. 19. A two percent general loan loss provision requirement (over two years) was announced in late 1997, and in March 1998, the implementation period for this provision was brought forward by one year to October 1, 1999. The criterion for classifying NPLs was also tightened effective from April 1998, reducing from six to three months the period for which overdue loans can be termed current. And as the risks to the banking system have increased the authorities have been refining their intervention and resolution strategies as discussed in Section III.B. B. The Current Banking Environment 20. The Philippine banking system has withstood the impact of the current crisis better than several neighboring countries as major bank failures or a systemic crisis have been avoided. This reflects stronger capitalization of the top tier banks and greater resiliency within the corporate sector. 21. Nevertheless, the banking and corporate sectors are encountering greater stress. The quality of bank assets has deteriorated, capital adequacy has weakened, and once exceptionally strong earnings have fallen. Annualized loan growth has slowed to approximately 10 percent, which incorporates conversions of dollar to peso-denominated loans and interest capitalization. Several banks have withdrawn from the SME and consumer credit markets and, rather than lend to new borrowers, have stayed liquid and used their funds to invest in government securities. Moreover, the banking system may have to go through a period of further consolidation and retrenching-this will depend in large part on the speed and vigor with which economic recovery can be attained. This section summarizes the main concerns.  -7- (i) Financial Condition of the Banking System 22. Total assets of the banking system stood at about P2.77 trillion at end-1997 (about equal to GNP), a 31 percent increase over 1996 (Table 5). Universal and commercial banks account for 90 percent of total assets; thrift and rural banks hold about 8 and 2 percent of assets respectively.7 Preliminary data through mid-1998 indicate a marked deceleration in asset growth. 23. As a group, universal and commercial banks reported healthy profit levels through 1997, largely as a result of widening gross interest margins. Nevertheless, rising NPLs. increased incidences of rollovers. rescheduling and corporate recourse to legal suspension of payments. falling real estate collateral values, use of BSP liquidity support by selected institutions, and difficulties in complying with legal reserve requirements for some banks, all point to increasing signs of stress. The BAP expects commercial bank earnings to drop by 10 to 25 percent in 1998. The problems are more acute among smaller commercial banks, thrift banks, and rural banks owing to the characteristics of their asset portfolios-comprising higher shares of lending to small businesses, consumer loans and real estate-weaker credit management systems. and a slower response capacity to the changing environment. 24. The growth of NPLs illustrates the increasing stress. BSP figures indicate the ratio of NPLs for all banks rose to 9.7 percent in June 1998. compared to 3.4 percent a year earlier. NPLs of commercial banks stood at 8.9 percent in June 1998, and those of thrift and rural banks stood at 16.7 percent and 15.4 percent. respectively (Table 6). 25. Capital Adequacy. As of June 1998. the banking system's average capital adequacy ratio is officially estimated at 17.1 percent, among the highest in the region. But, even as minimum capital requirements are being raised. capital levels will fall as banks fully provision for collateralized loans and restructured nonperforming loans. In most banks, capital will be further strained as the banks begin to follow international accounting standards and mark their trading books to market. 26. Moreover, the quatility of bank capital is as much a concern as its quantity, given the interlocked balance sheets of many groups owning financial and nonfinancial entities. If the interlocked balance sheets were fully consolidated, what appears as capital in the bank may. in fact. be offset by a liability to another bank through a related party. Through double leverage bank capital therefore could be supporting more assets than is readily apparent from viewing an individual bank's balance sheet. 27. Off-Balance Sheet Activities. The single largest component of such activity is trust department accounts, which are equivalent to about 14 percent of total assets. Most 7 Universal (or 'expanded commercial banks") are licensed for commercial and investment banking. There are 54 universal and commercial banks (of which 14 foreign), 117 thrift banks, and 832 rural banks.  -8- trust departments purchase loans from the commercial side of the bank or extend credit directly to borrowers who also borrow from the commercial bank. Although legally separated from the bank's operations. many market participants believe that in the event of problems, banks would have to stand behind their trust assets, particularly the trust holdings of loans. BSP regards common trusts to be 'deposit substitutes" and subjects them to deposit reserves. But trust loan holdings are not considered when determining the adequacy of bank capital or loan loss reserves. 28. Banks continue to be active in derivatives. However, the bulk of derivatives activity is concentrated in relatively simple contracts. particularly foreign exchange forwards and swaps. About two-thirds of these transactions are undertaken by foreign owned banks. The credit and market risks associated with Philippine bank derivative use are small in comparison with the credit risk exposure within the banks' loan books. 29. Transparency. Aside from the difficulties in interpreting true NPL and capital levels, transparency has been hampered by inadequate financial disclosure standards. Furthermore, the accounting industry is dominated by a single firm that audits most of the major banks' financial statements. 30. Loan Classification and Provisioning. Until recently, loan loss provisions were not required for assets backed by collateral even if such assets were classified as substandard, or for assets criticized as especially mentioned.8 While specific assets among these categories may not be immediately identified as having loss potential, there is loss potential within the aggregate of these assets, indicating the need for some form of provisioning. 31. Real Estate Exposure. The average outstanding real estate loan exposure of banks is relatively modest, about 12 percent of total loans in mid- 1998. Banks' exposure to the property sector however appears understated as it does not include their equity stakes in real estate companies and projects, or loans to individual investors whose capacity to repay depends upon the sale of the real estate. It is difficult to obtain a realistic value of real estate because there is little liquidity in the market. Overall, real estate is reported to have lost around 25 percent value since its recent peak in the high- end market but only 5 percent in the low/medium cost market. Bank exposures to the middle and low cost segments of the property sector appear less risky as the buyers tend to be end-users and not investors or speculators. 32. Systemic Liquidity. The interbank lending market has become segmented, with many larger banks reducing or ceasing credit lines to smaller banks. To help banks suffering from liquidity problems, the BSP's extension of emergency loans has increased significantly since the onset of the crisis. However, lack of detailed information on 8 A recent BSP directive however addresses this deficiency effective as of end 1998. A general loan loss provision was also introduced in October 1997, which is to reach 2 percent by October 1999 (Annex 4).  -9- liquidity support to the banking sector, including foreign currency funding. prevents a full assessment of current and potential liquidity problems. 33. Entry and Exit. The number of banks in the financial system has strained supervisory capacity. Entry into the system has been lax on occasion-e.g. Orient Bank obtained a commercial bank license less than a year before it ran into serious difficulty. and despite indications it was not a well managed thrift bank. The BSP recently imposed stricter criteria for new bank entry. Senior bank officers must now have at least two years experience in banking. BSP will also require the submission of a detailed plan of operation, chart of organization. and a manual of operations before a bank is issued a permit to operate. Exit from the system is constrained by weaknesses in the legal framework (para. 41). The current market environment also complicates the troubled bank resolution strategy. In 1998 through October. 21 banks had been closed, including 14 rural banks, six thrift banks. and the first commercial bank to be closed since the onset of the crisis. An average of 15 (primarily rural) banks have been closed annually since 1995. 34. Orient Bank. In February 1998. the Orient Commercial Banking Corporation, with assets of P8 billion, declared a self-imposed bank holiday after experiencing heavy deposit withdrawals. The bank had P2.3 billion and only P1 billion of these deposits are insured. A huge concentration of insider loans was discovered after the "holiday" was declared, and NPLs were reportedly 75 percent of assets. In mid-October, after protracted negotiations, the bank was finally placed under receivership by the Monetary Board. Thrift and Rural Banks 35. Thrift and rural banks in aggregate are experiencing far greater stress than commercial banks, and several may have difficulty meeting the BSP's new capital and loan loss provisioning requirements. 36. As of June 1998. thrift banks' NPLs were reported at 16.7 percent; when combined with totals of foreclosed and repossessed assets and loans reported as restructured, the total of all loans not performing according to original schedule rises to about 30 percent of total thrift loans. Three quarters of the total loans held by thrifts are concentrated in the ten largest thrift banks. and two have received open bank assistance from the BSP. Overall thrift profitability is down, and a number of thrift banks are expected to show losses in 1998. As of March 1998, 15.4 percent of rural bank loans were reported past due, rising to about 19 percent of total rural bank loans applying the above criteria. This level of performance is consistent with that of prior periods.  -10- (ii) Supervisory Effectiveness 9 37. On-site Examinations. On-site examinations have tended to focus excessively on compliance with numerous rules and are overly process and check-list driven. There has been too little prioritization of issues or criticisms. Examination reports have tended to emphasize asset quality at the near exclusion of: assessment of the bank's overall financial condition and performance and the quality of its management: liquidity; asset and liability management; profitability; the adequacy of capital; and the efficiency of the bank's risk management systems. Other weaknesses have included a lack of flexibility in examination scheduling, slow report processing. and a failure to adequately communicate report findings to a bank's board of directors. 38. The need for a more analytical approach. whereby assessments of the risk management practices of each bank and other important banking risks are thoroughly evaluated, solvency is assessed on a consolidated basis, and the results are communicated to bank management on a timely basis is now recognized. 39. Off-site Monitoring. The off-site monitoring of banks also requires strengthening. For instance, the early warning system (known as SLIM for solvency, liquidity, income, and management) takes selected ratios in isolation, weights them, and computes an aggregate score for the bank. The previous mechanistic approach is becoming more analytical. 40. Until recently, CAMEL ratings did not necessarily portray the financial condition of the institutions rated realistically. For example. to determine the overall rating, individual component ratings were summed and averaged, and the process lacked the element of judgment that is the supervisor's most important skill. Progress towards a more judgmental approach is now underway. and CAMEL ratings have also been improved: the new CAMEL rating can never be higher than a bank's capital adequacy rating. 41. Legal Concerns and Enforcement. Supervisory effectiveness and enforcement of regulatory standards have been constrained by a number of factors including: an unusual degree of personal liability of supervisors in the conduct of official business; bank secrecy provisions that restrict supervisor access to deposit information; inadequate penalties for bank noncompliance with regulatory norms; constraints on the examination cycle that discourage timely follow-up of corrective action; and a number of obstacles to closure of insolvent banks by the Monetary Board and prompt resolution of failed banks by the PDIC. Section III.E describes the legislative initiatives to address these constraints. 9 This section summarizes problems within supervision at the onset of the crisis. Significant progress is being made towards supervisory effectiveness in the past two years as described in Section III.A.  (iii) Structural Distortions in the Banking System 42. Distortions in the financial sector have led to significant regulatory and tax arbitrage across institutions and currency. Differences in the tax structure and in the treatment of reserve requirements on peso versus foreign currency deposits have encouraged dollar intermediation in the past. although the disincentives to peso intermediation were reduced recently with the introduction of a 7.5 percent tax on interest income of foreign currency deposits and a 30 percent liquid asset requirement on foreign currency assets of FCDUs. 43. The differentiated tax treatment across financial institutions may have prompted disintermediation from the commercial banking sector into bank-substitutes that may be less well-regulated. The uneven tax treatment, for example. has motivated some banks to establish thrifts subsidiaries. while the non-uniformity of prudential regulation may have led banks to establish foreign exchange subsidiaries. Peso intermediation is further discouraged by a peso payment system that appears less liquid and less efficient than the dollar payment system. C. The Corporate Sector 44. The Philippine corporate sector has been spared from the massive disruptions experienced in neighboring countries. This primarily reflects smaller exposure to foreign debt and lower debt-to-equity ratios.'