The Bangko Sentral ng Pilipinas (BSP) recently released the Status Report on the Philippine Financial System for the first semester of 2006. The report provides an account of the performance of the banking system and other financial institutions such as non-banks with quasi-banking functions, offshore banks, and trust operations under BSP supervision during the first half of 2006. Also included in the report are articles on rules governing joint venture agreements between banks and real estate development companies, prompt corrective action (PCA) framework of the BSP, financial reporting package (FRP), new guidelines on risk management and the rules on securities custodianship.
The report is submitted to the President and the Congress, in compliance with Section 39 (c), Article V of the New Central Bank Act (R.A. No. 7653).
Following are the highlights of the report.
The Philippine financial system continued to exhibit resiliency for the first semester of 2006, in the midst of a rapidly changing global financial landscape. Barely a year before the banking system fully shifts into the Basel 2 regime, key performance indicators suggest the overall soundness of the system’s underlying fundamentals as a result of continuing financial sector reforms.
As of end-June 2006, the system managed to register a soft loan growth in spite of limited corporate demand. Asset quality remarkably improved with post-crisis NPL/NPA ratios at their record lows. This is complemented by moderate expansions in assets, deposits and capital accounts.
Despite the prevailing difficult environment, banks likewise reported improved profitability with net income after tax (NIAT) for the first semester of 2006 settling at P27.7 billion (up by 14.2 percent over the same period last year).
Nonetheless, some issues still need to be resolved for these positive performance indicators to be sustainable and at par with international standards.
Foremost is the need to expedite the cleanup of remaining inventory of non-performing assets (NPAs) of the banking system through SPV-related transactions or other innovative modes of asset disposition. As local banking practices were progressively being aligned with international standards under IAS and Basel 2, it became quite costly for banks to hold on to these NPAs.
To effectively address the NPA problem, the Bangko Sentral ng Pilipinas (BSP) recently allowed banks to enter into joint venture agreements (JVAs) with real estate development companies (Circular No. 518 dated 06 March 2006) to dispose their foreclosed real properties and convert them into income-generating assets.
Another equally important issue is the individual bank compliance with the prescribed capital adequacy ratio (CAR) of 10 percent. While the industry average remained well above the BSP regulatory requirement and the international standard of 8 percent, there were a few banks with weak capitalization that could suffer the brunt of regulatory tightening under Basel 2 unless they shape up and improve their capital position.
The issuance of hybrid capital instruments is one way to strengthen bank capitalization. Toward this end, the BSP came out with additional guidelines on the issuance of unsecured subordinated debt (USD) qualifying as either Tier 2 (supplementary) capital or hybrid Tier 1 capital. (Circular No. 528 dated 03 May 2006).
Meanwhile, trigger events for the enforcement of a prompt corrective action or the PCA (Circular No. 523 dated 23 March 2006) were no longer limited to under capitalization in terms of minimum capital requirements per banking category. Under the new guidelines, a bank may be subject to a PCA, if: (1) any of its prescribed capital ratios fall below the required minimum, (2) its CAMELS (Capital adequacy, Asset quality, Management, Earning, Liquidity and Sensitivity to market risk) composite rating or Management component rating falls below “3” or (3) it has a serious supervisory concern placing the bank at more-than-normal risk of failure. Such improvement in BSP’s PCA framework is reflective of the changing financial environment and in line with international standards.
Parallel to this, the challenges posed by stringent regulations, tougher foreign competition and more demanding banking/finance standards necessitate a faster industry consolidation of domestic banks to enable them to compete globally. In order to facilitate the development of larger and stronger financial institutions, the BSP rationalized the incentives for merger and consolidations in 1998 and imposed the moratorium in the establishment of new bank and branches (except for the establishment of rural banks and microfinance-oriented banks in underserved areas) in 1999. There were five (5) cases of mergers recorded at end-June 2006, further trimming of bank structure from 996 operating banks in 1998 to 871 operating banks.
The system continued to exhibit a soft loan growth of 1.0 percent to P1,865.8 billion due to supply-demand factors. On supply side, banks remained risk-averse and intent on strengthening their balance sheets by reducing credit and maintaining high liquid assets-to-liabilities ratio in response to the technical demands of modern banking and finance standards (i.e., IAS/Basel 2). Meantime, the demand for corporate credit remained limited as corporate loan recipients focused their efforts on improving their operational efficiencies rather than resort to borrowing. Related capital market developments also provided an alternative route for corporate financing (i.e., highly rated corporate borrowers tapping both domestic and foreign capital markets). Consequently, the ratio of loans (gross) to deposits declined this semester to 68.5 percent from year ago’s 74.2 percent.
To promote an effective risk management of the banks’ credit exposure, the BSP has also supported the proposal to establish a centralized credit information system (CISA Bill) and enhance the country’s debt resolution framework (Corporate Recovery Act Bill) during the semester in review.
As highly leveraged entities, there is also a greater demand for financial institutions to strictly adhere to good corporate governance practices in an increasingly complex and sophisticated financial environment. Toward this end, the BSP further strengthened its corporate governance framework to align the same with the internationally accepted standards and best practices (i.e., OECD Codes of Corporate Governance).
During the semester in review, the BSP fortified the role of bank directors as corporate decision makers by amending its regulations on the fit and proper rule (Circular No. 513 dated 10 February 2006) and on DOSRI lending (Circular No. 514 dated 06 March 2006). Financial reporting and auditing practices were also aligned progressively with international standards following the issuance of guidelines for the new Financial Reporting Package or FRP (Circular No. 512 dated 10 February 2006) and the engagement of external auditors (Circular No. 529 dated 11 May 2006). These were aimed to promote transparency, fairness and accountability in financial reporting.
In the area of risk management and bank supervision, further technological advancements in E-banking will pave the way for the integration of e-banking risks into the bank’s overall risk management framework. This will be particularly significant for cross-border Overseas Filipino Workers (OFW) remittances captured by the banking system that grew in the first six months of 2006 by 15.4 percent to $6.0 billion over the same period last year. In response, the BSP has issued the guidelines on technology risk management (Circular No. 511 dated 03 February 2006) and on supervision by risk (Circular No. 510).
Beyond banking reform, the accelerated development of the domestic capital market is vital to effective financial intermediation and to the provision of alternative funding source for the economy. Although the financial system assets-to-GDP ratio has been declining in the last five years, the financial sector still accounts for 83.9 percent of the country’s economic output. With the banking sector holding the lion’s share of financial system’s assets at 95.4 percent, the economy relies on banks for its development needs. This makes the banking system susceptible to losses arising from economic downturns.
In order to fully develop the financial system and align the country’s savings allocation at par with other countries in the region, further capital market reforms have to be in place to reduce the reliance on banks as the main source of financing and strengthen the resilience of the corporate sector through the participation of securities firms, specialized intermediaries (i.e., investment houses) and the institutional investors (i.e., mutual funds) in financial intermediation.
Toward this end, the BSP has issued various circulars to accelerate the development of the domestic capital market. During the semester in review, the BSP has initiated further reforms to boost the trust business with the issuance of the guidelines on living trust accounts (Circular No. 521 dated 21 March 2006) and rules on the acceptance, management and administration of trust funds of pre-need companies (Memorandum to All Banks/Non-Bank Financial Institutions dated 28 March 2006).
Apart from these, the third party custody system (Circular No. 524 dated 31 March 2006) was institutionalized to complement the establishment of the Fixed-Income Exchange (FIE) and to promote greater investor protection.
In the area of microfinance, the BSP remained supportive of the national agenda on poverty alleviation through sustainable microfinance. As of end-March 2006 1 , there were 205 banks engaged in microfinance with a total loan portfolio of P3.6 billion and serving a total of 593,180 clients.
Summing up, the Philippine financial system has come a long way since it opened to deeper integration into the global financial market. In the course of forging the path ahead, the BSP and the rest of the stakeholders still have to tackle these remaining issues and challenges extensively to find the desirable balance between domestic reform priorities and regional opportunities. One way to forge this path to sustainable growth is a clear continuing commitment to genuine reforms.
Banking System Developments
The Philippine banking system remained resilient for the first half of 2006, even as the industry faced the challenges of a rapidly changing global financial environment. The overall performance may be modest compared to the previous years and by international standards, the hard numbers nevertheless indicate the overall soundness of the system’s fundamentals that benefited from continuing reforms in recent years.
Total assets of the banking system expanded on a slower pace of 4.3 percent to P4,519.0 billion for the first semester of 2006. The system’s resources was primarily funded by P3,221.2 billion deposits (71.3 percent) and P54.1 billion borrowings (i.e., unsecured subordinated debt at 1.2 percent), and supported by P519.5 billion capital (11.5 percent).
In terms of share to the system’s total assets, domestic universal and commercial banks continued to hold the bulk of the industry’s resources at 75.9 percent while domestic thrift banks (exclusive of foreign linked TBs) at 7.8 percent and rural and cooperative banks at 2.7 percent account for the remaining shares. Meanwhile, foreign banks (U/KBs and TBs) accounted for the remaining 13.6 percent.
Liquid assets to deposits lingered at 53.1 percent, albeit 1.9 percentage points lower than the 55.0 percent recorded over the same period last year.
Total loan portfolio (TLP), gross (exclusive of interbank loans) inched up by 1.0 percent to P1,865.8 billion due to supply-demand factors. In a nutshell, the slowdown in lending activities were traced to the banks’ risk-aversion from the overhang of non-performing assets and the prevailing limited corporate demand. Outside the corporate loan recipients, consumer lending sustained growth largely supported by upswings in residential real estate, automobile and credit card financing. This indicates that, as in the previous semesters, the domestic economy remains consumption-led, fueled by heavy inflows from OFW remittances.
Although investments, net slowed down by 1.7 percent from 22.8 percent at end-June 2005, investments still outpaced credit expansion as banks were still inclined to park their excess funds in less risky government securities.
Meanwhile, the alignment of local banking practices with international standards under IAS and Basel 2 makes it costly for banks to maintain a large stock of non-performing assets (NPAs). Spurred by these developments, brisk industry asset cleanup resulted to significant reduction in the level of NPAs as well as improvement in industry’s asset quality indicators with the NPL/NPA ratios much closer to their pre-crisis levels at the end of the semester.
The banking system continued to be solvent with the industry remained well above the BSP regulatory requirement of 10 percent and international standard of 8 percent. However, the main challenge is the individual compliance of banks to the prescribed capital adequacy ratio (CAR) as the system fully shifts to the Basel 2 framework in 2007.
Banks likewise reported improved profitability with net income after tax (NIAT) increasing by 14.0 percent to P27.7 billion over a year ago. Strong trading gains (32.3 percent) and positive trust department income (34.2 percent) bolstered the banking system’s overall bottomline figure.
Finally, there were 41 operating universal and commercial banks with 4,277 branches, 84 thrift banks with 1,209 branches, and 754 rural and cooperative banks with 1,305 branches at end-June 2006. Although the physical network (total number of head offices, branches, and other offices of the banking system) recorded a minimal increase at 7,670 from previous year’s total of 7,612, the overall bank structure contracted to 879 from 893 resulting from several cases of bank mergers and closures within the year.
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