Sound sector: Recent reforms and ongoing efforts promise to further bolster positive trends

The Philippine banking sector has strengthened significantly in recent years, tracking general economic trends and benefitting from prudent measures put into place over time to boost capital and improve supervision, corporate governance and transparency. Most institutions are now in good shape. They are both profitable and sound, able not only to play a vital role in the growing economy but also to withstand volatility along the way.

Like many banking sectors in East Asia, that in the Philippines has made great strides since the Asian financial crisis of 1997-98. It has addressed weaknesses, shored up bank capital, improved risk management systems and in general, applied lessons learned from the crash. The local institutions that emerged from the late 1990s are stable and more wary of excessive risk and asset-liability imbalances. The challenge now is to build off this foundation and to further develop the sector so it can deal with new risks while funding economic growth.

CONSOLIDATION: According to Bangko Sentral ng Pilipinas (BSP), the Philippine central bank, as of the end of 2012 the country had 696 banking institutions, down from 996 in 1998. As of end-June 2013 the Philippines had 17 universal banks, 16 commercial banks, 70 thrift banks, 541 rural banks, 36 cooperative banks and three government banks. Of the universal and commercial banks, 16 are branches and subsidiaries of foreign banks which operate within the country. Consolidation in part explains the decline in the number of institutions. As in other South-east Asian economies, it has been an official policy to foster the development of large, highly competitive institutions through mergers and acquisitions (M&As). “The BSP has been encouraging banks to merge,” said Vicky Lee-Salas, the head of Market Group 5, SGV, the local Ernst & Young affiliate. “Banks need bigger balance sheets to compete.”

The BSP issued Circular 172 in September 1998 to offer incentives for banks to combine and form larger, more stable institutions. That was followed by several other circulars that clarified, augmented, consolidated and extended the original provisions. For example, a three-year limit on incentives was dropped and the possibility of adjusting a number of required ratios, such as the net worth to risk asset ratio and the ratio of real estate loans to total loan portfolio, was introduced for newly merged entities. Within two years, 20 banks had taken advantage of the incentive programmes. Observers say the BSP’s push has left the sector in good shape. “Most of the weak banks have been rescued or closed,” said Renato Peronilla, president and CEO of the Philippine Rating Service Corporation. “Most of the banks that are left now are the stronger and better ones.”

While most transactions have been small, one sizable deal was recently concluded. On February 9, 2013 Philippine National Bank (PNB) and Allied Banking Corporation merged, creating the country’s fourth-largest bank. The former was founded in 1916 and was state-owned until 1989, when it was privatised. The latter was founded in 1977. Both banks were listed on the Philippine Stock Exchange. Following the merger, PNB is the surviving entity.

ACCESS: Despite the trend toward consolidation, the number of branches in the country has been rising steadily. As of June 2013, the Philippines had 9543 operating banking units (683 head offices and 8860 branches). A year earlier, the total was 9207; in 1998, the country had fewer than 7000 banking units in total. Of late, the BSP has been encouraging – or at least not discouraging – the opening of branches. In June 2011 it issued Circular 728, saying banks could open outlets in districts of Metro Manila that were previously restricted, including: Makati, Mandaluyong, Manila, Parañaque, Pasay, Pasig, Quezon and San Juan. Then Circular 759, issued in March 2012, allowed banks to open as many branches as they want provided they have the capital to support expansion. Previous liberalisations had permitted a rise in total numbers, but mandated growth in rural and other underserved areas.

Failures also in part explain the falling number of institutions. A total of 24 banks were closed in 2012, including the Cooperative Bank of Iloilo and the Rural Bank of Luna (La Union), both closed on January 20, 2012; Rural Bank of Balete (Aklan), shut down on August 16, 2012; and the Rural Bank of Bangar, shut down on December 19, 2012. In 2011, 25 banks were closed, and in the previous year 24 banks were shut. Most of the recent failures have been small, but one was relatively large. The Export and Industry Bank was declared insolvent on April 26, 2012, and the bank was put into receivership under the Philippine Deposit Insurance Corporation. It had an estimated P13.7bn ($330.17m) in assets, 50 branches and P24.8bn ($597.68m) in liabilities – of which P11.0bn ($265.1m) was uninsured deposits – and failed to attract interest from any strategic partners when it was put up for bid in early 2013.

REFORM: The banking sector has been undergoing reforms for years, and many changes were instituted even before the 1997-98 Asian financial crisis. The central bank itself has been through at least two major transformations, so fundamental that some argue the country has actually had three central banks in its history. The first, from 1948 to 1972, was a development-oriented policy central bank that used credit to promote production, employment and rising incomes. The second, which lasted from 1972 to 1993, emphasised stability over development, but resulted in racking up losses due to currency depreciation and subsidised loans made to certain industries at the direction of the government. The BSP itself was established in 1993 as an independent monetary authority for the country (previously independence was not clearly spelled out). Other reforms included the General Banking Law of 2000, revising the half-century-old General Banking Act. Among other measures, the law strengthened banking supervision and corporate governance standards and increased banks’ capital requirements. It also allowed for 100% ownership of existing banks by foreign entities through the seven-year window provided under the General Banking Law of 2000, which expired in 2007 (see analysis).

The industry has by all measures become steadily healthier over time and is now in excellent shape. Profits in the banking sector were up 16.4% in 2012 – and 10 times higher than they were in 2000. Profits did drop in 2004 and 2008, but the trend has been positive for more than a decade. The sector leaders have done particularly well. Banco de Oro Universal Bank (BDO), the largest bank by assets, reported a 36% jump in net income in 2012. Metropolitan Bank and Trust Company (Metrobank), the second largest by assets, reported a 40% rise in consolidated net income that year. Net income for the third-largest bank, Bank of the Philippine Islands (BPI), was up 27% in 2012. First quarter 2013 was even better. Metrobank’s net income was up 163% and BPI’s by 43%. The sector has been reporting a steep rise in non-interest income. For example, in 2012 Metrobank reported a 33% jump in non-interest income, compared with a 5% rise in interest income.

The banks are also quite sound and stable. The nonperforming loan (NPL) ratio fell to 3.3% at end-June 2013, down by 0.3 percentage points from the end of June 2012, according to the BSP. That level is the lowest since the 1997-98 Asian financial crisis. The central bank adds that the coverage ratio for NPLs is now 110.8%, double levels in 2003. The risk-based capital adequacy ratio (CAR) was 17.3% on a solo basis at the end of 2012, the highest in the ASEAN-5 (where the average CAR was 16.2%).

REGULATION: Soundness and stability seem set to continue improving. The country is planning to have Basel III capital rules implemented by January 2014. Circular 781, issued January 15, 2013 by the central bank, calls for a qualifying capital to risk-weighted asset ratio of not less than 10% on both a solo and consolidated basis (parent bank plus subsidiary financial allied undertakings, but excluding insurance companies), with Tier 1 common equity and Tier 1 capital ratios of 6.0 % and 7.5%, respectively, and a capital conversion buffer of 2.5%. The circular will go into effect on January 1, 2014.

While the transition to Basel III is not expected to be overly burdensome, the cost of greater security could be a short-term dip in profits. The BSP requires banks to maintain CAR of 10%, already higher than the 8% mandated by the Basel II rules. While the 10% limit will be retained after January 1, the central bank has changed the mix of capital holdings to be set aside under Basel III. Lenders will be required to increase Tier 1 common equity – mainly shareholders’ equity, manifested through common shares – from the present 5% to 6% of the total CAR. The minimum Tier 1 capital ratio will be 7.5% and in addition, the BSP has told banks they must establish a capital conservation buffer, setting aside 2.5% of their funds to serve as another line of defence against any sharp reversal of fortunes.

While the banking sector has generally welcomed the strengthening of regulation, supervision and risk management that Basel III entails, lenders are aware that compliance will come at a cost. Bank chiefs have pointed out that the increased safety measures included in the upgraded guidelines, along with the additional monitoring units and technology, will mean a hike in expenses. Banks could also reduce their lending to meet the risk-weighted capital requirements. According to Lorenzo Tan, president of the Bankers Association of the Philippines, while the impact of Basel III will vary among the majority of lenders, compliance will reduce expected net income generally, with investors facing a drop in return on assets of between 1% and 2% in 2014.

MOVING UP: Credit ratings agencies have also recognised the gains made by the Philippine economy in general and by the country’s banks. Fitch upgraded the Philippines’ foreign currency denominated debt to “BBB-” from “BB+” in March 2013, taking the country’s rating from junk status to investment grade. Standard & Poor’s followed suit in May 2013, and Moody’s upgraded the Philippines to investment grade with a positive outlook in October 2013. The credit markets immediately responded, and the entire yield curve ratcheted down. Yields on 91-day government paper dropped from 0.18% before the upgrade to 0.15% after. On 25-year paper, the yield fell from 3.97% to 3.77%. Banks also benefitted directly as some of their own ratings rose along with the country’s sovereign credit rating. Fitch upgraded BPI’s long-term, foreign-denominated issuer default rating (IDR) to “BBB-” from “BB+”, while BDO’s long-term local and foreign currency IDR and its viability rating were lifted from “BB” to “BB+”.

BSP’S LEADERSHIP: A lot of the banking sector’s success can be attributed to supportive conditions: the economy has been growing, inflation has been in check and the balance of payments situation has been generally positive. But it is also the result of competent management, especially at the highest levels. The BSP, for example, has been able to hold its own and pursue successive reforms while avoiding political interference. The institution is particularly independent, with much room to manoeuvre in the legal, institutional, human resources, functional and operational, and financial and organisational arenas. In March 2013, the national government increased the BSP’s capitalisation by another P10bn ($241m), bringing the bank to its full capitalisation of P50bn ($1.2bn). It had previously received P10bn ($241m) of capital in 1997, another P10bn ($241m) in 2011 and P20bn ($482m) in December 2012.

The BSP would like to improve its structure and is seeking a number of revisions to its charter. It is not only pushing to have its capital increased beyond the current P50bn ($1.2bn) – an amount set two decades ago and not at all appropriate for the conditions of the markets and their size today – it would also like to have its core operations made tax free, a formal arrangement for the sharing of losses with the national government, the establishment of reserves against foreign exchange losses and a legal mechanism for issuing its own debt securities. Currently, the BSP remits 75% of its profits to the national government, but when it incurs a loss, it is on its own and must dip into its capital base. It is also unable to issue debt in its own name, in part due to the fact that the previous central bank ran itself into the ground by selling too much paper.

The BSP tightly manages the sector when appropriate. In a major study carried out by the Bank of International Settlements in 2009, the BSP was found to have a particularly strong mandate with respect to regulation making, licensing, supervision, oversight and suasion/guidance when it came to the banks, far stronger than most of the major Western central banks and in some ways stronger than those of its peers in the region (Thailand and Malaysia).

PRAGMATIC: The bank is pragmatic, and this can been seen in its approach to currency reform, where progress has been slow but steady and positive. In April 2013 the central bank undertook its sixth round of foreign exchange liberalisation since 2007. The latest iteration allows foreign exchange that may be sold over-the-counter (OTC) by authorised banks and foreign exchange corporations amounting to $120,000 without documentation for service transactions, up from $60,000; purchase using unspent pesos of departing non-resident tourists or show proof of previous sale of FX of up to $10,000, up from $5000; and the funding of onshore peso accounts for non-residents for services rendered to residents and for expatriates with contracts of less than one year representing salary, allowance and other benefits. It also allows for the purchasing of a number of categories of foreign investments with money from authorised foreign exchange institutions, including foreign mutual funds, real property abroad, offshore debt instruments held by local banks and foreign-listed equity securities.

The BSP’s leaders are willing to evolve with the times, adjusting their policies to account for changes in economic conditions and the emergence of new theories, new products and new international norms. They are increasingly comfortable with macroprudential regulation and see that the central bank has a role, albeit a limited one, in promoting economic growth. “It is true that the BSP’s primary mandate is price stability, but price stability should be consistent with balanced and sustainable growth,” said Diwa Guinigundo, deputy governor of BSP’s Monetary Stability Sector. “That is why we decided to shift from monetary aggregate targeting to direct inflation targeting in 2002. Because of financial innovation, the relationship between monetary aggregates on the one hand and inflation and output on the other has actually weakened. Yes, we are very much concerned with achieving price stability, but if we have latitude and flexibility of ensuring support of real sector activity, we should do it. Economic growth is a kind of umbrella objective,” he added.

CONSOLIDATED QUESTIONS: But while the Philippine banking system has done well, it also faces significant challenges, and these challenges must be effectively dealt with if prosperity, in the sector and in the country, is going to continue.

While consolidation of banks has occurred, for example, relatively little has taken place, and the country has far more banks than other ASEAN nations – Malaysia, for example, has just eight domestic commercial banks. This is partly the natural result of a push decades ago to establish rural banks. But the great number of banks is also the consequence of the relative lack of mergers. Indeed, combinations of large banks have proven difficult. To a degree, this is because of the way the Philippines operates. The archipelagic landscape and economies of scale have made industry consolidation and financial access, particularly in remote, rural areas, a delicate balancing act for regulators.

BDO’s major shareholder is 40% owned by a company controlled by Henry Sy and family, SM Investments Corporation – though in total the Sy family controls approximately 47% of the bank. Sy, who started out in retailing, is the richest man in the Philippines, according to Forbes magazine. His SM Investments Corporation is also a nearly 20% shareholder of China Banking Corporation, the number four universal bank. BPI’s largest shareholder is the Ayala Corporation, which is controlled by the Ayala family. Lucio Tan was the lead shareholder of both PNB and Allied Bank. With such major stakes held by families, issues of control in addition to simple business considerations may play a role in M&A activity.

The case of the proposed merger between BPI and PNB is a good example. The talks between the two groups, each closely associated with leading families, commenced at the end of 2012, but the deadline for a deal passed with no agreement. According to a report in Inquirer Business, Tan decided not to follow through because it would leave him with too small a stake in the surviving entity.

SDAS: As a central monetary authority, it is one of the key mandates of the BSP to maintain price stability and the convertibility of the peso. In preserving the stability and convertibility of the local currency, the BSP participates in open market operation and purchases dollars to curb possible speculative movements in the domestic foreign exchange market. Strong foreign capital inflows resulting from quantitative easing of advanced economies and the country’s investment-grade status led to the BSP’s heavy dollar purchases to smoothen the peso’s appreciation against the dollar. Coupled with high interest payments, the BSP lost P95.38bn ($2.3bn) in 2012 on P50.38bn ($1.2bn) of foreign exchange losses, and P33.69bn ($811.9m) in 2011 on P36.22bn ($872.9m) of foreign exchange losses.

Special deposit accounts (SDAs) have been a challenge for the institution. Access to these central bank accounts, with short maturities and rates that are higher than government bonds, was expanded in 2007 when the money supply ballooned and the BSP wanted to mop up liquidity. The set-up turned out to be a great success, and the total placed in SDAs hit a record of P1.8trn ($43.38bn) as of July 2013. However, the central bank has to pay interest on the SDAs – a total of P65.5bn ($1.6bn) was paid out through November 2012.

SDAs are related to another challenge. Banks are not lending enough to those who most need money. The Philippines already has a loan-to-GDP ratio of less than 40% – compared with 100%-plus in Malaysia, Singapore and Thailand – and low-risk, high-return SDAs may be further crowding out individuals and corporations seeking funds.

In addition, when money is lent out, it tends to gravitate toward the same blue-chip names. While yield compression is not a major issue yet, the concentration on a few leading corporations is a growing concern, especially as the larger groups are able to access other funding sources. Banks, even the best of institutions, still lend mainly on the basis of collateral and are wary about venturing too far down the risk spectrum for yield.

OUTLOOK: The relevant institutions are beginning to take aim at the weaknesses that exist. The BSP has been encouraging inclusiveness, especially in rural areas (see analysis), and has implemented reforms on its SDA facility. In its first round of fine-tuning, the BSP disallowed foreign funds from SDAs in 2012. SDA rates were reduced to a total of 150 basis points by the first half of 2013. SDA access was also limited for domestic institutions. Under Memorandum 2013-021, issued by the central bank on May 17, 2013, the only pooled accounts that can access SDA facility beginning January 1, 2014 are unit investment trust funds. Other fiduciary accounts are banned, and banks are prohibited from opening any other trust accounts simply for accessing the SDA.