Bigger and stronger: Lending increases while the regulator ensures that the system will continue to remain stable

Having been largely unaffected by the global economic turmoil of the second half of 2011, banks in the Philippines are highly liquid and adequately capitalised. Performance indicators for 2011 have shown steady asset expansion, double-digit credit growth, above-standard solvency ratios and healthy bottom lines. Underscoring the resilience of the local banking sector, Philippine banks posted a 28% year-on-year (y-o-y) rise in profitability during the first six months of 2011 to P51.9bn ($1.2bn), according to Bangko Sentral ng Pilipinas (BSP), the country’s central bank. Furthermore, the banks are stable, with an average capital adequacy ratio (CAR) of 17% as of end-March 2011.

Liquidity has started to flow into more productive economic sectors as banks have become more comfortable with project finance and their appetite for risk has grown. However, there remains excess liquidity in the market. Many banks appear to be waiting for the implementation of more public-private partnership (PPP) initiatives, which will likely present opportunities to finance infrastructure projects. Lending to the sector could put to use funds that otherwise would have been used to purchase government securities or placed in the BSP’s fixed-term deposit facility for banks.

CHALLENGING TIMES: While the global economy has emerged from the recession of 2008-09, it continues to face a number of difficulties, including the eurozone crisis that continued through early 2012. Although the banking sector is not overly exposed to troubled regions such as the EU, exports have been hit by the slowdown in key markets, dampening growth and possibly affecting banks’ lending and profitability.

However, the local banking system is generally well positioned to handle any challenges that might arise as a result of international economic difficulties. In the post-Lehman period, European banks withdrew about 20% of their lending in the Philippines, but according to Nicholas Kwan, the regional head of research for Asia at Standard Chartered, this scenario is unlikely to be repeated. “[It] depends on how the European debt problems unfold,” Kwan told local press in October 2011. “Chances are any major withdrawal by European banks may be less than the post-Lehman levels given better preparedness and the Philippines’ solid fundamentals proven in the past three years.” In funding terms, banks in the Philippines are primarily retail-oriented with resident or domestic counterparties and not that reliant on foreign funding. Indeed, policymakers have worked hard to shore up the sector.

The central bank has continued to strengthen the regulation, supervision and risk management of banks (see analysis). The BSP has also indicated it will accelerate the implementation of Basel III banking standards. BSP has started to subject local lenders to stress tests to assess their ability to withstand a system-wide crisis. The move towards more stringent capital requirements under Basel III will also further encourage banks to give serious consideration to mergers and consolidation, according to the central bank.

MARKET STRUCTURE: Banks are grouped into three main categories: universal and commercial, thrift, and rural and cooperative banks. Universal and commercial banks represent the largest group in terms of assets and typically offer a variety of banking products and services. Universal banks are also allowed to provide investment banking services such as underwriting or invest in equities of allied and non-allied enterprises as determined and approved by the Monetary Board. Thrift banks, which include microfinance-oriented ones, mainly offer short-term working capital and medium- and long-term financing to businesses. They cater primarily to households for various forms of consumer finance-related products and services.

In rural communities, rural and cooperative banks play an important role, allowing individuals in these areas to access basic financial services. They also provide credit facilities to farmers, merchants and their cooperatives. Rural, cooperative and thrift banks are now allowed to sell microinsurance products, to better serve microfinance clients. The presentation, marketing and sale of microinsurance products by these types of banks, as an integral component of risk protection, are seen to be a necessary and complementary component of their microfinance portfolio. Moreover, the tighter relationships with the local communities of these banks would improve the distribution of insurance products.

As of end-June 2011, the BSP reported there were 739 operating banks in the Philippines – 34 fewer than the 773 recorded a year earlier. Rural banks accounted for all but one of the closures during the same period. Data further showed that the number of universal and commercial banks was steady at 38. Meanwhile, the number of thrift banks declined by two, to 72 from 74. The number of rural and cooperative banks likewise dropped to 629 from 661. Universal and commercial banks accounted for almost 89% of total system-wide assets, while thrift, rural and cooperative banks accounted for the remaining 11%.

CONSOLIDATION: Notable mergers have included UnionBank, International Exchange Bank, Banco de Oro (BDO) and Equitable PCI. The long-delayed merger of PNB and Allied Bank is expected to take place in 2012, after initially being announced in 2008 (see analysis). After the deal is completed, the merged entity will have the third-most-extensive distribution network amongst local banks.

There are solid economic reasons to merge, including the existence of economies of scale. Banks can be costly to operate in the Philippines. Business is labour intensive, as many customers prefer to visit their branch to perform even the most basic transactions. Recent developments in electronic banking, such as mobile and internet banking, are gradually changing this branch-oriented norm, resulting in the provision of various alternative service delivery platforms for bank clients and improving banks’ operational efficiencies. Accordingly, the banking system’s cost-to-income ratio went back to its pre-1997 Asian financial crisis level of 63.2% as of end-June 2011 from its peak of 81.8% during the oil and energy crises in 2000-01.

Minimum capital requirements have also been gradually rising, encouraging consolidation. Further increasing the minimum could generate new merger activity, according to Sergio Edeza, the president and CEO of Bank of Commerce. “There is definitely room for additional consolidation in the retail banking sector, and competition continues to be fierce. There are currently 19 commercial banks and 19 universal banks in the industry, whereas in reality, the Philippines could survive with maybe five of each. If capitalisation requirements are raised yet again, the industry can expect another wave of mergers and acquisitions,” he told OBG.

The BSP has also been encouraging consolidation in the sector by offering incentives such as the restructuring of penalties or outstanding payments to the central bank over a period of not more than 10 years. The state-run Land Bank of the Philippines has stepped in to help, allotting P1.3bn ($29.5m) worth of loan and equity support to cooperative banks that combine (see analysis). The BSP has acknowledged a large number of cooperative banks have been under financial distress and consolidation could help. The government would save money with fewer bank closures, as it is required to shoulder deposit insurance claims. Moving forward, financial regulators hope the Strengthening Programme for Cooperative Banks will mitigate the impact of bank closures on the deposit insurance fund and minimise the government’s administrative costs.

FOREIGN PRESENCE: There are 19 foreign bank branches and subsidiaries currently operating in the Philippines. Some foreign bank branches, such as Standard Chartered, HSBC and Citibank, have been in the country since before the Second World War. Since the liberalisation of the banking sector in 1994, a total of 10 additional foreign bank branches entered the market.

For all domestic banks (except those classified as cooperative banks) qualified foreign banks may own or control up to 60% of the voting stock. Meanwhile foreign individuals and non-bank corporations may own or control up to 40% of a domestic bank, except if it is a rural bank. To promote further competition and to strengthen the rural banking industry, a draft bill is under consideration by the House of Representatives that would allow up to 40% foreign ownership for these institutions. The Rural Bankers Association of the Philippines (RBAP) has applauded the move, saying the law would encourage capital inflows into the rural banking system, which would help these banks expand their services and implement technological upgrades.

Looking ahead, any interest for foreign acquisition is likely to come from regional players rather than lenders based in the EU or US. CIMB of Malaysia, for example, has been looking at the Bank of Commerce, a banking arm of San Miguel, the largest Philippine company by assets. “We are in talks,” Ramon Ang, the president of San Miguel Corporation, told local media in October 2011. CIMB is one of the largest banks in Malaysia, and San Miguel plans to sell “a portion” of the Philippine lender to the Malaysian firm, he said, declining to provide more details. Talks have continued with Nazir Razak, CIMB’s CEO, telling reporters in January 2012 that the company hopes negotiations will be concluded by the end of the first quarter. Bank of Commerce is the Philippine’s 16th-largest lender, with assets of P90.7bn ($2.1bn), as of end-June 2011.

WELL-CAPITALISED: The Philippine banking system is more than sufficiently capitalised. Indeed, as of March 2011, the banking system registered an average CAR of 16.5% on a solo basis and 17.4% on consolidated basis, an increase over the figures from December 2010. The system is also sufficiently capitalised to handle significant external shocks, according to the BSP. In August 2011, Amando Tetangco Jr, the BSP’s governor, announced the central bank had conducted a stress test showing local banks could withstand a downgrading of US debt, a concern at the time. The governor said during a press conference the results of the analysis showed “the banks here are fairly resilient and will not be adversely affected by an increase in spreads, for instance. There will, of course, be some effects, but it is unlikely that this is going to be very significant.”

GROWTH: The total assets of the banking system rose by 11.5% y-o-y to P7trn ($161.8bn) as of end-June 2011, according to the BSP. Despite the large number of banks, four banks – BDO, Metrobank, BPI and Landbank – hold almost half of total assets (see analysis). The value of assets at the country’s universal and commercial banks jumped 12.3% to P6.3trn ($144.6bn) as of end-June 2011, up from P5.6trn ($128.8bn) a year earlier. Assets held by thrift banks went up by 5.1% to P566.4bn ($13.1bn) from P538.8bn ($12.4bn). Rural banks’ assets increased by 5.8% to P566.4bn ($12.9bn) from P156.8bn ($3.6bn) over the same period. The assets of cooperative banks grew by 4% to P15.9bn ($400m) during the same period. BSP officials attributed these rising figures to a growth in lending and a stable funding base coming from deposit liabilities. According to the state-run Philippine Deposit Insurance Corporation, total peso- and foreign-currency-denominated deposits climbed 12.1% to P5.2trn ($118.9bn) from P4.8trn ($109.6bn) in the first half of 2011.

This is encouraging news, as the Philippines traditionally lags behind its neighbours in mobilising savings. The Philippines’ gross domestic savings as a percent of GDP stood at 20.5% in 2010, less than in Indonesia (34.2%), Thailand (33.4%) and Vietnam (27%), figures from the Asian Development Bank show. According to an October 2011 speech by the BSP governor, one cause of the low domestic savings rate may be a lack of access to banks for many Filipinos. Only 26% of the adult population has access to formal financial services. Indeed, a total of 610, or 37%, of the 1634 municipalities nationwide still do not have any bank branches, and 50% of deposits are in banks located in Metropolitan Manila. This lack of geographical dispersion may simply be due to the country’s archipelagic geography, as it remains costly for banks to set up offices all over the country.

OPPORTUNITY: Cognisant of this, the BSP has pursued reforms to further develop electronic banking as alternative service delivery channel for financial products and services. In particular, the country has been pioneering the use of mobile banking platforms for microfinance clients in rural areas.

However, sector players recognise this low penetration level presents a growth opportunity. “With only 20-25% of Filipinos utilising formal banking channels, there is ample room for growth in the sector in the Philippines,” Edeza told OBG. “This is especially true of the relatively untapped rural banking market, where potential customers have traditionally been discouraged by comparatively strict protocols in place at large banks.”

LENDING: In the decade up to 2011, loan growth had been relatively depressed. Deposits have steadily increased, but banks have used these funds to purchase government securities, due to good yields. Indeed, a 2008 report from global ratings agency Fitch asserted government and corporate debt represented about one-quarter of the banking system’s assets, with mainly the former dominating the mix. However, bond yields have since started to flatten, a trend that accelerated when President Benigno Aquino III was elected in mid-2010 with a strong mandate, instilling confidence in the local business community. At the time of the election the yield on 10-year sovereign bonds was 8.5%, but it has since fallen to as low as 5% as of March 2012.

With government securities looking less attractive, banks appear to be more willing to lend to individuals and businesses. “There is ample liquidity in the market, and banks are currently looking for investment opportunities. There are strong indications for growing demand for credit and loan levels,” Ricardo J Balbido Jr, the president and CEO of Philippine Veterans Bank, told OBG. According to the most recent data from the central bank, the y-o-y growth in outstanding loans by commercial banks stood at 22.2% in October 2011. By comparison, during 2010 this figure never rose above 12.5%. The expansion shown in the October 2011 data was primarily driven by relative rises in loans to manufacturing (30.6%); electricity, gas and water (51%); real estate, renting and business services (26.1%); wholesale and retail trade (31.6%); financial intermediation (25.9%); transportation, storage and communication (30.9%); and construction (24%). Lending to mining and quarrying nearly doubled from October 2010, continuing this sector’s triple-digit growth rate since May 2011. At the same time, consumer loans continue to rise, with 20.2% y-o-y growth reported in October 2011, largely due to the expansion of credit card receivables and auto loans. However, the flooding in Thailand during the second half of 2011 hit the local automotive industry, and auto loans are expected to decline for at least the first half of 2012. According to the Chamber of Automotive Manufacturers of the Philippines, auto sales dipped by 3% compared to a year earlier. Despite this, growth in consumer loans accelerated to 19.9% in January 2012 from 17.3% in December 2011.

An October 2011 statement by the BSP indicates that the bank expects loans to continue to grow in 2012. “Robust credit growth should help buoy the domestic economy in the midst of ongoing external headwinds. Going forward, the BSP will continue to monitor economic developments, especially liquidity expansion, to ensure that the monetary policy stance also remains supportive of domestic economic activity consistent with the price stability objective,” the statement said.

While the BSP will keep an eye on inflation, it is expected to focus on growth in 2012. With this in mind, the BSP’s Monetary Board cut interest rates at its first two board meetings in 2012, reducing the overnight borrowing rate to 4% from 4.5%, while the overnight lending rate was reduced to 6.25% from 6.5%. However, in the interim period between May and December, the regulator had increased the reserve requirement ratio for banks by a combined 200 basis points in June and July, bringing the threshold to 21% from 19% to remove some P70bn ($1.6bn) from the financial system and stave off inflationary pressures.

OUTLOOK: Weaker economic growth due to the lack of demand in key export markets and underspending by the government may both pose some risk going forward. However, this is expected to be temporary, as the state is set to increase spending in 2012 with several PPP projects. For banks, this represents an opportunity to return to basics and invest in project financing, instead of investing in capital markets and securities.