Banking in the Philippines expanding penetration and pushing consolidation

The Philippine banking system has been performing relatively well in recent years. Given the country’s strong economic growth, the sound regulation of the sector by the central bank and the global push towards increasing capital, the local institutions have been safe, sound and profitable. Major metrics are moving generally in the right direction. While many people in the country remain unbanked, the lack of inclusiveness is seen as providing an opportunity for expansion. The sector is now open to 100% foreign ownership, and international institutions have been entering the market in significant numbers (see analysis).

Some areas of concern do remain despite the progress that has been made. Questions about governance, ownership structures, concentration, efficiency and risk have been raised by the ratings agencies and others. The competitive landscape is not seen as ideal, with the strength of dominant players making it difficult for new entrants to succeed. Major international banks have also been leaving the market in recent years or reducing their activities in the country. While a good deal of work has been done since the 1997-98 Asian financial crisis, and overall the sector is greatly improved, unfinished business remains and imbalances persist in the banking system. A cyberheist of $81m in early 2016 highlighted possible deficiencies in the sector. The theft suggests that some laws need to be reviewed and that some institutions may be weak in certain key areas (see analysis).

Invested In Resilience

The first formal bank in the Philippines was El Banco Español Filipino de Isabel II, founded in 1851. It is regarded as the first bank in South-east Asia as well. In 1912 it became the Bank of Philippine Islands (BPI). Standard Chartered opened in the country in 1872 as the Chartered Bank of India, Australia and China. Then, the Hongkong & Shanghai Banking Corporation arrived in 1876. Other pre-1898 banks include Monte de Piedad (1882), which survived until the 1990s. A branch of Banco Peninsular Ultramarino de Madrid was also opened during Spanish times. After the country became US territory, Guaranty Trust and Citibank (as the International Banking Corporation) arrived, both in 1902. By 1940 Citi, then the National City Bank, was the largest non-government lender in the country with 12.4% of the assets, followed by BPI (9.9%) and HSBC (9.4%).

The Regulators

The idea of a central bank goes back to the 1930s when the Philippines started to prepare for its independence from the US. To that point, the country’s monetary system was under the Department of Finance and the National Treasury. In 1939 a law was passed authorising a central bank, but the institution was opposed by the US president. The central bank of the Philippines was finally inaugurated and formally opened in 1949. It was replaced by the Bangko Sentral ng Pilipinas (BSP) in 1993.

Over the years considerable reform has taken place. The Philippine Deposit Insurance Corporation (PDIC) was formed in 1963. Foreign interests were allowed to invest up to 60% in the banking sector from 1994. A Finance Companies Act was passed in 1998, followed in 2000 by the General Banking Law, which replaced the 50-year-old General Banking Act. It was a comprehensive overhaul, which among other things improved the fit-and-proper test, introduced risk-based capital, refined the single borrower limits, improved the supervision of connected-party transactions and called for higher levels of disclosure and better transparency. It also, notably, allowed for higher levels of foreign investment under certain limited conditions. In 2001 the Anti-Money Laundering Act was passed, and that act was amended in 2003 and 2012.

The regulators and the legislators have been particularly focused on the sector since the 1997 financial crisis in Asia, working to ensure that the banks and the banking system are prepared for instability. They endeavoured to make the institutions safer, sounder and more resilient. As a result, the 2008 crisis barely touched the Philippines. The banks were well positioned for turmoil. They had strong balance sheets, limited exposure to risky assets, good profitability and improved risk management. Oversight of the sector was also good. Importantly, the banks remained domestically oriented and retail funded, so they were insulated from problems in the money markets and the exit of hot money. When the world markets failed, the Philippine banking sector came through in good shape largely because of 1997. “The Asian financial crisis was a defining event,” said Nestor Espenilla, deputy governor of BSP. “We used that opportunity to deal with structural reform: bad assets, risk, capitalisation and governance. We invested in resilience.”

Further Reform

Reform continues. Much of it is incremental in nature, refining what is in place and dealing with missing pieces of the regulatory puzzle. To increase transparency, new reporting requirements have been introduced. Under Circular No. 883, of July 2015, auto and motorcycle loans must be broken out under the motor vehicle loan category. Universal banks, commercial banks and thrift banks must submit quarterly reports and disclose the real estate exposure in their portfolios under Memorandum No. M-2015-042. Guidelines covering the sale and marketing of financial products were issued in November 2015.

Under BSP Circular No. 889, measures were introduced to ensure that the treasury activities of BSP-supervised financial institutions are undertaken in a responsible manner. According to PwC, this means adhering to market conduct rules, instituting a code, segregating duties and undertaking regular oversight of treasury functions. Guidelines on internal controls and audit were issued under Circular No. 871, while new rules on related-party transactions were introduced under Circular No. 895. Fit and proper rules for banking institutions were updated under two circulars.

In early 2016 Benigno Aquino III, the former president, signed into law Republic Act 10846, which amends the PDIC charter. The changes allow for quicker payouts to depositors, using evidence of funds from customer-provided documents without waiting for reconciliation with internal bank records. In addition, the act allows the PDIC to intervene in the affairs of weak institutions earlier.

The upgrading of the charter is important and has significant implications for the sector. In the past people have remained suspicious of the banking system because of delays in payouts after insolvency. The perception was that a person could wait years. A faster, more responsive PDIC boosts confidence in the banking system overall, helping inclusiveness and encouraging more people onto the financial grid.

The central bank has been refining its operations. Along with many of its counterparts in other countries, the BSP has been examining ways to improve interest rate transmission. Traditional methods have proved to be relatively ineffective. The BSP thus decided to move to an interest rate corridor (IRC). Under the framework, the overnight lending facility acts as the ceiling and the overnight deposit facility as the floor for monetary policy. The overnight reverse repurchase rate will be the mid-rate. Actual policy will remain neutral; the move to the IRC is not a change in the stance. The new programme commenced on June 3, 2016.

Structural enhancements have been made to the banking system that promise to improve basic operations. In early 2016 the BSP signed an agreement with the Philippine Clearing House Corporation to speed check clearing from three days to one day. The oneday clearing system was operational in January 2017. The authorities believe that the shortened clearing time is important for the economic development of the country. As the physical transportation of checks will be ended, the risk of loss and forgery are lowered.

Sector Consolidation

The core of banking system in the Philippines is a relatively tight grouping of institutions, with a total of 12 private domestic universal banks, three government universal banks and six foreign branches operating as universal banks as of March 2017. The country also has 20 private domestic commercial banks, two subsidiaries of foreign banks operating as commercial banks and 13 branches of foreign banks operating as commercial banks. But the sector is much larger than just that. The country has a wide range of smaller banks: rural banks, savings banks and cooperative banks. As of June 2016 the Philippines had a total of 619 banks, according to the BSP.

As in many countries in East Asia, the Philippines has had an official policy of consolidation for some time. The sense is that mergers will create stronger, more efficient institutions, as they will be better capitalised and benefit from the combined experience, know-how and systems of the entities being brought together.

Incentives For Mergers

Under Circular No. 172 of 1998, incentives were provided to encourage bank consolidation. The 2000 General Banking Law also discusses the issue. Incentives provided over the years to encourage combinations have been extensive and attractive. The merging institutions have received relief from net-worth requirements, adjusted amortisation schedules, a higher rediscount ceiling and some relief in the payment of penalties. The process has been relatively effective. The total number of banks fell from 996 in 1998 to 632 by end-2015 and 619 in mid-2016.

The central bank and other institutions have continued to support the consolidation of the sector in creative ways. In 2015 the BSP in cooperation with the PDIC and the Land Bank of the Philippines introduced the Consolidation Programme for Rural Banks. The programme will run through 2017 and is backed with P25m ($529,000) of funding. It provides the merging banks with funding support, financial advisory services and business process improvement services. To qualify, the banks need a minimum of five branches, a 12% capital ratio and at least P100m ($2.1m) of capital. In addition, the BSP and the PDIC have the Strengthening Programme for Rural Banks Plus, which allows for a modification of the regulations and some financial assistance for situations in which a “white knight” institution agrees to come in and rescue a weak rural bank.

Mergers & Transactions

As a result of the official policy and commercial interest, institutions in the Philippines are combining and acquiring. Many transactions have involved smaller and regional lenders. In late 2015 Producers Savings Bank completed its acquisition of Rural Bank of Cainta. The former had been acquiring shares of the latter since 2014. Following the transaction, the new institution, which kept the Producers name, has a presence in 11 regions and 31 provinces. Producers Bank has also acquired Rural Bank of Rosales (Pangasinan), New Rural Bank of Victorias and Iloilo City Development Bank.

Also in 2015 the BSP approved the merger of China Savings Bank and Planters Development Bank, the former being the surviving entity and responsible for capitalising the new institution. Other mergers in 2015 include Philippine Business Bank acquiring Insular Savings Bank for P518m ($11m) and Rural Bank of Tanza Cavite, or Bangko Mabuhay, merging with the Rural Bank of Teresa (Rizal). The new entity will be Bangko Mabuhay (A Rural Bank). In early 2016, 14 rural banks under control of the PDIC were merged.

Local banks note that the rural and small bank sub-sectors have started to become particularly attractive. No longer is it so much a matter of convincing larger banks to take over institutions outside the urban areas. In their push for more customers beyond their core markets, the country’s major banks are seeking targets in what were previously considered less attractive areas. The smaller banks say that the larger banks need to buy this capacity rather than build it. They do not understand the customers and usually scare them off when they come into smaller markets with new, intimidating branches.

“Being already on the ground gives you a distinct advantage,” said Reginald Ocampo, president of First Macro Bank. “We deal regularly with the unbanked.” At the same time, the small banks understand that they have to adjust to the times. Higher costs related to compliance and technology mean that they can no longer remain strictly local. They must open new branches, merge with other small or regional banks or become a part of a major group.

“Since the regulations have been strengthened, the smaller banks see it is to the advantage of the bigger banks,” added Ocampo. “I don’t see how a bank with just one to three branches can survive.”

Bdo Going Rural

At least one major bank understands the attractiveness of rural properties and has been acquiring them in recent years. In 2015 BDO Unibank bought One Network Bank, a rural institution with 98 branches in Mindanao. BDO has made other related acquisitions. It purchased Real Bank, a thrift with 24 branches, in 2014 for P7.2bn ($144.9m). The same year BDO acquired Citibank Savings, which had been part of Citigroup before the transaction. The institution was renamed Banco De Oro Savings Bank.

The move was made to improve the company’s footprint within the Philippines and begin to serve more of the unbanked. Meanwhile, the TPG Group, a US private equity group, acquired a 40% interest in the rural banking operation of BDO Unibank in 2016.

While considerable activity is evident in the rural and small side of the business, large mergers have been lacking. One major transaction was set to happen, but seems to have been cancelled. The merger of Land Bank and the Development Bank of the Philippines (DBP) was called off in late 2016 by the Duterte administration. Proponents of the transaction had said that the combination would have created a massive institution, with assets of P1.71trn ($36.2bn). The new bank would have had the capacity to challenge the dominant players in the sector and the scale to become a major player regionally and internationally. It was also felt as though the combined entity would have been well suited for infrastructure financing. The institution would have an especially large single borrower limit of P26bn ($550m).

The new administration argued that there was little synergy between the institutions, as one is focused on agriculture and the other on industry. It also argued that the transaction could not simply be administratively ordered. As congress formed the institutions, only congress could merge them. As of end-2015 Land Bank was the fourth-largest bank in terms of assets and DBP number seven.

Strong Performance

The sector has been performing well overall. In 2015 total assets grew by 8.3% to P12.09trn ($255.8bn), while capital increased 2.7%. Loans to real estate grew rapidly, up 16.9% on the year, while loans to retail trade increased by 12.9%. Consumer loans grew by 17.5%, as a result primarily of increases in auto and home financing.

In 2016 the sector continued to strengthen. Total assets grew by 12.4% to P13.58trn ($287.3bn). The assets of large banks, or universal and commercial banks, increased by 12.8% to P12.3trn ($260.2bn), while that of mid-sized banks, or thrift banks, expanded by around 8.3% to P1.08trn ($22.8bn).

According to figures from the BSP, during the course of 2016 the banking sector data improved overall. The gross non-performing loan (NPL) ratio for the whole system dropped to 1.96% in January 2017 from 2.19% in January 2016, while the capital adequacy rose from 11.87% to 12.06%. Net profit for the entire sector also grew to P154.1bn ($3.3bn) in 2016, a 14% increase from the P135.3bn ($2.9bn) recorded the previous year. The longer-term trend has been encouraging. According to the IMF, NPL ratios have come down steadily from 3.9% in 2011 to 2.2% in 2015, while NPL coverage has increased from 102.7 in 2011 to 118 in 2015. The capital adequacy ratio has come off, but only slightly, dropping from 12.6% to 11.6% over that period.

Moody’s Investor Service has judged the banking sector to be sound overall, especially in light of strong economic growth. It has some reservations, however. The ratings company worries about some lingering governance issues and has noted a rapid growth in loans, an abundance of unseasoned credits on the books of the institutions and an increased exposure to small businesses and consumers.

According to Moody’s, the country’s top-three banks control 51% of total loans at present; however, the agency added that despite that fact there appears to be enough competition in the banking system. The sector is reliant mostly on deposits, and this brings considerable stability, as the institutions are not excessively dependent on the wholesale market.

In April 2016 ratings agency Fitch upgraded the rating of BDO Unibank, the country’s biggest bank in terms of assets, from “BB+” to “BBB-”. The company said that BDO’s NPLs had dropped from 1.5% at the end of 2014 to 1.2% at the end of 2015. But it did point out that capital ratios had fallen somewhat, leaving BDO with the lowest ratios among its peers.

In July 2016 Fitch upgraded the long-term issuer default rating of four banks, namely China Banking Corporation, Philippine National Bank, Rizal Commercial Banking Corporation and Security Bank Corporation. These institutions ratings were taken from “BB” to “BB+”. The ratings agency said that the advantages of a strong economy and improved regulation in recent years balanced the lingering negatives, which include family control, corporate governance issues and the concentration of loan portfolios.

Loan growth is seen remaining at double digits – the mid- to high teens – in 2017. In part, this rapid expansion will be the result of infrastructure spending by the government. Consumer demand will also be a driver. Fitch is confident in the BSP’s ability to keep bubbles under control, while it anticipates a push towards higher-yielding products, such as consumer finance, balancing competitive pressures.

Sustainable Growth

Bank profit growth is seen remaining strong. According to JPM organ, the sector’s profits are set to increase at a compound annual growth rate (CAGR) of 14% through to 2018, as loans grow at a CAGR of 19% over the period. It sees healthy underlying reasons for the strong performance. Corporations will be making investments and will need bank loans for their capital spending. Whereas before much of the growth came from real estate loans, the current trend is seen as more sustainable.

The individual banks have been performing well in recent years. In 2016 BDO reported record profits, with net income rising by 4.4% to P26.1bn ($552.1m) from P25bn ($503m) in 2015 and the bank meeting its full-year target of P26bn ($550m).

BPI’s 2016 net income reached 22.05bn ($466.5m), up 21% from the previous year. Metrobank, meanwhile, reported a consolidated net income of P18.1bn ($382.8m) in 2016, down 2.89% compared to the previous year’s P18.6bn ($393.5m). The bank, however, improved its fourth-quarter net income to P5.5bn ($116.4m), 3% increase year-on-year.

Push For Inclusiveness

An estimated 70% of the population remains unbanked, according to the World Bank. That compares with Malaysia, where less than 20% of the population lacks an account. Covering more of these people has become a priority of the central bank, and it is sponsoring an Economic and Financial Learning Programme to reduce the unbanked ratio. As of 2014, 595 municipalities out of 1490 had no bank at all. That figure is down from 611 in 2012, but still considered far too high. “Many unbanked small and medium-sized enterprises have significant borrowing capacity, however little access to formal lending channels. As a result, they rely on informal lenders at very high costs,” Cecilia C Borromeo, president and CEO of the Development Bank of the Philippines, told OBG. “If these enterprises can access formal lending, they could reduce their borrowing costs by as much as half.” The central bank believes technology will be important to closing the gap. While the country has an abundance of rural banking institutions, and many smaller towns do have branches, physical locations cannot solve all the last-mile issues in the country. In some cases, traditional banking will never be practical. For that reason, delivering financial solutions through handsets and wearable devices will have to be part of the answer to the inclusiveness problem. “If we stick with brick-and-mortar banking, I don’t think we could reach some areas,” the BSP’s Espenilla said. “If we stick with bricks and mortar, we’ll never catch up.”

According to Justo Ortiz, chairman and CEO of Union-Bank of the Philippines, mobile technology is essential for the expansion of banking services, otherwise the transportation costs relative to the value of their transaction is out of proportion. “The Philippine market is ripe for the adoption of mobile platforms given high internet usage and SIM penetration; it is just a question of the right applications,” Ortiz told OBG. A number of reasons for the lack of accounts have been identified. Some are general issues individual institutions have little control over. People lack money to open accounts, or do not need accounts because they deal locally and in cash, and have very little savings. The central bank also notes that many people consider the fees charged and minimum balances required too high. The banks have the power to make their products more attractive to people holding back for these reasons by making their accounts cheaper and more transparent on pricing.

Need For Innovation & Risk

The BSP has noted a number of challenges, including tightening monetary policy in the developed world and slowing growth in countries on which the Philippines depends, such as China. The ratings agencies also cite certain areas of concern. S&P has noted that the competitive situation is potentially destabilising. The country has too many banks and not enough meaningful consolidation.

The lack of profitability has been mentioned. While profits for the sector continue to rise, and the banks are healthy, the institutions are not currently optimising their assets. They are not taking enough risk, preferring to stay with safe, relatively lower-yielding loans to a core set of customers. The banks are not being innovative enough, their products for the most part remaining plain vanilla. “Big and mid-sized banks do not have sufficient skills to cater to small borrowers. One of the key issues is the lack of information to analyse the financial capabilities of this market, which increase their risk profile,” Higinio O Macadaeg Jr, president and CEO of United Coconut Planters Bank, told OBG. At the same time, the low incomes at the individual level and the lack of a repayment culture creates certain risks that have the potential to weaken the banks, especially during times of stress. Low levels of transparency and an inconsistent legal system also tax the resilience of the institutions. In March 2016 Fitch said that the banks are generally in a good position to meet Basel III rules. The domestic market has sufficient liquidity, while the banks themselves have strong balance sheets. However, the agency did note that some institutions are overly dependent on corporate deposits and should be pursuing more retail deposits. Fitch also noted that as banks other than the big three work to expand their customer bases, by opening more branches and ATMs, their profitability will come under pressure because of the capital expenditure required for expansion.

Outlook

After years of efforts in terms of regulation, consolidation and strategy, the Philippine banking sector is well positioned to grow with the economy, while at the same time it is structured to withstand any shocks it may encounter, internal or global in nature. The deficiencies are mostly centred on competitiveness. While the institutions are strong, they are not yet ready for fully global or regional competition.