## _cr1090

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### Banking sector resilience and system structure
- Banks dominate the Philippine financial system: about two-thirds of total financial institutions’ assets and about 75 percent of GDP in assets (almost P6 trillion, June 2009).
- System composition (June 2009): 804 deposit-taking institutions including universal and commercial banks, thrift, rural, and cooperative banks.
- Universal and commercial banks account for 88 percent of total banking assets; the ten largest banks account for about two-thirds of banking assets.
- Asset composition and credit:
  - Net loans equal 35 percent of GDP.
  - Loans represent 49 percent of banks’ total assets.
  - Investment in securities represents 25 percent of banks’ total assets (mostly long-term government securities).
- Asset quality:
  - Asset quality generally high for major banks; thrifts, cooperatives, and rural banks have weaker asset quality and low provisions.
  - NPLs declined from a peak of 16.9 percent of total loans in 2001 to about 4 percent in 2008-09.
  - Stock of ROPA fell from 6.3 percent of total assets in 2002 to 2.7 percent in June 2009.

### Progress since the 2002 FSAP and remaining supervisory weaknesses
- Progress:
  - Strengthened regulatory framework, enhanced BSP supervisory capabilities, adoption of Basel II and IFRS, strengthened risk-based supervision.
  - New AML Act (2003) broadly in line with FATF.
  - PDIC charter revisions and creation of Financial Sector Forum (FSF).
- Remaining weaknesses:
  - Capital market and insurance supervision remain largely compliance-oriented.
  - Legal framework and supervisory agencies in capital markets and insurance need further strengthening.
  - Overlapping and distortionary government policies persist.
  - Legal protection of supervisors remains weak; law treats supervisors as civilly liable unless they apply “extraordinary diligence.”

### Key supervisory and regulatory priorities
- Banking supervision recommendations:
  - Pass proposed amendments to the New Central Banking Act (NCBA), including deleting the “extraordinary diligence” requirement and broadening definition of control.
  - Increase BSP discretion to require additional capital and impose other limits; broaden definition of connected counterparties; expand/harmonize single borrower limits and large exposures definitions.
  - Roll back bank secrecy provisions that hamper PDIC and supervisors’ access to individual deposit and investment information; provide adequate legal protection for supervisors.
- Capital markets:
  - Enhance on-site examinations, enforcement, and use of self-regulatory organizations (SROs).
  - Rationalize SEC mandate and provide adequate resources; develop market surveillance program covering PSE, PDEX, and alternative trading systems.
  - Amend laws to exempt SEC from bank secrecy when investigating violations; grant SEC civil enforcement powers and disgorgement orders; increase maximum fines.
- Insurance supervision:
  - Pass pending amendments to the Insurance Code and supplement with provisions giving the Insurance Commission a broader set of discretionary intervention tools.
  - Move procedural approvals from law to Commission circulars; improve RBC formula and minimum liability rules; harmonize valuation approach with International Accounting Standards.
  - Increase Insurance Commission independence, resources, and staff remuneration.

### Financial safety nets, crisis management, and resolution framework
- PDIC and resolution:
  - PDIC coverage increases: P100,000→P250,000 (2004)→P500,000 (2009).
  - Deposit insurance covers 97 percent of all deposit accounts and about 31 percent of the monetary value of deposits.
  - Actual reserves are 1½ percent of total deposits; PDIC target is 2 percent.
  - Transitional three-year government coverage of the second P250,000 while PDIC builds reserves.
  - PDIC powers expanded to examine deposits in unsafe/unsound cases, but bank secrecy still hinders timely access.
  - Recommendation: grant PDIC authority to raise premiums and charge risk-based premiums.
- Prompt Corrective Action (PCA) and ELA:
  - BSP issued PCA regulation (circular 523) in 2006; banks under PCA increased from <20 to ~200 by June 2009.
  - PCA weaknesses: not progressive; long corrective action timelines (e.g., “required” actions within 90 days, “expected” actions undefined; maximum 3 years under MOU).
  - ELA design:
    - ELA may be up to 50 percent of the deposits of a bank under stress if solvent, secured by acceptable assets.
    - 2006 regulation: ELA cannot exceed 180 days and carries a penalty rate (BSP lending rate plus 2 percentage points).
    - Banks receiving ELA face restrictions (no loan expansion or dividends) and intensified supervision.
  - Recommended adjustments:
    - Critically undercapitalized institutions should receive very short-term central bank liquidity only to enable orderly resolution.
    - Longer-term risk capital assistance should be provided by government or PDIC in a resolution context, with public accountability.
    - Any uncollateralized BSP liquidity support should be granted only with government guarantees.
- Resolution framework recommendations:
  - Shift balance toward efficient resolution over shareholder rights; empower authorities to take full control once capital adequacy falls below a critical threshold.
  - Allow a bridge bank resolution mechanism.
  - Give PDIC access to asset and individual deposit information at an early stage.
  - Tighten conditions for emergency liquidity assistance.
- Institutional coordination:
  - FSF (BSP, PDIC, SEC, Insurance Commission) improved coordination; recommend FSF develop formal crisis contingency plans and forge closer links with Department of Finance.

### Nonbank sector development and key indicators
- Equity market:
  - 246 companies listed on the Philippine Stock Exchange at end-2008 (net increase of 12 since 2003).
  - Market capitalization dropped sharply in 2008 to 54 percent of GDP.
- Mutual funds and asset management:
  - 45 mutual funds with P63 billion in assets.
  - 115 unit investment trust funds with about P100 billion.
  - Bank private asset management/trust departments control another P1.4 trillion in assets.
- Debt market:
  - Corporate debt market about 4 percent of GDP; government securities dominate.
- Insurance:
  - Total insurance premium just over 1 percent of GDP in 2008; contracted in real terms since 2002 except for microinsurance.
- Housing finance:
  - Housing loans by financial intermediaries equal 4½ percent of GDP.
  - Comparators: Indonesia 2½ percent, Thailand 17 percent, Malaysia 26 percent.
  - Public entities account for slightly over half of housing loans.
- Conglomerates and market concentration:
  - About 60 percent of bank assets are controlled by banks belonging to conglomerates.
  - Estimated ¾ of effective market capitalization belongs to conglomerates.

### Developmental policy recommendations for nonbank sectors
- Housing finance:
  - Rationalize housing credit subsidy policy and role of public housing finance institutions.
  - Limit public agencies to core mandates; subject their lending to the same prudential rules as banks; close entities lacking clear business case.
  - Reduce foreclosure “redemption” period for individual borrowers (noted in Table 1 recommendations).
- Capital and insurance markets:
  - Harmonize tax treatment of financial products and services.
  - Reduce time and expense of debt and mutual fund offerings; remove unnecessary restrictions on sale of mutual funds; facilitate broader provision of insurance products.
- Access to finance measures (Table 1):
  - Short term: Establish a credit bureau with positive and negative credit information that includes the whole banking system and information about utility payments.
  - Medium term: Expand access points for mobile services provision.
- Timing definitions from Table 1:
  - Short term: 12–18 months.
  - Medium term: 2–3 years.
- Examples of short-term measures:
  - Expand legal protection for all supervisory staff (in line with proposed NCBA amendments).
  - Allow full access to individual deposit and investment accounts to all financial sector supervisory agencies.
  - Enact proposed amendments to NCBA.
  - Start onsite examinations for mutual funds and other SEC registered entities.
  - Harmonize minimum capital requirement to eliminate the distinction based on domestic or foreign ownership (insurance).
  - Amend PCA regulation to make it more progressive and timely; involve PDIC early in dealing with PCA failure banks.

### Macro-financial impact of the global financial crisis and near-term outlook
- External exposure:
  - Exports-to-GDP around 30 percent.
  - Workers’ remittances equal 10 percent of GDP.
- Macroeconomic effects and policy response:
  - Central bank cut interest rates by a cumulative 200 bps between December 2008 and July 2009.
  - Fiscal deficit expected to reach 4.4 percent of GDP in 2009, compared to 1.5 percent in 2008 (IMF definition).
  - Government adopted a fiscal stimulus package for infrastructure and social services.
- Growth and inflation:
  - Annual GDP growth slowed from 7.1 percent in 2007 to 3.8 percent in 2008.
  - GDP contracted 2.1 percent (q/q) in Q1 2009.
  - GDP rebounded by 1.7 and 1.0 percent (q/q) in Q2 and Q3 2009, respectively.
  - Inflation expected to stay near the middle of BSP’s target range of 3½  ± 1 percent in 2009.
- Financial markets and external accounts:
  - EMBI+PHL spread narrowed to around 220 bps from 780 bps at the height of the crisis.
  - Current account remained in surplus; exports drop offset by lower commodity prices and imports; remittances continued to increase.
- Growth forecasts:
  - Growth forecast to average ¾-1 percent in 2009 and 3-3½ percent in 2010.
  - Recovery led by private consumption, with exports and investment expected to increase as global economy recovers.

### Corporate sector resilience
- Balance-sheet improvements:
  - Average debt-to-asset ratio fell about 10 percent.
  - Debt-to-cash flow ratio fell by more than half from its peak before the Asia crisis and is now below the Emerging Asia average.
  - Share of external debt and short-term debt declined sharply.
- Profitability and liquidity:
  - Average rate of return on assets above Emerging Asia average.
  - Combined net income of listed companies (excluding financials) increased by 50 percent (y/y) during the first half of 2009 (partly due to one-off gains).
  - Quick ratio about 150 percent in 2007; declined slightly in 2008 but remains above Emerging Asia average.
- Expected default probabilities:
  - Spiked after Lehman Brothers’ collapse and declined sharply in recent months.
  - Current expected losses from corporate defaults in the Philippines broadly in line with regional peers.

### Stress tests—scenarios, findings, and vulnerabilities
- Scenarios and permanent assumptions used:
  - Remittances decline by 12 percent y/y.
  - Sovereign spreads increase of 250 bps.
  - Export values decline by 50 percent.
  - A combination of all the above shocks.
- Concentration and interbank risk scenarios:
  - Failure of each bank’s largest, two largest, and five largest borrowers; failure of the five largest borrowers in the system.
  - Default of a large bank (interbank risk).
- Market risk shocks:
  - Increase of 200 bps and 500 bps in interest rates.
  - A 50 percent appreciation or depreciation of the exchange rate.
- Liquidity shocks:
  - Combined deposit withdrawal, drawdown of committed credit lines, and haircut of debt securities of 10 percent each; and a similar shock of 25 percent.
- Coverage:
  - Stress tests focused on the largest banks, which together account for approximately two-thirds of total assets.
- Key stress-test findings:
  - Major banks generally resilient to extreme macroeconomic scenarios given high capital buffers.
  - Only in export and combined shocks do CARs of a few banks fall under the minimum requirement.
  - Most banks resilient to failure of single largest borrower, but CARs would fall below minimum if five largest borrowers of each bank failed—an extreme scenario.
  - All banks resilient to a permanent 200 bps parallel shift of the yield curve; a permanent 500 bps shift would significantly reduce CAR of several banks.
  - Banks can withstand a liquidity event of 10 percent withdrawals/drawdowns/haircuts; a 25 percent deposit withdrawal would exhaust liquid assets of a limited number of banks.
- Specific scenario risk assessments and likelihoods:
  - 1. Rise in interest rates — MEDIUM.
  - 2. Sustained decline in real estate prices — LOW-MEDIUM.
  - 3. Severe recession (growth between -2 and -6 percent) — LOW.
  - 4. Failure of a large economic group — LOW.
  - 5. Renewed international market turmoil / sudden stop — LOW.
  - 6. Illiquidity or insolvency of a large bank — LOW.
  - Note: In scenario summaries, some scenario likelihoods are adjusted based on stress test results (e.g., severe recession labeled MEDIUM in stress-test results section).

### Appendix I — Contingent Claims Analysis (CCA) of corporate vulnerabilities
- Methodology:
  - Uses balance sheet information and stock prices to obtain forward-looking default risk information.
  - Expected default probabilities one year ahead calculated using contingent claims framework (Moody’s KMV – Credit Edge data).
- Quantitative findings:
  - Estimated expected losses from corporate defaults in the Philippines: around 3½ percent of corporate liabilities over the next year.
  - Compared to GDP, potential corporate losses are around 1 percent of GDP for the Philippines.
  - For Asia as a whole, potential corporate losses are about 1¼ percent of GDP.
  - Implication: potential knock-on effect on Philippine banks expected to be manageable given low credit-to-GDP ratio.

### Appendix II — Bank derivatives activities and model-based stress testing
- Derivatives market size and composition:
  - Notional amount of stand-alone derivatives (average Feb 2008–Aug 2009): about P2.3 trillion ($50 billion).
  - Embedded derivatives represented about P13 billion ($275 million).
  - Foreign exchange forwards and swaps constitute two-thirds of all derivative contracts; foreign exchange swaps represent about half of derivatives markets.
  - Majority of derivative transactions are short-term (less than one year).
- Market structure and licenses:
  - Foreign banks lead derivatives activities; domestic banks have Type 2 (limited dealer) or Type 3 (end-user) authority; no domestic bank has Type 1 (expanded dealer).
- Exposures and reported metrics:
  - Derivatives current positive exposure (percent of Tier 1):
    - Dec-2008 5.69.6
    - June-2009 2.74.1
  - Derivatives negative exposure (percent of Tier 1):
    - Dec-2008 4.36.2
    - June-2009 3.88.7
  - As of October 2009, overall Value at Risk (included from derivatives) reported by the largest banks was less than 0.5 percent of Tier 1.
- Credit risk model for NPL forecasting:
  - NPL modeled via logit transformation as function of real GDP, remittances, five-year Philippine government bond yield (representative interest rate), and real effective exchange rate; sample 2001:Q1–2008:Q4; regressions estimated in first differences.
  - Model diagnostics:
    - R-squared 0.670892; Adjusted R-squared 0.622135.
    - GDP (-5) coefficient 0.017431 (t-stat 5.181294, p=0.000).
    - Remittances(-3) coefficient 0.001668 (t-stat 3.786741, p=0.001).
    - Real interest rate (-5) coefficient -0.002897 (t-stat -1.515242, p=0.141).
    - Real effective exchange rate coefficient 0.012245 (t-stat 3.695646, p=0.001).
    - MA(1) 0.671991 (t-stat 3.623721, p=0.001).
    - Mean dependent var 0.048715; S.D. dependent var 0.070452; S.E. of regression 0.043308; Durbin-Watson stat 1.935368.
  - Model implications:
    - One percentage point decrease in GDP growth translates into 0.5 percentage point increase in NPLs (model-implied).
    - Remittances growth improves credit quality with effect after three quarters; independent impact limited.
    - Real depreciation worsens portfolios quickly; higher interest rates have negative but not statistically significant impact.
- Stress scenarios for NPL forecasts (two-year horizon, gradual return by end of second year):
  - Remittance shock: remittances drop by 12 percent.
  - Export shock: export values decline by 50 percent.
  - Financial shock: sovereign spreads increase by about 250 basis points; policy response calibrated with depreciation about 28 percent.
  - Combined shock: all three shocks together (akin to global recession following recent global financial crisis).
- Forecasted NPL outcomes:
  - "NPL loans increase by 10, 26, 49 and 78 percent in each scenario respectively." (remittance shock, financial shock, export shock, combined shocks).
- Translation to bank capital metrics:
  - For each bank, NPL loans grew at the forecast growth for the system; provisions raised to keep current coverage constant for each bank.
  - Risk-weighted assets adjusted up by 150 percent of NPL (minus provisions), following the Basel rule.

*Source: Executive Summary and selected sections from the Philippines FSAP Update (IMF staff report), content unit _cr1090.*

### Executive Summary ......................................................................................................

### _cr1090 - Executive Summary

### Banking sector resilience and system structure
- Banks dominate the Philippine financial system: about two-thirds of total financial institutions’ assets and about 75 percent of GDP in assets (almost P6 trillion, June 2009).  
- The banking system (June 2009) comprises 804 deposit-taking institutions, including universal and commercial banks, thrift, rural, and cooperative banks.  
- Universal and commercial banks account for 88 percent of total banking assets; the ten largest banks account for about two-thirds of banking assets.  
- Since the late 1990s Asian crisis, improvements include bank restructuring, consolidation, and shedding of nonperforming assets; asset quality is generally high and the system is well-capitalized and liquid.  
- Despite accelerated loan growth after 2006, bank credit to the private sector remains low: net loans are 35 percent of GDP. Loans represent 49 percent of banks’ total assets; investment in securities represents 25 percent of banks’ total assets (mostly long-term government securities).  
- The asset quality of thrifts, cooperatives, and rural banks is weaker and provisions are low.

### Progress since the 2002 FSAP and remaining weaknesses
- Considerable progress in banking: strengthened regulatory framework, enhanced BSP supervisory capabilities, adoption of Basel II and IFRS, and strengthened risk-based supervision.  
- Partial progress in other areas: debt market development, partial relaxation of bank secrecy, improved supervisory coordination, and new AML legislation.  
- Remaining weaknesses:
  - Capital market and insurance supervision remain largely compliance-oriented.
  - Legal framework and supervisory agencies in capital markets and insurance need further strengthening.
  - A plethora of overlapping and distortionary government policies in the financial sector persist.
  - Legal protection of supervisors, though improved, remains weak.

### Nonbank sector development and key indicators
- Equity market: 246 companies listed on the Philippine Stock Exchange at end-2008 (a net increase of 12 since 2003); market capitalization dropped sharply in 2008 to 54 percent of GDP.  
- Mutual funds and related: 45 mutual funds with P63 billion in assets; 115 unit investment trust funds with about P100 billion; bank private asset management or trust departments control another P1.4 trillion in assets.  
- Debt market: corporate debt market remains relatively small at about 4 percent of GDP; government securities dominate.  
- Insurance: total insurance premium was just over 1 percent of GDP in 2008 and, except for microinsurance, contracted in real terms since 2002.  
- Housing finance: housing loans by financial intermediaries equal 4½ percent of GDP; comparison noted: Indonesia 2½ percent, Thailand 17 percent, Malaysia 26 percent. Public entities account for slightly over half of housing loans.  
- Conglomerates: about 60 percent of bank assets are controlled by banks belonging to conglomerates; an estimated ¾ of effective market capitalization belongs to conglomerates.

### Key supervisory and regulatory priorities (selected)
- Banking supervision:
  - Pass proposed amendments to the New Central Banking Act (NCBA).  
  - Consider reforms to give BSP greater discretion to require additional capital and impose other limits; broaden definition of connected counterparties; expand and harmonize single borrower limits and large exposures definitions.  
  - Roll back bank secrecy provisions that hamper PDIC and supervisors’ access to individual deposit and investment information; provide adequate legal protection for supervisors (in line with Basel Core Principles).  
- Capital market supervision:
  - Enhance on-site examinations, enforcement, and use of self-regulatory organizations (SROs).  
  - Rationalize the mandate of the SEC and provide adequate resources.  
- Insurance supervision:
  - Pass pending amendments to the Insurance Code and supplement with provisions to give the Insurance Commission a broader set of discretionary intervention tools.

### Financial safety nets and crisis management
- The enhanced Prompt Corrective Action framework of 2006 was significant; proposed NCBA amendments would strengthen resolution powers further.  
- Recommended shifts in resolution framework:
  - Shift the balance more in favor of efficient resolution over shareholder rights; empower authorities to take full control of a bank once capital adequacy falls below a critical threshold.  
  - Allow a bridge bank resolution mechanism.  
  - Give PDIC access to asset and individual deposit information at an early stage when bank viability is in question.  
  - Tighten conditions for emergency liquidity assistance.  
- Institutional coordination:
  - Creation of the Financial Sector Forum (BSP, PDIC, SEC, Insurance Commission) has improved supervisory coordination; further strengthening by crisis contingency planning and closer links with the Department of Finance is recommended.

### Developmental policy recommendations for nonbank sectors
- Housing finance:
  - Rationalize housing credit subsidy policy and the role of public housing finance institutions; limit public agencies to core mandates, subject their lending to the same prudential rules as banks, and close entities lacking a clear business case.  
  - Reduce foreclosure “redemption” period for individual borrowers (noted in Table 1 recommendations).  
- Capital and insurance markets:
  - Harmonize tax treatment of financial products and services.  
  - Reduce time and expense of debt and mutual fund offerings; remove unnecessary restrictions on the sale of mutual funds; facilitate broader provision of insurance products.  
- Access to finance measures (from Table 1):
  - Establish a credit bureau with positive and negative credit information that includes the whole banking system and information about utility payments (Short term).  
  - Expand access points for mobile services provision (Medium term).

### Selected items from Table 1—timing and measures
- Short term: 12–18 months; medium term: 2–3 years.  
- Examples of short-term measures:
  - Expand legal protection for all supervisory staff (in line with proposed NCBA amendments).  
  - Allow full access to individual deposit and investment accounts to all financial sector supervisory agencies (in line with proposed NCBA amendments).  
  - Enact proposed amendments to NCBA.  
  - Start onsite examinations for mutual funds and other SEC registered entities.  
  - Rationalize housing credit subsidy policy and role of public housing finance institutions.  
  - Harmonize minimum capital requirement to eliminate the distinction based on domestic or foreign ownership (insurance).  
  - Amend PCA regulation to make it more progressive and timely; involve PDIC early in dealing with PCA failure banks.

*Source: Executive Summary, Philippines FSAP Update (IMF).*

### 5.      The global financial crisis has affected the economy, though less than in several

### _cr1090 - 5.      The global financial crisis has affected the economy, though less than in several

### Impact of the global financial crisis on the Philippine economy
- Export exposure and remittances:
  - Exports-to-GDP around 30 percent.
  - Workers’ remittances equal 10 percent of GDP and constitute a major channel of external exposure.
- Macroeconomic shocks and policy response:
  - Exports declined sharply, remittance growth slowed, and investment and consumption weakened after the crisis onset.
  - The central bank cut interest rates by a cumulative 200 bps between December 2008 and July 2009.
  - The government adopted a fiscal stimulus package to boost investments in infrastructure and social services.
- Growth outcomes:
  - Annual GDP growth slowed from 7.1 percent in 2007 to 3.8 percent in 2008.
  - GDP contracted 2.1 percent (q/q) in the first quarter of 2009.
  - The impact was significant but smaller than initially feared.

### Near-term recovery and macrofinancial conditions (2009)
- Growth and inflation:
  - GDP rebounded by 1.7 and 1.0 percent (q/q) in the second and third quarters of 2009, respectively.
  - Recovery drivers: remittances, modest recovery in exports, fiscal stimulus, and low interest rates.
  - Inflation trended down and is expected to stay near the middle of the BSP’s target range of 3½  ± 1 percent in 2009.
- Public finances:
  - Fiscal deficit is expected to reach 4.4 percent of GDP in 2009, compared to 1.5 percent in 2008 (IMF definition).
- Financial markets and external accounts:
  - Stock prices returned to pre-crisis levels, in line with regional trends.
  - EMBI+PHL spread narrowed to around 220 bps from 780 bps at the height of the crisis.
  - Current account remains in surplus; drop in exports offset by lower commodity prices and imports, while remittances continued to increase.

### Growth outlook and drivers
- Growth forecasts:
  - Growth is forecast to average ¾-1 percent in 2009 and 3-3½ percent in 2010.
- Recovery composition:
  - Recovery led by private consumption as consumer confidence improves.
  - Exports and investment are expected to increase as the global economy recovers.

### Corporate sector: resilience and vulnerabilities
- Balance-sheet improvements:
  - The non-financial corporate sector entered the crisis in a relatively strong position due to balance-sheet strengthening over the last decade.
  - Average debt-to-asset ratio fell about 10 percent.
  - Debt structure improved with the share of external debt and short-term debt declining sharply.
  - Debt-to-cash flow ratio fell by more than half from its peak before the Asia crisis and is now below the Emerging Asia average.
- Profitability and liquidity:
  - Average rate of return on assets is now above the Emerging Asia average.
  - Combined net income of listed companies (excluding financials) increased by 50 percent (y/y) during the first half of 2009 (partly driven by one-off gains from asset sales).
  - Quick ratio (current assets net of inventories-to-current liabilities) reached about 150 percent in 2007, declining slightly in 2008 but remaining above Emerging Asia average.
- Default risk:
  - Expected default probabilities (one year ahead) spiked after Lehman Brothers’ collapse and have declined sharply in recent months.
  - Current expected losses from corporate defaults in the Philippines are broadly in line with regional peers.

### Banking sector stability — key risks and buffers
- Asset quality and legacy improvements:
  - NPLs declined from a peak of 16.9 percent of total loans in 2001 to about 4 percent in 2008-09.
  - Stock of foreclosed real estate and other property (ROPA) fell from 6.3 percent of total assets in 2002 to 2.7 percent in June 2009.
  - When the crisis initially hit, trading book losses were easily absorbed by profits.
- Systemic and segmentation risks:
  - Some asset quality deterioration among smallest and weakest institutions; their NPL ratios are more than twice that of universal and commercial banks—and rising.
  - About 200 mostly rural banks are currently under PCA.
  - Loans continued to grow in H1 2009, at a slowing pace; banks reported a mild recovery of profits from 2008.
- Capital and solvency:
  - Staff analysis notes relatively high capital (CAR over 15 percent).
  - NPLs net of provisions equal 7.2 percent of capital.
- Credit concentration and off-balance risks:
  - Credit concentration tends to be high.
  - Guarantees and credit lines (off-balance sheet) were about 14 percent of total assets.
  - Ten largest borrowers as a percent of total loans indicate high concentration among top borrowers.
- Interest rate and duration risk:
  - Fixed-rate government securities account for about 25 percent of banks’ assets.
  - Funding is concentrated in short-term deposits, producing substantial duration gaps.
  - For thrifts, rural, and cooperative banks, larger share of real estate loans (34 percent) magnifies interest rate risk compared with universal and commercial banks (12 percent).
- Foreign exchange and market risks:
  - Solo net open foreign exchange position was about 5 percent of capital at June 2009; open positions are capped at the lowest of 20 percent of unimpaired capital or US$50 million on a consolidated basis.
  - Most derivatives are plain vanilla; exposure to structured products has been reduced after the crisis.
  - Equity price risk is about 2 percent of banks’ trading portfolio.
- Liquidity and funding:
  - Banks hold large stocks of government securities (easily repo’d with the BSP).
  - Funding concentrated in core deposits.
  - Foreign currency liquidity risk limited by a liquid asset requirement of 30 percent of foreign currency deposits.
  - Off-balance sheet unit trust funds have grown to the equivalent of 20 percent of banks’ on-balance sheet assets; returns to investors are not guaranteed.
- Cross-border exposure:
  - Banks mostly raise funds and lend domestically; foreign banks’ market share is about 10 percent and limits exist on repatriation of profits.

### Near-term vulnerabilities and operating constraints
- Earnings and profitability pressures:
  - With GDP growth sluggish and inflation and interest rates expected to stay low in 2010, bank profits likely to remain below pre-crisis levels.
  - High operating costs to revenue (e.g., average operating costs about 3.4 percent of total assets) may weigh on internal capital generation.
- Tail risks:
  - Tail risks could produce significant impact; these are summarized in the Risk Assessment Matrix (Table 4).

### Stress-test scenarios and shocks assessed
- Credit and macroeconomic shocks (permanent assumptions used in tests):
  - Remittances decline by 12 percent y/y.
  - Sovereign spreads increase of 250 bps.
  - Export values decline by 50 percent.
  - A combination of all the above shocks.
- Concentration and interbank risk:
  - Failure of each bank’s largest, two largest, and five largest borrowers; failure of the five largest borrowers in the system.
  - Default of a large bank (interbank risk).
- Market risk shocks:
  - Increase of 200 bps and 500 bps in interest rates.
  - A 50 percent appreciation or depreciation of the exchange rate.
- Liquidity shocks:
  - Combined deposit withdrawal, drawdown of committed credit lines, and haircut of debt securities of 10 percent each; and a similar shock of 25 percent.
- Scope and coverage:
  - Stress tests focused on the largest banks, which together account for approximately two-thirds of total assets.
  - Methodology references and appendices described in Appendix III.

*Source: _cr1090 - 5.      The global financial crisis has affected the economy, though less than in several (IMF staff report).*

### 1.  A rise in interest rates (e.g.,

### _cr1090 - 1.  A rise in interest rates (e.g.,

### Scenario summaries and likelihoods
- 1. A rise in interest rates (e.g., through a sharp hike in policy rates and/or a higher sovereign risk premium). — MEDIUM
  - Public debt (60 percent of GDP) is high.
  - The 2009 budget deficit (IMF definition) is projected at 4.4 percent of GDP, up from 1½ percent last year.
  - Fiscal slippage due to the recent typhoons could create concerns about fiscal credibility and raise risk premiums.
  - With the moderate projected pace of economic rebound, policy rates are likely to be raised only gradually.
- 2. A sustained decline in real estate prices. — LOW-MEDIUM
  - After sharp falls following the crisis of the late 1990s, real estate prices have grown significantly during the last decade.
  - During 2009, growth in prices flattened.
  - No evidence of a real estate bubble; a recent law allowing REITs is likely to have a positive impact on investment demand.
- 3. A severe recession (growth between -2 and -6 percent) triggered by a decline in remittances, exports, consumer confidence, or a combination of these factors. — LOW
  - Baseline projections suggest GDP growth rates of 0.8 percent and 3.2 percent in 2009 and 2010, respectively.
  - Growth has proved stronger than expected due in part to supportive policies.
  - Downside risks to the baseline stem from weaker than expected global growth or a sharp rise in interest rates.
- 4. Failure of a large economic group. — LOW
  - Conglomerates are large and very diversified.
  - The corporate sector is generally much stronger than at the time of the last crisis and much more liquid.
- 5. Renewed turmoil in international financial markets causing a sudden stop/reversal of capital inflows with severe impact on asset prices (in particular exchange rate). — LOW
  - Recent WEO and GFSR point to a recovery in global financial and credit markets.
- 6. Illiquidity or insolvency of a large bank. — LOW
  - Preliminary analysis shows a few large or medium-sized banks could be undercapitalized under extreme scenarios.

### Stress-test findings and bank vulnerabilities
- General conclusion:
  - The results suggest that the major banks are resilient to extreme macroeconomic scenarios, given their high capital buffers.
- Capital adequacy and shocks:
  - Only in the case of the export and the combined shocks scenarios does the CAR of a few banks slip under the minimum requirement.
  - Most banks would be resilient to the failure of their single largest borrower, or even of the five largest borrowers in the system; but the CAR of most banks would fall below the minimum if the five largest borrowers of each of them failed—an extreme scenario.
  - Stress tests measure only the direct impact; indirect effects on the economy could be more significant if a large bank were to fail.
- Market and liquidity risk tolerances:
  - All banks would be resilient to a permanent 200 bps parallel shift of the yield curve.
  - A permanent 500 bps shift would significantly reduce the CAR of several banks.
  - Banks would be sensitive to large currency swings depending on whether their position would be short or long.
  - Banks can withstand a liquidity event characterized by withdrawals, drawdowns, and haircuts of 10 percent.
  - A 25 percent deposit withdrawal would exhaust the liquid assets of a limited number of banks.

### Specific risk-channel observations (from scenarios)
- Interest-rate shock (scenario 1) — LOW-MEDIUM (based on stress test results)
  - Banks have large duration gaps since they fund long-term assets with short-term deposits.
  - Banks’ security portfolio represents over 20 percent of bank assets.
  - Among the largest 10 banks, over 60 percent of these securities are holdings of government bonds.
  - Some banks have reclassified bond holdings from trading account to hold-to-maturity and available-for-sale accounts; losses would not be realized immediately.
- Real-estate shock (scenario 2) — LOW (Based on analysis in sections B and C)
  - Lending to property developers would slow and credit quality of property sector loans could deteriorate.
  - Largest banks still hold stock of foreclosed property (ROPA) conservatively booked with a cushion of about 40 percent or more, depending on the bank.
  - Smaller banks generally have higher ROPA and lower provisions.
- Severe recession (scenario 3) — MEDIUM (based on stress test results)
  - NPLs tend to increase as economic activity weakens; increases in NPLs would require additional provisions, affecting profits and potentially capital.
- Failure of large conglomerates (scenario 4) — HIGH (based on stress test results)
  - Banks’ exposures to large conglomerates is high.
  - In case of failure, some of the largest banks would see their Tier 1 capital wiped out.
  - Failure of more than one large economic group would seriously impair the capital of several major banks.
- FX, interest rate, cross-border, and liquidity risks (scenario 5)
  - Foreign exchange risk: MEDIUM (based on stress tests results). Banks have moderate net open foreign exchange positions that fluctuate frequently between short and long.
  - Interest rate risk: LOW-MEDIUM (based on stress test 2 and 7).
  - Cross-border risks (including through counterparty risks): LOW (based on FSI). Banks have reduced exposure to international banks and written off losses from the financial turmoil.
  - Liquidity risk: LOW (based on stress test 9). Banks depend mainly on deposit funding.
- Large-bank insolvency (scenario 6) — LOW (based on stress test results and only assessing the direct impact)
  - The interbank market is very shallow and direct bank exposures to other banks are small.
  - The BSP has facilities and flexibility to address a sudden liquidity shortfall.
  - The PDIC can provide financial assistance in systemic risk cases.

### Banking system safety nets — rehabilitation, resolution, and legal framework
- Progress since 2002 FSAP:
  - PDIC charter amendments (effective June 2009) partially relaxed bank secrecy of deposits and allow PDIC and BSP to look into individual deposit accounts during an examination in case of unsafe and unsound banking practices.
  - Financial Sector Forum (FSF) established in 2004 (BSP, PDIC, SEC and Insurance Commission) has enhanced information sharing and coordination.
  - BSP issued a new PCA regulation (circular 523) in 2006; banks under PCA increased from less than 20 to some 200 by June 2009. Of the 270 banks placed in PCA since 2006, only 14 graduated and 56 were placed under receivership.
- Remaining weaknesses:
  - The PCA regulation is not progressive; sanctions are imposed for unreasonable delay or after noncompliance with MOU (PCA “failure”).
  - Periods for corrective actions are overly long: “required” actions should be taken within 90 days; timeline for “expected” actions is undefined; once under PCA, a bank has 30 days to submit an MOU and 90 days to implement it; correction encouraged within one year but a maximum of 3 years under MOU may be allowed.
  - BSP authority to place a bank in receivership or suspend shareholder rights is strictly circumscribed in the law. PCA failure does not necessarily mean conservatorship or receivership; legal conditions for conservatorship/receivership do not include a specific capital threshold.
  - No statutory time period requires that critically undercapitalized banks be capitalized or put into receivership; once in receivership there is a 90-day period during which shareholders could seek to rehabilitate the failed bank.
- Proposed legislative amendments:
  - Additional sanctions: suspension, removal, or disqualification of directors and officers responsible for violations.
  - Additional grounds for receivership: deposit dormancy exceeding 60 days, suspension of deposit payments, refusal to submit to examination.
  - Enhanced resolution powers: if realizable assets insufficient to cover liabilities, BSP may direct shareholders to increase capital within 90 days; noncompliance could lead BSP to direct the bank to accept investments, merge, or consolidate.
  - Limitation on issuance of restraint or injunction—limited to a court of appeals.
- Further recommended strengthening:
  - PCA regulation should be more progressive with increasingly severe mandatory and discretionary actions based on worsening CAR (or other risk) triggers.
  - Law should establish a capital threshold above insolvency as the point at which authorities take full control of a bank for restructuring (or official administration).
  - Eliminate the rehabilitation period allowed owners during receivership.
  - Resolution framework should allow for a bridge bank.

### Deposit insurance — coverage, powers, and reserve adequacy
- Legal and operational changes since initial FSAP:
  - Increase in maximum deposit insurance coverage from P100,000 to P250,000 in 2004 and from P250,000 to P500,000 in 2009.
  - Stiffer penalties and ability to issue cease-and-desist orders for unsafe and unsound banking practices.
  - Power to conduct regular examinations (with BSP approval) and special examinations in coordination with the BSP in case of impending bank closure.
  - Authority to examine deposit accounts in case of unsafe and unsound practices.
  - Power to exclude certain deposits from coverage.
- Operational constraints and statistics:
  - Bank secrecy remains a hindrance to PDIC’s access to deposit information; the recent Legacy Bank group failure highlighted delays in prompt payouts due to lack of timely access to individual deposits.
  - Deposit insurance now covers 97 percent of all deposit accounts and about 31 percent of the monetary value of deposits.
  - Actual reserves are 1½ percent of total deposits, compared with a PDIC target of 2 percent.
  - During a transitional three-year period following the increase in coverage from P250,000 to P500,000, the government is to cover the second P250,000 of any deposit payouts while PDIC builds reserves to the target level.
  - PDIC can borrow from the BSP, from the market (up to two times reserves) with a government guarantee, or directly from the government, with no limit.
- Recommended powers:
  - Grant PDIC authority to raise premiums and, in particular, charge risk-based premiums.

### Liquidity and risk capital assistance
- Historical context:
  - At end-2001, financial assistance to banks by the BSP (either directly or through loans to the PDIC) amounted to 16 percent of reserve money.
  - By end-2007, this had declined to around 9 percent, of which only 1 percent was direct support through the Emergency Liquidity Assistance (ELA) facility.
- ELA design and concerns:
  - ELA may be up to 50 percent of the deposits of a bank under stress—provided it is solvent—secured by acceptable assets.
  - A 2006 regulation specifies ELA cannot exceed 180 days and carries a penalty rate (BSP lending rate plus 2 percentage points).
  - Banks receiving ELA may not expand loans or declare dividends, and are under intensified supervision.
  - Banks with CAR under 6 percent may receive ELA if they submit a business improvement plan within 6 months.
  - Banks with negative CAR may receive ELA if complying with an approved rehabilitation plan.
- Recommended adjustments:
  - Critically undercapitalized institutions should only be given very short-term central bank liquidity to enable an orderly resolution.
  - Longer-term risk capital assistance should only be provided by the government or PDIC in the context of resolution to ensure public accountability.
  - Any uncollateralized liquidity support by the BSP should be granted only with government guarantees.

### Crisis preparedness, crisis management arrangements, and coordination
- Existing arrangements:
  - BSP has an early warning system to identify weak banks and a measure of bank distress to assess systemic threat.
  - BSP has a Financial Stability Report (FSR) Committee and started producing an annual FSR in 2008.
  - Financial Sector Forum (FSF) meets at least bi-monthly to ensure information exchange and harmonization of policies; functions set out in MOUs between FSF agencies.
- Suggested enhancements:
  - FSF should develop formal crisis contingency plans, including key data requirements, contact lists, and a public communication strategy.
  - Forge closer, more formal links with the Department of Finance given the need for strong political support and timely responses in the event of a systemic crisis.

### Financial sector oversight — banking supervision progress
- Key areas of progress since 2002 FSAP:
  - Legal framework for special purpose vehicles enabled a major reduction of banks’ nonperforming assets following the late 1990s crisis.
  - A new AML Act (2003) is broadly in line with FATF recommendations.
  - Revised PDIC charter strengthened powers to examine banks.
  - Improved supervisory coordination via FSF and MOAs on information sharing; BSP has formal information-sharing agreements with five foreign supervisors.
  - Capital adequacy, risk management, and corporate governance rules and guidance updated; BSP implemented Basel II (standardized approach for credit risk, basic indicator approach and standardized approach for operational risk, standardized and internal models for market risk, and Pillar 3 requirements).
  - Enhanced compliance and auditing requirements including mandatory audit, corporate governance, and risk management committees.
  - Supervision advanced with strengthened market and liquidity risk supervision, new prudential reports, specialized on-site teams, enhanced guidance on large exposures and lending to related parties, updated Manual of Regulations, and supervision manuals emphasizing risk assessment.
  - Creation of a dedicated AML unit, intensive training, and extensive use of off-site tools.
  - Industry representatives recognized the improvement.

*Source: IMF staff analysis in the provided content unit.*

### 30.      However, there are still some shortcomings.

### _cr1090 - 30.      However, there are still some shortcomings.

### Banking supervision — legal and operational shortcomings
- Inconsistencies between regulatory guidance on related lending (DORSI) and the single borrower limit in the General Banking Law (GBL), with the GBL using a narrower definition of connected counterparties.
- Many prudential limits, sanctions, and fines are detailed in legislation, hampering the BSP’s ability to adjust these in a timely manner and preventing full compliance with international standards.
- Deficiencies in the legal power of and legal protection for supervisors hamper compliance with BCP principles on autonomy and constrain enforcement of principles related to capital, ownership, consolidated supervision, corrective and remedial powers, and risk-based supervision.

### Administrative fixes undertaken and their limits
- Creation of the Directors’ and Officers’ Liability Insurance in 2005 enhanced protection of supervisors acting in good faith.
- BSP has improved guidance on due process for supervisors.
- Remaining legal constraints:
  - Law still considers supervisors civilly liable if they have not applied “extraordinary diligence,” creating risk for supervisors taking timely remedial measures and producing long and cumbersome procedures (notably in the case of the PCA).
  - While recent Supreme Court rulings reinforced BSP’s intervention authority, another decision requires “prior notice” of AML inquiries, weakening investigative powers.

### Proposed New Central Banking Act (NCBA) amendments
- Proposed changes include:
  - deleting the “extraordinary diligence” requirement;
  - granting the BSP authority to request additional information, making it possible to supervise conglomerates “up the chain”;
  - broadening the definition of control;
  - expanding examination authority to align the text more with risk-based supervision needs;
  - establishing that lower courts cannot issue temporary restraining orders against BSP actions;
  - granting BSP authority to establish different capital ratios for individual financial institutions.

### Additional legal and regulatory changes recommended
- Relegate prudential limit levels and amount of fines to regulations.
- Increase BSP discretion to require additional capital and impose other limits relative to the risk profile of a bank, in line with the current capital adequacy regulation.
- Align the definition of connected counterparties in the law with the DOSRI regulations already in force.
- Ensure single borrower limits and large exposures are calculated on solo and consolidated basis, including all on- and off-balance sheet exposures, as a function of the same definition of capital (a recommendation of the 2002 FSAP).
- Set a regulatory aggregate limit for the sum of large exposures considering concentration risks in the system and international best practice.

### Capital market supervisory shortcomings and priorities
- Progress since 2002 FSAP recommendations, but legal and resource constraints persist; improved compliance depends on continued efforts by the SEC and Philippine Stock Exchange (PSE).
- Three key areas for improvement:
  - SEC regular on-site examinations:
    - SEC does not conduct routine on-site examinations; on-site exams are performed only “for cause” due to resource limitations.
    - All regulated entities should be subject to regular on-site examinations; focus areas include net asset value calculation by mutual funds and broker-dealer compliance with risk-based capital adequacy standards.
    - SEC should develop a market surveillance program covering the PSE, the Philippine Dealing and Exchange Corporation (PDEX), and two registered alternative trading systems when operations begin.
    - The Revised Investment Company Act must be enacted (identified as a priority in the initial FSAP).
  - SEC and PSE enforcement powers:
    - Legal constraints (e.g., the bank secrecy law) impede investigation of major misconduct.
    - SEC has referred 27 investigations to the Justice Department in the past three years with no resulting criminal convictions (the most recent conviction concerned a crime that happened a decade ago).
    - Recommendations: exempt the SEC from the bank secrecy act when investigating violations; grant the SEC authority to bring civil enforcement actions and issue disgorgement orders; increase the maximum fines the SEC may impose in a cease-and-desist order.
  - Self-regulatory structure:
    - PSE should comply with legal requirements on diversified ownership from demutualization.
    - Effective self-regulation requires adequate resources and independence from PSE business operations.
    - Interim step: creation of the Market Integrity Board; plan to create a legally independent, single, autonomous self-regulatory entity overseeing both the PSE and PDEX should be implemented.

### SEC mandate, resources, and legal protection
- Need to rationalize SEC’s mandate, ensure sufficient resources, and provide staff legal protection.
- Observations:
  - SEC performs functions not common to capital market regulators (e.g., company registration, government-sponsored credit bureau).
  - SEC has approximately 400 staff, about the same as in 2000, when staff was reduced almost by half after automation of company registration.
  - Automation of the company registration and reporting process has not been completed; almost 20 percent of SEC staff remains assigned to this task.
  - Due to lack of resources, SEC lacks an adequate market surveillance program and cannot hire sufficient staff for examinations of mutual funds and market intermediaries.
  - SEC has not been able to pay salaries commensurate with the BSP, as required by law.
  - SEC commissioners and staff may not be indemnified for costs and expenses if they fail to exercise “extraordinary diligence,” a term not defined in law and creating legal uncertainty.

### Insurance sector supervisory and regulatory issues
- Insurance Commission (IC) lacks sufficient independence; it is a government agency under the Department of Finance, funded by annual budget allocations; staff employed under public servant rules and at remuneration well below industry levels; staffing has declined and staff lack adequate legal protection.
- Supervision remains compliance-focused rather than risk-based; progress includes development of risk-based capital (RBC) and variable and proportionate regulations for Mutual Benefits Associations (MBAs), particularly microinsurance MBAs, but key components of a risk-based regime are not in place.
- Insurance Code (1978) and regulations are out of date and fall short of international best practice. Amendments prepared by the Commission and industry are insufficient and would reinforce a compliance-based regime unless supplemented by provisions that support a risk-based regime:
  - Broader set of discretionary intervention tools that can be initiated in a risk-based context.
  - Relegate procedural items requiring Insurance Commission approval (e.g., investments by individual companies or new retail products) from the law to Commission circulars to allow flexibility.
- RBC formula and minimum liability rules need improvement:
  - Current yields for new investments are below rates factored into product prices and liability valuation requirements for conventional insurance.
  - Minimum liability rules should be strengthened and valuation approach harmonized with International Accounting Standards.
  - RBC formula should have parameters more consistent with Philippine risk profiles, a threshold for intervention set at least at the level of the full RBC requirements, and incorporate more of the investment rules (reducing stand alone rules).
- Commission needs adequate resources, particularly given impending shift of pre-needs company supervision to the Insurance Commission.

### AML-CFT framework remaining shortcomings
- Significant steps taken since the 2003 AML/CFT assessment, but main remaining shortcomings:
  - Absence of several offenses from the predicate crimes list.
  - Failure to make terrorism financing a stand-alone offense.
  - Deficient implementation of UN Security Council resolutions.
  - Financial institutions are the only entities subject to full AML/CFT provisions.
  - Procedures for access to bank records by law enforcement agencies are cumbersome and their involvement in the financial component of predicate investigations is limited.
  - Limited integrity of the national government ID system undermines customer identity verification.
  - Mismatch between agencies’ resources and tasks assigned by law.

### Developmental issues in nonbank sectors — Capital markets, housing finance, insurance
- Capital markets — measures to improve market functioning and integrity:
  - Rationalize and reduce transaction-based taxes, notably the exemption for banks on Final Withholding Tax, calculation of transactions taxes on gross rather than net basis, and the Depository Stamp Tax.
  - Reduce the time and expense of debt offerings; filings duplicate annual and quarterly reports; SEC could adopt expedited process and a no-review policy for some companies or facilitate shelf registration statements.
  - Reduce time and expense of supplemental mutual fund offerings via short-form registration and expedited review for increases in authorized shares for open mutual funds.
  - Regulatory changes to assist mutual fund investors: amend SEC rules to permit licensed professionals to sell more than one company’s mutual funds and permit mutual fund companies to contract with banks, brokers, and other licensed professionals to sell their products.
- Housing finance — public entities need comprehensive reform:
  - Several government housing finance entities have unclear/overlapping mandates, poor management, low-quality portfolios, limited expertise, and extraordinarily high NPL ratios.
  - Many are mandated to distribute the same subsidized credit product: 6 percent fixed rate, 30 years.
  - These lenders create moral hazard, do not provide social housing effectively, and generate fiscal contingent liabilities.
  - Urgent reform needed for Home Guarantee Corporation (does not meet prudential actuarial principles), National Housing Mortgage Finance Corporation (unclear business case), and Pag-Ibig (elevated debt collection problems and NPLs; source of unfair competition for banks).
- Insurance — access improved but policy distortions persist:
  - Mutual benefit associations focused on micro-insurance expanded with regulatory capital concessions and tax incentives.
  - Once 2006 capital requirements are fully implemented in 2011, minimum capital levels will be among the highest in the world, especially for foreign-owned companies.
  - Restrictions on expanding range of providers and on micro-insurers introducing non-life products.
  - Premium-based taxes and tax on the savings element vary between provider types.
  - GSIS monopoly on insuring “government risks,” while also giving loans to non-members, competes directly with private market for insurance of government employees and requires borrowers to take out life insurance from GSIS.

### Appendix I — Contingent Claims Analysis (CCA) of corporate vulnerabilities
- CCA methodology:
  - Utilizes balance sheet information and stock prices to obtain forward-looking information about the risk of default.
  - Probability of default depends on (i) firm leverage (debt relative to market value of equity) and (ii) uncertainty about firm asset values driven by stock market movements.
  - Expected default probabilities one year ahead can be calculated using the contingent claims framework.
  - Analysis uses data from Moody’s KMV – Credit Edge, covering a significant share of listed Philippine companies by market capitalization.
- Expected losses and interpretation:
  - CCA allows calculation of expected losses from corporate defaults — present value of expected losses to creditors, bondholders, and banks after equity is wiped out.
  - These estimates are suitable for international comparisons or assessing effects on creditors such as the banking system.
- Key quantitative findings:
  - Estimated expected losses from corporate defaults in the Philippines: around 3½ percent of corporate liabilities over the next year.
  - Compared to GDP, potential corporate losses are around 1 percent of GDP for the Philippines.
  - For Asia as a whole, potential corporate losses are about 1¼ percent of GDP.
  - Implication: potential knock-on effect on Philippine banks is expected to be manageable, given the low credit-to-GDP ratio in the Philippines.

*Source: IMF staff report content as provided in the supplied PDF excerpt.*

### Appendix II. Bank Derivatives Activities in the Philippines

### Appendix II. Bank Derivatives Activities in the Philippines

### Overview of derivatives market size and composition
- The notional amount of stand-alone derivatives held by Philippine banks was—on average between February 2008 and August 2009—about P2.3 trillion ($50 billion).
- Embedded derivatives (e.g. structured notes) represented about P13 billion ($275 million).
- Foreign exchange derivatives are the most frequently stand-alone traded instruments, with foreign exchange forwards and swaps together constituting two-thirds of all derivative contracts and foreign exchange swaps representing about half of the derivatives markets.
- The majority of derivative transactions are short-term (less than one year).

### Market share (stand-alone by notional amount)
- Source: BSP (market-share listing shown in source text; foreign exchange forwards/swaps dominate).

### Structured notes and concentration risks
- The most popular structured notes in the Philippines are range-accrual notes, plain vanilla credit-linked notes, and leveraged credit-linked notes.
- Reference assets on which banks sell protection are usually Philippine government bonds—whose return/risk profile is well known by local banks—indicating a conservative approach to structured products.
- This concentration could create higher systemic risk in the event of fiscal problems, since it would compound bank losses from these products.
- For sellers of these notes, the structures imply a wrong way exposure (i.e., protection is sold on a risk to which the seller is also exposed).

### Market participants and licensing
- Foreign banks lead local derivatives activities due to expertise and regulatory regimes that prescribe different types of licenses to participate.
- Licenses depend on the complexity of products, their term, and whether banks take positions or act on behalf of clients.
- No domestic bank has the broadest type of license (Type 1 or expanded dealer); domestic banks have either Type 2 (limited dealer) or Type 3 (end-user) authority.
- Most domestic bank activities are end-user (proprietary trading or hedging) and counterparties are foreign banks with a presence in the Philippines or off-shore international banks.

### Exposures and risk measurement
- Derivatives expose banks to market and counterparty risks measured by current exposures (current value of the contract) and potential exposures (e.g., value-at-risk methodologies).
- Counterparty risk to foreign counterparties through credit-linked notes (CLN) was significantly reduced after the global crisis.
- Reported exposures (as presented in source):
  - Derivatives: Current Positive and Negative Exposures of Largest Banks (In percent of Tier 1)
  - Positive exposure (counterparty risk)
    - Dec-2008 5.69.6
    - June-2009 2.74.1
  - Negative exposure (market risk)
    - Dec-2008 4.36.2
    - June-2009 3.88.7
  - 1/ Excludes state-owned banks whose foreign exchange exposures (from loans with multilateral agencies) are covered by the Treasury.
- As of October 2009, the overall Value at Risk (included from derivatives) reported by the largest banks, following the Basel rules for the measurement of market risk, was less than 0.5 percent of Tier 1.

### Stress testing methodology (credit risk model)
- Credit risk modeled as a function of macroeconomic variables to capture systemic component; specific risk assumed diversified away.
- Credit risk represented by the ratio of NPL modeled by the logistic functional form so forecasts lie in the [0-1] interval. The logit transformation of NPL (y) is modeled as a function of exogenous macroeconomic factors and an error term.
- Equation estimation:
  - Sample period: 2001:Q1–2008:Q4.
  - NPL series corresponds to universal and commercial banks provided by the authorities.
  - Dickey-Fuller tests suggest the logit transformation has a unit root; regressions estimated in first differences.
- Regressors used: real GDP, remittances from Philippine workers abroad, a representative interest rate (the five-year bond yield on Philippine government bond), and the real effective exchange rate.
- Corporate leverage ratio was tested but not incorporated in the final regression.
- Estimation approach: one regression for the total Philippine banking system (available sectoral or bank-level NPL time series too short or unavailable).

### Key model findings and diagnostics
- All variables have the expected signs:
  - GDP growth improves portfolio quality with impact materializing in five quarters. The model implies that one percentage point decrease in GDP growth would translate in 0.5 percentage point increase in NPLs.
  - Remittances growth has a positive impact on credit quality with the effect becoming apparent after three quarters. The independent impact of remittances on NPL is limited (largely indirect through GDP).
  - Bank portfolios are affected by a real depreciation of the real effective exchange rate and the impact appears to materialize quite soon (possible balance-sheet channel on corporates with unhedged foreign-currency exposures).
  - Higher interest rates have a negative impact on portfolio quality, although this does not appear significant.
- The regression explains 67 percent of NPL variation.
- Corporate leverage has limited explanatory power and that disappears once other macroeconomic variables are included.
- Table 1 model estimates (as presented):
  - Dependent Variable: Logit transformation of NPL
  - Method: Least Squares
  - Sample (adjusted): 2001Q1 2008Q4
  - Included observations: 32 after adjustments
  - Convergence achieved after 13 iterations
  - MA Backcast: 2000Q4
  - Variable coefficients and statistics (as presented)
    - GDP (-5) 0.017431 0.003364 5.181294 0.000
    - Remittances(-3) 0.001668 0.000443 3.786741 0.001
    - Real interest rate (-5) -0.002897 0.001912 -1.515242 0.141
    - Real effective exchange rate (0.012245 0.003313 3.695646 0.001
    - MA(1) 0.671991 0.185442 3.623721 0.001
    - R-squared 0.670892     Mean dependent var 0.048715
    - Adjusted R-squared 0.622135     S.D. dependent var 0.070452
    - S.E. of regression 0.043308     Akaike info criterion -3.29838
    - Sum squared resid 0.05064     Schwarz criterion -3.069359
    - Log likelihood 57.77408     Hannan-Quinn criter. -3.222466
    - Durbin-Watson stat 1.935368
    - Inverted MA Roots -0.67
  - Model was estimated in first differences.

### Stress scenarios calibrated and rationale
- Four stress scenarios used to forecast NPLs:
  - A remittance shock characterized by a drop of 12 percent.
  - An export shock triggered by a 50 percent decline in export values.
  - A financial shock triggered by an increase in sovereign spreads of about 250 basis points.
  - A shock combining all three shocks above.
- Rationale:
  - Remittance and export shocks highlight dependence on external factors; remittances shock directly affects household default probabilities; export shock directly affects corporate defaults.
  - Financial shock replicates characteristics of the recent global financial crisis: high interest rates, global illiquidity and a current account deficit requiring currency depreciation—impacting credit quality through higher loan interest rates and potential burden on foreign-currency debt.
  - The combined scenario is akin to the global recession following the recent global financial crisis.
- Calibration details and context:
  - Financial shock: increase in sovereign spreads of about 250 basis points.
  - Export shock: 50 percent decline in exports value.
  - Policy response: depreciation of about 28 percent (about 3 standard deviations of changes in the real effective exchange rate for the period used for model estimates).
  - Remittance shock: 12 percent drop in their value. The worst decline in remittances during 1994-2008 was 22 percent in 1999. Average annual remittance growth about 13 percent since 2000.
  - Stress test risk horizon: two years.
  - All scenarios characterized by a gradual return to normal conditions by the end of the second year.

### Forecasts and translation to bank capital metrics
- Forecasted NPL outcomes (summarized):
  - Apart from the combined shocks scenario, the scenario with the larger impact is the export shock.
  - "NPL loans increase by 10, 26, 49 and 78 percent in each scenario respectively." (remittance shock, financial shock, export shock, combined shocks).
- Translating forecast NPL into bank capital ratios:
  - For each bank, NPL loans grew at the forecast growth for the system.
  - Provisions were raised so as to keep the current coverage constant for each bank.
  - Risk-weighted assets were adjusted up by 150 percent of NPL (minus provisions), following the Basel rule.

*Source: Appendix II. Bank Derivatives Activities in the Philippines (content unit provided).*

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_Source: https://www.imf.org/-/media/websites/imf/imported-full-text-pdf/external/pubs/ft/scr/2010/_cr1090.pdf_