Chapter

4 Crisis in the Financial Sector and the Authorities’ Reaction: The Philippines

Author(s):
International Monetary Fund
Published Date:
March 1991
Share
  • ShareShare
Show Summary Details
Author(s)
Jean-Claude Nascimento

Between 1981 and the middle of 1987, the Philippine economy faced a major crisis in the financial sector. Three commercial banks, 128 rural banks, and 32 thrift institutions failed, and 2 other private banks were under intervention. In addition, the biggest commercial bank, the Philippines National Bank, and the Development Bank of the Philippines, both government owned, became de facto insolvent and, in 1986, were bailed out by a transfer of their nonperforming assets (about ₱ 108 billion, equivalent to 80 percent of their combined assets) to the Asset Privatization Trust (APT), specially constituted to administer problem assets. The crisis began on a limited scale during 1980 and 1981 and intensified thereafter, culminating by the end of September 1986 in a significant contraction of the financial system (excluding the Central Bank of the Philippines—CBP). For the purpose of analysis, three distinct phases of the crisis have been identified.

The first phase, which spanned all of 1981, featured a crisis of confidence triggered by fraud in the commercial paper market.1 Although the crisis initially affected only a small part of the system outside the commercial and development banks, whose combined assets accounted for 16.5 percent of total assets of the financial system in 1980, the crisis had a lasting impact on confidence. The commercial paper market collapsed and many nonbank money market institutions went out of business. The two largest investment houses belonging to two major holding companies went bankrupt, provoking the failure of the holding companies themselves and leading to the bankruptcy or takeover of their numerous corporate subsidiaries. Wealth holders shifted funds to the highest-quality paper and to more stable and conservative banks.

The loss of confidence spread to the thrift banking system. Also, failures of rural banks, which had sharply increased in 1980, continued to rise in 1981. However, the assets of failed rural and thrift banks accounted for only 1.6 percent of the total assets of the banking system in 1981, and the failures among them did not pose a threat to stability but served to weaken confidence further.

In the second phase, which spanned 1982(I)—1983(III), the Government intensified its assistance to nonfinancial and financial institutions, which served to alleviate the growing distress among nonfinancial corporations but widened the budget deficit. The Government increased its emergency lending and equity contributions to public corporations, arranged for the takeover of troubled private banks by government financial institutions2 in order to facilitate their restructuring and eventual disposition, and supported the takeover by the government financial institutions of numerous nonfinancial firms in distress. The Government was attempting to prevent widespread private corporate failures and banking problems, while stepping up public investment to offset the slump in private sector investment. During this phase, political uncertainty became widespread and foreign exchange difficulties grew, although the problem was initially masked by swap and forward cover operations by the CBP as well as by irregular banking operations.3

When the third phase, which spanned 1983(IV)-1986(IV), began, there was widespread uncertainty in the economy, stemming from the unstable political environment of the first half of 1983 and the balance of payments crisis of October 1983. The effects spilled over to the banking system. Indeed, in October 1983, the authorities’ announcement of a moratorium on external debt payments to foreign commercial banks provoked financial panic; a series of runs on the banks ensued, and this time commercial banks were included. Large-scale flight to currency and outflows of capital occurred. The capital outflows that were recorded during this period may have occurred even earlier and been obscured by the banking irregularities. The disclosure or sudden loss of reserves in mid-October undermined confidence and exacerbated the crisis.

By the end of this phase the hardest hit financial institutions were the two largest government-owned banks—the DBP and the PNB. The depth of the crisis during this phase is illustrated by three events:

  • A staggering decline in commercial bank credit to the private sector, which fell by 53 percent in real terms between the end of September 1983 and the end of September 1986.
  • A massive restructuring of the DBP and the PNB, which led in November 1986 to a transfer of ₱ 108 billion of nonperforming assets (representing nearly 30 percent of total bank assets) to a government agency—the APT.4 Included in the transfer were ₱ 23.4 billion of nonperforming assets from the PNB, which contributed to a decline of 20.5 percent, in real terms, in commercial bank credit to the private sector during the last quarter of 1986.
  • Continued government intervention in weak private banks and the closing of three private commercial banks.5

Against this background, this chapter examines the causes and manifestations of the crisis in the Philippine financial sector and the reaction of the authorities to that crisis. Attention here is on the behavior of the financial system before and during the crisis; the aim is to clarify the linkages among financial reform, financial crisis, and macroeconomic performance.

The main conclusion of the chapter is that factors within the financial system caused and exacerbated the crisis. Although the political and economic climate of the late 1970s and early 1980s increased the fragility of the financial sector, weaknesses of the regulatory framework and loose banking practices triggered and exacerbated the crisis. In the end, the interventions by the authorities prevented the banking sector from collapsing, but at a high financial cost to taxpayers.

Section I discusses the background to the crisis and the role of the macroeconomic and regulatory environment. Section II discusses the manifestations of the crisis, with emphasis on money and credit developments. Section III describes the measures taken to deal with the crisis. Section IV highlights the main findings.

I. Setting of the Crisis

Three factors within and outside the financial system are examined here in order to differentiate their effects on the crisis: (1) the macroeconomic setting and political climate before and during the crisis; (2) the structure of the financial sector and its liberalization initiated in 1972 and completed in 1981; and (3) prudential regulation and supervision of financial institutions and related institutional practices.

Macroeconomic Setting

During the 1970s the economy experienced strong growth in real GNP, despite the low productivity of investment (see Table 1 and Chart 1). The unprecedented, demand-driven economic boom reflected the authorities’ development strategy based on intensive investment growth.6 The financing of the investment boom resulted in a widening of external imbalances and a sharp rise in foreign savings (in percent of nominal GNP) (Table 1). Also, the growth of domestic bank credit accelerated, particularly to the private sector (see Table 2). PNB and DBP accounted for a substantial portion of credit to the private sector, which often was granted on the basis of political, rather than economic, considerations.

During the late 1970s and early 1980s, a deterioration in world economic conditions further weakened the external position, while the limited crisis of confidence in 1981 seemed to dampen investors’ expectations regarding growth projections; these developments affected private investments adversely in the 1980s.7 By the second half of 1983, the effects of rapid expansion in earlier years, the growing uncertainty in the political climate, and unfavorable external conditions combined to cause a balance of payments crisis, which led to the announcement of a temporary moratorium on external debt repayments in October. This event triggered a run on banks, a cut-off of external financing, and some capital flight, all of which had significant feedback effects on the macroeconomy, particularly the balance of payments. In late 1983, CBP reacted by injecting reserve money to meet the increase in currency demand (see Table 2). The sharp increase in reserve money during 1983 also reflected large losses on swap operations.8 As a result, inflation and depreciation of the peso accelerated during 1983/84.

Chart 1.Selected Macroeconomic Indicators, 1970–86

(In percent)

Note: Shaded areas indicate crisis periods.

Sources: International Monetary Fund, International Financial Statistics, 1988; and Table 1.

Table 1.Selected Macroeconomic Indicators, Selected Years, 1970–86(In percent)
Indicator197019751980196119821983198419851986
Growth rate of real GNP
(at 1980 prices)4.35.85.03.41.91.1-7.1-4.12.0
Implicit GNP deflator
(at 1980 prices)14.58.315.611.08.311.650.018.21.6
Gross domestic investment
(in percent of GNP)21.529.630.730.728.827.117.414.313.8
Of which:
Private investment1(19.1)(27.0)(27.4)(16.2)(16.1)(17.6)(14.5)(11.4)(10.0)
Gross national savings20.625.224.825.320.719.013.414.316.5
Of which:
Private savings(18.6)(21.8)(19.4)(21.1)(16.5)(14.5)(11.9)(13.2)(17.8)
Foreign savings
(in percent of GNP)5.85.45.48.18.14.00.1-3.3
National government balance2
(deficit -)
(as percent of GNP)-1.1-1.3-4.0-4.3-2.0-1.8-1.8-5.1
Net foreign assets
(in billions of pesos)-0.62.8-21.1-30.1-50.5-95.3-125.0-94.0-28.5
Inflation rate314.08.218.213.110.210.050.323.10.7
Real GNP per capita
(in thousands of pesos)3.94.645.475.525.505.435.034.74.6
External debt/GNP31.348.954.462.872.780.681.792.9
Of which:
Total short-term/CNP(…)(12.4)(21.2)(24.9)(22.4)(37.9)(37.3)(32.7)(19.0)
From commercial
banks(…)(6.3)19.5)(11.5)(12.4)(10.9)(11.0)(7.7)(2.7)
Debt service ratio4
Exports of goods and
services29.218.120.925.233.138.944.648.3546.95
Of which: Share of
interest payment(29.8)(38.6)(58.5)(63.3)(65.2)(62.7)(65.2)(57.7)(50.6)
Exchange rate
(peso/U.S. dollar
at end of period)6.47.57.68.29.1714.019.819.020.5
Terms of trade
(growth rate)17.0-46.0-15.9-12.0-2.84.4-2.3-6.67.5
Memorandum item:
Consolidated public
sector balance (deficit—)
(in percent of GNP)-3.9-5.8-5.3-9.0-8.2-5.9-5.4
Sources: International Monetary Fund, International Financial Statistics, 1986, and IMF staff estimates.

Figures for 1970-80 are official data from the National Economic and Development Authority (NEDA); because these data are overstated, they are not comparable with the 1981–86 series, which represent IMF staff estimates.

Includes losses of government financial institutions 1 PNB, DBP, and CBP).

As measured by the consumer price index in Manila.

Before rescheduling.

Preliminary.

Sources: International Monetary Fund, International Financial Statistics, 1986, and IMF staff estimates.

Figures for 1970-80 are official data from the National Economic and Development Authority (NEDA); because these data are overstated, they are not comparable with the 1981–86 series, which represent IMF staff estimates.

Includes losses of government financial institutions 1 PNB, DBP, and CBP).

As measured by the consumer price index in Manila.

Before rescheduling.

Preliminary.

Table 2.Monetary Conditions, Selected Years, 1970–86
Reserve MoneyBank Credit1Interest Rates (in percent)
Of whichOf whichLendingDeposit
TotalCurrency with the publicExcess reserves3Liquidity2TotalTo private sector12-month treasury billrate (one year and less)rate (one year and less)
TotalOf which
M1M3
(In billions of pesos)(In nominal terms)
19703.22.4-0.59.14.39.110.68.113.712.06.5
19757.14.834.910.334.932.826.910.912.09.0
198017.010.20.679.222.579.294.679.712.814.014.0
198118.711.6-0.487.223.582.1114.397.013.116.015.3
198219.712.70.199.723.595.3133.1110.115.016.814.1
198329.119.6-3.4118.632.5113.0173.6139.914.918.813.7
198434.921.8-1.8139.533.6120.4183.3139.441.526.723.2
198539.924.1-3.1178.735.8132.8171.5115.335.128.821.8
198652 329.3-0.24205-942.6141.4118.989.2513.217.112.3
(In billions of pesos at 1980 prices)(In real terms)6
197012.7-2.036.916.936.942.531.6-1.6-3.3-8.5
197512.78.551.718.451.759.848.34.15.2-1.5
198017.010.20.679.222.579.289.975.8-5.4-4.2-4.2
198116.510.3-0.474.720.170.397.883.00.12.92.2
198215.810.20.178.118.474.6104.386.24.86.63.9
198321.214.3-2.578.917.173.1115.593.1-4.98.83.7
198416.910.6-0.958.714.250.777.158.68.8-23.6-27.1
198515.79.5-1.269.814.051.967.045.612.05.2-1.3
198620.411.5-0.180.716.751.346.535.014.416.311.5
Sources: International Monetary Fund, International Financial Statistics, 1967; and data provided by the authorities.

Starting in 1977, the authorities adopted a new classification system.

Starting in 1981, the figures include treasury bills and central bank certificates of indebtedness (CBCIs) held outside the banking sytem Thus, between 1970 and 1980, liquidity is equal to M3, which includes demand, savings, and time deposits collected by the banking system.

Between 1970 and 1980, excess reserves were calculated by multiplying the required reserve ratio by the deposit base and subtracting the result from bank reserves. Afterward, data are from IMF country reports.

End of November.

After transfer of ₱ 23 billion of nonperforming loans from the PNB to the Government.

Calculated by subtracting the inflation rate as measured by the consumer price index in Manila.

Sources: International Monetary Fund, International Financial Statistics, 1967; and data provided by the authorities.

Starting in 1977, the authorities adopted a new classification system.

Starting in 1981, the figures include treasury bills and central bank certificates of indebtedness (CBCIs) held outside the banking sytem Thus, between 1970 and 1980, liquidity is equal to M3, which includes demand, savings, and time deposits collected by the banking system.

Between 1970 and 1980, excess reserves were calculated by multiplying the required reserve ratio by the deposit base and subtracting the result from bank reserves. Afterward, data are from IMF country reports.

End of November.

After transfer of ₱ 23 billion of nonperforming loans from the PNB to the Government.

Calculated by subtracting the inflation rate as measured by the consumer price index in Manila.

The subsequent tightening of monetary policy, the soaring interest rates during 1984/85, and the continued devaluations of the peso all contributed to the spread of distress among financial and nonfinancial corporations. Indeed, the high real interest rate and the peso devaluation aggravated the debt-servicing problems of firms with foreign currency debt.9

With very high interest rates, growing uncertainty, and weakening of confidence, aggregate demand dropped, leading to a deep recession. Bank credit, especially to the private sector, fell sharply in real terms.

Structure of Financial Sector and Its Liberalization

To finance the development strategy based on intensive investment growth, CBP introduced numerous reforms between 1972 and 1981. Institutional reforms included the liberalization of controls on foreign capital. Regulatory reforms included the progressive liberalization of interest rates and the introduction of “universal banks.”10 Prudential reforms included the elimination of restrictions on the entry of foreign banks and on their equity participation in domestic banks, and higher barriers to entry for domestic banks (e.g., higher minimum capital requirements).

Liberalization of Controls on Foreign Capital

Evidence shows that the liberalization of controls on foreign capital, together with lending practices largely influenced by political considerations, increased the financial fragility of nongovernment entities. In the subsections that follow, the specific policy measures are presented and their impact on the external debt burden and the financial structure of nongovernment entities is discussed.

Measures. During the 1970s, CBP introduced the foreign currency deposit (FCD) system, created offshore banking units, and eased controls on direct foreign investment. These measures were aimed at attracting foreign capital and permitting wider portfolio selection for domestic investors.

Under the foreign currency deposit system, resident and nonresident nationals could hold foreign currency deposits with eligible banks.11 In turn, CBP allowed foreign currency deposit banks to make foreign currency loans to domestic residents subject to prior CBP approval, or peso loans after these banks had converted their foreign currency into pesos under a swap arrangement with CBP.12 Secrecy laws protected investors’ deposits. Depositors were also free to withdraw their funds or transfer them abroad. Interest rates on these foreign currency deposits were unregulated. Beginning in 1978, these banks’ foreign exchange operations were subject to open position limits.13

Under the offshore banking unit system, both domestic banks and nonresidents were allowed to hold foreign currency deposits with offshore banking units. Banks’ lending operations required prior CBP approval. In addition, banks were not allowed to make loans with a maturity exceeding 360 days.14

The relaxation of foreign capital controls included the following measures:

  • (1)Foreign direct cash investment made after 1973 became freely repatriable;
  • (2)Foreign-owned companies were granted authorization to raise loans in domestic currency;
  • (3)Foreign banks were allowed to take equity participation, with minority or majority ownership, in domestic banks. Although significant capital controls remained, the removal or relaxation of restrictions stimulated capital inflows.

Overindebtedness and Unsound Debt Structure. As a result of these developments and of the foreign financing of the investment boom, the external debt burden rose sharply while the maturity of this debt shortened (see Table 1). These developments disputed the contention that liberalization of capital controls would reduce foreign borrowing.15 Rather, these developments suggested that liberalization of the foreign capital flow contributed to excessive external borrowing, which permitted domestic investment to accelerate before the crisis.16

Incomplete financial reforms, combined with the political climate, encouraged such borrowing. Indeed, the authorities eased capital controls while maintaining controls in other areas, such as credit allocation and trade transactions.17 Excessive foreign borrowing and domestic protection contributed to weakening the financial position of nongovernment entities.

As large foreign capital inflows exerted strong inflationary pressures during the second half of the decade, real lending rates became negative by 1980 (see Table 2). Along with high trade barriers, these negative rates created widespread misallocation of resources and encouraged debt finance. Indeed, during the 1970s enterprises and banks had relied heavily on debt finance, especially foreign, to expand their activities.18 Consequently, the total outstanding debt of the nongovernment sector (both in real terms and in percent of national income) doubled between 1972 and 1980; the share of this debt denominated in foreign currency quadrupled to 40 percent in 1980 (see Table 3). For enterprises, the changes in the level and structure of indebtedness were even more dramatic. As a result of these changes, the quality of banks’ portfolios (especially of the DBP and PNB) and the soundness of their liability structure had deteriorated by 1980.

Until 1983, the rise in the debt burden and the weakening of the liability structure of nongovernment entities accelerated, reflecting the end of the economic boom and deterioration in the political and economic climate during that period. Thereafter, a massive liquidation of debt took place, as domestic and foreign creditors curtailed sharply the supply of funds (see Tables 1 and 3).

Interest Rate Liberalization

The statistical analysis in the subsections that follow suggests that despite a fairly open capital account, domestic monetary conditions played a significant role in explaining the behavior of interest rates after the liberalization. Between 1984 and 1986 these conditions, reflected in indicators of excess demand for real money (M3),19 were influenced largely by the uncertain environment and by CBP policy efforts to bring down inflation. The main reforms are presented first and the behavior of interest rates following the reforms is discussed.

Table 3.Indicators of Indebtedness of Nongovernment Sectors
1972198019811982198319841985
Debt, by borrowers(In billions of pesos at 1980 prices; end of period)
Total nongovernment1104.5246.7255.8281.3320.6245.3185.9
Enterprises2(30.2)(117.4)(123.7)(134.2)(169.1)(133.4)(95.3)
Commercial banks(62.5)(113.7)(116.6)(131.5)(136.0)(101.3)(84.5)
Individuals(11.8)(15.6)(15.5)(15.6)(15.5)(10.6)(6.1)
Denomination of debt(In percent of total)
Nongovernment
Total100.0100.0100.0100.0100.0100.0100.0
In pesos90.060.952.455.145.038.737.0
In U.S. dollars10.039.147.644.955.561.363.0
Enterprises
Total100.0100.0100.0100.0100.0100.0100.0
In pesos3100.042.437.734.124.915.812.2
In U.S. dollars57.662.365.975.184.287.8
Commercial banks
Total100.0100.0100.0100.0100.0100.0100.0
In pesos83.074.774.971.264.862.467.7
In U.S. dollars17.025.325.128.835.237.632.3
Debt burden ratio(In percent of nominal income of each sector)
Nongovernment65.7116.9120.5131.9155.9141.6115.3
Enterprises20.055.658.363.082.277.059.1
Memorandum items:
Enterprises’ foreign
debt (in billions of
U.S. dollars)8.910.812.413.414.012.8
Of which:
Short-term(—)(2.5)(3.7)(4.0)(4.0)(4.2)(3.0)
CPI (1980=100)28.8100.0114.6126.8147.1246.1290.8
National income4
(at current prices)45.8211.0243.2270.4302.4426.2468.8
Sources: Central Bank of the Philippines, Statistical Bulletin, 1982 and 1983; and Philippines Financial Statistics, 1982—1985; and International Monetary Fund.

Domestic and foreign debt (converted into pesos at the peso/U.S. dollar rate at end of period) of the nongovernment sector composed of enterprises, commercial banks, and individuals.

Composed of private and public corporations, single proprietorships, partnerships and associations, and cooperatives. The overwhelming share of the debt belonged to corporations.

Excludes the peso loans that were re-lent by the Central Bank of the Philippines or a commercial bank. As the ultimate borrowers (i.e., enterprises) assumed the exchange rate risk, this debt was included in foreign debt contracted in U.S. dollars. These data also exclude: overdue loans, items in litigation, domestic and foreign bills, “clean.”

Calculated by netting out indirect taxes (net of subsidies) and income plus profit taxes from nominal GNP.

Sources: Central Bank of the Philippines, Statistical Bulletin, 1982 and 1983; and Philippines Financial Statistics, 1982—1985; and International Monetary Fund.

Domestic and foreign debt (converted into pesos at the peso/U.S. dollar rate at end of period) of the nongovernment sector composed of enterprises, commercial banks, and individuals.

Composed of private and public corporations, single proprietorships, partnerships and associations, and cooperatives. The overwhelming share of the debt belonged to corporations.

Excludes the peso loans that were re-lent by the Central Bank of the Philippines or a commercial bank. As the ultimate borrowers (i.e., enterprises) assumed the exchange rate risk, this debt was included in foreign debt contracted in U.S. dollars. These data also exclude: overdue loans, items in litigation, domestic and foreign bills, “clean.”

Calculated by netting out indirect taxes (net of subsidies) and income plus profit taxes from nominal GNP.

Reforms. During the 1970s CBP administered the level and structure of interest rates. It tried to maintain positive rates in real terms and to keep nominal interest rates aligned with foreign interest rates. In 1976 the usury law was abolished, and CBP introduced ceilings on money market rates applied to deposit substitutes.20

In 1981, CBP deregulated all bank rates except short-term lending rates. Ceilings on all deposit rates were lifted in July; those on medium- and long-term lending were lifted in October. The ceiling on short-term lending rates was eliminated at the end of 1982. Meanwhile, in March 1982, to enhance transparency in the credit and deposit markets, both a Prime Rate and a Manila Reference Rate (MRR) began to be compiled and announced.21

Determinants of Interest Rate Levels. Following the liberalization, nominal interest rates first rose gradually, then shot up between 1984 and 1985, before declining in 1986 (see Chart 2). Despite a fairly open capital account, foreign factors (e.g., foreign interest rates and expected exchange rate changes) were not the only determinants of nominal interest rates after the liberalization.

Indeed, the uncovered interest arbitrage relation explained only part of the interest rate fluctuation from 1981(I) to 1986(IV). Empirical equations for domestic interest rates (nominal) indicated that the estimated short and long-run coefficients of the foreign interest rate (adjusted for ex post devaluations) were 0.1 and 0.5, respectively (see Table 4).22 The estimated coefficient of the dummy variable was statistically insignificant—a fact that points to a stable interest arbitrage relationship before and after the announcement of the moratorium. To test the significance of domestic factors affecting nominal interest rates, a more general relationship was estimated by including a variable measuring monetary disequilibrium.23 The statistical significance of this variable (defined as the difference between actual M3 and the estimated value of the demand for money, both in real terms) was evidence of the strong presence of the “liquidity” effect on nominal interest rates (see Table 4).

This liquidity effect was governed by both the CBP’s policy stance and the banks’ behavior. In 1982 and 1983 expansionary policies created an excess supply of real balances, which, in turn, put downward pressure on interest rates (see Chart 2). Although the expansionary stance was maintained in the first half of 1984, a shortage of real balances subsequently emerged because of the sharp decline in the money multiplier, which put strong upward pressure on interest rates; the fall in the money multiplier resulted from banks’ cautious lending policies in the presence of widespread economic uncertainty. The upward pressure on interest rates persisted in 1985 and 1986, as the monetary policy stance became tight (see Section II below).

Determinants of Interest Rate Structure. The gross margin between lending and deposit rate fluctuated by an average of about 4 percentage points annually between 1980 and 1984, and rose sharply between 1985 and 1986 (see Table 5).24 But quarterly data show that this margin was often larger and that it fluctuated sharply, particularly for short-term rates (see Chart 3). The larger margin for short-term rates was caused by the inverted term structure of bank lending rates which reflected the increase of inflationary expectations.25 Indeed, bankers took a cautious stance, incorporating a risk premium for inflation in their lending rates (see Buhat (1986)).26 Also, the gross margin between the short-term lending rate and the short-term deposit rate measured by the 90-day MRR rose steadily until 1983(III); this rise reflected a decline in the MRR soon after its introduction (see Chart 3, Panel (A). Fry (1988) suggests that the initial decline in the MRR pointed to oligopolistic pricing, whereas Buhat (1987) interprets this decline as a move by banks to offset the increase in other elements of their costs of funds (e.g., the cost of the promotional campaign for deposits). Evidence supports the latter interpretation, especially in view of the low concentration ratio in the banking industry (described later) and of the evolution of the net interest margin.

Chart 2.Movements of Nominal Rates, 1982(I)–1986(IV)

(In percent per annum; period average)

Sources: Central Bank of the Philippines, CB Review, Vols. 38 and 39, 1986.

1 London interbank offered rate.

Table 4.Estimates of Selected Financial Relationships, 1981(II)—1986(IV)1(Annual percentages)
Estimated Equations1

Dependent Variable
Estimated Coefficients
DummyRealActualAdjusted
1. Demand for money2ConstantvariableGNPinflationMt/Pt-1RhoRssR2DW
Real M3-4.695(0.076)0.082-0.0010.783-0.009-0.0020.9981.989
(-24.031)(10.646)(1.769)(-10.515)(41.968)
2. Uncovered interest arbitrage3Constant(i* + e)tit-1
Deposit rate (it)1.1650.0970.726-0.018135.10.824-0.103
(0.860)(3.889)(7.704)
3. Generalized version of
interest rate equation4Constant(i* + e)tEMStit-1
Deposit rate (it)0.2670.092-0.5110.7990.0171 18.70.8770.094
(0.226)(4.368)(-1.861)(9.495)
Source: IMF staff calculations.Notes: Table shows quarterly average data. Note also that: (i) Figures in parentheses represent the t-statistic whose critical value at 95 percent significance level is tc = 1.708 for 25 observations; and (ii) DW is the Durbin-Walson statistic.

Their specification posits a slow market-clearing process. Thus, the estimates reported are short-term coefficients with the coefficients of (Mt/Pt-1) and it-1, representing the adjustment lag coefficient in equations (1), (2), and (3), respectively.

The demand for real money (defined as M3) was assumed to depend positively on real GNP. and negatively on inflation (used as the opportunity cost variable capturing the substitution effect between money and goods). The adjustment process in the market for real money assumed that prices adjust to monetary imbalance with a lime lag; this process is decribed by the following equation:

The estimated equation was specified in semilog linear form. The reduced-form equation of this demand for money was tested, using an Orcutt-Cochrane procedure. The dummy variable taking a value of one before the announcement of the moratorium and zero thereafter was included to test the presence of a structural shift between these two periods.

A constant was added to this regulation to assess the presence of persistent deviation between domestic and foreign rates. Following a liberalization of foreign capital flows, the constant is expected not to be significant, while the long-run coefficient of (i* + e) would be close to one. Because of an adjustment lag, the short-term coefficient could be much lower than one within the period.

In essence, this equation tests the presence of a “liquidity” effect in the uncovered interest arbitrage relationship. In the short run, an excess supply of real money (demand) would cause the real interest rate to fall (rise); through the Fisher equation, this would cause the nominal interest rate to fall (rise). The monetary disequilibrium variable (i.e., actual real money minus the predicted value of the estimated demand for real money—equation (1)) is negatively correlated with the interest rate.

Source: IMF staff calculations.Notes: Table shows quarterly average data. Note also that: (i) Figures in parentheses represent the t-statistic whose critical value at 95 percent significance level is tc = 1.708 for 25 observations; and (ii) DW is the Durbin-Walson statistic.

Their specification posits a slow market-clearing process. Thus, the estimates reported are short-term coefficients with the coefficients of (Mt/Pt-1) and it-1, representing the adjustment lag coefficient in equations (1), (2), and (3), respectively.

The demand for real money (defined as M3) was assumed to depend positively on real GNP. and negatively on inflation (used as the opportunity cost variable capturing the substitution effect between money and goods). The adjustment process in the market for real money assumed that prices adjust to monetary imbalance with a lime lag; this process is decribed by the following equation:

The estimated equation was specified in semilog linear form. The reduced-form equation of this demand for money was tested, using an Orcutt-Cochrane procedure. The dummy variable taking a value of one before the announcement of the moratorium and zero thereafter was included to test the presence of a structural shift between these two periods.

A constant was added to this regulation to assess the presence of persistent deviation between domestic and foreign rates. Following a liberalization of foreign capital flows, the constant is expected not to be significant, while the long-run coefficient of (i* + e) would be close to one. Because of an adjustment lag, the short-term coefficient could be much lower than one within the period.

In essence, this equation tests the presence of a “liquidity” effect in the uncovered interest arbitrage relationship. In the short run, an excess supply of real money (demand) would cause the real interest rate to fall (rise); through the Fisher equation, this would cause the nominal interest rate to fall (rise). The monetary disequilibrium variable (i.e., actual real money minus the predicted value of the estimated demand for real money—equation (1)) is negatively correlated with the interest rate.

Chart 3.Banks’ Gross Interest Margins, 1982(1)–1986(IV)

(In percent per annum; period average)

Sources: Central Bank of the Philippines, CB Review, Vols. 38 and 39.

Table 5.Banks’ Interest Margins, Selected Years, 1970–86(In percent; period average)
Gross

Margins
Net unitary income (in) per peso lentNet

Margins
iL-idririnLit.ri.a(1-r)in(in–id)
(1)(2)(3)(4)(5)(6)(7)(8)
19706.820.03.08.880.600.009.485.18
19757.420.03.07.940.601.319.854.95
19804.520.03.08.720.601.5410.861.86
19813.620.03.09.820.601.5812.000.40
19823.018.03.012.050.541.8514.44-0.76
19834.323,01.012.000.231.7213.95-1.05
19844.524.04.016.380.964.7322.07-0.13
19857.124.04.017.310.964.0022.271.17
19866.422.04.011.400.881.5413.822.12
Sources: Buhat (1987); and IMF staff calculations.Definitions:iL-id= difference between lending (iL) and deposit rate (id), as defined in footnote 21, page 188.r = Required reserve ratio.ir = Interest rate on required reserves deposited at the CBP.inL = Net interest income per peso lent. iLn=i(1t)(1a)(1r)t = Gross tax receipts on lending operations; t = 5 percent on each unit income from lending.a = Agri/agra required ratio; a = 15 percent of banks’ loan portfolio.ia = Interest rate on treasury bill that banks can hold to meet other agri/agra required ratio. Thus, the net income per peso lent is derived by adding interest earnings on treasury bills held to meet the agri/agra requirement and on required reserves: in=iLn+ir.r+ia.a(1r).
Sources: Buhat (1987); and IMF staff calculations.Definitions:iL-id= difference between lending (iL) and deposit rate (id), as defined in footnote 21, page 188.r = Required reserve ratio.ir = Interest rate on required reserves deposited at the CBP.inL = Net interest income per peso lent. iLn=i(1t)(1a)(1r)t = Gross tax receipts on lending operations; t = 5 percent on each unit income from lending.a = Agri/agra required ratio; a = 15 percent of banks’ loan portfolio.ia = Interest rate on treasury bill that banks can hold to meet other agri/agra required ratio. Thus, the net income per peso lent is derived by adding interest earnings on treasury bills held to meet the agri/agra requirement and on required reserves: in=iLn+ir.r+ia.a(1r).

The net interest margin—after allowing for the cost of reserve requirements and other regulatory factors27—fell sharply between 1980 and 1983, but rose between 1984 and 1986 (see Table 5). The regulatory factors contributed about 5 percentage points to the average intermediation cost between 1984 and 1986; their impact on the marginal intermediation cost was even higher (around 8 percent) particularly in times of inflation and high interest rates. Thus, the reserve requirements and other regulatory factors served to aggravate the crisis by disproportionately raising the borrowing costs of firms. As noted earlier, the increase in overdue loans also contributed to widening the margins (to reflect risk premiums) and further raised borrowing costs. Particularly during 1984 and 1985, the increase in loan losses and the resulting caution in lending policies by banks served to raise lending rates and both gross and net margins.

Monetary Control Reforms

The reforms of monetary policy instruments facilitated greater flexibility in interest rates and rapid adjustments to major shocks, but the financial crisis itself strongly influenced the evolution of the instruments.

First, during the 1970s, CBP set a uniform legal reserve ratio of 20 percent across both institutions and instruments. In 1980, CBP announced a plan to lower gradually the legal reserve ratio to 16 percent, beginning in January 1982. The plan was to reduce the ratio by 1 percentage point every six months. During 1982, the plan went into effect and the legal reserve ratio declined from 20 percent to 18 percent at the end of 1982. As the crisis worsened in 1983, the plan was frozen; in 1984, CBP raised the legal reserve ratio to 24 percent in order to contain liquidity pressures.

Second, until 1983, CBP actively pursued selective credit policies. Special rediscount facilities were opened as an incentive to banks, especially development banks, to extend credit to priority sectors and activities (e.g., foodgrain production, land irrigation, promotion of small businesses). Following the crisis of confidence in 1981, CBP also opened a special rediscount window for medium- and long-term loans and equity investment to help government financial institutions finance the takeover and acquisition of troubled entities hit by the crisis. In November 1983, CBP also opened a liquidity window to counter the increasing pressures on the banking system. During 1984 and 1985, however, CBP drastically modified the rediscounting policy. It set access limits on the refinance facilities, raised the rediscount rates to market-related levels, unified the terms of access of these facilities, and, in November 1985, reduced the number of regular rediscount windows from five to one.

Third, beginning in the mid-1970s, CBP relied increasingly on open market operations, based on its own securities, to regulate the domestic liquidity of the banking system. Indeed, until 1981, CBP used central bank certificates of indebtedness (CBCIs) with maturities longer than 180 days.28 In 1983, however, CBP stopped issuing CBCIs by auction and sold them on tap at a fixed yield.29 In 1984, CBP introduced central bank bills with maturities of less than 180 days; during 1985 and 1986, auctions of central bank bills would become the main instrument for the dramatic tightening of monetary policy.

Finally, CBP introduced swap operations in 1982. This instrument, which became more important as the 1980s progressed, aimed at improving CBP’ s foreign exchange position and providing liquidity to deposit money banks so as to smooth out short-term interest rates. Because of the fall in the value of the peso, CBP incurred huge foreign exchange losses on these swap operations.

On the whole, these reforms had positive effects, because they allowed CBP to react promptly to the numerous monetary shocks (e.g., bank runs, portfolio shifts, increased domestic financing of budgetary deficits) that buffeted the economy between 1983 and 1986, and to transmit its policy actions to the banking system swiftly via interest rates. Through high interest rates, CBP was able to meet its reserve money targets and to bring down inflation by 48 percentage points within two years; in 1986, inflation stood at 1.8 percent.30 The adaptations of discount window policies served to prevent a collapse of the banking system.

The timing and sequencing of some measures, however, seemed to exacerbate instability. In view of expectation of further devaluation of the peso against the U.S. dollar as a result of the persistent weakening of the external position and accelerating rate of devaluation of the peso between 1979 and 1982, the introduction of swap operations with foreign exchange guarantees seemed ill-timed; CBP was able to finance unsustainable balance of payments deficits, but it risked large exchange losses if the trend in the peso depreciation continued.31 Furthermore, the opening of numerous special rediscount facilities, in addition to the emergency facility, between 1981 and 1983 was inconsistent with interest rate deregulation, insofar as access to these facilities by financial institutions weakened the effectiveness of open market operations. (Banks could obtain refinancing from CBP at below-market rates and at their own initiative.) As expected, these measures had inflationary effects between 1981 and 1983. The appropriate sequencing of the regulatory reforms should have been to modify the rediscount mechanism while interest rates were deregulated, not after.

Banking Structure

Measures. Between 1971 and 1981 CBP attempted to consolidate the domestic banking system while promoting greater competition by allowing foreign banks to enter. In 1972, CBP substantially raised the minimum capital requirement for all banks (see Table 6). After 1975, banks that could not comply with this requirement were permitted to merge with other domestic and foreign banks. However, CBP also actively encouraged banks to open branches, particularly in rural areas.

In 1980, CBP enacted legislation permitting the establishment of “universal” banks.32 They also raised the minimum capital requirement again. The previous functional classification of thrift banks into savings banks, private development banks, and savings and loan associations was eliminated. Thrift banks were allowed to carry on all operations performed by commercial banks except foreign exchange operations. The fact that they were also subject to lower reserve requirements gave them a cost advantage. Entry requirements for rural banks, which lend to farmers and rural entrepreneurs, were very liberal; capital requirements were low and limited management experience was accepted.33

Impact of the Crisis. The crisis significantly altered the banking structure. First, in terms of the volume of assets, by 1980 banks had increased their dominant position among financial institutions (see Table 7), but tiers had developed in the banking sector. The first tier consisted of a few commercial banks and development banks whose size had increased sharply during the 1970s, The second tier consisted of a large and growing number of rural and thrift banks, mostly small ones (see Table 8), A disproportionate number of institutions in this segment of the banking system were hit hard by the crisis, partly as a result of the weaknesses in entry regulations and the limited subsequent supervision. At the end of 1986, a total of 30 commercial banks in the Philippines (9 unibanks, 17 domestic commercial banks, and 4 foreign banks) accounted for 41 percent of the gross assets of the financial system (60 percent in 1980). In addition, there were 3 specialized government banks (16 percent),34 114 thrift banks (2.7 percent), and 877 rural banks (1 percent). Between 1981 and 1986, the relative position of banks was eroded somewhat by the growing role of the CBP in financing government budget deficits and in supporting troubled financial institutions because of the crisis itself.35

Table 6.Selected Prudential Ratios of Central Bank, 1972 and 1980
19721980
(In millions of pesos)
Minimum capital requirement1
Extended commercial banks (unibanks)500.0
Commercial banks2900.0300.0
Thrift banks (in Manila)320.0
Rural banks0.5
Investment houses20.0
(In percent)
Limits on equity investments
by commercial banks
including unibanks in:
Allied undertakings
Financial
Commercial banks49.030.0
Others49.0100.0
Nonfinancial100.0100.0
Nonallied undertakings40.035.0
Total equity investments
(in percent of net worth)
For commercial banks

For unibanks


35.0
25.0

50.0
Single-equity investments15.015.0
Capital risk assets ratio15.010.0
Borrowings by directors, officers, stockholders, and their
stockholders, and their
related interest (DOSRI)≤K5≤K5
Source: Central Bank of the Philippines.

Applies to newly established institutions.

For existing ones, it remains at ₱ 100 million.

In other places, it is ₱ 10 million for new institutions and ₱ 5 million for existing ones.

By unibanks; for commercial banks, it remains at zero percent.

CB Circular No. 357 dated January 22, 1973. K = the aggregate ceiling on capital accounts net of recommended valuation reserves. (This refers to net value of capital accounts.)

Source: Central Bank of the Philippines.

Applies to newly established institutions.

For existing ones, it remains at ₱ 100 million.

In other places, it is ₱ 10 million for new institutions and ₱ 5 million for existing ones.

By unibanks; for commercial banks, it remains at zero percent.

CB Circular No. 357 dated January 22, 1973. K = the aggregate ceiling on capital accounts net of recommended valuation reserves. (This refers to net value of capital accounts.)

Table 7.Assets of Financial Institutions, Selected Years, 1970–85
AmountDistribution
19701975198019851970197519801985
(in billions of pesos; end of period)(In percent of total)
Central Bank6.026.065.4251.617.621.220.933.7
Banks19.169.9188.8395.256.057.060.352.4
Commercial14.153.2138.4283.341.343.341.637.6
Of which:
Government(…)(18.1)(34.6)(70.3)(…)(14.8)(11.1)(9.3)
Foreign(—)(—)(18.7)(45.0)(—)(—)(6.0)(6.0)
Thrift1.02.110.615.12.91.73.42.0
Rural0.72.85.68.82.12.31.81.2
Specialized3.311.834.288.09.79.610.911.7
Of which:
DBP(…)(9.6)(28.0)(74.4)(…)(7.8)(8.9)(9.9)
Nonbanks9.026.858.7107.226.421.818.714.2
Total34.1122.7313.1754.0100.0100.0100.0100.0
Source: Central Bank of the Philippines.
Source: Central Bank of the Philippines.

Second, government-owned banks played a central role within the banking system, and the concentration of risks in some of them was a critical factor in the crisis.36 Their share of total bank assets, which averaged about 33 percent between 1970 and 1980, rose to 36 percent by the end of 1985. DBP alone accounted for 29 percent of total bank assets. Their troubles threatened the stability of the banking system and culminated in the major restructuring and rehabilitation of two of the largest state-owned institutions that became insolvent.

Third, significant parts of the banking system were characterized by a bank-holding-company structure. Twelve holding companies had interrelated ownership and interests in private banks and nonfinancial corporations. They controlled commercial or savings banks, investment houses, and insurance companies. Such was the case with the Herdis Group,37 which, between 1979 and 1980, controlled Summa Savings and Mortgage Banks, the Summa Insurance Corporation, the Equipment Credit Corporation, and Interbank and Commercial Bank of Manila.38 Furthermore, most groups had many interlocking directorships within the corporate business sector (see Doherty (1983)).

Table 8.Number of Banking Institutions, Selected Years, 1975–86
Total OfficesHead Offices
19751980198119861975198019811986
Total Banks2,1563,3643,6523,7748921,1711,2221,025
Commercial9961,5031,7321,71633323330
Domestic9961,4991,7281,71633282920
Of which:
Government(2)(2)(10)(10)
Foreign444444
Thrifts125967363166588144140116
Rural8341,0961,1671,2937689851,040877
Specialized
government267921221003332
Concentration ratio
of commercial
banking industry
(in percent)39.9910.0310.00
Sources: Central Bank of the Philippines, Private Development Banks, Annual Report, 1981.Note: For 1975, data reproduced from World Bank (1979).

Includes private development banks, savings banks, and stock savings and loan associations.

Includes DBP, Land Bank, and, starting in 1980, the Philippine Amanah Bank, which operates under Islamic principles.

As measured by the Herfindahl-Hirschman index.

Sources: Central Bank of the Philippines, Private Development Banks, Annual Report, 1981.Note: For 1975, data reproduced from World Bank (1979).

Includes private development banks, savings banks, and stock savings and loan associations.

Includes DBP, Land Bank, and, starting in 1980, the Philippine Amanah Bank, which operates under Islamic principles.

As measured by the Herfindahl-Hirschman index.

The number and size distribution of banks-—the Herfindahl-Hirschman index showed a ratio of only 0.10 as of December 31, 1986—suggest that the degree of concentration was not a problem.39 The previously noted fall in net interest margins between 1980 and 1983 following the deregulation of interest rates also suggests a competitive banking system. The rise in net interest margins between 1984 and 1986 was attributable to tighter monetary policies, high reserve requirements, and an increase in loan losses. Thus, oligopolistic pricing does not seem to have been a factor in interest rate developments. However, the bank-holding-company structure, together with the supervisory weaknesses discussed in the next section, permitted excessive risk taking following deregulation, and this risk taking seems to have helped cause and aggravate the crisis.

Prudential Regulation and Supervision and Related Institutional Practices

Supervisory weaknesses were conducive to loose banking practices, which later led to numerous bank failures. Also, the existence of a deposit insurance scheme did little to prevent or contain the crisis. In the following subsections, the supervisory system that regulates and oversees the conduct of banks’ operations is described, and the role of this system in ensuring the soundness and stability of the financial sector is discussed.

Supervisory Authority

Although CBP exercises supervisory authority over the banking institutions, the ultimate supervisory authority is the Monetary Board (MB), the policymaking body of CBP.40

The Department of Bank Supervision and Examination is the operational arm of CBP for supervision. Supervisory procedures in the Philippines, which include reporting requirements and examination, are regular, comprehensive, and thorough.41 Officers of the Department of Bank Supervision and Examination are responsible for bank examination to assess the soundness of operations and the solvency and liquidity of the bank. Reports of these bank examinations are then transmitted to the MB, which decides what action to take when a bank is found to be in trouble.

When a bank faces protracted liquidity or solvency problems, the MB may appoint a conservator to take charge of the assets, liabilities, and management of the bank in order to protect depositors and other creditors. If the conservator is unable to restore the viability of the bank, the bank is declared insolvent.42 The MB then appoints a receiver to take charge of all assets and liabilities of the bank, and forbids the bank from doing business. Within 60 days, the MB decides whether to liquidate the bank or to reorganize it to permit the resumption of business. In the former case, CBP appoints a liquidator to carry out the decision, provided no court challenges the decision.

The ultimate enforcement resides with the MB, and the closing of a troubled bank is subject to due process, which may take a long time, especially when litigation is brought by owners.

Supervisory Rules

Between 1972 and 1982, CBP also modified the main prudential regulations on commercial banks. Capital requirements, defined as a ratio of net worth to risk assets, were lowered from 15 percent in 1972 to 10 percent in 1973 (see Table 6). After 1980, ratios as low as 6 percent became permissible with the prior approval of the MB. The authorities sought to provide banks with greater leverage to expand their asset portfolios.

CBP relaxed its rules regarding credit accommodation to directors, officers, stockholders, and related interests (DOSRI). In 1973, DOSRI credit had an upper limit equal to a bank’ s total capital account, net of valuation reserves.43 By 1980, this limit had become less restrictive for commercial banks, because the authorities had somewhat relaxed the provisions designed to limit conflicts of interest between a bank and another financial or nonfinancial institution that were linked by interlocking directorate.44 In addition, regulations governing relations between a bank and its subsidiaries were eliminated.

To restrict banks’ risk exposure, the authorities established a single-borrower limit of 15 percent (including loans and equity investment) of the bank’ s net worth; the rule had been in force during the 1970s and is still valid, although exceptions have been made. For example, in 1983, the Government’ s takeover of the Construction and Development Corporation of the Philippines (CDCP) through the PNB violated this limit. After the takeover, PNB’ s total exposure (in equity alone) in CDCP went to 60 percent of its net worth.

In contrast to the trend toward relaxation of prudential regulations, CBP expanded the institutional coverage of bank supervision after 1972 in order to include the nonbank quasi-banks (NBQB). CBP also monitored the nonbank quasi-banks’ issues of commercial paper “with recourse” and regulated its terms, conditions of rollover, physical delivery, and the like.

Loose Lending Practices

As a result of the political climate both before and during the crisis, CBP failed to enforce supervisory rules regarding DOSRI credit, supervision of nonbank quasi-bank activities, and, most important, the treatment of past due loans and their provisioning.

DOSRI Credit. Failure by the MB to enforce the rules reportedly led to substantial bank lending to DOSRI, to the detriment of other legitimate borrowers.45 Inappropriate loans to DOSRI are cited as a major contributor to bank failures over the past decade. In reaction to the 1981 crisis, CBP tightened the regulations on DOSRI credit.46 Bank credit to firms with interlocking directorship/officership was tightened again (reversing the earlier stance), but the restrictions regarding institutional relationships between holding companies and subsidiaries were loosened.

Supervision of Money Market Operations.47 Prior to 1980, regulations governing the functioning of the money market were differentiated by type of participant and type of operation, each type falling under the purview of a different supervisory authority. CBP supervised only banks and nonbank quasi-banks and monitored only transactions on a “with recourse” basis. The Securities and Exchange Commission supervised other participants, while monitoring transactions on a “without recourse” basis. Subsequently, CBP imposed regulations on nonbank quasi-banks. These regulations included the requirement that nonbank quasi-banks hold 20 percent of their liabilities—deposit substitutes—in the form of deposits with the CBP; a ceiling on interest rates of these institutions (the maximum rate paid for borrowing was 17 percent; the rate charged for lending was 18 percent); and a minimum trading lot. Because nonbank financial institutions were not subject to such regulations by the Securities and Exchange Commission, nonbank quasi-banks lost their competitiveness. In response, nonbank quasi-banks started to deal in paper on a “without recourse” basis; this paper was issued mostly by subsidiaries or affiliates of “groups” to which the nonbank quasi-banks belonged. This practice allowed nonbank quasi-banks not only to circumvent CBP regulations and monitoring of their money market activities, but also to help businesses of their “group” to mobilize short-term funds by issuing less-than-prime commercial paper. These unsound lending practices contributed to the collapse of the commercial paper market in 1981.48

Accounting Rules. The 1980 reforms did not cover CBP rules governing the treatment of overdue loans, the provisioning for bad debt, and scrutiny of deposit transactions by CBP examiners. The inadequacies of these rules, which remained unchanged until 1986, played a significant role in the worsening of the financial crisis.

CBP used the following rules for its own assessment of bank conditions: demand loans were considered past due if payment was not received within six months of a written demand. For loans payable in installments, the determining factor was the number of payments in arrears, a number that varied with the repayment schedule of the loan (monthly, quarterly, semiannually, or annually). The threshold for monthly installment loans was ten missed installments. For other loans, the period varied between one and two years. Whenever 20 percent of the outstanding balance of a loan was in arrears, the entire loan was to be considered overdue; once a loan was classified as overdue, interest could no longer be accrued. In practice, however, banks differed considerably in their treatment of overdue loans. Conservatively managed banks generally placed loans on a nonaccrual status more promptly than did the schedule used by CBP, in order to avoid the tax on gross revenues; other banks followed loose practices, especially as they began facing financial distress.

Regarding provisions for bad debt, CBP is empowered by law to establish rules, either generally or in individual cases. CBP has not enforced the rules, however, leaving reserve or provisioning policies to bank managements.49 In the supervisory process, the CBP does compare the reserves established by a bank with those it believes are required on the basis of its own assessment of asset quality. Under the law, banks are allowed to write off bad loans up to ₱ 100,000, but they must have CBP approval before writing off loans above that amount. Requests for writeoff approval concerning DOSRI loans are passed on to the MB; other requests are handled by CBP staff.

Examiners are not allowed to investigate deposit transactions that are protected by strict secrecy rules, unless they are duly authorized by the MB. The MB may permit scrutiny of deposit transactions only if it is satisfied that a bank fraud or serious irregularity has been committed and that it is necessary to look at deposit transactions to determine the facts.

Negligible Role of Philippines Deposit Insurance Company (PDIC). Because of its severe staffing constraints and low capital base, PDIC played no significant role in improving depositors’ confidence in the banking system during the crisis period of the 1980s.50 Despite the capital increase from ₱ 20 million to ₱ 2 billion in 1985, PDIC’ s resources, human and financial, were insufficient.51 As a result, PDIC faced major difficulties in settling the growing claims of insured depositors of failed banks (see Table 9).52 Thus, CBP was compelled to tie up most of its supervisory staff in helping PDIC settle these claims.

Summary

The absence of significant reforms in prudential supervision aggravated the banking crisis. First, the existing rules were not enforced in practice, although the MB was informed promptly of the problem-bank cases. Second, some of the accounting rules themselves were not codified to ensure consistency and transparency. This situation encouraged troubled banks to book accrued interest on nonperforming loans and to distribute the book profits. The main problem with provisioning rules arose after the crisis of 1981. The MB had to decide between forcing banks to provision for bad debt so as to maintain confidence in banking institutions or remaining tolerant on this issue to give troubled banks time to overcome their financial difficulties. The MB took the second option, which accelerated the deterioration of bank finances.

Table 9.PDIC Payments to Insured Depositors of Failed Banks as of June 1987
Deposit

Liabilities
Estimated

Insured

Deposits
Total

Payments
RatioRatio
(1)(2)(3)(3)/(2)(2)/(1)
Commercial banks4,447.31,463.1226.515.532.9
1970–80338.745.245.2100.013.3
1981–874,108.61,417.9181.312.834.5
Savings and mortgage
banks1,015,9815.8771,794.680,3
1970–8016.411.511.5100.070.1
1981–85999.5804.3760.294.580.5
Private development
banks1294.6183.4124.267.762.2
Savings and Loan
Associations11,310.31,083.8740.768.382.7
Total7,068.13,546.11,863.152.550.2
1970–80355.156.756.7100.016.0
1981–876,713.03,489.51,806.451.852.0
Source: Philippine Deposit Insurance Corporation.

Covers the 1981—87 period; figures for the 1970—80 period amount to zero.

Source: Philippine Deposit Insurance Corporation.

Covers the 1981—87 period; figures for the 1970—80 period amount to zero.

II. Manifestations of the Crisis and Its Monetary Effects

The manifestations of the crisis—loss of public trust in the banking system and the spread of financial distress and bank failures—and the monetary effects of the crisis, which complicated the conduct of CBP monetary policy and caused a severe credit crunch, are described in this section.

Loss of Public Trust

During the crisis, financial wealth holders lost trust in the banking system, causing both runs on banks and “flight to quality.”53 The spread of banking distress weakened the public’ s confidence in financial institutions, adding fears about the safety of banks’ deposits.

Surge in Demand for Reserve Money

As noted earlier, the Dewey Dee affair triggered a crisis of confidence that provoked bank runs and capital flight in 1981.54 The bank runs caused an increase in the ratio of currency to narrow money in 1981, which was a sharp reversal of the declining trend in the ratio during the 1970s. Evidence pointed also to capital flight (see Table 10).

The currency ratios continued to increase in 1982 and jumped in 1983; these increased ratios reflected a major erosion of confidence in the banking system. The largest increase occurred in the last quarter of 1983 after the authorities announced, in late September 1983, the suspension of repayments on external debt. Capital flight intensified in 1983 (see Table 10), because the announcement of the moratorium raised concern among foreign creditors and led to the cutoff of suppliers’ credit.

“Flight to Quality”

The 1981 panic also caused a redeployment of funds, mostly to institutions perceived as sound, namely, the commercial banks. As already noted, investors in the commercial paper market switched to bank deposits. Indeed, as shown in Table 11, banks’ deposit accounts increased as a whole by ₱ 1.6 million (from ₱ 21 million in 1980 to ₱ 22.6 million in 1981), but there was also a switch of deposits away from thrift banks. Whereas total bank deposits increased by 11 percent between 1980 and 1981, deposits of thrift banks fell by 9 percent, triggering failures among these institutions.55 In addition, commercial banks gained 3.2 million deposit accounts in 1981—a 32 percent increase over 1980, while thrift and savings banks lost 2.1 million accounts—a decline of about 30 percent over the same period.

Table 10.Selected Financial Ratios and Years, 1970–86
“Financial Deepening”

Ratios
Ratios Measuring Stability

of Banking Sector
M1LM3CpCpK11ΔCp
YearGNPGNPGNPM1LΔDΔD
(In percent at end of period)
197010.321.821.855.826.420.030.0
19759.030.530.546.613.843.911.4
19808.529.929.945.312.931.310.1
19817.728.727.049.413.3-51.67.5
19827.029.728.454.012.7-17.68.8
19838.531.329.860.316.5-46.036.5
19846.426.522.864.915.66.210.5
19856.030.022.367.313.5-33.95.9
19866.933.523.068.814.2-52.919.1
Sources: International Monetary Fund, International Financial Statistics, 1987; Table 2; and IMF staff estimates.

Short-term capital (net), including errors and omissions (these flows represent nonmonetary capital flows); this ratio is used as a rough measure of capital flight (minus sign), including the trade credit squeeze.

Sources: International Monetary Fund, International Financial Statistics, 1987; Table 2; and IMF staff estimates.

Short-term capital (net), including errors and omissions (these flows represent nonmonetary capital flows); this ratio is used as a rough measure of capital flight (minus sign), including the trade credit squeeze.

After 1983, financial investors again redeployed their funds, this time toward safe securities with high yields. Specifically, the public shifted out of deposits and into treasury and central bank bills. The ratio of M3 to total liquidity fell sharply after 1983 (Table 2), owing in part to the sharp increases in interest rates on treasury and central bank bills beginning in 1984. Banks as a group lost a large number of deposit accounts.

Banking Distress

Between 1981 and 1985, financial difficulties of corporate businesses steadily worsened, increasing the distress among banking institutions.56 The limited data on the financial performance of the top 1,000 corporations from 1980 to 1984 showed a sharp increase in debt/equity ratios in 1982, declining profitability from 1981 to 1983 with negative net incomes in 1982 and 1983, and a sizable weakening of the liquidity positions of firms (as measured by the ratio of current assets to current liabilities) between 1980 and 1984 (Appendix Table 2). The sharp increase in the debt/equity ratio and in the indebtedness of the nongovernment sector (Table 3) in 1982 and 1983 when real lending rates were at a peak seems to suggest that distress borrowing was a significant factor. These developments were reflected in the evolution of overdue loans in the banking system. Overdue loans rose from ₱ 12.5 billion (11.5 percent of total loans) in 1980 to ₱ 16.6 billion (13.2 percent) in 1981. The situation deteriorated sharply after 1983, and overdue loans rose to a record high of 19.3 percent in 1986.

Until 1983, the ratio of nonperforming loans to banks’ loan portfolio remained below the critical ratio of 15 percent that is perceived by bankers and the public as a threshold for individual banks’ solvency.57 Between 1981 and 1984, banks’ ratio of capital to outstanding loans remained above banks’ ratio of overdue to outstanding loans. Hence until 1983, banks as a whole appear to have been sufficiently capitalized to provision for bad debt and absorb eventual losses from bad loans. Beginning in 1985, the ratio of capital to outstanding bank loans fell below the ratio of overdue loans, indicating major solvency problems in the banking system. The size of overdue loans was contained in part by the authorities’ rescue of (at least) 123 failing businesses and by the troubled banks’ practice of keeping bad loans current by renegotiating them at maturity.58 In addition, the Government alleviated the banking distress by acquiring six troubled commercial banks between 1981 and 1983.

The authorities’ rescue of distressed banks significantly helped to limit the number of liquidations among commercial banks. By the end of 1986, only three sizable commercial banks had failed. The liquidations occurred mostly among the many small rural and thrift banks.

Between 1981 and 1983, 138 thrift and rural banks failed; this number amounts to 12 percent of all banks existing in 1980 (Table 10). Although these failures did not threaten the stability of the banking system, they tied down CBP supervisory staff. In addition, the Philippines Deposit Insurance Corporation, with its low capital base and inadequate contributions, found it increasingly difficult to settle the growing claims of depositors of the failed banks.

Table 11.Indicators of the Financial Crisis, Selected Years, 1970—87

(In percent)1

197019751980198119821983198419851986June

1987
Number of bank failures26724308726442622
Of which:
Commercial banks(3)(1)(0)(0)(0)(0)(0)(2)(0)(1)
Thrift(…)(…)(0)(4)(2)(1)(16)(6)(0)(3)
Ratio of failed bank assets
to total assets2
Commercial banks1.91.00.00.00.00.00.01.20.04.03
Thrift banks5.20.00.00.40.31.310.835.40.05.04
Rural banks0.30.31.11.20.20.20.41.91.41.0
Ratio of overdue loans to
total outstanding loans16.719.211.513.213.08.912.716.719.3
Of which:
Commercial banks(…)(…)(11.9)(13.1)(11.5)(7.5)(11.0)(15.6)(18.4)(…)
Ratio of capital to
outstanding loans512.113.614.412.516.716.117.7
Number of bank deposit
accounts (in millions)5.321.022.624.925.623.720.219.518.6
Of which:
Commercial banks(…)(…)(10.1)(13.3)(15.1)(15.2)(14.0)(12.6)(12.4)(11.8)
Thrift(…)(3.3)(7.2)(5.1)(5.5)(5.8)(5.0)(3.1)(2.7)(2.5)
Broad money/Total
liquidity100.094.295.695.386.374.368.7
Bank deposits (in billions
of pesos, end of period)27.690.4100.1116.7140.0152.2167.5166.3159.84
Of which:
Commercial banks(…)(20.7)(72.6)(79.3)(93.2)(116.2)(134.5)(143.0)(138.0)(132.1)
Thrift(…)(1.6)(7.9)(7.2)(9.3)(11.2)(7.1)(10.5)(13.0)(13.2)4
Source: Central Bank of the Philippines.

Unless otherwise specified.

For 1970 and 1975, data refer to cumulative amounts between 1970 and 1974 and 1975 and 1979, respectively. Data for the rate of bank failure exclude the five commercial banks in distress which have been acquired by CFIs; they are: Republic Planters’ Bank (1978); International Corporate Bank (1982); Union Bank of the Philippines (1982); Associated Bank (1983); and Philipinas Bank (1979). The numbers in parentheses refer to the year of acquisition by government financial institutions.

September.

June.

Capital defined as “net worth” or unimpaired capital plus free reserves.

Source: Central Bank of the Philippines.

Unless otherwise specified.

For 1970 and 1975, data refer to cumulative amounts between 1970 and 1974 and 1975 and 1979, respectively. Data for the rate of bank failure exclude the five commercial banks in distress which have been acquired by CFIs; they are: Republic Planters’ Bank (1978); International Corporate Bank (1982); Union Bank of the Philippines (1982); Associated Bank (1983); and Philipinas Bank (1979). The numbers in parentheses refer to the year of acquisition by government financial institutions.

September.

June.

Capital defined as “net worth” or unimpaired capital plus free reserves.

Monetary Management During the Crisis

Actions on Supply of Banks’ Reserves

Between 1981 and 1986, CBP had increasing difficulty in achieving its often conflicting objectives of monetary stability, confidence in the banking system, and credit allocation to priority sectors, as both the financial crisis and the recession deepened.

Between 1981 and 1983, CBP gave priority to containing the spread of financial distress and stepping up selective credit policies. As a lender of last resort, CBP intervened appropriately by providing emergency credit during 1981 and by absorbing excess liquidity as the crisis abated in 1982 (see Table 12). Meanwhile, CBP increased concessional rediscount credit to financial institutions. In the aftermath of the banking panics of 1983 CBP also replenished the banks’ loss of deposits and began to realize exchange losses on swap operations; as a result of these developments, reserve money jumped 48 percent between the end of 1982 and the end of 1983.

Between 1984 and 1986, to offset the expansionary effects on reserve money of the earlier policies and to restore monetary stability, the CBP absorbed huge amounts of liquidity from financial institutions through massive sales of its own securities and tighter access to rediscount facilities.59 However, the effect of these actions was mitigated by the huge financing of the public sector deficit in 1984, following the drastic cutback in foreign financing of these deficits.60 This policy stance caused inflation to jump from 12 percent in 1983 to 50 percent in 1984, and led to a crowding out of the private sector. Between 1985 and 1986, CBP finally brought inflation under control by maintaining a tight policy.

CBP continued to provide extensive emergency assistance between 1984 and 1985, reacting essentially to financial distress rather than to panics as in earlier years. To prevent failures of financially distressed firms, CBP, through the decisions of the MB, adopted a remedial rather than punitive approach. This approach, however, led to a trade-off between short-run stability and long-run cost effectiveness of rescue operations.

The long negotiations over corrective actions to rehabilitate troubled institutions may have prolonged the public’ s perception of uncertainty and raised the ultimate cost of rescue operations. Also, CBP’ s attempt to seek additional capital and merger partners for troubled banks proved difficult between 1983 and 1986, when all domestic hanks faced financial difficulties. As the MB was deliberating the appropriate disposition of problem institutions, CBP continued to extend emergency loans, overdrafts, and equity lending to prevent a collapse of the banking system. This policy, combined with the Government’ s massive issuance of treasury bills to finance its budget deficit, had expansionary effects on total liquidity after 1983 despite the decline in the money multiplier (see Charts 4 and 5).

Table 12.Descriptive Statistics for Reserve Money and CBP Credit During the Crisis, 1981 (I)-1986(IV)
1981(I)-1986(IV)198l(I)-1983(III)1983(IV)-1986(IV)
MeanCoefficient1

of variation
MeanCoefficient

of variation
MeanCoefficient

of variation
Money and credit aggregates(In billions of pesos, unless otherwise specified)
Reserve money25.840.616.19.634.120.4
Net domestic credit15.870.323.311.49.5123.0
To: Public sector12.542.78.013.016.327.4
Of which:
Government(11.7)(32.8)(8.8)(16.1)(14.2)24.4
financial institutions3.3460.315.217.3-6.8-203.2
Of which:
Assistance7.672.52.730.011.735.9
Rediscounting10.330.512.130.08.818.4
Open market operations-14.6-127.10.31,690.4-27.358.2
Selected ratios(In percent of reserve money)
Net domestic credit84.678.2145.915.232.940.6
To: Public sector49.218.150.011.148.523.0
Financial institutions35.4184.495.821.6-15.7-260.3
Source: IMF staff calculations.

Defined as the ratio (in percent, between the standard deviation (σ) and the mean (X).

Source: IMF staff calculations.

Defined as the ratio (in percent, between the standard deviation (σ) and the mean (X).

Complications from Portfolio Shifts

Empirical results showed that the estimated demand for real M3 shifted downward in 1983(III) because investors shifted from deposit substitutes into treasury and central bank bills; as a result, M3 became an unreliable indicator of monetary policy.61 CBP’ s overestimation of actual M3 contributed to the loose monetary policy and skyrocketing inflation observed until late 1984.

CBP then reversed its stance to bring inflation under control and began targeting reserve money. CBP tightened the supply of bank reserves through massive sales of central bank bills, but the surge in the demand for reserve money (partly reflecting the currency flight) probably led to excessive tightening and thereby caused the steep increases in nominal interest rates from late 1985 to the middle of 1986. Large increases in domestic government borrowing added upward pressure on nominal interest rates, and contributed to crowding out the private sector. Such increases, which occurred despite the tightening of fiscal policy, stemmed from the drying up of foreign financing after the announcement of the moratorium.

Credit Crunch

After 1981, declining economic growth compounded the negative effect of rising interest rates on the demand for real credit, particularly in the private sector. The increase in overdue loans, many of which were renegotiated between 1984 and 1986, mitigated the sharp decline in this demand. Indeed, with private investment (in percent of GNP) plummeting in 1981 and debts being liquidated, demand for new investment loans by the private sector nearly came to a halt.

Nonetheless, banks apparently curtailed the supply of real credit to the private sector by more than the drop in demand, thereby resorting to credit rationing as the crisis deepened. Between 1983 and the end of September I986, real credit to the private sector fell a staggering 53 percent, and cumulative output fell by 9 percent. Consistent with their prudent lending policy, the uncertain economic outlook, and the chronic shortage of reserves, banks may have preferred to stop lending rather than to charge higher interest rates. Furthermore, banks found investing their liquidity in public securities (of treasury bills and central bank bills) more attractive than lending, for safety reasons. Banks’ holdings of public securities rose sharply during the crisis, particularly between 1984 and 1986.62 Banks’ shift of funds to the public sector crowded out the private sector. Therefore, the banks’ actions seem to have exacerbated the shortage of funds in the credit market and worsened the recession.

Chart 4.Movements of Seasonally Adjusted Aggregates, 1981(I)-1986(III)

Sources: International Monetary Fund, International Financial Statistics.

1 Deflated by consumer price index in Manila (end of period).

Chart 5.Evolution of Selected Monetary Ratios, 1981 (I)-1986(III)

(In percent; end of period)

Source: International Monetary Fund, International Financial Statistics Year Book, 1989.

III. Measures to Deal with the Crisis

Measures to deal with the crisis included, in addition to emergency assistance and some liquidations, recapitalization through government funds, financial assistance to nonfinancial corporations, takeover of weak financial and nonfinancial firms by government financial institutions, and eventually a massive restructuring of some of the government financial institutions themselves.

Financial Assistance to Troubled Entities

During the 1981-86 crisis period, CBP and the Government provided massive financial assistance to troubled entities under various schemes.

Schemes

When the 1981 crisis broke out, the CBP lender-of-last-resort facility did not cover quasi-banks. To enable these quasi-banks to meet the demand for withdrawal of funds, CBP provided emergency loans through a special rediscount facility.63 However, the primary issuers of commercial papers, mostly corporate businesses, continued to face liquidity problems and failed to honor their obligations as they came due. At that point, quasi-banks were the major holders of this paper.

CBP then set up the Industrial Fund with resources from CBP and the national government budget. Through the GFIs and unibanks, the Industrial Fund, in turn, lent these funds to troubled corporations, which then settled their obligations to the quasi-banks.64 The latter, in turn, repaid the CBP emergency loans. This scheme amounted to a conversion of short-term emergency loans extended through the special rediscount window into long-term CBP lending through the Industrial Fund.

In early 1982, the Industrial Fund was replaced by a CBP special rediscount window, through which CBP extended medium- and long-term loans to universal banks, including PNB and DBP, to allow them to finance their acquisition of and merger with troubled entities (see Lamberte (1985)). That same year, CBP began to provide emergency loans and overdrafts to financial institutions facing unexpected liquidity shortages.

Similarly, the Government provided emergency lending and equity contributions to nonfinancial public corporations (mostly from 1981 to the middle of 1983) and to the government financial institutions (mostly from 1983 to 1985). The Government channeled its financial assistance directly through the capital budget, which recorded large deficits. Direct financial assistance to distressed public sector firms in 1981 and 1982 was aimed both at financing their operating deficits and at stepping up public investment to offset the decline in private investment after 1981. Assistance to government financial institutions, beginning in 1983, was aimed mostly at financing their acquisition and merger of distressed entities, and facilitated the conversion of debt owed to government financial institutions into equity. The Government provided both loans and equity funds to government financial institutions, thus allowing these institutions to absorb the loan losses and to assist distressed corporations by converting the bad loans provided to these corporations into equity. Because no dividends were expected from these corporations for a long time, this operation amounted to forgoing interest payments. In fact, the PNB lost an estimated ₱ 400 million in annual interest payments from the Construction Development Corporation of the Philippines as a result of such debt/equity conversion.

Government financial institutions took over large businesses that were virtually bankrupt, including the largest conglomerates that had been hit severely by the 1981 crisis. To illustrate, the National Industrial Development Corporation—a government financial institution and subsidiary of PNB—took over 9 corporations of the Construction and Development Corporation of the Philippines (CDCP) and 15 corporations of the Herdis Group; DBP and PNB took over 87 other CDCP corporations and 14 Herdis corporations.65 The Social Security System (SSS), which had put 24 percent of its investment portfolio into the hotel sector during the 1970s, took over 9 hotels.

Volume

Between 1981 and 1985, the volume of financial assistance that the authorities granted to troubled entities mirrored the intensity of the crisis over its three phases. This volume more than doubled during the 1981 episode, continued to rise in 1982, and doubled again between 1983 and 1984 (Table 13). In addition, the role played by CBP and the Government, as well as the destination of their financial assistance, differed over these phases. During 1981 and in the period from late 1983 to 1985, both the CBP and the Government provided massive financial assistance to financial corporations. In 1982 and 1983, however, the Government provided the bulk of financial assistance, mostly to public corporations (financial and nonfinancial).

As the crisis progressed, the main recipients of government financial assistance shifted gradually from nonfinancial to financial public corporations. Until 1982, the Government provided assistance to troubled nonfinancial firms in part to maintain overall domestic investment, and in part to finance takeovers and acquisition of distressed and bankrupt corporations by government financial institutions. Beginning in 1983, the Government curtailed public investment to reduce budget deficits. As a result, financial assistance to nonfinancial corporations declined somewhat; but assistance to financial corporations accelerated.

Over the whole crisis period, the Government’ s financial assistance to troubled entities, which rose from 13.6 percent of all government expenditure in 1980 to 20.1 percent in 1985, aggravated the Government’ s own position.

Terms of CBP Financial Assistance

The terms of the CBP financial assistance rapidly shifted from penalty rates to subsidized rates. In 1981, for emergency loans and overdrafts of 60 days, CBP applied a rate of interest of 24 percent, plus 2 percent for each rollover of outstanding amount. Compared with the market rate of 16 percent charged by banks on short-term borrowing, this amounted to a heavy penalty rate. Moreover, CBP extended emergency loans against any collateral that troubled institutions could submit, even collateral previously unacceptable to CBP. With the establishment of the Industrial Fund in the middle of 1981, however, CBP provided an implicit interest subsidy. On the medium- and long-term resources provided by that fund, CBP charged an interest rate of 16 percent, compared with the long-term market rate of 21.6 percent.

Table 13.Authorities’ Financial Assistance Flows to Distressed Corporations, 1980—95
198019811982198319841985
(in millions of pesos)
To financial corporations2773,0541,5742,07714,28913,549
From Central Bank
Emergency loans/overdraft
facilities11202,4241631,9005,9002,800
From Government
Emergency lending and
equity contribution21576301,4081778,38910,749
To nonfinancial corporations5,0408,38010,1787,9555,6415,328
From Government
Equity contribution and
net lending5,0408,38010,1787,9555,6415,328
Total (1) + (2)5,31711,43411,75210,03220,23018,877
Memorandum items(in percent)
Central Bank assistance/reserve
money at end of previous period0.813.60.89.620.38.0
Government assistance/total
government expenditures13.618.722.015.321.020.1
Flow of government assistance/
budget deficit31.517.9-46.760.218.3
Government equity contribution
(in percent of GNP)2.02.72.81.51.82.4
Sources: International Monetary Fund, International Financial Statistics, 1988; data provided by the authorities; and IMF staff estimates.

These figures represent changes from end of period stock. They exclude ₱ 700 million of promissory notes of Union Bank’ s borrowers such as the Rancom Corporation, and ₱ 2.8 billion of National Investment and Development Corporation promissory notes accepted as payments to clear emergency loans of Intercom (financed from the rediscount window). The figure for 1980 refers to commercial banks only.

To government financial institutions only, financed from the budget.

Sources: International Monetary Fund, International Financial Statistics, 1988; data provided by the authorities; and IMF staff estimates.

These figures represent changes from end of period stock. They exclude ₱ 700 million of promissory notes of Union Bank’ s borrowers such as the Rancom Corporation, and ₱ 2.8 billion of National Investment and Development Corporation promissory notes accepted as payments to clear emergency loans of Intercom (financed from the rediscount window). The figure for 1980 refers to commercial banks only.

To government financial institutions only, financed from the budget.

Between 1983 and 1985, CBP continued to accept less than first-rate collateral for its emergency loans. Furthermore, between 1984 and 1985, CBP provided interest rate subsidies on emergency loans and overdrafts as well as on medium- and long-term equity loans provided through the special rediscount window. For instance, on short-term loans of 180-day maturity CBP charged an interest rate of 27 percent (MRR plus 2 percent, see Table 14), which was lower than the comparable treasury bill rates.66 Similarly, on medium- and long-term equity loans to finance mergers and acquisitions, CBP charged 11 percent, which was well below market rates.

Disposition of Private Banks in Distress

During the crisis, the authorities arranged for government financial institutions to take over four private commercial banks with ₱ 13.5 billion in assets in order to work out appropriate rehabilitation and decide on eventual disposition. If the two banks acquired in the late 1970s prior to the crisis are included, the Government owned, by the end of 1986, six formerly private banks with ₱ 20.3 billion in assets (12.7 percent of the total assets of the private banking sector).67 The rehabilitation scheme for these banks consisted of an initial capital infusion from the government financial institution that took over each bank, placement of a central bank comptroller (if warranted) to work out restructuring, continued central bank financial assistance where needed, and arrangement of new private sector partners for mergers or acquisitions (sometimes on a “clean balance-sheet basis”).68

The eventual disposition of these banks has varied with the depth of their problems and the complexity of the litigation that followed. As of 1988, two banks had been successfully rehabilitated and were about to be reprivatized. Two others have been declared insolvent; one of these has been closed, but lawsuits by the owners have delayed liquidation of the other.69 The fate of the other two banks remained undecided. The authorities intended to divest themselves and reprivatize all government-acquired banks. Change in ownership and management of these troubled banks was not always required. In one case, old stockholders were even allowed to maintain their equity position.

Table 14.Terms of financial Assistance to Distressed Corporations, 1982–85
FacilityDateCircular

No.
Rediscount

Credit (in percent

of bank loan)
Rediscount

Rate

(in percent)
Maturity
Special rediscounting
Medium-and long-term1Feb. 1982846
For acquisition
of fixed assets751110 years or less (nonrenewable)
For investment
in affiliates70147 years or less (nonrenewable)
Lender of last resortMar. 1982864.907802
Commercial bankMRR3 + 2 percent min.90 days
Thrift bankMRR + 2 percent min.90 days
NGBGs24 percent for loans of ₱ 150-

300 million + 2 percent

for each rollover
60 days
Emergency rediscountingDec. 1982Section 90

RA 265/907
16 percent or MRR + 3 percent (whichever is higher)90 days
Dec. 1983MRR + 2 percent180 days
Dec. 1985TB4 + 2 percent90 days
Source: International Monetary Fund.

Medium - and long-term; also covers lending for working capital in connection with a proposed or ongoing expansion development program, and investment in high-grade securities.

Or as may be provided for under a Monetary Board resolution.

MRR = Manila Reference Rate.

TB = treasury bill.

Source: International Monetary Fund.

Medium - and long-term; also covers lending for working capital in connection with a proposed or ongoing expansion development program, and investment in high-grade securities.

Or as may be provided for under a Monetary Board resolution.

MRR = Manila Reference Rate.

TB = treasury bill.

Rehabilitation/Restructuring of DBP and PNB

By the end of 1985, DBP and PNB, which together accounted for nearly one half of banking assets in the country, were recognized as insolvent. Their asset portfolios had deteriorated beyond repair; about 80 percent of the combined portfolio was regarded as nonperforming. This deterioration reflected the politically motivated loans these institutions had granted during the 1970s and early 1980s, plus their poor internal controls, auditing, and lending standards; their takeover of troubled corporations; the economic recession; and the massive devaluation of the peso.70 The rehabilitation and restructuring of the two institutions began in November 1986.

The Rehabilitation Program71

The program of rehabilitating DBP and PNB included a restructuring of the finances, the establishment of new charters, the reorganization of staff and management, the setting up of new credit appraisal procedures, the introduction of improved budgeting and planning processes, and a rationalization of branch networks.

Following an external audit to re-evaluate the assets and liabilities of the two banks, most of their nonperforming assets72 were transferred to the Assets Privatization Trust (APT) and others were written off. (APT, which was set up to facilitate the administration and disposition of non-performing assets of government banks, mainly DBP and PNB, is discussed in the next subsection.) The Government recapitalized the banks and assumed the deposit liabilities equal in amount to the book value of nonperforming assets transferred minus the capital infusion. Government deposits constituted a large part of these deposit liabilities. The liabilities taken over by the Government, net of the Government’ s own deposits, became part of public debt.

The bailout operation involved the transfer of ₱ 107.5 billion of assets to APT, equivalent to 27.2 percent of the total assets of the banking system at the end of 1985 (see Table 15).73 PNB accounted for ₱ 47 billion, of which ₱ 6 billion worth of nonperforming assets came from its subsidiary, the National Investment Development Corporation, which was also heavily involved in the rescue of failing businesses, DBP accounted for the remaining ₱ 60.5 billion. As a result, the balance sheets of these two government financial institutions were scaled down sharply. Total assets of PNB declined from ₱ 79 billion in 1985 to ₱ 26 billion in 1986, while total assets of DBP went from ₱ 74 billion to ₱ 11 billion.

Table 15.Financial Restructuring of GFIs, June 1986(In billions of pesos)
DBP1PNB2Total
June

1986
Adjust

ment
TransferRemainingJune

1986
Adjust

ment
TransferRemainingJune

1986
Adjust

ment
TransferRemaining
Total assets73.92.860.410.778.56.047.025.5152.48.8107.436.2
Of which:
Loans39.30.033.36.038.11.523.413.277.41.556.719.2
Equity investment
and other bonds6.70.05.90.87.00.02.34.713.70.08.25.5
Total liabilities and
net worth73.92.860.410.778.56.047.025.5152.46.8107.436.2
Of which:
Peso deposits7.91.45.031.519.60.06.213.427.51.411.214.9
Borrowing52.60.049.63.039.40.038.31.192.00.087.94.1
Of which.
Foreign exchange(35.2)(0.0)(35.2)(0.0)(22.3)(0.0)(21.9)(0.4)(57.5)(0.0)(57.1)(0.4)
Capital1.60.20.62.50.036.298.452.51.636.499.055.0
Contingent421.50.021.30.225.40.016.78.746.90.038.08.9
Source: Data provided by the Central Bank of the Philippines.

Adjustments and transfers are subtracted from outstanding stock as of June 1986; adjustments for the DBP are before transfers.

Includes the operations of the subsidiary, NIDC; adjustments are made after transfers.

All government deposits.

Includes outstanding and unavailed guarantees.

Source: Data provided by the Central Bank of the Philippines.

Adjustments and transfers are subtracted from outstanding stock as of June 1986; adjustments for the DBP are before transfers.

Includes the operations of the subsidiary, NIDC; adjustments are made after transfers.

All government deposits.

Includes outstanding and unavailed guarantees.

Second, new management was introduced into both banks, and staffs were reorganized. The size of each staff was reduced over time. DBP staff was reduced from 4,147 employees in July 1985 to 1,981 employees by the end of October 1987; PNB staff was reduced from 6,500 to 4,700. The number of branches and the size of each head office also were reduced.

The rehabilitation plan established new charters for the two banks. DBP was given the status of a thrift bank and hence will be subject to normal central bank regulations governing thrift banks.74 At first it will concentrate on lending for agriculture, small- and medium-scale industry, and housing. Expanded lending in other areas—including wholesale rather than retail lending—was to be permitted only after a three-year rehabilitation period (1987-89). PNB will continue to operate as a universal bank, but without access to special privileges or funds, and it will continue to serve as the principal banker for the Government and public enterprises, but within the rules prescribed for public deposits. After a two-year period of successful operations, PNB will be privatized through public offering of stock.

The Handling of Nonperforming Assets Through APT

As already mentioned, APT is a government entity set up to administer and dispose of the nonperforming assets and government corporations transferred to it.75 It has a paid-up capital of ₱ 100 million, a five-man Board of Trustees appointed by the President of the Philippines, and an expected life span of five years.76 The Government contributed the entire capital of APT.

Banks were allowed to transfer any nonperforming account with a value in excess of ₱ 10 million as well as smaller loans they had made with a government guarantee. Transfers were effected at book value. In accordance with these criteria, legal titles on some 400 nonperforming accounts were transferred to APT in 1986 and 1987; about 75 percent of these are financial claims requiring foreclosure procedures that are expected to be long and costly. The remaining assets over which APT has physical control were being disposed of expeditiously.

APT was to dispose of transferred assets according to a given set of principles and disposition mechanisms, including the following:

  • Sales were to be open to qualified buyers through competitive bidding or auction arrangements.
  • Rehabilitation prior to disposal was to be undertaken only in exceptional cases, when it would lead to a justifiable increase in the assets’ salability and price.
  • As a general rule, nonperforming accounts were not to be returned to their original owners.
  • In the case of deferred payment, terms were to be consistent among the various individual transactions.

APT could sell the transferred assets either directly or indirectly through the use of agents or brokers. The price and terms of settlement of the sale were to be decided on a case-by-case basis, upon approval by the Board of Trustees. Revenues from APT sales of nonperforming assets were to be transferred to the government budget as capital revenues.

Both DBP and PNB selected members of their staff to participate on loan-workout task forces and charged them with managing the nonperforming assets transferred to APT: preparing the assets for sale/recovery, preparing legal documentation preliminary to the sale or seizure of collateral, and so on.77 A management contract was signed under which APT reimburses all expenses related to handling of these nonperforming assets by the task forces, including salaries of task force staff. This effective transfer of staff was done to ensure that the bank was protected from political influence during the recovery process. For nonperforming accounts retained in DBP and PNB (i.e., less than ₱ 10 million in value per account), additional task forces went to work to manage loan recovery, and loan recovery rates are reported to be satisfactory.

IV. Main Findings

The paper has analyzed the causes of the Philippine financial crisis and the authorities’ reactions to the crisis. The Philippine crisis followed a boom-bust phenomenon typical of those analyzed in crisis literature. After experiencing tremendous growth in the 1970s, both the real sector of the economy and the financial sector experienced a major contraction in the 1980s. The main conclusion of this paper is that factors within the financial system were instrumental in provoking and exacerbating the crisis, and thus, a key transmission mechanism of the crisis ran from the financial sector to the real sector of the economy. This feedback from the financial to the real sector constituted the main focus of the paper.

Although the deteriorating economy, the political climate, and the balance of payments crisis increased the financial fragility of corporate and noncorporate institutions, three phenomena originating inside the financial system provoked the crisis and exacerbated its impact on the real sector. First, improper sequencing of financial sector reforms in a period of macroeconomic and political shocks led to widespread loose lending practices, fraud, and mismanagement by numerous banks. In particular, the financial reforms neglected to tighten bank supervision as regulatory restrictions were dismantled in some areas (activity regulations, interest rate setting) and even kept in other areas (e.g., selective credit).

Second, the limited competition in loan markets (reflecting in part the domination by bank holding companies) played a key role, although competition in deposit markets (reflecting low concentration in the banking industry as a whole) was strong. Before the crisis, the bank holding company structure allowed banks that belonged to these holding companies to engage in excessive risk taking with newly created and inexperienced subsidiaries. Many of these subsidiaries would be hit by the limited crisis of 1981, causing the entire holding group to collapse. During the crisis, this structure contributed to the upward pressure on nominal lending rates. Statistical evidence suggests that, faced with mounting overdue loans, banks passed along to customers the cost of carrying overdue loans. Thus poor quality of the banks’ own portfolios contributed to higher interest rates and exacerbated the effects of tight monetary policies.

Third, sharp portfolio shifts in the banking and nonbanking sectors appear to have complicated monetary and fiscal management, and contributed to crowding out the private sector. After 1983, monetary management based on indirect instruments not only became vulnerable to prediction errors and M3 was no longer a reliable intermediate target, but also faced conflicting objectives during a crisis—namely, maintaining monetary stability while preventing the collapse of the banking system. Also, despite a tighter stance and a reduction of the budgetary deficit (in percent of GNP) after 1983, the fiscal authorities had to step up domestic borrowing because foreign financing had dried up. These demand management policies, in turn, caused interest rates to skyrocket and reduced sharply-domestic funds available to the private sector, thereby worsening the recession.

Banks’ behavior also contributed to the recession as widespread uncertainty in the economic outlook and attractive rates on central bank and government securities led banks to ration private sector credit during the crisis and to allocate investible funds into safe outlets. However, this issue requires further empirical scrutiny.

In reaction, CBP and the Government took financial assistance measures to contain the crisis and long-term restructuring measures to restore the soundness of the financial system. The various support measures to deal with problem banks helped to contain the crisis during the difficult macroeconomic environment which existed between 1983 and 1986, and the Government eventually had to assume the large accumulated losses. The institutional solutions in this regard—the specific recapitalization and restructuring of the banking system and the method of disposition of problem assets—seem comprehensive and well conceived; their effectiveness in terms of minimizing future problems remains to be assessed.

APPENDIX
Appendix Table 1.Estimation of the Determinants of Banks’ Interest Margins, 1981 (IV)-1986(IV)(Annual percentages)
Dependent

Variable

(iL-iD
Independent VariablesSummary Statistics
ConstantInflationHerfindahl

Hirschman

index1
Overdue1 loansAdjustedDurbin

Watson

statistic
Equation I5.950.07-0.400.190.201.14
(0.38)(1.77)(-0.29)(1.13)
Equation II0.140.060.220.231.17
(0.82)(2.54)(1.89)
Note: (iL - iD) = gross interest margin on short-term bank rates.

Annual data were divided by four and repeated for each quarter.

Note: (iL - iD) = gross interest margin on short-term bank rates.

Annual data were divided by four and repeated for each quarter.

Appendix Table 2.Indicators of Activity and Financial Performance of 1,000 Top Industrial Corporations, 1980—84
19601981198219831984
Total assets (TA)116.5130.0184.8251.5284.2
Current assets (CA)58.962.769.582.196.8
Fixed assets (FA)47.353.896.3136.1160.4
Other assets (OA)10.313.519.033.327.0
Total liabilities (TL)77.689.3126.1178.9209.4
Current liabilities (CL)50.757.467.883.896.7
Long-term liabilities (LL)26.931.958.395.1112.7
Equity (E)38.759.240.772.675.0
Net income (IN)0.2-1.7-2.02.6
Gross revenue (R)119.2140.9167.9230.0
Sales114.6137.2163.5223.5
(In percent)
Selected financial ratios
Leverage
TL/E2.11.53.12.52.8
Activity
S/CA182.8197.4199.1230.9
S/TA88.174.265.078.6
Profitability
IN/E0.2-4.2-2.73.5
IN/TA0.1-0.9-0.80.9
Liquidity
CA/CI116.2109.3108.588.9100.1
Source: Business Day (1981–84).Note: The 1,000 top industrial corporations consist of the largest corporations in construction; electricity, gas, and water; manufacturing; and mining and quarrying sectors.
Source: Business Day (1981–84).Note: The 1,000 top industrial corporations consist of the largest corporations in construction; electricity, gas, and water; manufacturing; and mining and quarrying sectors.
Appendix Table 3.Evolution of Nongovernment Sector Debt in Nominal Terms by Borrowers and Origin; Selected Years, 1972–85(In billions of pesos at current prices; end of period)
19721978198019811982198319841985
Nongovernment1
Total30.1179.7246.7293.2356.7471.6603.5540.5
Domestic27.1104.4150.3153.6196.5214.4233.3200.1
Foreign3.075.396.4121.8160.2257.2370.2322.8
Enterprises2
Total8.790.8117.4141.8170.2248.7328.3277.1
Domestic8.733.249.853.558.061.951.933.7
Foreign57.767.688.3112.2186.8276.4243.4
Commercial banks
Total18.076.5113.7133.6166.7200.1249.3245.8
Domestic15.058.964.9100.1118.7129.7155.5166.4
Foreign3.317.628.633.548.070.493.879.4
Individuals
Total3.412.415.617.819.822.825.917.6
Memorandum items:
Enterprises’ foreign debt3(In billions of U.S. dollars)
Total7.88.910.812.413.414.012.8
Of which:
Short-term(—)1.4(2.5)(3.7)(4.0)(4.0)(4.2)(3.0)
(In billions of pesos)
Net national income445.8157.5211.0243.2270.4302.4426.2468.8
Sources: Central Bank of the Philippines, Annual Report, 1983; Philippines financial Statistics, 1964-86; and International Monetary Fund.

Sum of debt contracted by enterprises, commercial banks, and individuals.

Composed of business corporations [private and public), single proprietorships, partnerships and associations, and cooperatives. More than 80 percent of the debt was attributed to corporations.

Contracted in local currency from domestic commercial banks. The debt contracted in local currency but re-lent by the Central Bank of the Philippines or commercial banks (including the DBPj is netted out. Such debt is included in the foreign currency debt because, as ultimate borrowers, these firms assumed the exchange risk.

Includes foreign debt re-lent to enterprises.

Sources: Central Bank of the Philippines, Annual Report, 1983; Philippines financial Statistics, 1964-86; and International Monetary Fund.

Sum of debt contracted by enterprises, commercial banks, and individuals.

Composed of business corporations [private and public), single proprietorships, partnerships and associations, and cooperatives. More than 80 percent of the debt was attributed to corporations.

Contracted in local currency from domestic commercial banks. The debt contracted in local currency but re-lent by the Central Bank of the Philippines or commercial banks (including the DBPj is netted out. Such debt is included in the foreign currency debt because, as ultimate borrowers, these firms assumed the exchange risk.

Includes foreign debt re-lent to enterprises.

Bibliography

    BuhatV.“Trends in Peso Deposits and Secured Loans of Commercial Banks (1981–1985),”CB ReviewVol.38No. 6 (June1986).

    BuhatV.“Movements in the Manila Reference Rates and Lending Rates of Commercial Banks (1982–1986),”CB ReviewVol.39No. 2 (February1987).

    • Search Google Scholar
    • Export Citation

    Business Day“1,000 Top Corporations in the Philippines” (in cooperation with the Securities and Exchange Commission) Vol.15 (1982); and Vol. 17 (1984).

    • Search Google Scholar
    • Export Citation

    CapieF. and E.G. Woodseds.Financial Crisis and the World Banking System (New York: St. Martin’ s Press1986).

    Central Bank of the PhilippinesStatistical Bulletin1982.

    Central Bank of the PhilippinesBanking Laws (Manila: Central the philippine1983).

    Central Bank of the Philippines“Governar’ s Report,”CB Reviewvol.40(February1988).

    Central Bank of the Philippines“The philippines External Debt monitoring system,”CB ReviewVol.41 (January1989).

    Central Bank of the PhilippinesPhilippines Financial Statistics1982–85.

    Central Bank of the Philippines“Rationale and Expanded Dimensions of Universal Banking in the Philippines,”Bondiine(April-June1980) (Manila: Central Bank of the philippines).

    • Search Google Scholar
    • Export Citation

    DeDiosEmmanuelS.An Analysis of the Philippine Economic Crisis (Manila: University of the Philippines Press1984).

    DohertyJohnF.“Who Controls the Philippine Economy: Some Need Not Try as Hard as Others,”in Cronies and Enemies: The Current Philippine Sceneed.BelindaA.AquinoPhilippine Studies Occasional Paper No. 5 (Honolulu: Center for Asian and Pacific Studies, University of HawaiiAugust1983) pp. 735.

    • Search Google Scholar
    • Export Citation

    EdwardsS. and M.Khan“Interest Rate Determination in Developing Countries,”Staff Papers International Monetary FundVol.32 (September1985).

    • Search Google Scholar
    • Export Citation

    FryM.Money Interest and Banking in Economic Development (Baltimore: Johns Hopkins University Press1988).

    Golds boroughD. and I.Zaidi“Monetary Policy in the Philippines During the Period of the Financial Crisis and Changes in the Exchange Rate Regime,”IMF Working Paper WP/89/98 (December1989).

    • Search Google Scholar
    • Export Citation

    International Monetary FundInternational Financial Statistics Yearbook1988.

    LamberteMarioB.“Financial Liberalization: What Have We Learned?”journal of Philippine DevelopmentVol.12No. 2 (1985).

    LayaJaimeC.A Crisis of Confidence (Manila: Central Bank of the Philippines1982).

    LayaJaimeC.Gearing Toward Recovery (Manila: Central Bank of the Philippines1983).

    LicarosG.S.“Regulations in the Financial System,”BondlineVol.23No. 3 (Manila: Central Bank of the Philippines) 1979).

    LirioRicardoP.“The Philippine Banking Industry: A Historical Perspective,”BondlineVol.24 (April-June1985) (Manila: Central Bank of the Philippines) pp. 413.

    • Search Google Scholar
    • Export Citation

    LontocFranciscoL. “A lime of Crisis and Reform,”BondlineVol.20 (November1981) (Manila: Central Bank of the Philippines) pp. 713.

    • Search Google Scholar
    • Export Citation

    McKinnonR.I.Money and Capital in Economic Development (Washington: The Brookings Institution1973).

    PaulinoH.“Government Securities: A Review of 1985 Performance,”CB ReviewVol.38 (January1986).

    RobledoCatalinaT.“Deficit Financing of Government Corporations, 1973–83,”Central Bank Review (May1984) (Manila: Central Bank of the Philippines) pp. 1215.

    • Search Google Scholar
    • Export Citation

    SaldanaCesarG.“The Philippine Commercial Banking System: Structure, Performance, and the Impact of the Capital Buildup Program of 1972,”Philippine Review of Economics and BusinessVols. 3 and 4 (1984) pp. 14564.

    • Search Google Scholar
    • Export Citation

    ShawE.Financial Deepening in Economic Development (London: Oxford University Press1973).

    SicatGerardoP.“A Historical and Current Perspective of the Philippine Economic Problems,”Philippine Economic journalVol.24No. 1 (1985).

    • Search Google Scholar
    • Export Citation

    SycipGorresVelayo and Co.“A Study of Commercial Banks in te Philippines”(Manila: Sycip and Others Publication Unit, various issues: December1972 1978 1983 and 1986).

    • Search Google Scholar
    • Export Citation

    TeodoroProcesaL.“Non-Bank Financial Intermediaries—A Decade of Performance,”Central Bank Review (September1985) (Manila: Central Bank of the Philippines) pp. 1620.

    • Search Google Scholar
    • Export Citation
1This event was known as the Dewev Dee Affair. In January 1981, Dewey Dee, an industrial magnate who had borrowed heavily in the commercial paper market, fled the country, leaving behind an estimated ₱ 500-800 million of debt. The news sent a wave of pan/italicic through money market investors and small depositors. The former did not renew their funding, causing commercial paper borrowers to default on a large scale. The small depositors shifted their deposits to large commercial banks, perceived as sounder financial institutions.
2Government financial institutions include the Development Bank of the Philippines (DBP), the Philippines National Bank(PNB), the Land Bank of the Philippines (LBP), the Government Service Insurance System (GSIS), and the Social Security System (SSS).
3Some of these deficiencies are discussed in Central Bank of the Philippines (1988, p. 6; and 1989, p. 15).
4This agency was set up in December 1986 to take over the nonperforming assets of state banks and to resell them to private investors. In 1986, the value of these assets was estimated at ₱ 20 billion (i.e., 19 percent of their book value).
5The fate of one insolvent commercial bank remained undecided as of the end of 1987 because of litigation contesting the liquidation.
6In line with this strategy, the authorities carried out in ward-looking and expansionary macroeconomic policies during the 1970s, namely, protectionist trade policies, widespread tax incentives, and preferential lending by government financial institutions to priority sectors (i.e., construction, manufacturing, and energy).
7The sharp decline of private investment (in percent of GNP) in 1980/81 is overstated because the investment data during the 1970-80 period are unreliable. However, the magnitude of the decline and the downturn in economic growth point to more sluggish investment in the 1980s than in the 1970s.
8These losses amounted to about ₱ 5 billion in the last quarter representing half of the yearly increase in reserve money from end-1982 to end-1983.
9The share of foreign currency debt in the total debt of the nongovernment sector rose from an average of 44 percent between 1980 and 1982 to 60 percent between 1983 and 1985.
10Commercial banks with a capital of ₱ 500 million or more can apply to become a universal bank or “unibank” and, upon approval. are authorized to expand their activities to include investment banking services, securities transactions, credit guarantees, leasing, and equity investments in allied and nonallied undertakings.
11Eligibility criteria included competence in the conduct of foreign exchange operations as well as the minimum unimpaired capital requirement. Liability restrictions consisted of holding a minimum foreign currency reserve ratio with CBP. Furthermore, foreign exchange receipts from exports and most invisible transactions could not be deposited in these FCD accounts.
12Banks were prohibited from converting foreign currency into pesos, except under swap arrangements with CBP.
13Under Circular No. 547, issued in 1978, banks were required to cover at least 70 percent of the foreign currency liabilities with eligible assets in the same currency. This foreign currency cover included deposits with the CBP and other Philippine-based commercial banks, deposits with foreign banks and offshore banking units, foreign currency loans or securities, foreign currency notes and coins, and foreign currency swapped with the CBP.
14This restriction applied also to domestic banks operating under the FCD system.
15According to McKinnon (1973), freer capital flows would deter capital flight and boost the national saving rate, thereby reducing external borrowing.
16As Fry (1988) notes: “Foreign capital flow liberalization can stimulate investment more than domestic savings, causing excess indebtedness” (p. 345).
17For instance, banks were required to allocate 15 percent of their total deposit base for credit to the rural sector. This was known as the agri/agra requirement. Other portfolio restrictions included banks* minimum holdings of government securities. Furthermore, selective credit policies designed to allocate credit to priority sectors (e.g., exports of traditional products) were maintained. DBP was a main conduit for channeling these funds to the priority sectors.
18Individuals also resorted to domestic debt to finance their rapidly rising consumption.
19M3 consists of M2 (currency, demand deposits, time and savings deposits) plus deposit substitutes (interest-bearing securities issued by banks to their customers).
20This measure was aimed at curbing the flow of financial savings from bank deposits into deposit substitutes whose yield was unregulated. The ceiling on short-term deposit substitutes was set at 17 percent in 1976 and then lowered to 16 percent in 1978. Both ceilings were higher than the rates on savings and short-term time deposits.
21Under the Prime Rate system, a sample of ten commercial banks regularly publicized the rate that they charged to their best customers on a 90-day loan. Under the MRR system, CBP compiled an average cost of bank funds—of 30-day, 60-day, and 90-day maturities—from a sample of ten commercial banks. These costs of funds were market determined and known as the Manila Reference Rates or MRRs.
22A simple equation for uncovered interest arbitrage was estimated for the 1981(11) to 1986(IV) period. Because the financial market was assumed to adjust with a lag, a lagged dependent variable was introduced in the tested equation, A dummy variable (1 from 1981(11) to 1983(III) and 0 for the remaining quarters) was added to detect the presence of a structural shift in the equation after the announcement of the debt moratorium. The Orcutt-Cochrane estimation procedure was used. The results reported in Table 4 were quite satisfactory. The coefficients for the foreign interest rate (adjusted for ex post devaluation) and the lagged dependent variable were significant at a 5 percent significance level.
23The empirical specification builds on Edwards and Khan (1985). Domestic interest rate is related to a weighted average of the foreign interest rate adjusted for expected exchange rate changes and of domestic factors, namely, monetary disequilibrium, expected inflation, and the long-term equilibrium rate of interest in real terms—a constant. Equations were estimated by the Orcutt-Cochrane procedure and two types of tests were performed. First, the interest rate equation was estimated in both an unrestricted form and a restricted form that posited that the liquidity effect was absent (i.e., monetary disequilibrium has no short-term effect on the real interest rate); a Chow test was applied to test the statistical significance of this restriction. Second, a dummy variable was used to test the stability of the slope coefficients during the two periods 1981(I) to 1983(III) and 1983(IV)to 1986(IV).
24Using a weighted average interest rate on secured loans (lending rate) and MRRs (banks’ costs of funds) for a sample of ten commercial banks.
25Growing macroeconomic imbalance and large devaluations contributed to increased inflationary expectations.
26The gross interest margins (for short-term rates) was regressed on inflation, the ratio of overdue to total loans outstanding, and the Herfindahl-Hirschman index (a measure of concentration in the banking industry) to identify the determinants of banks’ gross spread after the liberalization. Only inflation and overdue loan ratios were found to be statistically significant; the other coefficient had the right sign (see Appendix Table 1).
27The authorities applied a lower reserve ratio of 5 percent on long-term deposits, compared with the ratio on shorter time deposits in column (2) of Table 5. Other regulatory factors include gross receipts, tax, agri/agra requirements, and the 3 percent (now 4 percent) interest paid on required reserves.
28Owing to their unattractive features and low budgetary pressures, treasury bills played no role in the conduct of open market operations. After an unsuccessful attempt to restore the primacy of treasury bill issues in 1981, CBP pursued the conduct of open market operations using primarily its own securities until 1986.
29Treasury bill issues were also being sold on tap at that time.
30The management and impact of monetary policy at the height of the crisis (i.e., between 1984 and 1986) are discussed in greater detail in Section II.
31Actually, in 1983, CBP had abandoned its earlier stance and indicated that the outstanding amount of swap operations at cnd-1982 would not be increased.
32Nine commercial banks converted to unibanks, one of which (Manila Bank) was recently liquidated and another (Philippine National Bank) was subject to major restructuring. Unibanks did not actively pursue the opportunities in near-hanking activities permitted to them because of the unstable environment and the preoccupation with survival.
33The banking experience of management often consisted of only a few weeks of training.
34The specialized government banks are DBP, LBP, and the Amanah Bank.
35As the crisis worsened after 1981, CBP granted massive indirect financial assistance to public corporations through some government financial institutions. This aid allowed these financial institutions to finance their acquisition of troubled nonfinancial entities between 1982 and 1985. Furthermore, CBP accumulated huge losses on foreign exchange swap operations linked to successive and massive devaluations during the first half of the 1980s.
36Government-owned banks included the DBP, LBP. PNB, the Amanah Bank, and the Philippines Veterans’ Bank.
37This group effectively went out of business after the 1981 crisis, and many of its companies and subsidiaries were bought out by the Government.
38Similar cases included the Ayala Group, which controlled 37,0 percent of the paid-up capital of the Bank of Philippine Islands (the second-largest commercial bank after PNB), the Bancom Group, the Cojuango Group (United Coconut Planters Bank, the seventh-largest commercial bank in 1981); the First Philippine Hoiding Group (Philippine Commercial and International Bank, the fifth-largest bank in 1981).
39The number of banking institutions, including branches, is shown in Table 8.
40The MB is composed of the Governor acting as chief executive, the Minister of Finance, the Director General of the National Economic Development Authority, the Chairman of the Board of Investments, the Minister of the Budget, and two pan-time members of the private sector.
41For instance, the reporting system covers every item of banks’ balance sheets, and information such as credit to directors, officers, and shareholders and their related interest (DOSRI credit) is even reported daily. On-site examinations and inspections, patterned after the U.S. system, focus on the quality of banks’ assets, which are classified accordingly. A rating system, CAMEL (Capital Asset, Management, taming, and Liquidity), is used to assess quantitatively a hank’ s soundness, along with a questionnaire for a qualitative assessment.
42Insolvency is defined in the law as the inability of a bank to pay its liabilities as they fall due in the usual and ordinary course of business. One important limitation of this definition is that it does not apply to insolvency stemming from extraordinary deposit withdrawals caused by a financial panic.
43See CB Circular No. 357 dated January 22, 1973.
44See CB Circular No. 596 dated March 1, 1978, whereby the Central Bank amended CB Circular No. 357 to exclude from the maximum credit accommodation to DOSRI, among others, “the credit accommodations to a corporation in whose board of directors, a director or officer or stockholder of the lending bank seats as a representative of the bank. However, the bank representative’ s equity interest in the borrower corporation shall only be the minimum shares required by law, rules and regulations, or the by-laws of the corporations to qualify a person as director to the corporation.” (Sycip and others (1978), p. 15.)
46The CBP adopted new ceilings on unsecured DOSRI credit of 30 percent of total credit accommodations for each DOSRI. Total DOSRI credit was subsequently limited to 15 percent of a bank’ s loan portfolio or its entire capital account, whichever was lower. Also, new accounting and repotting standards for DOSRI loans have been adopted.
47The money market in the Philippines is characterized by a variety of participants, including all financial institutions; the Treasury and nonfinancial corporations; and a wide range of instruments such as promissory notes issued by banks and nonbank quasi-banks, government securities, central bank bills, certificates of participation/assignments, and commercial paper issued by corporations. Commercial paper can be issued “with or without recourse.” Deposit substitutes issued by nonbank quasi-banks are also referred to as commercial paper issued by these institutions. See Lontoc (1981), p.8.
48In reaction, the authorities modified the regulations governing money market operations. Among other things, the new regulations limited the issuance of commercial paper to prime companies; required that issuers have at their disposal a bank credit line covering 35 percent of their money market issues; and required that all commercial papers be registered with the Securities and Exchange Commission and be printed serially on security paper, by the Central Bank Printing Plant.
49The policy was formalized in 1987, when the MB passed a resolution requiring all banks to set up a system for reviewing loans and other assets for the purpose of establishing appropriate and adequate reserves.
50Deposit insurance limit was ₱ 10,000.
51Annual premium contribution by financial institutions amounted to ₱ 100 million.
52However, in the case of the largest failed bank, PDIC quickly settled the claims of insured deposits.
53A “flight to quality” refers to financial wealth holders’ shift from deposits to safer assets such as treasury bills, or from weak banks to banks perceived to be more sound.
54Capital flight is defined here as “the acquisition or mention of a claim on nonresident that is motivated by the owner’ s concern that the value of his asset would be subject to discrete losses if his claims continued to be held domestically.” See International Monetary Fund (1988).
55The collapse of the commercial paper market had also triggered a panic in the thrift banking sector.
56Official figures on business failures do not exist. In this section, partial data from nongovernment sources are relied on to provide an idea of businesses’ financial distress.
57See Business Day (1982)s, p. 139.
58Renegotiated loans doubled between 1984 and 1985 while loans past due for more than one year rose steadily from ₱ 6 billion in 1984 to ₱ 8 billion in 1986.
59After 1983, CBP closed a number of special rediscount facilities and set the discount rate on the remaining ones at market-related levels.
60Despite the reduction in the public sector deficit (in percent of GNP) after 1983, CBP stepped up its financing to this sector in order to offset the sharp decline in foreign financing of the public sector budgetary deficit.
61When the economic and financial environment became very uncertain in late 1983, investors moved interest-bearing securities issued by banks to their customers into safer assets (see Section I of this chapter). A recent study (Goldsborough and Zaidi (1989)) also provides evidence of instability in the demand for Ml, an instability consistent with the currency flight taking place during the 1983(IV)-1986(IV) period of the crisis.
62Between 1984 and 1985, banks (commercial, thrift, and savings) were the heaviest subscribers of government securities. These banks’ holdings of government securities nearly-doubled. See Paulino(1986), p. 29.
63Before 1981, the CBP law required the Central Bank to provide unlimited financial assistance during a crisis, but only to banks. This situation was corrected in 1982, when nonbanks became eligible for emergency assistance.
64Most of the universal banks involved in the scheme were major creditors of the troubled corporations (see Lava (1982)).
65These figures are quoted from Business Day (1982), the publication of the Securities and Exchange Commission. This issue also reported (p. 294) that of the 20 biggest corporations 8 had substantial government investments in 1981.
66Beginning in December 1984, CBP applied the treasury bill rate plus 2 percent to emergency loans with 90-day maturity.
67Republic Planters Bank and Philipinas Bank were acquired in the late 1970s. The private banks acquired since 1982 were International Corporate Bank, Union Bank of the Philippines, Associated Bank, and the Commercial Bank of Manila.
68Only one proposal for merger of an insolvent bank was on this clean balance sheet basis. Bad loans would be taken out of the balance sheet and the new partner would bring in funds to recapitalize the bank.
69These two banks and the government-owned Philippine Veterans Bank are the three commercial banks that were actually liquidated during the 1980s.
70The special position of DBP and PNB allowed them unlimited use of government deposits, exemptions from taxes, and access to government-guaranteed borrowing.
71This program was supported by World Bank resources under its Economic Recovery Loan.
72Nonperforming assets also included real assets and some contingent liabilities.
73Bank credit to the private sector, in nominal terms, went from ₱ 153 billion at the end of 1983 to ₱ 96 billion (after transfer) at the end of 1986, compared with ₱ 114 billion before transfer at the end of 1986.
74These regulations include limits on equity investments, limits on exposure to any one borrower, and the use of guarantees. However, the gearing ratio for the DBP will not exceed 5:1 during the rehabilitation period although a 10:1 ratio is permitted for thrifts.
75In theory, APT could also receive public corporations that the Government wished to privatize.
76APT is supervised by the Committee on Privatization (COP), which is the first tier of the asset disposition mechanism. COP is a five-man interministcrial body chaired by the Minister of Finance. It is empowered to issue guidelines governing the disposition process, approve or disapprove individual disposition proposals on terms and purchasers, approve organizational and financial requirements of API, and monitor the overall disinvestment program.
77The names of borrowers have become public and a number of them have now acted to settle their obligations.

    Other Resources Citing This Publication