Filipino banks to adopt Basel II amid tide of corporate governance problems
Two-step introduction of new accord as supervisors struggle to enforce existing regulations and banks grapple with bad loans. But should corporate clean-up take priority?
In the light of the enormous corporate governance problems besetting Philippine banks, it would have been quite understandable if regulators in Manila had decided to delay for some years the application of the new Basel capital adequacy rules to their local banks. It is a measure of how important the proposed risk sensitive capital regime - Basel II - is viewed in much of east Asia, that the Philippines central bank is pressing the country's commercial banks to be ready to apply the new rules by the beginning of 2007 - when many banks in Europe and some other advanced jurisdictions are expected to do so.
Not all bank analysts in the region are convinced this is really a priority for a country that only began applying the original, 1988 capital accord (Basel I) in 2002, and the 1996 market risk amendment last year. And, given the levels of bad loans on Filipino bank balance sheets, the problems of related-party lending, the lack of transparency, and the up-hill task supervisors face in trying to enforce compliance with current local bank regulations, the moves towards Basel II are seen by some analysts as, at best, a distraction.
"We are in catch-up mode," says Nestor Espenilla, assistant governor for supervision and examination at the Bangko Sentral ng Pilipinas (BSP), the country's central bank. It was necessary to amend the basic banking law for Basel I to be applied in the Philippines, and this took quite a long time as the country's legislative process is quite protracted. The change in the law, which allows banking regulation to be brought into line with international practices, will also permit the Basel II accord to be adopted without further legislation, Espenilla tells Global Risk Regulator.
The plan is for the country's 42 commercial banks (the largest of which are also referred to as universal banks) to implement the new regime in two stages, Espenilla explains. They will be required to implement the simplest of the accord's three approaches to the measurement of credit risk - the standardised approach - by the beginning of 2007. Commercial banks should also implement, by the same date, one of the two simpler measures of operational risk - a basic or standardised approach.
At the second stage, in 2010, banks will be allowed to avail themselves of the more sophisticated measurement options for credit risk (the foundation and advanced internal ratings based approaches) and operational risk (the advanced measurement approaches). This will give them time to collect the necessary default histories and other data that is currently even sparser in the Philippines than in other, comparable countries.
"Enhanced Basel I"
The numerous thrift banks and rural and cooperative banks will not be required to apply Basel II. Instead, they will be subject to what is described as an "enhanced Basel I" regime. What this means is that pillar 2 and pillar 3 of the new accord will also apply to them. Even though they do not have to change the way they calculate risk, and hence their capital levels (pillar 1 of the new accord), they will be subject to enhanced supervisory oversight (pillar 2) and greater information disclosure (pillar 3).
Disclosure, under pillar 3, will be gradually introduced from 2007, while pillar 2 is viewed as a continuous process that has already started.
The timetable involves draft implementation guidelines being exposed for consultation to the industry in the first quarter of 2005; industry comments by June next year; and final guidelines published by the end of the year. And this whole process is intended to be complemented by the introduction of new international accounting standards in 2006.
Although some sceptics think this timetable is not realistic, Espenilla says: "It is certainly do-able." In fact, the BSP intends to begin introducing aspects of Basel II, notably some of the new credit weights, during 2006, rather than undertake a "big bang" implementation in 2007, he says.
But bank regulation in the Philippines does not get high marks from credit analysts. It is "below average for the region," says John Tham, a senior analyst at Moody's rating agency, in Singapore.
Many of the individual regulators are dedicated and committed, but they are handicapped by a legal framework that allows bad practices to continue unchecked. In some cases, regulators have attempted to close insolvent banks, but found themselves personally liable when the bank owner has got the decision over-turned in the courts.
Owners have somehow persuaded the courts that the bank's problems have been caused by over-zealous regulators. In such cases, the regulator may personally have to meet the legal costs, according to local analysts. "No regulator in his right mind would attempt to close a bank," reckons Rolando Valenzuela, chief risk officer of Export and Industry Bank, a medium-size commercial bank, and a member of the risk management committee at the Bankers Association of the Philippines (BAP), in Metro Manila. BAP has been championing reform in the financial sector
There are currently moves, says Valenzuela, to get a change in the charter of the BSP, to give it greater enforcement powers and independence. As an executive of one of the country's better-run banks, Valenzuela hopes to see the charter changed by 2007, when commercial banks start to implement Basel II.
The country's other regulator, the Philippine Deposit Insurance Corporation (PDIC) is also struggling to get the law changed to protect its officers from lawsuits launched by disgruntled bank owners. The willingness of the courts to provide protection to bank owners, even those that have seriously mismanaged their institutions, "is a long standing problem that has undermined effective bank supervision in the Philippines," Fitch Ratings, the credit rating agency, said in a hard-hitting commentary on the country's banking sector in 2002.
A stark illustration of the central bank's enforcement difficulties came in August 2003, when the Philippine Court of Appeal even imposed a year-long suspension from office of the BSP governor, Rafael Buenaventura, over the closure of a commercial bank that was alleged to have been executed without the full exercise of proper procedures.
The Fitch commentary noted that the "banking system in the Philippines has, over the years, been afflicted by most of the weaknesses found in the emerging market economies, including poor management, supervision, and transparency, fraud, corruption, an ineffective legal system, family ownership, related party lending, and political influence on bank lending."
Even the central bank became insolvent, and had to be closed down in 1993, having been seriously weakened during the dictatorship of President Marcos, and the aftermath of his rule (another central bank was subsequently created). Despite some reforms in more recent years, the system remained fragile, concluded Fitch.
Unlike countries such as Thailand, Indonesia and South Korea, the Philippines was not hit very hard by the financial crisis that swept east Asia in 1997-98. Those that suffered most acutely were forced to thoroughly overhaul their bank regulations and risk management. Standards were raised sharply. The Philippines did not have to go through the painful reforms, and its problems have continued to simmer, notably the increase in non-performing loans, says one analyst that monitors the country.
He attributes the difficulties of getting regulatory compliance to the power and influence of a handful of wealthy families that own some of the banks, and much of the rest of the national economy. These families have influence over Congress and the political system, and have more power than the central bank, he says.
Despite opposition to reform in some quarters, the BSP continues to issue new regulations. Espenilla describes the central bank's current programme of reforms as "very extensive," starting with the move to more risk-based capital regulation under Basel I. Other changes cited include the setting of minimum standards for banks' internal credit grading, starting in 2005; a strengthening of the rules for lending to directors, officers, shareholders and related interests (DORSI lending); and a bigger role for independent directors to improve corporate governance. Additionally, there is now consolidated supervision of financial conglomerates, whereas before the constituent financial firms were examined separately by different units of the BSP. And special purpose vehicles have also been set up to buy the banks' bad loans at a discount.
On top of this, the BSP is trying to increase its supervisory capacity, with more, and better-trained staff.
Meanwhile, the Banking Association of the Philippines operates training programmes for executives and middle level bankers such as credit officers and risk managers. The training programmes, organised by Rolando Valenzuela, and undertaken through the Ateneo Graduate School of Business - where he is also a professor of economics - are aimed at imbuing an understanding of internal risk rating and scoring systems in readiness for Basel II, as well as meeting the minimum standards set by the BSP.
Despite these efforts to improve the banking sector, analysts remain sceptical, not only over the ability of supervisors to enforce the rules, but also over the willingness of some banks to really grapple with their non-performing assets (NPAs). John Tham at Moody's estimates that non- performing loans (payments more than 90 days over due), amount to around 15-16% of the banking sector's total outstanding loans. But this only accounts for part of the banks' NPAs. A high proportion of loans are backed by collateral in the form of property, and banks tend to foreclose aggressively when borrowers fail to repay. This effectively cancels the loans, which do not appear on the balance sheet as non-performing.
Stuck with unsold property
However, the bank is often left with property that cannot be sold. It may frequently be vacant, even derelict. When these properties are added to the non-performing loans, the resulting NPAs probably amount to close to 30% of all banking sector assets, reckons Tham. A 2003 law encourages the creation of special purpose vehicles (SPVs) to buy these non-performing assets and assist banks to clean up their balance sheets. Tax breaks are on offer for banks that sell these NPAs to the special vehicles before the end of next April.
So far, the scheme has not been very successful because the discount banks must accept on the face value of the bad assets can be as much as 60% or 70%. But last September's deadline for participating in the scheme will probably be extended, and there are hopes that banks can yet be persuaded to bite the bullet.
Positive element
The main positive element for the banks is that they remain fairly well capitalised, at least nominally. On average, the ratio of bank capital to risk weighted assets is estimated to be in the 15%-18% range for the sector. One analyst reckons, however, that if the banks wrote down the value of their NPAs to appropriate levels, the average capital adequacy ratio would be "struggling to reach 10%." On top of this, the banks hold significant quantities of government securities. If local interest rates rise without a commensurate pick-up in economic growth, the fall in the book value of those securities would also severely reduce bank capital.
Apart from these pressures on capital, the move to Basel II is likely to result in an overall reduction in the capital adequacy ratio of the country's banking system. This was indicated during the third quantitative study into the impact of Basel II, undertaken in 2002-2003 by banks in over 40 countries, including six Filipino banks. For the latter banks, the study suggested that the capital adequacy ratio could drop by 3 or 4 percentage points under the proposed new regime, explains Nestor Espanilla. The main cause seems to be operational risk problems, arising from documentation errors, legal issues and fraud.
Averages mask many differences, however. And, the quality of balance sheets varies quite markedly, analysts say. Of the seven largest commercial/universal banks, which account for almost 60% of the market, Bank of the Philippine Islands and the government-owned Development Bank of the Philippines, are described as among the better-run institutions (see table), while the Philippine National Bank, has the weakest capital adequacy ratio and highest non-performing assets ratio among this group. Analysts also say there are some reasonably strong banks among the next half dozen, medium-size institutions, notably Union Banking Corporation, with a capital ratio of almost 42%.
Not least of the banks' difficulties is that they are operating in a tough economic climate. Economic growth is fairly anemic, while the public finances have deteriorated for several years. In 2003, the fiscal deficit was equal to 4.6% of gross domestic product (down from 5.2% the previous year), and it is expected to be around 4.2% this year. As a result, national government debt, on the widest measure, is now estimated by Moody's to have climbed to over 100% of GDP.
Yet, the administration of President Gloria Macapagal Arroyo has pushed back the target date for achieving a balanced budget to 2009, from 2006. This worries the credit rating agencies. On November 9, Moody's announced that it was putting the Philippines' long term credit rating of Ba2 on review for possible downgrade. The credit ratings of eleven of the country's banks were, consequently, also under review for possible downgrade.
For many of the banks, already exposed and hobbled by problems, there is little margin for dealing with new shocks. And, in the present economic climate of the Philippines, the potential for new shocks is high.
