Philippine Financial System

Financial System: Overview

A vibrant and healthy economy requires a financial system that makes or channels
funds from people who save to people who have productive investment opportunities.
The financial system is complex in structure and functions throughout the world. A
developed economy relies on financial markets and institutions for efficient transfer of
funds. Every person’s life, family, business, and government are affected by the
financial system.
A strong financial system is a necessary ingredient for a growing and prosperous
economy. Companies raising capital to finance capital expenditures and investors
saving to accumulate funds for future use require well-functioning financial markets and
institutions.
Over the past few decades changing technology and improving communications have
increased cross-border transactions and expanded the scope and efficiency of the
global financial system. Companies routinely raise funds throughout the world to finance
projects all around the globe. Likewise, with the click of a mouse an individual investor
in Metro Manila can deposit funds in a US Bank or purchase a mutual fund that invests
in Chinese Securities. These investors helped spur global economic growth by providing
capital to an increasing number of individuals throughout the world.
However, along the way, the financial industry attracted a lot of talented people who
created, marketed, and traded a larger number of new financial products. Despite
however their benefits, many of these same factors led to excess which culminated in
the financial crisis in 2008 in the United States of America, in Europe, and Southeast
Asia. At the height if the crisis, many were worried that the entire financial system could
collapse and in response regulators took emergency steps.
In many ways, this crisis illustrates that financial manager and investors do not operate
in vacuum they make decisions within a large and complex financial environment.
The environment both determines the available financial alternatives and affects the
outcome of various decisions. Thus, it is crucial that investors and finance managers
have a good understanding of the environment in which they operate.
The financial system is complex, comprising many different types of private sector
financial institutions, including banks, insurance companies, finance companies, mutual
funds, and investment banks, all of which are regulated by the government.
 
NATURE AND OBJECTIVE OF THE FINANCIAL SYSTEM
The financial system consists of all financial intermediaries and financial markets and
their relations with respect to the flow of funds to and from households, governments,
business firms and foreigners, as well as the financial infrastructure.
Having a well-functioning system in place that directs funds to their most productive
uses is a crucial prerequisite for economic development.
This process is shown schematically in Figure 5-1. Those who have saved and are
lending funds, the lender-savers, are at the left, and those who must borrow funds to
finance their spending, the borrower-spenders, are at the right. The principal lender-
savers are households, but business enterprises and the government (particularly state
and local government), as well as foreigners and their governments, sometimes also
find themselves with excess funds and so lend them out. The most important borrower-
spenders are business and the government (particularly the national government), but
households ad foreigners also borrow to finance their purchases of cars, furniture and
houses. The arrows show that funds flow from lenders-savers to borrower-spenders via
two routes.
In direct finance (the route at the bottom of Figure 5-1), borrowers borrow funds directly
from lenders in financial markets by selling them securities (also called financial
instruments), which are claims on the borrower’s future income of assets. Securities are
assets for the person who buys them but liabilities. (IOUs or debts) for the individual or
firm that sells (issues) them.
FIGURE 5-1: Flow of Funds through the Financial System

KEY COMPONENTS OF THE FINANCIAL SYSTEM

The major components of the financial system include:
a) Financial Instruments
b) Financial Markets and Financial Institutions
c) The Central Bank and Other Financial Regulators
 
FUNCTIONS OF THE FINANCIAL SYSTEM
The main task of the financial system is to channel funds from sectors that have a
surplus to sectors that have a shortage of funds. In the financial system, banks,
insurance companies, mutual funds, stockbrokers, and other financial services firms
compete to provide financial services to households and business.
Economists believe there are three key services that the financial system provides to
savers and borrowers: risk sharing, liquidity and information. Financial services firms
provide these services in different ways, which makes different financial assets and
financial liabilities more or less attractive to individual savers and borrowers.
a) Risk sharing
b) Liquidity
c) Information
 
DISCUSSION
             Risk Sharing
             Risk is the chance that the value of financial assets will change relative to what
one expects. One advantage of using the financial system to match individual savers
and borrowers is that it allows the sharing of risk. Most individual savers seek a steady
return on their assets rather than erratic savings between high and low earnings. This
splitting of wealth into many assets to reduce risk is known as diversification.
             The financial system provides risk sharing by allowing savers to hold many
assets. Hence, because of the ability of the financial system to provide risk sharing
makes savers more willing to buy stocks, bonds and other financial assets. This
willingness, in turn increases the ability of borrowers to raise funds on the financial
system. Financial intermediaries have developed expertise in holding a diversified
portfolio of innovative projects which reduces risk and promotes investment in growth
enhancing innovative activities.
             Liquidity
             Another key service that the financial system offers savers and borrowers is
liquidity. Liquidity is the ease with which an asset can be exchanged for money which
savers view as a benefit. Generally, assets created by the financial system such as
stocks, bonds or checking accounts, are more liquid than are physical assets such as
cars, machinery or real estate.
             Financial markets and intermediaries help make financial assets more liquid.
Investors can easily sell their holdings of government securities and the stocks and
bonds of large corporations, making those assets very liquid.
             The financial system has increased the liquidity of many assets besides of
stocks and bonds through the process of securitization. This process has made it
possible to buy and sell securities based on loans. As a result, mortgages and other
loans have become more desirable assets for savers to hold. Savers are willing to
accept interest rates on assets with greater liquidity which reduces the costs of
borrowing for many households and firms.
             Information
             A third service of the financial system is the collection and communication of
information, or facts about borrowers and expectations of returns on financial assets.
Banks collect information on borrowers to forecast their likelihood of repaying loans.
Because the bank specializes in collecting and processing information its costs for
information gathering are lower than yours would be if you tried to gather information
about a pool of borrowers. The profit the bank earns on its loans is partly compensation
for the resources and time bank employees spend to gather and store information.
             Financial markets convey information to both savers and borrowers by
determining the prices of stocks, bonds, and other securities. This information can help
one decide whether to continue investing in the securities preciously purchased or to
sell more stock or bonds to finance a planned expansion. The incorporation of available
information into asset prices is an important feature of well-functioning financial
markets.
 
              THE PROBLEM OF ADVERSE SELECTION AND MORAL HAZARD
A key consideration for savers is the financial health of borrowers. Savers do not lend to
borrowers who are unlikely to pay them back. Unfortunately for savers, borrowers in
poor financial health have an incentive to disguise this fact. For example. A company
selling bonds to investors may know that its sales are declining rapidly, and it is near
bankruptcy, but the buyers of the bonds may lack this information.
A vital service of the financial system is the collection and communication of information
or facts about borrowers and expectation of returns in financial assets. Financial
markets convey information to both savers and borrowers by determining the prices of
stocks, bonds and other securities.
Asymmetric information describes the situation in which one party to an economic
transaction has better information than does the other party. In financial transactions,
typically the borrower has more information than does the lender.
Two problems arising from asymmetric information are:
1)           Adverse selection. This is the problem investors experience in distinguishing
low-risk borrowers from high-risk borrowers before making an investment.
2)           Moral hazard. This is the problem investors experience in verifying that
borrowers are using their funds as intended.
Sometimes an investor will consider the costs arising from asymmetric information to be
so great that the investor will lend only to borrowers who are transparently low risk, such
as the national government. However, more generally, there are practical solutions to
the problems of symmetric information, in which financial markets or financial
intermediaries lower the cost of information needed to make investment decisions.
The financial system helps overcome an information asymmetry between borrowers and
lenders. An information asymmetry can occur before or after a financial contract has
been agreed upon.
 
Adverse Selection
The information asymmetry before the contract is agreed upon arises because
borrowers generally know more about their investment projects than lenders. Borrowers
most eager to engage in a transaction are the most likely ones to produce an
undesirable outcome for the lender (adverse selection). Individual savers may not have
time, especially or means to collect and take advantage of economies of scale and
scope.
Moral Hazard
Even after a lender has gathered information on whether a borrower is a good borrower
or a lemon borrower, the lender’s information problems haven’t ended. There is still a
possibility that after a lender makes a loan to what appears to be a good borrower, the
borrower will not use the funds as intended. This situation, known as moral hazard, is
more likely to occur when the borrower has an incentive to conceal information or to act
in a way that does not coincide with the lender’s interests. Moral hazard arises because
of asymmetric information. The borrower knows more than the lender does about how
the borrowed funds will actually be used.
 
HOW FINANCIAL INTERMEDIARIES REDUCE “Adverse Selection”
The problem of “adverse selection” can be minimized if not totally avoided using the
following approaches:
1) Requires borrowers to disclose material information on their financial performance
and financial position.
Financial market participants and the government have taken steps to try to reduce
problems of adverse selection in financial markets. The SEC requires the publicly
traded firms report their performance in financial statements, such as balance sheets,
which show the value of the firm’s assets, liabilities, and stockholders’ equity (the
difference between the value of the firm’s assets and the value of liabilities), and income
statements, which show a firm’s revenue, costs, and profit. Firms must prepare these
statements using standard accounting methods. In addition, firms must disclose
material information, which is information that, if known, would likely affect the price of a
firm’s stock.
2) Collecting information on firms and selling that information to investors.
3) Convincing lenders to require borrowers to pledge some of their assets as collateral
which the lender can claim of the borrower defaults.
 
 
HOW FINANCIAL INTERMEDIARIES REDUCE MORAL HAZARD PROBLEMS
Financial Intermediaries can reduce moral hazard problems by adopting more stringent
procedures in monitoring the borrower’s use of funds. This will include:
1) Specializing in monitoring borrowers and developing effective techniques to ensure
that the funds they loan are actually used for their intended purpose.
2)  Imposing Restrictive Covenants
Restrictive covenants may involve placing limitations on the uses of funds borrowed or
requiring the borrowers to pay off the debt even before maturity ate if the borrower’s net
worth drop below a certain level.
 
NATURE AND IMPACT OF TRANSACTION AND INFORMATION COSTS
Transaction Costs
The cost of a trade or a financial transaction; for example. The brokerage commission
charged for buying or selling a financial asset.
Information Costs
The costs that savers incur to determine the creditworthiness of borrowers and to
monitor how they use the funds acquired.
Because of transaction costs and information costs, savers receive a lower return on
their investments and borrowers must pay more for the funds they borrow. As we have
just seen, these costs can sometimes mean that funds are never lent or borrowed at all.
Although transactions costs and information costs reduce the efficiency of the financial
system, they also create a profit opportunity for individuals and firms that can discover
ways to reduce those costs.
 
HOW FINANCIAL INTERMEDIARIES REDUCE TRANSACTIONS COSTS
Transaction costs may be reduced by adopting the following techniques:
1) Financial intermediaries take advantage of economies of scale, which refers to the
reduction in average cost that results from an increase in the volume of a good or
service produced. For example, the fees dealers in Treasury bonds charge investors to
purchase P10 million worth of bonds are not much higher than the fees they charge to
purchase P11 million worth of bonds. By buying P500 worth of shares in a bond mutual
fund that purchases millions of pesos worth of bonds, an individual investor can take
advantage of economies of scale.
2) Financial intermediaries can also take advantage of economies of scale in other
ways. For example, because banks make many loans, they rely on standardized legal
contracts, so the costs of writing the contracts are spread over many loans. Similarly,
bank loan officers devote their time to evaluating and processing loans, and through this
specialization, they are able to process loans effectively, reducing the time required –
and, therefore, the cost per loan.
3) Financial intermediaries also take advantage of technology to provide financial
services, such as those that automated teller machine networks provide.
4) Financial intermediaries also increasingly rely on sophisticated software to evaluate
the credit worthiness of loan applicants.
 
THE PHILIPPINE FINANCIAL SYSTEM
INTRODUCTION
Well-functioning financial system is crucial to a country’s economic health so much so
that when the financial system breaks down, as it has in Russia and in Southeast Asia
recently, severe economic hardship results.
The financial system, through the various financial markets and financial intermediaries
has the basic function of moving funds from those who have a surplus to those who
have shortage of funds.
To study the effects if financial markets and financial intermediaries on the economy, we
need to acquire an understanding of their general structure and operation.
 
STRUCTURE OF THE PHILIPPINE FINANCIAL SYSTEM
I. Bangko Sentral ng Pilipinas
II. Banking Institutions
A. Private Banking Institutions
1. Expanded Commercial Banks/Universal Banks (EKB/UB)
2. Commercial Banks (KB)
o Thrift Banks (TB)
o Savings and Mortgage Banks (SMB)
o Private Development Banks (PDB)
3. Stock Savings and Loan Associations (SSLA)
4. Rural Banks (RB)
5. Cooperative Banks

B. Government Banking Institutions

1. Development Bank of the Philippines (DBP)

2. Land Bank of the Philippines (LBP)
3. Philippine Al-Amanah Islamic Investment Bank

III. Non-Bank Financial Institutions

A. Private Non-Bank Financial Institutions

1. Investment houses
2. Investment banks
3. Financing companies
4. Securities dealers/brokers
5. Savings and loan associations
6. Mutual funds
7. Pawnshops
8. Lending investors
9. Pension funds
10. Insurance companies
11. Credit union

B. Government Non-Bank Financial Institutions

1. Government Service Insurance System (GSIS)

2. Social Security System (SSS)
3. Pag-ibig

 
BRIEF DESCRIPTION OF THE FINANCIAL INSTITUTIONS
I. Banko Sentral ng Pilipinas
II. Banking Institutions
A. Private Banking Institutions

1.
 1.
1. Universal Bank (UB) or Expanded Commercial Bank (EKB) is any
commercial bank, which performs the investment house function in addition
to its commercial banking authority. It may invest in the equities of allied and
non-allied enterprises. Allied enterprises may either be financial or non-
financial.
2. Commercial Bank or Domestic Bank (KB) is any commercial bank
that is confined only to commercial bank functions such as accepting drafts
and issuing letters of credit, discounting and negotiating promissory notes,
drafts and bills of exchange, and other evidences of debts, accepting or
creating demand deposits, receiving other types of deposits and deposit
substitutes, buying and selling foreign exchange, and gold or silver bullions,
acquiring marketable bonds and other debt securities, and extending credit
subject to such rules that the Monetary Board may promulgate.
3. Thrift Banks (TB) – shall include savings and mortgage banks,
stock savings and loan associations and private development banks. Their
function is to accumulate the savings of depositors and invest them together
with their capital, loans secured by bonds, mortgages in real estate and
insured improvements thereon, chattel mortgages, bonds and other forms of
security or loans for personal or household finance, whether, secured or
unsecured, or in financing for home building and home development; in
readily marketable and debt securities; in commercial papers and accounts
receivables, drafts, bills of exchange, acceptances or notes arising out
commercial transactions; and in such other investments and loans which the
Monetary Board may determine as necessary in the furtherance of national
economic objectives.

a. Stock Savings and Mortgage Bank (SSMB) is any corporation organized for the
purpose of accumulating the savings of depositors and investing them, together with its
capital, in readily marketable bonds and debt securities; check, bills of exchange,
acceptances or notes arising out of commercial transactions or in loans secured by
bonds, mortgages or real estate and insured improvements thereon and other forms of
security or in loans for personal or household finances whether secured or unsecured,
and financing for home building and home development.
b. Private Development Bank (PDB) is a bank that exercise all the powers and assumes
all the obligations of the savings and mortgage bank as provided in the General Banking
Act except as otherwise stated. The private development bank helps construct, expand
and rehabilitate agricultural and industrial sectors. The Development Bank of the
Philippines is the government counterpart of the private development banks and helps,
the private development banks augment their capitalization as provided under R.A.
4093 as amended.
c. Stock Savings and Loan Association (SLA) is any corporation engaged in the
business of accumulating the savings of its members or stockholders and using such
accumulated funds, together with its capital for loans and investment in securities of
productive enterprises, or in securities of the government and its instrumentalities,
provided that they are primarily engaged in servicing the needs of households by
providing personal finance and long term financing for home building and development.
4. Rural Bank (RB) is any bank authorized by the Central Bank to accept deposits and
make credit available to farmers, businessmen and cottage industries in the rural areas.
Loans may be granted by the owner of private property can show five (5) years or more
of peaceful continuous and uninterrupted possession of the land in the concept of
ownership. This will include portions of friar land estates or other lands administered by
the Bureau of Lands that are covered by sale contracts and purchases and have paid at
least five (5) years installment thereon, without the necessity of prior approval and
consent of the Director of Lands or portions of other estates under the administration of
the Department of Agrarian Reform.
5. Cooperative Banks are banks established to assist the various cooperatives by
lending those funds at reasonable interest rates.
 
B. Government Banks or Specialized Government Banking Institutions

1. Development Bank of the Philippines (DBP) – provides loans for developmental

purposes, given loans to the agricultural sector, commercial sector and the industrial
sector.
2. Land Bank of the Philippines (LBP) – is a government bank, which provides
financial support in the implementation of the Agrarian Reform Program (CARP) of
the government.
3. Al-Amanah Islamic Investment Bank – Republic Act No. 6048, provides for the
charter of the Al-Amanah Islamic Investment Bank. This Act authorizes the bank to
promote and accelerate the socio-economic development of the Autonomous
Region of Muslim Mindanao by performing banking, financing and investment
operations, and to establish and participate in agriculture, commercial and industrial
ventures based on the Islamic concept of banking.

III.  Non-Bank Financial Institutions

A. Private Non-Bank Financial Institutions

1.
1. Investment House is any enterprise, which engages in underwriting
securities of other corporations. It also generates income from sale of
investments in securities.
2. Investment Banks such as Goldman Sachs and Morgan Stanley, differ
from commercial banks in that they do not take in deposits and until very recently
rarely lent directly to households. They provide advice to firms issuing stocks and
bonds or considering mergers with others firms. They also engage in
underwriting in which they guarantee a price to a firm issuing stocks or bonds
and then make profit by selling the stocks or bonds at a higher price.
3. Financing Company is any business enterprise where the primary purpose
is to extend credit facilities to consumers and to industrial, commercial or
agricultural entities either by discounting or factoring commercial papers or
accounts, or by buying installment contracts, leases, chattel mortgages, or other
evidences of indebtedness or by leasing motor vehicles, heavy equipment and
industrial machineries and business and office equipment, appliance and other
movable properties.
4. Securities Dealer is any person or entity engaged in the business of
buying and selling securities for his own or its client’s account thereby making a
profit from the difference between the purchase prices and selling price of
securities.
5. Savings and Loan Association (S&Ls), which have traditionally served
individual savers and residential and commercial mortgage borrowers,
accumulate the funds of many small savers and then lend this money to home
buyers and other types of borrowers. Because the savers obtain a degree of
liquidity that would be absent if they bought the mortgages or other securities
directly, perhaps the most significant economic function of the S&Ls is to “create
liquidity”. Also, the S&Ls have more expertise in analyzing credit, setting up
loans, and making collections than individual savers, so they reduce the
transaction costs and increase the availability of real estate loans.
6. Mutual Funds are corporations which accept money from savers and then
use these funds to buy stocks, long-term bonds, or short-term debt instruments
issued by business or government units. These organizations pool funds and
thus reduce risks by diversification. They also achieve economies of scale, which
lower the costs of analyzing securities, managing portfolio, and buying and
selling securities. Different funds are designed to meet the objectives of different
types of savers. Hence, there are bond funds for those who desire safety, stock
funds for savers who are willing to accept significant risks in the hope of higher
returns, and still other funds that are used as interest-bearing checking accounts
(the money market funds). There are literally hundreds of different mutual funds
with dozens of different goals and purposes.
7. Pawnshops refer to persons or entities engaged in the business of lending
money with personal property, jewelry and other durable goods as collateral for
the loans given.
8. Lending Investor is any person or entity engaged in the business of
effecting securities transactions, giving loans and earn interest for them.
9. Pension Funds are retirement plan funded by corporations or government
agencies for their workers and administered primarily by the trust departments of
commercial banks or by life insurance companies. Pension funds invest primarily
in bonds, stocks, mortgages and real estate.
10. Insurance Companies take savings in the form of annual premiums then
invest these funds in stocks, bonds, real estate and mortgages and finally make
payments to the beneficiaries of the insured parties. In recent years, life
insurance companies have also offered a variety of tax-deferred savings plan
designed to provide benefits to the participants when they retire.
 11. Credit Unions are cooperative associations whose members have a
common bond, such as being employees of the same firm. Members’ savings
are loaned only to other members, generally for auto purchases, home
improvement loans, and even home mortgages. Credit unions often are the
cheapest source of funds available to individual borrowers.

B. Government Non-Bank Financial Institutions

1.
1. Government Service Insurance System (GSIS). Provides retirement
benefits, housing loans, personal loans, emergency and calamity loans to
government employees.
2. Social Security System (SSS). Provides retirement benefits, funeral
benefits, housing loans, personal loans and calamity loans to employees who
are working in private companies and offers.
3. Pag-ibig. Provides housing loans to both government and private
employees.

 
THE EVOLVING PHILIPPINE FINANCIAL SYSTEM
The Philippine financial system continues to experience growth against a backdrop of
strengthening domestic economy. Political reforms, i.e., tax reforms and greater
infrastructure spending, are projected to drive the domestic growth in 2018 as these
lead to higher spending by both the government and households. The domestic
economy is also seen to gain from the momentum of global economic recovery, based
on the upward revisions of growth projections by third party analyst. However, despite
the positive outlook for the Philippines, there are internal and external developments
that pose downside risks to the domestic financial system.
To counteract the downside risks and smooth functioning of the Philippine financial
system more stringent initiatives are being pursued by the four regulatory agencies,
namely:

1. Bangko Sentral ng Pilipinas (BSP)

2. Securities and Exchange Commission (SEC)
3. Insurance Commission (IC)
4. Philippine Deposit Insurance Commission (PDIC)

 
FINANCIAL STABILITY ASSESSMENT OF THE PHILIPPINE FINANCIAL SYSTEM
As its core, financial stability is preemptive in nature because it needs to mitigate the
buildup of system-wide dislocations before these vulnerabilities take concrete form. With
financial markets constantly evolving, it is however not clear what past data can tell
about future conditions. Adding another layer of complication is the fact that there are
competing measures of systemic risk while a unique set of financial stability indicators
has yet to be defined.
These issues notwithstanding, financial stability is clearly understood to reflect a “well-
functioning” financial market, addressing the financial needs of stakeholders, and
avoiding distortions. This view of the overall market will then require a holistic
appreciation of the market situation in various segments of the market. Since these may
be experiencing different pressure points, judgments is often essential in the overall
assessment of systemic risks.
This is the reason why the FSR focuses more on thematic topics. While the market
landscape is a useful baseline, the focus is on risks and vulnerabilities that may derail
further growth as well as raise issues that may potentially have systemic implications.
The section on current risks shows how the outstanding debt level has grown rapidly,
particularly in the post-GCF period. Whether the buildup of debt is already an issue is
still open for discussion. Yet, what is clear is that interest rates are rising and emerging
market currencies have been depreciating versus the United States Dollar (USD). There
must mean that debt servicing is now at a higher cost than in the past, separate from
the issue of having more outstanding debt. This is our central financial stability issue.
The opportunity to discuss fintech and Association of Southeast Asian Nation (ASEAN)
financial integration is taken. There is no doubt that fintech provides benefits over
paper-based face-to-face transactions. This gain is especially of value to an economy
such as the Philippines which is segregated both geographically and by demographic
factors. Nevertheless, the assessment for fintech thus far has focused on micro risks,
e.g., credit and liquidity, among others. The prevailing view is that its financial stability
risks are limited, but this is also premised on the understanding that fintech remains a
small portion of market activity.
*Source: Financial Stability Report (www.bsp.gov/publications/regular_fsr.asp)
December 31, 2018
The intention is to allow fintech to develop further. One should be mindful of a key
lesson from the GCF that systemic risks may arise from seemingly smaller shocks
because accounting for the amplifying effects of interconnectedness was neglected.
Regulatory sandboxes and constant dialogues among stakeholders are critical to
ensure that one remains vigilant of the downside risks from the “disruptive” side of
fintech.
Similar to fintech, the business case is compelling for the integration of the financial
markets among member states of the ASEAN. The region continues to outpace global
growth, it saves at a higher rate than the rest of the world and it is home to a vast base
of millennials who are tech-savvy and drive retail markets. With much of ASEAN’s
savings actually deployed out of the region, financial integration should provide a better
and more organized platform for retaining such savings and funding the region’s growth
even more.
Yet, higher levels of cross-border interconnectedness will also provide another possible
venue for contagion risk. More generally, the previous works of Dani Rodrik and Dirk
Schoenmaker, respectively, suggest that there may be trade-offs between sovereign
policy, regional integration, and financial stability. This section presents a discussion of
the issues as it is certainly relevant to the current work of various committees on
ASEAN integration.