Topic #1

1.An overview of the Philippine Financial System

1.1. Nature of the Philippine Financial System
1.2. Elements of the Financial System
1.3. Functions of the Financial System
1.4. Development of the Philippine Financial System
1.5. The Structure of the Philippine Financial System

Financial System.
https://www.investopedia.com/terms/f/financial-system.asp

What Is a Financial System?

A financial system is a set of institutions, such as banks, insurance companies, and

stock exchanges, that permit the exchange of funds. Financial systems exist on firm,
regional, and global levels. Borrowers, lenders, and investors exchange current funds to
finance projects, either for consumption or productive investments, and to pursue a
return on their financial assets. The financial system also includes sets of rules and
practices that borrowers and lenders use to decide which projects get financed, who
finances projects, and terms of financial deals.

It's the collective of all banks and non-bank financial institutions, working together in
an economy or in a country. Here in the Philippines, we have the Department of
Finance and below it is the Bangko Sentral ng Pilipinas. They regulate and supervise all
the banks and nonbank financial institutions. There are laws governing them. Both
general and specific. There are rules and regulations that must be complied with.
So, it’s not only the institutions, it includes the laws and how they are being regulated.
The system involves money. Money is used by the public, everyone, so it’s imperative
that things are regulated.
It relates to other subjects, topics, systems, in such that the economic side of things
regulate prices, conduct of business, interest rates, exchange rates… things that make
use of money. This is a separate subject, which we will have in the second half of the
semester. Monetary Policy and Central Banking.
So, just keep in mind. The financial system is composed of the institutions as well as
the regulations.

KEY TAKEAWAYS

 A financial system is the set of global, regional, or firm-specific institutions and practices
used to facilitate the exchange of funds.
 Financial systems can be organized using market principles, central planning, or a hybrid
of both.
 Institutions within a financial system include everything from banks to stock exchanges
and government treasuries.

Understanding the Financial System

Like any other industry, the financial system can be organized using markets, central
planning, or some mix of both.

Financial markets involve borrowers, lenders, and investors negotiating loans and other
transactions. In these markets, the economic good traded on both sides is usually some
form of money: current money (cash), claims on future money (credit), or claims on the
future income potential or value of real assets (equity). These also include derivative
instruments. Derivative instruments, such as commodity futures or stock options, are
financial instruments that are dependent on an underlying real or financial asset's
performance. In financial markets, these are all traded among borrowers, lenders, and
investors according to the normal laws of supply and demand.

Financial markets, basically the players. We have borrowers, the ones who need the
money. The lenders and investors who have extra cash that they aren’t using, but they
would like to earn profit. What’s being exchanged here is money for interest. You
borrow money, you have to pay charges and interest. You lend money, you earn a
profit for letting someone else use your money.
Derivatives, commodity futures, stock options, we’ll discuss them in a separate subject.
Investment and Portfolio Management. Basically, as Financial Management students,
your subjects are linked together. But I can’t give you everything all at once.
One thing that affects the exchange of money is supply and demand. There won’t be a
lender if there isn’t a borrower. If someone doesn’t need money, someone with extra
cash would have nothing to do with it.
In our current situation, with the existence of poverty, there is definitely a large
demand for it. People need money. And the financial institutions are providing the
service. A lot of loans. Different types of it.

In a centrally planned financial system (e.g., a single firm or a command economy), the
financing of consumption and investment plans is not decided by counterparties in a
transaction but directly by a manager or central planner. Which projects receive funds,
whose projects receive funds, and who funds them is determined by the planner,
whether that means a business manager or a party boss.

In our financial system, we have the government on one side and the general public on
the other. The government side of things are definitely under one command. The
executive branch of the government, supported or scrutinized by the legislative body.
Every year, they prepare the annual budget. I’m sure you’ve heart of it from the news.
And each branch of the government would have to spend while adhering to the budget
provided to them, subject to availability of funds as monitored by the Department of
Budget and Management. Above describes how our government collects money and
then spends them.

Most financial systems contain elements of both give-and-take markets and top-down
central planning. For example, a business firm is a centrally planned financial system
with respect to its internal financial decisions; however, it typically operates within a
broader market interacting with external lenders and investors to carry out its long-term
plans.

True. How one company operates and manages its funds is the almost the same how it
is in the industry as a whole, the so-called financial system. In a business, you have to
decide where to put the money. How much of it would be used for a particular expense
and how would it be earned back? Is it going to earn us more money? If it’s not
properly managed, the business would fail. If banks and nonbank financial institutions
are left unmanaged, they would most likely commit grave mistakes. In fact, a lot of
them already did make mistakes and over the years, the BSP and other regulatory
bodies (international) would come up with new rules and regulations.
During the financial crisis of 2008, a lot of banks especially rural banks or smaller
banks, were unable to survive. They went bankrupt. At that time, some of their
activities are not regulated. After that experience, the regulatory bodies issued new
regulations that would ensure banks would not make the same mistake. Capital
retention requirements were laid down, they’re not allowed to engage in activities not
provided by law, they would need to secure permits from the BSP before they can offer
new services. They would need to prove they are capable, and in worst case scenarios
how are they going to deal with them? Have they thought of all the possible
consequences, all the problems that may arise?
Take digital banking. If there’s a glitch in the system and the account suddenly shows
zero, what’s their procedure to correct the mistake? How long will it take? How would
they communicate it with the customers? Remember BPI’s error in 2017? It affected a
lot of people and it surely lost them quite a number of customers. Even my account
was suddenly negative.
Only the fact that I worked in a bank before and their explanation was highly plausible
that I believed it was merely an error and not any sort of hacker attack.
Remember the Bangladesh Central Bank heist in 2016 involving RCBC? The money
involved hasn’t been returned in full.
Probably decades ago, people have been able to open accounts using fake names,
other people’s names, so long as they have money to deposit. In the late 1990s, early
2000, money laundering is a huge issue. Scams using digital wallets or online banking
has proliferated decades ago, when it’s still new and no regulations are in place yet.
People lost money with no recourse on how to get them back.
These days, a lot of changes have already been put in place. It’s more difficult to
commit financial fraud. There are digital traces now. If someone stole your login
credentials, there are ways to know the IP address of who used it. The banks can be
contacted to suspend your card if you think someone else is using it. You can apply for
chargebacks, if there are unauthorized charges on your account. That one still takes a
long time to process before you get your money back but at least we now have hope to
reclaim our money. Back then, you can literally lose all your money in just a snap. The
regulations have made it harder for criminals to steal. They protected people’s money
lodged in financial institutions. They protected the operations of financial institutions as
well.
At the same time, all modern financial markets operate within some kind of government
regulatory framework that sets limits on what types of transactions are allowed.
Financial systems are often strictly regulated because they directly influence decisions
over real assets, economic performance, and consumer protection.

Financial Market Components

Multiple components make up the financial system at different levels. The firm's
financial system is the set of implemented procedures that track the financial activities
of the company. Within a firm, the financial system encompasses all aspects of
finances, including accounting measures, revenue and expense schedules, wages, and
balance sheet verification.

On a regional scale, the financial system is the system that enables lenders and
borrowers to exchange funds. Regional financial systems include banks and other
institutions, such as securities exchanges and financial clearinghouses.

The global financial system is basically a broader regional system that encompasses all
financial institutions, borrowers, and lenders within the global economy. In a global
view, financial systems include the International Monetary Fund, central banks,
government treasuries and monetary authorities, the World Bank, and major private
international banks.
Elements of a financial system
Different searches provide different answers, but let’s go with this one.
The financial system primarily concerns itself with borrowing and lending.
 Lenders and borrowers
 Financial intermediaries
 Financial instruments
 Financial markets
 Money creation
 Price discovery
You have your depositors, saving their money in banks. The banks serve as the
intermediary. The banks loan money to borrowers, but the money mostly came from
the depositors. Essentially, the depositors are the lenders, but since it’s the bank doing
the hard work, they’re the ones who earn the most amount of money from lending. The
depositors are only given 0.25% to 2%. The rest becomes income of the bank.
Financial instruments, you have the savings, loans, investments…
Financial markets, where trading or exchange of money occurs. Mostly at financial
institutions. But there’s also the stock market, bond market, forex market, and
derivatives market.
Money creation. This is done by BSP in our country.
Quote from Inquirer article: The amount of currency printed and minted every year is
dictated by the size of the economy and the need to replace notes and coins that are
no longer fit for use. All notes and coins—every peso every Filipino has—are backed up
by the BSP's assets.
These will be discussed in FM104.
Price discovery. Quote from Wikipedia: The price discovery process is the process of
determining the price of an asset in the marketplace through the interactions of buyers
and sellers.
Basically, what’s agreed upon by the parties. How much one is willing to pay for
something versus how much one is willing to sell something, and they meet at a certain
point.
Functions of a financial system
https://www.indrastra.com/2016/05/FEATURED-5-Basic-Functions-of-a-Financial-
System-002-05-2016-0026.html
From Indastra Global: A financial system functions as an intermediary and facilitates the
flow of funds from the areas of surplus to the areas of deficit. It is a composition of
various institutions, markets, regulations and laws, practices, money managers,
analysts, transactions, and claims & liabilities.
People with excess cash, that they won’t be needing in the short-term or even long-
term, would put their money in banks. Those who need money would borrow from the
banks. Banks, and other financial institutions, serve as intermediary between lenders
and borrowers. Those who has money, and those who need them.
So, the function of a financial system would be to facilitate that flow of funds.
Savings
Liquidity (stocks, bonds, debentures, etc.)
Payment (check, credit card, bills payment, etc.)
Risk (insurance)
Policy (interest rates, inflation)

https://analystprep.com/cfa-level-1-exam/equity/main-functions-financial-system/
Saving
Borrowing
Raising Equity capital
Managing risks
Exchanging Assets for Immediate Delivery (Spot market trading)
Information-motivated trading
Determining appropriate rates of return
Efficient capital allocation
Development of the Philippine Financial System
http://manilynnataba.weebly.com/financial-system.html
History of Financial System

Financial System is like the heart of the human beings, if it stops working
then the person is dead in the same way that if the financial system stops working,
then the economy would collapse. It is inherent in every society the law of supply and
demand. There will always be those who have surplus resources and others will have
deficit. Financial System is crucial to the allocation of these resources.
In the Philippines settings, Financial System is composed of banking
institutions and nonbank financial intermediaries, including commercial banks,
specialized government banks, thrift banks and rural banks. It is also composed of
offshore banking units, building and loan associations, investment and brokerage
houses and finance companies. The Bangko Sentral ng Pilipinas and the Securities and
Exchange Commission maintained the regulatory and supervisory control.
The first credit institution in the Philippines, "The ObrasPias" was started by
Father Juan Fernandez de Leon in 1754 and ended in 1820. It was in 1851 that the first
Philippine Bank was established, the "Banco Espanol-Filipino de Isabela II". Banco
Español-Filipino de Isabela II is now known as Bank of the Philippine Islands. It is the
oldest standing bank in the Philippines and in the whole of Southeast Asia. It was
established on August 1, 1851 and named after the mother of then Spanish King
Alfonso XII. Her mother's name was Isabella. The bank only came into being after 23
years after Spanish Monarch Ferdinand VII decreed that a public bank was to be
established in the Spanish colonized country of the Philippines. The bank began its
operations in 1852 and was given the honor of being the first to issue paper money. In
1906 "First Agricultural Bank of the Philippines" was established and in 1916 all of its
assets and liabilities were transferred to the newly organized Philippine National Bank.

Towards a Resilient and Inclusive Financial Sector

The financial sector intermediates claims between savings and investors.

The credibility and stability of financial institutions and the relative attractiveness of
various financial instruments to borrowers and lenders alike determine how much
saving will mobilized, how much it stays in the country to be invested, and how this is
to be allocated among the various firms and industries. Together with the state of
confidence and long-term expectation, therefore, the stability and performance of
financial institutions such as banks, equity and bonds markets, insurance companies,
and other financial entities have an indirect but vital bearing on investment and the
growth of output and employment in the country.

Assessment

The Philippine financial system manifested its strength over the past decade,
including the period of recent global financial crisis. After significant dislocations in prior
crises in the 1980s and 1990s as well as the 1997 Asian Financial Crisis, the system saw
a steady improvement in the balance sheet of the banking industry, the issuance and
listing of corporate bonds, and the underwriting of insurance contracts. Moving forward,
however, the system will need to address concerns about the sustainability of its
performance if it is to contribute significantly to development.

Parallel to these, policymakers pursued broad-based financial sector reforms

centered on restructuring the banking sector, institutionalizing corporate governance
reforms, improving risk management and strengthening the supervisory oversight of
financial regulators1 in the early 2000s. Together with improved macroeconomic
conditions, the steady inflow of remittances from OFWs, a minimal investment exposure
to foreign structured products and a low dependence on exports, these reforms allowed
the financial system to avoid the worst difficulties encountered by other economies
during the 2007- 2008 financial crisis.

The financial system’s performance has been positively reviewed by third

parties.2 Stress tests conducted on banks also confirm the strength of the banking
system’s capitalization even with extreme test parameters. For inclusive finance
advocacy, local supervisory initiatives have also been repeatedly acknowledged by
international institutions.3 These external validations of the improvements in the
financial sector culminated in the sovereign ratings or outlook upgrades from some the
major ratings firms.
Structure of the Philippine Financial System
http://manilynnataba.weebly.com/financial-system.html

Current Structure of the Financial System

The Philippine financial system is primarily bank-based rather than capital

market-based. The banking sector, whose total assets accounted for more than 80
percent of the total resources of the financial system4 and of GDP in 2010, plays the
primary role in financial intermediation and is the main source of credit in the economy.

Across banking groups, universal and commercial banks continued to hold

the lion’s share of key balance sheet accounts of the banking system on account of
their market maturity, branch network and capitalization. The comparative market
shares of key banking groups are summarized in Table 6.1.

Meanwhile, the market share of nonbank financial institutions remains

relatively small, accounting for about 18 percent of total assets of the financial system
and 17 percent of economic output in 2010. The Insurance Commission (IC), for
instance, reports that only 13.9 percent of the Philippine population has private life
insurance coverage. In 2008, the private insurer’s penetration rate or the proportion of
the premiums to the country’s GDP was only 1.1 percent. Among the reasons cited for
the low insurance coverage is the lack of priority being placed on insurance products by
the citizenry and the low financial literacy level among low-income households including
the informal sector.
Picture
Picture

The insurance industry’s total assets reached P528.2 billion as of end-

December 2009 with 122 market players. Life insurers captured the bulk of the
insurance market at 79% while nonlife insurers at 19% and professional reinsurers at 2
percent.
 Meanwhile, the number of companies listed in the Philippine Stock Exchange
(PSE) grew to 259 companies in 2011 from just 12 companies in 2003. Despite the rise
in the number of listed companies, market capitalization as a percentage of economic
output remained small (except Indonesia) compared to other ASEAN-5 economies. In
2009, market capitalization dropped to 45.8 percent of GDP from 54 percent in 2002.
This reflects that the market remains illiquid and the free float of listed companies in
the PSE still limited.

Mutual funds, with market size likewise smallest in Asia, are managed by
broker-dealers and investment companies where largest of them in terms of asset size
are either subsidiaries or affiliates of banks.

https://www.bworldonline.com/philippine-financial-system-grows-in-2018-as-lenders-
assets-expand/
THE PHILIPPINE financial system sustained its growth in the second half of 2018 on the
back of the banking industry’s expansion, ending the year with an uptrend in assets,
loans, deposits, and capital, according to the Bangko Sentral ng Pilipinas (BSP).

“With the banking system at its core, the Philippine financial system has exhibited
resilience amid evolving domestic and global environment. It continued to expand its
assets, particularly its lending and investment portfolios, to support private and public
financing needs and in turn promote economic growth. Its activities brought higher
profitability, while maintaining adequate capitalization and liquidity buffers to absorb
potential shocks to operations,” the BSP said in its Report on the Philippine Financial
System for the second semester released over the weekend.

The report said the financial system’s resources expanded by 9.3% year-on-year in
2018. The growth of the financial system was driven by the growth of the banking
system’s assets by 11.5% year-on-year to P16.9 trillion. Meanwhile, non-bank financial
institutions’ assets increased by 7.6%, mainly driven by the expansion in the loan
portfolio of financing companies and non-stock savings and loans associations.

The financial system is composed of the banking industry as well as non-bank financial
institutions. Banks accounted for 83% of the total resources of the Philippine financial
system as of end-December 2018, the report said.
The growth of the banking system’s assets was primarily driven by the expansion of the
resources of universal and commercial banks, which held bulk of the industry’s assets at
P15.42 trillion, up 12% year-on-year, the BSP said. Thrift banks and rural and
cooperative lenders meanwhile logged slower asset growth at 6.5% (to P1.25 trillion)
and 7.2% (to P245.6 billion), respectively.

“The Philippine banking system sustained its growth story capping the year 2018 with
notable uptrends in assets, loans, deposits and capital. The banking system maintained
its solid footing as evidenced by its satisfactory asset quality, ample liquidity and
solvency, profitable operations and streamlined physical network,” the report said.

Loan growth supported banks’ asset expansion. The banking system’s total loan
portfolio expanded by 13.7% year-on-year to P10.08 trillion, comprising bulk of the
banking system’s resources at 59.6%, followed by financial assets other than loans and
cash and due from banks with 22% share (P3.73 trillion) and 15.4% share (P2.61
trillion), respectively.

However, the expansion of the banking system’s loans was slower than the 16.4% and
16.6% growth rates in December 2017 and December 2016, respectively.

“The recent deceleration in loan growth may be attributed mostly to supply-side factors.
On the supply-side, banks have opted to be more discerning in the grant of credit to
borrowers,” the BSP said.

Universal and commercial banks’ loans grew 14.6% to P9.02 trillion. Meanwhile, the
loan portfolio of thrift banks went up 6.6% to P916.9 billion, while that of rural and
cooperative banks expanded by just 4.1% to P140.9 billion.

The central bank said real estate activities still had the largest share of the banking
system’s total loan portfolio at 16.9%. This was followed by wholesale and retail trade
(12.5%), manufacturing (10.9%), and loans for household consumption (10.2%).
“For the thrift bank and rural and cooperative bank industries, the retail segment had
the largest share of lending,” the BSP said. “The rural and cooperative banks reported
high micro, small, medium enterprise and agri-agra compliance ratios as compared to
the universal and commercial banks.”

Meanwhile, total deposits of the banking system reached P12.76 trillion as of end-
December 2018, up 8.8% year-on-year. In terms of deposit types, savings deposits
from individuals were the biggest source of banks’ funding amounting to P6.02 trillion
or a 47.1% share in total deposits

The banking system’s capital also surpassed the P2-trillion mark, reaching P2.1 trillion
as of end-December 2018, up 17.7% from the previous year’s level of P1.76 trillion.

Under the Basel Committee on Banking Supervision’s risk-based capital adequacy

framework, banks remained well above the minimum thresholds set by the BSP (10%)
and the Bank for International Settlements (8%). The banking system’s capital
adequacy ratios, both on solo and consolidated bases, improved year-on-year to 15%
and 15.1%, respectively, as of end-December 2018.

The Philippine banking industry also ended 2018 with a positive bottom line as net
profit stood at P178.8 billion, 6.7% higher than the year-ago level.

The banking system likewise continued to expand its geographic footprint, with
universal and commercial lenders having the largest share of branches and other
offices. As of December 2018, there were 12,364 bank offices in the country.

“The outlook on the banking system remains positive given relatively robust
macroeconomic performance, adequate liquidity, as well as rising capital buffers and
opportunities presented by the growing economy and technological innovations,” the
central bank said.

“Moreover, the enactment of Republic Act (RA) No. 11211, which amends the Charter
of the Bangko Sentral ng Pilipinas, and RA No. 11127, which fosters the efficiency of
domestic financial transactions, further bolsters the BSP’s capability to promote the
stability of the financial system as required by the fast-evolving market landscape.”
Topic #2
2.Central Bank of the Philippines
2.1.The Development of Central Banking
2.2.Brief History of the Bangko Sentral ng Pilipinas
2.3.Objective of BSP
2.4.Functions of Central Bank

The Development of Central Banking

https://www.clevelandfed.org/en/newsroom-and-events/publications/economic-
commentary/economic-commentary-archives/2007-economic-commentaries/ec-
20071201-a-brief-history-of-central-banks.aspx
A central bank is the term used to describe the authority responsible for policies that
affect a country’s supply of money and credit. More specifically, a central bank uses its
tools of monetary policy—open market operations, discount window lending, changes in
reserve requirements—to affect short-term interest rates and the monetary base
(currency held by the public plus bank reserves) and to achieve important policy goals.

One of the world’s foremost economic historians explains the forces behind the
development of modern central banks, providing insight into their role in the financial
system and the economy.

There are three key goals of modern monetary policy. The first and most important is
price stability or stability in the value of money. Today this means maintaining a
sustained low rate of inflation. The second goal is a stable real economy, often
interpreted as high employment and high and sustainable economic growth. Another
way to put it is to say that monetary policy is expected to smooth the business cycle
and offset shocks to the economy. The third goal is financial stability. This encompasses
an efficient and smoothly running payments system and the prevention of financial
crises.

Beginnings
The story of central banking goes back at least to the seventeenth century, to the
founding of the first institution recognized as a central bank, the Swedish Riksbank.
Established in 1668 as a joint stock bank, it was chartered to lend the government
funds and to act as a clearing house for commerce. A few decades later (1694), the
most famous central bank of the era, the Bank of England, was founded also as a joint
stock company to purchase government debt. Other central banks were set up later in
Europe for similar purposes, though some were established to deal with monetary
disarray. For example, the Banque de France was established by Napoleon in 1800 to
stabilize the currency after the hyperinflation of paper money during the French
Revolution, as well as to aid in government finance. Early central banks issued private
notes which served as currency, and they often had a monopoly over such note issue.

While these early central banks helped fund the government’s debt, they were also
private entities that engaged in banking activities. Because they held the deposits of
other banks, they came to serve as banks for bankers, facilitating transactions between
banks or providing other banking services. They became the repository for most banks
in the banking system because of their large reserves and extensive networks of
correspondent banks. These factors allowed them to become the lender of last resort in
the face of a financial crisis. In other words, they became willing to provide emergency
cash to their correspondents in times of financial distress.

Transition

The Federal Reserve System belongs to a later wave of central banks, which emerged
at the turn of the twentieth century. These banks were created primarily to consolidate
the various instruments that people were using for currency and to provide financial
stability. Many also were created to manage the gold standard, to which most countries
adhered.

The gold standard, which prevailed until 1914, meant that each country defined its
currency in terms of a fixed weight of gold. Central banks held large gold reserves to
ensure that their notes could be converted into gold, as was required by their charters.
When their reserves declined because of a balance of payments deficit or adverse
domestic circumstances, they would raise their discount rates (the interest rates at
which they would lend money to the other banks). Doing so would raise interest rates
more generally, which in turn attracted foreign investment, thereby bringing more gold
into the country.
Central banks adhered to the gold standard’s rule of maintaining gold convertibility
above all other considerations. Gold convertibility served as the economy’s nominal
anchor. That is, the amount of money banks could supply was constrained by the value
of the gold they held in reserve, and this in turn determined the prevailing price level.
And because the price level was tied to a known commodity whose long-run value was
determined by market forces, expectations about the future price level were tied to it as
well. In a sense, early central banks were strongly committed to price stability. They did
not worry too much about one of the modern goals of central banking—the stability of
the real economy—because they were constrained by their obligation to adhere to the
gold standard.

Central banks of this era also learned to act as lenders of last resort in times of financial
stress—when events like bad harvests, defaults by railroads, or wars precipitated a
scramble for liquidity (in which depositors ran to their banks and tried to convert their
deposits into cash). The lesson began early in the nineteenth century as a consequence
of the Bank of England’s routine response to such panics. At the time, the Bank (and
other European central banks) would often protect their own gold reserves first, turning
away their correspondents in need. Doing so precipitated major panics in 1825, 1837,
1847, and 1857, and led to severe criticism of the Bank. In response, the Bank adopted
the “responsibility doctrine,” proposed by the economic writer Walter Bagehot, which
required the Bank to subsume its private interest to the public interest of the banking
system as a whole. The Bank began to follow Bagehot’s rule, which was to lend freely
on the basis of any sound collateral offered—but at a penalty rate (that is, above
market rates) to prevent moral hazard. The bank learned its lesson well. No financial
crises occurred in England for nearly 150 years after 1866. It wasn’t until August 2007
that the country experienced its next crisis.

The U.S. experience was most interesting. It had two central banks in the early
nineteenth century, the Bank of the United States (1791–1811) and a second Bank of
the United States (1816–1836). Both were set up on the model of the Bank of England,
but unlike the British, Americans bore a deep-seated distrust of any concentration of
financial power in general, and of central banks in particular, so that in each case, the
charters were not renewed.

There followed an 80-year period characterized by considerable financial instability.

Between 1836 and the onset of the Civil War—a period known as the Free Banking Era
—states allowed virtual free entry into banking with minimal regulation. Throughout the
period, banks failed frequently, and several banking panics occurred. The payments
system was notoriously inefficient, with thousands of dissimilar-looking state bank notes
and counterfeits in circulation. In response, the government created the national
banking system during the Civil War. While the system improved the efficiency of the
payments system by providing a uniform currency based on national bank notes, it still
provided no lender of last resort, and the era was rife with severe banking panics.

The crisis of 1907 was the straw that broke the camel’s back. It led to the creation of
the Federal Reserve in 1913, which was given the mandate of providing a uniform and
elastic currency (that is, one which would accommodate the seasonal, cyclical, and
secular movements in the economy) and to serve as a lender of last resort.
The Genesis of Modern Central Banking Goals

Before 1914, central banks didn’t attach great weight to the goal of maintaining the
domestic economy’s stability. This changed after World War I, when they began to be
concerned about employment, real activity, and the price level. The shift reflected a
change in the political economy of many countries—suffrage was expanding, labor
movements were rising, and restrictions on migration were being set. In the 1920s, the
Fed began focusing on both external stability (which meant keeping an eye on gold
reserves, because the U.S. was still on the gold standard) and internal stability (which
meant keeping an eye on prices, output, and employment). But as long as the gold
standard prevailed, external goals dominated.

Unfortunately, the Fed’s monetary policy led to serious problems in the 1920s and
1930s. When it came to managing the nation’s quantity of money, the Fed followed a
principle called the real bills doctrine. The doctrine argued that the quantity of money
needed in the economy would naturally be supplied so long as Reserve Banks lent funds
only when banks presented eligible self-liquidating commercial paper for collateral. One
corollary of the real bills doctrine was that the Fed should not permit bank lending to
finance stock market speculation, which explains why it followed a tight policy in 1928
to offset the Wall Street boom. The policy led to the beginning of recession in August
1929 and the crash in October. Then, in the face of a series of banking panics between
1930 and 1933, the Fed failed to act as a lender of last resort. As a result, the money
supply collapsed, and massive deflation and depression followed. The Fed erred
because the real bills doctrine led it to interpret the prevailing low short-term nominal
interest rates as a sign of monetary ease, and they believed no banks needed funds
because very few member banks came to the discount window.

After the Great Depression, the Federal Reserve System was reorganized. The Banking
Acts of 1933 and 1935 shifted power definitively from the Reserve Banks to the Board
of Governors. In addition, the Fed was made subservient to the Treasury.
The Fed regained its independence from the Treasury in 1951, whereupon it began
following a deliberate countercyclical policy under the directorship of William
McChesney Martin. During the 1950s this policy was quite successful in ameliorating
several recessions and in maintaining low inflation. At the time, the United States and
the other advanced countries were part of the Bretton Woods System, under which the
U.S. pegged the dollar to gold at $35 per ounce and the other countries pegged to the
dollar. The link to gold may have carried over some of the credibility of a nominal
anchor and helped to keep inflation low.

The picture changed dramatically in the 1960s when the Fed began following a more
activist stabilization policy. In this decade it shifted its priorities from low inflation
toward high employment. Possible reasons include the adoption of Keynesian ideas and
the belief in the Phillips curve trade-off between inflation and unemployment. The
consequence of the shift in policy was the buildup of inflationary pressures from the
late 1960s until the end of the 1970s. The causes of the Great Inflation are still being
debated, but the era is renowned as one of the low points in Fed history. The
restraining influence of the nominal anchor disappeared, and for the next two decades,
inflation expectations took off.

The inflation ended with Paul Volcker’s shock therapy from 1979 to 1982, which
involved monetary tightening and the raising of policy interest rates to double digits.
The Volcker shock led to a sharp recession, but it was successful in breaking the back
of high inflation expectations. In the following decades, inflation declined significantly
and has stayed low ever since. Since the early 1990s the Fed has followed a policy of
implicit inflation targeting, using the federal funds rate as its policy instrument. In many
respects, the policy regime currently followed echoes the convertibility principle of the
gold standard, in the sense that the public has come to believe in the credibility of the
Fed’s commitment to low inflation.
A key force in the history of central banking has been central bank independence. The
original central banks were private and independent. They depended on the
government to maintain their charters but were otherwise free to choose their own
tools and policies. Their goals were constrained by gold convertibility. In the twentieth
century, most of these central banks were nationalized and completely lost their
independence. Their policies were dictated by the fiscal authorities. The Fed regained
its independence after 1951, but its independence is not absolute. It must report to
Congress, which ultimately has the power to change the Federal Reserve Act. Other
central banks had to wait until the 1990s to regain their independence.

Financial Stability

An increasingly important role for central banks is financial stability. The evolution of
this responsibility has been similar across the advanced countries. In the gold standard
era, central banks developed a lender-of-last-resort function, following Bagehot’s rule.
But financial systems became unstable between the world wars, as widespread banking
crises plagued the early 1920s and the 1930s. The experience of the Fed was the worst.
The response to banking crises in Europe at the time was generally to bail out the
troubled banks with public funds. This approach was later adopted by the United States
with the Reconstruction Finance Corporation, but on a limited scale. After the
Depression, every country established a financial safety net, comprising deposit
insurance and heavy regulation that included interest rate ceilings and firewalls
between financial and commercial institutions. As a result, there were no banking crises
from the late 1930s until the mid-1970s anywhere in the advanced world.

This changed dramatically in the 1970s. The Great Inflation undermined interest rate
ceilings and inspired financial innovations designed to circumvent the ceilings and other
restrictions. These innovations led to deregulation and increased competition. Banking
instability reemerged in the United States and abroad, with such examples of large-
scale financial disturbances as the failures of Franklin National in 1974 and Continental
Illinois in 1984 and the savings and loan crisis in the 1980s. The reaction to these
disturbances was to bail out banks considered too big to fail, a reaction which likely
increased the possibility of moral hazard. Many of these issues were resolved by the
Depository Institutions Deregulation and Monetary Control Act of 1980 and the Basel I
Accords, which emphasized the holding of bank capital as a way to encourage prudent
behavior.
Another problem that has reemerged in modern times is that of asset booms and busts.
Stock market and housing booms are often associated with the business cycle boom
phase, and busts often trigger economic downturns. Orthodox central bank policy is to
not defuse booms before they turn to busts for fear of triggering a recession but to
react after the bust occurs and to supply ample liquidity to protect the payments and
banking systems. This was the policy followed by Alan Greenspan after the stock
market crash of 1987. It was also the policy followed later in the incipient financial
crises of the 1990s and 2000s. Ideally, the policies should remove the excess liquidity
once the threat of crisis has passed.

Challenges for the Future

The key challenge I see facing central banks in the future will be to balance their three
policy goals. The primary goal of the central bank is to provide price stability (currently
viewed as low inflation over a long-run period). This goal requires credibility to work. In
other words, people need to believe that the central bank will tighten its policy if
inflation threatens. This belief needs to be backed by actions. Such was the case in the
mid-1990s when the Fed tightened in response to an inflation scare. Such a strategy
can be greatly enhanced by good communication.

The second policy goal is stability and growth of the real economy. Considerable
evidence suggests that low inflation is associated with better growth and overall
macroeconomic performance. Nevertheless, big shocks still occur, threatening to derail
the economy from its growth path. When such situations threaten, research also
suggests that the central bank should temporarily depart from its long-run inflation goal
and ease monetary policy to offset recessionary forces. Moreover, if market agents
believe in the long-run credibility of the central bank’s commitment to low inflation, the
cut in policy interest rates will not engender high inflation expectations. Once the
recession is avoided or has played its course, the central bank needs to raise rates and
return to its low-inflation goal.

The third policy goal is financial stability. Research has shown that it also will be
improved in an environment of low inflation, although some economists argue that
asset price booms are spawned in such an environment. In the case of an incipient
financial crisis such as that just witnessed in August 2007, the current view is that the
course of policy should be to provide whatever liquidity is required to allay the fears of
the money market. An open discount window and the acceptance of whatever sound
collateral is offered are seen as the correct prescription. Moreover, funds should be
offered at a penalty rate. The Fed followed these rules in September 2007, although it
is unclear whether the funds were provided at a penalty rate. Once the crisis is over,
which generally is in a matter of days or weeks, the central bank must remove the
excess liquidity and return to its inflation objective.

The Federal Reserve followed this strategy after Y2K. When no financial crisis occurred,
it promptly withdrew the massive infusion of liquidity it had provided. By contrast, after
providing funds following the attacks of 9/11 and the technology bust of 2001, it
permitted the additional funds to remain in the money market once the threat of crisis
was over. If the markets had not been infused with so much liquidity for so long,
interest rates would not have been as low in recent years as they have been, and the
housing boom might not have as expanded as much as it did.

A second challenge related to the first is for the central bank to keep abreast of
financial innovations, which can derail financial stability. Innovations in the financial
markets are a challenge to deal with, as they represent attempts to circumvent
regulation as well as to reduce transactions costs and enhance leverage. The recent
subprime crisis exemplifies the danger, as many problems were caused by derivatives
created to package mortgages of dubious quality with sounder ones so the instruments
could be unloaded off the balance sheets of commercial and investment banks. This
strategy, designed to dissipate risk, may have backfired because of the opacity of the
new instruments.

A third challenge facing the Federal Reserve in particular is whether to adopt an explicit
inflation targeting objective like the Bank of England, the Bank of Canada, and other
central banks. The advantages of doing so are that it simplifies policy and makes it
more transparent, which eases communication with the public and enhances credibility.
However, it might be difficult to combine an explicit target with the Fed’s dual mandate
of price stability and high employment.

A fourth challenge for all central banks is to account for globalization and other supply-
side developments, such as political instability and oil price and other shocks, which are
outside of their control but which may affect global and domestic prices.
The final challenge I wish to mention concerns whether implicit or explicit inflation
targeting should be replaced with price-level targeting, whereby inflation would be kept
at zero percent. Research has shown that a price level may be the superior target,
because it avoids the problem of base drift (where inflation is allowed to cumulate), and
it also has less long-run price uncertainty. The disadvantage is that recessionary shocks
might cause a deflation, where the price level declines. This possibility should not be a
problem if the nominal anchor is credible, because the public would realize that
inflationary and deflationary episodes are transitory and prices will always revert to
their mean, that is, toward stability.

Such a strategy is not likely to be adopted in the near future because central banks are
concerned that deflation might get out of control or be associated with recession on
account of nominal rigidities. In addition, the transition would involve reducing inflation
expectations from the present plateau of about 2 percent, which would likely involve
deliberately engineering a recession—a policy not likely to ever be popular.
Brief History of the Bangko Sentral ng Pilipinas
https://www.bsp.gov.ph/Pages/History.aspx

Creating a Central Bank for the Philippines

A group of Filipinos had conceptualized a central bank for the Philippines as early as
1933. It came up with the rudiments of a bill for the establishment of a central bank for
the country after a careful study of the economic provisions of the Hare-Hawes Cutting
bill, the Philippine independence bill approved by the US Congress.

During the Commonwealth period (1935-1941), the discussion about a Philippine

central bank that would promote price stability and economic growth continued. The
country’s monetary system then was administered by the Department of Finance and
the National Treasury. The Philippines was on the exchange standard using the US
dollar—which was backed by 100 percent gold reserve—as the standard currency.

In 1939, as required by the Tydings-McDuffie Act, the Philippine legislature passed a

law establishing a central bank. As it was a monetary law, it required the approval of
the United States president. However, President Franklin D. Roosevelt disapproved it
due to strong opposition from vested interests. A second law was passed in 1944 during
the Japanese occupation, but the arrival of the American liberalization forces aborted its
implementation.

Shortly after President Manuel Roxas assumed office in 1946, he instructed then
Finance Secretary Miguel Cuaderno, Sr. to draw up a charter for a central bank. The
establishment of a monetary authority became imperative a year later as a result of the
findings of the Joint Philippine-American Finance Commission chaired by Mr. Cuaderno.
The Commission, which studied Philippine financial, monetary and fiscal problems in
1947, recommended a shift from the dollar exchange standard to a managed currency
system. A central bank was necessary to implement the proposed shift to the new
system.
Immediately, the Central Bank Council, which was created by President Manuel Roxas
to prepare the charter of a proposed monetary authority, produced a draft. It was
submitted to Congress in February1948. By June of the same year, the newly-
proclaimed President Elpidio Quirino, who succeeded President Roxas, affixed his
signature on Republic Act No. 265, the Central Bank Act of 1948. The establishment of
the Central Bank of the Philippines was a definite step toward national sovereignty.
Over the years, changes were introduced to make the charter more responsive to the
needs of the economy. On 29 November 1972, Presidential Decree No. 72 adopted the
recommendations of the Joint IMF-CB Banking Survey Commission which made a study
of the Philippine banking system. The Commission proposed a program designed to
ensure the system’s soundness and healthy growth. Its most important
recommendations were related to the objectives of the Central Bank, its policy-making
structures, scope of its authority and procedures for dealing with problem financial
institutions.

Subsequent changes sought to enhance the capability of the Central Bank, in the light
of a developing economy, to enforce banking laws and regulations and to respond to
emerging central banking issues. Thus, in the 1973 Constitution, the National Assembly
was mandated to establish an independent central monetary authority. Later, PD 1801
designated the Central Bank of the Philippines as the central monetary authority (CMA).
Years later, the 1987 Constitution adopted the provisions on the CMA from the 1973
Constitution that were aimed essentially at establishing an independent monetary
authority through increased capitalization and greater private sector representation in
the Monetary Board.

The administration that followed the transition government of President Corazon C.

Aquino saw the turning of another chapter in Philippine central banking. In accordance
with a provision in the 1987 Constitution, President Fidel V. Ramos signed into law
Republic Act No. 7653, the New Central Bank Act, on 14 June 1993. The law provides
for the establishment of an independent monetary authority to be known as the Bangko
Sentral ng Pilipinas, with the maintenance of price stability explicitly stated as its
primary objective. This objective was only implied in the old Central Bank charter. The
law also gives the Bangko Sentral fiscal and administrative autonomy which the old
Central Bank did not have. On 3 July 1993, the New Central Bank Act took effect.
Objectives of BSP

https://www.bsp.gov.ph/SitePages/AboutTheBank/AboutTheBank.aspx
Vision
The BSP aims to be recognized globally as the monetary authority and primary financial
system supervisor that supports a strong economy and promotes a high quality of life
for all Filipinos.

Mission
To promote and maintain price stability, a strong financial system, and a safe and
efficient payments and settlements system conducive to a sustainable and inclusive
growth of the economy.

https://www.bsp.gov.ph/SitePages/CitizensCharter/CitizensCharter.aspx
The primary objective of the Bangko Sentral is to maintain price stability conducive to a
balanced and sustainable growth of the economy and employment. It shall also
promote and maintain monetary stability and the convertibility of the peso.

The Bangko Sentral shall promote financial stability and closely work with the National
Government, including, but not limited to, the Department of Finance, Securities and
Exchange Commission, the Insurance Commission, and the Philippine Deposit Insurance
Corporation.

The Bangko Sentral shall oversee the payment and settlement systems in the
Philippines, including critical financial market infrastructures, in order to promote sound
and prudent practices consistent with the maintenance of financial stability. In the
attainment of its objectives, the Bangko Sentral shall promote broad and convenient
access to high quality financial services and consider the interest of the general public.
Functions of Central Bank
https://lawphil.net/administ/bsp/bsp.html
Responsibilities
The BSP provides policy directions in the areas of money, banking and credit. It
supervises operations of banks and exercises regulatory powers over non-bank financial
institutions with quasi-banking functions.

Functions of the BSP

Under the New Central Bank Act of 1993, the BSP performs the following functions, all
of which relate to its status as the Republic’s central monetary authority.

Liquidity Management.
The BSP formulates and implements monetary policy aimed at influencing money
supply consistent with its primary objective to maintain price stability.

Currency issue.
The BSP has the exclusive power to issue the national currency. All notes and coins
issued by the BSP are fully guaranteed by the Government and are considered legal
tender for all private and public debts.

Lender of last resort.

The BSP extends discounts, loans and advances to banking institutions for liquidity
purposes.

Financial Supervision.
The BSP supervises banks and exercises regulatory powers over non-bank
institutions performing quasi-banking functions.

Management of foreign currency reserves.

 The BSP seeks to maintain sufficient international reserves to meet any foreseeable
net demands for foreign currencies in order to preserve the international stability and
convertibility of the Philippine peso.

Determination of exchange rate policy.

The BSP determines the exchange rate policy of the Philippines. Currently, the BSP
adheres to a market-oriented foreign exchange rate policy such that the role of Bangko
Sentral is principally to ensure orderly conditions in the market.

Other activities.
The BSP functions as the banker, financial advisor and official depository of the
Government, its political subdivisions and instrumentalities and GOCCs.