CHAPTER 1. THE FINANCIAL SYSTEM et on the Keep your eyes on the stars, and your feet on th ‘ground. Dream big and work for it. Adapted from Theodore Roosevelt LEARNING OUTCOMES. Pe UIRO Toten eevee nate Bee eaitenWiciec UECINTRODUCTION cotton International Monetary Fund (IMF) and the World Bank (we) c’ — 7 assessments of countries that they help. It is imperative that the IMF 2 nancial standing of country borrowers. A study of the country’s financial s onduct financial nd WB monitor system is crucial in the study of capital markets because the financial market is central to the financial system The following report shows the standing of the Philippine financial sector. int work of IMF The Financial Sector Stability Assessment (FSSA) was based on the joi to Manila from and World Bank Financial Sector Assessment Program (FSAP) Update Mission November 4 to 17, 2009. The initial FSAP took place in 2002. The Update team comprised of World Bank staff including Pamela Madrid, the main author of the report. The FSSA Update on the Philippines was prepared as background documentation for the periodic IMF consultation with the member country. It was based on the information available at the time it was completed last January 11, 2010. The views expressed in the document are those of the staff team and do not necessarily reflect the views of the government of the Philippines or the Executive Board of the IMF. (Madrid 2010) FSAP assessments are designed to assess the stability of the financial system as a whole and not that of individual institutions. It has been developed to help countries identify and remedy weaknesses in their financial sector structure, thereby enhancing their resilience to macroeconomic shocks and cross-border contagion. FSAP assessments do not cover risks that are specific to individual institutions such as asset quality, operational or legal risks, or fraud. The main findings of this assessment are: © The banking sector has been strengthened considerably since the Asian crisis of the late 1990s and today appears generally resilient to a broad range of macroeconomic risks. The impact of the ongoing global crisis has thus far been milder than originally feared and the macroeconomic outlook is improving, although risks remain elevated in the near term. Considerable progress has been made toward implementing the recommendations of the initial FSAP, particularly in banking supervision, but also in strengthening the bank resolution framework and nonbank supervision. «Further strengthening of supervisory powers and practices is needed to bring supervision and bank safety nets to the best international standards and practices. In particular, it is critical to ensure adequate legal protection for supervisors and eliminate bank secrecy with respect to supervisory duties. * Development of the nonbank financial sectors would help growth and risk diversification. Capital markets and the insurance sector would benefit from harmonizing various taxes and lowering the regulatory burden on some products and services. In the housing finance sector, the multitude of government interventions and institutions need to be rationalized. All members of society—households, businesses, non-profit organizations, the church, and the government—are affected by the financial system of the country to which they belong. The government is primarily responsible for defining and regulating the financial system itself.the rules, regulations, and monetary The cen ral bank and its Monetary Board determine im for the policies that need to be implemented to ensure a stable and healthy financial syste country. “Business firms, households, and governments play a wide variety of roles in our modern financial system, All of us, one way or the other, are involved in the financial system either as a borrower or a lender or both. ‘ A country’s financial system is not however solely determined by the country itself Cecause other worldwide organizations like WB, IMF, Asian Development Bank, New York tock Exchange (NYSE), Osaka Securities Exchange (OSE), Australian Stock Exchange (ASK), Bats Global Markets (Bats), and Shenzen Stock Exchange, among others and the transnational banks affect the financial system of the country. Our modern world has a complex and Sophisticated financial system that has been and will always be affected by globalization. This chapter will discuss what a financial system is and its role in the economy. It will also tackle the roles the different participants in a financial system play. The monetary system, the monetary policy and its effect in the economic system of a country, and the tools of monetary policy and how they affect money supply and interest rates will also be dealt with in this chapter. Lastly, the role of the Bangko Sentral ng Pilipinas (BSP) in the economic development of the Philippines will be elaborated. FINANCIAL SYSTEM: DEFINITION Financial system describes collectively the financial markets, the financial system participants, and the financial instruments and securities that are traded in the financial markets. The functions of the financial system are: . to channel the funds from the savings units (lenders) to the deficit units (borrowers); . to provide a medium of exchange; ° to provide a mechanism for risk sharing; and . to provide a channel through which the central bank can influence the economy, in general and the financial system, in particular. With the advent of globalization, we have a multinational financial system. Multinational financial system refers to the collective financial transfer mechanisms that facilitate the movement of money and profits between and among financial system participants throughout the world. These mechanisms include transfer of prices on goods and services traded internally and internationally; intercompany loans and leading (speeding up) and lagging (slowing down) payments, fees, and royalty charges wherever they are located in the world; and dividend payments. Together, they lead to a “pattern of profits and movements of funds that would be impossible in the world of Adam Smith” (Shapiro 2003). Kidwell et al. (2013) cited the inferences that we can draw about the financial system: ° If the financial system is competitive, the interest rate that the bank pays on certificates of deposit (CDs) will bear at or near the highest rate that you can earn on CDs of similar maturity and risk. At the same time, borrowers will have borrowed atAL Mannnrs or near the lowest possible interest cost, given their risk class. Competition among banks for deposits will drive CD rates up and loan rates down. * Banks and other depository institutions, such as insurance companies, gathe, Money from consumers in small dollar amounts, aggregate it, and then make joan, in much larger dollar amounts, * One important function of the financial system is to allocate money to the mos, productive investment projects in the economy. If the financial system is workin, properly, only projects with high-risk adjusted rates of return are funded, and those with low rates are rejected, * Finally, banks are profit-making organizations, and the bank and other lenders ear, much of their profits from the spread between lending and borrowing rates, From the foregoing discussion, we can see that financial system performs four basic functions, which are also the functions of. finance and financial managers. * Fund acquisition —a way of getting deposits and necessary funds to finance projects and investments * Fund allocation — determining to which uses, projects, or investments the acquireq funds will be used * Fund distribution — the process by which necessary funds are given to the uses, projects, or investments that need funds . Fund utilization — using the funds for its intended purpose FINANCIAL SYSTEM PARTICIPANTS There are six participants or sectors in the financial system: 1. households or consumers financial institutions/intermediaries non-financial institutions 2 3 4. government 5. central bank 6. foreign participants Households or Consumers Households or consumers are generally described as the group that receives income ‘majority of which typically comes from wages and salaries. Such income is spent on goods an services, anda partis saved. Gross savings is equal to current income less current expenditure: What is spent is termed consumption. Goods that are consumed within a current period ar termed non-durable consumer goods or non-durables. Goods that will last for more thanyear are termed durable consumer goods of durables. According to the Hadjimichalakises (1995), “the standard definition of consumer durables, however, is that they.are consumption goods with a life of three or more years. The assumption is that all consumer goods with shorter lives are used up in the year in which they are purchased.” Typically, consumers or households purchase non-durables from current income and borrow for the durables like cars, washing machines, air conditioners, or houses, Financial Institutions/Intermediaries Financial institutions/intermediaries are the firms that bridge the gap between surplus units (SUs) or investors/lenders and deficit units (DUs) or borrowers. They channel funds from lenders to borrowers. They include depository institutions and non-depository institutions. Other than being channels, they are lenders and borrowers at times. When they underwrite securities or acts as brokers or dealers, they are intermediaries. If they buy securities, they are investors or lenders, and when they are the ones issuing the securities, they are borrowers. Non-Financial Institutions Non-financial institutions are businesses other than financial institutions or intermediaries. They include trading, manufacturing, extractive industries, construction, genetic industries, and all firms other than the financial ones. Just like households and financial. institutions, these are also borrowers or lenders or both at one time or another. When these non-financial institutions buy securities, they are lenders, investors, or savers; when they issue the securities, they are the borrowers. Government The government means the national, provincial, municipal or city governments, and barangays or towns comprising the Philippines as a whole, Each division has its heads and agencies that help in running the division they are responsible for. The president is responsible forthe entire country, the governor is responsible for his own province, the mayor is responsible for his own city, and the barangay captain is responsible for his own barangay. Each of them has his own agencies. The Bureau of the Treasury (BTR) is part of the government that is a participant in the financial system. When BTR or any other subdivisions of government issue their own securities, they act as borrowers/deficit units, and when the BTR or any other subdivisions of government buy securities, they act as investors or savers/surplus units, Central Bank The Bangko Sentral ng Pilipinas and all the other central banks of the different countries are mandated to ensure that their respective countries have a stable and healthy financial system. They oversee the operations of their entire financial system and mandate the rules, regulations, and monetary policies that will help them maintain a healthy and stable economy. Central bank is the “banker” to banks. It provides various services to banks such as helpingThe Bangko Sentral ng Pilipinas (BSP) was established on July 3, 1993 pursuant to the provisions of the 1987 Philippine Constitution and Republic Act No. 7653, the New Central Bank Act of 1993 to replace the Central Bank of the Philippines. BSP enjoys fiscal and administrative autonomy in the pursuit of its mandated responsibilities. New Logo - The new BSP logo is a perfect round shape in blue that features three gold stars and a stylized Philippine eagle rendered in white strokes. These main elements are framed on the left side with the text inscription “Bangko Sentral ng Pilipinas” underscored by a gold line drawn in half circle. The right side remains open, signifying freedom, openness, and readiness of BSP as represented by the Philippine eagle (signifying strength, clear vision, and freedom) to soar and fly toward its goal. Putting all these elements together in a solid blue background signifies stability. The stars are rendered in gold to symbolize wisdom, wealth, idealism, and high quality. The white color c the eagle and the text for BSP represent purity, neutrality, and mental clarity. Principal Elements: 1. The Philippine eagle, our national bird, is the world’s largest eagle and a symbol « strength, clear vision, and freedom, the qualities we aspire for as a central bank. 2, The three stars represent the three pillars of central banking: price stabilit stable banking system, and a safe and reliable payments system. It may also t interpreted as a geographical representation of BSP’s equal concern for the impa of its policies and programs on all Filipinos, whether they are in Luzon, Visayas, Mindanao. altraprnse LT EEXANcial SYSTEM 3. Colors * The blue background signifies stability. + The stars are rendered in gold to symbolize wisdom, wealth, idealism, and high quality. . The white color of the eagle and the text for BSP represent purity, neutrality, and mental clarity. 4. Font or typeface, Non-serif, bold for “BANGKO SENTRAL NG PILIPINAS” to suggest solidity, strength, and stability. The use of Non-serif font characterized by clean lines portrays the no-nonsense professional manner of doing business at BSP. 5. Round shape to symbolize the continuing and unending quest to become an excellent monetary authority committed to improve the quality of life of Filipinos. This round shape is also evocative of our coins, the basic units of our currency. History 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. According to Fajardo (1994), Miguel Cuaderno, the first governor of the Central Bank of the Philippines (the former name of the now Bangko Sentral ng Pilipinas) initiated the development of the concept of a central bank in 1933 (For thirteen years, he conducted a research on the various central banks of many countries). 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 the then Finance Secretary Miguel Cuaderno, Sr. to draw up a charter for a central bank. As governor, he chose the charter of the Central Bank of Guatemala as the model for the charter of the Central Bank of the Philippines because of the similar economic and social conditions of Guatemala and the Philippines. 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 February 1948, By June of the same year, the newly proclaimed President Elpidic 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 <Carvrat, Marae ges were introduced to make definite step toward national sovereignty. Over the years, chant the charter more responsive to the needs of the economy. Organizational Structure By organization, the basic structure of the Bangko Sentral ng The Monetary Board exercises the powers and functions of BSP, such as the conduct of monetary policy and supervision of the financial system. Its chairman is the Bsp Governor, with five full-time members from the private sector and one member from the Cabinet. The Governor is the Chief Executive Officer of BSP and is required to direct and supervise the operations and internal administration of BSP. A deputy governor heads each of the BSP’s operating sectors. * Executive Management Services is the functional grouping of all units directly reporting to the Monetary Board or to the Governor. ilipinas includes: Functional Sectors: {= Monetary Stability Sector takes charge of the formulation and implementation of the BSP’s monetary policy, including serving the banking needs of all banks through accepting deposits, servicin, withdrawals, and extending credit through the rediscounting facility, SUPERVISION AND EXAMINATION SECTOR SP’S Organi ‘Ph 2015)Crrren 1: Tun FInaxctat SYSTEM (83 goeph 2015) Examination Sector (BSP gowph 2015)Cariran Maners . Deputy Governor RESOURCE MANAGEMENT SECTOR Provident Fund Office |_| Payments & Crisis Management Settlements Office Office oe Gomrlenin eee| |Seitereoat Services Sub-sector Sub-sector Sub-sector eed & ——l T Budget Policy, Planning Human Resource Standards Administrative & Special Development & Planning Services Studies Department Group Department Group ea Enterprise luman Resource Facilities Financial Management a |_| Management ‘Accounting DERE se & Engineering Department bes Department ro [4 asP institute Taformation Project Technology r| Development & Infrastructure Mgmt Office & Operations Medical & Dental Re linc Preatapest Information oe ‘Systems, Support & Development Security Paes LI} tnvestigation & Transport Department , Figure 4: The Resource Management Sector (BSP.gov.ph 2015)OFFICE OF THE ASSISTANT GovERNOR FINANCIAL SERVICES GRouP BANKNOTES AND CON RAND | secunrmies prooucrion| | MINT ANO REFINERY DEPARTMENT OF SECURITIES PRINTING ‘OPERATIONS: Galfer ceeee DEPARTMENT pinaneEMeN DEPARTMENT DEPARTMENT. Figure 5: The Security Plant Complex (BSP.gov.ph 2015) The Monetary Board The Board that governs the Central Bank is called the Monetary Board. Hence, the Powers and functions of Bangko Sentral are exercised by its Monetary Board, which has seven members appointed by the President of the Philippines. The Chairman is the Governor of 8SP. Under Republic Act No. 7653, the New Central Bank Act, one of the government sector members of the Monetary Board must also be a member of the Cabinet designated by the President. Five other members come from the private sector. The New Central Bank Act took effect on June 14, 1993, during the reign of then President Fidel Ramos. It established an independent Central Monetary Authority, which is now known as the Bangko Sentral ng Pilipinas (BSP) with a capital of P50 billion. The New Central Bank Act established certain qualifications for the members of the Monetary Board and also prohibited members from holding certain positions with other governmental agencies and private institutions that may give rise to conflicts of interest, With the exception of the members of the Cabinet, the Governor and the other members of the Monetary Board serve terms of six years and may only be removed for cause, The Monetary Board meets at least once a week. The Board may be called toa meeting by the Governor of the Bangko Sentral or by two other members of the Board. Usually, the Board meets every Thursday but on some occasions, it convenes to discuss urgent issues. The major functions of the Monetary Board include the power to: 1. Issue rules and regulations it considers necessary for the effective discharge of the responsibilities and exercise of the powers vested in it. 2. Direct the management, operations, and administration of Bangko Sentral, organize its Personnel, and issue such rules and regulations as it may deem necessary or desirable for this purpose. Establish a human resource management system which governs the selection, hiring, appointment, transfer, promotion, or dismissal of all personnel. Such system shall aim to 11Carvear Mani establish professionalism and excellence at all levels of the Bangko Sentral in accordance with sound principles of management. 4, Adopt an annual budget for and authorize such expenditures by Bangko Sentral iH the interest of the effective administration and operations of Bangko Sentral in accordance with applicable laws and regulations. 5. Indemnify its members and other officials of Bangko Sentral, including personnel of the departments performing supervision and examination functions, against all costs and expenses reasonably incurred by such persons in connection with any civil or criminal action, suit, or proceeding, to which any of them may be made a party by reason of the performance of his functions or duties, unless such members or other officials are found to be liable for negligence or misconduct. The current composition of the Monetary Board is shown in the following table: Table 1: The BSP Monetary Board Chairman_| Nestor Espenilla, J Members _| Carlos Dominguez III Antonio Abacan, Jr. Juan De Zuftiga, Jr. Valentin Araneta Felipe Medalla Peter Favila The figures on the succeeding pages show the Bangko Sentral ng Pilipinas and the Philippine Financial System. The Bangko Sentral ng Pilipinas is at the top of the structure being mandated to oversee the financial system of the country. It is the agency that is to ensure that the country has a healthy financial system and a stable economy. It is the central monetary authority. Figure 6 shows BSP in relation to the different banking and non-bank financial institutions and Figure 7 details the different non-bank financial institutions under BSP. The Bangko Sentral ng Pilipinas is primarily responsible for regulating the flow of money and credit into the whole economy in order to attain monetary stability and sustainable economic growth. Its major task is to mobilize and direct the resources of the Philippine Financial System toward the social and economic growth of the economy, in particular and the country, in general. Its paramount importance is the improvement of the life of the masses by alleviating poverty, Through its different monetary instruments, the Bangko Sentral ng Pilipinas is'able to fashion a desirable level of prices, investments, production, incomes, and consumptions (Fajardo et al. 1994). The Bangko Sentral ng Pilipinas has the ultimate social responsibility of uplifting the economy and fostering growth and development of the country. Under the Bangko Sentral are the different banking institutions, both private anc government, and the non-bank financial institutions, also both private and government. The Private banking institutions are composed of the commercial banking institutions, the thrifCnarrer 1: Tue Five banks, and the rural banks. This is depicted in the chart representation as derived from the descriptive narration in Fajardo and Mananisala's Money, Credit and Banking (1993). The government banking institutions include the Philippine National Bank, the Development Bank of the Philippines, the Land Bank of the Philippines, and the Philippine Amanah Bank. Under the non-bank financial institutions are the private non-bank financial institutions and the government non-bank financial institutions. Under the private non- bank financial institutions are the investment banks/houses, investment companies, finance companies, securities dealers and brokers, non-stack savings and loan associations, building and loan associations, pawnshops, lending investors, fund managers, trust companies/ departments, insurance companies, and venture capital corporations. Under the government non-bank financial institutions are the Government Service Insurance System (GSIS) for the government employees and the Social Security System (SSS) for the private company employees. . Also under the Bangko Sentral ng Pilipinas are the cooperatives that are handled directly by the Cooperative Development Authority under the Office of the President. Private insurance companies are under the Insurance Commission, These organizations are however mandated to submit reports to the Bangko Sentral ng Pilipinas so that BSP can monitor their operations and the effects on the financial and monetary system of the country. Other financial institutions are overseen by the Securities and Exchange Commission (SEC). BANGKO SENTRAL NG PILIPINAS. BANKING INSTITUTIONS NON-BANK FINANCIAL INSTITUTIONS ‘covennvent “CANKING PRIVATE BANKING INsTITUTIONS NSTTUTIONS Canmerc nz I es Prose Hf [ Peoprent [and aore Piipine i | tos ‘nkorone che “insta estates ese LJ Fritpines rriipines Sine Sang ordre, eral Montoae omer nies | Banke erased Figure 6: BSP and the Banking Institutions and the Non-Bank cama Financial Institutions ‘Continuation of Non-bank Financial Insitutions is presented in gure 7, wae ed asians| eas iaencnmmnmmmialaenlen saan Carrrat MARKETS 4_Garrran Mangers 00 BANGKO SENTRAL NG PILIPINAS TNON BANK FINANCIAL INSTITUTIONS Trivate Non-Bank Financial Isttution } Government Non-Bank Financia Institution Lending investors li Securities dealers/brokers li “Government Service | — Insurance System Pewnshons Fund Managers | Social Security System Trust Companies/Departments i} Figure 7: BSP and the Non-Bank Financial institutions BSP Vision and Mission Vision: Mission: BSP aims to be a world-class monetary authority and a catalyst for a globally competitive economy and financial system that delivers a high quality of life for all Filipinos. BSP is committed to promote and maintain price stability and provide proactive leadership in bringing about a strong financial system conducive to a balanced and sustainable growth of the economy. Towards this end, it shall conduct sound monetary policy and effective supervision over financial institutions under its jurisdiction. Objectives of BSP BSP, as the central monetary authority of the country, is expected to provide the country with a safer, more flexible, and more stable and healthy monetary and financial system that will support a stronger economy. It is enjoined to: 1. maintain monetary policies conducive to a balanced and sustainable growth of the economy; maintain price stability in the country; Promote and maintain monetary stability and the convertibility of the peso;4. maintain stability of the financial system; 5. provide payment and other financial services to the government, the public, financial institutions, and foreign official institutions; and 6. supervise and regulate depository institutions. To attain its objectives, the monetary and fiscal policies of the country need to be closely and efficiently coordinated. The different agencies of the government, both financial and fiscal, need to cooperate with one another. Moreover, it is important that there would be coordination and cooperation between the government and the private sectors. These sectors are partners in nation- building. Functions of BSP Being the primary monetary authority, BSP performs the following functions: 1. Bank of issue BSP has the monopoly of printing money bills and minting money coins. This monopoly is designed to: * ensure the uniformity of design and content of money; * effect government supervision over money supply; * give prestige and honor to the central bank; and ° become a good source of income for the government. 2. Government's banker, agent, and adviser BSP handles the banking accounts of government instrumentalities. All government agencies deposit their funds with BSP. It provides foreign exchange to the government for the importation of goods and services and for payment of foreign loans. If funds are not sufficient for the needs of the country, BSP borrows from international financial institutions like WB and IMF. agencies and 3. Custodian of the cash reserves of banks All banks are regulated to have adequate reserves in proportion to their deposit liabilities with BSP to ensure availability of cash to depositors who wish to withdraw deposits. These reserve requirements create the interbank call loans, that is, when one bank lacks funds to comply with the reserve requirement of BSP, it borrows money from other banks’ reserves with BSP for say, overnight. The interest rate on these interbank call loans is called the reverse repo rate (RRP), which is the overnight borrowing rate, the official interest rate in the Philippines. In the Philippines, interest rate decisions are taken by the Monetary Board of BSP. In case of oversupply of money creating inflation, the legal reserve requirement is made higher to cut down liquidity or too much money in circulation. The reserve requirement, say 20%, means that for every peso of deposit, the bank can onlyTAL MARKETS lend 80 centavos because the 20 centavos is deposited with BSP. The reserves deposited at BSP only earn minimal interest, unlike the loans granted by the banks to borrowers. This is the reason the banks do not like a high reserve reduirement, that is, they are unable to earn more because the amount they can lend is limited by the reserve requirement. The cash reserves, aside from regulating money supply, are able to help the government in times of financial crises. Custodian of the nation’s reserves of international currency The éarly years of central banking required central banks to maintain a minimum reserve of gold, and later of international currency, a5 @ guarantee for its issuance of currency bills or notes and deposit liabilities (cash reserves of commercial banks). This is designed to meet problems relevant to balance of payments and maintaining the external value of the local currency. A central bank must meet its domestic and international payments to create confidence in the people it serves and the countries it deals with abroad. The US dollar, Swiss franc, Japanese yen, German mark, British pound and more recently, the euro are among the currencies accepted as international currency. Bank of rediscount and lender of last resort The rediscounting function of the central bank means the central bank lends money to banks in distress on the basis of their promissory notes or the promissory notes of the bank borrowers. When banks grant loans to borrowers, borrowers execute a promissory note, which the bank discounts. Interest is immediately deducted from the proceeds of the loans, for example, if the interest is P200 on a 1,000 loan, the net proceeds that the borrower gets is P1,000 — 200 = P800. The process is known as discounting. These notes are presented by these banks to obtain a loan from the central bank, that is why it is termed rediscounting, that is, the discounted notes are again discounted. Bank of central clearance and settlement The central bank acts as a sort of clearing house. This means that banks send representatives to the clearing house at the central bank where claims are demanded by one bank against another. Banks have their own boxes at the clearing house. All checks placed in the boxes are payable to banks that .cashed them. For example, a representative of Bank A has the check of Bank B. The representative places the check of Bank B in the box of Bank B. This means that Bank A demands payment from Bank B. Through the process of bookkeeping (debits and credits), banks’ claims against other banks are settled and cleared. These settlements are done through the reserves that all the banks have with the central bank. For checks issued and cashed in Metro Manila, the clearing of checks is conducted by the Philippine Clearing House Corporation (PCHC). Trusted as a neutral service bureau of banks, PCHC extended its operating outfit by implementing several electronic-based payment system services for the banking community such as the Electronic Peso Clearing System (EPCS), Philippine Domestic Dollar Transfer System (PDDTS), and Project Abstract Secure System (PASS). Sorting, processing,Tih FINANCIAL SYSTEM Currie and clearing of checks are done by computers. Clearing of checks for provincial Checks and Metro Manila checks is done manually at the Manila Clearing/Regional Clearing Units of BSP. Cebu, Davao, and Bacolod have their own clearing units. 7. Controller of credit Controlling money supply requires controlling credit, The higher the money supply in circulation, the higher the prices of goods and services. Limited supply of money means lower prices, which do not encourage production. Hence, it is imperative for the central bank to limit, not only the money supply, but also credit. This is because credit is in addition to the money supply in circulation. The more credit there is available, the more production is encouraged because the consumers can also spend more if they are also able to obtain credit. BSP can control credit by: a. increasing or decreasing interest rates; b. increasing or decreasing the legal reserve requirement of banks; ©. regulating the margin requirements of stock exchange securities; d. open market operations (buying or selling government securities); 2 imposing ceilings on total amounts bank can lend; rationing central bank credit; 8- restricting imports; h. selecting projects for funding; and moral suasion (i.e., encouraging people and businesses to support and cooperate with central bank policies and regulations). MONETARY POLICY AND FINANCIAL SYSTEM Monetary policy refers to the manipulation of money supply to affect the economy of a country as a whole. It largely impacts interest rates. Increases in the money supply lower short-term interest rates and will encourage investments and consumption. On the long run, however, an abundance of money supply leads to increased prices or inflation and is undesirable. This is where BSP plays its role as the balancer. Generally speaking, expansionary monetary policies and contractionary monetary policies involve changing the level of the money supply in a country. Expansionary monetary policy is simply a policy which expands (increases) the supply of money, whereas contractionary monetary policy contracts (decreases) the supply of a country’s currency. Money supply is the total of currency and coins and demand deposits in the economy. Moffatt (2016) discussed the effects of monetary policy in his article “What Effects Does Monetary Policy Have?” Expansionary monetary policy that increases the money supply causes an increase in bond prices and a reduction in interest rates. Lower interest rates lead to} Gagrisy Mynerye higher levels of Capital Wnvestener. They mate domedtic bond lets attractive, 40) the demand for domestic bonds tallt hd the demand tor foreign tones Hee Ait ete being equal, a larger money supply lower market Interest tates. Conversety, emalter money supplies tend to merken interme rates ms, “ us Sean wishes to increase money supply, it can do a combination of thras 1 Porchave securities in the open market, known #s open market operations. 2 Lower the government discount rate, 3. Lower reverve requirement on banks. ‘These directly impact the interest rate. When the national treasury buys securities in the ‘open marker. the price of those securities rises Bond prices and interest rates are inversely related. Government discount rate is an interest rate, so lowering it is essentially lowering interest rates if the national treasury decides instead to lower reserve requirements, this will ‘cause banks to have an increase in the amount of money they can invest or lend. This causes ‘he price of investments such as bonds to rise, so interest rates must fall. No matter what toot ‘She central bank uses to expand the money supply, interest rates will decline and bond prices will roe. increases in bond prices will affect the exchange market. Assuming an increase in Philippine bond prices, investors would want sell those bonds in ‘exchange for other lower-priced bonds. Investors will sell the Philippine bonds because they will receive higher proceeds. So an investor will sell his Philippine bond, exchange his peso for dollar, and buy a US bond. This causes the supply of peso in foreign exchange markets to ‘imorease and the supply of dollar in the foreign exchange markets to decrease. This will cause peso to become less valuable relative to the dollar. The lower exchange rate makes Philippine- produced goods cheaper in the US and US-produced goods more expensive in the Philippines, Therefore, exports will increase and imports will decrease causing the balance of trade to increase When interest rates are lower, the cost of financing capital projects is less. So all else being equal, lower interest rates lead to higher rates of capital investment. ‘We can observe the following relative to contractionary monetary policy: i Comtractionary monetary policy causes an increase in bond prices and a reduction in imerest rates. 2 Lower interest rates lead to higher levels of capital investment. 2 The lower interest rates make domestic bonds less attractive, so the demand for Gomesnc bonds falls and the demand for foreign bonds rises. 4 The demand for domestic currency falls and the demand for foreign currency rises, Causing 2 decrease in the exchange rate. The value of the domestic currency is now lower relative to foreign currencies, 5 Lower exchange rate Causes exports to increase, imports to decrease, and balance Of trade to increase.rer 1: ‘Tim FINANCIAL SYSTEM The effects of a contractionary monetary policy are precisely the opposite of an expansionary monetary policy. When the central bank wishes to decrease money supply, it can do a combination of three things: 1. _ Sell securities in the open market, known as open market operations. 2. — Raise the discount rate. 3. Raise the reserve requirements. These cause interest rates to rise, either directly or through the increase in the supply of bonds in the open market through sales by the national treasury or by banks. This increase in supply of bonds reduces the price for bonds. These bonds will be bought by foreign investors, so the demand for domestic currency will rise and the demand for foreign currency will fall. Thus, the domestic currency will appreciate in value relative to the foreign currency. The higher exchange rate makes domestically produced goods more expensive in foreign markets and foreign goods cheaper in the domestic market. Since this causes more foreign goods to be sold domestically and less domestic goods sold abroad, the balance of trade decreases. The interest rates cause the cost of financing capital projects to go higher, so capital investment will be reduced, We can observe the following relative to contractionary monetary policy: 1. Contractionary monetary policy causes a decrease in bond prices and an increase in interest rates. 2. Higher interest rates lead to lower levels of capital investment. 3. Higher interest rates make domestic bonds more attractive, so the demand for domestic bonds rises and the demand for foreign bonds falls. 4, The demand for domestic currency rises and the demand for foreign currency falls, causing an increase in the exchange rate. The value of the domestic currency is higher relative to foreign currencies. 5. Higher exchange rate causes exports to decrease, imports to increase, and balance of trade to decrease. The primary objective of the BSP’s monetary policyis “to promote price stability conducive to a balanced and sustainable growth of the economy” (Republic Act 7653). The adoption of inflation targeting framework of monetary policy in January 2002 is aimed at achieving this objective. inflation targeting is focused mainly on achieving a low and stable inflation, supportive of the economy's growth objective. This approach entails the announcement of an explicit inflation target that BSP promises to achieve over a given time period. The government's inflation target is defined in terms of the average year-on-year change in the consumer price index (CPI) over the calendar year. In line with the inflation targeting approach to the conduct of monetary policy, the Development Budget Coordination Committee (DBCC) through its Resolution No. 2015-7 dated 29 December 2015, maintained the current inflation target at 3.0 percent + 1.0 percentage point for 2016-2018.= ard on™ regu Cartan MARKETS _ The highlights of the meeting of the Monetary Boar’. © 23 March 2016 approved by the Monetary Board during ! 2016 include the following: 1, The Monetary Board (MB) decided to: a.° maintain the BSP’s key policy inte! RRP (borrowing) facility and 6.0 facility; spans s, an ‘s; ant b. maintain the current interest rates on term RRPS, RP: onetary policy stance helg 5 jar meeting held on 7 Ai i 0 percent for the overnighy ites at 4.0! ‘ rest rate he overnight RP (lending) 10 percent for t it ratios. 2. The Monetary Board's assessment of a manageable infatio”® ee and robust growth conditions continues to support Keepin’ Coe range ne aemanged. Average inflation is projected to settle within the fa7E™ NE of 3.9 percent + 1 percentage point for 2016-2018, while inflation expectat ae continue aetpe frmy anchored within the inflation target band over the pelicy horizon, The risks surrounding the inflation outlook have remained tilted to the downside, Downward pressures on inflation could arise from slower-than-expected global d effects from lower international economic activity and potential second-roun a oil prices, while upside risks could come from the impact of EI Nifilo dry weather conditions on food prices and utility rates as well as pending petitions for power rate adjustments. cc. maintain the current reserve requiremen 3, Atthe same time, the Monetary Board observed that domestic demand conditions continue to be buoyant, supported by solid private household and capital spending, positive business sentiment, and adequate credit and domestic liquidity. 4, The Monetary Board also recognized that uncertainty over economic growth prospects across the globe could continue to drive volatility in global financial markets in the months ahead. BSP uses several tools to implement its monetary policies other than controlling interest and selling government rates. Among these tools are its open market operations (buying securities), reserve requirements on banks, discount rate, credit control, money supply, etc. Monetary policy seeks to influence either the demand for or supply of excess reserves resulting from the implementation of monetary policy triggering a sequence of events that affect such ‘economic factors as short-term interest rates, long-term interest rates, foreign exchange rates, the amount of money and credit in the economy, and the levels of employment, output, and prices. Depository institutions trade excess reserves held at the central bank among themselves. Those with excess reserves earn by lending them to banks with deficit as explained under interbank call loan. The rate of interest on these interbank transactions becomes a benchmark interest rate to guide monetary policy. This rate is a function of the supply and demand for cea ben funds among banks and the effects of the central bank trading in its open marketit sells The open market operations of BSP influence money supply because when money securities, it siphons off the funds or money supply in the economy, thereby eee eB supply. When it buys back securities, it gives back to the economy the money supply. When BSP increases the reserve requirement on banks, it reduces the amount alate to banks for lending to borrowers, thus limiting the credit and ultimately the money supp! te When this reserve requirement is lowered, loans that banks can grant are increased ultimately increasing the money supply. Monetary policy works largely through its impact on interest rates. Increases in money supply lower interest rates, which stimulate demand. As money supply increases, investors will be encouraged to buy more securities (stocks or bonds) forcing securities prices up and interest rates down. In the long run, investors may increase their holdings of securities and ultimately buy tangible assets, which stimulate consumption demand directly. In implementing monetary policy, BSP can take one of two basic approaches to affect the market for bank excess reserves: 1. _ Target the quantity of reserves in the market based on BSP’s open market operations’ objectives for growth in the monetary base (the sum of money in circulation and reserves) and in turn, the money supply; or 2. Target the interest rate on those reserves that BSP is granting. The approach taken varies according to the need to combat inflation and the desire to encourage sustainable economic growth. . CHAPTER SUMMARY — sa. * Financial system encompasses the financial markets, participants, and instruments dealt with in said markets. * The functions of the financial system include channeling funds from saving units to deficit units, providing a medium of exchange, providing a mechanism for risk-sharing, and providing a channel through which the central bank can influence the economy in general and the financial system in particular. * There are six participants or sectors in the financial system. They are households, financial institutions, non-financial firms, government, central bank, and foreign participants. * Households or consumers are the wage/salary-earners whose income is spent on goods and services and if there is something left to save, they save it, * Financial institutions/intermediaries are the firms that act as bridge between surplus units/lenders, and deficit units/borrowers, * Non-financial institutions are businesses other than the financial institutions/ intermediaries like trading, manufacturing, mining, and other businesses, * Government includes all levels of government from barangays up to the national government. All government units act as either lenders or borrowers at one time or another.