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«Melanie S. Milo October 2007 ADB Institute Discussion Paper No. 81 Melanie S. Milo was a visiting researcher at ADBI from July–December 2007. She ...»

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Integrated Financial Supervision:

An Institutional Perspective for the Philippines

Melanie S. Milo

October 2007

ADB Institute Discussion Paper No. 81

Melanie S. Milo was a visiting researcher at ADBI from July–December 2007. She

is also a senior research fellow at the Philippine Institute for Development Studies.

Fatima del Prado and Don Yasay provided excellent research assistance.

The views expressed in this paper are the views of the author and do not necessarily reflect the view or policies of ADBI nor Asian Development Bank.

Names of countries or economies mentioned are chosen by the author, in the exercise of her academic freedom, and the Institute is in no way responsible for such usage.

ADBI’s discussion papers reflect initial ideas on a topic, and are posted online for discussion. ADBI encourages readers to post their comments on the main page for each discussion paper (given in the citation below). Some discussion papers may develop into research papers or other forms of publication.

Suggested citation:

Milo, Melanie S. 2007. Integrated Financial Supervision: An Institutional Perspective for the Philippines. ADBI Discussion Paper 81. Tokyo: Asian Development Bank Institute. Available: http://www.adbi.org/discussionpaper/2007/10/25/2381.integrated.financial.supervision/ Asian Development Bank Institute Kasumigaseki Building 8F 3-2-5 Kasumigaseki, Chiyoda-ku Tokyo 100-6008, Japan Tel: +81-3-3593-5500 Fax: +81-3-3593-5571 URL: www.adbi.org E-mail: info@adbi.org © 2007 Asian Development Bank Institute ADBI Discussion Paper 81 Melanie S. Milo Abstract This paper looks at the issue of reforming financial regulatory structures from the New Institutional Economics perspective. In particular, it examines how the broader institutional environment prevailing in developing countries like the Philippines may affect the institutional arrangements for financial regulation, and how these might be taken into consideration when designing or reforming financial regulatory structures. The paper argues that the state of financial conglomerates in the Philippines does not warrant a shift toward integrated financial supervision. Instead, any effort to reform the financial supervisory structure must explicitly address the country’s most fundamental need, which is to strengthen institutions and governance structures. Key institutional characteristics must already be in place to undertake such a reform successfully, including sound political and legal systems and enforcement mechanisms. That being said, properly structured independent regulatory agencies in the financial sector can play a part in strengthening the overall regulatory environment.

JEL Classifications: G20, G28, H11, O16, P16 ADBI Discussion Paper 81

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The literature on the Asian financial crisis typically contends that financial liberalization and the removal of obstacles to foreign borrowing by banks and the corporate sector, coupled with poor and inadequate prudential supervision, gave rise to the risk of moral hazard and the resulting financial crisis. Consequently and not surprisingly, the enhancement of prudential regulation and supervision 1 of banks through the adoption of international standards or “best practices” was among the recommendations and prerequisites for the recovery of the affected Asian economies. The architecture of financial supervision and any need for change also became an important issue to be addressed. Thus, strengthening the supervisory mechanism under the International Monetary Fund (IMF) programs for Indonesia, the Republic of Korea, and Thailand also required the establishment of integrated prudential regulators (Gochoco-Bautista et al., 1999). However, to date, only the Republic of Korea has managed to completely undertake such a reform. In fact, the desirability of unified regulatory agencies—that is, agencies that supervise two or more of the traditional financial services sectors—has in itself become the focus of significant research recently. The primary reason has been the trend towards the forming of financial conglomerates.

This paper examines the issue of reforming financial regulatory structures from the New Institutional Economics perspective. That is, it investigates how the broader institutional environment prevailing in a developing country like the Philippines may affect the institutional arrangements for financial regulation, and how these might be taken into consideration when designing or reforming financial regulatory structures.

The paper has six sections. Section II describes the state of financial conglomerates in the Philippines and how they are currently supervised to determine whether any significant reform in the financial regulatory structure is warranted. Section II also discusses how the Philippine experience compares to those in other countries in the region. Section III discusses the supervisory implications of financial conglomeration, and the various regulatory approaches that have been adopted to address them. In Section IV, the role of institutions in economic development is discussed, particularly as seen through the New Institutional Economics (NIE) paradigm. The overall institutional environment of the Philippines is also discussed. Drawing on the NIE perspective, alternative approaches taking an institutional perspective to view financial sector issues and policies are then presented in Section V. In particular, the issue of reforming financial regulatory structures is analyzed from the new political economy perspective. Finally, Section VI presents some recommended modifications to the financial regulatory framework in the Philippines.

This paper does not cover the theoretical arguments for and against financial conglomerates or the historical rationale, evolution, and supervision of financial conglomerates in the Philippines. Neither does it analyze the various regulatory approaches, including the trend towards having a single financial regulator model. These approaches have been discussed in an earlier paper.2 Current regulatory problems in individual financial sectors that are not directly related to financial conglomerates are mentioned to highlight the key issue with respect to the Philippine financial regulatory framework.

As traditionally defined, regulation refers to the set of rules and standards that govern the operation of financial institutions, while supervision refers to the oversight/monitoring of the application of those rules and standards.

For the purposes of this paper, the two terminologies are used interchangeably.

Milo (2002).

ADBI Discussion Paper 81 Melanie S. Milo

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A. Overview of the Philippine Financial Sector The Philippine financial system consists of banks and nonbank financial institutions (NBFIs).

Banks are classified into the categories of universal banks (or expanded commercial banks), commercial banks, thrift banks (savings and mortgage banks, stock savings and loan associations, and private development banks), rural banks, cooperative banks, and Islamic banks. NBFIs include insurance companies, investment houses, financing companies, securities dealers and brokers, fund managers, lending investors, pension funds, pawn shops, and nonstock savings and loan associations.

Figure 1 shows the total assets of the Philippine financial system from 1980 to 2006. Total assets of the financial system as a percentage of GDP rose from around 102% in 1980 to 117% in 1983, and then continuously declined to 66% in 1988 as a result of the financial and economic crises in the mid-1980s. The ratio in 1988 was around the same level as that in

1970. The ratio then steadily rose to around 140% in 1997. But the trend was again reversed in the aftermath of the Asian financial crisis, with the ratio falling to its 1980 level of 102% in

2006. Thus, there has been no significant and consistent growth in the size of the Philippine financial sector in the past 35 years.

Figure 1: Assets of the Philippine Financial System, by Type of Institution, 1980–2006 (In Billion Pesos, Constant Prices)

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Note: *Commercial includes commercial bank and universal banks.

Source of basic data: Bangko Sentral ng Pilipinas; National Statistical Coordination Board. The Philippine financial system has consistently been dominated by banks, particularly commercial banks.3 In fact, the importance of commercial banks has increased over time.

The banking system accounted for 81% of total financial assets in 2006, compared to around 76% in 1970. The asset share of commercial banks also increased from around 57% in 1970 to 72% in 2006. Total assets of commercial banks grew significantly in the 1990s due to the successive increases in minimum capital requirements, the upgrading of the specialized government banks into universal banks, and the entry of new local and foreign banks. In particular, universal banks dominate with an asset share of 80% of total commercial banking assets in 2006. In contrast, the asset share of rural banks fell from around 3% in the 1970s Commercial banks refer to both commercial banks and universal banks, unless otherwise specified.

ADBI Discussion Paper 81 Melanie S. Milo to 2% in 2006, while the asset share of thrift banks only slightly rose to 7% in 2006 from 4% in 1970. In contrast, the share of NBFIs in total financial assets fell from a high of 28% in 1975 to 19% in 2006. The dominant sector under NBFIs is the insurance sector. In fact, the share of the insurance sector in total NBFI assets significantly increased over the past two decades, from 47% in 1980 to almost 80% in 2005. However, around 60% of the assets of

the insurance sector were in turn accounted for by two government insurance corporations:

the Government Service Insurance System (GSIS) and the Social Security System (SSS).

Thus, there has been no significant structural change in the Philippine financial sector. A bank-dominated financial system is not necessarily bad. The issue is whether such a structure is a market outcome or the result of government regulation. In the case of the Philippines, it was clearly the latter. The banking sector has historically been the focus of financial sector policy, development, and reform. In contrast, efforts to reform and develop the other sectors of the financial system began only in the mid-1990s. A theory on the relationship between financial development and economic development in a market-oriented economy posits that the banking system, which initially leads financial development, declines in importance as real growth and financial development continue (Goldsmith, 1969). One observed characteristic of the process of economic development over time in a marketoriented economy is an expansion and elaboration of the financial structure (institutions, instruments, and activities). On the other hand, economic development is retarded if financial intermediaries do not evolve (Patrick, 1966). This theory has been borne out by recent empirical literature.4 The dominance of banks in the financial system is not unique to the Philippines. Banks continue to be the biggest sector in most financial systems in East Asia, although there has been progress in diversifying financial markets especially after the 1997 Asian financial crisis. In particular, the focus of policymakers in the region has been to develop the equity and bond markets (Ghosh, 2006). Table 1 shows the structure of financial systems in East Asia. Overall, financial development in the Philippines lags behind other comparable countries in the region, particularly Thailand and Malaysia.

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Given the dominance of universal banks in the Philippine financial sector, the next section discusses Philippine and worldwide trends in financial conglomeration.

See Levine (2003) and Demetriades and Andrianova (2003) for recent overviews of the literature.

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B. Overview of Financial Conglomerates in the Philippines Figure 2 presents three alternative structures for the undertaking of nontraditional activities by commercial banks: the universal bank, in which the nontraditional activity is consolidated within the same corporate unit as the bank; the holding company affiliate, in which the bank is in one subsidiary of a holding company and the nontraditional activity is in another subsidiary of the holding company; and the operating subsidiary, in which the nontraditional activity is located in a subsidiary of the bank (Shull and White, 1998). A pure universal bank is one that manufactures and distributes all financial services within a single corporate structure, while the German variant combines commercial and investment banking in a single corporation but conducts other financial activities through separately capitalized subsidiaries. A universal bank can also be considered a financial conglomerate. The Joint Forum on Financial Conglomerates 5 defines financial conglomerates as “any group of companies under common control whose exclusive or predominant activities consist of providing significant services in at least two different financial sectors (banking, securities, insurance)” (Joint Forum, 1995: 1). Bancassurance, a marketing arrangement wherein banks sell insurance products, that involves affiliated firms also meets the definition of a financial conglomerate. The structure that a bank adopts in delivering integrated financial services is influenced primarily by regulation. There are also other factors, including the historical development of a country’s financial markets, market power, and economies of scale and scope (Skipper, 2000).

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Sources: Shull and White (1998), Skipper (2000).

The Philippines introduced extended commercial banking or the German variant of universal banking as part of the initial financial liberalization program in 1980. A universal bank was allowed to perform the functions of an investment house either directly or indirectly through a subsidiary. Table 2 shows the number of commercial and universal banks from 1980 to

2006. In contrast to previous decades, the period after 1995 was characterized by significant movement in terms of new entries and consolidations. In particular, the number of foreign bank branches and subsidiaries increased as a result of deregulation of foreign entry in

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