The World of Financial Markets and Institutions

Unit 2 – Financial System

A strong financial system is a necessary ingredient for a growing and prosperous

economy. Companies raising capital to finance capital expenditures and
investors saving to accumulate funds for future use require well-functioning
financial markets and institutions.
The financial system consists of all financial intermediaries and financial markets
and their relations with respect to the flow of funds to and from households,
governments, business firms and foreigners, as well as the financial
infrastructure.
Having a well-functioning financial system in place that directs funds to their
most productive uses is a crucial prerequisite for economic development.

Learning Outcomes

At the end of this unit, you will able to

 To explain the significance and functions of financial system, it’s nature and
impact to the nation’s economy at the same time to explain the structure of the
Philippine financial system.
Pretest

Directions: Read the following sentences. Write the letter “T” if the statement is True and
“F” if the statement is False. Write your answer on the space before the number. You may
view this test at our google class.

_______1. The main task of the financial system is to channel funds from sectors that have a
Surplus to sectors that have a shortage of funds.
______2. Transaction and information cost will result to a lower return on investment on the
part of borrower.
______3. This splitting of wealth into many assets to reduce risk is known as diversification.
______4. Well-functioning financial system is crucial to a country's economic health so such
so that when the financial system breaks down severe economic hardship results.
______5. Restrictive covenants may involve placing limitations on the use funds borrowed or
requiring the borrowers to pay off the debt evenafter maturity date if the borrowers net worth
drop below a certain level.
______6. Financial intermediaries can increase moral hazard problems by adopting more
stringent procedures in monitoring the borrower's use of funds.
______7.Asymmetric information describes the situation in which one party to an economic
transaction has better information than does the other party.In financial transactions, typically
the lender has more information than does the borrower.

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______8. Western unions often are the cheapest source of fundsavailable to individual
borrowers.
______9. The financial system, through the various financial markets and financial
intermediaries, has the basic function of moving funds from those who have a surplus to
those who have a shortage of funds.
_____10. Economies of scalerefers to the reduction in average cost that results from an
increase in the volume of a good or service produced.

Thank you for answering the test. Please see the back
content for the answer key or you may view it in the google
class.
The next section is the content of this unit. It contains
vital information. Please read the content.

Content

OVERVIEW OF THE FINANCIAL SYSTEM

INTRODUCTION
A vibrant and healthy economy requires a financial system that makes or channels funds from
people who save to people who have productive investment Opportunities. The financial system
is complex in structure and functions throughout the world. A developed economy relies on
financial markets and institutions for efficient transfer of funds. Every person's life, family,
business, and government are affected by the financial system.
A strong financial system is a necessary ingredient for a growing and prosperous economy.
Companies raising capital to finance capital expenditures and investors saving to accumulate
funds for future use require well-functioning financial markets and institutions. Over the past few
decades changing technology and improving communications have increased cross-border
transactions and expanded the scope and efficiency of the global financial system.
Companies routinely raise funds throughout the world to finance projects all around the globe.
Likewise, with the click of a mouse an individual investor in Metro Manila can deposit funds in a
US Bank or purchase a mutual fund that invests in Chinese Securities. These investors helped
spur global economic growth by providing capital to an increasing number of individuals
throughout the world.
However, along the way, the financial industry attracted a lot of talented people who created,
marketed, and traded a larger number of new financial products. Despite however their benefits,
many of these same factors led to excesses which culminated in the financial crisis. In 2008 in
the United States of America, in Europe and Southeast Asia. At the height of the crisis, many
were worried that the entire financial system could collapse and in response regulators took
emergency steps. In many ways, this crisis illustrates that financial manager and investors do
not operate in vacuum they make decisions within a large and complex financial environment.

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The World of Financial Markets and Institutions

The environment both determines the available financial alternatives and affects the outcome of
various decisions. Thus, it is crucial that Investors and finance managers have a good
understanding of the environment in which they operate.The financial system is complex,
comprising many different types of private sector financial institutions, including banks,
insurance companies, finance companies, mutual funds, and investment banks, all of which are
regulated by the government.
NATURE AND OBJECTIVE OF THE FINANCIAL SYSTEM
The financial system consists of all financial intermediaries and financial markets and their
relations with respect to the flow of funds to and from households, governments, business firms
and foreigners, as well as the financial infrastructure.Having a well-functioning financial system
in place that directs funds to their most productive uses is a crucial prerequisite for economic
development.
This process is shown schematically in Figure 5-1. Those who have saved and are lending
funds, the lender-savers, are at the left, and those who must borrow funds to finance their
spending the borrower-spenders, are at the right. The principal lender-savers are households,
but business enterprises and the government (particularly state and local government), as well
as foreigners and their governments, sometimes also find themselves with excess funds and so
lend them out.
The most important borrower-spenders are businesses and the government (particularly the
national government), but households and foreigners also borrow to finance their purchases of
cars, furniture, and houses. The arrows show that funds flow from lenders-savers to borrower-
spenders viatwo routes.
In direct finance (the route at the bottom of Figure 5-1), borrowers borrow funds directly from
lenders in financial markets by selling them securities (also called financial instruments), which
are claims on the borrower's future income or assets. Securities are assets for the person who
buys them buy liabilities. (IOUs or debts) for the individual or firm that sells (issues) them.
Figure 5-1: Flows of Funds though the Financial System

Indirect Finance

Financial
Funds Intermediaries Funds

Funds
Lender-Savers Funds Borrowers- Spenders
Financial Market Funds
1. Households 1. Business firm
2. Business firms 2. Government
3. Government 3. Households
4. Foreigners 4. Foreigners
Direct Finance 5.

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KEY COMPONENTS OF THE FINANCIAL SYSTEM

Financial instrument

Financial System Financial market and financial

institutions

The Central Bank and Other

Financial Regulators

FUNCTIONS OF THE FINANCIAL SYSTEM

The main task of the financial system is to channel funds from sectors that have a Surplus to
sectors that have a shortage of funds. In the financial system, banks, insurance companies,
mutual funds, stockbrokers, and other financial services firms compete to provide financial
services to households and businesses.

Three key services that the financial system

provides to savers and borrowers:

Risk sharing Information

Liquidity

Financial Services firms provide these services in different ways, which makes differentfinancial
assets and financial liabilities more or less attractive to individual Saversand borrowers.
Risk sharing
Risk is the chance that the value of financial assets will change relative to what one expects.
One advantage of using the financial system to match individual savers and borrowers is that it
allows the sharing of risk. Most individual savers seek a steady return on their assets rather
than erratic savings between high and low earnings. This splitting of wealth into many assets to
reduce risk is known as diversification.
The financial system provides risk sharing by allowing savers to hold many assets. Hence,
because of the ability of the financial system to provide risk sharing makes savers more willing
to buy stocks, bonds and other financial assets. This willingness, in turn increases the ability of
borrowers to raise funds in the financial system. Financial intermediaries have developed
expertise in holding a diversified portfolio of innovative projects when reduces risk and promotes
investment in growth enhancing innovativeactivities.

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The World of Financial Markets and Institutions

Liquidity
Another key service that the financial system offers savers and borrowers is liquidity.Liquidity is
the ease with which an asset can be exchanged for money which savers view as a benefit.
Generally, assets created by the financial system such as stocks, bonds or checking accounts,
are more liquid than are physical assets such as cars, machinery or real estate.
Financial markets and intermediaries help make financial assets more liquid. Investors can
easily sell their holdings of government securities and the stocks and bonds of large
corporations, making those assets very liquid.
The financial system has increased the liquidity of many assets besides stocks and bonds
through the process of securitization. This process has made it possible to buy and sell
securities based on loans. As a result, mortgages and other loans have become more desirable
assets for savers tohold. Savers are willing to accept interest rates on assets with greater
liquidity which reduces the costs of borrowing for many households andfirms.
Information
A third service of the financial system is the collection and communication of information, or
facts about borrowers and expectations of returns on financial assets. Banks collect information
on borrowers to forecast their likelihood of repaying loans. Because the bank specializes in
collecting and processing information, its costs for information gathering are lower than yours
would be if you tried to gather information about a p0ol of borrowers. The profit the bank earns
on its loans is partly compensation for the resources and time bank employees spend to gather
and store information.
Financial markets convey information to both savers and borrowers by determining the prices of
stocks, bonds, and other securities. This information can help one decide whether to continue
investing in the securities previously purchased or to sell more stock or bonds to finance a
planned expansion: The incorporation of available information into asset prices is an important
feature of well-functioning financial markets.
The Problems of Adverse Selection and Moral Hazard
A key consideration for savers is the financial health of borrowers. Savers do not lend to
borrowers who are unlikely to pay them back. Unfortunately, tor savers, borrowers in poor
financial health have an incentive to disguise this fact. For example, a company selling bonds to
investors may know that its sales are declining rapidly, and it is near bankruptcy, but the buyers
of the bonds may lack this information.
A vital service of the financial system is the collection and communication of information or facts
about borrowers and expectation of returns in financial assets. Financial markets convey
information to both savers and borrowers by determining the prices of stocks, bonds and other
securities.
Asymmetric information describes the situation in which one party to an economic transaction
has better information than does the other party. In financial transactions, typically the borrower
has more information than does the lender

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The World of Financial Markets and Institutions

Two problems arising from asymmetric information are:

 Adverse selection. This is the problem investors experience in distinguishing low-risk

borrowersfrom high-risk borrowers before making an investment.

 Moral hazard. This is the problem investors experience in verifying thatborrowers are
using their funds as intended.
Sometimes an investor will consider the costs arising from asymmetric information to be so
great that the investor will lend only to borrowers who are transparently low risk, such as the
national government. However, more generally, there are practical solutions to the problems of
asymmetric information, in which financial markets or financial intermediaries lower the costof
information needed to make investment decisions.
The financial system helps overcome an information asymmetry between borrowers and
lenders. An information asymmetry can occurbefore or alt financial contract has been agreed
upon.
Adverse Selection
The information asymmetry before the contract is agreed upon arises because Borrowers
generally know more about their investment projects than lenders. Borrowers most eager to
engage in a transaction are the most likely ones to produce an undesirable outcome for the
lender (adverse selection). Individual savers may not have the time, especially or means to
collect and take advantage of economies of scale and scope.
Moral Hazard
Even after a lender has gathered information on whether a borrower is a good borrower or a
lemon borrower, the lender's information problems haven't ended. There is still a possibility that
after a lender makes a loan to what appears to be a good borrower, the borrower will not use
the funds as intended. This situation, known as moral hazard, is more likelyto occur when the
borrower has an incentive to conceal information or toact in a way that does not coincide with
the lender's interests. Moral hazard arises because of asymmetric information: The borrower
knows more than the lender does about how the borrowed funds will actually beused.
NATURE AND IMPACT OF TRANSACTION ANDINFORMATION COSTS
Transaction Costs
The cost of a trade or a financial transaction, for example, the brokerage commission charged
for buying or selling a financial asset.
Information Costs
The costs that savers incur to determine the creditworthiness of borrowers and to monitor how
they use the funds acquired.
Because of transaction costs and information costs, savers receive alower return on their
investments and borrowers must pay more for the funds they borrow. As we have just seen,
these costs can sometimes mean that funds are never lent or borrowed at all. Although
transactions costs and information costs reduce the efficiency of the financial system, they also

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The World of Financial Markets and Institutions

create a profit opportunity for individuals and firms that can discover ways to reduce those
costs.

How Financial Intermediaries Reduce *Adverse Selection"

The problem of "adverse selection" can be minimized if not totally avoided using the following
approaches:
 Requiring borrowers to disclose material information on their financial performance and
financial position.

Financial market participants and the government have taken steps to try to reduce
problems of adverse selection in financial markets. I he SEC requires the publicly traded
firms report their performance in financial statements, such as balance sheets, which
show the value of the firm's assets, liabilities, and stockholders’ equity (the difference
between the value of the firm's assets and the value of its Iiabilities), and income
statements, which show a firm's revenue, costs, and profit. Firms mustprepare these
statements using standard accounting methods. In addition, firms must disclose material
information, which is information that, if known, would likely affect the price of a firm's
stock.

 Collecting information on firms and selling that information to investors.

 Convincing lenders to require borrowers to pledge some of their assets as collateral

which the lender can claim of the borrower defaults.
How Financial Intermediaries Reduce Moral Hazard Problems
Financial intermediaries can reduce moral hazard problems by adopting more stringent
procedures in monitoring the borrower's use of funds. This will include

 Specializing in monitoring borrowers and developing effective techniques to ensure that

the funds they loan are actually used for their intended purpose.

 Imposing Restrictive Covenants

Restrictive covenants may involve placing limitations on the use funds borrowed or
requiring the borrowers to pay off the debt even before maturity date if the borrowers net
worth drop below a certainlevel.
How Financial Intermediaries Reduce Transaction costs
Transaction costs may be reduced by adopting the following techniques
 Financial intermediaries take advantage of economies of scale, which refers to the
reduction in average cost that results from an increase in the volume of a good or
service produced. For example, the fees dealers in Treasury bonds charge investors to
purchase P10 million worth of bonds are not much higher than the fees they charge to
purchase PII million Worth of bonds. By buying P500 worth of shares in a bond mutual

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The World of Financial Markets and Institutions

fund that purchases millions of pesos worth of bonds, an individual investor can take
advantage of economies of scale.

 Financial intermediaries can also take advantage of economies of scale in other ways.
For example, because banks make many loans, they rely onstandardized legal
contracts, so the costs of writing the contracts are spread over many loans. Similarly,
bank loan officers devote their time to evaluating and processing loans, and through this
specialization, they are able to process loans efficiently, reducing the time required and,
therefore, the cost per loan.

 Financial intermediaries also take advantage of technology to provide financial services,

such as those that automated teller machine networksprovide.

 Financial intermediaries also increasingly rely on sophisticated software to evaluate the

credit worthiness of loan applicants.

THE PHILIPPINE FINANCIAL SYSTEM

INTRODUCTION
Well-functioning financial system is crucial to a country's economic health so such so that when
the financial system breaks down, as it has in Russia and in Southeast Asia recently, severe
economic hardship results.
The financial system, through the various financial markets and financial intermediaries, has the
basic function of moving funds from those who have a surplus to those who have a shortage of
funds.
To study the effects of financial markets and financial intermediaries on the economy, we need
to acquire an understanding of their general structure andoperation.
STRUCTURE OF THE PHILIPPINE FINANCIAL SYSTEM
I. Bangko Sentral Ng Pilipinas

II. Banking Institutions

A. Private Banking Institutions

 Expanded Commercial Banks/Universal Banks (EKB/UB)

 Commercial Banks (KB
 Thrift Banks (TB)
 Savings and Mortgage Banks (SMB)
 Private Development Banks (PDB)
 Stock Savings and Loan Associations (SSLA)
 Rural Banks (RB)
 Cooperative Banks
B. Government banking institutions

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 Development Bank of the Philippines (DBP)

 Land Bank of the Philippines (LBP)
 Philippine Al-Amanah Islamic Investment Bank

III. Non-Bank Financial Institutions

A. Private non-bank financial institutions

 Investment houses
 Investment banks
 Financing companies
 Securities dealers/brokers
 Savings and loan associations
 Mutual funds
 Pawnshops
 Lending investors
 Pension funds
 Insurance companies
 Credit union
B.Government Non-bank financial institutions

 Government Service Insurance System (GSIS)

 Social Security System (SSS)
 Pag-ibig
BRIEF DESCRIPTION OF THE FINANCIAL INSTITUTIONS
I. Bangko Sentral ng Pilipinas
II. Banking Institutions
A. Private Banking Institutions
 Universal Bank (UB) or Expanded Commercial Bank (EKB) is any commercial bank,
which performs the investment house function in addition to its commercial banking
authority. It may invest in the equities of allied and non-allied enterprises. Allied
enterprises may either be financial or non-financial.

 Commercial Bank or Domestic Bank (KB) is any commercial bank that is confined
only to commercial bank functions such as accepting drafts and issuing letters of credit,
discounting and negotiating promissory notes, drafts and bills of exchange, and other
evidences of debt, accepting or creating demand deposits, receiving other types of
deposits and deposit substitutes, buying and selling foreign exchange, and gold or silver
bullions, acquiring marketable bonds and other debt securities, and extending credit
subject to such rules that the Monetary Board may promulgate.

 Thrift Banks (TB) shall include savings and mortgage banks, Stock savings and loan
associations and private development banks. Their function is to accumulate the savings
of depositors and invest them together with their capital, loans secured by bonds,

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The World of Financial Markets and Institutions

mortgages in real estate and insured improvements thereon, chattel mortgages, bonds
and other forms of security or loans for personal or household finance, whether, secured
or unsecured, or in financing for home building and home development, in readily
marketable and debt securities; in commercial papers and accounts receivables, drafts,
bills of exchange, acceptances or notes arising out of commercial transactions, and in
Such other investments and loans which the Monetary Board may determine as
necessary in the furtherance of national economic objectives.

 Stock Savings and Mortgage Bank (SSMB) is any corporation organized for
the purpose of accumulating the savings of depositors and investing them,
together with its capital, in readily marketable bonds and debt securities; checks,
bills of exchange, acceptances or notes arising out of commercial transactions
or in loans secured by bonds, mortgages or real estate and insured
improvements thereon and other forms of security or in loans for personal or
household finances whether Secured or unsecured, and financing tor home
building and home development.
 Private Development Bank (PDB) is a bank that exercises all the powers and
assumes all the obligations of the savings and mortgage bank as provided in the
General Banking Act except as otherwise stated. The private development bank
helps construct, expand and rehabilitate agricultural and industrial sectors. The
Development Bank of the Philippines is government counterpart of the private
development banks and helps the private development banks augment their
capitalization as provided under R.A.4093 as amended.

 Stock Savings and Loan Association (SLA) is any corporation engaged in the
business of accumulating the savings of its members or stockholders and using
such accumulated funds, together with its capital for loans and investment in
securities of productive enterprises, or in securities of the government and its
instrumentalities, provided that they are primary engaged in servicing the needs
of households by providing personal finance and long-term financing for home
building and development.

 Rural Bank (RB) is any bank authorized by the. Central Bank to accept deposits and
make credit available to farmers, businessmen and. cottage industries in the rural areas.
Loans may be granted Dy ne rural banks on the security of land without Torrens title
where e owner of private property can show five (5) years or more of peaceful
continuous and uninterrupted possession of the land in the Concept of ownership. This
will include portions of friar land estates or other lands administered by the Bureau of
Lands that are covered by sale contracts and purchases and have paid at least five)
years installment thereon, without the necessity of prior approval and consent of the
Director of Lands or portions of other estates under the administration of the Department
of Agrarian Reform.

 Cooperative Banks are banks established to assist the various cooperatives by lending
those funds at reasonable interest rates.
B. Government Banks or Specialized Government Banking Institutions

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The World of Financial Markets and Institutions

 Development Bank of the Philippines- (DBP) provides loans for developmental

purposes, gives loans to the agricultural sector,commercial sector and the industrial
sector.

 Land Bank of the Philippines (LBP) is a government bank, which provides financial
support in the implementation of the Agrarian Reform Program (CARP) of the
government.

 AL-Amanah Islamic Investment Bank: Republic Act No. 6048 provides for the charter
of the A1-Amanah Islamic Investment Bank. This Act authorizes the bank to promote
and accelerate the socio-economic development of the Autonomous Region of Muslim
Mindanao by performing banking, financing and investment operations, and to establish
and participate in agriculture, commercial and industrial ventures based on the Islamic
concept of banking.

III. Non-bank Financial Institutions

A. Private non-bank Financial Institutions
 Investment House is any enterprise, which engages in underwriting securities of other
corporations. It also generates incomefrom sale of investments in securities.

 Investment Banks. Investment banks, such as Goldman Sachs and Morgan Stanley,
differ from commercial banks in that they do not take in deposits and until very recently
rarely lent directly to households. They provide advice to firms issuing stocks and bonds
or considering mergers with other firms. They also engage inunderwritingin which they
guarantee a price to a firm issuing stocks or bonds and then make a profit by selling the
stocks or bonds at a higher price.

 Financing Company is any business enterprise where the primary purpose is to extend
credit facilities to consumers and to industrial, commercial or agricultural entities either
by discounting or factoring commercial papers or accounts, or by buying installment
contracts, leases, chattel mortgages, or other evidences ofindebtedness, or by leasing
motor vehicles, heavy equipment and industrial machineries and business and office
equipment, appliance and other movable properties.

 Securities Dealer is any person or entity engaged in the business of buying and selling
securities for his own or its client's account thereby making a profit from the difference
between the purchase prices and selling price of securities.

 Savings and Loan Associations (S&Ls), which have traditionally served individual
savers and residential and commercial mortgageborrowers, accumulate the funds of
many small savers and then lend this money to home buyers and other types of
borrowers. Because the savers obtain a degree of liquidity that would De absent if they
bought the mortgages or other securities directly perhaps the most significant economic
function of the S&LS is to "create liquidity". Also, the S&Ls have more expertise 1
analyzing credit, setting up loans, and making collections than individual savers, so they
reduce the transaction costs and increase the availability of real estate loans.

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 Mutual Funds are corporations which accept money from saver and then use these
funds to buy stocks, long-term bonds, or shorter-term debt instruments issued by
businesses or government units. these organizations pool funds and thus reduce risksby
diversification. They also achieve economies of scale, which lower the costs of analyzing
securities, managing portfolio, and buying and selling securities. Different funds are
designed to meet the objectives of different types of savers. Hence, there are bond
funds for those who desire safety, tock funds for savers who are willing to accept
significant risks in the hope of higher returns, and still other funds that are used as
interest-bearing checking accounts (the money market funds). There are literally
hundreds or different mutual funds with dozens of different goals and purposes.

 Pawnshops refer to persons or entities engaged in the business of lending money with
personal property, jewelry, and other durable goods as collateral for the loans given.

 Lending investor is any person or entity engaged in the business of effecting securities
transactions, giving loans and earns interestfromthem.

 Pension Funds are retirement plans funded by corporations orgovernment agencies for
their workers and administered primarily by the trust departments of commercial banks
or by life insurance companies, Pension funds invest primarily in bonds, stocks,
mortgages, and real estate.

 Insurance companies take savings in the form of annual premiums, then invest these
funds in stocks, bonds, real estate, and mortgages, and finally make payments to the
beneficiaries of the insured parties. In recent years, insurance companies have also
offered a variety of tax-deferred savings plans designed to providebenefits to the
participants when they retire.

 Credit unions are cooperative associations whose members have a common bond,
such as being employees of the same firm. Members savings are loaned only to other
members. Generally, for auto purchases, home improvement loans, and even home
mortgages.Credit unions often are the cheapest source of fundsavailable to individual
borrowers.
B. Government Non-bank financial institution
 Government Service Insurance System (GSIS). Provides retirement benefits, housing
loans personal loans, and emergency and calamity loans to government employees.

 Social Security System (SSS). Provides retirement benefits, funeral benefits, housing
loans, personal loans and calamity loans to employees who are working in private
companies and offers.

 Pag-Ibig. Provides housing loans to both government and private employees.

THE EVOLVING PHILIPPINE FINANCIAL SYSTEM

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The Philippine financial system continues to experience growth against a backdrop of

strengthening domestic economy. Political reforms, i.e., tax reforms and greater infrastructure
spending, are projected to drive the domestic growth in 2018 as these lead to higher spending
by both the government and households. The domestic economy is also seen to gain from the
momentum of global economic recovery, based on the upward revisions of growth projections
by third party analysts. However, despite the positive outlook for the Philippines, there are
internal and external developments that pose downside risks to the domesticfinancial system.
To counteract the downside risks and smooth functioning of the Philippine financial system
more stringent initiatives are being pursued by the four regulatory agencies, namely
 Bangko Sentral ng Pilipinas (BSP)
 Securities and Exchange Commission (SEC)
 Insurance Commission (IC)
 Philippine Deposit Insurance Commission (PDIC)
SIGNS OF GROWTH IN THE DOMESTIC MARKET
In recent years, growth in financial intermediation is observed in the three major segments of
the Philippine financial system.
a) The Philippine banking system has been consistently posting double digit asset growth
since January 2016. Latest data show that to resources of the banking system amounted
to PHPI55.3 trillion as of end- March, 2018, an 11.3 percent increase from the previous
year’slevel o PHP13.8 trillion. This asset growth trend is mirrored by the growth in
liabilities (see Figure A)
b) Meanwhile, total assets of the insurance industry more than doubled from 2008 to 2016
(see Figure B). Although there was a two-year slowdown after 2013, the growth
rebounded in 2016, posting an 11.2 percent increase. Moreover, there has been a
steady increase in the industry’s revenues relative to GDP after the GFC, with a break in
the year proceeding typhoon Yolanda in 2013. The life insurance segment continues to
be the driver of the insurance companies’ revenues.
c) The securities market has also exhibited growth. The bond market, in particular, is
comprised mostly of peso-denominated government issued Securities, to which
outstanding amount as of end-March 2018 grew by 7.1 percent to reach USDI17.2 billion
(see Figure C). The equities market, on the other hand, registered 12 additional
companies with the PSE in the past three years, bringing the total listed companies to
268, equivalent to PHPI7.3I trillion market capitalization as of end-October 2017.
REGULATORY LANDSCAPE
A. Alignment with global standards
a) The BSP has released Circular No. 975 in October 2017 tostreamline the requirements
on the issuance of bonds and commercial papers by banks and quasi-banks and
Circular Nos. 984 and 985 in December 2017 in furtherance of liberalizing the foreign
exchange (FX) regulatory framework. It has also set the target to 01 September 2018 for
banks to comply with the revised rules on liquidity risk management anchored on the
Principles for Sound Liquidity Risk Management and Supervision under the Basel 1
reform agenda.

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b) A key priority of the Insurance Commission (lC) is the adoption of international reporting
practices. The IC is preparing for the implementation of the Philippine Financial
Reporting Standards by the Financial Reporting Standards Council that will be applied to
insurance companies. For subsidiaries and branches of Global Systemically Important
Insurers operating in the Philippines, the IC requires keeping reserves to pay
policyholders in the event of insolvency and has set the guidelines for the orderly
acquisition, merger, consolidation, sale of insurance portfolio, and exit from the domestic
insurance business should another financial crisis global inscale triggers a sell-of
c) The SEC approved amendments to the Securities Regulation Code (SRC) and the
Corporation Code as well as supporting the bills on regulating Collective Investment
Schemes to enhance local regulations and conform to international best practices.
Considering the rising popularity 9f crypto currency, the SEC is also studying the ideal
regulatory treatment of virtual currencies (VCs) from the perspective of investor
protection. For internet-based scams, the SEC coordinates with the Philippine National
Police and the National Bureau of Investigation which possess the resources and
expertise to assist in the investigation of cybercrimes committed by online organizations.
d) For its part, the PDIC has entered into a cross-border partnership by way of a
Memorandum of Understanding (MOU) with eight deposit insurance agencies from Asia,
the UK and the US. The MOU fosters enhanced cooperation through exchange of
information, prompt response to technical inquiries, effective support for exchange of
experts and staff, conduct of bilateral meetings, and other collaborations to the extent
permitted by each country's laws, rules and regulations.

B. Deepening capital markets

Various financial products have been introduced to the different Segments of the domestic
market aimed at providing alternative options Tor raising funds or for investing money. These
include:

 dollar-denominated securities,
 exchange-traded funds,
 green bonds (upcoming),
 Personal Equity and Retirement Account,
 PHP government fund forward,
 public-private partnership shares, and
 real estate investment trust
Furthermore, the SEC has initiated reforms on minimum public Ownership, repurchase
agreements and shelf registration that underscore the need for improved liquidity in the market
and the importance of price discovery. The SEC is also finalizing its rules governing the crowd
funding market.
Meanwhile, the BSP, Bureau of the Treasury and SEC, with the support of the DOF, rolled out
in August 2017 the roadmap to accelerate the development of the Philippine debt market. The
three agencies, which comprise the Capital Market Working Group, agreed to prioritize
deepening of the local bond market, creating reliable financial benchmarks and valuation of
financial instruments, and establishing an integrated financial market infrastructure (FMI).

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The World of Financial Markets and Institutions

C. Strengthening surveillance
a) The BSP has recently completed the requirements of becoming a BIS-reporting country.
This will allow access to detailed information on cross-border exposures of other
countries to the Philippines. The BSP through the FSCC has also initiated collaborations
with the Housing and Land Use Regulatory Board to develop a maiden reportorial
template targeted to real estate companies.
To further its conduct of surveillance and understanding of the underlying developments in the
insurance industry, the IC is in the process of building a database from the quarterly reports
required from insurance companies and developing analytical tools for data mining purposes.
a. Currently, the SEC is proposing the creation of a unit or handling the rules, regulations,
policies, and guidelines concerning anti-money laundering (AML) and counter terrorist
financing (CTF) for covered entities. With the implementation of the 2015 Revised
Implementing Rules and Regulations of the SRC, the SEC intends to amend and update
its guidelines on the preparation of the AML manual of covered entities. Additionally, the

SEC aims to prepare an audit plan and program regarding the conduct of regular audits
on covered entities, focusing on the compliance with AML/CTE requirements.

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The World of Financial Markets and Institutions

FINANCIAL STABILITY ASSESSMENT OF THE PHILIPPINE FINANCIAL SYSTEM *

At its core, financial stability is preemptive in nature because it needs to mitigate the buildup of
system-wide dislocations before these vulnerabilities take concrete form. With financial markets
constantly evolving. it is however not clear what past data can tell about future conditions.
Adding another layer of complication is the fact that there are competing measures of systemic
risk while a unique set of financial stability indicators has yet to be defined.
These issues notwithstanding, financial stability is clearly understood to reflect a well-functioning
financial market, addressing the financial needs of stakeholders and avoiding distortions. This
view of the overall market will then require a holistic appreciation of the market situation in
various segments of the market. Since these segments may be experiencing different pressure
points, judgment is often essential in the overall assessment of systemic risks.
This is the reason why the FSR focuses more on thematic topics. While the market landscape is
a useful baseline, the focus is on risks and vulnerabilities that may derail further growth as well
as raise issues that may potentially have systemic implications.

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The World of Financial Markets and Institutions

The section on current risks shows how the outstanding debt level has grown rapidly,
particularly in the post-GFC period. Whether the build up of debt is already an issue is still open
for discussion. Yet, what is clear is that interest rates are rising and emerging market currencies
have been depreciating versus the United States dollar (USD) These must mean that debt
servicing is now at a higher cost than in the past, separate from the Issue of having more
outstanding debt. This is our central financial stability issue.
The opportunity to discuss fintech and Association of Southeast Asian Nations ASEAN) financial
integration is taken. There is no doubt that fintech provides benefits over paper-based face-to-
face transactions. This gain is especially value to an economy such as the Philippines which is
segregated both geographically and by demographic factors. Nevertheless, the assessment for
fintech thus far has focused on micro risks, e.g., credit and liquidity, among others. The
prevailing view is that its financial stability risks are limited, but this is also premised on the
understanding that fintech remains a small portion or market activity.
The intention is to allow fintech to develop further. One should be mindful of a key lessonfrom
the GFC that systemic risks may arise from seemingly smaller shocks because accounting for
the amplifying effects of interconnectedness was neglected. Regulatory sandboxes and
constant dialogues among stakeholders are critical to ensure that one remains vigilant of the
downside risks rom he disruptive side of fintech
Similar to fintech, the business case is compelling for the integration or the financial markets
among member states of the ASEAN. The region continuesto outpaceglobal growth, it saves at
a higher rate than the rest of the world and it is home toa vast base of millennials who are tech-
savvy and drive retail markets. With much of ASEAN'S savings actually deployed out of the
region, financial integration should provide a better and more organized platform for retaining
such savings and funding the region s growth even more.
Yet, higher levels of cross-border interconnectedness will also provide another possible venue
for contagion risk. More generally, the previous works of Dani Rodrik and Dirk Schoenmaker,
respectively, suggest that there may be trade-offs between sovereign policy. Regional
integration and financial stability. This section presents a discussion of the issues as it is
certainly relevant to the current work of various committees on ASEAN integration.
CURRENT RISKS IN THE PHILIPPINE FINANCIAL SYSTEM
A. Repricing, refinancing and repayment risks (3Rs)
Several jurisdictions have pointed to various sources of risks that heighten financial stability
concerns. These are:

 The normalization of US monetary policy creates the incentive for global capital flows to
be directed towards the US, affecting asset and currency prices along the way.
 A slowdown in global growth and deceleration of international trade will undermine the
growth of many economies.
 Higher debt levels across countries will continue to leave economies vulnerable to the
changes in the growth outlook and the (continuing) rise in interest rates.
The risks flagged by other jurisdictions highlight the fact that global developments largely affect
the domestic economies. The impact, however, is much more significant for a small and open
economy such as the Philippines which is a price taker, rather than a price setter. 1nere are

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The World of Financial Markets and Institutions

risks with rising Philippine interest rates and a local currency (LCY) that continues to depreciate
against the US dollar. Drivers of growth are shifting from are quarter and the authorities need to
be cognizant or the factors that could derail the growth momentum. All of these market changes
have to be understood in the context of repricing, refinancing and repayment risks.
B. Developments in the credit market
Local intermediation continues to be peso-funded but with some support from foreign currency
(FCY) sources. The total loan portfolio of the banking system increased significantly over the
years (figure 3.l) and is principally funded by peso deposits. Looking at the spot and forward
rates in the currency and interest rate markets, the incentive would have been to borrow in
Philippine peso and to invest these in US dollar instruments. Yet, this is not the case and
instead, banks have increased their FCY debts toaugment the growth in domestic currency
loans (Figure 3.2).
This can be validated in Figure 3.3 which shows that borrowings of Philippine banks from BIS-
reporting jurisdictions have increased to USDI1.7 billion as of end-December 2017. This can
only mean that Philippine banks want to maximize the benefits of taking on added credit risks in
Philippine peso terms and they see as manageable the cross-currency risks from sourcing the
incremental funds from FCY loans.
C. Continuous demand for credit by corporate enterprises and households is evident in
the domestic economy
This funding strategy is a clear positive vote for local economic activity Specifically, non-
financial corporation's (NFCs) and households account for a significant portion of the
incremental loans provided by the banking system. As a matter of tact, firms listed in the PSEI5
exhibited a rising debt: to-equity ratio, from about 45 percent in 2008 to more than 86 percent as
of end-March 2018 (Figure 3.4).
Apart from bank loans, NFCs have also resorted to the bond market for that financing needs.
Figure 3.5 shows increasing levels of corporate debt issuances, both in LCY and in US dollars.
The level of corporate debt issue in US dollars, in particular, had increased since 2010, reaching
USDI1.2 billion as of end-March 2018 after tapering in recent periods.
Data limitation prevents an accurate assessment of household debt. As a proxy, Figure 3.6
shows rising consumer loans since 2012, of which majority were residential real estate loans
and motor vehicle loans. Nevertheless, beyond the increase in consumer loans, the greater
concern lies with what appears to be higher household leverage. Aside from consumer loans,
the 2014 BSP Consumer Finance Survey (CFS) indicates that less than 14 percent of the
households were borrowing from banks to finance the purchase of a residential real estate,
motor vehicle or household appliance (Figure 3.7). This only makes urgent the need to get a
better handle of household debt outside the formal sector. Box Article 4 presents an alternative
way of estimating household indebtedness using the Family Income and Expenditure Survey
(FIES). 16
The continuous demand for credit is welcomed as it represents further "financial deepening" of
the economy. However, one has to also appreciate the higher debt levels against the potential
risks from rising interest rates and the peso depreciation. This is a debt service burden issue
and is at the core of what is referred to as the 3Rs or repricing, refinancing and repayment risks.

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The World of Financial Markets and Institutions

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The World of Financial Markets and Institutions

“Not intended for publication. For classroom instruction purposes only”.