The impact of the U.S. credit crisis on investor sentiment: evidence from Philippine financial markets and institutions.

Araneta, Leonardo B. ; Calderon-Kabigting, Leila Y. ; Hapitan, Rene B. 等

INTRODUCTION

In 2008, the subprime mortgage crisis led to the collapse and bankruptcy of a number of American companies, and the bailout or purchase of others.

The impact of the crisis was not limited to American financial institutions and intermediaries. European and Asian financial institutions were also affected through asset-backed securities (ABS) such as collateralized debt obligations (CDOs). The Asian and European stock markets also mimicked the plunge of the U.S. Dow Jones Industrial Average (DJIA). Investors' risk aversion increased. Liquidity concerns forced central banks around the world to provide ready credit to member banks with looming obligations.

This study covers events that led to the current subprime crisis from March 2007 to September 30, 2008. For an analysis on the crisis's effect on the Philippine stock market, we present data up to October 27, 2008, when the Philippine Stock Exchange (PSE) experienced a circuit break after losing 10 percent of the PSE composite index (PSEi) value within one trading session. Notwithstanding the trading halt, the PSEi closed 12 percent lower that day. An update of events affecting Philippine markets and institutions up until March 2009 is also provided.

The research proposes lessons from the crisis for Philippine financial markets and institutions. We evaluate existing financial market regulation and policy responses, and conclude with recommendations to further minimize the adverse impact of similar crises in the future.

THE SUBPRIME CRISIS

After the burst of the dot com bubble and the terror of September 11, 2001, the Federal Reserve slashed interest rates. Borrowers were offered enticing introductory non-traditional mortgage schemes. Initial loan payment schemes were purely 'interest-only' with principal repayments to be made at a latter part of the loan period. The U.S. home ownership rate rose from 64 percent to 69 percent during 1995-2005, about 0.5 percent per year. Home prices appreciated because of increased demand.

As demand for subprime loans grew, financial institutions sought to remove risky assets from their balance sheets. Banks learned to offload subprime loans through securitization. Mortgage originators combined the riskiest subprime mortgages with other types of debt and created structured credit products like mortgaged backed securities (MBS) and collateralized debt obligations (CDOs). Special purpose vehicles (SPVs) and structured investment vehicles (SIVs) were set up to purchase risky loans from banks. SPVs issued CDOs and subprime residential mortgage backed securities (RMBS) in separate tranches with different credit ratings to meet varying investor risk-return tradeoff requirements. Outstanding RMBS grew from USD52 billion in 2000 to USD449 billion in 2005, a 763 percent increase over five years (Moore & Brauneis, 2008; Neal, 2008).

In early 2006, interest rates on 30-year fixed rate mortgage (FRM) was at 6.76 percent while the interest rate on 1-year adjustable rate mortgage (ARM) reached 5.79 percent. Higher interest rates led to: 1) borrowers' difficulty in refinancing mortgages; 2) fewer new loans; 3) subprime borrower defaults and increased foreclosures; and 4) falling property prices due to decreasing demand. To ease subprime borrowers' credit problems, the Fed lowered interest rates, with mortgage rates following suit. The 30-year FRM moved only slightly, from 6.1 percent in December 2006 to 5.92 percent in April 2007, and interest rates for one-year ARMs slid from 5.5 percent in December 2006 to 5.19 percent in April 2008 (Moore & Braunes 2008; Neal, 2008).

By August 2007, the effects of subprime loan delinquencies began to show. A liquidity crunch ensued as U.S. investment banks and other institutions incurred losses. Access to credit within financial institutions tightened as banks chose not to lend to peers due to the growing risk of counterparty default. Beginning September 15, 2008, a series of events led to more bankruptcies, government bailouts, and takeovers or buy-outs. The timeline in Table 1 covers the significant events that led to the U.S. government's USD700billion bailout of affected institutions.

THE GLOBALIZATION OF FINANCIAL CRISES, BEHAVIORAL FINANCE, AND THE LESSONS OF HISTORY: SOME THEORETICAL SPECULATIONS

Scholars argue that the global financial crisis is the result of the collapse of capitalism and the downside of financial internationalization and market liberalization. Kindleberger (1978) and Minsky (1977, 1982, 1986) attempt to explain 'crisis' within the context of the financial sector (cited in Heffernan, 2005). For monetary economists, crises are usually linked to the banking sector, and customer panic and bank runs are likely effects of the absence of appropriate central bank intervention. The Minsky model posits that a financial crisis is an endogenous component of the business cycle. Profit opportunities become available for certain market sectors due to an exogenous 'shock'--an economic recession, new technology, a surprise financial event (Heffernan, 2005). In the case of the U.S., the repeal of the Glass-Steagall Act via the Gramm-Leach-Bliley Act of 1999 is cited as the most likely cause of the rise of subprime lending after 2006 and a contributor to the meltdowns of MBS, CDOs, and other structured vehicles.

Consumers with savings or credit exploit these profit opportunities, and increases in credit trigger a 'boom' as investor confidence soars. During these good times, money is poured into real estate and big corporations, but financial systems become 'fragile' (Hefferman, 2005):

   Investors speculate due to the banks' decreased provisions for risk
   given an optimistic view of the economy. Price increases create new
   opportunities for profit and more investment, which raise incomes,
   and prompt more investments; and, speculation triggers 'herd
   behavior.'

The boom continues until some event begins to damage the sector(s) at the center of speculative activity or the economy as a whole. As prices escalate, excessive speculation and overconfidence create the 'bubble.' This increases financial fragility and distress, with firms and households defaulting on loans and selling off assets, and bank panic ensues, possibly with contagion on a wide scale. A 'crash,' in Kindleberger's view, is an extended negative bubble. In AIG's case, the Fed as lender of last resort stepped in with a bailout to restore market confidence.

In retrospect, Wall Street traders and mortgage originators grew excessively optimistic--even greedy--about the future prices of assets. Prudence and compliance with regulations were forgotten. With greed comes ignorance--both traders and investors created, bought, sold, and traded securities too complex for them to fully understand (Serwer and Sloan, 2008).

The field of Behavioral Finance acknowledges the possibility of investors' irrational behavior, and uses financial bubbles to demonstrate this point. Behavioral finance challenges traditional economic thinking--in particular, the view that when everyone pursues his own self-interest, the collective result satisfies the interest of the whole society--by recognizing the existence and baneful effects of overconfidence, heuristics (mental shortcuts) and biases.

It is human to desire to feel safe. Psychological costs and benefits are a proven major influence on the cost-benefit analysis that drives decision-making, and can be very different from economic costs and benefits. Decision-making can suffer from misapplied heuristics, biases and cognitive errors. As the behavioral finance critic Daniel Kahneman points out, the failure of the rational model is not in its logic but in the human brain, which is not purely rational. The persistent trade-off in computations and emotional impulses leads to a capital market that fails to perform as consistently as theoretical models predict (Bernstein, 1998).

Some analysts say they saw the financial crisis coming in 2007 as U.S. banks' profits fell in the last quarter of the year. The surge in commodity prices likewise confirms the intertwining of speculation and physical market supply and demand. The fundamentals of the underlying physical markets change-in terms of asset concentration, firm behavior, cost structures and technology. As a result, actual prices, and the range of feasible ones, change over time as well. Ideally, feedback loops between actual and forecast prices and markets' actual decisions should determine future prices. Forecasts have to be dynamic and sensitive to assumptions about feedback and behavioral change (Kemp, 2008).

The Kindleberger notion that agents are actually irrational clashes with Eugene Fama's Efficient Markets Hypothesis (EMH). The EMH states that, in the absence of full information, speculators make mistakes (but not systematically) if expectations are rational (Heffernan, 2005). In the context of portfolio management and the mean-variance framework, 'normal' behavior occurs where investors are presumed to be rational and to care only about the expected return and risk of the overall portfolio. However, in the current crisis, the logic bears revisiting: perhaps investors were dazzled by upside potential, and blind to downside protection.

In the Asian financial crisis of 1997, the problem was largely due to a crisis of confidence and shortage of market liquidity. Today, the global problem is seen as more a shortage of solvency and credit flow, which are actually harder to solve. The earlier crises were largely confined to the banking sector; the more recent ones involve the currency, banking, and other financial markets.

In the U.S., bank panic exerted a downward pressure on overall economic activity in two ways. Lower depositor confidence led to bank withdrawals and a preference for hard cash. Withdrawals affect the money supply and the resulting deflation pushes up the real burden of household debts. Moreover, heavy withdrawals mean bank runs, and trigger bank closures, which throttle the availability of credit, especially to small businesses, and impair the economy's ability to channel financial resources towards their best use (Mankiw, 2008).

Analyst Philip Delhaise's extensive study concludes that the Asian crisis of 1997 was both a crisis of growth and a panic resulting from changed perceptions in the minds of domestic and foreign investors and lenders. 'Antiquated' financial systems in Asia's emerging economies were at the core of the crash. The panic, covering the currency, debt, social, and even political crises, were all a string of consequences flowing from the main source--systems that relied almost exclusively on commercial banks to provide capital for economic expansion (Delhaise, 1998).

THE IMPACT OF THE U.S. CREDIT CRISIS ON PHILIPPINE FINANCIAL INSTITUTIONS AND MARKETS: TWO U.S. COMPANIES

American International Group, Inc.

On September 15, 2008, American International Group, Inc. (AIG), once the world's largest insurer in terms of market capitalization with over USD1.0 trillion in assets, sought an emergency loan of up to USD85billion from the Federal Reserve Bank of New York. A Standard & Poor's (S&P) credit rating downgrade from AA- to A- created an unprecedented liquidity crunch due to collateral calls that the firm was required to put up on insurance contracts it had written. Although the emergency loan was ultimately granted by the Federal Reserve, it came at a steep price--the insurer would effectively be nationalized, with the U.S. government acquiring a 79.9 percent stake in the company, and the right to revamp the management team. The loan would be payable in two years at a spread of 850 basis points over the three-month LIBOR on interest setting date. The terms of the loan compel AIG to repay the USD 85 billion loan via issuance of debt or equity securities or through asset disposals with the sole purpose of repayment.

AIG's liquidity problems stemmed from a tiny London subsidiary called AIG Financial Products (AIGFP). With only 377 employees out of AIG's 116,000-strong workforce, the unit was a huge profit center, contributing close to 18 percent of the conglomerate's operating income in 2005. The London unit had entered into credit default swap (CDS) contracts with various counterparties, mostly large investment houses and banks in the U.S. and Europe, to insure against default collateralized debt obligations (CDOs), corporate debt, and subprime mortgage securities with blue-chip and investment grade credit ratings. In exchange for default protection, the counterparties paid AIG a premium for bearing the default risk of the pool of debt underlying these securities. Given the exceptional credit quality of the securitized assets, default was quite inconceivable. Hence the spreads earned from AIGFP's credit protection were a very lucrative income source for the subsidiary. The unit insured a total of USD 513 billion of notional principal--USD 294 billion of notional value in corporate debt, USD 141 billion in European residential mortgages, and USD 78 billion in CDOs including subprime mortgages. AIG's own high credit rating enabled it to issue these CDS contracts sans any form of collateral. The unit banked on this competitive advantage, and on the fact that CDS are unregulated over-the-counter transactions, to aggressively sell default insurance. Its employees were richly compensated, earning an average of over USD 1 million per year.

When the excesses of the U.S. subprime mortgage market began surfacing in 2007, AIG suffered the the repercussions of its aggressive CDS positions. By September 30, 2007, AIG had reported USD 352 million in mark-to-market losses from its CDS portfolio-and it was a downward spiral from then on. The company's fourth quarter 2007 charges for CDS-related mark-to-market losses rose to USD 7.5 billion. As news spread about troubles in the London subsidiary, more analysts warned that rate cuts might follow. In May 2008, the company raised USD 20 billion in capital via issuances of equity and debt in an effort to strengthen its financial position. Despite the added cash, credit rating agencies seemed more concerned about AIG's growing losses from its CDS business, which reached USD 10.5 billion in the first half of 2008. The tightening of credit during the year made it even more difficult for AIG to tap short term credit lines from banks to stay liquid and avert a credit rating downgrade. On September 15, 2008, a day now known in the financial world as "Black Monday," Moody's Investor Service and Fitch Ratings reduced AIG's credit standing by two notches, in concert with S&P's three-peg rating cutback. Although still considered investment grade, AIG's short-term liquidity position suffered as collateral calls had to be made in the event of a rating downgrade, as stipulated in many of AIG's insurance contracts. When all potential sources of funding were exhausted, including credit facilities granted by AIG's own subsidiaries around the world, the insurance giant was forced to run to the Federal Reserve, hat in hand.

The Fed's rescue is viewed as a boon for the insurance giant, as Lehman Brothers is reported to have also approached the U.S. central bank for aid, only to be turned down. An analysis of AIG's counterparty and client base shows that the troubled insurer had entered into insurance arrangements with almost all major banks and financial institutions around the world, making it practically impossible for the world financial market to avoid collapse if AIG were left to fail. AIG's demise could have triggered a systemic global banking crisis since it would have reneged on its contracts with banks all over the globe.

Equity markets were the first to react to the catastrophic September news about Lehman Brothers, Merrill Lynch, and AIG. Risk aversion surged, with investors shifting funds from equities and emerging market assets to safer U.S. Treasury investments. As world stock market indices plummeted, U.S. Treasury Bill yields declined to near-zero levels. Short term inter-bank rates soared as banks chose to hold on to cash instead of lending to troubled financial institutions. The Federal Reserve was compelled to implement measures such as liquidity injections into the banking system to avert excess interest rate volatility and further equity sell-offs.

Investments by Philippine insurance firms are generally restricted to the domestic market. Nonetheless, investors in insurance and other products of AIG's local subsidiary, the Philippine American Life and General Insurance Company (Philamlife), the Philippines' largest life insurance firm (with consolidated assets of over PHP 170 billion in 2007), expressed fears, given the financial problems of its U.S. parent. AIG owns 99 percent of Philamlife, which in turn has substantial equity stakes in affiliates such as Philam Equitable Life Assurance Company (bancassurance), Philam Plans, Inc. (pre-need plans), PhilamCare Health Systems, Inc. (healthcare management), AIG Business Processing Services, Inc. (business process outsourcing), Philam Insurance Company, Inc. (property and casualty insurance), AIG Philam Savings Bank (banking and credit cards), Philam Asset Management, Inc. (mutual fund investments), AIG Global Investments Corporation (Asia), Ltd. (asset management), and Philam Properties Corporation (property development).

Sentiment towards Philamlife and its subsidiaries was downbeat when news of AIG's cash problems broke in September 2008. Many Philamlife investors pre-terminated their investments and insurance policies. The AIG debacle and ultimate rescue fueled speculation that the Philippine unit and its affiliates would have to be sold to pay off AIG's loan to the Federal Reserve, thereby jeopardizing investor placements. To assure clients, Philamlife and its subsidiaries issued official statements declaring that Philamlife's financial resources and assets were invested in easily liquidated blue chip equities and government securities, and reiterating the entire Philam Group's financial strength. Moreover, Philamlife was separately capitalized from AIG and was regulated and overseen by the local Securities and Exchange Commission (SEC) and Insurance Commission (IC), hence shielded from the problems of its U.S. parent. To prevent investor panic and further speculation, an IC statement attested to Philamlife's market leadership and its capacity to pay out policyholder claims. Philam Asset Management, Inc. (PAMI), the investment company affiliate of Philamlife, also released a statement reiterating that the mutual funds managed by the Philam Group companies are corporations separate and distinct from PAMI or Philamlife, with a broad shareholder base, independent boards of directors, and assets invested in safe and liquid government paper and blue chips.

On March 2, 2009, after receiving unattractive bids for its Asian "crown jewel", AIG announced it would retain the highly profitable Philam Companies. AIG struck a deal with the U.S. Department of the Treasury and the Federal Reserve, allowing AIG to repay its debts to the U.S. government without having to resort to outright divestiture of its most lucrative insurance franchises. The new setup effectively placed American International Assurance Company, Ltd. (AIA) and American Life Insurance Company (ALICO), AIG's Asian insurance operations, in Special Purpose Vehicles (SPVs) that will facilitate AIG's restructuring and debt repayment plan. The Philam Group of Companies comes directly under the umbrella organization of AIA. AIG holds preferred and common interests in these SPVs as a holding company, allowing AIA and ALICO to operate independently. The Federal Reserve also received preferred interests from these SPVs as repayment for a portion of the loan facility earlier granted to AIG. This arrangement reduced AIG's debt and interest carrying costs while maintaining the value of AIA and ALICO and positioning them to enhance their franchises. After these announcements, investor jitters over Philamlife simmered down by November 2008.

Lehman Brothers Bankruptcy's Effect on Philippine Banks

Lehman Brothers Holdings, Inc., the fourth-largest U.S. investment bank, went bankrupt due to its USD613 billion debt. Seven banks in the Philippines had a total of USD356 million in exposures to Lehman Brothers. Table 2 details this exposure.

Listed banks Banco de Oro (BDO), Metropolitan Bank and Trust Company (Metrobank), and Rizal Commercial Banking Corporation (RCBC) set provisions for possible losses from their investments in Lehman Brothers. Bank of the Philippine Islands (BPI), Union Bank of the Philippines (UBP), Philippine Savings Bank (PSB), and Security Bank (SBC) declared to the PSE that they had no direct or indirect exposure and thus made no provisions.

Table 2 also shows the non-listed banks with exposures to Lehman: Standard Chartered Bank Manila (SCB), Bank of Commerce (BOC), and United Coconut Planters Bank (UCPB).

BDO accounted for the lion's share of the USD356 million exposure at 38 percent. BDO's 2008 net income dropped by 66% to PHP2.2 billion, from 2007's PHP6.5 billion, due to investment losses. BDO made provision for PHP3.8 billion (USD80.7 million) in the third quarter for its exposure to Lehman. As of end-2008, BDO ranked first among banks in terms of assets, loans and deposits, and ranked third in terms of capital. It announced plans to raise up to PHP13 billion by selling notes and new shares for further expansion and acquisition opportunities (De La Cruz, March 4, 2008)

Metrobank allocated PHP658 million (USD14 million) for USD20.4 million in bonds issued by Lehman. Metrobank's exposure to a Lehman subsidiary in the Philippines amounted to PHP2.4 billion. Metrobank treasurer Ferdinand Antonio Tansingco said that "only USD20 million of the reported USD71 million exposure comprised direct investments. The rest was used to buy distressed assets of local banks by Lehman's SPVs. The USD20million is equivalent to only 0.1 percent of the bank's assets" (Businessworld, September 30, 2008). Metrobank reported net income of P4.4 billion in 2008, a 37 percent decline from the previous year. Although its core business remained stable, Metrobank recognized the mark-to-market value decline of all financial instruments affected by the crisis. (De La Cruz, March 4, 2008)

RCBC set aside PHP980 million (USD20.8 million) to cover possible write-downs in its investments in structured products with exposure to Lehman. RCBC posted a 33 percent income decline from 2007's PHP3.21 billion to 2008's PHP2.15 billion. (De La Cruz, March 10, 2008)

In 2008, BDO, Metrobank, and RCBC accounted for some PHP15 billion or only 0.3percent of the PHP5.0 trillion assets of local banks. The banking industry had a capital adequacy ratio of15.7 percent--well above the BSP regulatory standard of 10 percent--thus the impact of provisions for losses was limited to earnings. Banks had enough liquidity and capital to meet obligations and withdrawals. The BSP also provided credit to support any bank in difficulty from exposure to Lehman (Business World, September 30, 2008; De La Pena, 2008).

Table 3 summarizes the closing prices of listed local banks for the one-day, three-day, one-week, and two-week periods after the announcement of Lehman's bankruptcy. BDO and Metrobank shares fell by 15 percent and 10 percent respectively a day after Black Monday. BDO's stock price plunged 24.1 percent after three days. Bank stocks continued to decline whether or not they had exposure to Lehman.

After a week, BDO and Metrobank began to recover, although over the next two weeks, their stock prices continued to experience a general decline.

CREDIT CRISIS IMPACT ON PHILIPPINE FINANCIAL MARKETS AND INSTITUTIONS

The Philippine financial system had no significant exposure to CDOs and credit linked notes (CLNs). BSP rules on structured products and derivative instruments kept local banks from significant exposure to soured mortgage debts securitized by U.S. investment banks. According to BSP Governor Tetangco, "Banks without appropriate derivatives licenses cannot sell structured product beyond a given unit of their capital base." (Dumlao, 2007).

Reforms adopted by the BSP after the Asian financial crisis eased the impact of the U.S. credit crisis on Philippine banks. Increases in minimum capital requirements and circulars mandating strengthened risk management procedures were implemented to improve banks' shock absorbency. Philippine banks also tightened loan policies as a precautionary measure. Local lending continued but its pace slackened.

Figure 1 shows that the local bourse was on a bull run from 2005 to early 2007 and the first sign of trouble was seen in mid-2007. The index however recovered and closed at an all-time-high of 3,873.50 in October 2007. The subsequent decline of foreign investor positions in the local stock market reversed the upward movement.

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A possible cause for the drop was investors' post-subprime crisis risk aversion. As shown in Figure 2, the PSEi reflected this loss of appetite, dropping by 51 percent from 3,501.38 points on January 3, 2008 to 1,713.83 points on October 27, 2008. This was also the day of a one-hour circuit break in the exchange after the PSEi fell 10 percent. Eventually, the PSEi dropped by 239.66 points (12.27 percent) that day as foreign funds pulled out.

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The Philippine Peso generally appreciated vis-a-vis the greenback from 2005 to the end of 2007. The Peso fell against the U.S. Dollar in June 2007 when the subprime mortgage problem was first observed, and in early 2008 when inflation concerns heightened risk aversion among foreign investors. The Peso appreciated when oil prices began to ease. Figure 3 shows that the Peso's September 2008 decline was driven more by the low US Dollar supply rather than by risk aversion. Towards the end of September when USD liquidity problems became more apparent, the demand for greenbacks skyrocketed, adding further pressure on the domestic currency.

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Figure 4 shows that yields on local debt paper remained strongly influenced by the new monetary measures implemented to address inflation and domestic liquidity, impacting the supply of and demand for government securities. Notwithstanding the turbulence in global financial markets, the Philippine Bureau of the Treasury (BTr) maintained a healthy cash position, rejecting all bids in the primary market which were deemed too high.

The local currency swaps market was much affected when the subprime bubble burst. The implied Peso rates of the USD/PHP swaps market were driven mainly by supply and demand of domestic liquidity and policy rates and regulations of the BSP. The downward spikes prior to 2008 were caused by reimplementation of the tiering scheme while the upward spikes were driven mostly by demand for Peso liquidity. In 2008, downward spikes occurred at the end of each month as most foreign banks sourced US Dollars through the swaps market to improve their financial statements. Figure 5 shows that towards the end of September 2008, the heightened demand for US Dollars pushed implied Peso rates deep into negative territory.

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LOOKING AHEAD: SOME POLICY IMPLICATIONS FOR PHILIPPINE BANKS AND FINANCIAL MARKETS

Neal (2008) and Khor and Kee (2008) discussed early warning signals of an impending financial Crisis--abundant liquidity, lax credit, and escalating property prices. The first two signals were evident in the Asian financial crisis. The third jolted the Japanese economy in the 1990s.

The global effects of the ongoing U.S. financial turmoil are comparable to the regional contagion of the Asian financial crisis. In 1998, the Philippines experienced major volatility in its exchange rate as well as spiking inflation numbers detrimental to economic growth. However, the Philippines proved to be more economically resilient during the crisis than its Asian neighbors because of regulators' policies and timely actions.

The World Bank sounded pessimistic in its December 2008 report 'Global Economic Prospects', predicting a global recession in 2009 and recovery in 2010. It proposed that policymakers of both developing and developed countries prepare for a 'worst-case scenario' of currency crises and even bank failures (BizNews Asia No. 45, 2009).

The Philippines instituted reforms to ward off a repeat of the 1997 Asian crisis. One such reform concerned risk management: Banks, stock brokerages, and insurance companies were required to implement risk management policies and guidelines on operations, credit, and market. Some companies which set up risk management department are working towards having an enterprise-wide risk management system.

The passage of the General Banking Law of 2000 is another key improvement that institutionalized a critical mass of banking reforms. Its rules and regulations cover adoption of a risk-based capital adequacy ratio (CAR), observance of proper rules of bank management, acquisition of domestic banks by foreign banks/nationals, and the granting of microfinance loans by financial institutions. The BSP also reinforced corporate governance standards to curb excessive risk-taking, ensure fair business transactions, promote consumer protection, and make the board of directors fully accountable to shareholders and the public. To complement banking reforms, the BSP promoted the further development of the local capital market. The development of the capital markets will open up new financing sources to investors and companies, and reduce the latter's overdependence on the banking industry.

The banking industry has also acted to improve conditions during crises. Bankers' Association of the Philippines (BAP) members forged a commitment to reduce the interest spread on lending rates. To complement their efforts, the Bureau of Treasury (BTr) has rejected relatively high bid rates for its short-term Treasury bills, refrained from crowding out the domestic market by tapping foreign sources to finance requirements, and rationalized fiscal expenditures.

Concerned over fluctuations in foreign exchange rates in Asia and the activity of speculators, the BAP introduced a volatility band for the Dollar-Peso exchange rate in 1997, which helped slow down the Peso's depreciation (this was lifted in March, 1998). The BSP discouraged intense currency speculation by intervening with foreign exchange regulations, imposing sales clearances of non-deliverable forwards (NDFs) on non-residents, and reducing banks' net open position limits. Its action reduced pressures in the foreign exchange spot market and stemmed the aggravated outflow of foreign currencies from the country.

Some BSP measures were implemented simply to discipline the market; others were designed to spur of economic growth. In January 1998, the Currency Risk Protection Program was launched, enabling eligible corporate borrowers to limit their foreign exchange risk on unhedged outstanding foreign exchange obligations. In addition, the BSP provided USD liquidity to the market without tapping its international reserves by issuing controlled amounts of NDFs to banks.

The introduction of the BSP's Special Deposits Account (SDA) in 1998--when the country was experiencing double-digit inflation rates--was also timely. The SDA served as an alternative investment channel, priced at a premium against the existing Reverse-Repurchase Agreement (RRP). The SDA also siphoned excess liquidity from the market, thereby easing inflation.

The BSP's policy rates have been set at high levels for long periods, to rein in inflation by controlling the market's excess liquidity levels while arresting further Peso depreciation. Banks' reserve requirements were also adjusted to manage liquidity.

To address asset quality issues, the BSP pursued passage of the Special Purpose Vehicle Act, a private sector-led mechanism to dispose of non-performing loans. SPVA implementation improved bank asset quality and reduced the system's problem assets to manageable levels.

After the first SPVA law expired, the BSP pushed for its extension to give banks more time to dispose of their non-performing assets. The BSP supplemented the financial incentives under the SPV Law with regulatory relief measures to jumpstart the asset clean-up.

Efforts were also initiated to implement the Basel II Accord fully even as local banks had already adopted international accounting standards. The BSP pushed to make the banking system compliant with Basel II provisions for a standardized approach by 2007 and for an internal rating-based approach by 2010. Compliance would further strengthen transparency and disclosure requirements in financial reporting, and bring local banking practices up to internationally accepted standards.

Following the concerted efforts of other central banks to infuse liquidity into financial systems by cutting interest rates and improving loan availment facilities and capitalizations towards the end of 2008, the BSP reevaluated its valuation methods for government securities (GS) collaterals and loans, effectively increasing the collaterals' value. A Repurchase Agreement (RP) on USD using Republic of the Philippines (ROP) securities as collaterals was also made available, increasing the possible sources of USD liquidity for the country's banks.

The BSP also supported the private sector initiative to operate a Fixed Income Exchange, to serve as the secondary trading platform for debt securities. To foster liquidity and trading, the BSP created an environment conducive to new investment product development. One key problem in the subprime crisis was the lack of prudent supervision, particularly over financial derivatives. The BSP issued guidelines on new investment and financial products such as unit investment trust funds (UITFs), credit derivatives, and securitization, to ensure that comprehensive information on financial engineering is available to the originators and investing public so they are made fully aware of the risks inherent in these innovations. While the BSP has formulated policies on financial derivatives and risk management in 2008, it should enhance policies in bank regulation and supervision to deal with off-balance sheet (OBS) transactions.

While the tribulations of the Asian financial crisis seem to have returned with the onset of the U.S. subprime crisis, some differences between the two crises may be noted. Prior to the turbulence in the U.S. financial markets, the Philippines was recovering from the surge in inflation brought about by rising oil prices. The country was not directly involved in the turmoil at Lehman Brothers, AIG. Only local banks exposed to Lehman Brothers were directly affected although they remained resilient. As BSP Governor Amando Tetangco noted, their exposure accounted for less than half a percent of the banking system's total assets. Governor Tetangco is confident that the Philippine banking and financial systems are not likely to experience a liquidity crisis since there is money generated by the business process outsourcing (BPO), agri-industry, mining, and service sectors (BizNews Asia No. 32, 2008).

In December 2008, President Gloria Macapagal-Arroyo approved the government's PHP300 billion economic sustainability plan for 2009. The National Government made clear that this plan, funded through both local and national budgets and private sector investments, is neither a contingency nor a recovery plan, but the coordinated execution of existing plans to sustain infrastructure, employment, and economic activities to ensure domestic growth (BizNews Asia No. 45, 2009).

Banks should be more rules-based and strictly implement the next phases of Basel II. Banks should continue to dispose of their non-performing asset (NPA) portfolios and likewise improve their CAR beyond the BSP and BIS (Bank of International Settlements) standards and improve their approaches to financial risk management.

RA 8799, the Securities Regulation Code, was enacted to create a more transparent market through full disclosure of material information by listed companies, standards aligned with international best practices, and eventually, demutualization of the stock exchange. These have helped the local bourse reach new highs with the entry of more foreign investors. While the equities market is not immune from the ongoing crisis, and many foreign investors have indeed pulled out, Philippine listed corporations are showing their mettle and strong fundamentals during this crisis, and foreign investors should eventually return. The PSE continues to encourage small and medium enterprises to list in the markets. The PSE must offer new products, evaluate current fees, taxes and listing requirements which may be cumbersome for those who would want to list.

The IC policy for insurance companies not to invest in derivatives proved advantageous under this current crisis. However, some insurance companies may want to invest in sophisticated products like derivatives later on. It is suggested that the IC provide policies, guidelines, circulars to insurance companies who may want to offer or invest in sophisticated products to protect them and the investing public.

The regulators should continue to promote financial liberalization but ensure that specific policies are in place to guide new market entrants. Continuous monitoring should set off early warning signals. Regulators and policymakers need to conduct financial surveillance and supervise financial innovations and developments in financial markets. The BSP, PSE, and IC, as regulators of the bank, stock market, and insurance sectors, require that companies submit vital information monthly, quarterly, and annually to track corporate governance practice, capital market development, and transparency in financial reporting (Khor, Kee, 2008; John, 2008; Suleik 2008). The SEC can continue with the self-assessment scorecard on corporate governance for listed firms. The IC can also develop a similar scorecard on corporate governance for insurance companies. Also, firms should work on developing enterprise-wide risk management to create a strong culture of risk management.

Finally, the Philippines' earlier exposure to the Asian financial crisis resulted in reforms to improve the banking industry and the development of the local capital markets. The following reforms should continue to cushion the impact of the subprime crisis on the Philippine financial system.

REFERENCES

BizNews Asia (2008, September 22-29). Banks are strong, stable. BizNews Asia, Vol. 6 (32), pp. 30-31.

BizNews Asia, Vol. 6 (45), page 32.

BizNews Asia (2009, January). The World Bank Crystal Ball: Recession in 2009, recovery in 2010.

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Leonardo B. Araneta, De La Salle University-Manila

Leila Y. Calderon-Kabigting, De La Salle University-Manila

Rene B. Hapitan, De La Salle University-Manila

Steven S. Lim, De La Salle University-Manila

Christian E. Romagos, De La Salle University-Manila

Clive Manuel O. Wee Sit, De La Salle University-Manila

Table 1: Timeline of the U.S. Financial Crisis

TIMELINE          EVENT

March 2007        More than 100 subprime mortgage lenders fail or
                  file for bankruptcy

October 2007      Merrill Lynch announces a USD8.4 billion loss and
                  fires its CEO

March 2008        Investment bank Bear Stearns, with substantial
                  mortgage-backed securities MBS investments,
                  collapses

September 2008    The credit crisis, which had long moved to
                  accelerate beyond its origins in subprime
                  mortgages, began

September 7       The Fed bails out Fannie Mae and Freddie Mac

September 14      Bank of America buys Merrill Lynch in a forced
                  merger worth roughly USD50 billion

September 15      Investment bank Lehman Brothers declares
                  bankruptcy. It is the largest bankruptcy filing in
                  U.S. history with Lehman holding over USD600
                  billion in assets. The Dow Jones Industrial plunges
                  504 points (4.4 percent), the worst index loss
                  since 9/11 terrorist attacks

September 16      The U.S. Fed agrees to lend AIG LTSD85 billion,
                  leading to government control over the troubled
                  insurance giant

September 20      U.S. President George W. Bush formally seeks USD700
                  billion for bailout of financial institutions

September 21      The Fed announces transformation of Goldman Sachs
                  and Morgan Stanley into bank holding companies
                  subject to greater regulation

September 25      Washington Mutual, the nation's largest Savings &
                  Loan, is seized by the FDIC, and its banking assets
                  sold to JP Morgan Chase for USD 1.9 billion

October 1, 2008   * The U.S. Senate passes the requested USD700
                  billion financial bailout package

Source: New York Times: Seven Weeks of Financial Turmoil (Interactive
feature available inwww.nytirnes.com)

Table 2
Philippine Banks' Exposure to Lehman Brothers

                                          EXPOSURE         PERCENT
BANK                                   (USD Million)       OF TOTAL

Banco de Oro                                134          37.6 percent
Metrobank                                    71              19.9
Development Bank of the Philippines          60              16.9
RCBC                                         40              11.2
Standard Chartered                           26               7.3
Bank of Commerce                             15               4.2
UCPB                                         10               2.8
TOTAL                                       356         100.0 percent

* BSP estimates cited by Suleik (2008); Businessworld, 2008

Table 3: Stock Prices of Listed Banks After the Announcement of the
Lehman Bankruptcy

Closing                                1 day
Stock prices       12-Sep    15-Sep    price        16-Sep
Of lifted banks    (PHP)     (PHP)     decline      (PHP)
                                       (percent)

BDO                41.5      39        -6.02        33
Metrobank          38        37        -2.63        33
PXB                30        28.5      -5.00        27.5
RCBC               17.25     17        -1.45        16
BPI                45.5      43        -5.49        41 5
UnionBank          30        30        0.00         29
Security Bank      59        58.5      -0.85        57.5

Closing            2 day                  3 day
Stock prices       price        16-Sep    price        18-Sep
Of lifted banks    decline      (PHP)     decline      (PHP)
                   (percent)              (percent)

BDO                -20.48       31.5      -24.10       34.5
Metrobank          -13.16       32        -15.80       30.5
PXB                -8.33        27.5      -8.30        25
RCBC               -7.25        16        -7.2         15
BPI                -8.79        43        -5.50        40
UnionBank          -3.33        28.5      -5.00        25
Security Bank      -2.54        56.5      -4.2

Closing            4 day                  5 day
Stock prices       price        19 Sep    price        30 Sep
Of lifted banks    decline      (PHP)     decline      (PHP)
                   (percent)              (percent)

BDO                -16.9        37.5      -9 64        38
Metrobank          -19.7        34.5      -9.21        33
PXB                -16.7        26        -13.33       28.5
RCBC               -13.0        15.75     -8.70        15.75
BPI                -12.1        44        -3.30        45
UnionBank          -16.7        26.5      -11.67       26
Security Bank                   57.5      -2.54        54.5

Closing            15 day
Stock prices       price
Of lifted banks    decline
                   (percent)

BDO                -8.43
Metrobank          -13.16
PXB                -5 00
RCBC               -8.70
BPI                -1.1
UnionBank          -13 33
Security Bank      -7.63

Source: The Philippine Stock Exchange;
http://services.inquirer.net/print/print.php?article
id=20080919-161523