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WorldApril 1 2014

Philippines banks looking to adapt and thrive

A strong economy and good governance have helped maintain healthy profitability at most of the Philippines' largest lenders, but with plans to establish a semi-integrated regional banking industry among the Association of South-east Asian Nations members – which would pit local institutions against much more mature banks – many are looking to diversify, both in terms of the products they offer and the customer base they serve.
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Philippines banks looking to adapt and thrive

Life in the Philippines can be unpredictable. For example, in November 2013, super typhoon Yolanda swept across the archipelago destroying 500,000 houses, displacing 4 million people, injuring nearly 28,000 and killing at least 6000. It is estimated that repairing the damage will cost nearly $1bn. Then there is the odd earthquake, 18 active volcanoes and, in some of the southern islands, separatists are fighting for an independent Islamic state.

The Philippines' banks are, however, on the whole, pretty robust. The country's economy is healthy and key to the banking system's strength. Both Moody's and Standard & Poor's say that the country's banks are the most stable in the region, with a favourable outlook for the next year to 18 months. Both ratings agencies, together with Fitch Ratings, upgraded the country's sovereign debt to investment grade in 2013.

Strong base

Filipino banks weathered the storm of the global financial crisis well, thanks in part to past difficulties. “When we talk to the management of all the major banks they all say they've learned their lessons from the Asian financial crisis [in 1997], and that they're all being very careful in extending their loans and expanding their business,” says Simon Chen, an analyst at Moody's financial institutions group in Singapore.

“Philippine banks are in a very strong position. If you look at the liquidity buffers and the capital buffers that they have, they're sufficient to stand a high level of stress compared to other Asean [Association of South-east Asian Nations] banks,” he adds.

Most of the banks in the Philippines exceed the international requirements of Basel III. The country's central bank, Bangko Sentral ng Pilipinas (BSP), implemented Basel III on January 1, 2014, and banks must now maintain a capital adequacy ratio (CAR) of 10%, compared with the 8% required under Basel II rules. BSP's statistics show that the country's banks' average Tier 1 CAR is greater than 15%, and for some banks, such as Landbank and BDO Unibank, the figure is more than 20%.

The central bank expected that all banks would be able to meet the Basel III standards. Nevertheless, some major banks had to raise extra capital before they could do so. BDO Unibank, the bank with the biggest stock market value in the Philippines, raised about $1bn in July 2012 through a rights offer. Philippine National Bank and Bank of the Philippine Islands also used rights issues in February 2014, to help strengthen core capital.

The country's banks have benefited from a strong economy, thanks partly to the stewardship of a well-respected finance minister Cesar Purisima. He has started to tackle corruption, improve rates of tax collection, and focus on raising the quality of corporate governance and regulation. (Mr Purisima was The Banker's Asia-Pacific Finance Minister of the Year in 2013.)

Corruption is still a problem, however. Transparency International's 2013 annual report on corruption perceptions ranked the Philippines 94th out of 177 countries and territories. This was, however, a big improvement on 2012, when it ranked 105th.

Another issue that will be more difficult to tackle is the fact that the country's banking sector is highly polarised. One-third of Filipinos live in the capital, Manila, on the main island of Luzon, while the rest are spread out over more than 2000 islands. This means that there are hundreds of tiny rural banks – some good, some bad, most of them tiny, many owned by families – and consolidation is slow. Currently, about three-quarters of assets in the country are accounted for by 36 big commercial lenders.

Steaming ahead?

The Philippines' output growth is outpacing much of the rest of Asia, and, in January, the International Monetary Fund (IMF) upgraded its growth forecast for the country for 2014 to 6.3% from 6%. It is expecting 6.75% growth in 2015. And while the Philippines' south-east Asian neighbours depend heavily on exports – which makes them vulnerable to the US Federal Reserve's tapering depressing foreign demand – household consumption creates nearly two-thirds of gross domestic product (GDP) in the Philippines. Government consumption accounts for a further one-fifth, with spending on infrastructure supporting overall economic growth.

The system also benefits from the 10 million Filipinos that work overseas, who contribute liquidity to the banking system and stabilise the economy. Last year, $22.8bn in cash was sent home by the country's diaspora, accounting for 8.4% of GDP.

The country's growing economy has led to an increased demand for loans. In the year to December 2013, commercial banks' lending portfolios grew by 16.4%, while the gross loan-to-deposit ratio was 64.3% at the end of the year. “There's very little reliance on volatile wholesale funding,” says Ivan Tan, Standard & Poor's director of financial institutions ratings in Singapore. “Retail customer deposits are able to entirely fund the loan book. And, from a ratings agency perspective, they're the best form of deposits you can have.”

The proportion of bad loans has been falling. Non-performing loans (NPLs) rose to about one-fifth of the banking system's total portfolio during the Asian financial crisis of the late 1990s, but the central bank says that the gross NPL ratio has stayed at less than 4% since the end of June 2011, while the net NPL ratio has been less than 1%. This is, in part, a natural consequence of the rapid growth in bank lending: the size of NPLs may be constant in absolute terms, but the loan book as a whole has been expanding at an annual rate of 10% to 15% in the past few years.

“When you couple that with a supportive economic environment where no new NPLs are being formed, simply with the passage of time, the NPL ratio will go down,” says Mr Tan. He adds that people often overlook the banks' stock of non-performing real assets: foreclosed property that delinquent borrowers had used as collateral. “Most of this was in the form of factory properties and warehouses. Generally, the demand for foreclosed properties has not been high and it's been very difficult task to get rid of them. Most of the good ones, they've been able to sell, but there are still some remaining from the Asian financial crisis 15 years back," he says.

“So the rate of improvement has gradually slowed down, and we are of the view that most of the improvement in asset quality has already taken place.”

Getting competitive

Moreover, the banking system is fragmented, and returns on assets are low by global standards. Issuing extra shares to meet Basel III requirements also shrank returns on equity for many banks. Margins have also compressed – in part the downside of savings remitted from Filipinos abroad. The cash helps to keep the banking system liquid. But too much liquidity can depress returns. And Nestor Tan, president of BDO Unibank, believes that margins could be compressed further.

The central bank is phasing out special deposit accounts – which it created in November 1998 to widen its range of tools to manage liquidity – and BDO's Mr Tan estimates that this could potentially increase deposits in the banking system by 20% to 30%.

The Asean Banking Integration Framework also looms on the horizon. Its programme of reforms aim to create a semi-integrated regional banking industry within six years, but this might not be beneficial for banks in the Philippines. “Philippine banks, which have been somewhat sheltered, will need to compete head-on with more advanced banks from, for example, Singapore,” says Stephen Schuster, who is senior financial sector specialist in the Asian Development Bank's south-east Asia department in Manila.

China Banking Corporation, which was the first local commercial bank in the Philippines, established in 1920 to serve Chinese-Philippine businesses, is all too aware of the challenge this will create for Filipino banks. Alexander C Escucha, who heads the bank's corporate planning team in Manila, says: “Our biggest banks are not as big or as deep as the biggest banks in other Asean countries.”

The oldest banks in the country are the foreign bank subsidiaries, such as Citibank and Standard Chartered, which were originally drawn to the country by the sugar trade.

“There's always been foreign competition,” says Mr Escucha, but he does not envisage many new entrants coming to the market. "The sense that I have is that the Basel III rules will tend to constrain foreign takeovers rather than encourage them," he says, citing Singapore's DBS as an example, which started to reduce its stake in the Bank of Philippine Islands in 2012, and sold its remaining shares in November. DBS needed the cash to bolster its own capital cushion.

Deeper water

At home, Filipino banks are having to look beyond their traditional small pool of customers, according to Mr Schuster. Their buy-and-hold strategy makes them vulnerable. “The sector has become concentrated with large amounts of credit directed to a small number of large local corporations," he says, adding that shifting to buy-and-securitise would make more sense.

“The challenge for the Philippine banking system is advancing [into deriving] fee income from intermediation. In other words, to develop the capital markets, diversify funding sources and earn from intermediating the funding, not parking it on its balance sheets,” says Mr Schuster.

The central bank says that banks are well behind their regional competitors in the consumer credit sector. At the end of September 2013, consumer loans exposure in the Philippine banking system was 16.6%. In comparison, Malaysia stood at 57.1%, Indonesia was 28.8%, Thailand 26.8% and Singapore 26.4%.

The IMF, in its most recent Article IV consultation report for the Philippines, worried about the impacts should a large, highly leveraged local conglomerate have problems servicing its debt – which it said was a real possibility, although probability was low. The results could be sharply higher funding costs for other big companies, a reduction in bank capital, and a domestic credit crunch because of the banks' concentrated portfolios.

The IMF has also warned several times that a rapid expansion of funds could threaten the Philippine financial system if they fuel demand for real estate, and the central bank seems to be taking this possibility seriously. In February, the central bank governor, Amando M Tetangco Junior, said that regulators were considering stricter guidelines on bank exposure to mortgages if the country's property boom continued.

The growth in real estate loan books has slowed. At the start of last year, outstanding loans in this category were expanding by an annual 28.5%. But at the end of 2013, the growth rate was 22%. However, loans to the construction sector were still growing at an annual rate of 50% in December 2013.

Opportunities knock

The real source of growth for the country's banks lie in the large, and largely unbanked, population. Demographics point to huge future opportunities for the banking system. Official estimates suggest that the median age of Filipinos will be at the upper end of the 20- to 24-year-old age range. And that should rise to about 25 in 2020. The central bank says that this shows the Philippines has a stable core of young people whose main financing needs lie 10 to 15 years ahead.

At the moment, there are still plenty of potential new customers. Large parts of he country are underbanked. The Manila conurbation is fully covered, but the central bank estimates that even densely populated urban areas such as Davao and Western Visayas only have 80% coverage. The island of Mindanao in the south is even worse: only 8% of the region’s cities and municipalities have banking offices. The central bank is considering regulations to allow Islamic banking, which would expand the number of potential customers in predominately Muslim areas such as Mindanao.

Even now, in a country of 100 million, only 20% of households have bank accounts. Reaching the other 80% may be a daunting prospect for the country's banks, but they must tap into this unbanked segment if they are to compete with their much larger regional counterparts.

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