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Fitch Ratings hits the nail, and Philippine banks, on the head

(Article published in the Jan 14,2005 issue of TODAY, Business Section)

Media and Government simply shrugged it off.  But the somber Special Report on Philippine banks put out by Fitch Ratings in the second to the last day of 2004 ought to be taken seriously.  For not only did it articulate publicly what had heretofore been whispered secrets among those in the inner circles of Philippine banking, it also pinpointed with laser accuracy what is probably the single biggest stumbling block to moving our country forward.  In cool clinician detachment, the Fitch Report said:

“The fact that the central bank has not enforced stricter prudential regulations is a concern.  Supervisors in the Philippines have found it difficult to take on the powerful vested interests that own some of the banks.  And while the central bank has over more recent times laboured intensively towards lifting bank standards, constraints on how tough it can be remain.”

Fitch Ratings is a leading global rating agency, with headquarters in both sides of the Atlantic, in New York and in London, and its mission is to provide accurate, timely and prospective opinions to the players in the world’s credit markets.  It is in 50 locations the world over and covers more than 80 countries.  It is a wholly owned subsidiary of Fimalac, S.A., which has its head office in Paris, France, and is engaged in the business of providing various support services to business.

It is not easy to rate banks internationally because different banks operate in different ways under different constraints.  It is not useful at all to construct, in Plato’s world of ideas, an ideal bank, against which to measure mechanically banks in the real world.  What Fitch Ratings does is apply a methodology that adheres to a coherent approach at the same time allowing for differing circumstances.  It tries to understand the business of the bank being rated, including the risks inherent in that business, the objectives of its management, the environment under which it operates, and the most likely future development of its business. The interplay of macro-micro factors thus allows for comparison among the rated financial institutions that is both fair to them and meaningful to their constituents.

The Special Report on Philippine banks considered thirteen banks which together own 73% of the assets of the banking system.  It noted that the local business environment under which they operated was marked by stagnant credit demand and declining interest rates.  The result was the channeling of funds to government debt securities.  Non-performing loans were estimated at 28% of total loans and foreclosed properties and a loss rate of 67% of the non-performing loans was not considered unreasonable.  The resulting equity/asset ratio, when these rates were applied to the 13 banks, is a barely adequate 6.1%.

Profit of the banks came from trading gains from the sale of their holdings of government securities, made possible by the southward movement of interest rates.  But then, with the rates expected to go northward, due to inflation, increased rates in the U.S., worries of the government fiscal situation and weakness of the peso, rather than due to strong loan demand or strong economic growth, the banks are foreseen to lose this source of profit.   A weak income statement  will not augur well with an alrealdy weak balance sheet.

This pessimistic prognosis borne of the figures crunched in the financial statements is made worse by Fitch Ratings’ observation that not all the banks’ holdings of debt paper, which is currently predominantly government securities, are recorded in the banks’ balance sheet.  We locally refer to them oxymoronically as “off-books transactions.”

Fitch Ratings did not elaborate, but it was very clear that it was aware of the two major ways our banks do their thing, to wit, by going into informal buy-backs or repurchase arrangements and by mangling the noble concept of a trust, particularly the common trust fund, and making it function like a deposit. 

In fairness to Philippine banks, these dubious devices, to a large extent, are local investor driven.  Locals unabashedly ask for high rates and safety at the same time, tempting banks to enter into agreements that , on paper, show that the  investor takes all the risk, by way of outright sale documentation or trust agreements, and at the same time deliver the message, with a wink-wink and a nudge-nudge, that they stand, not just behind, but in front of, the credit risk.  Thus, an “informal” buy-back is written as an absolute transfer and a trust agreement carries the magic words of “risk for the account of the trustor”, but, in practice, the investor gets his periodic  interest, which may or may not be at the same as the underlying debtor pays the coupon rate, and is paid back his investment at the appointed time, which may or may not be the maturity date of the instrument “sold” or “held in trust”.

For as long as the bank is able to raise money from Peter to pay Paul, then everyone, except the revenue officials which lose taxes and the regulators which are given a false idea of system  they are governing, is happy.  But when the money flow is disrupted, as when ten-years ago, the Bank of Commerce cut off the credit line of Bancap or in the recent collapse of Urban Bank, when the investors of Urcoin decided en masse to demand their money back, there suddenly is not enough assets underneath the emperor’s clothes.

A flurry of regulations have come out in recent memory, such as the requirement that collective investment arrangements mark to market their holdings, thus necessitating, to avoid confusion, the re-baptism of the common trust fund into the unified investment trust; the institution of third-party custodians for securities that are sold to the public; and, what appears to be just the initial salvo against the informal repo,  the new rule demanding that financial institutions’ CEOs personally certify that there are no informal buy-backs that over-hang the stated financial liabilities in their balance sheets.

Moving very ever so slowly from concept to reality, but moving nevertheless, is the idea of a fixed-income exchange that would be provide investors the final ingredient of price discovery of their debt holdings.  In addition, it will also inform borrowers how the public regard their issues, thus giving them incentives for good governance and upright corporate citizenship.

All these reform, course, cost money and, like taxes, no want wants to bear the pain.  And vested interests in the private sector as well as turf protecting bureaucrats,  thinking short term and selfishly parochial, use their ignoble size to stand in the way of reform.