Bangko Sentral ng Pilipinas

BSP Working Paper Series

Bangko Sentral ng Pilipinas

Modernization:
A Policy Perspective
Cristeta B. Bagsic and Eloisa T. Glindro

Series No. 2006-01

August 2006

Center for Monetary and Financial Policy

Monetary Policy Sub-Sector
 Bangko Sentral ng Pilipinas
BSP Working Paper Series

Bangko Sentral ng Pilipinas

Modernization:
A Policy Perspective
Cristeta B. Bagsic and Eloisa T. Glindro

Series No. 2006-01

August 2006

The BSP Working Paper Series constitutes studies that are preliminary and
subject to further revisions. They are being circulated in a limited number
of copies for the purpose of soliciting comments and suggestions for further
refinements.

The views and opinions expressed are those of the author(s) and do not
necessarily reflect those of the Bangko Sentral ng Pilipinas.

Not for quotation without permission from author(s) and the Bangko Sentral
ng Pilipinas.

Center for Monetary and Financial Policy

Monetary Policy Sub-Sector
 Bangho Sentral ng Pilipinas Modernization:
A PoliGY PerSPEGTive

ABSTRACT

Now more than ever, central banks must arm themselves with the capacity
to read financial markets and their correlations with the real economy and with the
necessary physical infrastructure to efficiently and effectively conduct market
transactions and assess their impact on central bank financial statements.
Meanwhile, even though profit maximization is not the primary objective of a central
bank, keeping an eye on its bottomline is considered necessary because, at the end
of the day, its independence rests on it ability to generate financial resources
independent of congressional appropriation. For its part, the Bangko Sentral ng
Pilipinas has embarked on activities to enhance its capabilities to investigate and
quantify the impacts of economic realities on the transmission mechanism of
monetary policy actions to the real economy and to come up with policy
prescriptions that will strengthen BSP’s adherence to its mandate of promoting and
maintaining price stability that is conducive to balanced and sustainable growth of
the economy.

The BSP’s effectiveness in accomplishing its mandates rests primarily on

timely information and analytical inputs that is supported by well-founded
understanding of economic relationships and dynamics, and a pool of human capital
committed to its vision and objectives. This perspective paper helps set the policy
research agenda and cites options for the Bank to cultivate research-oriented
human capital.

BSP Working Paper Series No. 2006-

001 i
TABLE OF CONTENTS PAGE
1. INTRODUCTION ………………………….……………………………………….. …. 1
2. MODERN CENTRAL BANKING ….. ……………………… ……………………… 2
2.1 MONETARY POLICY :A MODERN DESIGN ………………………………………. 3
2.1.1 THE PRICE STABILITY OBJECTIVE …………………………………….. 3
2.1.2 MARKET-BASED MONETARY POLICY TOOLS …………………………. 5
2.2 FINANCIAL SYSTEM STABILITY AND SUPERVISION ……………………………… 6
3. THE BSP POLICY FRAMEWORK ………………………………………………………. 8
3.1 MONETARY POLICY FRAMEWORK: INFLATION RATE TARGETING 9
3.2 THE PHILIPPINE FINANCIAL SYSTEM SUPERVISORY ENVIRONMENT .…………. 12
3.3 THE PHILIPPINES PAYMENTS AND SETTLEMENTS SYSTEM .………………….. 12
4. CHALLENGES CONFRONTING THE BSP ……………………................................... 14
4.1. ECONOMIC AND TECHNOLOGICAL INNOVATIONS ……………………………….. 16
4.1.1. MONETARY TRANSMISSION MECHANISMS AND CONTROLLABILITY OF 16
TARGETS IN LIBERALIZED FINANCIAL SYSTEM
4.1.2. PAYMENT SYSTEM 20
4.1.3. FINANCIAL PRODUCTS AND SERVICES ………………………................ 21
4.1.3.1.ELECTRONIC-MONEY …………………………………………….. 23
4.1.3.2.FINANCIAL SYSTEM SUPERVISORY FRAMEWORK ...…………… 24
4.2. RISK MANAGEMENT …………… ………………………………………………... 30
4.3. FINANCIAL CRIMES …………………………….………………………………… 31
4.4. ANALYTICAL TOOLS FOR POLICY ANALYSIS AND DECISION-MAKING ………….. 33
4.4.1.INFLATION FORECASTING ………………………………………………… 33
4.4.2.STABILITY ANALYSES ……………………………………………………. 34
4.4.2.1. STRESS-TESTING AT THE MACRO-LEVEL ……………………… 35
4.4.2.2. STRESS-TESTING AT THE MICRO LEVEL ……………………….. 37
4.5. ORGANIZATIONAL DEVELOPMENT …………………………….…………………. 38
4.5.1. CORPORATE CULTURE FOR MODERN STRUCTURE ………………........ 38
4.5.2. FLATTER ORGANIZATIONAL STRUCTURE ………………………………. 38
4.5.3. SEAMLESS FLOW OF INFORMATION …….………………………………. 40
4.5.3.1. EFFICIENT DATABANK MANAGEMENT ………………………….. 40
4.5.3.2. PRIVATE SECTOR PROPRIETARY DATA ….…………………….. 42
4.5.4. MANAGEMENT STRUCTURE AND HUMAN RESOURCE DEVELOPMENT ….. 42
4.5.4.1. INCENTIVES …..…………………………………………………. 43
4.5.4.2. WELL-STRUCTURED TRAINING PROGRAMS …………………. 43
4.5.4.3. MENTORING PROGRAM AND MANAGEMENT SUCCESSION ……. 45
4.5.4.4. PHYSICAL SET-UP AND INFRASTRUCTURE ……………………. 45
5. CONCLUSION ……………………………………….…………………………………. 45

REFERENCES
APPENDIX I. EARLY WARNING SYSTEMS FOR MACROECONOMIC SURVEILLANCE
 Bangho Sentral ng Pilipinas Modernization:
A PoliGY PerspeGtive

BANGKO SENTRAL NG PILIPINAS MODERNIZATION:

1
A POLICY PERSPECTIVE
2
By Cristeta B. Bagsic and Eloisa T. Glindro

1. INTRODUCTION

Central banks face challenges today that necessitate an integrated and

comprehensive evaluation of their structures, goals, conduct of policy, and
even the traditional roles assigned them. Modern-day central banks must deal with
greater economic and financial integration, progressively more deregulated and
liberalized markets, greater volatility in exchange rate markets and other asset
markets, rapid financial innovation, rapid technological progress, and ever more
sophisticated players in financial markets in search of above-normal returns.

Rapid technological progress interacting with deregulation has significantly

altered the financial landscape within which central banks operate. While these
milestones deepened efficiency, they, nonetheless, heightened uncertainties and
risks for financial markets. The upshot of these developments is that central
banks are compelled to re-assess their long-established ways of doing things.
With the Asian financial crisis adding further impetus for structural changes, the
reform process gathered pace in its aftermath.

In keeping with the times, monetary policymaking in the Philippines has

strived to proactively respond to the demands of modern central banking.
Reforms date back to the pre-Asian crisis period. In 1981, the interest rate cap on
deposits and loans – except for short-term loans which was removed later in 1983 –
was abolished. (Manasan, 2000) In 1992, the Monetary Board issued Circular Nos.
1318 and 1353, deregulating foreign exchange transactions. The banking sector was
liberalized in 1994 (Republic Act 7721) and selected foreign banks were awarded
licenses. The BSP has curtailed its role in development financing, veering towards
indirect implementation of monetary policy. Post-1998, reforms in financial disclosure
rules, accounting standards, corporate governance standards, capital adequacy
requirements, and banking/securities industry structure have been instituted. For
instance, in 2000, the General Banking Law was enacted.

For the BSP, the last five years were distinctly marked by a number of
significant measures which include the adoption of a risk-based capital adequacy
framework; shift to inflation targeting as the framework for monetary policy; the
implementation of a modern payment and settlement infrastructure (the PhilPASS) for
large value interbank transactions; and the ratification of the Special Purpose Vehicle
Act.

Also, in an effort to deepen the institutional reforms begun in the early

days of the Bangko Sentral ng Pilipinas (BSP), the Bank held its first Strategic
1 This paper is part of the research program of the BSP Center for Monetary and Financial Policy (CMFP). The authors are
indebted to MBM Dr. Vicente B. Valdepeñas, Jr., Deputy Governor Diwa C. Guinigundo, MD Ramona GDT Santiago (TD) and
Director Iluminada T. Sicat (DES) as well as to CMFP-OIC Dr. Francis G. Dakila, Jr. for very insightful comments.

2
Bank Officers IV at the Center for Monetary and Financial Policy, Bangko Sentral ng Pilipinas. The authors may be reached
through cbagsic@bsp.gov.ph or eglindro@bsp.gov.ph.

BSP Working Paper Series No. 2006-

001 1
Planning Conference in 2002. Consequently, the initial set of a comprehensive
medium-term program – covering key areas of supervision and regulation, economic
research and analysis, statistics, treasury operations, information technology
infrastructure, and human resource management – was implemented in 2003.

Moving forward, it is vital that the BSP remains vigilant in the face of the
challenge to balance the need to make the organization flexible so as not to stifle the
profit-driven dynamics of an increasingly-global financial market on the one hand,
and, on the other, safeguard its credibility in implementing monetary policy and in
imposing its regulatory powers. In this regard, the hierarchical set-up, typical of
traditional central banks, is being reassessed. In view of the fast-paced
innovations in financial markets, among other things, a flatter and leaner
structure with a strengthened research and bias-for-action culture would
enhance the Bank’s efficiency and effectiveness in pursuing its mandates.
Under this structure, efficient knowledge management both within and outside the
organization is vital. Middle and top management play a critical role in harnessing
both explicit and tacit knowledge in reconciling lofty leadership visions with the
chaotic realities at the frontline, such that at the end of the day each employee
internalizes the corporate goals into his own career development goals.

The main objective of this paper is to identify areas that today’s

monetary authorities face with the end in view that more detailed investigation,
if warranted, be pursued at an opportune time. Admittedly, the issues identified
here are far from being the “complete list”, so to speak, though they are, in our
humble opinion, at the forefront of challenges to its policymaking and regulatory
powers being faced by the BSP. The discussion flow begins with Section 2, which
gives an overview of the facets of modern central banking as these apply to the
monetary stability and financial stability functions of central banks. It is important to
emphasize at this juncture that far from being definitive, discussions on what makes
for a modern central bank are not exclusive. Section 3 is devoted to the current
operational environment of the BSP while Section 4 talks about the challenges
confronting BSP as well as some of the important initiatives to address such. Section
5 concludes.

2. MODERN CENTRAL BANKING

Within the domestic economy it serves, a central bank traditionally

determines monetary policy, and supervises and acts as the lender of last
resort to the banks therein. In its determination of the appropriate policy, it may
decide to cede control of monetary policy to another central bank/monetary authority
by pegging its currency to another. Consequently, it has been operationally difficult to
detach the implementation of monetary policy from the choice of foreign exchange
policy. For one, foreign exchange swap transactions are recognized tools of monetary
operation. Moves by the central bank in the foreign exchange markets impact (unless
sterilized) on monetary variables.

In implementing monetary policy, a central bank exposes itself to various risks

just like other financial intermediaries or any other participant in the financial markets,
albeit at lesser degrees in some instances (e.g., because it can charge to deposits at
the central bank any unsettled amount arising from transactions with banking
institutions). Thus, a central bank must arm itself with the capacity to read financial
markets and their correlations with the real economy, and with the necessary physical
infrastructure to efficiently and effectively conduct market transactions and assess
their
impact on its financial statements. Furthermore, keeping an eye on its bottomline –
even though profit maximization is not the primary objective of a central bank – is
considered necessary because, at the end of the day, its independence rests on it
ability to generate financial resources independent of congressional appropriation. In
sum, the staff of central banks require “not only the skills of a bureaucrat,
formulating and implementing official policy, but also some of the skills of the
commercial banker”. (Allen [2004], p.9)

Meanwhile, attendant to a central bank’s role as the lender of last resort

is the need to have up-to-date assessment of the state of each of the banks and
the banking system in general, and of the payment system. This has been the
cornerstone of the arguments for keeping supervision of the banking sector with the
monetary authorities. The strength of central bank independence and its capacity to
respond to the many challenges of modern central banking would be largely defined
by the regulatory structure aimed at preventing and minimizing systemic risks as well
as by the effectivity of the enforcement mechanisms in place.

Such regulatory structure, however, is not necessarily immune from the

phenomenon of ‘regulatory capture’, wherein regulated institutions exercise
their lobby power to ensure that regulations work to their advantage. The
essence of banking regulatory capture has to do with how bank owners strive to
preserve their banks’ “franchise value,” defined as the value of being an incumbent in
an oligopolistic industry. It is, therefore, not surprising for incumbent banks to support,
for example, entry barriers imposed by regulators such as tough licensing
requirements. Regulatory capture can also arise from overt political pressures or from
misperception among politicians that bank failures reflect poor supervision and
hence, low supervisory skill. Conscious of its reputation, central banks might balk at
implementing monetary policy that would stress certain banks or lower the industry’s
profits. This undermines the independence of monetary policy (Hardy, 2006).

2.1. MONETARY POLICY: A MODERN DESIGN

Bank of Canada’s Tiff Macklem (2006) enunciates the four key aspects of
modern central banking: “clear objectives and effective tools; legitimacy [of the
policy objectives]; the effective use of markets [in the implementation of
monetary policy]; and transparency and accountability”. The inflation targeting
framework is essentially characterized by having a clear objective and of
transparency and accountability in the conduct of monetary policy. In general, a clear
undertaking between the monetary and fiscal authorities confers legitimacy to the
monetary policy objective. This undertaking could take the nature of either a joint
announcement of the target by the authorities or by the announcement of the target
by the fiscal authority. Such goal dependence does not diminish the independence of
monetary authorities from fiscal dominance. After all, as part of the public sector, its
endgame goal is to contribute to the maximization of social welfare – same as the
elected government – by promoting an environment conducive to price stability. More
importantly, goal dependence allows the central bank to more effectively implement
monetary policy by cementing support from the fiscal authorities given that fiscal
policy impacts on the success or failure of any monetary policy framework.

To ensure the success of the inflation targeting framework, it is

necessary to clarify the transmission mechanisms of policy instruments to the
real economy so that monetary authorities could identify and use intervention
instruments most effectively and efficiently. Lastly, to minimize externalities,
central banks must rely on market-based instruments in the course of implementing
monetary policy, presupposing the existence of efficient domestic financial markets.

2.1.1. THE PRICE STABILITY OBJECTIVE

The price stability objective or, more specifically, inflation targeting

rests on the argument in classical economics of money neutrality, which
implies that monetary policy can only affect nominal variables (e.g., wages,
prices, foreign exchange rate) in the long run. It is but logical, then, to assign to
monetary authorities only those objectives which they have the capacity to achieve
given their powers and functions. At the same time, history is replete with examples
of high and variable inflation derailing the real economy. For one, high and variable
inflation discourages long-term investments, thus, affecting the production capacity of
the economy.

Price stability could refer to either domestic (e.g., CPI), or external (e.g.,
peso-dollar exchange rate) price stability. Domestic price stability, in turn, could be
translated into either price index targeting or inflation rate targeting. Usually, inflation
targeting central banks target the inflation rate, as opposed to the price index. In brief,
inflation rate targeting implies that when the target is breached in the previous period
the policymaker can “charge it to experience” and focus on achieving the future
targets, whereas with price index targeting, the authorities will have to implement a
greater amount of intervention since it would be necessary to also correct for the
deviation from target in the previous period to keep the target on track.

In an inflation targeting regime, it is not enough that a target is identified. It is

equally important that the instruments and tools to achieve the target within an
appropriate time period be identified. The degree of independence of the monetary
authority, the maturity of the domestic financial markets, the stability of fiscal
policy, and clear communication of the policy direction determine the success
of an inflation targeting regime.

The independence of a nation’s central bank is the hallmark of modern-

day monetary order and has often been taken synonymously with the goal of
price stability. The sound workings of the monetary system is intrinsically built on
mutual trust wherein the implicit social contract confers upon the central bank the
unique authority to determine the appropriate monetary base, preserve the integrity of
money, and act as the lender of last resort, in support of the objectives of monetary
stability and financial stability. 3 In fulfilling this social contract amidst modern
challenges, it is almost indispensable for central banks to adhere to the principles of
independence, transparency and accountability.

3
The essence of an independent central bank is best encapsulated in the Bank of England’s declaration of its core purposes.
Monetary stability means stable prices and confidence in the currency. Stable prices are defined by the Government's
inflation target, which the Bank seeks to meet through the decisions on interest rates taken by its monetary board,
explaining those decisions transparently and implementing them effectively in the money markets.
Financial stability entails detecting and reducing threats to the financial system as a whole. Such threats are detected
through the Bank’s surveillance and market intelligence functions. They are reduced by strengthening infrastructure, and by
financial and other operations, at home and abroad, including, in exceptional circumstances, by acting as the lender of last
resort. (http://www.bankofengland.co.uk/about/corepurposes/index.htm)
 Central bank independence is a multi-faceted concept 4 that underscores
the autonomy of central banks in designing and implementing monetary
policies. The different aspects of independence enunciated by the European Central
Bank (ECB) 5 are very instructive:

 Institutional independence means that setting monetary policy is the

sole prerogative of the monetary authority. Hence, central bank
decisionmakers neither seek nor take instructions from other government
instrumentalities, which, in turn, are expressly forbidden from attempting to
give instructions.

 Legal independence gives the monetary authority the distinct legal

personality that allows it to exercise its powers and functions unimpaired,
i.e., with full flexibility and accountability. In this manner, the central bank
is insulated from politics.

 Personal independence entails fixed but secured terms of office for its
decision makers. While they may be relieved from office by any competent
national authority on the basis of civil service guidelines and stipulations,
they are protected from summary dismissal.

 Functional and operational independence highlight the special role of

the monetary authority in controlling the monetary base by using
instruments at its disposal. The concept also extends to the absence of
fiscal dominance that unduly compromises the conduct of monetary policy.

 Financial and organizational independence means full budgetary

autonomy in carrying out its tasks and functions. This includes setting up
own staffing and profit distribution mechanisms.

Transparency facilitates the process of holding an independent central

bank accountable. The accountability of an independent central bank rests on its
important role of explaining to the public how it uses the powers and prerogatives it
has been entrusted with. Specifically, it entails not just disclosure of information but
more importantly, designing effective and well-structured information that can be
readily understood by the public. This concept necessarily refers to an ex post
justification and explanation, otherwise, the involvement of other parties in the
decision making process by the monetary authority contravenes the essence of
independence.

In turn, independence, transparency, and accountability impact on a

central bank’s credibility. The greater the central bank’s credibility, the more
effective and efficient it is in achieving its targets.

Still, arguments on the performance of inflation targeting as a monetary

regime are not conclusive as yet. For one, inflation targeting has not been around
long enough and it has been adopted during a relatively benign economic era. For
another, it may be argued that what is being seen as benefits from inflation targeting

4
This section draws heavily from Scheller’s work on the European Central Bank (2004).

5
The European Central Bank (ECB) represents the most encompassing surrender of sovereign right on monetary policy to a
supranational monetary authority. Each member country has to ratify its accession to the Economic Monetary Union (EMU).
Specifically, the adoption of a single currency and convergence criteria set forth in the Maascricht Treaty require an
exceptional subordination of sovereignty over monetary policy to a group of country representatives.
derive primarily from credibility of monetary authorities. In other words, since these
central banks were seen as serious enough in fighting inflation and promoting
macroeconomic stability, the monetary regime they chose could have been not the
primary determinant of the resulting stability. Nonetheless, the inflation targeting
framework holds strong promise especially for countries that are susceptible to
monetary and real shocks.

2.1.2. MARKET-BASED MONETARY POLICY TOOLS

In essence, monetary policy is implemented by setting a policy tool, say the

repo rate, and implementing such rate through the conduct of open market
operations. The policy rate should ideally then affect the short-term rate, and,
depending on market expectations, the long-term rates, thereby either shifting
or twisting the yield curve. The long-term rates are linked to sustainable economic
growth and welfare improvement, e.g., in evaluating capital investment decisions,
firms react to long-term interest rate movements. Meanwhile, in the short to medium
term, these interest rate decisions of the central bank can affect expenditure
decisions of households and businesses and thus, the deviation of actual output from
potential output of the economy depending on the active transmission channels.

Shallow, inefficient and unstable financial markets have several

undesirable implications. On one level, they impede the conduct of monetary policy
because they distract policymakers from focusing attention and resources in refining
objectives and tools to attain monetary objectives and instead require that resources
be diverted towards averting system instability. On another level, the inefficiency in
the financial markets obstructs the transmission channels of policy instruments. For
instance, inefficiencies in the domestic foreign exchange market blunt monetary
policy.

Thus, mature domestic financial markets not only imply less inefficiency
in the allocation of financial resources but also highlight the degree of ease for
the central bank to resort more to market-based instruments in effectively
implementing monetary policy. The latter is preferred since “monetary policy works
best when it is market based [rather than through] direct controls” (Macklem, 2006).
Allen (2004) defines direct implementation of monetary policy as opposed to indirect
implementation, to wit:

“Direct methods [of implementing monetary policy] involve the state (government or the central
bank) giving instructions to the banks on what loans they should and should not make, or on what
interest rates they should charge to borrowers or pay to depositors, or on other aspects of their
relationships with their customers. … Indirect methods of monetary control, in their most idealized
form, allow the state no role at all in the relationship between commercial banks and their
customers. In the idealized model, the state, in the guise of the central bank, deals only with
commercial banks and perhaps some other financial institutions. The role of the central bank is
purely to supply central bank money to the financial system in such a way as to enable the
objectives of monetary policy to be achieved. Decisions about how much credit to extend to non-
bank borrowers, and at what interest rate, and about what interest rates to pay depositors, are all
left entirely to the private sector. Of course, those decisions are influenced by the behavior of the
central bank. To give an obvious example, if the central bank increases the interest rate at which it
is willing to lend central bank money to commercial banks, then it can be expected that the
commercial banks will increase the interest rates at which they lend money to borrowers.” ( p.7)

Tools of indirect implementation are reserve and liquidity requirements

(although it can be argued that these bear some nature of direct controls), open
market operations (OMOs) and standing facilities. Since indirect implementation of
monetary policy is executed mainly through the financial markets, an efficient
and mature financial market is desirable for primarily two reasons: (1) efficient
conduct of OMOs, and (2) reliable transmission mechanism of monetary policy
to the real economy.

2.2. FINANCIAL SYSTEM STABILITY AND SUPERVISION

The financial system is composed of financial markets (i.e., equities and

debt markets) and financial intermediaries. The latter include deposit-taking
institutions (e.g., banks); contractual savings institutions (e.g., insurance companies,
private pension plans); and investment intermediaries (e.g., mutual funds). (Mishkin,
2003)

In general, financial regulation aims to correct market failures (arising

from anticompetitive behavior, market misconduct, asymmetric information,
and system instability), to protect consumers, to ensure the safety and
soundness of markets, and to enhance the implementation of monetary policy.
A fundamental tenet of regulation is the compatibility between the structure of the
regulatory institution(s) and the structure of the industry being regulated so as to
ensure a regulatory-neutral environment, and to minimize externalities. An
inappropriate regulatory environment or system of incentives increases the probability
of systemic failure because it encourages mispricing of risk.

For instance, “because banks play a very important role in determining

the supply of money (which in turn affects many aspects of the economy),
much regulation of…financial intermediaries is intended to improve control
over the money supply. One such regulation is reserve requirement… Deposit
insurance regulation can also be rationalized along these lines…[because it] gives
depositors confidence in the banking system and eliminates widespread bank
failures, which can in turn cause large, uncontrollable fluctuations in the quantity of
money”. (Mishkin (2003), p45)

Systemic risk, which refers to risk to the overall stability of the financial
system, can be minimized by deposit insurance, emergency liquidity
assistance from central bank (e.g., lender of last resort role), a well-designed
payment system, and market discipline. Because of evidences that an unstable or
fragile financial system makes it difficult for the monetary authorities to effectively and
efficiently implement monetary policy, it has been necessary that emergency liquidity
assistance be made available to banks in order to assure the public that the payment
system will continue to work during emergencies and crises. During such crises the
policy instrument likely will not work as intended, or as efficiently as intended. The
role of central banks as the lender of last resort has been used to rationalize their
supervisory role over banks, and in turn, their responsibility for the payment system.
Lastly, easy access to financial disclosures by market participants magnifies the
impact of efforts by financial supervisors by enabling market agents to make informed
decisions, e.g., badly managed firms are appropriately subjected to the disciplinary
mechanism of the capital markets.

From a micro-prudential point of view, shocks to a bank’s liquidity

position can be addressed by deposit insurance, reserve and liquidity
requirements, and capital adequacy requirements. As to the latter requirement, as
long as a bank is solvent it may still be possible to access the inter-bank market.
However, when the shock is common to all, it then becomes necessary to have the
safety net provided by a lender of last resort to avoid disrupting the payment system
and propagating financial system instability. “The payment system represents a major
component of the infrastructure of any modern economy and systemic failure therein
can undermine the effectiveness of monetary policy, the soundness of financial
institutions and the economy in general.” (Buenaventura, 2004)

The information technology revolution has had significant impact on

payment systems, which integrity constitutes a foundation of central bank core
functions of monetary stability and financial stability. Since payment systems
operate in a network, they are highly vulnerable to systemic risks. This vulnerability
arises either from contagion from the failure of one agent, or from dependence of
network participants on a single supplier; thus, potentially giving rise to snarl-up in the
system.

Diverse home currency payment systems6 entail considerable risks

when settling cross-border and multi-currency transactions. For one,
simultaneous settlement of foreign exchange transactions may not be feasible given
the non- convergence of home currency payment systems’ operating hours. This
limitation can, however, be eventually remedied with 24-hour service facility.
Nevertheless, the risk inherent in non-finality of settlements gives rise to potential
loss of principal. This is commonly referred to as Herstatt risk 7 whereby transfers in
one currency become final while associated transfers in other currencies have not yet
taken place.

The payment system is susceptible to liquidity crisis when the financial

standing of a counterparty is in doubt. The fear of incurring principal risk can
trigger liquidity risks as some participants may not honor earlier-settling currencies
out of misgivings about the capacity of, say, counterparty A to settle its counterpart
obligations in later-settling currencies. The sudden disruption of a significant level of
expected flows could cause serious liquidity problems for counterparty A as well as
other participants that expect payment from counterparty A.

Individual participants have little incentive to fully mitigate systemic

risks but it is in everyone’s collective interest that such risks are mitigated. The
inherent “public bad” nature of systemic risks in the payment system (Haldane and
Latter, 2005) demonstrates the need for unambiguous public policy oversight that
would protect stability of the payment systems. Such protection could either be direct,
where central banks both directly own and operate the high value payment system, or
indirect, where private participants directly provide payment services but with public
authority providing oversight in the form of regulations.

6
“Some systems complete home-currency large value funds transfers on a gross payment-by-payment basis while others
rely on net settlement procedures. In some countries, final (irrevocable and unconditional) transfers can be made in “real
time” throughout the business day while in others, such transfers might not become final after several hours or possibly a
day or more after the transfers are initiated. Each country has its own hours of operation and typically are not synchronized
with payment system operating hours in other countries.” (BIS, 1993).

7
Herstatt risk generally refers to settlement risk, which is a type of credit risk. The term ‘Herstatt risk’ is derived from the
Herstatt Bank, which on June 26, 1974 was closed by the Bundesbank before it settled its dollar obligations to its New York
counterparties in New York time. When the bank was closed, the US banks had already transferred deutschemarks to the
Herstatt Bank in European time. (http://www.riskglossary.com/link/settlement_risk.htm)
3. THE BSP POLICY FRAMEWORK

Starting with the abolition of interest rate ceilings on deposits and the
abandonment of the policy of development financing, or directed credit, the
BSP has come to increasingly rely on “indirect” tools of monetary policy. The
key policy levers it uses in implementing the inflation targeting framework are
overnight reverse repurchase (RRPs) and repurchase (RPs) rates, and statutory and
liquidity reserve ratio requirements. The Monetary Board sets rates for the BSP’s
overnight borrowing and lending facility to influence the timing, cost and availability of
money and credit, for the purpose of stabilizing the price level. The use of these
policy levers is undertaken within a floating exchange rate system and market-
oriented interest rate policies.

8
3.1 MONETARY POLICY FRAMEWORK: INFLATION RATE TARGETING

The New Central Bank law stipulates that the primary objective of the
BSP is to maintain “price stability conducive to a balanced and sustainable
economic growth”.9 The law empowers the BSP to take remedial measures when
there are abnormal movements in prices, monetary aggregates, or credit, or when the
international stability of the peso is threatened. Thus, even though the BSP is no
longer encumbered with multiple objectives such as financing the national
government (NG) deficit, fixing the exchange rate, or other policy agenda of the
national government, other economic goals—such as promoting financial stability and
achieving broad-based, sustainable economic growth—are still given consideration to
ensure that monetary policies are part of a consistent and coherent overall policy
framework.

The BSP started implementing inflation targeting as its framework for

monetary policy in January 2002. The shift has been occasioned by the vast
changes in the structure of the financial system and the advent of innovative financial
products and services following financial deregulation and liberalization, two forces
which appeared to have undermined the traditional relationship10 linking money
supply to income and prices.

The inflation targeting regime that governs the BSP’s monetary policy
decision-making process is within what Bernanke and Mishkin (1997) describe
as an exercise of “constrained discretion” rather than an “ironclad policy rule”.
The framework, although clear in its objective, is easily adapted to the judgments and
other policy considerations of the monetary authorities. Rather than being a hard-and-

8
The description of the rationale and implementation details of BSP’s inflation targeting framework were sourced from
http://www.bsp.gov.ph/about_bsp/inflation/default.htm

9
Chapter 1, Article 1.Section 3 of Republic Act 7653 or the New Central Bank Act (passed into law in 1993).

10
This approach was modified beginning in the second semester of 1995 to put greater emphasis on price stability instead of
rigidly observing the targets set for monetary aggregates. In addition, monetary authorities wanted to address one of the
pitfalls of monetary targeting, i.e., it does not account for the long and variable time lag in the effects of monetary policy on
the economy. Under the modified framework, the BSP can exceed the monetary targets as long as the actual inflation rate
is kept within program levels. Thus, a larger set of economic variables are being monitored and analyzed for monetary
policy decision making. The goal of price stability became the centerpiece of monetary policy when inflation targeting was
adopted as the official framework in 2002. It would, however, be presumptuous to credit the success of monetary policy
setting to inflation targeting alone because of the relatively short experience with it. As noted by the IMF, the institutional
requirements of inflation targeting may not be as stringent as once thought of to be.
fast rule for low inflation at all costs, the inflation targeting framework can, for
instance, give due considerations to possible increases in the volatility of output
growth. On the other hand, it is important that this framework be complemented by a
strong political commitment to a consistent fiscal policy as suboptimal fiscal policy
choices can derail effective use of monetary policy instruments.

On hindsight, the timing of BSP’s decision to adopt inflation targeting was

auspicious in the sense that the legal and institutional independence granted to the
BSP in 1993 has been steadily buoyed by its increasing credibility in setting monetary
policy. In addition, it must be pointed out that the national government fiscal deficit
reduction program has been proceeding as planned. On the other hand,
developments in the global oil markets had resulted to the targets being breached.

The BSP’s inflation targeting entails the announcement of an explicit

inflation target, with a two-year policy horizon. The inflation target is a range, with
a band of 1 percentage point.11 It is defined in terms of the consumer price index
(CPI) inflation rate or the headline inflation rate. It is a commonly used measure of
inflation and therefore, has the advantage of being easily understood by the public.
However, the BSP also examines the movements of “core inflation” in setting the
monetary policy stance to account for price movements that are not within the control
of monetary policy.12

The “legitimacy” of the policy objective is validated by institutional and

political support of the target. The inflation target is jointly set by the Government
and the BSP, through the Development Budget Coordination Committee (DBCC). In
fact, in the budgeting process, the inflation target is an important input. Furthermore,
through Republic Act 7653 or the New Central Bank Act and the various resolutions
and regulations by the Monetary Board, the price stability objective, in general, and
inflation targeting, in particular, has been advocated, implemented and strengthened.

Even though the BSP is goal dependent, it is instrument independent

and the responsibility for achieving the target rests primarily on the BSP.
However, for deviations that are not within the BSP’s control, exemption clauses
apply. In the Primer on Inflation Targeting posted in its website, the BSP lists four
major causes of increased inflation volatilities outside its purview and under which
monetary policy has limited, if not non-existent, influence:

(1) volatility in the prices of agricultural products;

(2) natural calamities or events that affect a major part of the economy;
(3) volatility in the prices of oil products; [and]
(4) significant government policy changes that directly affect prices such as changes in the tax
structure, incentives and subsidies.

The design of the inflation targeting framework requires BSP to issue an

open letter to the President in the event that inflation targets are breached. This
open letter explains the reasons for the discrepancy and sets out the measures that

11
A range inflation target provides the monetary authorities more flexibility, while a point target helps focus the expectations of
the public.
12
Core or underlying inflation is an alternative measure of inflation that removes certain components of the CPI basket that are
subject to volatile price movements such as food and energy and whose price changes are not within the control of
monetary policy inasmuch as these are supply shocks.
will be adopted to bring inflation back to target. Open letters were issued for the years
2003, 2004, and 2005 on account of supply-side shocks.

The exercise of greater transparency is intrinsic in an inflation targeting

regime because its effectiveness is largely contingent on the disclosure
mechanisms on BSP’s policy actions and decisions. Given that information is
pivotal in influencing public expectations as well as in facilitating informed discussion
on monetary issues, a well-structured communication program also helps reinforce
BSP’s accountability to meet its objectives. Towards this end, inflation reports are
published on a quarterly basis. These reports contain information on price and cost
developments, prospects for aggregate demand and output, monetary and financial
market conditions, labor market conditions, fiscal developments and international
developments.13 Calendar of Monetary Board meetings and minutes of the MB
meetings are similarly made public through the BSP website with a lag of six weeks.
Regional briefings have also become a staple in BSP’s communication and advocacy
toolkit.

A modest attempt at appraising BSP’s observance of the modern central

banking principles is presented in Table 1.

TABLE 1. THE BSP CHARTER VIS-À-VIS THE PRINCIPLES OF MODERN CENTRAL BANKING
PRINCIPLES OF MODERN BSP’S OBSERVANCE OF MODERN CENTRAL BANKING PRINCIPLES
CENTRAL BANKING

I. INDEPENDENCE Article XII, Section 20 of the 1987 Constitution of the Republic of the Philippines provides
that there shall be an “independent central monetary authority, the members of whose governing board
must be natural-born Filipino citizens, of known probity, integrity, and patriotism, the majority of whom shall
come from the private sector. They shall also be subject to such other qualifications and disabilities as may
be prescribed by law. The authority shall provide policy direction in the areas of money, banking, and
credit. It shall have supervision over the operations of banks and exercise such regulatory powers as may
be provided by law over the operations of finance companies and other institutions performing similar
functions.”

Chapter 1, Article I. Section 1 of Republic Act (RA) 7653 or the New Central Bank Act
clearly stipulates in its declaration of policy that the “State shall maintain a central monetary authority that
shall function and operate as an independent and accountable body corporate in the discharge of its
mandated responsibilities concerning money, banking and credit. In line with this policy, and considering
its unique functions and responsibilities, the central monetary authority established under this Act, while
being a government-owned corporation, shall enjoy fiscal and administrative autonomy.”
1.1 Legal independence RA 7653 explicitly provides the requisite legal mantle for the conduct of independent monetary policy.
1.2 Institutional BSP has its own Monetary Board that has been empowered to design and implement monetary and
independence financial policies in accordance with the primary objective of price stability, conducive to balanced and
sustainable growth of the economy. The Board is also responsible for promoting and maintaining monetary
stability and the convertibility of the peso. (Chapter 1, Article II, RA 7653)
1.3 Personal While the members of the MB are all Presidential appointees serving for a fixed term, the appointment is
Independence subject to fit and proper rule. Correspondingly, no member can be summarily dismissed as removal from
office is also subject to certain conditions. (Chapter 1, Article II. Monetary Board, RA 7653)

1.4 Functional and Chapter IV – Instruments of Bangko Sentral Action (RA 7653) delineates the powers and
operational functions of the Monetary Board in operations in gold and foreign exchange, regulation of foreign
independence exchange operations of banks, loans to banking and financial institutions, OMO, composition of BSP’s
portfolio, bank reserves, selective regulation of bank operations, and coordination of credit policies by
government institutions. Specifically, it empowers the MB to use policy instruments at its disposal for the
conduct of monetary policy.

13
BSP 4th Quarter 2005 Inflation Report. (available at www.bsp.gov.ph)
  Article IV, Section 74 states that MB “shall determine the exchange rate policy of the country”;
 Article IV, Section 85 states that MB shall fix the interest and rediscount rates on BSP’s “credit
operations in accordance with the character and term of operation but after due consideration has
been given to the credit needs of the market…and the general requirements of the national monetary
policy”.
Chapter VI, Article II, Section 128 (RA 7653) proscribes the central bank from ownership of
equities securities and from “engagement in development banking”.
Chapter VII, Article II. Sections 129 of the Transitory Provisions limits the role of the BSP in
the borrowing activities of the national government and other fiscal agencies.
Furthermore, the BSP’s provisional advances to the NG were shortened to three months, renewable for
another three months but not to exceed 20% of the government’s annual income in the preceding three
fiscal years (Chapter IV, Article IV, Section 89)
Lastly, Section 130 transfers to the Securities and Exchange Commission the regulation of finance
corporations not engaged in banking or quasi-banking.
1.5 Financial and Section 15 on the Exercise of Authority delineates powers and functions of the Monetary Board with
organizational regards to the issuance of rules and regulations, management and operations of the BSP, establishment
independence of a human resource management system, adoption of annual budget and expenditure program. The
Monetary Board is also empowered to authorize the payment of costs related to the litigation of its
members and other Bank personnel provided that (1) such actions arise from the performance of their
duties, and (2) they are found not guilty of negligence or misconduct. (Chapter I, Article II. Section
15)
II. TRANSPARENCY Chapter I, Article V, Sections 39, 40 and 41 prescribe the reportorial duties of the BSP to the
President, Congress, and the general public.
III. ACCOUNTABILITY Chapter I, Article II. Section 16 stipulates that “members of the Monetary Board, officials,
examiners, and employees of the Bangko Sentral who willfully violate this Act or who are guilty of
negligence, abuses or acts of malfeasance or misfeasance or fail to exercise extraordinary diligence in the
performance of his duties shall be held liable for any loss or injury suffered by the Bangko Sentral or other
banking institutions as a result of such violation, negligence, abuse, malfeasance, misfeasance or failure to
exercise extraordinary diligence.”
The parties above shall also be held accountable for any unauthorized communication of privileged
information or from profiting from such information.

Sources: RA 7653 or the New Central Bank Act; 1987 Constitution

3.2 THE PHILIPPINE FINANCIAL SYSTEM SUPERVISORY ENVIRONMENT

The regulation of the Philippine financial system is shared by four

agencies: the Bangko Sentral ng Pilipinas (BSP), the Philippine Deposit
Insurance Corporation (PDIC), the Securities and Exchange Commission (SEC)
and the Insurance Commission (IC). Article XII, Section 20 of the 1987 Constitution
of the Republic of the Philippines provides that the BSP, as the “independent central
monetary authority…shall have supervision over the operations of banks and
exercise such regulatory powers as may be provided by law over the operations of
finance companies and other institutions performing similar functions.” The BSP
supervises the banking industry and non-banks with quasi-banking functions, while
the PDIC also regulates banks to protect depositors. Financial markets (equity and
debt securities markets), exchanges, and investment houses are under the SEC. The
IC oversees life and non-life insurance companies.

On 05 July 2004, the four agencies formed the Financial Sector Forum
(FSF) to strengthen coordination amongst them. Even though the member-
agencies agree to implement agreements in the FSF, it is “not intended to be a
regulatory superbody since it is not vested with any powers.” (BSP, 2004b) The FSF
aims to:

(1) push for risk-based frameworks in the entities the members regulate;
 (2) synchronize regulation in the financial sector in order to minimize
regulatory arbitrage;
(3) enhance the reliability of financial data and disclosure system; and
(4) inform consumers and investors of their rights and responsibilities.

Through the FSF, guidelines have been established between the BSP and
PDIC with respect to information sharing, and between the BSP and the SEC with
respect to sharing of regulatory tasks.

3.3. THE PHILIPPINES PAYMENTS AND SETTLEMENTS SYSTEM

The Philippine payment system is characterized by banks and non-

banks with quasi-banking (NBQB) functions providing peso payment services
for retail transactions, while the BSP, together with some privately-owned
institutions, handles large value fund transfers. The Philippine Postal Corporation
is also authorized under Republic Act 7254 to issue domestic and international
money orders.

For large value interbank transactions, several systems were developed

and linked to the Philpass,14 a real-time gross settlement system (RGTS)
operated by the BSP, to effect high-value payment transactions between banks
through the deposit accounts of the banks that are maintained with BSP. The
system was implemented in 2002. It provides the required infrastructure for modern
and automated payment and settlement system. Transactions settled in the system
are final and irrevocable, thus, minimizing settlement, credit and liquidity risks. 15
Although participants have to comply with qualifying requirements, no admission or
membership fees are levied. Participants, however, pay transaction fees for using the
system. The 2005-2011 BSP Medium-Term Strategic Plan (2005) provides a
comprehensive description and analysis of the Philippine payment system.

The BSP, as owner and operator of the PhilPaSS, is responsible for

ensuring system integrity. It had already laid out the requisite periodic testing of the
back-up system as among its medium-term strategic deliverables. The central bank is
also charged with maintaining and upgrading the system and ensuring uninterrupted
operations between the System and SWIFT (the network provider), and instituting
adequate Continuity of Business Plans (CBP).

As the settlement bank, the responsibilities of the BSP are

multidimensional. It is responsible for “(a) creating a Participant’s PhilPaSS account
in the system, wherein all PhilPaSS transactions and other bank transactions shall be
14
“Prior to 12 December 2002, banks/financial institutions were using the Enhanced Multi-transaction Interbank Payment
System (MIPS2) for their interbank transactions. MIPS2 was an electronic net clearing system that was operated by the
Bankers Association of the Philippines (BAP) and Philippine Clearing House Corporation (PCHC) in coordination with the
BSP. Both counter-parties in an interbank transaction under MIPS2 had to input their transaction through the PCHC System
who, in turn, verified and authenticated the transactions prior to its electronic transmission to the BSP for settlement.
Banks/financial institutions secured transaction status through reports from MIPS2, while the BSP/ Comptrollership
Department communicates the balances of their demand deposits through hourly electronic broadcast.” (BSP, 2004a)

15
“The PhilPaSS makes use of the Logica Clearing and Settlement System/Central Accounting System (LCSS/CAS). Its basic
function is to process incoming SWIFT settlement instructions by participants and prompt the accounting and recording of
these transactions to the participants’ accounts with BSP. The existing global communication network of SWIFT is a
component of the system that enables the participants to transmit electronically their financial transactions to their counter-
parties. The participants are required to enroll and subscribe to SWIFT FIN Copy Service to allow them to transmit directly
their PhilPaSS transactions to BSP’s LCSS/CAS for processing and settlement.” (BSP, 2004a)
posted during the PhilPaSS business day; (b) receiving and authenticating electronic
fund transfer instructions from the participants; (c) checking if the paying bank has
sufficient balance and posting the debit entry in its account and credit entry in the
beneficiary bank’s account; and (d) providing feedback to participants regarding their
PhilPaSS transactions, balances and queries.” (BSP)

The Bankers Association of the Philippines (BAP), Chamber of Thrift

Banks (CTB) and Investment House Association of the Philippines (IHAP) have
been designated by their members to negotiate and sign the agreement for
PhilPaSS. As such, they are responsible for ensuring that their member
banks/financial institutions adhere strictly to the terms and conditions of the PhilPaSS
agreement and PhilPaSS rules and regulations.

Participants are responsible for the upgrading, testing and maintenance

of their Computer Based Terminal (CBT) for the SWIFT FIN Service Facility or
PPS-FES to ensure uninterrupted linkage with the system. They shall likewise
ensure that a back-up computer site configuration is available to recover their
systems operations if their primary computers fail.

4. CHALLENGES CONFRONTING THE BSP

According to Goodhart (2000), inflation targeting central banks are confronted

with the following conundrums in the short-run:

(1) returning inflation to the target within the shortest period versus real
stabilization;
(2) supporting the internal value versus supporting the external value of the
currency (e.g., domestic inflation versus foreign exchange stability); and
(3) the role of asset price movements on the one hand and consumer price
inflation on the other.

The BSP is working towards finding the appropriate balance between

monetary and real stabilization, and a suitable role of asset prices in inflation
targeting by enhancing its analytical capability, advocating reforms in the statistical
system to address statistical gaps, and reorganizing its corporate structure to better
address the challenges that modern-day central banks must face. Because the BSP
is a small and open economy, the BSP advocates a market-driven foreign exchange
policy and participates in the foreign exchange market to the extent that inflation
outcomes are contained within targets.

The set of rationale that gave birth to central banking has accordingly given
rise to a universal set of minimum institutional requirements for an effective monetary
authority. Consequently, the requisite business systems and processes for modern
central banking are essentially the same across all central banks. Viewed against
the backdrop of near-seamless global flow of capital and the ever-increasing
linkages among economies, it may be argued that central banks of emerging
markets are confronted with deeper challenges than its counterparts in
industrialized countries. For one, they have to undertake similar functions despite
constraints in expertise and resources. Moreover, they have to function in a national
financial system that is not as sophisticated or as stable as in more developed
economies. A summary, albeit not exhaustive one, of identified challenges and BSP’s
responses is presented in Table 2.
TABLE 2. SUMMARY OF CB MODERNIZATION CHALLENGES AND BSP’S RESPONSE
CHALLENGES ARISING FROM: BSP’S RESPONSE
1. ECONOMIC AND TECHNOLOGICAL
INNOVATIONS
RAPID INNOVATIONS OF FINANCIAL As early as 1995, the BSP has issued a number of directives defining the scope of
PRODUCTS trading activities and disclosure requirements for banks and other financial institutions.
In 2005 alone, the BSP released two circulars detailing the rules and regulations
governing banks’ investments in securities overlying securitization structures (Circular
269) as well as the capital treatment of banks’ exposures to structure products (Circular
469).
COMPLEXITIES IN TRANSMISSION One of the medium-term thrusts embodied in the BSP MT-Strategic Plan is the
CHANNELS development of a model on the transmission mechanisms of monetary policy.
Econometric modeling of the different channels can be done through the micro-founded
dynamic stochastic general equilibrium (DSGE) model of the economy that would allow
a theory-consistent approach to identifying a shock and tracing its transmission to the
different sectors of the economy.
RAPID TECHNOLOGICAL The BSP has prescribed prudential guidelines in the conduct of electronic banking.
INNOVATIONS: ELECTRONIC Applicant banks must prove that they have in place a risk management process that is
MONEY adequate to assess, control and monitor any risks arising from the proposed electronic
banking activities.
The Core Information Technology Supervision Unit (CITSU) was established in June
2005 to help banks align their information technology policies with international best
practices.
INCREASING ECONOMIC The PhilPASS, a real-time gross settlement system operated by the BSP was
INTEGRATION: PAYMENT SYSTEM implemented in 2002. The BSP has sufficiently administered the PhilPASS in
accordance with the Core Principles for Systematically Important Payment Systems
although its powers to apply the core principles to systems outside its jurisdiction
remain limited because of the absence of statutory power over the entire payment
system.
CHANGING FINANCIAL SECTOR A more consolidated supervision is being considered in the Financial Sector Forum, a
STRUCTURE CHARACTERIZED BY group composed of the BSP, SEC, the IC, and the PDIC.
REGULATORY ARBITRAGE AND “The creation of the FSF is underscored by the need to establish an overall framework
CONGLOMERATION that will provide the exchange of relevant reports and/or data for the development of
comprehensive statistics on the financial system and the sharing of relevant market
information on individual financial institutions; facilitate sharing of lists of reputation
agents and provide proper forum to discuss and resolve issues of common concern;
and supplement existing bilateral data sharing arrangements”. (Aquino, 2005)
2. RISK MANAGEMENT Several guidelines and regulations were issued regarding the adoption of risk-based
supervision. The new risk-based capital adequacy framework has already incorporated
both credit and market risk for universal and commercial banks as well as modified the
required minimum ratio; the qualifying capital; and the classification used on the risk
weighting system.
The Monetary Board, in its Resolution No. 1516 dated 14 October 2004, approved the
implementation plans for Basel 2 Accord, or the International Convergence of Capital
Measurement and Capital Standards:
(a) Universal/Commercial Banks (U/KBs) are expected to comply with the standardized
approaches for credit risk and operational risk by 2007. By 2010, these banks may
move to the foundation internal rating based (IRB) or advanced IRB approaches for
credit risk, and advanced measurement approaches for operational risk. TBs
affiliated with U/KBs should use the same approach used by U/KBs.
(b) Small thrift banks and rural banks are expected to be subject to an enhanced
Basel-1 type approach by 2007.
3. FINANCIAL CRIMES Since the ratification of the enabling laws and the issuance of the implementing rules
and regulations, a total of 27 BSP issuances in support of the AMLA have been
released.
For instance, the BSP has been actively promoting strict implementation of the know-
your-customer (KYC) doctrine. The new rules and regulations highlight the customer-
identification requirements by requiring, among others, the proper identification of the
payee of cashier’s or manager’s checks payable to cash or bearer; the maintenance of
banks of parallel customer-identification records for numbered foreign currency deposit
accounts; and the introduction of a suspicious transaction reporting system.
4. GROWING COMPLEXITY OF THE
ECONOMY AND INCREASING
SOPHISTICATION OF ECONOMIC
AGENTS
 INFLATION FORECASTING MODELS The BSP continuously endeavors to improve its existing models for better inflation
forecasts. These include the two short-term forecasting models (single-equation model
and multi-equation model) and the long-term structural model.
STABILITY ANALYSES AT THE Early warning systems (EWS) for surveillance work have been developed and are
MACRO AND MICRO LEVELS continuously being improved.
Macro stress-testing
 EWS on Business Cycles
 EWS on Currency Crisis
 Bank Distress Index
 External Debt Sustainability Stress-Testing
Micro stress-testing
 Bank Performance Report System
 Comprehensive Bank Folders
 Top Corporate Borrower Reports
 Bank Early Warning System
5. ORGANIZATIONAL DEVELOPMENT In recognition of evolving challenges, strategic planning conferences are conducted
periodically to assess and map out BSP’s medium-term program encompassing areas
of organizational structure; systems and processes; human resource development;
merit-based incentive structure; culture change; databank management; and space
rationalization.
Sources: SEC Presentation to the 2005 PICPA Annual National Convention
http://www.bsp.gov.ph/regulations/regulations.asp
BSP Medium-Term Strategic Plan (2005)

4.1. ECONOMIC AND TECHNOLOGICAL INNOVATIONS

The forces of globalization and the rapid development of new

technology have radically transformed the major aspects of bank operation,
such as access to liquidity, transformation of assets, and monitoring of risks.
Because of the revolution in information and data processing technology, there are
greater potentials for reducing transactions costs and improving risk management.
On the other extreme, the same technology that allows real-time execution of
massive transactions is equally capable of generating huge losses previously thought
of to be inconceivable.16

The evolution of e-money, e-banking, and e-finance continue to

transform the financial system in ways that would require intensive build-up of
market intelligence capability. With these new developments, BSP will have to
adapt its technology to emerging business needs without overstretching its
resources, lest its own financial sustainability gets compromised in the process.

4.1.1. MONETARY TRANSMISSION MECHANISMS AND CONTROLABILITY OF

TARGETS IN A LIBERALIZED FINANCIAL SYSTEM

Monetary policy feeds largely through aggregate demand with minimal effect
on supply capacity in the short run. In the long run, it determines how much the
purchasing power of money has changed over time, thus, setting the rationale for the
central role played by price stability in monetary policy making.

While indeed a “powerful tool”, monetary policy sometimes engender

externalities. (Nualtaranee, undated) The design and implementation of monetary
policy must, therefore, consciously take into account the changes in the structure of

16
Quaden (2001), in his speech, noted that most new technology spreads via an S-shaped curve whose base section can be
quite long and practically horizontal. However, it will sooner or later be succeeded by a steep section as experienced in
Nordic countries.
the economy – including changes in the balance sheet position, in financial sector
technology and institutions, or in expectations concerning future policy. Hence,
central banks must be able to continuously reinterpret the channels of transmission of
monetary policy (Kamin, et al, 1998) since these channels are not invariant over time.

An overview of the different transmission channels of monetary policy distilled

from Kamin, et al (1998), Drew, et al (2004) and Nualtaranee (undated) is provided
below.

(a) Interest Rate Channel

While views on the transmission channels continue to diverge in view of

the different economic environment within which such channels operate, there
is merit to strengthening the interest rate channel. This channel enjoys primacy
over explanations of the workings of the monetary policy transmission mechanism
since adjustments in the monetary policy stance is normally done through repo and
reverse repo rates. Central banks’ monopoly power over the creation of high-powered
money (also known as the base money) confers upon them the power to set the
interest rates in the wholesale money markets.

When the central bank decides to tighten monetary conditions to stem

inflationary pressures, it raises policy rates, which in turn, affect the market
rates banks charge their customers. Higher cost of credit stemming from higher
bank lending rates alters the investment decision of firms. Higher deposit rates, on
the other hand, may affect households’ decision between present and future
consumption. These forces dampen aggregate demand and temper inflationary
pressures.

Kamin et al (1998) propounded that the key issue in the interest rate
channel is the extent to which monetary policy action is transmitted along the
yield curve. This transmission process is largely a function of market expectations,
and the structure and level of development of the domestic financial markets. This
underscores the importance of the pass-through effects of policy-induced movements
in interest rate on both marginal costs of borrowing and average rates on outstanding
contracts. Aggregate demand is influenced by changes in expectations of future
inflation as seen in nominal interest rates and by changes in investment attitude
which is a function of the real interest rates.

Recent study by Dakila and Claveria (2005) indicates that even as the
BSP policy rates retains its capability to influence market interest rates, the
pass- through from the policy rate to the Treasury bill rate 17 remains limited.
Causality tests undertaken also show that the channel of impact may also be indirect,
through secondary markets. In addition, the impact of policy rate increase on inflation
is relatively smaller compared to those in developed countries.

(b) Credit Channel

Over time, the importance of the credit channel of monetary policy compared
with the interest rate channel (and related effects) may have diminished as a result of
liberalization of financial system. For instance, hedging instruments could insulate
firms’ cash flows. On the other hand, recent crisis experiences show that a more

17
Apart from the past trend in the T-bill rate itself, the policy rate is the most significant determinant of the T-bill rate over the very
near term (within three months). Beyond this period, exchange rate begins to dominate the policy rate in influencing the T-bill
rate.
liberalized global financial system may have also deepened the fragility of the
financial sector. These financial crises in the late 1990’s have emphasized the credit
availability channel.

The credit channel, considered more of an extension of the interest rate

channel, highlights the roles of “asymmetric information and costly
enforcement of contracts”. (Bernanke and Gertler [1995] cited in Nualtaranee)
Consistent with Akerlof’s market for lemons, only firms with very risky projects will be
willing to accept high rates during periods of contractions making interest rates
insufficient as a screening device, thus higher loan rates may be complemented by
more stringent standards. As a result, even creditworthy borrowers will have to face
higher costs of credit. Unless firms can easily substitute at zero cost bonds and
commercial paper for loans, the changes in the supply of loans will affect the real
economy. In this respect, credit channel works on the supply side while at the same
time highlights the more traditional “money channel,” i.e. the demand effect of a
monetary contraction, which modifies borrowing conditions and affects asset prices,
and thus, the market value of wealth.

The credit channel was highlighted anew in the financial crises that hit Mexico
in 1994-1995 and Asia in 1997. Many economists, Mishkin (1999) included, believe
that these crises were fundamentally triggered by the deterioration in bank balance
sheets following surge in credit growth on the back of heavy inflows of foreign capital.
The regulatory and supervisory systems then were ill-prepared to mitigate the moral
hazard arising from the government safety net or subsidies. Thus, the opportunities
opened up by financial liberalization led to excessive risk taking by banks that
eventually led to corrosion of their balance sheets.

Weakness in the banking sector, in turn, fueled speculative attacks on

domestic currencies. Attempts by central banks to stave off the depreciation by
raising interest rates further compounded the balance sheet problem. In emerging
markets, many of banks’ liabilities were in foreign currency. A region-wide currency
crisis materialized when it became apparent that the various central banks were no
longer able to defend their currencies.

Meanwhile, the rise in interest rates constrained the ability of firms and
households to service their debts. This put in doubt and in a lot of cases even made
worthless portions of banks’ assets. The worsening balance sheet conditions resulted
in lending restrictions, limiting access to funds of otherwise sound economic
investments.

(c) Asset Price Channel

The liberalization of financial systems in emerging market countries gave

impetus to balance sheet diversification of private non-financial sector, which, in turn,
enhanced the role of asset prices.

As for the wealth channel, a rise in the policy rate as a response to

higher inflation will ultimately give rise to increase in market rates and lower
market values of bonds, securities and equities. Since the present value of the
future stream of income from such assets is lower than the replacement cost of
capital, firms may opt to defer investment. This implies that even if loan rates respond
sluggishly to policy-induced changes in interest rate, monetary authorities can still
influence aggregate demand by affecting prices of securities and other financial
assets. The
extent of this power is function of the maturity and efficiency of the domestic capital
and financial market.

The propagation of the policy rate changes into asset prices also alters
the net worth of households and firms, which affects their income prospects.
These changes become functions of the consumption-investment decisions of
households and firms. If sufficiently severe, the ensuing decline in asset prices may
impact on the abilities of households and firms to pay their debts. In these
circumstances, households and firms will react by tightening their belts, possibly
blunting the efficacy of subsequent countermeasures by the monetary authorities
once the negative shock has dissipated.

(d) Exchange Rate Channel

Changes in policy rate and its ensuing impact on market rates have
implications on the demand for domestic assets and eventually on the
exchange rate. Exchange rate feeds though spending via two channels: the
relative price effect and balance sheet effects.

For example, the relative price effects of a currency appreciation emanating

from higher policy rate and market rate relieve inflationary pressures by making
domestic goods more expensive, thereby, reducing exports and aggregate demand.
The balance sheet effect, on the other hand, can be an important channel when
households and firms hold foreign currency debt. When residents are net debtors to
the rest of the world, a large appreciation, can improve the debt positions and net
worth of the residents and hence, domestic demand. Thus, it may be possible that the
balance sheet effects offset or even dominate the relative price effect.

Any effort, therefore, to strengthen the channels assumes an accurately

estimated model of such channels. This further highlights the necessity of strong
modelling and research capability in the BSP. It is worth noting that the development
of a model on the transmission mechanisms of monetary policy is among the
medium- term thrusts of the BSP. Econometric modelling of the different channels
can be done through the micro-founded dynamic stochastic general equilibrium
(DSGE) model of the economy that would allow for a theory-consistent approach to
identifying a shock and tracing its transmission to the different sectors of the economy
(BSP Strategic Plan, 2005). In any case, the following considerations will have to be
taken into account in determining the strength of the pass-through from policy rates,:
(i) state of capital market development, (ii) role of banks in the financial system, (iii)
changes in the regulatory framework, (iv) extent of securitization, and (v) degree of
flexibility of product and labor markets. At the same time, the importance of initiatives
to improve the efficiency of markets – both real and financial – cannot be overly
emphasized.

4.1.2. PAYMENT SYSTEM

While the BSP has sufficiently administered the PhilPASS in accordance

with the Core Principles for Systematically Important Payment Systems, its
powers to apply the core principles to systems outside its jurisdiction are
limited.18 The legal framework for the complete implementation of the core principles

18
About 63.9 percent of the total universal/commercial and thrift banks are participants in the Philpass (Updates on BSP
Supervision and Regulation, June 2005.
remains inadequate. The current payment system is governed by fragmented rules
and regulations issued by means of circulars (BSP MT Strategic Plan, 2005). For
one, the BSP’s oversight function over the payment system is not explicitly included
in its Charter. The untenable legal backing could spill into credit and liquidity risks in
the event of systems breakdown or severe economic distress. It will be noted that the
Bank of England recognizes the challenge posed on its payment system by the
absence of statutory powers in effecting remedial measures in the event of system
breakdown.

In the area of payment system legislation, the New Zealand experience is very
instructive. The Reserve Bank of New Zealand Amendment Act 2003 granted it
with (1) oversight power over the payment systems, and (2) the power to collect
and publish information relating to the payment system. (DeSourdy, 2004) The
amendments ensure the finality and irrevocability of payments executed through the
system even in the event of insolvency. 19 However, protection is accorded only to the
transactions settled and not to the underlying transactions 20. Even so, the NZ rules
allow one party to challenge or sue another party who has acted fraudulently or
dishonestly without invalidating the enforceability of rules, payment, and netting in the
designated payment system. Similar arrangements exist in the UK, Canada,
Australia, and Singapore.

The reputational capital of the BSP and its good relationship with the
banking sector provide justification for strengthening BSP’s oversight
authority over the payments and settlement system. Sound legal basis for the
payment system will aid the migration to online, real-time facility of existing
infrastructure for transmission of transactions from the regional and branch offices.
However, BSP’s reputational capital is only as good as the structure of the payment
system itself because BSP’s enforcement credibility largely hinges on the efficiency of
the system.

The BSP recognizes the advantages of a single Payments System Act. The
proposed Payment System Act is envisioned to support multilateral netting, 21 and
finality and irrevocability of payments done through the designated payment system
(BSP MT Strategic Plan, 2005). Likewise, in an effort to further reinforce the legal
basis for statutory responsibility over the payment system, one of the proposed
amendments to the New Central Bank Act of 1993 is an explicit provision giving the
BSP the responsibility to promote, oversee and maintain the stability of the financial
and payments system.

Haldane (2005) maintained that greater risk challenges in the future may
arise from operational dependencies on technology platforms that support
multiple payment systems of financial markets. These risks will most likely
intensify

19
“Prior to the amendment, New Zealand has few specific legislative and regulation requirements concerning payment systems.
Payment systems must operate within the general law, including general commercial and consumer law. However, there
existed possibility that settlements through a payment system may have to be unwound if a participant became insolvent.
This is due to voidable preference provisions in the insolvency law.” (DeSourdy, 2004, p.22 )

20
The NZ law describes “underlying transaction” as “a transaction that gives rise to a payment or a payment obligation
but does not include a payment instruction or settlement in accordance with the rules of a designated system”.
(DeSourdy, 2004, p.25)
21
Multilateral netting means offsetting of receivables and payables among 3 or more parties to a transaction, with each making
payments to an agent of clearing house for net obligations due to others or receiving net payments due from others. This
mitigates credit and settlement risk.
with increasing consolidation, global integration and technical sophistication of the key
systems.

Corporate governance constitutes another area which requires

continuous enhancements. In view of uncertainties governing the adequacy of
mutually-owned infrastructures in safeguarding public interest, strengthening
corporate governance will provide further checks in the system and ensure that
corporate risk- taking are not overly-excessive.

Meanwhile, the payment system could play a greater role in facilitating

remittance flows. OFW remittances have already outpaced other sources of
financial flows such as net exports, foreign direct investment and change in external
debt (Songwe, 2005). The flows could still go higher if transaction costs of
remittances are substantially lowered. Not only will the value of inflows go up, lower
remittance costs could induce higher welfare gains for the household recipients. A
good example of the use of payment system technology is the Sistema de
Transferencia Electrónica de Fondos Internacionales (TEFI)/Fed Automated Clearing
House (ACH) International Mexico Service. 22 The system provides for low-cost
government and commercial cross-border payments through the financial
interconnection of the United States and Mexico, supporting Mexico’s financial
infrastructure. Another Mexican policy of reducing remittance cost is the issuance of
identification cards to migrant workers to facilitate their banking transactions.

4.1.3. FINANCIAL PRODUCTS AND SERVICES

Due in part to the complex nature of derivatives, different studies have

reached diverse conclusions regarding their impact on the monetary policy
transmission mechanism and on financial system stability. The jury is still out on
the net impact of derivatives on monetary policy and financial stability.

For instance, Fender (2000) concludes that hedging activities by

corporations weaken the financial accelerator or the broad credit channel of
monetary policy. A firm that, say, borrows long-term at floating interest rates
essentially makes a bet that future interest rates will decrease. Financial derivatives
would allow such a firm to cover its bet and mitigate the balance-sheet effect of
possible contractionary policy interventions. Thus, when this practice becomes the
norm, the power of BSP interest rate interventions on the real economy could
weaken, other things remaining the same.

Particular attention has been given to credit derivatives. Credit derivatives

present supervisors with regulatory issues and stability risks. Instefjord (2005)
argues that credit derivatives and the trading of credit derivatives increase both
the concentration of risk and total risk in the banking sector. According to him,
“[c]redit derivatives trading is…a potential threat to bank stability even if banks use
these instruments solely to hedge or securitize their credit exposures”. (p.344)

On the other hand, Rule (2001) finds that the credit derivatives market
effectively allows the banking sector to concentrate on what it does best:
originating loans and allocating credit. Effectively, the resulting credit risks are
borne by entities more equipped to deal with them. Because of the improvement in
risk allocation, there are efficiency gains, which could redound to bank margins. Yet
22
Part of the US-Mexico Partnership for Prosperity (P4P) Program.
still, Hentschel and Smith (1996) conclude that the impact of derivatives on monetary
policy and on the payment system has been exaggerated.

The IMF, in its 2006 Global Financial Stability Report, recognized that the
transition from bank-dominated to market-based financial systems present new
challenges and vulnerabilities. The report noted that “the remarkable growth of the
derivative and structured credit markets over the past few years transpired in a
relatively benign environment such that market liquidity and certain aspects of the
market infrastructure have not yet been fully tested by a prolonged or severe credit
downturn. Thus, while these markets facilitated primary transfer of risks, secondary
market liquidity is still absent within some segments, thus creating potential for
market disruptions.”

The same IMF study concludes that while the potential vulnerabilities
elicit supervisory concerns, the information generated from the credit
derivatives market are useful for financial sector surveillance and for instilling
market discipline. Specifically, these information signal broad credit conditions and
progressively provide a gauge for the marginal price of credit. For one, the
enlargement of the product base similarly is an early warning indication of stress in
sectors other than banking. For another, the ensuing transparency in the pricing of
credit risks would facilitate proactive portfolio adjustments that may help smoothen
the credit cycles. This implies that notwithstanding the still ambiguous relationship of
asset price changes and the underlying economic fundamentals, the regulatory
environment would have to increasingly monitor asset markets in order to better
understand credit flows and their impact on the monetary transmission mechanism.

Future studies to validate the foregoing findings using Philippine data

will add to the proper understanding of the monetary transmission mechanism.
A rigorous investigation of the impact of derivatives on the conduct of monetary policy
and on financial stability should reward policymakers with a richer appreciation of how
financial products innovations could affect the goals of the monetary authorities.

In any event, promoting best practices and educating the public on the
nature and risks involved in different types of transactions should be pursued
to mitigate risks engendered by information asymmetry. Already, the BSP has
issued a number of directives (e.g., Circular 102 dated 29 December 1995 defining
the scope of trading activities and disclosure requirements for banks and other
financial institutions; Circular 135 dated 22 July 1997 requiring prior clearance from
BSP of non- deliverable forward contracts with non-residents). For regulators and
policymakers concerned with risk management and system stability, it is important is
to ensure that processes and reporting channels in corporations - not only in financial
institutions – are adequate to safeguard against one employee or group of employees
running unjustifiable level of risks to the detriment of the entire institution/system.

4.1.3.1. ELECTRONIC-MONEY

One aspect of the technological revolution that has a direct and long-
lived impact on the conduct of monetary policy and on financial regulatory
requirements is the increasing use of electronic money products 23. In particular,

23
Marcelo (2002) defines electronic money products, or e-money, as “stored-value or prepaid products in which a prepaid
balance of funds or value is recorded on a device (e.g., card) held by the consumer. Electronic money products can be
categorized into three groups: (1) card-based products; (2) prepaid software products that use computer networks such as
e-money affects the demand for coins and currency and, by definition, the monetary
base. This means that there is a direct link from e-money to liquidity, and thereby, the
price stability objective of the BSP. A negative impact on the demand for currency will
consequently be reflected on central bank financial performance as lower income
from seigniorage. Note, however, that there is as yet no general agreement among
economists on whether e-money products have significant impact on monetary
policy.24 On the regulatory side, the concomitant risks on the payment system arising
from widespread use of e-money products presents supervisors with further
challenges.

Goodhart (2000) concludes that even if the information technology

revolution were to eliminate demand for currency – which he argues will not
happen primarily because it is the legal tender and it allows transacting agents
to feel secure under a blanket of anonymity – a central bank can still set the
nominal interest rate. A central bank can pay interest on its own liabilities, such as
bank reserves. If a central bank wants to lower the interest rate, it will lend at its
desired rate. However, under these scenarios, Goodhart pointed out that the central
bank may have to absorb losses or suffer lower profits from its open market
operations. On the other hand, its credibility may be enough such that an
announcement (what Goodhart calls “open mouth operation”) of its intention might be
enough to lead the market to the interest rate the central bank deems appropriate.

One way to blunt system instability risks arising from e-money products
is to require that these products be subject to reserve requirement. (Marcelo,
2002) The BSP will have to weigh this consideration with the advantages of lowering
the reserve requirement. So far, to strengthen the monitoring of internet banking as
an IT-related service, the BSP, through its Monetary Board (MB) Resolution No. 864
dated 30 June 2005, approved the establishment of an information technology
supervision unit – Core Information Technology Supervision Unit (CITSU) – to help
banks and non-bank institutions align their information technology policies with
international best practices. The responsibilities of the CITSU 25 include the review of
requests from banks to offer services that involve the use of electronic channels via
the Internet, particularly the overseas or domestic wire transfers of funds, payment of
bills and other online transactions offered to retail and wholesale customers.
Assessments of safeguard procedures are done to forestall operational problems
such as collapse of the computer system resulting in the disruption of banking
services and fraud in internal and external transactions.

4.1.3.2. FINANCIAL SYSTEM SUPERVISORY FRAMEWORK

Because of the rapid pace of financial products innovation, the

advantages of being a financial conglomerate or financial supermarket, and the

the Internet; and (3) access devices.”

24
Please see Marcelo [2002] for a detailed discussion of electronic money and electronic banking in the Philippines, and
the challenge they pose to the conduct of monetary policy and financial supervision.

25
The CITSU is also mandated to:
(a) Provide baseline minimum standard through issuance of information technology risk policies including the
management of IT risk, which is an operational risk under Basel II.
(b) Conduct information technology examination of banks and other payment entities.
(c) Inspect banks’ technology-related risk management process, including the plan for the use of technology, the
implementation procedure, and the measurement and monitoring of risk-taking activities of financial institutions.
incentives to engage in regulatory arbitrage, a reassessment of our current
financial regulatory framework is timely. Under the current set-up, regulation is
done according to industry and not according to activities. Thus, even if two entities
are essentially engaged in the same activity (e.g., getting money from the public
either through “deposits” or through “premium”), they may be subject to different rules
of the game if one calls itself, say, a bank while the other calls itself a pre-need
company. Should either fail, the impact of the problems posed to the institutions and
markets likely are similar, except probably in magnitude.

To counter the challenges posed by regulatory arbitrage and

conglomeration, an increasingly well-coordinated and consolidated
supervision is being considered in the Financial Sector Forum. Because of (1)
the bank- dominated nature of the Philippine financial system; (2) the increasing
vertical/horizontal integration in the financial sector (e.g., emergence of financial
conglomerates); (3) the advantages of keeping bank supervision and monetary policy
under one roof in a bank-dominated economy; and (4) the resources and institutional
credibility of the BSP, it may be appropriate to consider the lessons that the set-up of
the Monetary Authority of Singapore (MAS) (integrated regulator model), the
Financial Services Authorities of England (lead regulator), and the Financial
Supervision Authority of Finland (lead regulator) can provide.

Citing Goodhart et al (1998), Taylor and Fleming (1999, p3) pinned down the
reasons why adoption of an integrated financial regulation system has been gaining
serious consideration:

1. The rapid structural change that has taken place in financial markets spurred by the
acceleration in financial innovation. This has challenged the assumptions behind the original
structuring of regulatory organization. The question that arises here is whether institutional
structure should mirror the evolution of the structure of the financial sector.
2. The realization that financial structure in the past has been the result of a series of ad hoc and
pragmatic policy initiatives raising the question of whether – particularly in the wake of
recurrent banking crises and dislocation – a more coherent structure should be put in place.
3. The increasing complexity of financial business as evidenced by the emergence of financial
conglomerates. This has raised the issue of whether a series of agencies supervising parts of
an institution can have a grasp of developments in the institutions as a whole.
4. The increasing demands being placed on regulation and its complexity, in particular the
development of a need for enhanced regulation of “conduct of business” (e.g., covering
financial products like pension schemes and insurance offered to consumers)
5. The changing risk characteristics of financial firms occasioned by financial innovation.
6. The increasing internationalization of banking which has implications for the institutional
structure of agencies at both the national and international level.

Under integrated supervisory systems, regulatory arbitrage is

minimized. Since all regulators are assembled under and/or reports to one entity,
gaps, overlaps, and other frictions arising from inter-agency coordination are
minimized. However, the inter-agency friction eliminated might become
interdepartmental tensions because of the inherent differences in the objectives of
prudential regulation, market conduct regulation, systemic stability regulation and
competition regulation. Also, the authorities need to be careful in defining the
eligibility for deposit insurance safety net under this framework.

Australia, Canada, Denmark, Finland, Japan, Norway, Singapore, Sweden,

and the UK all follow the integrated regulator model. The case of Finland provides a
useful picture of a lead regulator model where banking supervision resides
with the central bank. For Finland, the lead regulator is the Financial Supervision
Authority. The FSA, while administratively under the Bank of Finland is operation-
independent. (Jännäri, 2001, p. 91) The law creating the FSA directs it to cooperate
with the other financial regulators, namely, the Insurance Supervision Authority, Bank
of Finland, Ministry of Finance, and Ministry of Social Affairs and Health. The Bank of
Finland, the Ministry of Finance and the Insurance Supervision Authority are all
represented in the Board of the FSA.

Under the “lead regulator” setup, a single regulator takes the lead in
coordinating among the regulators involved but market sectors are supervised
by separate institutional regulators. In Finland, the central bank supervises the
banking sector, is responsible for the stability of the payment system, and, in general,
performs oversight of the financial system. Because it is a member of the euro zone,
the European System of Central Banks (ESCB) steers its monetary policy. The credit
institutions and securities markets in Finland are regulated by the Financial
Supervision Authority. Insurance and social security concerns report to the Insurance
Supervision Authority, which is administratively under the Ministry of Social Affairs
and Health.

In the case of England, since the “Bank of England had established a

substantial banking supervisory capacity and had stressed, over many years, the
need to keep monetary policy making and banking supervision in the same body…
[m]uch stress was put on the argument that monetary and financial stability are inter-
related” during the debates leading to the shift to the current system. (Taylor and
Fleming [1999] p2) Eventually, policymakers decided that while the Bank of
England is to remain responsible for monetary policy, the Financial Services
Authority is to supervise “banking, insurance, investments, listing and other
financial services concerns”. 26 Decisions by the FSA that impinge on competition
are reviewable by the Director General of Fair Trading, who shall, in turn, advise the
Competition Commission of any “anti-competitive” impact of such decisions. 27
Meanwhile, the Bank of England, the Financial Services Authority and England’s
Treasury are jointly responsible for stability of England’s financial system.

The Monetary Authority of Singapore (MAS) is a super-regulator. In

addition to being responsible for monetary policy of the city state and the supervision
of the banking industry, the MAS regulates the other players in the financial sector:
insurance companies, securities firms.

Australia has also adopted integrated regulation of its financial system. Unlike
the kind of integrated systems practiced in England, Finland, and Singapore
though, the Australian system is explicitly organized according to sources of
market failure or goals of financial regulation, e.g., functional regulation. The
Reserve Bank of Australia (RBA) is in-charge of monetary policy and financial system
stability. Although the RBA still is the lender of last resort, it “no longer has an
obligation to protect the interests of bank depositors”. (CFR (2002), p.10) The
Australian Prudential Regulation Authority (APRA) crafts and implements prudential
policies that “balance financial safety and efficiency, competition, contestability and
competitive neutrality” among deposit-taking (e.g., banks, life and general insurance
and pensions) financial intermediaries. (CFR (2002), p.8) However, the Australian
Competition and Consumer Commission (ACCC) is the overall arbiter of competition
policy. For instance, it is the final arbiter of competition and access to the Australian
payment system. Lastly, the Australian Securities and Investments Commission

26 http://www.fsa.gov.uk/Pages/About/Who/Accountability/legal/index.shtml
27 http://www.fsa.gov.uk/Pages/About/Who/Accountability/index.shtml
(ASIC) is in charge of consumer protection and market integrity regulations. More
specifically, it “administers and enforces a range of legislative provisions relating to
financial markets, financial sector intermediaries and financial products, including
investments, insurance, superannuation and deposit-taking activities (but not
lending). ASIC’s aim is to protect markets and consumers from manipulation,
deception and unfair practices and, more generally, to promote confident participation
in the financial system by investors and consumers.” (CFR [2002] p.9)

Table 3. Financial System Regulatory Frameworks

Jurisdiction Philippines England Singapore Finland Australia
(separate (super regulator) (lead regulator) (functional
monetary policy regulators)
and bank
supervision)
Monetary Policy BSP BoE MAS ESCB RBA

Banking BSP FSA_E MAS BoF APRA, ASIC,

Supervision PDIC ACCC
Capital Markets SEC FSA_E MAS FSA_F ASIC, ACCC
Supervision
Insurance IC FSA_E MAS ISA APRA, ASIC,
Supervision ACCC
Functional Regulation
Consumer BSP; SEC; IC; FSA_E MAS FSA_F ASIC
Protection DTI
Competition BSP; SEC; IC; FSA_E; OFT; CC MAS FSA_F ACCC
Regulation DTI
Market Integrity BSP; SEC; IC; FSA_E MAS BoF; FSA_F ASIC
DTI
System Stability BSP BoE, Treasury, MAS BoF RBA
FSA_E
Prudential BSP; SEC; IC FSA_E MAS BoF; FSA_F APRA
Regulation
Sources: www.fsa.gov.uk; www.rba.gov.au; www.accc.gov.au; www.pdic.gov.ph; www.bsp.gov.ph; www.insurance.gov.ph;
Jännäri (2001); www.bankofengland.co.uk; www.mas.gov.sg

ACCC : Australian Competition and Consumer Commission MAS : Monetary Authority of Singapore
APRA : Australian Prudential Regulation Authority OFT : Office of Fair Trading, England
ASIC : Australian Securities and Investments Commission PDIC : Phil. Deposit Insurance Corporation
BoE : Bank of England RBA : Reserve Bank of Australia
BoF : Bank of Finland SEC : Securities and Exchange Commission,
CC : Competition Commission, England Philippines
DTI : Department of Trade and Industry,
Philippines ESCB : European System of Central Banks
FSA_E : Financial Services Authority, England
FSA_F : Financial Supervision Authority, Finland
IC : Insurance Commission
ISA : Insurance Supervision Authority, Finland

Taylor and Fleming’s (1999) integrated supervision decision tree (Figure 1),
discussed below provides a useful guide on how to proceed with the choice of
organizational model.

The first step in the decision tree asks whether there could be economies of
scale if an integrated financial sector supervisor is created. Aside from cost savings
from consolidating overlapping functions and infrastructure, an integrated supervisor
within a small country could also benefit from the concentration of top notch
professionals who would otherwise be scattered among different agencies. This
environment could then be a good breeding ground for the formation of a stronger
pool of supervisors.

If the economy could not achieve economies of scale from integrating its
financial supervisors, the policymakers are then to consider, successively, the
following until they get an affirmative answer:

(1) whether one group or a few large financial institutions dominate the
financial sector;
(2) whether a significant number of financial institutions offer a range of
financial products and services that encompass banking, insurance
and securities markets (i.e., financial supermarkets); and
(3) whether the domestic financial sector is experiencing swift
developments, e.g., in terms of products and services they offer or that
are demanded from them; legal environment; major players.

If market power is highly concentrated, a politically and professionally powerful

integrated supervisor may be more capable of balancing the requirements of a free
market with consumer protection and a stable financial system. Likewise, if financial
conglomerates play a major role, a regulator which would have control of how
banking, insurance, and securities markets are supervised would be more effective
and more efficient in limiting the possibility of firm activities falling between regulatory
cracks. Furthermore, in an environment where new products and services are being
developed and demanded, where the legal and economic landscape is rapidly
shifting, and where the financial sector could be consolidating or undergoing a merger
and acquisition phase, an integrated supervisor might be able to limit negative
externalities and achieve regulatory objectives better than a system of separate and
independent regulators that supervise according to the conventional segregation of
regulatory turfs.

Should it then be decided that the creation of an integrated regulator is

appropriate, the policymakers then have two options for the basic setup of the
integrated supervisor that depend on the powers and degree of independence the
country’s central bank enjoys. If the banking sector is under the central bank in the
current framework and the central bank is highly independent, Taylor and Fleming
(1999) recommend the Finnish model where the integrated regulator is
administratively under the Bank of Finland. Otherwise, if either of these two
conditions is lacking, it is suggested that the policymakers design a system that can
guarantee independence of the integrated supervisor. Lastly, Taylor and Fleming
(1999) emphasized that since a central bank which supervises the banking sector in
the current regulatory regime might likely yield some of its authority and functions, it
would be beneficial if a “crisis management arrangement” where the central bank can
share its expertise can be arranged among the parties involved.

Using Taylor and Fleming’s (1999) decision tree, it would seem that the
Finnish model is worth considering for the Philippines. Furthermore, citing Shirai
(2001), Milo (2002) argues that:

…an umbrella approach, in which separate regulatory authorities are

established and coordinated, has been deemed as desirable for Asian
developing countries because they typically do not have sufficiently strong
prudential regulations or banking sector supervision. In such a situation,
integrating nonbanking regulators with bank regulators could weaken the
regulatory capacity of the latter if human and financial resources are limited,
 which could in turn reduce confidence in the overall financial system. Thus,
integrating the various regulators without ensuring independence may weaken
the quality and credibility of the overall regulatory regime. Instead, the priority
should be the strengthening of bank regulation, while improving regulatory
capacities for nonbanking business. (p13)

FIGURE 1. INTEGRATED SUPERVISION DECISION TREE

Source: Taylor and Fleming (1999), p26

 Ultimately, the choice between these models may depend on how much
accountability the central bank is willing and able to bear and how much power the
other regulatory bodies are willing to cede to the BSP on the one hand, and on the
perceived benefits of seamless supervision of the financial system, on the other.

4.2. RISK MANAGEMENT

A key policy area that Basle II brings to focus pertain to the risk
management systems employed by banks in measuring their credit, market,
and operational risks. This entails requiring banks to set up systems that allow their
managements to have the information and procedures to assess their “true” risk
exposures on a global basis, and to modify such exposures in a timely manner.

Appropriate risk information systems and control processes enhance

the abilities of banks in balancing risk-return tradeoffs and the powers of
central banks in assessing minimum capital adequacy standards. These should
help minimize the probability of system instability or the need for assistance from
central bank/deposit insurance institutions to arrest system instability. However, since
risk management systems work best when they are tailored to the individual needs of
the institution being assessed, each bank could have a unique risk management
model. Therefore, regulators, supervisors and policymakers must have intimate
knowledge of the various risk management models, and – particularly in the case of
the supervisors
– of the particular company supervised. 28

This tailor-fitting of risk management systems gives rise to information

asymmetry. Inter-company comparison and industry analysis would be particularly
challenging and would require appreciation of subtle elements of finance, economics
and accounting. For the regulators and the monetary policy decision-makers, it
means an additional dimension in crafting consumer protection and market conduct
regulations. On the other hand, investors and savers would need a level of financial
sophistication greater than the average investor to be able to participate profitably in
the system.

In view of the foregoing, it becomes imperative that the accompanying

external risk assessment relied on by supervisors and investors be robust and be
imbued with integrity. Only credible credit rating agencies (CRAs) should be
awarded status of recognition. Such recognition must be founded on the existence
of a credit rating methodology that is “rigorous, systematic, continuous, and subject to
validation”. (Datschetzky et al, 2003). To date, status of recognition has been
conferred to the Philippine Rating Services Corporation (PhilRatings). Its ratings shall
be used as basis for determining risk weights in compliance with risk-based capital
requirements. For bank supervisory purposes, international CRAs that will undertake
local and national ratings, are to have at least a representative office in the
Philippines.29

It has been argued that the high costs entailed by a top-of-the-line risk
management system means that bigger banks will gain greater market power to

28
The intimate relationship that a supervisor must develop to attain this level of understanding could likely have an unintended
and undesirable effect for the central bank, human resource-wise. Because the bank employee will need to be highly-
specialized in a particular company, the employee would naturally look at such firm as one avenue for career advancement.
29
Circular No. 473 dated 01 February 2005. Among international CRAs recognized by BSP are Moody’s Standard and Poor’s
and Fitch Ratings.
the detriment of smaller banks. Thus, the BSP must ensure that the aim to
minimize systemic risk does not unintentionally provide a competitive edge to one
group over another. On the other hand, a case could also be made that since this
process could improve efficiency, the benefits of improved overall welfare justify the
pain and that as long as markets remain contestable, monopolistic/oligopolistic
tendencies are restrained.

However, at the end of the day, the benefits to the public of efforts to
enhance risk management are only as good as the ability of the BSP to enforce
its supervisory powers. A strong supervisory body should be able to independently
carry out its responsibilities and examine closely compliance with prudent banking
practices and sound corporate governance standards. In recognition of this,
reinforcement of regulations in accordance with international standards for greater
transparency and accountability has been set as one of the reform priorities in the
Medium-Term Philippine Development Plan (MTPDP) 2004-2010. Towards such end,
amendments to the BSP Charter have been proposed to include “immunity of
supervisors from law suits, authority to compel banks to implement prompt corrective
action and higher capital build-up, shift away from the strategy of forbearance and
liquidity assistance, and stronger criminal and administrative penalties for violations of
banking laws”. (MTPDP 2004-2011, p.108). Such immunity is aimed to minimize
adverse regulatory capture that can undermine enforcement of prudential regulations.

These multidimensional issues evoked by the shift to risk-based supervision

as put forward by Basle II clearly calls for a distinctive breed of technocrats. Both the
central bank and the financial institutions face the challenge of recruiting and
harnessing a human resource pool adept at the progressively complicated,
specialized and model-dependent art and science of risk management.

4.3. FINANCIAL CRIMES

The BSP must boost its abilities to keep abreast with the greater-than-
ever sophistication and ingenuity of perpetrators of financial crimes, who
progressively are leveraging on the information technology revolution. High
Incidence of financial and bank fraud also reflect weak controls and reporting
systems, and a low level of public awareness regarding safety measures. When
perpetrated in significant magnitude and breadth, bank fraud and other financial
crimes impinge on bank solvency and impair payment system stability. For instance,
phishing30 scams and other methods to commit identity theft are direct and present
threats to the integrity of financial systems.

Likewise, the challenges that a 21st century central bank faces include
not only activities that directly use the financial system in the commission of
crimes but also those that erode its integrity by hijacking it to hide evidence of
or fruits from criminal activities. This is a case when the use of regulation to
achieve a social objective improves efficiency. Money laundering activities have direct
implication on the integrity of the country’s financial system and, thus, on the
competitiveness of a country’s financial institutions and corporations among their
global peers.

30
An example of phishing activity would be the email messages that purport to come from a reputable bank asking the
recipient to click a link in the body of the email and update his account details. The link appears to lead to the site of the
bank (e.g., when one hovers his mouse pointer over the link, a website address that appears to be that of the legitimate
establishment will be displayed) but in reality leads to a site controlled by the phisters. (www.antiphishing.org).
 On 29 September 2001, the Anti Money Laundering Act (AMLA), 31 which
criminalizes money laundering in the Philippine was signed into law. The law
defines unlawful activities that constitute money laundering; makes mandatory the
submission of reports on suspicious transactions; grants immunity to reporting
institutions and officers; provides for forfeiture of laundered money; creates a financial
intelligence unit; allows access to deposit accounts; and provides for international
cooperation.

Meanwhile, recognizing the merits of the FATF 32-proposed

amendments, RA No. 9194, an Act Amending R.A. No. 9160, was signed into law
on 7 March 2003. The law’s implementing rules and regulations was approved by
the Congressional Oversight Committee on 6 August 2003. Specifically, the amended
law:

(1) gives the Anti Money Laundering Council (AMLC) access to suspicious
bank accounts without first securing a court order in special
circumstances;
(2) lowers the transaction threshold amount that could be examined
without a court order to P500,000.00 from P4 million;
(3) includes kidnapping for ransom, violation of the Dangerous Drugs Act,
and hijacking as crimes under unlawful activities;
(4) extends the law’s coverage to suspicious transactions under certain
specified circumstances, regardless of the amount involved;
(5) allows the Court of Appeals to freeze accounts upon application by the
AMLC; and
(6) authorizes the BSP to inspect any deposit or investment with any bank
or non-bank financial institutions (NBFI) in the course of BSP’s periodic
or special examination.

As a result of the enactment of R.A. No. 9194, the members of the FATF have
decided not to apply any countermeasures to the Philippines in addition to
Recommendation 2133.

Since the ratification of the enabling laws and the issuance of the
implementing rules and regulations, the BSP has issued a number of circulars 34
in support of the AMLA. For instance, the BSP has been actively promoting strict
implementation of the know-your-customer (KYC) doctrine. Nonetheless, the
regulatory authorities – much more the BSP – cannot rest satisfied that what have
been done so far are enough to deter persons involved in unlawful activities from
using the financial system to camouflage their tracks. Meanwhile, the authorities must
remain mindful that implementing the law does not unnecessarily impinge on the
rights of law-abiding citizens and discourage them from participating in the domestic
financial
31
R. A. No. 9160
32
The Financial Action Task Force (FATF) is an international group composed of banking industry representatives from
developed countries.
33
Recommendation 21 states that “[f]inancial institutions should give special attention to business relations and transactions
with persons, including companies and financial institutions, from countries which do not or insufficiently apply these
Recommendations. Whenever these transactions have no apparent economic or visible lawful purpose, their background
and purpose should, as far as possible, be examined, the findings established in writing, and be available to help
supervisors, auditors and law enforcement agencies.” (Updates on BSP Supervision and Regulation, June 2005, p. 215)

34
Circular Nos. 258, 279, 291, 333.
system. This balancing act becomes harder in view of the efforts to contain terroristic
activities.

4.4. ANALYTICAL TOOLS FOR POLICY ANALYSIS AND DECISION-MAKING

The role of econometric models and statistical methodologies in

undertaking monetary policy analyses is becoming more pronounced. The
analyses required for credible inflation targeting and robust treatment of system
stability demand substantial analytical and statistical skills in central banks. Analysts
from large central banks such as the US Federal Reserve Bank and the European
Central Bank are extensively using econometric models in making policy simulations
and analyses for their monetary boards, monetary policy committees, or board of
governors.

At the same time, judgment has never been more central in the analytical
and statistical work of central bankers. Knowledge of data nuances and economic
and policy development milestones are essential in the analytical and statistical work
of central bankers. No matter how sophisticated and user-friendly statistical packages
for economic analysis have become, they need to be substantiated with a well-
considered evaluation by the analysts. At the same time, since judgment plays a
critical role in many statistical model-driven policy-simulation works, prudence is
necessary in interpreting model-generated results.

Aside from macro surveillance tools, it is also vital to give due

consideration to the development of portfolio and risk models given the
growing sophistication of the financial market. It is expectedly within the ambit of
central bank responsibilities to develop methodology to stress test the financial
system.

More importantly, the ability to package information into useful analyses

requires a strong research culture. The benefit of a research-oriented
organizational mindset is that it fosters entrepreneurship in ideas. Research culture is
characterized by, among others, constant examination of causes and effects of
certain trends in macro and micro indicators, efficient utilization of the mass of
statistical information available, keeping abreast of latest literature on methodological
and policy oriented issues; and closely tracking domestic and global developments.

4.4.1. INFLATION FORECASTING

The shift to inflation targeting has brought inflation forecasting to the

fore of monetary policy making. The credibility of the BSP and the success of
monetary policy strategy largely depend on the reliability of inflation forecasts as
these play a crucial role in the determination of appropriate policy interventions.

Since inflation forecasting has become an institutional priority under the

inflation targeting framework, the process and system for generating the
forecasts will have to be efficiently managed. Forecasting is a complicated
business that requires efficient data management, adequate hardware and software
support, and a specialized forecasting team with knowledge of different forecasting
methods. The various models used for forecasting help the central bank provide a
coherent story about how it sees the economy evolving, thus, serving also as a potent
communication device.
 In terms of data management, members of the forecasting team should
have access to a common set of real-time data and should be equipped with
adequate information about the nuances on methodological revisions. In this
manner, the team will be spared from the arduous task of data validation and
consistency checking (thus, minimizing possible errors and omissions) and
concentrate more on data analysis and forecasting (Kriljenko, et al, 2006). Real-time
data also underpin a more informed judgement regarding adjustments and
calibrations needed for estimation.

Under the new set-up of the BSP, an Economic and Financial

Forecasting Group was created within the Department of Economic Research.
The more focused delineation of functions arising from this new set-up is seen to
create better synergies among the different groups for sustained strengthening of the
inflation targeting framework. The group currently utilizes two short-term forecasting
models – single equation model and multi-equation model – which are continuously
being improved. Since the inception of inflation targeting framework in 2002, the
accuracy of one-month ahead forecasts in terms of “hits” has averaged 60 percent.
This is reasonable considering the still relatively short period of inflation targeting
implementation, a period also characterized by the confluence of internal and external
challenges such as growing fiscal imbalance, peace and order concerns, geopolitical
tensions in the aftermath of 9/11, slump in the electronics and information technology
sector, severe acute respiratory syndrome (SARS), and unprecedented oil price
increases (MTPDP, 2005-2011).

35
4.4.2. STABILITY ANALYSES

Studies on robustness of financial sectors have traditionally focused on

averages, but there is a growing interest in the “dispersion of experiences
around the mean”. (Stevens, 2005) An example is the analysis on the concentration
of defaulting borrowers. The policy response would differ significantly if those facing
risk of default are small borrowers or large borrowers as the latter has the potential to
induce systemic panics.

Second, stability analyses also deal with relationships among financial

institutions, markets and portfolios. Developments that, say, negatively impact on
the financial health of major employers in the economy could affect the spending
power and the asset portfolios of the employees. It is also possible that over time
relationships can evolve.

The aforementioned interdependence highlights the need for stress

testing36 markets, institutions, and the entire banking system. The development
of
35
This rationale for stability analysis draws heavily from Stevens (2005).
36
The Austrian central bank explains in its website that “[s]tress tests were originally used in risk management by banks in
order to determine how certain crisis scenarios would affect the value of their portfolios or subportfolios. Typical crisis
scenarios examined in this context include stock market crashes, interest and exchange rate shocks, as well as a general
economic recession leading to deterioration in the average creditworthiness of the bank’s borrowers. Generally speaking,
the objective of stress tests is to determine the (hypothetical) losses which would arise from the realization of certain risks
generally inherent to banking operations. Depending on the type of risk, main distinctions are made between market risk
factors (e.g. prices, interest rates, stock indices, exchange rates, etc.) and credit risk factors (e.g. expected default rates,
creditworthiness of business partners, etc.). In addition, stress tests may also extend to other risk categories (e.g. liquidity
risk, operational risk, etc.).”
(http://www.oenb.at/en/finanzm_stab/finanzmarktstabilitaet/Systemrisikoanalyse/Stress/stress_tests.jsp)
a methodology to stress test the system will typically be under the purview of the
central bank. 37 This entails assessing how a sudden crisis scenario will affect the
financial market and the banking system as a whole. Such macro stress test focuses
on "systemic risk," which refers to risks to the overall stability of the financial system.

In stress-testing the entire banking system, additional aspects other

than credit and market risks need to be taken into account. One of these is the
contagion risk due to wide-ranging credit relationships among banks such that
insolvency in one institution could set off a domino effect that threatens the stability of
the overall system. There are also macroeconomic risks. An example of which is the
risk of considerable deterioration in the average creditworthiness during a recession,
thereby eventually triggering higher default rates.

In recognition of the evolving analytical requirements, the BSP has

begun work in stress testing both at the macro and micro levels.

4.4.2.1. STRESS-TESTING AT THE MACRO-LEVEL

Several in-house analytical tools have been developed and are

continuously being enhanced for regular macroeconomic surveillance in aid of
monetary policy review. This is part of the effort to ensure that risks to the
attainment of the inflation target are incorporated in the formulation of monetary
policy.

The analytical methods developed can be broadly categorized under the

family of early warning systems (EWS), whose prominence was highlighted
anew in the aftermath of the 1997 Asian financial crisis. An EWS, as the name
implies, is forward-looking and probabilistic. EWS models typically have an empirical
structure and attempt to forecast the likelihood of certain types of “crises” using
factors such as country fundamentals, developments in the global economy and/or
global financial markets, and, in some cases, political risks (IMF, 2002).

Being forward-looking, the assessment of likely scenarios is carried out

through stress-testing using different assumptions of economic shocks. Such
type of analysis helps authorities monitor movements of key macroeconomic
variables particularly when their values diverge from normal trends within the time
horizon over which the forecast of a crisis is defined. Deviations from normal trends
are interpreted as warning signals of a potential crisis occurring within a specified
timeframe. These signals allow them to issue prompt corrective action, if deemed
warranted, and thus, avert a full-blown crisis.

In 2005, the BSP conducted a study on “Early Warning System (EWS) on

Macro Economic-Identification of Business Cycles in the Philippines.” The
study provides an early warning system for monitoring turning points in economic
activities, especially on any impending slowdown or contraction in the economy.
(DES, 2005)

The Vulnerability Indicator Early Warning System (VIEWS) for economic

and financial monitoring was also completed under the auspices of the Asian
Development Bank. VIEWS has the advantage of providing an automated process
for assessing the probability of both currency and banking crises within a 24-month
horizon. It adopts a non-parametric method, using high-frequency data with long back
37
This points to the need for arrangements which foster close co-operation, particularly where the central bank is not the
bank supervisor and hence may not collect data directly (as is the case in Australia).
series. Being a prototype model and hence, subject to different response to country-
specific conditions, VIEWS is currently undergoing review and fine-tuning.

Efforts are currently underway in developing a parametric EWS currency

crisis model. This is intended to complement the analysis made from the BSP’s
macroeconometric models, and will be used to prompt the BSP of possible impending
period of serious difficulty so that preemptive measures could be undertaken
accordingly.

The BSP likewise conducted a study that attempts to gauge the extent of
banking sector fragility using the Bank Distress Index (BDI). The dates of
banking crisis as derived from the BDI model may be used in the construction of the
signal indicators that will constitute an early warning system model for banking crisis.
More importantly, the BDI may be used in the quantification of systemic risk arising
from the grant of financial assistance by BSP to troubled banks and PDIC. However,
data problems pose limitations to the use of BDI (DER, 2003).

A crucial part of the mandate of the BSP is to ensure external debt

sustainability. Sustainability and vulnerability are key concepts used in assessing
debt sustainability. Sustainability relates to solvency and liquidity while vulnerability
pertains to the risk of insolvency or illiquidity. Put simply, debts are unsustainable if
the debt ratio rises without bounds. Since the evolution of the debt-to-GDP ratio is
defined by key macroeconomic parameters such as GDP growth, interest rate, and
primary balance, macroeconomic stability is a pre-requisite for debt sustainability. It is
generally accepted that an economy with larger and volatile macrofluctuations is also
highly vulnerable to liquidity shortfalls that can readily spill into debt-servicing
problems.38

The BSP-Department of Economic Statistics and the International

Department had already completed the first phase of external debt
sustainability system whose design is akin to the EWS for currency crisis . As
with any early warning system, the crucial decision point is the level of distress the
government is able to tolerate. While the approach is non-parametric, it, nonetheless,
provides a gauge of potential source of vulnerability and policy prescriptions to stay
within the sustainable path, i.e., debt can be continuously serviced without resort to
exceptional financing or a major correction in the future balance of income and
expenditures.39 Just like other EWS, the new debt sustainability management system
also undergoes periodic assessment and recalibrations to improve the reliability of
estimates.

Appendix I explains methodologies for the EWS described above more fully.

4.4.2.2. STRESS-TESTING AT THE MICRO-LEVEL

At the micro level, new early warning tools were added to existing
regulatory reports for the purpose of enhancing offsite surveillance system.
The new early warning tools are:40

38
2004 Socioeconomic Report (box article on fiscal sustainability in the Philippines).
39
IMF (2004)

40
Bangko Sentral ng Pilipinas. Updates on BSP Supervision and Regulation. June 2005.
 (a) Bank Performance Reports (BPR) system
(b) Use of Comprehensive Bank Folders
(c) Preparation of Top Corporate Borrower Reports
(d) Bank Early Warning System

The BPR system and the comprehensive bank folders are intended for
monitoring the financial performance of supervised entities in between on-site
examinations. The BPR contains compact information on key performance
indicators that support CAMELS 41 soundness analysis. Current performance levels
are related to historical trends and relative performance vis-a-vis peer group.

The Top Corporate Borrower Reports, on the other hand, are used to
measure and monitor the total exposures of the banking system to a particular
borrower, family, and/or business group, as well as any developments in the
loan-beneficiary industries which could affect the status of such exposures.
The reports provide bank-by-bank exposure of major corporate borrowers, on both
solo and affiliated group basis, as well as facilitate comparison and harmonization of
individual bank classification of corporate accounts and regular monitoring of potential
lending concentrations that can have serious consequences on banking stability.

The Bank Early Warning System (EWS) is a statistical model that

generates one-year-ahead forecasts of key bank performance variables,
especially solvency and asset quality. This is used to help prioritize on-site
examinations.

4.5. ORGANIZATIONAL DEVELOPMENT

The ability of the central bank to effectively foster monetary and

financial stability rests on strengthened market intelligence capability. Central
bankers are essentially knowledge workers whose primary tasks involve the
management of knowledge and information. Management’s role, therefore, is to
influence the effective and efficient use of knowledge and to maximize its impact
towards the attainment of the Bank’s objectives.

4.5.1. CORPORATE CULTURE FOR MODERN STRUCTURE

The ideal culture for a modern corporate structure is one that is driven
by commitment to outputs rather than inputs. Thus, performance rating is heavily
anchored on the quality of outputs and less emphasis on the amount of resources
spent doing the tasks. Quality encompasses meeting work objectives through
complete staff work delivered well within targeted dates of completion. By
emphasizing on quality and timeliness, every employee is empowered to take
responsibility for his outputs. As such, there is a need for constant re-examination of
tasks for greater focus on core assignments.

The emphasis on outputs rather than inputs calls for adopting leaner
and flatter corporate structure that rewards excellence and commitment.
Towards this end, the BSP has engaged an organizational development consultant to
explore the benefits of making its organizational structure flatter, which is considered
more apt for

41
Capital adequacy ratios; Asset quality ratios; Management indicators; Earnings quality indicators; Liquidity ratios;
Sensitivity to market risks
knowledge workers. A flatter structure can result in faster turnaround time for tasks,
even as it allows employees to gain better appreciation of various dimensions of their
assignments.

To ensure adequate safeguards and proactive response to demands from the

BSP, a performance assessment program, which include analysis of gaps in service
delivery, has to be sustainably carried out. Toward this end, well-structured
client/customer satisfaction surveys can be periodically conducted among internal
and external clients. In this manner, management can improve on gains achieved as
well as proactively assess and address the gaps and dysfunctions identified.

4.5.2. FLATTER ORGANIZATIONAL STRUCTURE

A flatter organizational structure is perceived to better aid knowledge

creation. The BSP’s top-bottom structure is typical of central banks and other
institutions in the bureaucracy. There has been a growing trend among public
institutions, however, in adopting leaner and flatter corporate structure. Oftentimes,
the process of knowledge creation evolves in an unorganized manner, and therefore,
difficult to predict. Since all organizations engage in knowledge creation, it is
important to develop a more systematic knowledge management system within the
organization. It has been argued that such effort necessitates departure from the
traditional hierarchical model. Nonaka and Takeuchi (1995) provide a cogent and
simple description of three management models and how each facilitates knowledge
creation. A summary is discussed below.

Under the top-down model, knowledge creation is limited to information-

processing where simple and selected information is relayed up the pyramid to
senior management, who then use it to create plans and orders, which are
eventually passed down the hierarchy. Top management decisions become the
operational conditions for middle managers, who then decide on the means to realize
them. Middle managers’ decisions, in turn, constitute the operational conditions for
front line work. Thus, work at the frontline becomes largely routine and the whole
knowledge creation process involves huge amount of work and information.

At the other extreme is the bottom-top model, which emphasizes

autonomy and has a flat and horizontal shape. Interaction is minimal and only
certain individuals, not a group of individuals, interact to create knowledge.

The top-down model is suited for dealing with explicit knowledge but it could
neglect the development of tacit knowledge that takes place at the front line. Bottom-
up model, on the other hand, is appropriate for the creation of tacit knowledge.
However, its emphasis on autonomy makes it difficult to disseminate information
within the organization.

A middle ground is the Japanese-model of middle-up-down management

process. The approach emphasizes the role of middle managers in knowledge
creation. Middle managers are often disparagingly portrayed as unnecessary layers
in the bureaucracy and obstructions to knowledge creation. In Western societies,
there has been a trend in downsizing middle management in the process of attaining
flatter structure. In this new model, however, they are seen as the prime movers of
change and ideas. Hence, they should reflect the essential qualities of leadership,
innovativeness and dynamism required of top management.
 The requisite qualifications for middle managers to become effective
knowledge engineers are highlighted in this new model. These include:

(a) top notch capabilities in project coordination and management;

(b) highly skilled at formulating hypotheses in order to create new concepts;
(c) ability to integrate various methodologies for knowledge creation;
(d) effective communication skills to encourage dialogue among members of the team;
(e) proficient at employing metaphors in order to help others generate and articulate
imagination;
(f) capability to engender trust among team members; and
(g) ability to envision the future based on deep understanding of the past.

A mutually reinforcing loop among the top, middle, and bottom rungs in the
corporate ladder would also call for visionary leaders, who can effectively articulate
corporate visions and objectives, and challenge the employees in actualizing these
corporate goals. They have the uncanny ability of choosing the right team leaders as
well as possess the willingness to take risks and failures.

In a central bank, task differentiation among diverse units would require

different structure. Flatter set-ups with strong middle management would seem to
work best for units involved in, say, research and analysis but the top-down set-up
would seem to fit highly sensitive and structured sectors such as those in cash and
comptrollership, among others. Thus, it may be important to have an assessment of
how each unit should be reconfigured to better respond to the demands of modern
central banking. Such reconfiguration will also mean modification of the qualification
requirements for entry into the BSP.

4.5.3. SEAMLESS FLOW OF INFORMATION

A strong research and bias-for-action culture calls for “seamlessness”

of flow of ideas and information among analysts. Area specialization should not
be associated with monopoly of sector/area-specific information and skills.
Oftentimes, sectoral specialization overlooks the need for constant information
exchange for enhanced cross-leveling of information across the different units in the
organization.

Known as the embodiment of middle-up-bottom structure, Canon’s corporate

philosophy of “three self spirit” (Nonaka and Takeuchi (1995), pp140-150) – the spirit
of self-motivation, self-knowledge and self-government – is highly informative. Its
management philosophy also enabled Canon in some ways to operate in a
bottom-up manner, where views and opinions generated from various technical
fora were strategically packaged into concrete operational details. Middle
managers remain in constant dialogue with senior management as the operational
details of the ideas are being developed. In this manner, they provide the strategic
link in knowledge creation --- link that binds the grand vision of management with the
chaotic realities at the bottom of the corporate ladder. 42 This is akin to 3M’s approach
42
“The Canon Minicopier (PC-10 and PC-20) introduced in 1982 was an offshoot of senior management’s vision of developing
a small multi-feature product that could be used by anyone and produced at minimum cost. It was the brainchild of the
Feasibility study team headed by Hiroshi Nitanda whose members consisted of people from R&D, marketing, production,
and product design. The team produced a conceptual breakthrough in the form of disposable cartridge, which does away
with costly regular maintenance service. With management’s imprimatur, the idea of disposable cartridge was transformed
into actual production through the Mini Copier Task Force consisting of 130 members and eventually involved more than
200 scientists in pure research, product development, product engineering and consumer research”. (Nonaka, 1995).
that has the so-called 11 th commandment, i.e., “Thou shall not kill ideas for new
products,” which could be very useful especially in generating ideas from the rank-
and- file about systems and processes and even policy options and implications.

4.5.3.1. EFFICIENT DATABANK MANAGEMENT

In developing a research and bias-for-action culture, the databank

system is highly critical. The systems and processes in files organization and
databanking can be streamlined to ensure that analysts have uncomplicated but
privileged access (hence, subject to internal policies on use and dissemination of
data) to real-time data and relevant common-use files. This is particularly important to
units that are normally given quick-response assignments. Access to real time data
saves time and effort in terms of data validation and face-to-face contact with data
compilers, thus, allowing analysts to concentrate on the analytical aspect of the work.
As access is facilitated, data integrity should not be compromised.

In July 2003, the Monetary Board laid the groundwork for centralized
data warehousing and query system within the BSP to facilitate the handling
and exchange of information on financial and non-financial data. The data
warehousing project is a bank-wide initiative to be executed in phases. The first
phase will focus on the requirements of the Supervision and Examination Sector
(SES) with linkages to the Department of Economic Research (DER) and Philippine
Deposit Insurance Corporation (PDIC) while the second phase shall cater to the data
requirement of other BSP departments.

Phase I of the Data Warehouse project is envisioned to deliver timely

data essential for off-site and on-site examination with value-added
functionalities for data analysis. The general framework of the Data warehouse is
designed to extract, load and transfer essential financial and non-financial data from
existing databases which shall be processed and made available to different users of
information with varied levels of access for security purposes. Business intelligence
tools available through the Data Warehouse will enable users to define essential
report parameters with options for automated report generation, financial statement
analysis and peer analysis, among others. Design, development and implementation
of Phase I will span a period of one year.

Prior to the data warehousing project, the DER already has the DBank
project that facilitates remote access to time series maintained by the
Department of Economic Statistics. 43 To date, the DBank remains operational and
continues to service the needs of the Monetary Board, BSP Senior Management and
DER analysts. Since the design of the DBank is expectedly more attuned to the
requirements of the data compilers, its user-friendliness feature is limited. For the
uninitiated researchers, the initial use of DBank is a hit-or-miss experience because
the data codes and latest workfiles are not readily known. 44 Despite the goodwill
established with the statisticians, it would have been more efficient if users have
uncomplicated access to real-time data, complemented by search buttons where

43
Prior to BSP reorganization, the current Department of Economic Statistics was a unit under the Department of Economic
Research (DER).
44
Unless one is sufficiently briefed about the need to approach individual statisticians maintaining the time series of interest to
obtain accurate information on data codes and workfiles, a bank researcher with access to the DBank may inadvertently cull
series from erroneous workfiles.
definitions, corrections, and even changes in methodology can be similarly accessed.
These features could save a lot of time and effort of both data compilers and users
and at the same time, prevent data errors used in research work. Auspiciously, the
data warehousing project is seen to address these gaps.

Another program aimed at enhancing the quality of data management is

the proposed creation of the One-Stop Economic and Financial Literacy Center
(EFLC) that would integrate the Library, Statistical Center, Archives and other
information sources within the BSP. For one, BSP’s journal collections are
impressive. It is unfortunate, however, that these are rarely utilized. The planned
modernization of library facilities and digitization of library materials would enhance
efficiency of library services by making possible remote access to the BSP library.
Access to the virtual library will, nonetheless, require certain proprietary protocols and
security codes to ensure the integrity of the database and library collections.

4.5.3.2. PRIVATE SECTOR PROPRIETARY DATA

Another feature of the statistical landscape today is the proliferation of

private sector data,45 particularly in the area of financial asset prices. Prices in
the exchange are readily available and verifiable. However, with the increasing shift
towards over-the-counter (OTC) and non-standard products, this task is more difficult
and it becomes necessary to rely more on financial institutions' proprietary data.
Hence, the use of such datasets to infer market attitudes to risk and expectations
about the future would require increasingly sophisticated analytical skills.

4.5.4. MANAGEMENT STRUCTURE AND HUMAN RESOURCE DEVELOPMENT

An organization’s success depends on a strong employee base interacting

with visionary leaders.

A look at BSP’s manpower complement (as reported in the 2004 draft

BSP strategic report) reveals an organizational structure that is bottom-heavy
with the non-executive positions accounting for the bulk of its manpower
complement. The challenge with bottom-heavy organizations has to do with
considerable time lags in sharpening both institutional and industry knowledge and
skills, deficiency in which impinges on management succession program.
Notwithstanding its limitations, the BSP has consistently remained as the best
performing and among the most highly respected government agencies in public
surveys. One can therefore envision impact that developing the full potentials of its
employee base through strategic human resource development program will have on
its performance.

Bottom-heavy organizations with rigid, hierarchical structure could also

dampen initiative and creativity, thus, undermining the culture of
accountability. Weak accountability slows down upward mobility, which, in turn,
could spawn disenchantment particularly among those with longer tenure. There is,
therefore, a need to develop a management culture and processes that facilitate
shorter and

45
The caveat on the use of survey of economic conditions applies, i.e., policy analysts should not attach too much weight to it
until after performance over a period of time long enough for some business cycle fluctuations to have been observed and
methodologies for compilation are known to the users. A good dialogue with the compilers of these data is therefore
necessary.
quicker reporting; and promote employee creativity, greater participation in the work
process, greater sense of ownership and accountability, and development of
leadership skills.

This management culture expectedly demands greater accountability

from middle managers since they provide the crucial link between the top
management and the rest of the workforce. A critical aspect of the role of middle
managers in the organization is to influence their staff to aspire for the realization of
BSP’s goals by improving their own competencies, which will manifest in the
improvement in service delivery to the Bank’s internal and external clients. In the end,
empowering an organization entails having individuals possess the knowledge, skill,
desire, and opportunity to succeed in a way that leads to collective organizational
success (Covey, 1996).

4.5.4.1. INCENTIVES

The BSP’s new incentive package has opened the avenue for culture
change and for exacting greater accountability from its people. Nonetheless, the
security of tenure provided by civil service rules together with this corporate pay
structure may also prove to be perverse incentive and produce complacency. To
guard against that, it may be helpful to conduct comprehensive skills and
performance mapping vis-à-vis organizational skills and competencies requirements.
Such mapping would help identify knowledge gaps more clearly and aid in the
formulation of a comprehensive and strategic human resource development program
that is responsive both to individual career goals and organizational modernization
thrusts.

In this respect, the extent of BSP’s administrative independence in designing

its human resource management system may have to be re-evaluated, considering
that it remains circumscribed by Civil Service rules.

4.5.4.2. WELL-STRUCTURED TRAINING PROGRAMS

Trainings have to be viewed as much more than a part of the incentive

package. The concomitant responsibilities of both the staff trained and management
to appropriately accommodate new learnings into the work process require particular
attention. Organizational and administrative structures that are compatible with and
that facilitate the efforts to make the acquired skills and knowledge more productive
should be introduced or reinforced.

Notwithstanding the demonstrated commitment and individual capacity

of BSP employees, the statistics on employees obtaining higher education has
been rather low for an organization as big as, and like the BSP. For instance,
based on the professional profile of BSP, 46 12.86 percent of regular employees have
Master’s degrees, 0.33 percent have doctoral degrees, and 53.11 percent of the
4,873-strong workforce have college degrees.

Knowledge gap could become particularly acute in a fast-paced and

highly deregulated environment, where more involved analyses underpinned
by stronger market intelligence capability are primordial. There are, of course,
departments whose functions do not necessitate obtaining post-graduate degree for

46
Source: BSP-HRMD. Statistics on Personnel Highest Educational Attainment, as of March 15, 2006.
upward mobility and effective discharge of responsibilities. Even so, obtaining higher
education, whether or not it is necessary for current functions, would greatly facilitate
lateral mobility.

Section 24 of RA 7653 authorizes the Bangko Sentral to sponsor the training

of qualified technical personnel. Realizing the imperative of upgrading and
sustaining technical skills and knowledge of BSP personnel, the BSP
Educational Scholarship and Training (BEST) Program for graduate studies
abroad was established in December 2004 under MB Resolution No. 1773, as
amended by MB Resolution No. 1904. The BEST program is a mechanism for
creating a pool of BSP personnel with specialized skills and training suited for
advances in central banking practices.

More so, financial innovation and the changing nature of financial

supervision and structure necessitate retooling/rechanneling of current human
resources through well-structured academic and non-academic training
programs and recruitment of new personnel with the needed background.
These are complicated further by the sui generis nature of central banks in their
respective countries at least such that it might be necessary for them to create their
own supply of human resource.

The development of appropriate training programs will require closer

networking with the industry and the academe. Central banks increasingly need to
be attuned to the latest insights of market participants. In addition, the curricula of
leading business schools and actual industry practices provide the best signals to the
central bank on trends in banking and finance, and hence, help it design appropriate
training programs. A closer relationship with the academe not only facilitates access
to their research capability but also presents the BSP as a viable career option to
their best students.

Part of the effort to link up with the academe is the establishment of the BSP
Professorial Sterling Chair in Monetary and Banking Economics, a partnership with
the UP School of Economics. A similar partnership with the UP School of Statistics
has been established through the BSP Sterling Professorial Chair in Government and
Official Statistics. It is hoped that these partnerships with the UPSE and UP School of
Statistics, institutions that are known for their outstanding reputation for research,
would inject greater rigor in research at the BSP and encourage a more dynamic
dialogue between theorists and market practitioners. Environmental scanning fora
also serve as avenues for gaining insights on topical economic issues from industry
practitioners and researchers from the academe.

To ensure a deep pool of human assets, strategic implementation of the

following, or a combination of them, would be useful:

(i) Designing and implementing Certificate courses (under the BSP Institute)
on various and specialized aspects of finance/monetary/central banking
for employees/outsiders in coordination with foreign or local
professors/visiting scholars/industry practitioners. This is important for
career mobility among employees and for outsiders interested in applying
to the BSP/working in the market.

(ii) Coordinating with Economics, Finance, Math, and Science departments of

universities to include courses relevant to finance/central banking in their
 undergraduate/graduate programs.

(iii) Six-month training programs similar to those of other financial and

multilateral institutions, which shall be open to both incumbents and
outsiders on a limited-slot and competitive basis:

(a) Officer Development Program for MA/PhD degree holders; and

(b) Junior Officer/Specialist Program for BA/BS graduates;

The participants will have to pass written and oral exams, and do group
projects. They will be assigned for 6 months, after passing the training
phase, to a sector, preferably operations and not the sector where the
trainee will eventually be detailed. In this manner, the trainee gains deeper
appreciation of what the BSP does and will have the appropriate
perspective when he applies/is appointed to his chosen unit.

4.5.4.3. MENTORING PROGRAM AND MANAGEMENT SUCCESSION

To foster broad-based acquisition of sectoral knowledge as well as

application of acquired skills in the work setting, well structured
mentoring/coaching program on major Bank operations (with clear timetable
and measurable outputs) will have to be institutionalized. In this manner, gains
from both academic and non-academic trainings can be maximized. Knowledge and
skills gained from trainings, if not properly applied in the actual work setting, will
eventually become meaningless.

An effective mentoring program is a good complement to a management

succession program. This is a self-reinforcing process that allows cross validation
of learning. Staffs are not only trained but supervisors also continuously sharpen their
knowledge and skills as they progressively impart knowledge to their staff. Continued
enhancement of knowledge and competencies facilitate achievement of greater
productivity, thus, promoting the well-being of the organization and its people.

4.5.4.4. PHYSICAL SET-UP AND INFRASTRUCTURE

Apart from monetary incentives and improved systems and processes,

organization development literature also gives equal emphasis to the physical set-up.
Differentiated set-ups may be necessary for different types of work. An
assessment of how physical set-ups affect work flow and processes has been integral
in the Bank’s organizational development planning and has been embodied in the
Bank’s Space Rationalization and Furniture Standardization project.

5. CONCLUSION

The foregoing discussion highlights the pillars, so to speak, that support the
conduct of monetary policy, the challenges that could weaken these pillars, and
possible courses of actions that BSP might want to explore to turn these challenges
into opportunities to improve the evaluation, setting, and execution of monetary and
financial stability policies.
 The BSP is fully aware of the need to ensure that policy prescriptions to
address modern-day challenges are appropriate. It has, in fact, embarked on
activities aimed to strengthen its research capability in terms of personnel and
physical infrastructure. It also has a clear, comprehensive and integrated research
agenda that seeks to clarify and continuously evaluate policy objective, the
transmission channels of the policy instrument, and the policy-setting framework
(e.g., rules versus discretion). Its plan documents also spell out the role that each
sector plays in attaining its objectives. What remains, therefore, is undistracted
implementation of its strategic plan.

Former Federal Reserve Governor Alan Blinder (1998) concludes that

“looking out of the window” is not optimal for monetary policymaking. The
increasingly complex economic landscape requires central bankers to
rigorously think through the end policy actions and commit to a stand in the
current period given presently available information even if it is known that in
the next round of evaluation, a revision of long-term plans is inevitable. Thus, it
may be instructive to the policy-setting process for the BSP to specify policy “rules” or
policy objective functions. It is worth noting that doing so does not mean an
abandonment of the inflation targeting framework. Far from supplanting Monetary
Board judgment with model outcomes, rules enhance the ability of policymakers in
exercising discretion. Models help in evaluating the assumptions that go into the
various scenarios being evaluated, the transmission mechanism, and the impacts of
changes in economic variables. Implementing this, however, requires statistics on
potential output, and estimates of the neutral interest rate and the optimal inflation
rate target in the long run. Current efforts in the central bank to evaluate output gap
estimation methodologies and the usefulness of output gap in monetary policy should
be a useful foundation of this end.

Likewise these efforts to estimate and investigate the usefulness of output gap
could provide the springboard for evaluating whether it pays for the central bank to
engage in real stabilization. The optimal point in the so-called Taylor curve, with
inflation variability in the y-axis and output variability in the x-axis, implies
some weight being given to the deviation of output from potential. The
estimates of potential output, along with those for long-run inflation target, can be
used to evaluate policy rules, e.g., Taylor rule, and the role, if any, that such rules
should play in the conduct of monetary policy.

A vital analytical tool for any central bank is a clear representation of

active transmission channels of monetary policy. Because – as famously pointed
out by Milton Friedman – of the “long and variable lags” of the effects of monetary
policy on the real economy, central banks must be guided by empirically estimated
transmission channels in order to maximize the impact of policy interventions. It is
vital that the impact of structural changes in the economy and in the monetary and
financial system be clarified to ensure that the economy is not only moving towards
the desired direction but also at an appropriate pace. For this reason and also for any
real47 or monetary stabilization policy to be effective and efficient, the transmission
channels to the real economy of the policy instrument need to be specified and
estimated. The value of transmission channels to policymakers is, likewise, a function
of their ability to explain the impact of rapid financial products innovation, economic
integration, e- money, technological shocks, and asset prices on the channel itself.
47
There is agreement that even though monetary policy cannot and should not try to control output in the long run, it impacts
on the variability of actual output around potential in the short- to medium-term.
 Domestic asset markets have yet to shed inefficiencies. It is hardly debatable
that an efficient peso-dollar market or securities market, for example, redounds to
more effective implementation of monetary policy. Thus, theoretical and empirical
investigations of methods to increase the efficiency of asset markets would seem to
be in order. At a practical level, a system of statistics that would allow rigorous
studies on asset valuation has to be strengthened at the onset. The procedure and
the timing for reforms need more intensive treatment than this paper could allot. On
the whole, what is relevant to the BSP is the role that the foreign exchange and
the asset market in general should play in an inflation targeting regime. For
instance, in the aftermath of the Asian financial crisis, a number of studies tried to
address the question of whether central banks should – or could – arrest the onset of
price bubbles, prick asset bubbles, or just ensure soft landing for the economy once
bubbles burst.

Meanwhile, it is generally admitted that a stable financial system is a

responsibility of central banks.48 The success – and hence, stability – of any
financial system rests, not merely on having the most modern exchanges and
most sophisticated financial legislations, but, more importantly, on the level of
sophistication of the financial reporting and audit system, enforcement of
property rights, debt resolution/bankruptcy mechanism, credit rating and
corporate governance system.

Many of the reform areas within the BSP’s control would necessitate
continuous strengthening of its oversight functions principally by adapting its
own systems, processes, and HRD programs to the growing sophistication of
the financial market. Flatter structure complemented by competency-based HR
program would greatly aid in infusing greater efficiency in the selection process both
for hiring and training.

For reform areas not explicitly within the ambit of the BSP’s powers and
responsibilities, actively promoting them would not only strengthen the corporate
sector and the economy in general but would also help in deepening the financial
sector (e.g., capital market development).

No matter the regulatory form the BSP decides to take, it may be hard put to
take out of the equation the nature of the increasingly globalized financial system and
the moves towards a more economically integrated Asian/ASEAN region. For any
shift in the regulatory framework, it is best to follow a gradualist approach
rather than a “Big Bang” technique. To minimize things falling “between chairs”,
the integrated regulator model might be considered, or the Financial Sector Forum
could be given formal powers to define responsibilities and strengthen coordination
among the financial sector regulators.

48
The debate in current literature is whether to explicitly include financial stability objective in central bank objective functions.
For instance, Svensson (2002) writes that during “normal circumstances, financial stability does not pose a constraint on
monetary policy” (p.288)
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 Appendix I
EARLY WARNING SYSTEMS ESTIMATION METHODOLOGIES

EARLY WARNING SYSTEM (EWS) ON MACRO ECONOMIC-IDENTIFICATION OF BUSINESS CYCLES IN THE

PHILIPPINES.

Using the real Gross Domestic Product as the overall measure of current economic activity, the
business cycle path of the economy was measured using the growth cycle method, i.e., by examining the
quarterly movement of real GDP (net of agriculture) from 1981-2004. The RGDP growth rate series was
adjusted by removing seasonal and long-term trend components. The resulting series identifies the
business cycle turning points.

EARLY WARNING SYSTEM FOR DETECTING THE PROBABILITY OF CURRENCY CRISIS

In the non-parametric currency crisis model, a currency crisis is defined as a situation in which
an attack on the peso leads to sharp depreciation, a large decline in gross international reserves, or a
combination of the two. The identification of a currency crisis is based on the index of exchange market
pressure (EMP). The EMP index is computed as follows:

EMPt = % et - %rt

where:
% et - monthly percentage change in the nominal exchange rate
%rt - monthly percentage change in the gross international reserves
 - % et / % rt
% et - standard deviation of % et
% rt - standard deviation of % rt

A currency crisis occurs if EMPt > EMP + TEMP

where:
EMP - mean of EMPt
EMP - standard deviation of EMPt
T - 1.5 with  = 5% level of significance

Using monthly time series data on exchange rate and GIR, the EMP threshold = EMP + 1.5 EMP
equals 7.2. This threshold means that any month is classified as a currency crisis point if the EMP
exceeds 7.2.

The signals approach was then used to evaluate the ability of an indicator to provide advance
warning on an impending currency crisis. When an indicator deviates from its normal value and assumes
an extreme value beyond a certain threshold, this is taken as a warning signal of an impending currency
crisis. The possible thresholds of an indicator are the values corresponding to the 80 th percentile and
above or the 20th percentile or below or some other predetermined percentile.

A parametric EWS model currently being developed is essentially based on the probit regression
analysis.49 Compared to the signals approach, a major advantage of a regression-based EWS model is
that it is multivariate and considers all explanatory variables simultaneously. The impact of a particular
indicator on the probability of a crisis is conditional on values of other indicators in the model. A further
advantage, as mentioned earlier, is that it allows testing of statistical significance of individual indicators.

The parametric EWS currency crisis model being developed deviates from the earlier models in
that it is basically a combination of autoregressive conditional heteroskedasticity (ARCH) and probit

49
In a typical regression, the dependent variable can take on any number of possible numerical values. This would be true, for
example, in research which relates the level of consumption to its determinants. By contrast, in the first stage of this paper, we
attempt to explain whether or not a crisis occurs. A probit model would be appropriate for the present case, when the
dependent variable can take on only two possible values (i.e., 1 for crisis periods and 0 for non-crisis periods). The probit
equation then yields the initial estimate of the probability that the dependent variable takes on a value of 1 (i.e., the probability
that a crisis occurs). This estimate is refined further in the second stage, which uses an autoregressive conditional
heteroskedasticity (ARCH) equation.
approaches. In addition, the DER employed the results obtained in the non-parametric EWS model of the
BSP in constructing the parametric EWS model. The model was estimated using quarterly data from Q1
1980 to Q4 2004.

The development of the BSP’s parametric EWS model for currency crises consists of two steps.
First, a probit model is estimated by regressing the crisis index—the binary transformation exchange
market pressure (EMP) index in the non-parametric EWS model—on the composite index, likewise
computed in the non-parametric model. Predicted values of crisis probabilities are generated from this
probit estimation. Second, a generalized autoregressive conditional heteroskedasticity (GARCH) model is
estimated by regressing EMP raw index on various indicators used in the non-parametric model and by
including the predicted crisis probabilities generated from step one as an additional explanatory variable
in the variance equation.50

THE VULNERABILITY INDICATOR EARLY WARNING SYSTEM (VIEWS)

In essence, VIEWS identifies leading indicators of crises and estimates their corresponding
threshold levels. The identification of leading indicators is based on established economic rationale while
threshold estimation for each leading indicator involves minimization of noise-to-signal ratio (NSR). 51 All
indicators with NSR less than unity are shortlisted. Composite indices are then computed and their
respective probability distribution mapped out, from which the overall probability of crisis 52 can be
estimated.

Currency crisis is defined using exchange rate market pressure index (EMPI) 53 where a standard
deviation higher than two indicates a crisis episode. Crisis identification for banking crisis, on the other
hand, is events-based, i.e., the duration of a crisis episode is defined to be equivalent to one year. Thus,
in cases of multiple crisis episodes within a 12-month period, the reckoning of crisis episode would be the
month when the crisis first became manifest.

BANK DISTRESS INDEX (BDI)

The Bank Distress Index (BDI), was developed to date the banking crisis episodes in the
country. This measure uses the numerical-based method in identifying banking crises. The BDI was
computed as follows:

t 23
BDI = 
t Financial Assistance + Liabilities of Closed Banks

Gross Domestic Product

The numerator in this BDI has two components: financial assistance and outstanding liabilities of
closed banks. Financial assistance granted by the BSP consists of emergency loans to banks, loans to
PDIC and overdrafts incurred by banks. The second item in the numerator refers to the outstanding value
of liabilities of banks as of period of closure. To avoid double counting, however, we deduct from total

50 Essentially, while a typical regression equation specifies how the level of a dependent variable changes in response to
changes in values of explanatory variables, an equation in the ARCH family of models accounts for changing variance of the
dependent variable through time by modeling how this variance responds to certain other variables. A GARCH model extends
the ARCH model by allowing for lagged forecast variances in the conditional variance equation.

51
Noise- to-signal ratio (NSR) = probability of signaling non-crisis episodes
probability of signaling crisis episode
for an indicator to qualify, the NSR should be less than 1.
52
p = number of months with IL < I < IU with crisis occurring after 24 months
number of months with IL < I < IU
where: I refers to lower-bound index (minimum number of crisis episodes)
L

IU refers to upper-bound index (maximum number of crisis

episodes)
53
{ standarddeviation of exchange rate ⎞
EMPI  % change in exchangerate  | | % changein foreignexchangereserves
⎝ standarddeviation of foreign exchange reserves⎠
liabilities of closed banks their liabilities to BSP and PDIC, because the said liabilities already form part of
the financial assistance that has been factored in earlier.

The numerator includes only the financial assistance granted to and liabilities of closed banks
during a two-year window. The choice of a two-year window is consistent with the estimated 15-18 month
period for the full impact of monetary policy adjustments on inflation and output to take hold. It may be
noted that the grant of financial assistance expands reserve money and eventually domestic liquidity and
can have a similar impact as an expansionary monetary policy action. The approach of including only the
financial assistance and bank closure data in the past two years also eliminates from the BDI information
about the distant past which have no more impact on the system. Thus, the BDI is more representative of
the current situation of the banking system.

The BDI measure takes into account both the cost of rescue to the banking system as well as
the exposure of other sectors to the closed banks (i.e. liabilities of closed banks net of), and compares
this aggregate to the size of the economy (i.e., the country’s Gross Domestic Product or GDP, the
denominator in the formula). The ratio gives an indication of the effects on the economy of bank rescues
and could provide a measure of whether the costs involved have reached a certain proportion that could
be considered systemic.

Banking crisis literature points to excessive credit growth, recessions, burst of asset price
bubbles, and deterioration of loan quality and equity as factors precipitating a banking crisis. However, the
lack of consistent time series information on these variables or the relatively long time lags before they
become available make bank failure quite difficult to predict. The methodology is also not able to
distinguish the degree by which the BDI is below or above the crisis threshold level, which may contain
important information in assessing the sector’s fragility.

Sources: Department of Economic Research and Department of Economic Statistics