79232 This volume is a product of the staff of the International Bank for Reconstruction and Development/The World Bank. The World Bank does not guarantee the accuracy of the data included in this work. The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the views of the Executive Directors of the World Bank or the governments they represent. The material in this publication is copyrighted. FINANCIAL SECTOR ASSESSMENT PROGRAM UPDATE PHILIPPINES FOCUSED UPDATE OF THE BASEL CORE PRINCIPLES FOR EFFECTIVE BANKING SUPERVISION TECHNICAL NOTE APRIL 2010 INTERNATIONAL MONETARY FUND THE WORLD BANK MONETARY AND CAPITAL MARKETS FINANCIAL AND PRIVATE SECTOR DEVELOPMENT DEPARTMENT VICE PRESIDENCY EAST ASIA AND PACIFIC REGION VICE PRESIDENCY i CONTENTS PAGE Glossary of Terms ..................................................................................................................... ii I. Introduction ............................................................................................................................1 II. Overview ...............................................................................................................................1 III. BCP Update .........................................................................................................................2 A. Objectives, independence, powers, transparency, and cooperation (CP 1) ....................2 B. Transfer of Significant Ownership (CP 4) ......................................................................7 C. Large Exposure Limits (CP 10) ......................................................................................8 D. Exposures to Related Parties (CP 11) .............................................................................9 E. Country and Transfer Risks (CP 12) .............................................................................11 F. Internal Control and Audit (CP 17) ...............................................................................11 G. Abuse of Financial Services (CP 18) ............................................................................12 H. Corrective and Remedial Powers (CP 23) ....................................................................13 I. Consolidated Supervision (CP 24) .................................................................................15 J. Home-Host Relationships (CP 25) .................................................................................16 IV. Recommendations And Authorities’ Reactions.................................................................16 A. Recommendations .........................................................................................................16 B. Authorities’ reactions ....................................................................................................18 ii GLOSSARY AML Anti-money laundering BCP Basle Core Principles for Effective Banking Supervision BSP Bangko Sentral ng Pilipinas—Central Bank of the Philippines CAR Capital-Asset Ratio CP Core Principle DOLI Directors’ and officers’ liability insurance DOSRI Directors, officers, stockholders and related interests FSAP Financial Sector Assessment Program FSF Financial Sector Forum FSR Financial Stability Report FRP Financial Reporting Package GBL General banking law GSIS Government Services Insurance System IAS International Accounting Standards ICAAP Internal capital adequacy assessment process MOU Memorandum of Understanding PCA Prompt corrective action PDIC Philippine Deposit Insurance Corporation ROPA Real and other property acquired SBL Single borrower limits SEC Securities and Exchange Commission SME Small- and medium-size enterprise SPV Special purpose vehicle SRP Supervisory Review Process 1 FOCUSED UPDATE OF THE BASEL CORE PRINCIPLES FOR EFFECTIVE BANKING SUPERVISION INTRODUCTION 1. This focused assessment of the current state of the Philippines’ compliance1 with the Basel Core Principles for Effective Banking Supervision is an update of the detailed assessment completed as part of the IMF-World Bank Financial Sector Assessment Program (FSAP) that took place in 2002. Thus, the current assessment targets those BCPs for which the initial assessment was Non-Compliant or Materially Non-Compliant, and those for which the FSAP had recommended reforms. As the original assessment had been made using the 1997 Methodology, which was superseded by the 2006 Methodology, the principles that were reviewed were mapped into the 2006 Principles. 2. This report should provide inputs for the enhancement of the BSP’s action plan to move toward full compliance with the Core Principles. The team expresses its thanks to the governor; the deputy governor of the supervision and examination sector (SES); the SES managing directors; assistant governors; the Legal Unit; and the SES directors and staff of the Bangko Sentral Ng Pilipinas (BSP), who cooperated in the completion of the assessment. 3. This assessment of the effectiveness of banking supervision was based on an examination of the legal and regulatory framework and benefited from the inputs of the IMF resident advisor, as well as the BSP’s very detailed self-assessment and responses to a questionnaire. OVERVIEW 4. The regulatory and supervisory framework for banks has been significantly strengthened since 2002, addressing several of the FSAP recommendations. Key changes included establishing the conditions for special-purpose vehicles to acquire the nonperforming assets that were left with the banks from the 1990s crisis; promulgating a new Anti-Money Laundering Act, broadly in line with FATF recommendations; and revising the PDIC charter, increasing the coverage for deposits and strengthening its power to examine banks. The same amendment to the PDIC charter also relaxed somewhat the bank secrecy law, so as to give both the PDIC and BSP more power to examine deposit accounts, which was a concrete recommendation of the previous FSAP. 5. The BSP has issued rules and guidance aimed at improving risk management and corporate governance of banks and strengthened its own capacity to monitor and 1 Prepared by Ms. Fabiana Melo (MCM). 2 intervene. The BSP issued new capital adequacy guidelines in line with Basel II (standardized approach for credit risk, basic indicator approach and standardized approach for operational risk, standardized and internal models for market risk, and Pillar 3 requirements), and introduced important guidance regarding risk-management functions in financial institutions. The supervisory overview of market and liquidity risks was enhanced with the introduction of new supervisory reports (the very comprehensive Financial Reporting Package and the Capital Adequacy Ratio Report) and with the coordination of the off-site function by central points of contact and specialized teams within on-site examinations. Monitoring of credit and concentration risk has improved with enhancements in guidance regarding large exposures and lending to related parties. 6. Supervisory coordination has also been strengthened with the creation of the Financial Sector Forum (FSF), which has resulted in improved exchange of information between the BSP and SEC for the mapping of conglomerates, and with the establishment of formal information-sharing agreements with five foreign supervisors. BCP UPDATE Objectives, independence, powers, transparency, and cooperation (CP 1) Principles 1(4) and 1(5) – Legal powers and Legal Protection 7. Principle 1(4) was previously assessed as Materially Non-Compliant, in particular because the bank secrecy law prevented the supervisors from having access to the names of deposit holders, with very restricted exceptions, and because there was ample evidence that the BSP’s enforcement action had been delayed and overruled by lawsuits. Subsequent analysis reinforced this perception and added that the PDIC situation is further complicated by the lack of resolution powers, such as bridge-bank authority. In order to comply with this principle, the 2002 FSAP recommended the bank secrecy law should be relaxed and the PDIC should be invested with more resolution legal powers. 8. Likewise, the previous detailed assessment considered Principe 1(5) Non-Compliant, since there were contradictory legal texts, whereas, if the BSP examiner did not exercise “extraordinary diligence in the performance of his duties,” he could be held liable. Recommendations then were that such legal inconsistency had to be solved and that the BSP and PDIC put in place the system of advancing litigation costs and expenses that was under construction at the time. 9. Since 2002 several changes in laws and regulations show a better picture. Circular No. 523/2006 amplified the scope of prompt corrective action powers of the BSP and expanded the remedial instruments available. More importantly, in April 2009, the government approved the Republic Act 9576, which relaxed R.A. No. 1405 (Law on Secrecy 3 of Bank Deposits), allowing the PDIC and/or the BSP “to inquire into or examine deposit accounts and all information related thereto in case there is a finding of unsafe or unsound banking practice.” The Charter of the PDIC has also been amended (R.A. 9302/2004 and the same R.A. 9576/2009) to give the PDIC more powers to conduct examination of banks and strengthening its regulatory and administrative authority. 10. Moreover, a recent decision by the Supreme Court on the Legacy Banks case stated that “the Monetary Board’s actions could not just be restrained or set aside by the [lower] courts unless it acted on a matter with grave abuse of discretion.” To do so “violates the “close now, hear later” doctrine, as implied under the New Central Bank Act or Republic Act 7653.”2 It reinforces that “Swift action is called for on the part of the BSP when it finds that a bank is in dire straits.” 11. Regarding legal protection for supervisors, some timid improvements have been implemented since the last FSAP. In 2004, the government allowed the Government Service Insurance System (GSIS) to insure BSP’s top-level officials (i.e., governor, members of the Monetary Board, assistant and deputy governors, and directors) against lawsuits derived of their supervisory actions and decisions. The GSIS covers legal expenses and damage claims filed by banks. In addition, in 2005 the BSP created a self-insurance fund: Directors and Officers Liability Insurance (DOLI). This complements the insurance provided by the GSIS and covers “all cases or suits—past and present—filed against a central bank official in relation to his/her work.” In addition, in 2008 the BSP created a dedicated Legal Services Unit (LSU) within the Supervision and Examination Sector (SES) to assist on legal issues examiners and supervisors come across in their day-to-day duties. 12. However, there are still major shortcomings in the current legal framework that affect not only the compliance with CP 1, but also the overall enforcement of the principles related to capital; ownership; consolidated supervision; corrective and remedial powers; and, mostly, the BSP’s capacity to conduct risk-based supervision. Given the widespread litigiousness of the domestic environment, these legal shortcomings are particularly relevant. 13. Recent improvements are not sufficient to guarantee that the supervisory work conducted by the BSP and PDIC is unfettered from fear of legal complications. There is evidence that the coverage of litigation costs by an insurance scheme is not sufficient to ascertain that the supervisors will not be troubled by litigation concerns while carrying out their daily duties. The legal text that considers supervisors not civilly liable only if they can 2 http://sc.judiciary.gov.ph/jurisprudence/2009/october2009/184778.htm 4 prove that they applied “extraordinary diligence” is still in force. In the meantime, some supervisors may limit themselves to checklists and procedural documentation, and the investments in training and selection of supervisory staff may be rendered ineffective if the more proactive supervisors start facing lawsuits and personal and professional insecurity. 14. Moreover, the emphasis on “extraordinary diligence” and “due process,” especially for procedural reasons, in fact limits the legal powers of the supervisors. The possibility of litigation by aggrieved parties based on procedural details seems to hinder different aspects of supervision, such as licensing and remedial and corrective actions. There is evidence that such peculiarity of the Filipino environment may explain the long and burdensome processing and grace periods encountered in regulations and supervisory actions. For instance, the PCA framework, though considerably improved, still involves long periods for the response of the financial institution before and after PCA is triggered.3 Although the above-mentioned recent Supreme Court ruling brings some hope that such excessive “due process” concern will not hamper the timeliness of BSP’s action in the future (so it is able to preserve the value of a troubled institution), there are conflicting signs: another recent decision by the same Court on AML disputes, for instance, stated that the owner of deposit accounts must be given prior notice of AMLA inquiries. 15. More power needs to be given to the BSP to update prudential regulation without the need of legislative change. This essential criterion is related to the discretionary powers of the supervisor and needs to be met, if full compliance is to be achieved. The BSP has put in extraordinary effort to update its prudential regulation to converge with internationally accepted practices and standards, but the establishment of detailed prudential limits, sanctions, and values of fines in legal texts instead of lower-level regulation makes it difficult for the BSP to fully achieve its goals. 16. The BSP is well aware that the curbs on discretionary powers and gaps in legal protection undermine its hard work toward risk-based supervision, as was highlighted by the 2002 FSAP assessment and subsequent IMF/WB evaluations. In that sense, the BSP has proposed amendments to the New Central Banking Act that address several of the most important issues:  The inclusion of financial stability in the BSP’s mandate, as well as the oversight of payments and settlements systems. 3 There are three types of corrective actions that can be taken by the supervisor before PCA is triggered: observation, expected action, and required action. The required action, which comprehends serious breaches of systemic nature, involves a written notice from the BSP to the institutions, then 90 days for an action plan to be submitted, then the analysis of the adequacy of such plan by the BSP. The BSP explained one of the reasons for the long proceedings is exactly to leave little margin for lawsuits. 5  The indemnification of all BSP personnel (not only senior officials) for legal expenses and the deletion of the “extraordinary diligence” requirement.  The authority to the BSP to request needed information from all persons and entities, which makes it possible for the BSP to supervise conglomerates “up the chain.”  BSP’s powers over transfer of control or ownership, applying a broader definition of control that includes influence exerted through other means than voting power.  The expansion of the BSP’s authority to examine accounts and replace the mentions to “books” for the word “operations” (to align the text to a more risk-based supervision).  Establishing that the suspension or revocation of government licenses necessary for the operation of a BSP-supervised entity requires the prior approval of the BSP.  Establishing that lower courts cannot issue temporary restraining orders against BSP’s acts.  Granting the authority to the BSP to establish different capital ratios for individual financial institutions. 17. The enactment of these amendments is essential; still, they fall short of what is needed, basically by detailing issues (such as the values of penalties) still under legal text, thus jeopardizing their prompt update, and, in particular, by tying the discretionary action of the supervision to the existence of “abnormal” conditions. A good example of the latter is the proposed amendment regarding capital ratios: “SEC. 108. MINIMUM CAPITAL RATIOS. — The Monetary Board may prescribe minimum RISK-BASED CAPITAL ADEQUACY ratios BASED ON INTERNATIONALLY ACCEPTED STANDARDS [which the capital and surplus of the banks must bear to the volume of their assets, or to specific categories thereof,] and may alter said ratios whenever it deems necessary. IN THE EXERCISE OF ITS AUTHORITY UNDER THIS SECTION, THE MONETARY BOARD MAY PRESCRIBE A HIGHER MINIMUM CAPITAL ADEQUACY RATIO FOR INDIVIDUAL FINANCIAL INSTITUTIONS WHICH ARE DEEMED TO BE EXPOSED TO MORE THAN NORMAL RISKS.” 18. While the new text is a clear advancement compared to the existing legislation, this formulation leaves no margin for future introduction of other limits and ratios as being discussed today in the international regulatory community, such as leverage 6 ratios and counter-cyclical requirements.4 Second, it only allows for the use of a capital ratio above the minimum to individual banks that are exposed to “more than normal risks.” However, risks covered by Pillar 2—reputation, concentration, strategic and others—are not “more than normal.” These are intrinsically normal in the banking business but lack a standard measurement for the calculation of capital. The international recommendation is that banks must have capital above the minimum—how much more depends on their risk profile, business strategies, controls, and other factors. 19. Moreover, the amendments in their present form do not leave much room for the application of discretionary power and may be inconsistent with the proposed ICAAP framework. The ICAAP framework, which is expected to be applicable in 2010, is well-designed, but if supervisors lack the power to impose adjustments to capital and other limits, the supervisory review process will be jeopardized and Circular 639 may be unenforceable. Since the existing BSP approach to risk management and the ICAAP guidance already embody the concept that a capital adequacy ratio (CAR) above the minimum is part of the daily risk management of any financial institution, there is a potential inconsistency between what the BSP is set to do under Pillar 2 and the proposed amendments. Principle 1(6) – Cooperation 20. This principle had been considered Materially Non-Compliant in 2002, because there were no formal arrangements for cooperation with PDIC and other financial supervisors nor with foreign supervisors, although there was some evidence of effective informal cooperation. It is important to note that according to the modifications introduced by the new Core Principles Methodology in 2006, the cooperation and information exchange agreements need not be formal, but there needs to be evidence that these arrangements work in practice, where necessary. 21. Significant improvements were made since that assessment. In July 2004, the heads of the four financial system regulators (BSP, Securities and Exchange Commission, Insurance Commission, and PDIC) signed a Memorandum of Agreement (MoA) creating the Financial Sector Forum (FSF). The purpose of this forum is to institutionalize the coordination of supervisory and regulatory activities of the members. The FSF does not have regulatory powers, but under the MoA its members are to individually enforce its guidance and agreements in each agency. 4 According to the G-20 timetable, the Basel Committee of Banking Supervision will release its macro- prudential framework by December 2009. 7 22. In April 2006, the members of the FSF agreed and signed a Memorandum for information exchange, so that relevant reports and data can be shared by the agencies. Restricted information, defined as “those that are sensitive and are subject of existing rules on confidentiality and disclosures,” can be transmitted from one agency to the other upon the authorization of the source agency. All the parties involved must treat the information received under the Memorandum as confidential. The BSP informed that this MOA for information exchange is effective and has recently been used by the BSP to request information on corporations while mapping conglomerates. 23. While MOUs between the BSP and PDIC have improved the basis for information sharing, there is room for improvement in inter-agency coordination when dealing with weak banks. Currently, the PDIC receives information and reports from the BSP and is informed when a bank is placed in, graduated from, or has failed PCA. However, it often only has access to detailed deposit information once a bank enters receivership (although the June 2009 PDIC amendments now give it the power to conduct, in conjunction with the BSP, a special examination of bank that is likely to close). Having more detailed information on assets and deposits of a bank under PCA at an earlier stage, according to well-defined criteria, could help the PDIC plan better for dealing with bank failures. 24. Internationally, in 2004 the Monetary Board approved general guidelines for the exchange of information with foreign counterparts.5 The guidance aims at giving both supervisors access to examination reports and other information, without the need of case-by- case approval by the Monetary Board. Under these guidelines, the BSP has already formalized agreements with five countries and is negotiating MoUs with five more. Transfer of Significant Ownership (CP 4) 25. This principle was considered Materially Non-Compliant in 2002. Although rules bring some definition of significant ownership and controlling interest, they are very narrow and do not capture situations where the controlling interest is exercised through vehicles that might be used to disguise ownership as required by the Core Principle. All reporting and other requirements are only linked to cases of transfer of control by means of sale or transfer of voting stock. In addition, although regulation (Circular 309) mentions that breach of ownership regulation will entice sanctions “without prejudice to the appropriate legal actions for the rescission and invalidation of the sale and transfer,” there is no legal base for the BSP’s action in this regard. 5 Minimum Ground Rules for Information Sharing between Home and Host Supervisors - Min 31, July 15, 2004. 8 26. The assessment in 2002 made it clear that a broader definition of significant control or ownership was warranted, and an enhanced regulatory framework for the BSP’s actions in freezing voting rights on shares acquired in contravention of the regulation, or reversing sales and transfers. Given the complex ownership structures in the Philippines, such deficiencies are all the more relevant. 27. As discussed over CP 1 above, BSP is aware of its need for enhanced powers in this regard and amendments to the NCBA concerning the issue have been included in the draft bill under discussion in Congress. By the proposed amendments, the BSP would have powers over transfer of control or ownership, and to that end a broader definition of control, which includes influence exerted through other means than voting power, would be applied. Large Exposure Limits (CP 10) 28. This principle was considered Materially Non-Compliant in 2002, since the single-borrower limit of 25 percent was applicable on a solo basis, hiding the potential complications of a mostly group-based financial system. It was the FSAP’s recommendation that this (and other) limits be applicable on a consolidated basis. Since then, the 2006 Methodology has amplified the criteria and more is required of large exposure management and control. 29. The BSP has introduced changes in this regard through Circular No. 414/2004, which makes the Board of Directors responsible for establishing and monitoring compliance with policies governing large exposures and credit risk concentrations of the bank. This regulation greatly enhances concentration risk management and control, requiring that the policy on large exposures and credit risk concentrations must cover not only name concentrations but also sector and geographical concentrations. The rules define “large exposures” as “exposures to a counterparty or a group of related counterparties equal or greater than 5 percent of bank’s qualifying capital,” a noticeable enhancement from the previous legislation (that inexplicably used a 30 percent threshold to define a large exposure). Banks are required to have systems to identify, measure, monitor, and report such exposures, although the rule stops short of imposing an aggregate limit for the sum of large exposures. 30. In spite of this regulatory progress, there is some inconsistency between the Circular on the management of large exposures and the higher-level legal text (GBL) that actually determines the Single Borrower Limit (SBL)6 limit. The limit is “25% of the net worth” of the bank, while the Circular’s definition of large exposure is based on the 6 MORB Sec X.303. 9 “qualifying capital.” Although the BSP is capable of monitoring concentration on a consolidated basis, the actual limit is calculated on a solo basis only, contrary to international practice and the 2002 FSAP recommendations. 31. In addition, there are further inconsistencies in the application of the SBL limit to a “group of connected counterparties.” The definition of groups used in the GBL considers groups only companies and individuals who “own or control a majority interest in such entities,” and, even so, such exposures “shall be combined under certain circumstances.”7 Circular No. 414/2004 has a guidance format and leaves to the bank’s policy to clarify the criteria for “identifying a group of related persons.” Therefore, both the limit and the large exposure rule fail to capture an important feature of the Filipino environment, since connections between individuals through family and other relationships, and connections between individuals and companies where control is exercised by other means than voting power or written arrangements are not covered by this definition. The inconsistency is especially flagrant when compared to the new rules regarding lending limits to related parties8 (CP 11), which uses a much broader definition of “related interest” and “stockholders” than the law. 32. It also seems that the definitions of exposure used by the Law and the regulation are not consistent. Circular No. 414/2004 leaves it again to the bank to define exposure, while guiding that such definition must be commensurate with the business and products of the bank, and stating that, “In any case, a bank’s exposures to a counterparty should include its on- and off-balance sheet exposures and indirect exposures,” whereas the single exposure limit applies to “loans, credit accommodations and guarantees,” which does not seem to cover all of the trading book. There are also several exceptions and a 10 percent waiver for some trade-related credit. Exposures to Related Parties (CP 11) 33. This principle was considered largely compliant by the previous FSAP and the assessment was updated due to a specific recommendation regarding the definition of “related parties.” The 2002 assessment recommended that the definition of “directors, officers, stockholders, and related interests” (DOSRI) should be expanded to include corporations that are subsidiaries or associates of the banks. The FSAP also recommended that different ceilings should apply to DOSRI that are related companies to the bank. 7 MORB Sec. X303. 8 Circular 423/2004 establishes lending ceilings for “directors, officers, stockholders and related interests” (DOSRI). 10 34. The regulation has hence been amended accordingly. Circular 423/2004 expanded the definition of related parties in DOSRI to include related corporations (also using a very comprehensive definition for related companies and individuals), and also established differentiated ceilings for companies and subsidiaries. It is important to note that unsecured loans to DOSRI continue to be deducted from capital. 35. Due to new exchange of information arrangements (see CP 1); the BSP has been able to liaise with other financial supervisors and is carrying out a detailed mapping of the Filipino conglomerates. The completion of this work will greatly assist in the identification of related interests that are not easily detected by voting rights only. Counterparty Ceiling (a) DOSRI Individual Ceiling Limited to an amount equivalent to the unencumbered deposits and book value of the paid-in capital contribution of the DOSRI borrower in the bank. Unsecured 30% of the total loan granted to the DOSRI borrower Aggregate Ceiling 15% of the total loan portfolio of the bank or 100% of net worth whichever is lower Unsecured 30% of the aggregate ceiling or the outstanding loans, other credit accommodations and guarantees, whichever is lower (b) Subsidiaries/Affiliates Individual Ceiling 10% of net worth Unsecured 5% of net worth Aggregate Ceiling 20% of net worth Power/Energy Generation 25% of net worth Unsecured 12.5% of net worth (c) Non DOSRI (SBL) 25% of net worth (Summary table provided by BSP) 11 E. Country and Transfer Risks (CP 12) 36. This principle was considered Materially Non-Compliant in the previous assessment, and no significant developments were made in this area since 2002. The reporting of credit and market risks to BSP (FRP) requires classification of exposures based on the residency of the counterparties, which can help to a certain extent on the monitoring of country risks. However, country and transfer risk were not included in the Internal Capital Adequacy Assessment Process (ICAAP), established by Circular 639/2009, nor are they part of the risks covered by the risk-based supervision guidance (Circular 510/2006). Internal Control and Audit (CP 17) 37. Main regulation on internal controls continues to be circular 283/2001 and section X.163 of the MORB. These are focused basically on the procedural checks and balances of internal controls and the emphasis continues to be on internal audit. In that regard, Circular 434/2004, Circular 456/2004, and Circular 499/2005 established the obligation that the Board of Directors constitutes an Audit Committee, a Corporate Governance Committee, and a Risk Management Committee (including provisions for the presence of independent directors in each). Circular 499/2005, specifically, strengthened the internal audit function reinforcing requirements for independency, access of reporting, and qualification. 38. Compliance function was also much enhanced by Circular 429/2004 and Circular 598/2008. The first formalized the compliance function and established proper Board oversight of the compliance policy (which must take into account cross-border considerations and outsourcing), while the second requires all larger financial institutions to appoint an independent full-time compliance officer who should be at least a vice president or equivalent. 39. Circular 510/2006 establishes compliance risk as a major risk to be included in risk management systems and is thus subject to identification, measurement, monitoring, and control. However, even the broad requirements for internal controls made by that Circular are not reflected in the current guidance for supervision of internal controls, which has not been updated since 2001. Therefore, the section on Internal Controls and Audit of the Institutional Overview document produced by the supervisors on each bank covers only audit issues and whatever assessment of internal controls and risk management are left to the risk management section, where compliance risk is only briefly assessed. 12 Abuse of Financial Services (CP 18) 40. Since 20029 there has been noticeable improvement in relation to the last FSAP recommendations. The Anti-Money Laundering Law was amended in 2003 (RA 9194/2003), and many circulars and memoranda were issued, addressing several points raised by the previous FSAP. For instance, the minimum level below which there is no legal reporting requirement of suspicious transactions was lowered to international levels (PhP 400,000, about US$10,000). In addition, the BSP was granted the authority to verify customer information in the course of their examinations and a dedicated unit for AML supervision was created within the BSP. 41. Some deficiencies remain and need to be addressed. The BSP has no authority to request customer information between examinations and, therefore, whenever some suspicious activity is flagged, there is the need to request authorization from the Monetary Board for a special examination. Although the BSP staff did not report difficulties in obtaining such authorization, the timeliness of the verification may be lost in the process. 42. An additional difficulty is the local resistance to a broader definition of politically exposed persons (PEP). The BSP recommends banks to have an internal definition of PEP, but, after some backslash from local politicians, recommendations were amended to focus mainly on foreign PEPs (Memorandum on Customer Identification Due Diligence, October 17, 2003). 43. The guidance for client identification is scattered among many rules and recommendations, which makes it difficult to have a concise view of KYC due-diligence requirements. The BSP informed they are in the process of elaborating a consolidated manual for AML. 44. Given the number of supervised entities under the BSP, the numbers of AML dedicated supervisors are clearly insufficient. Although they have provided training to other onsite examiners, there is a population of nonbank and quasi-bank entities actively involved in money transfers and other related activities that have hardly received any AML supervision at all. 9 The assessment of this principle also benefited from the findings of the comprehensive assessment of Forty Recommendations 2003 and the Nine Special Recommendations on Terrorist Financing of the Financial Action Task Force (FATF) conducted by the World Bank and the Asia Pacific Group on Money Laundering in September/October 2008, and published in 2009. http://www.apgml.org/documents/docs/17/The%20Philippines%20DAR%20- %20Final%20%20210809.pdf 13 Corrective and Remedial Powers (CP 23)10 45. This CP was considered materially Non-Compliant in 2002, mostly given the evidence that the BSP and PDIC were not able to apply corrective and remedial actions on a timely basis. Therefore, there were recommendations on the strengthening of PCA framework, including powers, so that the BSP/PDIC would be able, for instance, to place banks under temporary administration or take full control of banks when capital fell below a certain threshold. 46. Since 2002, there have been improvements. The new regulation (Circular No. 523/2006) expanded the possible triggers and measures for PCA to include undercapitalization relative to risk-weighted assets or deposits, low CAMELS or management ratings, and supervisory concerns, and expanded the corrective measures to include business improvement plans and governance reforms.11As a result, the number of banks under PCA increased from fewer than 20 at the beginning of 2006 to 214 by September 2009. However, Circular 523 does not mandate actions on the basis of risk-based capital, nor does it require increasingly severe measures, as would be expected under a PCA or structured early intervention and resolution framework.12 47. Thus, in practice, the regulation lacks proportionality, i.e., increasingly severe mandatory actions or sanctions as the bank’s financial condition deteriorates. This means MOUs with undercapitalized banks under PCA (formal written agreements) do not always contain increasing operating restrictions or impose sanctions other than prohibiting the declaration of dividends.13 More severe sanctions are imposed for unreasonable delay or after a bank has not complied with its MOU (PCA “failure”). 10 Prepared with Pamela Madrid, MCMFO. 11 Previously, Circular 181 of 1998 only required a PCA program in case of undercapitalization relative to minimum required capital level. 12 Circular 181—which is still in force—does specify mandatory sanctions that increase with the size of shortfall relative to minimum paid-in capital levels. In practice, however, this provision is too weak. In many other countries, banks are categorized according to their level of CAR and increasingly severe mandatory sanctions kick in on the basis of these categories. 13 The Manual of Banking Regulation (MORB), X116.6, calls for the prohibition of dividends in case of undercapitalization relative to minimum required CAR, but other restrictions are discretionary and are not structured on the basis of worsening CAR. Also, the emergency loan regulation calls for restrictions on activities if such a loan is granted, but again these restrictions are not a function of undercapitalization. 14 48. The 2002 BCP assessment noted the overly long periods involved in PCA, and the problem seems to persist under the new framework. Following an examination, there is a period when supervisory concerns are communicated to a bank, which is then supposed to take “required” or “expected” corrective actions. “Required” actions (in case of safety and soundness concerns) must be taken within 90 days; the timeline for “expected” actions is not well defined, and often stretches over several months. If “expected” actions are not complied with, the BSP may impose penalties and escalate to “required” actions. If a bank has failed to take “required” actions, or, based on on-site or off-site examination, meets the conditions for PCA under Circular 523, it may be placed under PCA. Initiation of PCA requires approval by the Monetary Board (within 20 days of recommendation). Once under PCA, a bank has 30 days to submit an MOU, 90 days to submit a PCA plan, and up to three years to comply with the capital restoration plan contained in the MOU14. Deadlines may be (and have been) extended in case the bank offers a “reasonable explanation.” These long periods for corrective actions may result in significant further deterioration of the bank, making it difficult to use resolution tools other than liquidation, as well as being less likely to recover assets. 49. Suspending some or all of shareholders’ rights or placing a bank in receivership, even when a bank is close to failure, is strictly circumscribed in the law. PCA failure (even of a critically undercapitalized bank) does not necessarily mean that a bank goes into conservatorship or receivership. Rather, there are separate conditions for receivership that must be satisfied, which do not include a specific capital threshold or safety and soundness considerations. 15 Moreover, the law or regulations do not specify a time period in which critically undercapitalized banks must be capitalized or face closure. And the 90-day period for rehabilitation during receivership, as well as the inability of the BSP or PDIC to suspend some or all shareholder rights during this period (except, possibly, in case of extreme liquidity problems), provide the owners too much leeway in the resolution of a troubled bank. This constrains the authority to the BSP and PDIC to take timely and meaningful action to ensure remedial actions and preservation of asset values. 14 New internal guidelines (2009) now direct supervisors to request immediate recapitalization to 1 percent when a bank has negative CAR or else be recommended for receivership or face sanctions. Furthermore, at least 30 percent of the total required recapitalization must be concluded within one year. 15 These are (i) unable to pay its liabilities as they become due in the ordinary course of business; (ii) insufficient realizable assets to meet its liabilities; (iii) cannot continue in business without involving probable losses to its depositors or creditors; or (iv) willful violation of a cease-and-desist order under Section 37, which has become final, involving fraud or a dissipation of the assets. 15 50. Many of these weaknesses are addressed in legal amendments prepared by the BSP. These include, besides those mentioned under CP 1:  additional sanctions, such as suspension, removal, or disqualification of directors and officers responsible for violations;  additional grounds for receivership—(a) unilateral closure; (b) deposits dormancy in operations for at least 60 days; (c) suspension of payment of deposits; and (d) the refusal of a supervised institution to permit examination;  resolution powers—when a bank has insufficient realizable assets to meet its liabilities, BSP’s Monetary Board may direct shareholders to provide additional capital within 90 days; in case they do not comply, the Board may direct the bank to accept investments, merge, or consolidate; and  receivership powers—the receiver shall have authority to transfer or dispose of any or all of the assets of a closed bank for purposes of rehabilitation. Consolidated Supervision (CP 24) 51. There has been some progress in consolidated supervision since 2002. The BSP has issued several regulations that require prudential limits and requirements to be calculated on a solo and consolidated basis, such as the regulations for capital adequacy (Circular 538/2006 and Circular 639/2009), foreign exposure limits and risk management (Circular 510/2006). Furthermore, by Circular 494, which introduced international accounting standards, financial institutions have to report on both solo and consolidated basis the extensive Financial Reporting Package. Large exposures and single-borrower limits are, however, required only on a solo basis (although there is some information that is also provided on a consolidated basis). 52. The consolidated supervision of banking groups is hindered by the complex organizational structures of Filipino conglomerates. As mentioned above (CP 1), the legal definition of control is somewhat limited and does not capture the intricate family and corporate connections commonly found in the country. In addition, the BSP has no authority to require information from the parent holding companies. In this regard, the enactment of proposed amendments to the NCBA will represent a crucial step to the compliance to this Principle. 53. It must be noted that the actual monitoring and understanding of the conglomerates are perhaps more profound in practice than seems to be warranted by legal text. In addition, the BSP has benefited from better coordination and exchange of information with other supervisors through the FSF. For instance, within the Institutional 16 Overview of the banks prepared by the Central Points of Contact, there is a discussion on the conglomerate’s situation and a group map that includes family (“dynasty”) connections with nonfinancial corporations. The ICAAP proposed to be enforced in 2010 also requests the assessment of the risks posed to the banking group by the related companies and parties, including cross-border activities, in financial and nonfinancial activities. As mentioned above, however, without adequate legal foundation BSP’s actions are limited. Home-Host Relationships (CP 25) 54. The contact between the BSP and its foreign counterparts is not frequent, given the small presence of foreign banks in the Philippines and of limited activities of domestic banks abroad. Nevertheless, there is progress since the last FSAP. As mentioned under CP 1, the Monetary Board approved in 2004 guidelines on information exchange between BSP and foreign supervisors. Foreign supervisors, under MoUs, can obtain information contained in BSP supervisory reports and documents. BSP informed such MoUs have been formalized with five countries, and five more MoUs are under negotiation. 55. Although such guidelines and MoUs are a good basis for cooperation, due to BSP’s and PDIC’s own restrictions to customer accounts, the access of such information by foreign authorities is also limited. Therefore, the MoUs are established on a “best endeavor basis,” and access to customer information would not “normally” be included. RECOMMENDATIONS AND AUTHORITIES’ REACTIONS Recommendations 56. BSP and PDIC are well aware of current shortcomings and are very active in improving their supervisory environment through regulation changes, legal amendment proposals, and investment in supervisory capacity. They are also following closely developments in the international discussions that may affect regulatory standards in the near future. As discussed with the authorities, it is strongly recommended that (i) the proposed amendments mentioned proposed by BSP/PDIC be enacted as soon as possible; and (ii) the authorities, either in the context of these amendments or separately, consider additional changes in the following areas:  Further amendments to GBL and the NCBA to give the BSP more flexibility to issue prudential regulations without legislative approval, and to delegate the establishment of detailed guidance and prudential limits to the BSP. 17  Further amendments to the NCBA to give the BSP more discretionary power to require additional capital and impose other limits to the risk profile of a bank, using wording similar to what is used in Circular 639.16  Amendment to the GBL, so that the definition of group of connected counterparties captures situations where family influence and effective control are exerted by means other than voting rights, aligning it with the DOSRI regulations already in force (and the proposed amendment to NCBA regarding BSP powers over transfer of control or ownership, that includes control without a majority of voting rights).  Authorities should be allowed to take full control of a bank for restructuring (or at least initiating official administration) once capital adequacy has fallen below a critical capital threshold;17 the rehabilitation period allowed to owners during receivership should be eliminated.  The PCA framework should allow for a bridge-bank resolution mechanism. 57. The second major challenge in improving banking supervision and compliance with the BCP is to ensure that the single-borrower limits and large exposures are calculated on solo and consolidated bases, including on all on- and off-balance sheet exposures (and as a function of the same definition of capital). This was one of the recommendations of the 2002 FSAP that still remains relevant. Also, considering the sensitivity of banks to concentration risk, risk management could benefit from the introduction of an aggregate limit for the sum of large exposures, in line with best international practice. 58. In addition, we recommend the BSP to:  issue guidance on country risk;  amend internal supervisory guidance/practice to reflect the broader scope of internal controls, as warranted by new regulation, including the review of the “Internal Control Questionnaires” – in practice, the section of the Institution Overview document should cover more than only internal audit, as has been observed; 16 Circular 639 makes it clear that capital should cover all the “risks that are inherent in their activi ties and material to their bank,” and “consistent with their risk profile, operating environment, and business plans.” 17 In many countries, this threshold is set at half the required Tier CAR. The United States uses a leverage ratio (2 percent of tangible equity to assets). 18  amend the definition of PEP to include national PEPs; and  consolidate scattered AML rules and recommendations in a AML manual. 59. Last but not least, the BSP should maintain the pace toward the implementation of risk-based supervision, including by continuing to invest in staff training. Authorities’ Reactions 60. On large exposure limits: the authorities have clarified that “Other credit accommodations,” is defined under Subsection X303.1 of the MORB (http://www.bsp.gov.ph/downloads/Regulations/MORB/MORB_4_of_13.pdf) as those “credit and specific market risk exposures of banks arising from accommodations other than loans such as receivables (sales contract receivables, accounts receivables and other receivables), and debt securities booked as investments.” Securities under the trading book are considered as investments of banks, hence, are likewise considered for purposes of computing the exposures of a single borrower.” 61. On country risk, the BSP understands that the ICAAP guidelines (Circular 639), that require “bank management to take into account all material risks that banks are exposed to,” “may include” country and transfer risks, and that the list of risks mentioned under Circular 510 is a minimum: “there was no explicit mention of country and transfer risks in both issuances in view that currently, banks have limited exposures to such type of risk. This does not mean, however, that country and transfer risks are not covered by the existing guidelines.” 62. On corrective and remedial powers, the authorities disagree that the new regulation lacks proportionality. They understand that “measures relating to PCA banks can be considered progressive in the sense that the strength of required actions is commensurate to the degree of bank’s problems and any delays in entering into an acceptable MOU or noncompliance with the commitments made in such MOU will lead to PCA failure declaration. Once PCA failure is declared on banks, nonmonetary sanctions, in addition to monetary penalties as provided under Circular 523, are imposed as follows: (a) prohibition of dividend declaration; (b) restriction on existing activities such as expansion of loan portfolio, suspension of authority to invest except in government securities, suspension of privileges of directors/officers and denial of application for branching and other special authorities; and (c) denial or restriction of access to BSP credit facilities.” 63. Authorities also believe that the imposition of nonmonetary sanctions is not discretionary on the part of BSP but is mandated under existing regulations, as Circular No. 523 specifically provides imposition of Sec. X116.6 of the MORB restrictions (“the Monetary Board may restrict or prohibit banks with CAR below the prescribed 19 minimum from making new investments of any sort, with the exception of purchases of readily marketable evidences of indebtedness issued by the Philippine National Government and BSP”). Such sanctions are only mandatory in case of “unreasonable delay in entering into PCA or non-compliance with PCA directives which are grounds for PCA failure.” 64. The BSP has also expressed its views that the periods involved in PCA are not overly long, as “for PCA initiation, starting late 2008, the response of banks to “required” actions is no longer a prerequisite to initiate banks to PCA. Rather, it has been the practice that Monetary Board approval to initiate a bank to PCA shall be sought within 20 days from discovery of the need for bank to be placed”