Diokno’s 2018 FSR Report Warns on Bank’s Mounting Liquidity, Fund Mismatching, Settlement Fails and Concentration Risks; the BSP Chops RRR rates by 100 bps!

We can conclude here that the presence of a central bank provides an opening for the creation of non-productive credit, which is an agent of economic destruction. This type of credit generates money out of thin air thereby setting in motion an exchange of nothing for something—Frank Shostak

In this issue:

Diokno’s 2018 FSR Report Warns on Bank’s Mounting Liquidity, Fund Mismatching, Settlement Fails and Concentration Risks; the BSP Chops RRR rates by 100 bps!

-The 2018 Financial Stability Report: Diokno Led FSCC Sugarcoats Escalating Risks

-Credit Expansion as the Main Engine of the Philippine Economy

-Stock market’s Surging Interest Expense, FSR Allays Concerns on NPLs Despite V-Shape Spike!

-The FSR’s Admits to Intensifying Concentration Risks and to Deteriorating Capital Adequacy Ratios!

-The FSR Confesses on Intensifying Risks from Maturity Mismatches and the Narrowing of the Banking System’s Credit Maturity Profile!

-The FSR Admits to Rising Risks from Falling Liquidity and from Settlement Fails!

-The FSR Cites Contagion Risks But Uses Flawed Econometric Models to Downplay It!

-The FSR Concludes with an Assurance Predicated on Self-Contradiction; The Insurance Industry’s Fragility to Market Risks

-Summary and Conclusion, Thank You Governor Ben Diokno

Diokno’s 2018 FSR Report Warns on Bank’s Mounting Liquidity, Fund Mismatching, Settlement Fails and Concentration Risks; the BSP Chops RRR rates by 100 bps!

The 2018 Financial Stability Report: Diokno Led FSCC Sugarcoats Escalating Risks

The Bangko Sentral ng Pilipinas reduced the banking system's reserve requirement ratio (RRR) by 100 bps, the third this year, a day after it announced the highly anticipated policy ON RRP rate cut on the 26th of September.  The latest RRR adjustment will take hold on the first reserve week of November, three months after the 50 bps reduction signifying the last phase of the total 200 bps cut on July 26th.

Here are questions you won’t hear from anywhere:

-Why the immediacy or the urgency to free up an estimated Php 250 billion of bank reserves if the banking system’s capital base had been sound as publicized?  

-Why the necessity to ease policy rates if the Philippine economy has been robust as popularly supposed?

-Why has the Philippine economy become entirely dependent on the permanence of instituted emergency monetary measures (as well as fiscal measures)?

Ever since the Philippines became a Bank for International Settlements (BIS) reporting country in January 2018, the Financial Stability Coordinating Council (FSCC), representing a consortium of state financial institutions led by the BSP, was established with the requirement of issuing an annual Financial Stability Report (FSR).  The 2018 FSR was released last September 25 marking “the second issuance that has been made available to the general public”.

Though the BSP releases the FSR to the public, its target audience has been the central bank member peers at the BIS, as well as, the BIS bureaucracy. In contrast, reports targeted at domesticaudiences barely touches the risk agenda raised in the FSR.

Differently stated, the BSP has mostly been candid about risks in the financial system when reporting to their colleagues, but the topic about risks evaporates when it publishes the financial system conditions to its domestic audiences.

That said, the BSP’s press release has sanitized the contents in its 2018 FSR report. And such spin was anticipated here*:

Oh don’t worry, all the risks cited by the late BSP Governor Espenilla led Financial Stability Coordinating Council’s FSR will likely vanish in the next FSR report.

*From One Crisis to the Next: The Water Crisis, The Revenge of Economics! March 17, 2019

Whatever happened to the late BSP Governor Nestor’s Espenilla’s warnings in the 2017 FSR report? The 2017 FSR’s conclusion:

“While there is no definitive evidence of a looming crisis, it is also clear that shocks that have caused dislocations of crisis proportions have come as a surprise. What is not debatable is that repricing, refinancing and repayment risks (3Rs) are escalated versus last year and this could result in systemic risk if not properly addressed in a timely manner” (bold mine)

The Ben Diokno-led FSCC omitted his predecessor’s analytical methodology partly formulated upon on Hyman Minsky’s Financial Instability Hypothesis (FIH) and Nassim Taleb’s Black Swan Theory (BST).

Nevertheless, despite attempts to dilute risks on the banking system, the 2018 FSR contains striking elements of entrenched and escalating risks that have only affirmed or corroborated my observations.

This analysis will incorporate most of the entire section on the banking system, Chapter 2 (p.12-19), in the 2018 FSR’s report, accompanied by my commentaries (in black italics).

Credit Expansion as the Main Engine of the Philippine Economy

The build up of credit, however, is among the fastest in ASEAN. Since 2008, the CGDP ratio has been rising and reflects a point-to-point growth of 71.5 percent (Table 2.1). Outside of the triple digit growth in Myanmar (677 percent) and Cambodia (325 percent), the rise of the Philippines’ CGDP ratio is actually the fastest in the region. This is impressive if one considers the Philippine economy as among the fastest growing in the world, suggesting a very aggressive rise in credit. Looked at from a different perspective, the world’s CGDP ratio has only grown by half a percentage point annually from 2008 to 2018 but the Philippines is actually running at 11 times that pace at 5.5 percent growth annually.

Analysis: The FSCC defines credit growth in the context of economic growth. If such an assertion had been valid, then the list of imbalances reckoned below would have hardly emerged. The FSCC has it backward. The enumerated risks are instead symptomatic of credit driving the economy than the economy using credit as support.

The gap between the current CGDP ratio and its long-term level has decreased. Applying the most common filtering technique, 15 the long-term path for private credit is still rising (Figure 2.2). Coupled with a long-term trend for nominal GDP that is moderating, the net effect is that the long-term CGDP ratio is likewise still rising.

This is an important consideration because of concerns that the credit build up may have been overdone. Analysts note, for example, that the current CGDP ratio is above its long-term level and as interest rates have moved higher since 2018, then the debt service burden is likewise higher and the possibility of the debt levels being a concern could not be dismissed.

The Credit-to-GDP (CGDP) ratio is an apple-to-orange comparison. While the banks deal with facts, the GDP is an estimate of an aggregated or simplified economy statistically constructed using surveys.

Nevertheless, rising CGDP above long-term level, higher-interest rates, and debt service burden provide further evidence that credit has propped up the Philippine economy than vice versa.

Nonetheless, we find the gap between the current ratio and its estimated long-term trend to be declining. This is the result of the ratio declining over recent periods while its long-term value continues to rise. Between the two diverging developments, one should arguably give more weight to the former.16 Specifically, the CGDP ratio has fallen between end-2018 and first quarter of 2019 on account of the negative quarter-on-quarter growth of private sector credit, in particular to the non-financial sector.17

The declining gap between the current ratio and its estimated long-term trend of the CGDP represents a sharp decrease in the GDP’s PCE deflator or the plunge in the CPI that depressed the Nominal GDP in the face of the recent declines in bank credit transactions.  Or, lower growth in credit transactions affected the GDP downward. It’s further proof that the primary driver of the economy has been bank credit expansion.

Stock market’s Surging Interest Expense, FSR Allays Concerns on NPLs Despite V-Shape Spike!

The recent decline in the CGDP ratio could be a welcome rebalancing. Higher interest rates from 2018 to mid-2019 suggest that debt servicing should be examined further. Based on the audited financial statements of the 148 Philippine Stock Exchange (PSE)-listed non-financial corporations (NFCs), the growth of interest expense (IE) has outpaced the rise of earnings before interest and taxes (EBIT) (Figure 2.3). In addition to the rate of growth, the ratio of IE to EBIT shows a rise from 14.5 percent at the start of the first quarter of 2016 to 22.6 percent as of March 2019, with a high of 27.8 percent in December 2017 (Figure 2.4). The same companies have also reported lower profitability with respect to return on assets (Figure 2.5).

This paragraph should serve as proverbial writing on the wall on the stock market.

Growth in interest expense outpacing the EBITDA didn’t emerge out of a vacuum, as the FSR implicitly narrated.  Interest expense growth should naturally follow because the PSE’s earnings growth has long been dwarfed by its credit growth.

And profitability, aside from profit margins and revenues, have likewise been affected by escalating financial costs that emerged along with a higher cost of living.

In the Espenilla 2017 FSR report, the concern was more about overvaluation. The Espenilla FSR cited the possibility of a “Minsky Moment waiting to happen” in Philippine stocks. (p.46)

The thing is, in the two FSRs, the BSP has painted the Philippine stocks in a negative light.

The sins of the past, as implied by the FSRs, have come to haunt the present!

And yet, the sustained gaming of the headline equity benchmark, conducted through rampant marking-the-closes, compounds on the distortions of the marketplace, financial and the economic allocations!

As noted above, the build up of private sector credit is one of the most aggressive in ASEAN and yet the reported non-performing loans (NPL) ratio of corporate credit remains very modest. At less than one percent as of end-2018, the latest figure is PHP66 billion as of March 2019. 18 This rise may look minimal but a conservative approach requires that we monitor the NPL level which actually shows a V-shaped pattern (Figure 2.6). Since the inflection point in late 2015, the amount of NPLs has been increasing, reversing the previous positive trend of a decrease despite the rise in outstanding loans.

The FSR opens with a statement that begs the question. It concludes, using the 1% ratio, that NPLs remain ‘very modest’. Nonetheless, not only does the FSR unexpectedly observe a reversal in the previous positive trend, but it also has noted of the V-shape or a sharp spike in the growth of NPLs!

However, the FSR also naively assumes that banks have been candid in disclosing their distress assets and NPLs. Hence, the liquidity shortfall, the FSR noted below, have been attributed to mounting maturity mismatches while understating the role of NPLs.

Figure 1

The FSR’s Admits to Intensifying Concentration Risks and to Deteriorating Capital Adequacy Ratios!

Aside from the level of credit, its distribution is likewise an important consideration. The three economic sectors of wholesale and retail trade, manufacturing, and RE activities account for more than 50 percent of the outstanding resident loans to productive activities (Figure 2.7).19 When we include electricity, gas and steam, these four sectors collectively constitute roughly half of Philippine GDP (Figure 2.8). In this context, any impairment will affect both the financial industry as well as the broader macroeconomy, the very definition of systemic risk.

To pursue this point, the FSCC tested against credit stress in wholesale and retail trade, manufacturing and RE activities. The results showed that eight universal and commercial banks will have their stressed capital adequacy ratio falling below or nearly at the regulatory minimum. Apart from comparing against an absolute threshold, it bears highlighting that the surplus of the stressed capital levels of banks over the regulatory minimum has been diminishing over time. This is not indicative of an industry in crisis but it does reflect that banks have accumulated credit-based risk-weighted assets at a faster pace than qualifying bank capital.

Not only does the FSR corroborate my observations over mounting concentration risks, but it has likewise revealed its ramifications: falling capital adequacy ratios!

AWESOME MONEY QUOTES:

-eight universal and commercial banks will have their stressed capital adequacy ratio falling below or nearly at the regulatory minimum.

-stressed capital levels of banks over the regulatory minimum has been diminishing over time.

-not indicative of an industry in crisis but it does reflect that banks have accumulated credit-based risk-weighted assets at a faster pace than qualifying bank capital.

To be sure, a crisis is an ex-post event. The absence of a crisis does not entail its improbability. But the fact that the BSP admitted that “banks have accumulated credit-based risk-weighted assets at a faster pace than qualifying bank capital” points to the path that increases the odds of a crisis.

Nothing exists in a vacuum.

As a side note, there are 46 universal and commercial banks (UCB), most of which are foreign banks. There are 15 listed universal and commercial banks at the PSE. Three are government-owned banks or GOCC banks (including UCPB). Since there are eight banks with CAR below or at the regulatory minimum, this translates to 17% of the total UCB population or 53% of listed UCB banks. Even more important has been the general trend of the industry: diminishing stressed capital levels over time! Assuming the accuracy of reporting, should these numbers, having been affected by the evolving entropic trends, be disregarded or downplayed?

And absent in the explanation is the WHYs and the WHATs?

WHY the drop in capital adequacy ratio? WHY have capital levels been diminishing at a faster rate than qualifying bank capital? WHAT has been the casual link to these degenerating developments?

Does the BSP know, or have they been withholding information, to the public?

As previously pointed out**…

If banks have been truly profitable and if they have sufficient capital as publicly declared, then why engage in frantic borrowing, in competition with the NG, for the public’s savings through the capital markets?

Such logic, embraced by the mainstream, may be an embodiment of “a square peg in a round hole”.

**After 3 Cuts in the BSP’s Reserve Requirement Ratio in July, Banks Remain Starved of Cash and Deposits, Borrowed Frantically as Net NPLs Expands Anew! September 15, 2019

And do you now see the rationale behind the regulatory bailout, through the mandate of countercyclical buffer, the BSP instituted in December last year? ***

***Regulatory Bailout 2.0: BSP Launches Countercyclical Capital Buffer (CCyB) Intended to Ease Capital Reserves! December 16, 2018

The FSR also pointed to the escalating concentration in the bank’s availments of BSP rediscounting mainly “from covered loans extended against credit instruments resulting from commercial activities, such as manufacturing and trading, and other services which include RE activities”.

And as credit transactions have clustered to a few industries, the other repercussions have surfaced. …

On the retail side of bank credit, the rise in consumer loans (CL) has also been accompanied by an increasing level of non-performing loans (Figure 2.10). Since residential RE loans which comprise 40.5 percent of the CL portfolio of the banking system as of end-March 2019 have a direct impact on consumers, developments in the RE sector need to be monitored.

So NPLs have been rising on the consumer credit’s real estate exposure! Need we be surprised?! And that’s just the demand side of the real estate credit. How about the supply side (developers, mall operators, marketers, non-bank financial firms, and more)? And what of the feedback loop?

And why the rising loan delinquencies from the consumers? Have many consumers been tapped out? Have they been overextended with leverage?

Surely, such are signs of the escalation of Espenilla’s 3Rs (Repricing, Refinancing and Repayment) in the 2017 FSR!

The obverse side of a credit financed malinvestment boom is a bust.

Figure  2

The FSR Confesses on Intensifying Risks from Maturity Mismatches and the Narrowing of the Banking System’s Credit Maturity Profile!

Now to the mounting risks from maturity transformation.

The build up of leverage creates mismatch risks in the banking books. While financial authorities look at the CGDP ratio and the CGDP gap to get a holistic view of the standing of credit vis-à-vis the economy, banks get a similar—though own-view—perspective from its loan-to-deposit ratio (LDR). As expected, this has trended upwards (Figures 2.11) near to levels that would theoretically represent the upper bound as a result of the reserve requirement. The rising LDR suggests that the maturity mismatch is likewise increasing. Funds sourced by banks are largely savings deposits which are then used to fund longer-term credits. As Figure 2.12 shows, this creates a gap between the amount of assets and the corresponding amount of deposits categorized by maturity. With the average maturity of loans calculated at 4.25 years (Figure 2.13), the maturity gap then translates into a liquidity gap as well. Banks would, therefore, not only provide for the difference between the tenor of what they lent versus the short-term deposits that they borrowed but they will also have to provide liquidity for the periodic withdrawals of those deposits.

All actions have (intertemporal) consequences.

The repercussions from the paradigm shift in the business model undertaken by the banking system in 2013, of concentrating the buildup of their assets through the loan portfolio, have arrived. Again, the FSR cites the current liquidity juncture as resulting from the increasing gap in the banking system’s maturity transformation (borrow short, lend long).

The FSR didn’t say WHAT drove banks to take reckless mismatching of their balance sheets and WHY they behaved this way even under their watch.

To what extent has the BSP’s monetary policy anchored on inflation targeting, through artificially lowered rates (negative real rates), incited the banking industry’s paradigm shift that has brought upon the current risk environment? 

By forcing rates below its equilibrium or natural rate, which has propelled a ‘very aggressive rise in credit’ (p.12), has the banking system reduced its lending standards, through the inordinate expansion of subprime loans, which has led to the rise of maturity mismatches, credit delinquencies, and subsequently, liquidity drought?

The FSR extends the discourse on this in the next chapter on NON-BANK FINANCIAL MARKETS AND INTERMEDIARIES (p.21)

As Figure 3.2 shows, two-thirds of the outstanding amount of loans and receivables has a remaining term of five years or less. This explains why the average remaining maturity of loans is just over four years. At the same time, this is a remarkably large proportion of outstanding credit since one naturally assumes that economic investments (which extends the economy’s productive capacity) require a longer gestation period before their full benefits are realized.

The status quo creates a natural link between the banking industry and the capital market. At the surface, this link will be defined by the ability of traditional merchant banking to take the active role in investment funding. Aside from shorter-term loans being structured to meet long-term requirements, Figure 3.2 shows that a third of bank loans have remaining terms of more than five years and that the term bucket that has the largest outstanding amount is for 5-15 years.

...

 As one would note, the FSCC has been incredibly puzzled by the paradox of “remarkably large proportion of outstanding credit” on short-term loans when it expected that “economic investments require a longer gestation period”. Or, why the shift in the industry’s credit profile through a shortened tenor, if this has been about ‘economic investments’ or economic growth?

Importantly, not only does this exhibit little understanding of the credit cycle, but this reveals that BSP-FSCC has been oblivious to the causal linkages of the risks it mentioned! And if its roots are unidentified or unknown, how then can the probabilities of a credit event be assessed and or predicted???

Here is the thing. How has the cash flow of 'concentrated' bank borrowers been affected by the escalation of malinvestments, where the borrower’s operational cash shortfalls have prompted an increase in the demand for shorter maturity loans, incited the move towards the decrease in the credit maturity profile of the industry? And, how about the rise of cash deficient overleveraged (proto-zombie/Ponzi) firms that have become entirely dependent on (shorter) borrowings to repay existing liabilities, as well as fund working capital?

The FSR wrote of the bank’s dilemma to finance this ballooning mismatch. (back to chapter 2)

In this sense, it might help to take a look at some variations of the LDR. At one level, we know that banks cannot totally rely on loans maturing to cover deposit withdrawals. They maintain a cash position as well as have some amounts that are due from other banks. One can then think of hypothetically deducting this from the numerator (some of the loans are liquidity supported by funds other than deposits) or from the denominator (some of the deposits are covered by the cash and due from banks accounts). These result in Figure 2.14 and Figure 2.15, respectively, both of which still show a sharply rising trajectory. The rising LDR must also suggest that loans outstanding has been rising faster than deposit growth. This is evident from Figure 2.16 which depicts growth rates and from Figure 2.17 which literally shows that the amount of incremental loans exceeds that of incremental deposits. This can only mean that banks are tapping into funds from non-traditional sources.

Why should there be a chasm between “loans maturing to cover deposit withdrawals”? Are banks not in the position to adequately calculate, evaluate, and conduct the necessary financing required to match their liquidity requirements? If so, what keeps the banks from processing these efficiently?

Furthermore, the FSR doesn’t explain WHY the banking system’s deposit growth has significantly lagged the loan growth. WHAT happened to the chain linkages of loan issuance, deposits, and money supply? What has been the source of the implicit disruption that has caused such imbalance? And which of these chained linked segments have been most affected?

Nonetheless, the FSR rationalizes the obvious: The inadequate funding from deposits has prompted the “tapping into funds from non-traditional sources” by the banking system. Bluntly put, out of desperation, banks have tapped the MOST expensive sources of funding, such as bonds.

Figure 3

The FSR doesn’t include the impact of the BSP’s stealth QE on the banking system, and most importantly, the indirect effect of its competition with the National Government for access to the public’s savings—the crowding out syndrome.  (figure 3 middle window)

Is the public supposed to expect that the interventions to liquefy the system through the record high direct funding (net claims) of the National Government would only have neutral effect on the bank’s balance sheets? (figure 3, middle window)

And, what of the funding requirements for the ambitious pet project of the National Government? Would competition with the banking system for funding have an insignificant impact on the latter's balance sheet? If the effect has been substantial, what has been the transmission mechanism? Or how does the crowding out syndrome affect the banking industry?

And what of the escalation of systemic leverage, not only signified by the sharp rise in bank credit but by public credit as well? (figure 3, upper window)

And what of the historic collapse of the Philippine Treasury yield curve that led to an inversion, the first since at least 2001? What signals did it impart regarding the health conditions of the banking system? Have inverted curves not signaled the dearth of liquidity in the financial system? (figure 3, lowest window)

The FSR Admits to Rising Risks from Falling Liquidity and from Settlement Fails!

While the FSCC points to the use of cash reserves for funding, it puts a spin on the ability of banks to withstand the possibility of a liquidity crunch.

There is some evidence that incremental funding has been sourced from the banks’ liquid assets. We can see from Figure 2.18 that cash and due from banks had been rising until August 2017 after which it has followed a downward trajectory. In contrast, investments (Figure 2.19) have been growing at an exponential pace, which has been driven by the growth of securities classified as held-to-maturity (HTM) (Figure 2.20). These developments have implications on maintaining the balance between profitability and liquidity. Liquidity coverage ratio (LCR) figures assure, nonetheless, that there is enough liquidity to address a 30-day stress period. All of the above provide an asset-liability management perspective of liquidity. From a risk regulatory standpoint though, the LCR numbers from the industry provides comfort that market liquidity can handle expected outflows (Figure 2.21). 20 The caveat though is that expected outflows is rising and it would be useful to monitor this alongside the LCR itself. To the extent that high-quality liquid assets (HQLA) is comprised largely by reserves with the central bank, 21 an unexpected and persistent withdrawal would have the effect of reducing the LCR, both by reducing HQLA and increasing the outflows.

Let us identify the one-to two-year growth trajectories of the banking system’s balance sheet. On the downside, bank lending, cash and liquidity reserves, deposit (peso and forex), and total asset. On the upside, loans to deposit ratio, bonds- and bills payable, non-performing loans, equity in net direct investments, investment gains, and total investments.

Though it may be partly true that growth of cash and due banks climaxed in August 2017, as signified by the % rate and nominal peso value, this observation constitutes a ‘Recency bias’. That’s because this ignores the longer-term perspective. In reality, after hitting a pinnacle in 2013, the growth rate trend of cash and due banks has downshifted, which underscored the plateauing of the nominal peso value. (figure 4, upmost pane)

Because the growth rate in cash and due banks turned negative in December 2017, does this not strike a chord why the BSP embarked on the incipient phases of RRR cutbacks in March and June 2018?

The seismic transition in the banking system’s funding source can also be seen from the “tapping into funds from non-traditional sources”.

The % share of Bond Payable to Total Liabilities has skyrocketed since 2017 from .74% share to 3.13% in July 2019! (figure 4, middle pane)

While it may be true that “incremental funding has been sourced from the banks’ liquid assets”, the FSR doesn’t explain how and why this should lead to the downward trajectory in cash reserves.

Also, though it has been true that total investments have been rising, the growth trajectory of investment subcategories has performed differently.

Figure 4

The % share of Held to Maturity (HTM) to financial assets (gross of amortization) zoomed from 14.3%  on September 2013 to a peak of 70.94% on September 18, 2018, while the % share of Available for Sale (AFS) plunged from the pinnacle of 67.8% in September 2013 to July 2019’s 28.5%. The % share of Held for Trading (HFT) climaxed at 15.18% in September 2009 and dived to 6.87% in July 2019. (figure 4, lowest pane)

The recent boom in Philippine treasuries in 2019 has shifted the investment mix with HTMs losing some ground to AFS, as well as having powered the banking system’s investment gains, and profits.

Nevertheless, bank exposure to HTMs remains a hefty 64% share of gross Financial Assets as of July 2019.

In the Espenilla 2017 FSR, the FSCC disclosed implicitly, how HTMs were used by the banking system to shield asset losses from higher rates: “Banks face marked-to-market (MtM) losses from rising interest rates. Higher market rates affect trading since existing holders of tradable securities are taking MtM losses as a result. While some banks have resorted to reclassifying their available-for-sale (AFS) securities into held-to-maturity (HTM), some PHP845.8 billion in AFS (as of end-March 2018) are still subject to MtMlosses (Figure 3.8). Furthermore, the shift to HTM would take away market liquidity since these securities could no longer be traded prior to their maturity.” (p.24) [italics added] 

Embedded in choices are tradeoffs. Applied to the banking system’s investments, the opportunity cost of the banking system’s decision to shift away from pricing their investments on MtM (mark to market), which would have revealed expanded losses, had been to compound the buildup of liquidity strains. And despite the recent Treasury boom, the decreased exposure on HTMs has barely augmented the liquidity conditions of the banking system.

And what has been noteworthy is the paradigm shift in the banking system’s distribution of investments, which has resonated with the asset (loan-investment) distribution, as well as the liquidity, deposit growth and funding conditions.

That said, the untoward effects of the structural transformation of the current banking system model have become apparent.

And though the FSR downplayed risks to liquidity by citing a 30-day buffer, they note that ‘expected outflows is rising and it would be useful to monitor this alongside the LCR itself.”

Liquidity coverage ratio (LCR) figures assure, nonetheless, that there is enough liquidity to address a 30-day stress period. All of the above provide an asset-liability management perspective of liquidity. From a risk regulatory standpoint though, the LCR numbers from the industry provides comfort that market liquidity can handle expected outflows (Figure 2.21). 20 The caveat though is that expected outflows is rising and it would be useful to monitor this alongside the LCR itself. To the extent that high-quality liquid assets (HQLA) is comprised largely by reserves with the central bank, 21 an unexpected and persistent withdrawal would have the effect of reducing the LCR, both by reducing HQLA and increasing the outflows.

The BSP uses estimates derived from econometric models to arrive at its indicated “stress period” from which it uses in forecasting. Factors affecting “stress” are arbitrarily assumed, such that when magnified stress levels surfaces, liquidity can deteriorate faster than their models’ predictions. 

In the same vein, the FSR even cites potential risks from clearing and settlements in the next chapter. (p.29)

3.3 Clearing and settlement systems Developments in the clearing and settlement space are unfolding at two distinct levels. At the most basic, the amounts processed for payments are significant, of the order of 15 times that of the resources of the banking system or of the economy (Figure 3.13). This highlights the substantial amount of (gross) liquidity needed to support financial market activity. This point is not trivial because it means that the magnitude of settlement/pre-settlement risk may be a much bigger concern than credit risk.

It also suggests why unwinding failed transactions can have broad system-level implications. Despite institutionalizing the delivery-versuspayment protocol, the system remains vulnerable because a single bilateral failed trade may require a network of unwinding. Unfortunately, such data is not easily accessible and the extent to which these “settlement fails” represent a possible systemic risk—not just in size but more so in terms of interlinkages that can spillover to the rest of the economy—is not readily determinable, at least at this time. In general, payments system data remain largely untapped and not having even a cursory view of the dynamics of the payments network leaves financial authorities blind to their possible consequences. This is a major concern.

Fundamentally, a liquidity crunch ventilated as “settlement fails” or “failed transactions” can actually gum up the clearing and settlement system. The FSR admitted that because “such data is not easily accessible and the extent to which these “settlement fails” represent a possible systemic risk”, thereby, “the system remains vulnerable because a single bilateral failed trade may require a network of unwinding”.

To repeat: a single failed transaction can ripple into a network of unwinding!

So how does this square with the BSP’s assumption that because banks have a 30-day cushion, it can handle a squeeze in liquidity, in the face of the prospective risks that a single tremor may jolt the clearing and settlement systems that may have systemic ramifications????

In the first place, if a single transaction can do sufficient damage, what happens to the so-called buffer?

The FSR even confessed that the BSP have been oblivious to these: “such data…on possible systemic risks…in terms of interlinkages” are “not readily determinable”!

How can the BSP-FSCC come up with a complete assessment, and subsequently, a reliable forecast, if it has insufficient working causal and operational knowledge of such risks?

More importantly, “settlement fails” as pointed out earlier, signify as collateral issues, whether bottlenecks or shortages, stemming from mostly insufficient collateral and or counterparty insolvencies****.

****The US Federal Reserve Has Lost Control: As Repo Rates Skyrocket, Rumblings in US Money Markets Reverberate Across the World! September 22, 2019

To put a long story short, escalating strains in financial liquidity can morph readily into collateral gridlocks that may incite settlement fails, which may trigger a contagion.

After a 200 bps decrease in 2018, should it be a wonder why the BSP had to slash RRRs by 300 bps in 2019??? That’s 500 bps in two years!  (figure 5, upper and middle window)

In the FSR framework, the BSP’s RRR cuts have barely been intended to align reserve policies with global standards, nor has it been designed to boost lending as peddled in media. Instead, these are engineered to fill the liquidity void in the financial system. Because such measures are about releasing bank’s funds from bureaucratic rein or control, therefore, RRR cuts represent another form of regulatory bailout.

The RRR cuts and the countercyclical capital buffer. What’s next?

Figure 5

In the past, RRR cuts were used by the BSP as an emergency stabilizer for the financial system.

The BSP reduced RRRs (under old rules) by 600 bps from 21% to 15%, in 6 phases between August 29, 1997, to May 29, 1998, or during the ONSET of the Asian crisis. After reversing this with an increase of 200 bps to 17%, the next wave of 500 bps cuts, from 17% to 12%, were imposed in four phases, from October 2, 1998, to July 2, 1999. (Events of 1998 to 1999: post Asian crisis, 1998 LTCM crisis, and 1998 Russian Crisis) (figure 5: lowest pane)

The FSR Cites Contagion Risks But Uses Flawed Econometric Models to Downplay It!

The FSR expands its coverage of risks to contagion. …

Measures of contagion paint contrasting signals. Risks from leverage, concentration and liquidity would not escalate to being systemic in nature unless contagion is fully accounted for. Using delta conditional value-at-risk (ΔCoVaR) and marginal expected shortfall (MES)22 as metrics, contrasting– but not necessarily contradictory–signals were found. In Figure 2.22, the average value for the ΔCoVaR of banks has been declining since October 2018, all the way to June 2019. This can be interpreted as a decrease in the sensitivity of the system as a whole to the banks’ distressed state taken on average.23 On the other hand, the MES likewise has a turning point in October 2018 but bottoms out by the start of March 2019, thereafter reversing and heading upwards (Figure 2.23). This means that the sensitivity of the banks to a distressed state of the system as a whole has increased since March 2019.24 Banks continue to be highly interconnected with other sectors. Taken together, any vulnerabilities emanating from the system appear to be the bigger concern than those from banks to the rest of the system. This is a source of comfort yet it is hard to overlook how banks are central to the functioning of the economic network, that is, the macroeconomy.

Here the BSP-FSCC uses a statistical model, the VAR, to minimize the outlook on contagion risks.

Well, value at risk (VAR) is a poor measure of analyzing the probability of risks, considering that it understates the likelihood of a tail event.

In a public debate between David Einhorn and Aaron Brown in 2008, the former analogized the inaccuracies of VAR to "an airbag that works all the time, except when you have a car accident" and explained its flaws:

-Led to excessive risk-taking and leverage at financial institutions

-Focused on the manageable risks near the center of the distribution and ignored the tails

-Created an incentive to take "excessive but remote risks"

-Was "potentially catastrophic when its use creates a false sense of security among senior executives and watchdogs."

Mathematician, philosopher, and iconoclast Nassim Taleb even testified at the US Congress to have the use of VAR banned in financial institutions not only because tail risks are non-measurable, but such models have been used to justify the unnecessary risk-taking that contributed significantly to the scale of the 2008 Lehman crisis.

That is to say, since the BSP’s use of a quant tool barely captures the comprehensive context of risks, therefore, it is easy to downplay the probability of a systemic event from happening.

Why should VAR be relied on as a dependable risk management tool when it didn’t foresee the buildup of the present imbalances?

The FSR Concludes with an Assurance Predicated on Self-Contradiction; The Insurance Industry’s Fragility to Market Risks

After enumerating the escalating risks from multiple sources: NPLs, funding mismatches, liquidity, concentration, settlement fails, and contagion, the FSR concludes by diluting the likelihood of its impact on the economy.

On the whole, there are no indications of immediate vulnerabilities in the banking system. While credit levels have increased aggressively, the CGDP ratio has also decreased in recent periods. Contagion risk, from banks to the system, has decreased although the banking system remains—as it should be—an important element of a well-functioning macroeconomy. If there are risk issues to raise, it will have to be the prospects of managing liquidity. Aside from simply having more loans versus deposits, using liquid assets as a source for funding more earning assets needs our attention. However, the bigger issue will be that continuing on the path of being a bank-based financial market means that the provision of credit will require taking on mismatches in tenor and in liquidity. As more credit is dispensed, such mismatches will only increase. Certainly, the banking industry has been able to sustain itself despite these mismatches but moving forward, there is value to providing other avenues to alleviate the pressures on the banking books.

Such a conclusion demonstrates the web of incorrigible self-contradiction the BSP-FSCC has espoused. While dismissing the immediacy of systemic fragilities, it acknowledged that managing liquidity should be a paramount concern.

However, the FSR has been bewildered by the banking system’s continued use of “liquid assets as a source for funding more earning assets”, hence, it states that such “needs our attention”. Such excerpt exhibits that the BSP will merely resort to band-aid or whac-a-mole solutions unless it comprehends the causal linkages leading to such junctures.

Even more, the BSP’s predicament can be seen by their admitted inability to address the feedback loop of “the provision of credit will require taking on mismatches in tenor and in liquidity. As more credit is dispensed, such mismatches will only increase”. Thus, with such circularity, its policy approach depends on hope, “the banking industry has been able to sustain itself despite these mismatches”, while not identifying the “other avenues” that must be taken “to alleviate the pressures on the banking books”.

That’s how immediate vulnerabilities are dismissed.

If the BSP has failed to see the emergence of the litany of enumerated risks plaguing the banking system today, which stems from its inadequacy to understand the repercussions of their policies, then why give credence to such assurance?

And as further proof that econometric model based prediction often fails, not even credit rating agencies can be relied on when crunch time surfaces.

India’s current experience should give a practical example. From the Bloomberg-Business Standard (October 1): Mounting debt failures in India have been catching rating companies off guard, underscoring continued challenges a year after the landmark failure of shadow bank IL&FS increased scrutiny of the industry. Defaults at companies including Dewan Housing Finance Corp., Cox & Kings Ltd. and Altico Capital India Ltd. have occurred even as their long-term ratings indicated very low to moderate risk of non-payment. “Ratershave not been able to detect stress in time,” said Ashutosh Khajuria, chief financial officer at Federal Bank Ltd. “Cutting credit profiles after the defaults is no rocket science.”

And risks don’t apply just to the banks.

The FSR has an interesting observation on the insurance industry under the non-bank financials. (p.27-28)

As of March 2019, the resources in the books of banks amounted to PHP17.02 trillion, considerably larger than the PHP1.68 trillion asset size of the insurance markets as of the same period. The modest size of the insurance sector is also reflective of its low penetration rate of 1.65 percent (market premiums as a percentage of GDP) for 201733 when the comparable rate in other ASEAN-5 jurisdictions is said to be at least 3 percent. Our penetration rate has marginally improved to 1.68 percent as of March 2019 but the ASEAN average has likewise increased to 3.6 percent (Mohamad Zahid , 2018). Further, for ASEAN-5 countries, most insurance services are supplied by foreign service suppliers (Figure 3.9). 34…

In 2018, insurance companies placed PHP1.33 trillion as investments in various instruments, of which more than 40 percent are in bonds and around 30 percent are in stocks. These are not small amounts as they represent 11.1 percent of GS outstanding and 30.3 percent of equities market capitalization as of 2018. Insurance companies, in particular, will look to the capital market for investment opportunities. The regulation that increases their minimum capital from PHP550 million to PHP900 million by end-2019 represents a considerable amount of liquidity that needs to be productively placed, either to build up operations or as additional risk buffers which will need to be invested. By 2022, this minimum capital would be increased further to PHP1.3 billion which again is a significant uptick. On the whole then, we should expect the contingent market to be active institutional investors in the near to medium-term.

With 79.2% of the assets invested in the capital markets, the insurance industry is highly vulnerable to market risks. Adding to this, regulatory requirements for increases of its capital may add to the liquidity strains on the financial system.

Like banks, the insurance industry depends on the sustained easy money policies for its health. Unfortunately, the banking system’s balance sheets tell us that there are limits to everything. 

It’s about time to pay the piper.

Summary and Conclusion, Thank You Governor Ben Diokno

1. Despite the FSCC’s sugarcoating, the 2018 Financial Stability Report enumerated striking elements of escalating risks in the banking system. And in spite of the FSR’s target audience for the report, its central bank contemporaries, the BSP has been, at least, forthright about the present buildup of imbalances.

2. The FSR opens by citing the Philippines as having one of the most aggressive growth rates in private sector credit in the ASEAN, which it had associated with economic growth. Unfortunately, the development of various inequities contradicts such a claim.

3. The FSR lauded the recent decline in the credit-to-GDP ratio, although it noted that the long-term trend has been rising and continues to trek above its long-term level. Additionally, as interest rates moved higher, the debt service burden has likewise increased.

4. However, the recent decrease in the credit-to-GDP ratio came in the light of falling credit growth, which pulled down the PCE deflator, thereby affecting the GDP to the downside. In short, current events are likely deviation from an entrenched trend.

5. For the second straight year, the FSCC has placed the stock market in dim light. In 2017, overvaluation, which could result in a Minsky Moment, was the primary source of their concern. This year, the PSE’s rising interest expenses and falling profitability have anchored the FSCC’s worries.

6. The FSR seemed surprised at the recent V-shape spike of NPLs, as well as the pivotal reversal of its trend, even if it doused concerns over it as ‘very modest’, validating my previous commentaries.

7. The FSR also confirmed my observation that bank credit growth has been clustering disproportionately around several industries, amplifying concentration risks in the bank's credit portfolio.

8. The FSR also admitted to the drop in capital adequacy ratio in several banks, and as a general trend in the industry. There was no explanation given for this. By avoiding associating the swelling of risks as a boomerang to its policies, the FSR’s downplaying of risks renders their assertion as self-contradictory.

9. Significant increases in non-performing loans have emerged in the bank’s real estate portfolio of consumer loans.  What would be the feedback loop from these demand side NPLs to the industry’s supply and financial chain?

10. The FSR attributes the tightening of financial liquidity to the increasing mismatches in the banking system’s books. The FSCC seems also baffled why the bank’s loan tenor continues to shrink, when its profile should reflect on the long-term growth prospects. The BSP-FSCC seems unaware to the causal chain of events that has led to the current conditions.

11. The FSR seems also mystified by the asymmetric growth rates between loans and deposits. They have ignored the effects of their QE, the yield curve inversion, and the competition with the National Government for access to the public’s savings or the crowding out syndrome on the banking system’s books.

12. The FSR likewise noticed that while bank investments have grown sharply, cash reserves have dropped steeply. And since HTMs remain the most significant source of investments, despite the recent boom in Philippine treasuries, the current liquidity strains have partly been due to the choice of the industry to immerse in HTMs.

13. The FSR raises a potential systemic risk from the gumming of the clearing and settlement system through ‘settlement fails’, which are related to liquidity conditions. However, ‘failed transactions’ are manifestations of counterparty insolvencies and or insufficient collateral.

14. Given the present risk conditions from the deepening maladjustments in the banking system’s balance sheet, RRR cuts are primarily intended to plug its liquidity vortex.

15. With the use of Value at Risk (VAR), the FSCC diminished the likelihood of contagion from a credit event as a trigger. Unfortunately, because tail risks are hardly measurable, the VAR has had a dismal record of spotting major financial inflection points.

16. The FSR sees pressures on liquidity as a paramount concern. However, the FSCC appears to be bollixed by the fact that liquidity signifies a symptom of the business or credit cycle.

17. Finally, with the extensive scale of exposure on the capital markets as reported by the FSR, the insurance industry has been exposed as vulnerable to market risks.

For confirming most of my concerns, THANK YOU, Governor Ben Diokno!

Oh, here is a splendid reminder of the business cycle from great Austrian Economist, Ludwig von Mises, [INTERVENTIONISM: AN ECONOMIC ANALYSIS p.40]

But the boom cannot continue indefinitely. There are two alternatives. Either the banks continue the credit expansion without restriction and thus cause constantly mounting price increases and an ever-growing orgy of speculation, which, as in all other cases of unlimited inflation, ends in a “crack-up boom” and in a collapse of the money and credit system. Or the banks stop before this point is reached, voluntarily renounce further credit expansion and thus bring about the crisis. The depression follows in both instances.