It is well enough that people of the nation do not understand our banking and monetary system, for if they did, I believe there would be a revolution before tomorrow morning—Henry Ford (attributed)
In this issue
Is the Banking System Prepared for an Era of Stagflation and Higher Rates?
I. How the BSP’s Inflation Targeting Policy Framework Influenced the Banking System
II. Banking and Financial Stress Buildup Even Before the Pandemic!
III. Despite Relief Measures, HTMs Soar and Market Losses Mount!
IV. Stagflation Ahoy! More Interventions Increase the Fragility of Banking and Financial System
Is the Banking System Prepared for an Era of Stagflation and Higher Rates?
Central banks only know how to institute an easy money regime.
I. How the BSP’s Inflation Targeting Policy Framework Influenced the Banking System
The BSP on Inflation Targeting…
Among the various government bodies, the Bangko Sentral ng Pilipinas (BSP) is uniquely qualified to promote price stability because it has the sole ability to influence short‐term market interest rates. By influencing short term interest rates, the BSP is able to affect the demand of households and firms for various goods and services. Domestic demand and the aggregate supply of goods and services determine the general price level. (BSP, 2020)
The banking system has thrived and grown under the inflation-targeting monetary policy framework of the BSP. Or, the financial ecosystem has become dependent on the eternity of a low-inflation, low-interest rate environment.
The challenge is, what if the era of zero-bound rates has reversed? Are banks prepared for it?
The balance sheet of the banking system provides us an insight.
As of August 2022, the industry's loans and investments comprised 82% of its overall assets. (Figure 1, topmost pane)
Although loans constituted 52.91% of the total assets in August 2022, this was sharply down from its pinnacle of 59.04% in March 2020. This slump was mainly due to the economicfreeze imposed by authorities in response to the pandemic.
Historically, the banking system had a more balanced distribution of assets (loans/investments/cash). This model changed post-GFC.
Banks shifted their emphasis towards loans, so the segment's share ballooned from 45.4% in November 2010 to the March 2020 peak of 59.04%!
But when authorities froze the economy in response to the 2020 pandemic, the BSP couldn't afford a liquidity crunch. It implemented an aggressive emergency bundle consisting of historic liquidity injections, unparalleled monetary policy, released reserves, and provided a package of relief measures.
Overall, this rescue policy was the most audacious among emerging markets.
Then the BSP patted on themselves: "For the authorities, lesson #1 states the obvious: financial market activity is dependent on market liquidity. When the distribution of that liquidity stalls, the financial market stalls as well". (Diokno, 2021)
As a measure of total liquidity, following the spike from pre-pandemic Q3 2019 to Q1 2021, money supply growth remains adrift at a record share of the GDP. (Figure 1, middle window)
Faced with unprecedented excess liquidity and other measures that relieved banks from disclosing their actual conditions, the industry remodeled its operations by shifting towards financial asset speculation.
The hope was that excess liquidity would find its way to the asset markets, lifting its value to forestall or prevent credit and collateral deflation.
Therefore, from 22.42% in March 2020, the share of total investments soared! It culminated to 29.13% in July 2022. It was down by a smidgen to 29% last August.
In the meantime, excess liquidity flowed into the bank's balance sheet through its cash buffers. Cash and due from banks jumped from 14.4% in March 2020 to its zenith at 18.71% on March 2021 and trended south after. It had a 12.75% share of the industry's assets last August.
However, the sharpest fall in cash reserves occurred in 2022. Cash had a share of 17.2% in December 2021. (Figure 1, lowest window)
Above all, since the industry's business model recalibrated to focus on lending, the share of cash crescendoed to 25.6% nine years ago, or in December 2013, and has eroded since.
Bank loans, total investments, and cash accounted for 94.6% of the industry's balance sheet as of August 2022.
In a nutshell, the resulting transformation of the banking industry from the BSP's "inflation-targeting" framework increased their exposure to various risks while reducing their cash buffers by half.
II. Banking and Financial Stress Buildup Even Before the Pandemic!
There's more to this. But here's a backstory.
Inflation reared its ugly head thrice in the last decade.
It first emerged in response to the ten consecutive months of over 30% growth in the money supply from July 2013 to April 2014. The CPI surged to its pinnacle of 4.2%.
The BSP responded by modestly tightening through a 50 bps increase.
Inflation turned into a two-month deflation. The CPI 2012 posted two straight months of negative (September -.4% and October 2015 -.2%).
The response of the BSP was to inject liquidity by monetizing government debt through banks.
Bent on pushing a centralized economy, the newly installed political leadership of 2016 vowed to increase spending on infrastructure and other welfare programs.
Throughout his regime, the fiscal deficit swelled to unprecedented levels. The mild trade deficit morphed into an unparalleled bulge.
Though the BSP "knew" the economic ramification of this, they accommodated the desires of the political authority. Through zero-bound policies, domestic monetary authorities, in collaboration with their international peers, harbored and nurtured the "twin deficits."
[As an aside, rising rates have barely stopped the domestic economy from overspending, as the trade deficit mushroomed to a record USD 6 billion in August 2022!] (Figure 2, upper window)
Hence, the CPI surged anew to a multi-year zenith of 6.7% in 2018.
Although authorities convinced the public that the inflation spike represented a supply-side problem, specifically a 'rice crisis,' strangely, it compelled a monetary response.
The BSP rapidly raise rates by 175 bps or from 3% to 4.75% in 7 months (March to November 2018)!
Eventually, Non-Performing Loans (NPL) picked up speed, and bank liquidity strains emerged, so the BSP not only trimmed rates to 4% but also released bank reserves. The late BSP Governor Nestor Espenilla Jr. warned that rising rates "caused dislocations of crisis proportions." (Espenilla, 2018) [Figure 2, lower pane]
Bluntly, banking and financial stress had been building up even before the pandemic.
III. Despite Relief Measures, HTMs Soar and Market Losses Mount!
Fast forward to the pandemic of 2020.
The pandemic provided the BSP the convenient political camouflage to mount a historic rescue of the banking system.
In their consumer infographics on interest rates, the BSP explained that extended low rates and fiscal deficits cause interest rates to rise.
So why shouldn't interest rates surge as street prices have been raging?
Why should these factors be a surprise to almost everyone?
Despite the relief measures to conceal the banking industry's actual health, the symptoms of stress have been conspicuous.
In the 2018 inflationary cycle, rising rates didn't only push up NPLs but also prompted banks to disguise market losses by reclassifying assets as Held to Maturity (HTM). (Figure 3, topmost pane)
In the current inflationary crisis, HTMs have ballooned to RECORD levels surpassing their 2018 episode!
For one thing, today, HTMs PILED on the imbalances acquired during the inflationary cycle of 2018.
And since HTMs sops up liquidity, their record buildup helped vacuum cash buffers of banks!
But that's not all.
One of the most feared phrases on Wall Street is, "This time is different."
When rates rose in 2018, banks barely reported market-based losses from investments. But this time is different. Reported market losses are at a record!
Banks reported a cumulative market loss of Php 88.2 billion in August 2022, slightly lower than the record Php 97.12 billion in June 2022.
While losses are a speck of the net financial assets, one can add HTMs and declared and undeclared NPLs.
What's more, the non-transparent emergency operational, regulatory, and capital relief measures amplify the likelihood of substantial skeletons in the closet.
IV. Stagflation Ahoy! More Interventions Increase the Fragility of Banking and Financial System
Think of it this way.
Logic backed by empirics has shown that higher rates result in increased NPLs. And that's from half of the bank's assets (bank lending).
But because banks increased their weights on investments, which accounted for about a third of their total assets, particularly with exposure in fixed income, rising rates have taken a toll through reported and camouflaged losses through HTM (also off-balance sheets?).
Figure 4
As such, cash buffers have declined, draining financial liquidity.
The BSP data shows this: Cash-to-deposits has shrunk, while liquid assets-to-deposits have rolled over. (Figure 4, topmost pane)
Even with the record injections in 2020, liquidity conditions have barely gained ground to the levels of the last decade. But the artificial injections have started to unravel, which points to tighter financial conditions.
Another is the aftermath of contrived easy money policies.
Through the record low policy rates, the BSP has bankrolled subsidies that led to accounting profits for the industry. For instance, the record low rates have pulled down bank deposit liabilities, expanding net interest margins.
But even then, the profit metrics of the BSP have barely recovered from the pre-pandemic levels. Despite the latest unmatched rescue efforts by the BSP, the banking system's Return on Equity (ROE) and Return on Assets (ROA) have remarkably cascaded.
Worst, despite the unprecedented interventions/rescue efforts, these are substantially lower than levels attained about a decade ago.
From this, we can conclude that the massive misallocation of resources didn't deliver the desired effects but also strip-mined the economy.
Principally, the structure of the banking system lies entrenched in the artificially lowered rates based on an 'inflation targeting' policy and the constant support and rescue from the BSP.
What happens when the structural trend of inflation and interest rates reverses? And or when these upset the BSP's capability to mount rescues?
What happens to the economy and financial system should the industry decide to conserve resources by pulling back on lending and investing? Does the BSP know?
Does the BSP have, in its policy toolkit, contingencies for an extended period of elevated rates?
The evidence has only exhibited a single direction for its policies: an easy money regime! Past emergency measures have barely seen any "exit" through the years. (Figure 4, lowest pane]
By extension, the industry's mounting losses on multiple fronts, official and undisclosed NPLs, realized and floating investment losses, which contribute to the drain in cash and liquidity, herald even MORE interventions to rescue or bail out the system.
And to this end, the more interventions, the weaker the banking system; the greater the odds of a financial crisis.
In turn, these interventions foster more resource, financial and monetary imbalances that should escalate pressures on street inflation.
As it is, financial stress will likely become even more evident in the financial markets; the peso, fixed income, and stocks.
And when financial assets are all under pressure, the much-touted Capital Adequacy Ratio (CAR) becomes meaningless statistics.
Transitory. Peak Inflation. Not a chance (under the present overspending paradigm).
Though NO TREND IS A STRAIGHT LINE, unless an overhaul in the present policies occurs, like it or not, STAGFLATION is OUR future.
___
References
Bangko Sentral ng Pilipinas, Inflation Targeting, March 2020 bsp.gov.ph
Diokno, Benjamin 2nd Semester 2021 FINANCIAL STABILITY REPORT, FINANCIAL STABILITY COORDINATION COUNCIL, p.4 December 2021, bsp.gov.ph
Espenilla Jr., Nestor 2017 FINANCIAL STABILITY REPORT, FINANCIAL STABILITY COORDINATION COUNCIL, June 2018, bsp.gov.ph
