Amando M Tetangco, Jr: Central Bank of the Philippines' initiatives to
strengthen risk management practices in banks
Keynote address by Mr Amando M Tetangco, Jr, Governor of the Central Bank of the Philippines
(Bangko Sentral ng Pilipinas), at the Quarterly Risk Management Forum, Makati City,
6 December 2006.
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Good afternoon, and thank you for inviting me to speak in this quarter's risk management forum
organized by the Gov. Jose B. Fernandez, Jr. Center for Banking and Finance (JBF Center), in
cooperation with the Professional Risk Managers' International Association (PRMIA).
My remarks this afternoon will focus on BSP's initiatives to strengthen risk management practices in
banks under our supervision. Since banks still dominate the financial landscape in our country, the
BSP as the banking supervisor has to be at the forefront of the development of better risk
management practices in the country. Although this is a very challenging role to play given the pace of
development in the field of risk management, I do believe that the BSP is up to the challenge and has
been proactive judging by the number of initiatives we have put in place starting in the mid-90s.
It is my pleasure to share with you our experience on the implementation of these initiatives, but
before that let me highlight the risk profile of the Philippine banking system, which dictated the
direction and pace of these regulatory actions.
Risk profile of the Philippine banking system
As of end-June 2006, total on-balance sheet assets of the banking industry amounted to P4.5 trillion,
of which about 89 percent are accounted for by the dominant commercial banking segment.
Additionally, off-balance sheet notional accounts - consisting of derivatives, trust and trade-related
contingent exposures - amounted to P2.3 trillion. In terms of risk-weighted assets or RWA - which is a
supervisory measure of banks' risk exposures to credit risk and market risk only - commercial banks'
exposures are made up of 90 percent credit risk and 10 percent market risk. With the addition of
operational risk in the risk-based capital adequacy framework of the BSP on 1 July 2007, our
simulations show that commercial banks' RWA will be made up of 77 percent credit risk, 8 percent
market risk, and 15 percent operational risk.
As primary buffer against these risk exposures, Tier 1 capitalization of the banking system, which
includes hybrid Tier 1 capital stood at P433 billion as of end-March 2006. Our banks have also issued
P79 billion in Tier 2 capital as allowed under our regulations consistent with international practices.
CAR (capital adequacy ratio) stood at 19.4 percent as of end-March 20061 while loss provisions,
which serve as cushion for expected losses have been significantly boosted from just 1.44 percent of
total assets in end-December 1997, to 2.72 percent as of end-June 2006.
BSP's risk management initiatives
Now, let me guide you through the important historical highlights of BSP's risk management initiatives.
In 1995, the BSP recognized the greater risk exposure in the system brought about by derivatives
activities. To mitigate this, the BSP issued Circular No. 102 prescribing the minimum standards for risk
management of derivatives. This was probably the first BSP regulation that specifically focused on
banks' market risk taking activities and risk management practices. Prior to this, risk management
regulations were largely confined to basic credit risk management and to internal control issues.
In 1997, the thrust of bank supervision started to shift its focus towards a more forward-looking view of
risk management and whether a bank has the infrastructure to manage its own risks, instead of just
mainly performing financial audit and compliance review. The objective was to address weaknesses in
management and internal controls before financial performance suffers rather than being satisfied with
identifying what went wrong after the fact.
The BSP's effort to focus on risk management is ultimately intended to give banks greater flexibility to
respond to changing opportunities and challenges in the face of global competition under a more
deregulated environment and at a time of rapid technological advances.
Traditional bank supervision tended to micromanage banks to avoid risks that seem too high. The new
approach to supervision is now more focused on the assessment of the quality of risk-management
practices and generally allows banks to take on greater risks so long as the banks demonstrate the
ability to identify, measure, manage and price for those risks.
This more liberal approach to supervision, which allows banks more opportunities for success, entails
that the BSP emphasize the responsibility of the banks' board of directors and senior management to
ensure the soundness and stability of their respective banks. The regulators' role is primarily to
evaluate the quality of oversight and management provided by these critical actors - that is, the quality
of corporate governance.
Strengthening banks' corporate governance has thus been the theme of a number of BSP regulations.
In June 1997, Circular No. 130 requiring the board of directors of banks to, among others, adopt and
maintain adequate risk management policy was issued. A few months after, or in October 1997, the
BSP also issued Circular No. 145 requiring banks to develop and implement a compliance system and
to appoint/designate a compliance officer to oversee its implementation. In September 2001, the BSP
issued Circular No. 296 which implemented the fit and proper standards for directors and officers of
banks and non-banks as mandated by the General Banking Law (GBL) of 2000. The same Circular
also prescribed a mandatory orientation program on corporate governance for banks' board of
directors. Moreover, the BSP issued in October 2003 Circular No. 410 which provided the
accreditation guidelines for banks' external auditors.
In 2004, the BSP continued to issue a number of guidelines that aimed to further enhance governance
practices in banks. Earlier that year, the BSP issued the guidelines for the management of banks'
large exposures (Circular No. 414). This was followed by the strengthening of rules on connected
party transactions or DOSRI by expanding both the coverage of transactions and the definition of
related interests (Circular No. 423). The BSP also issued Circular No. 429 that year which aimed to
further strengthen banks' compliance function. The BSP also issued that year the guidelines for the
development and implementation of banks' internal credit risk rating systems (Circular No. 439) in
anticipation of Basel II. The guidelines strongly emphasize the oversight function of the board of
directors over these systems. Before 2004 ended, BSP issued Circular No. 456 amending the
provisions on the specific duties and responsibilities of the board of directors in the Manual of
Regulations for Banks. The said Circular created three board-of-director-level committees, namely;
audit committee, corporate governance committee, and risk management committee.
This year, the BSP pushed forward with its shift to risk-based supervision by issuing the guidelines on
the supervision by risk, setting forth the expectations of the BSP with respect to the conduct of risk
management by financial institutions under its jurisdiction. This was followed closely by the issuance of
the guidelines on technology risk management, which is aimed at ensuring effective management of
technology-related risks by financial institutions. Just recently, the BSP issued broad guidelines on
market risk management and liquidity risk management, which set forth BSP's expectations on the
management of these risks by banks.
BSP's risk-based capital initiatives
While the BSP has been trying to enhance banks' risk management practices, it is also simultaneously
working on improving the risk-based capital adequacy framework as empowered under the GBL of
2000. We responded swiftly once the legal framework was put in place. In March 2001, the BSP
adopted Basel I-type framework through Circular No. 280. This Circular provided the guidelines for the
computation of risk-based capital for credit risk. The BSP's risk-based capital adequacy framework
was further enhanced with the issuance of Circular No. 360 in December 2002. Circular No. 360
incorporated market risk into the framework.
In 2005, the focus was on preparing the implementing regulations for the eventual implementation of
Basel II in the Philippines. At the time, preparatory works on Basel II implementation were already at
an advanced stage globally. The discussions during international fora had already become complex
and rather extended. For our part, the approach to implementation has been more calculated. Certain
elements of the Basel II approaches such as those pertaining to risk weights for corporates and NPLs,
were gradually incorporated in existing regulations to pave the way for a smoother implementation of
the whole new framework in 2007. Meanwhile, in response to heightened appetite and growing
exposure of banks to structured products and in preparation for the envisaged take-off of the domestic
securitization market following the approval of the Securitization Act of 2004, the BSP pre-emptively
issued in 2005 the risk-based capital treatment of banks' exposures to structured products and
securitization structures. In support of major policy objectives of enhancing credit access and
expediting the clean-up of bad assets from the system, the BSP likewise advanced lower credit risk
weightings for high grade corporate debt exposures and micro and SME exposures, but also
increased the risk weighting on non-performing loans.
This year, the BSP has issued the much-awaited Basel II implementing guidelines for the Philippines.
The BSP's Task Force on the Implementation of Basel II has just concluded their series of briefings
both within and outside of the BSP in preparation for the parallel run that will be conducted starting
end this year until mid next year. Unlike the existing BSP risk-based capital adequacy framework, the
new Basel II-based framework does not only focus on the computation of the appropriate level of
capital given a certain level of risk exposure, but it also highlights the need for more market
disclosures by banks on their risk management exposures and practices. This is fully consistent with
Basel II Pillar 3 recommendations, as well as the new International Financial Reporting Standards or
IFRS which we fully adopted since 2005. The rationale is that the market itself contains disciplinary
mechanisms that can reinforce the efforts of supervisors by rewarding banks that manage risk
effectively and penalizing those whose risk management is inept or imprudent through their patronage
or non-patronage.
Basel II and risk management
As we move into implementation of Basel II, industry reaction is both revealing and interesting. On one
hand, the commotion it is causing with banks doubling their efforts in improving their risk management
systems to meet the requirements of the advanced approaches is a very positive development as far
as the BSP is concerned. On the other hand, it is rather disappointing that it takes regulatory pressure
for many banks to finally start investing in a sound risk management system.
I understand that there are certain problems that now face banks as they aim to improve their own risk
management systems. . A survey of emerging market central banks conducted by the BIS reveals the
three main difficulties faced not just by you, but by banks in emerging markets in general, in
implementing more sophisticated risk assessment techniques. These are:
1. Data problems. Modern techniques of risk assessment in Basle II involve estimation of
probabilities of default on the lenders' portfolio, as well as of loss-given-default. Foreign
banks get around by relying on data from their home country operations, but these data may
not be applicable in the emerging markets they operate in. Many emerging markets are
however taking steps to improve data availability. For example, Malaysia and Thailand have
respectively established centralized credit registry for households and corporations and a
credit information bureau.
2. Lack of suitable techniques for designing and calibrating models to evaluate alternative
scenarios.
3. Large human resources and infrastructure (IT and other) costs of implementing advanced
techniques for risk assessment.
But improvements in risk management have inherent value to banks by avoiding major costs, including
potentially catastrophic costs that can break a bank. Thus they should be pursued with or without
regulatory requirements. Those of you who are sports fans can relate to this. As you know, success in
many sports today relies on a solid defense that is always there whether the breaks are with you or
not.
Sophisticated risk management systems should be put in place because the bank sees the need to,
and not just to impress, or perhaps intimidate the supervisors. The latter I guarantee is highly unlikely
to happen because our supervisory personnel have also been doing their homework. Indeed, we have
not just strengthened the regulatory framework. No less important, the BSP has invested heavily in the
last few years in enhancing our supervisory capacity in line with the new demands. These efforts have
ranged from individual skills enhancement through world class in-house structured training program to
acquisition of relevant international certification, to creation of highly trained special teams, and
currently a wholesale re-engineering and reorganization of the whole supervision and examination
set-up. I assure you, we will be up to the task. We practice what we preach.
Wrong motivations for improving banks' risk management systems may obscure the ultimate aim for
such actions - i.e., to make banks' shareholders and other stakeholders, NOT the regulators, happy
by safeguarding and enhancing the value of their investments. On our part, BSP's interest in
promoting better risk management is motivated more by macro considerations - that is, a safe and
sound banking system is crucial to economic growth and to the stability of financial markets.
Concluding remarks
Let me now sum up. If you notice, the BSP initiatives I have mentioned are geared towards
simultaneously promoting sound risk management practices in banks, and strengthening the
riskbased capital adequacy framework. This is because both robust risk management and strong capital
positions are critical in ensuring that individual banks operate in a safe and sound manner, which in
turn enhances the stability of the financial system. In addition, strong capital helps banks absorb
unexpected shocks and reduces moral hazard associated with the regulatory safety nets.
Finally, let me reiterate BSP's commitment to the identification, assessment, and promotion of sound
risk management practices in the financial system, which it considers as central elements of good
supervisory practice. But of course the BSP can only do this with the invaluable help of our allies from
the academe and the industry, such as the JBF Center and PRMIA.
Before I end, let me just quote Captain James Kirk of the Star Trek Enterprise: "Risk is our business.
That's what this starship is all about. That's why we're aboard her." Indeed, the same can be said of
banking.
Thank you very much and good day to all of you.