Sunlight is the Best Disinfectant to Purge the Rot in the Philippine Banking System

Editor's Note:  This blog was inspired by the spectacular failure of Banco Filipino Savings and Mortgage Bank for the second time in its 38 years of existence.  This blog post and other blog posts like it attempt to describe why the bank failed.  But it also attempts to assess what other Philippine Banks have the potential to fail in the not too distant future. To see blog posts on other banks, click on the Banco Filipino Graphic at the top of the blog or click on the blog archive on the right hand column, or simply go to bancofilipinofailure.blogspot.com.

“Sunlight is the Best Disinfectant”

- U.S. Supreme Court Justice Louis Brandeis (1916 to 1939)

Now that the Philippine Court of Appeals has ruled last January 27, 2011 that Banco Filipino should be reopened, this controversial bank and its colorful Vice-Chairman has once again jumped back into the spotlight. In months prior, no less than the Bangko Sentral ng Pilipinas (BSP) claimed that the bank was closed because it was insolvent and “was operating as a pyramid or Ponzi scheme, using new deposits to pay old ones, with its officers paying themselves and their lawyers much more than the bank was earning.”¹

One major reason why Banco Filipino got away with operating as a ponzi scheme for so long was that, outside of Banco Filipino management, no one else but the BSP and its fellow regulators knew the true financial condition of the bank. Why? Because Banco Filipino had not issued financial statements - let alone audited financial statements - since 2002!

So when the bank closed last March 2011, thousands of depositors (reportedly 33,000 depositors) were taken by absolute surprise. Other than Banco Filipino's tantalizingly higher interest rates (as much as 5.75% higher than market average), depositors had absolutely no clue that the bank was about to fail. After all, the bank was expanding, adding both depositors and branches. Because of this information vacuum, the decision to close BF looked arbitrary to the uninformed general public. Moreover, Banco Filipino management was able to use the public's cluelessness to their full advantage. They claimed that the bank was solvent because its inflated assets outweighed its liabilities and, thus, was arbitrarily closed by the BSP and Monetary Board (MB). Apparently, no less than the Court of Appeals was convinced.

Had the BSP/MB and their fellow regulators such as the Securities and Exchange Commission (SEC), the Philippine Deposit Insurance Corporation (PDIC), as well as the Philippine Stock Exchange (PSE), exercised their power as regulators and compelled the bank to submit audited financial statements years ago, it would have possibly cast some light on the financial rot in Banco Filipino. The general public would have had a way of making their own independent evaluation of Banco Filipino's health.  Maybe some would-be depositors would have stayed away, limiting the damage to the general public.

One basic problem of Philippine financial regulators is in the area of public disclosure. Public disclosure is often:

1. Limited or Non-Existent
2. Irregularly Enforced
3. Not Timely
4. Not Granular
5. DOSRI Loans and Insider Transactions are not adequately described or quantified.

Limited or Non-Existent Public Disclosure

Banks are generally required to publish their statement of condition every quarter. They are required to make their financial data accessible to the public through BSP's website at www.bsp.gov.ph. Banks that do not want their statement of condition published must get approval from at least five members of the seven-man Monetary Board.² The regulators themselves may also decide to exclude certain kinds of banks from mandatory public disclosure.  One curious result of this “opt-out” policy is that there is a whole swath of the Philippine Banking System that is in the dark. The general public cannot get any data on individual Rural and Cooperative Banks from the BSP website. Only consolidated data is available. (See here: http://www.bsp.gov.ph/banking/bspsup_rural.asp) Considering that 187 rural banks have failed in the past ten years³, rural and cooperative bank depositors have no means of evaluating the health of their bank other than what is disclosed in the individual bank's website or what is available in back-dated issues of obscure rural newspapers.

Irregular Enforcement of Disclosure

Banco Filipino's years not disclosing its financial condition is not an isolated case. Regulators can and do waive this requirement.

AsiaTrust Development Bank, which, like Banco Filipino, is a publicly listed thrift bank, has not disclosed its financial statements since 2009. Its published statement of condition on the BSP website is empty of figures: http://www.bsp.gov.ph/banking/psoc_tb/asiatrustdb.htm.  It has been this way for a number of years. Despite being listed on the Philippine Stock Exchange, its financials are not available on the PSE website http://www2.pse.com.ph/. The same is true for its corporate website, which lists financial reports only until 2009. And yet the bank's existence is precarious. Like Banco Filipino, it is surviving through continuous government support, this time through another regulator, Philippine Deposit Insurance Corporation (PDIC).⁴ Like Banco Filipino, once that government support vanishes or the government deems the bank not viable, depositors will be left holding the bag.

Despite its inability to comply with financial disclosure, which is a major requirement for listing on any stock exchange throughout the world, AsiaTrust has not been delisted from the PSE.  This anomaly stands in stark contrast to the policies of other global exchanges, which takes compliance with its basic listing requirements very seriously.

For instance, in August 2006, Nasdaq OMX exchange threatened to delist Apple for failing to file its quarterly earnings statements or Form 10-Qs in a timely manner.⁵ At that time, Apple had some problems quantifying the financial impact of an options backdating scandal and was seeking an extension from the Nasdaq OMX exchange for the release of its financial statements. Apple, which has one of the largest market capitalizations in the world, was already a heavyweight (as much as 20% to 25%) of the Nasdaq 100 index back then. Its delisting would have sent shock waves throughout the global stock markets and drained market liquidity. This is like the PSE forcing a major component of the PSE Composite Index like PLDT or San Miguel Corporation to delist because it was late in its financial disclosures. Simply unthinkable in the Philippines.

Timeliness of Disclosures

Disclosures on the BSP's website are not very timely. For instance, the latest available published statement of condition for LBC Development Bank, at the time of closure in September 2011, was as of March 31, 2011 - some six months prior.  To date, the latest available published statements of condition for individual thrift banks on the BSP website is as of June 30, 2011⁶. As a result, the defunct LBC Bank's financial statements are still reflected as part of the data and they show that its financial condition continued to deteriorate.

Again, this stands in stark contrast to other regulators. For instance, the latest available financial statements of BankEast of Knoxville, Tennessee in the USA, which was closed by the FDIC (the US counterpart of PDIC) last January 27, 2012⁷, are as of December 31, 2011 - less than thirty days prior to its closure. The files can be downloaded by anyone at the Chicago Federal Reserve website: https://cdr.ffiec.gov/public/. Moreover, the financial disclosures of most FDIC-insured banks, even the tiniest rural bank, can be found on that website.

Granularity or Level of Disclosure

As can be seen in the downloadable report on the now defunct BankEast, US financial regulators have made Bank Call Reports (financial disclosures in the form of a balance sheet, income statement, and supporting schedules⁸) as well as other financial data publicly available. The financial disclosures are fairly detailed, providing schedules on assets, liabilities, capital accounts, income and expenses. And they can be downloaded in bulk, allowing the general public to make detailed assessments of an individual bank's financial condition, if they wanted to.

This level of disclosure allows independent research firms such as Institutional Risk Analytics (http://us1.institutionalriskanalytics.com/www/index.asp) to provide individual or institutional investors with ratings on individual banks. It also allows consumer advocacy groups such as “Move Your Money” http://moveyourmoneyproject.org/, which is against the so-called "Too Big To Fail" banks, to point consumers to smaller institutions that they deem safer for ordinary depositors. The bulk extraction also allows third-party data providers such as SNL Financial http://www.snl.com/Sectors/Fig/Default.aspx to provide financial analysts, corporate treasurers, and financial institutions with detailed financial profiles on more than 20,000 financial institutions.

This level of disclosure on financial institutions is simply not available in the Philippines.

DOSRI Loans and Transactions

DOSRI Loans

All major Philippine banks and financial institutions are significantly owned and controlled by families. These families often use the banks they control as funding vehicles for their diverse business interests. As a result of this, Philippine financial authorities have issued what is known as DOSRI rules - rules that limit loans to Directors, Officers, Stockholders, and Related Interests (DOSRI). In the aggregate, DOSRI loans generally should not exceed the total capital funds or 15% of the total loan portfolio of the Parent Company and/or any of its lending and nonbanking financial subsidiaries, whichever is lower.

As it stands right now, banks are required to disclose the amount of these DOSRI loans and receivables, the amount of past due DOSRI loans and receivables, the ratio of the unsecured DOSRI accounts to total DOSRI loans, and the ratio of past due DOSRI loans and receivables to the Total Loan Portfolio (TLP).

For instance, the Rizal Commercial Banking Corporation (RCBC), a bank owned and controlled by the Yuchengco family, reported PHP 4.627 billion in DOSRI loans as of June 30, 2011 - around 12.5% of RCBC's Total Stockholders Equity of PHP 36.969 billion. The DOSRI loans represent roughly 3.7% of RCBC's Total Loan Portfolio. Of this amount, around 11.3% of the DOSRI loans or PHP 525 million is past due. These past due DOSRI loans represent 0.40% of RCBC's Total Loan Portfolio.⁹

DOSRI limits are often prone to abuse and DOSRI violations have led to the downfall of many Philippine banks. As recently as November 30, 2010, BSP placed as many as 8 big commercial banks under close monitoring for DOSRI violations.¹⁰ Although bank policies often state that these DOSRI loans are “on commercial, arm's length terms, i.e., substantially on the same terms as loans to other individuals and businesses of comparable risks”,¹¹ very little is disclosed regarding the nature of these loans such as:

1. Names of DOSRI Borrowers
2. Amount of Loan
3. Date of Loan
4. Loan Tenor and Maturity Date
5. Price of Loan (Interest Rates)
6. Purpose of Loan
7. Nature of the Collateral provided
8. Collateral Valuation and Appraisal
9. Loan Status such as Current, Past Due, Restructured

As a result, it is hard for the public to ascertain whether the loans were really given at market rates or at preferential rates, whether the collateral provided was widely overvalued, or whether the DOSRI loans were restructured to keep them from being labeled as past due.

DOSRI violations commonly include excess or breach of DOSRI caps and failure to report the loans. For instance, the now defunct LBC Development Bank, which reported only PHP 19.145 million in DOSRI loans as of June 30, 2011 and zero as in zero past due DOSRI loans), failed because it had unpaid cash advances to a sister company, the remittance firm LBC Express, running into the billions of pesos.¹² Instead reflecting these cash advances as DOSRI loans in its Total Loan Portfolio, it book them as "Other Assets." As a result, LBC Development Bank had PHP 4.760 billion in “Other Assets” as of June 30, 2011.¹³ In other cases, such as in the case of Banco Filipino, other banks used dummy accounts for the borrowers to circumvent DOSRI limits (See http://bancofilipinofailure.blogspot.com/2011/08/system-is-broken.html).

Insider Transactions

Philippine banks disclosures on Insider or Related Party Transactions, are very limited. Very often, they do not quantify the transactions themselves and only provide a general description.

For example, RCBC does not quantify the costs of its lease with RCBC Realty:

“The Bank is a lessee of RCBC Realty of which it directly owns 25.0 per cent. and indirectly owns 9.8 per cent. through its equity holdings in RCBC Land. RCBC owns 49.0 per cent. of RCBC Land, which owns 20 per cent. of RCBC Realty.”¹⁴

Furthermore, RCBC did not quantify the cost savings of its agreement with House of Investments, a Yuchengco Group Company, for the procurement of outsourcing services. So there is no way to substantiate the bank's claim that it getting a fair deal for its public shareholders. Very often, controlling stockholders use such outsourcing deals to extract money away from the business entities they do not fully own, at the expense of minority shareholders.

“The Bank entered into a Memorandum of Agreement with HI, a member of the YGC, for the procurement of outsourcing services. Under the agreement, HI is the Bank’s sole representative in negotiating the terms of the contracts with selected suppliers or service providers for the procurement of certain outsourcing services, primarily IT related services. The agreement stipulated that HI would not charge fees for its service except for its share in the savings generated from suppliers and service providers. Moreover, HI is obligated to ensure that the contracts they initiate do not prejudice the Bank in any way and that the Bank does not pay more than the cost of buying the items without aggregation.”

RCBC also does not quantify the cost of legal services provided by non-executive, non-independent director Atty. Teodoro Dy-Liaco Regala, who is a partner in ACCRA, which serves as RCBC's external legal counsel:

“The law firm of Angara Abello Concepcion Regala & Cruz (ACCRA) Law Office is among the firms engaged by the Bank to render legal services. Atty. Teodoro Dy-Liaco Regala, Board Member, is a Senior Partner of ACCRA Law Office. During the year, the Company paid ACCRA legal fees that the Company believes to be reasonable for the services provided.”

RCBC's disclosures are typical of Philippine banks and are compliant with current laws and regulations. But they are “de minimis” as compared to the disclosures of global banks that operate in regulatory regimes with stricter disclosure requirements.

For instance, under its corporate governance guidelines, Citigroup has almost no “DOSRI” loans.

“The Guidelines restrict certain financial transactions between Citi and its subsidiaries on the one hand and directors, senior management and their immediate family members on the other. Personal loans to executive officers and directors of Citi and its public issuer subsidiaries and the most senior executives of the company, or immediate family members who share any such person’s household, are prohibited, except for mortgage loans, home equity loans, consumer loans, credit cards, charge cards, overdraft checking privileges and margin loans to employees of a broker-dealer subsidiary of Citi made on market terms in the ordinary course of business.”¹⁵

Citigroup's guidelines on business relationships severely limit business relationships between the bank and its affiliated directors and officers.

"All business relationships, lending relationships, deposit and other banking relationships between the company and a director’s primary business affiliation or the primary business affiliation of an immediate family member of a director must be made in the ordinary course of business and on substantially the same terms as those prevailing at the time for comparable transactions with non-affiliated persons."

"In addition, the aggregate amount of payments for property or services in any of the last three fiscal years by the company to, and to the company from, any company of which a director is an executive officer or employee or where an immediate family member of a director is an executive officer, must not exceed the greater of $1 million or 2% of such other company’s consolidated gross revenues in any single fiscal year."

Under its guidelines, even charitable contributions of Citigroup's directors are covered and disclosed.

"Annual contributions in any of the last three calendar years from the company and/or the Citi Foundation to a charitable organization of which a director, or an immediate family member who shares the director’s household, serves as a director, trustee or executive officer (other than the Citi Foundation and other charitable organizations sponsored by the company) may not exceed the greater of $250,000 or 10% of the charitable organization’s annual consolidated gross revenue."

The disclosures are very painstakingly detailed. Here's Citigroup's disclosure on the purchase of CEO Vikram Pandit's hedge fund, prior to his assumption of the CEO title.

“In April 2007, Citi entered into an agreement to purchase 100% of the outstanding partnership interests in Old Lane Partners L.P. (Old Lane), a hedge fund firm co-founded by Vikram Pandit and John Havens in which each of Vikram Pandit, John Havens and Brian Leach had an interest. At the time of the Old Lane acquisition in 2007, a substantial portion of the purchase price paid to the former owners of Old Lane was required to be invested in the Old Lane Fund until July 2011, the fourth anniversary of the closing of the transaction. Accordingly, on behalf of each of Vikram Pandit and John Havens, $100,273,630 was invested (a substantial portion of which was subject to forfeiture until July 2011), and on behalf of Brian Leach, $10,862,222 was invested in the Old Lane Fund. In June 2008, Citi purchased substantially all of the assets in the Old Lane Fund and redeemed substantially all of the interests of investors in the Old Lane Fund. In connection with the redemptions of investors’ interests, distributions were made in respect of a portion of the investments made by the former owners of Old Lane in the Old Lane Fund, including $79,706,630 each, in the case of Mr. Pandit and Mr. Havens, and $8,634,283, in the case of Mr. Leach. The amounts distributed are invested, and all future distributions will be invested, in an account at the Citi Private Bank for the remainder of the period ending July 2011. The funds may be withdrawn earlier in the event the executive dies or his employment with Citi terminates by reason of his disability or without cause or for good reason or, in the case of Mr. Leach, upon termination of his employment with Citi for any reason. A substantial portion of Mr. Pandit’s and Mr. Havens’ investment remains subject to forfeiture if the executive’s employment with Citi terminates for cause or without good reason before July 2011.”

Here's Citigroup's disclosure of its consulting relationship with non-executive, non-independent director Robert L. Joss:

“On April 5, 2010, Citi entered into an agreement with Robert L. Joss, who serves as a director of Citi. Pursuant to the agreement, Mr. Joss would receive $350,000, payable quarterly in arrears, to provide consulting services during 2010 to the company and its subsidiaries and affiliates. Mr. Joss’ agreement was renewed for 2011. Pursuant to Citi’s Policy on Related Party Transactions, the nomination and governance committee approved the agreement with Mr. Joss.”

Here's Citigroup's disclosure of services provided by the son of Citigroup executive Manuel Medina Mora, who is CEO of Citigroup's Global Consumer Banking:

“In 2010, a Citi subsidiary entered into an agreement with a company that is majority owned by Mr. Jose Manuel Medina Mora, a son of Manuel Medina Mora, to provide web design services for a transactional website focusing on the subsidiary’s products and services. The vendor was paid approximately $800,000 for its services. The assignment has been fulfilled and the agreement is no longer in effect.”

Citigroup even details the compensation of the spouse of Citigroup Vice-Chairman Lewis Kaden's adult child:

“An adult spouse of an adult child of Lewis Kaden, an executive officer, was employed full time during part of 2010 by Citi’s Global Consumer Group. As of May 2010, this employee became a part-time employee. The total compensation paid to this employee in 2010 for the full-time and part-time work was $225,540. This employee is one of the approximately 260,000 employees of Citi.”

Conclusion

It is highly unlikely that the BSP will severely limit DOSRI loans and transactions to a tiny sliver of bank capital.  Large global banks such as Citigroup are not family owned.  Instead, ownership is dispersed widely among various large financial institutions such as asset management firms and pension funds.  But providing more detail as to the nature, status, and cost of these loans and transactions will go a long way in providing market discipline to the banking system.  Shedding more light in the form of more regular, detailed, and timely public disclosures will certainly go a long way in purging the rot of the Philippine Banking System.

1“BSP: Our lawyers will review CA ruling on reopening Banco Filipino,” February 2, 2012, GMA News Network. http://www.gmanetwork.com/news/story/246533/economy/moneyandbanking/bsp-our-lawyers-will-review-ca-ruling-on-reopening-banco-filipino?ref=section_latest

2“BSP asked to identify banks similar to Legacy Group,” May 11, 2009, by Eileen A. Mencias, Manila Standard Today. http://www.manilastandardtoday.com/2009/may/11/business2.htm

3Saksi: Pagsasara ng Banco Filipino at LBC Devt. Bank, ikinadismaya”, October 4 2011, GMA News Online, http://www.gmanetwork.com/news/video/93600/saksi-pagsasara-ng-banco-filipino-at-lbc-devt-bank-ikinadismaya

4“Bizz Buzz: Pros and Cons, September 26, 2011, Philippine Daily Inquirer. http://business.inquirer.net/21431/biz-buzz-pros-and-cons

5“Apple Receives Stock Delisting Threat”, by Ed Oswald, August 11, 2006, Betanews.com, http://betanews.com/2006/08/11/apple-receives-stock-delisting-threat/

6http://www.bsp.gov.ph/banking/psoc_tb/lbcdb.htm

7http://www.fdic.gov/bank/individual/failed/banklist.html

8http://www.chicagofed.org/webpages/banking/financial_institution_reports/call_report_regulatory_reporting_guide.cfm

9http://www.bsp.gov.ph/banking/psoc/by_banks/R%20C%20B%20C%20.htm

10“8 big banks violated DOSRI rule - BSP”, by Lee C. Chipongian, November 30, 2010, Philippine Development Finance http://phildevfinance.posterous.com/8-big-banks-violated-dosri-rule-bsp

11RCBC's Consolidated Financial Statements as of December 31, 2010. http://www.docstoc.com/docs/111840464/RCBC-Financial-Statements-2010

12“BSP: LBC Bank doomed by huge cash advances to LBC Express”, by Michelle V. Remo, September 13, 2011, Philippine Daily Inquirer. http://business.inquirer.net/18915/bsp-lbc-bank-doomed-by-huge-cash-advances-to-lbc-express

13http://www.bsp.gov.ph/banking/psoc_tb/lbcdb.htm

14RCBC's Definitive Information Statement, as of May 28, 2011, page 19, http://www.docstoc.com/docs/111840222/RCBC-Proxy-Statement-2011

15Citigroup 2011 Proxy Statement, http://www.citigroup.com/citi/fin/data/ar11cp.pdf?ieNocache=96