The financial system is both institutions and markets

OWe have no doubt that the huge off-cycle adjustment in policy rates made by the Bangko Sentral ng Pilipinas (BSP) last month continues to surprise both market analysts and economists. Positively, many of them admit that such a unique movement re-rooted inFLinflation expectations and minimized the volatility of the peso exchange rate. Yet many die-hard proponents of growth argue that such monetary tightening could jeopardize economic recovery by restricting business activity via bank lending operations.

But four years ago, two senior economists from BSP’s Department of Economic Research (DER), Carolina P. Austria and Bernadette Marie M. Bondoc (“The Impact of Monetary Policy on Bank Lending Activity in the Philippines”, 2018) had already found very little, if any, transmission of monetary policy through the lending channel of Philippine banks. They used Kashyap and Stein’s model which posits the idea “that banks cannot frictionlessly tap uninsured sources of funds to offset a central bank-induced insured deposit shortfall”.

This proposition implies that monetary policy affects banks in various ways. Those with adequate liquidity, for example, might reduce their holdings of securities to maintain their level of credit transactions. For those with limited liquidity, loans may indeed have to be reduced if the level of securities is low.

The Austria-Bondoc research was signiIffrom the perspective of the BSP itself because its own internal research activities had yielded mixed results on the existence and strength of the interest rate and bank lending channels of monetary policy. A 2008 article revealed that with the move to FLFlexible Inflation Targeting (FIT) In 2002, the expectations channel assumed greater importance in the transmission of monetary policy in the Philippines while the interest rate channel weakened. The credit channel and the asset price channel remain closely linked due to the dominance of banks in the market. Iffinancial system.

Further research found that the FIT actually strengthened both the interest rate and bank lending channels, although the transmission remains relatively weak given our shallow financial markets. It was found that the BSP retained the ability to influence market interest rates through the adjustment of the policy rate. A study focused on the bank lending channel also confirmed both its existence and its magnitude.

But using a larger sample size and covering a longer period compared to previous BSP studies, with a number of robustness checks by varying the banking groupings, the policy rate used and removing foreign banks from the sample. sample, Austria and Bondoc, to reiterate, did not see strong evidence of the transmission of monetary policy through the channel of bank lending.

The explanation from BSP senior economists is robust:

1. Banks are rebalancing their loan portfolio instead of reducing it. This is consistent with other empirical results showing that monetary policy tightening could have an immediate impact on home and consumer lending, but that commercial and industrial lending need not adjust.

2. Well-capitalized banks, as in the Philippines, could decouple their lending operations from monetary policy shocks such as an adjustment in policy rates. Banks have become risk conscious in their credit operations as loan quality has remained stable. This means that even in a credit boom, banks could still choose to lend wisely. Proof of this is that despite the economic lockdown, non-performing loans have remained relatively low.

3. Financial market liberalization in the Philippines in the 1990s weakened the ability of bank lending to reflect the stance of monetary policy. Proliferation of bank loan alternatives, Ifthe deregulation of financial markets and the increase in securities trading have weakened the link between the real economy and the bank credit channel. The weakening of this monetary policy transmission mechanism actually motivated the BSP to set up the interest rate corridor system.

4. BSP regulations impose heavy penalties on banks that mix funds in ordinary and foreign currency deposits. External liquidity could only affect domestic lending if the BSP purchases these products in the market.

5. The period 2008-2015 could be abnormal due to unorthodox monetary policies in major economies. Since the capital surge led to an extraordinary increase in monetary growth, the restrictive monetary policy could have been more than overwhelmed by the expansionary impact of these capital flows.

Austria and Bondoc were right that the main challenge for monetary authorities is to ensure “that the tools, including the policy rate, reserve requirements, auction volumes for deposit facilities and macroprudential measures are used in concert to effectively transmit monetary policy to the economy”. Monetary policy makers can still take advantage of the different channels of monetary policy, establish good coordination between monetary policy and operations, and employ macroprudential measures to influence the lending behavior of banks.

Which brings us to another excellent BSP working paper just released last month titled “Introducing a multi-dimensional financial development index for the Philippines” by Jean Christine A. Armas and Nerissa D. De Guzman, both senior BSP economists. DER.

What is interesting in this working paper is that it clarifies this link between the financial system and economic growth. Economic growth is driven by an efficient channel of savings-investment, productive capital and technological innovation. These growth channels are optimized when the financial system is well developed. But therein lies the rub – we would normally equate financial development only with private sector credit to GDP and, to some extent, stock market capitalization. Or in other words, when we assess the impact of a tightening of monetary policy, for example, we only have in mind the bank lending channel of monetary policy. Therefore, high interest rates erode economic growth and hence the BSP should be slow to navigate the trade-off between growth and inflation.

Following Armas and Guzman, we can argue that limiting the assessment to the implications of monetary action on credit and stock markets would only capture the depth of the financial system. What they proposed in their working paper is a multidimensional index that measures the level of development of system institutions and markets in terms of access, depth, efficiency and stability. BSP senior economists have therefore improved and extended the index originally constructed by the International Monetary Fund (IMF) in 2016.

This improvement is very helpful because of the dramatic evolution of financial systems around the world and, in its wake, has also spilled over to those in emerging markets, including the Philippines. As banks continue to dominate the financial system, consider the growing importance of non-banks, especially private insurance companies. Future research should cover other financial companies for which data series only started in the first quarter of 2017.

Elsewhere in their article, BSP senior economists also noted that “large amounts of credit do not necessarily equate to broad access and efficient delivery of financial services…” We need to go beyond a only dimension of the financial system, or only the financial institutions.

Examining financial developments in Financial Institutions (FI) and Financial Markets (FM) in the Philippines across the four measures of Access, Depth, Efficiency and Stability and the Singular Index (Global FD Index) would show that the Philippine financial system “has progressed and developed quite remarkably”.

As this chart shows, both external developments (e.g., the US Federal Reserve’s quantitative easing in 2010, 2012; US-China trade tensions in 2018; the COVID-19 pandemic in 2020) and major national regulatory and policy reforms (e.g. access and inclusion in 2014 and 2018, normalization of monetary policy in 2014) determine the access, depth, efficiency and stability of the system.

The article by Armas and De Guzman is very significant because it proves that to focus only on financial institutions, as most of us do today, would be to ignore the other element which is the financial markets, as well as key financial dimensions other than depth. On the other hand, Austria and Bondoc alerted us to the need to consider different transmission channels of monetary policy other than the usual channel of bank credit to assess the impact of monetary action, for example. Otherwise, we might miss many points.

This is how you carry an elephant around the room.

Diwa C. Guinigundo is the former Deputy Governor of Monetary and Economic Sector of Bangko Sentral ng Pilipinas (BSP). He served the BSP for 41 years. From 2001 to 2003, he was Alternate Executive Director of the International Monetary Fund in Washington, DC. He is the Senior Pastor of Christ Fulness International Ministries in Mandaluyong.

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Don F. Davis