Financial dominance and monetary policy in the wake of SVB collapse

We need to be level headed in assessing the potential impact of the biggest bank failure since the Global Financial Crisis on the Philippine banking system and the economy. Failure to fully appreciate the consequences, whether intended or unintended, could mislead us into thinking that it’s now all a financial stability game. The fight against inflation is far from over.

For instance, last May, Fitch Ratings reported that Philippine banks’ asset quality risks were increasing due to high domestic inflation and increasing interest rates. Without reading the rest of its report, it was easy to be nervous of possible bank runs. But Fitch qualified its finding by saying that “any deterioration in credit quality is likely to be manageable due to adequate financial buffers of the main borrowers and the robustly growing economy.”

In the wake of the Silicon Valley Bank (SVB) debacle, it was timely for both the Bangko Sentral ng Pilipinas (BSP) and the Bankers Association of the Philippines (BAP) to have promptly explained to the market that SVB has no substantial or material impact on Philippine banks.

The BSP governor disclosed that local banks have no reported exposure to SVB or its parent company. Local banks’ foreign assets are mostly loans, Philippine government dollar bonds and sovereign bonds of countries with high investment credit ratings. That means shockwaves from California should not be forthcoming, and its series of rapid bank runs a remote possibility.

Moody’s Investors Service recently confirmed this point by clarifying that “most institutions in Asia Pacific are not exposed to the failed US banks, and only a handful of institutions have immaterial exposures.”

The BAP was more specific in anticipating possible queries from the general public. It claimed that Philippine banks have diversified deposit bases and that their capital and liquidity ratios far exceed the standards prescribed by the BSP. Thanks to prudential measures of the regulators and the banks’ faithful compliance, the banks have been resilient in their mission to provide credit to the economy.

But a few days ago, Fitch Group’s CreditSights issued a commentary about three domestic second-tier banks, indicating that their competitive positions, “were weak, likely forcing these banks to dip their toes in risky lending waters considering roiling external headwinds.” CreditSights explained the risky consequences of lower net interest margins because of what it called “weaker deposit franchises and competition in the term loan market.” These could lead to greater propensity to search for higher, but perhaps riskier, yields.

It is quite strange that CreditSights should raise the issue of the banks’ size, exposure to small business, and modest credit growth. SVB was gigantic, yet it failed. It had little exposure to small business, but it exposed itself more to short-termist startups and the IT sector. While its credit growth fell behind its rapid deposit growth, it was its investment decisions that ultimately resulted in its collapse.

As much could one make of the recent assessment of the region’s financial condition by the ASEAN+3 Macroeconomic Research Office (AMRO). To AMRO, the closure of SVB and Credit Suisse triggered a sharp increase in risk aversion. But banks in our region of the world are considered resilient because they have built sufficient buffers in terms of liquidity, capital and funding standards.

HSBC was even more specific by saying that Asian banks in general are well capitalized. Their macroeconomic situation remains favorable; their performance during the pandemic and post-pandemic economic recovery has been creditable. A large part must have been due to the BSP’s diligent supervision and regulation of the financial system.

Unfortunately, the three failed American banks considered themselves victims of serious loss of trust and confidence by their depositing public. But they were not quite the victims because it was their choice to postpone the diversification of their portfolio. Their deposits, consisting mainly of short-term funds from their tech and IT clients’ many initial public offerings, were also invested heavily into high-yielding government bonds and mortgage-backed securities. These instruments went under when the US Fed started to hike interest rates against inflation.

These banks could by no means plead innocent when they had not bothered to put up a good risk management system, and one of them even managed to operate without a risk officer for months. The US Fed could not be blamed if the SVB chief executive officer sold his own share before the collapse.

Therefore, the BSP’s assurance last Tuesday, March 21, that the Philippine banking system is stable could not have come at a better time. We believe that our domestic banks are well capitalized and “strong and prepared to withstand possible shocks posed by the collapse of some banks in the US.”

The BSP’s explanation is weighty. One, Philippine banks’ security holdings relative to their assets are much less than their counterparts. Two, US Fed rate hikes were more significant than the adjustments made by the BSP. Three, domestic yield curves did not invert unlike the US’ yield curves. And four, local banks’ securities holdings have much shorter duration. Their lending base is diversified across counterparties and industries. Liquidity is mostly available, while the risk management system is quite strong.

With these explanations, and the strong prospects of economic growth, we find any hint that the BSP may pause tightening incredible. While insisting the local banks are strong and unaffected by the US financial fallout, it is puzzling why some quarters would hint at a possible policy of slowing down the pace of rate hikes.

We don’t know the subtexts of market players and economists who were quoted by some broadsheets to be expecting that the BSP could go for only 25 basis points when domestic inflation proved stubborn at over 8% in the first two months of 2023. One of them even voted for a pause. Not a few seem to have ignored this year’s forecast at 6.1% against the 2-4% target. Next year’s projection is also iffy, hovering above the midpoint of the target inflation rate at 3.1%.

What is starkly clear is that inflation is yet to peak, the underlying demand or core inflation continues to gain momentum, and already, additional signs of secondary effects have emerged. A labor coalition last Tuesday asked the regional wage board to increase the minimum wage in Metro Manila to P1,100 “to help workers cope with the rising prices of basic goods.” HB 7568 was filed in Congress to legislate a wage hike to P750 from the current level of P570.

In the first place, the prices of basic goods — including rice, sugar and meat products — remain elevated and negative base effects might only have some marginal effect. Oil prices continue to be volatile, and therefore unpredictable. Oil is expected to remain elevated at $92/bbl this year and $80/bbl in 2024, down from the projected $100/bbl last year. But what is more certain is that average oil prices could reach above the five-year average of $60/bbl.

There are other wild cards in forecasting.

The European Union sanctions on Russia would curtail its oil production and contribute to price pressures. It is quite difficult to rule out strong inflation dynamics because shale oil production by the US is expected to reduce fuel supply and its declining strategic oil inventories may give rise to higher demand for oil.

A pause would be nothing short of wimping out. That may signal to the market that there are undisclosed weaknesses of the Philippine banking system. Inflation is a real threat now and should be dealt with by tight monetary policy and appropriate fiscal and other non-monetary measures. Financial instability remains a risk but with output growth assured to hit at least 5-7%, the probability is minimal.

the usual metrics on how monetary policy should evolve, the BSP needs to sustain its policy stance before pausing. Given the inflation forecast of around 6% and the so-called neutral real rate of between 1-2%, the BSP may still have to continue jacking up its policy rate. Its policy rate was hiked to just 6% last February.

When central banks respond to financial challenges rather than to inflation, they are said to be facing financial dominance. As the IMF observed, regardless of whether central banks intend to be dominated, market forecasts incorporating the view that the central bank would pause or cut policy rates makes the central bank’s job to sustain monetary tightening a tougher act. Fighting inflation would be distracted.

The US Fed’s announcement of another tightening move last Wednesday demonstrates its decision to stay the course and keep financial dominance at bay.

Under the current circumstances, central banks should indeed continue to pursue their primary mandate to keep prices stable while monitoring the safety of the financial system. After all, macro- and micro-prudential regulations, rather than monetary policy, are best cut out to deal with banks and other financial institutions.

The SVB and similar tales of bank failures are cautionary, but they are no excuse for monetary policy to slack off.

Diwa C. Guinigundo is the former deputy governor for the Monetary and Economics Sector, the Bangko Sentral ng Pilipinas (BSP). He served the BSP for 41 years. In 2001-2003, he was alternate executive director at the International Monetary Fund in Washington, DC. He is the senior pastor of the Fullness of Christ International Ministries in Mandaluyong.