ASIAN DEVELOPMENT BANK RRP: PHI 31655

REPORT AND RECOMMENDATION

OF THE

PRESIDENT

TO THE

BOARD OF DIRECTORS

ON A

PROPOSED LOAN

AND TECHNICAL ASSISTANCE GRANT

TO THE

REPUBLIC OF THE PHILIPPINES

FOR THE

NONBANK FINANCIAL GOVERNANCE PROGRAM

October 2001 CURRENCY EQUIVALENTS (as of 10 October 2001)

Currency Unit – Peso (P) P1.00 = $0.02 $1.00 = P51.90

ABBREVIATIONS

ADAPS – automated debt auction processing system ADB – Asian Development Bank ASEAN – Association of Southeast Asian Nations BOA – Board of Accountancy BSP – Bangko Sentral ng Pilipinas CMDP – Capital Market Development Program CPA – certified public accountant DOF – Department of Finance DST – documentary stamp tax DVP – delivery-versus-payment FSAP – Financial Sector Assessment Program GDP – gross domestic product GNP – gross national product GSED – Government securities eligible dealers IAS – international accounting standards IMF – International Monetary Fund IOSCO – International Organization of Securities Commissions IPO – initial public offering IRR – implementing rules and regulations LIBOR – London interbank offered rate MIS – management information system NBFI – nonbank financial institution NFG – nonbank financial governance NPL – nonperforming loan PCDI – Philippine Central Depository, Inc. PDIC – Philippine Deposit Insurance Corporation PICPA – Philippine Institute of Certified Public Accountants PNB – Philippine National Bank PRC – Professional Regulation Commission PSE – Philippine Stock Exchange QB – quasi bank RTGS – real time gross settlement SCCP – Securities Clearing Corporation of the Philippines SDR – special drawing rights SEC – Securities and Exchange Commission SRC – Securities Regulation Code SRO – self-regulatory organization TA – technical assistance USAID – United States Agency for International Development

NOTE

In this report, "$" refers to US dollars. CONTENTS

Page

LOAN AND PROGRAM SUMMARY ii

I. THE PROPOSAL 1

II. INTRODUCTION 1

III. THE MACROECONOMIC CONTEXT 3

A. Government Development Objectives, Strategy, and Plans 3 B. Recent Economic Performance and Prospects 4

IV. THE SECTOR 7

A. Background and Recent Perfromance 7 B. Constraints and Issues 13 C. External Assistance to the Sector and Aid Agency Coordination 19 D. ADB’s Operations and Strategy in the Sector 20

V. THE PROGRAM 21

A. Rationale 21 B. Objective and Scope 22 C. Policy Framework and Actions 22 D. Social and Environmental Issues 28

VI. THE PROPOSED LOAN 29

A. Amount of Loan and Source of Funds 29 B. Interest, Maturity, and Utilization Period 30 C. Implementation Arrangements 30 D. Procurement and Disbursement 30 E. Counterpart Funds 30 F. Monitoring and Tranching 30

VII. THE TECHNICAL ASSISTANCE 31

VIII. PROGRAM BENEFITS AND RISKS 31

A. Benefits 31 B. Risks 32

IX. ASSURANCES 34

X. RECOMMENDATION 34

APPENDIXES 35 LOAN AND PROGRAM SUMMARY

Borrower The Republic of the Philippines

The Proposal Support to the Government for its Nonbank Financial Governance (NFG) Program through a program loan of $75 million, and technical assistance (TA) of $1 million for Strengthening Regulatory and Market Governance.

The Program

Rationale The Asian crisis highlighted the risks associated with vulnerable financial structures in a financially integrated world. The buildup of vulnerabilities stemmed from excessive reliance on bank financing, weak corporate and financial regulation, including poor compliance with accounting and auditing standards, and inadequate disclosure of financial information. These developments are inevitable if enforcement and governance at the regulator level are weak. Despite the fact that the Philippines withstood the Asian financial crisis relatively well, its financial and corporate structures continue to make it vulnerable to external shocks. This vulnerability stems from the uneven application of good governance standards and lack of risk diversification in the financial market. Indeed, the Philippines exhibits a very high dependence on bank financing and has not been able to develop sufficient levels of financial intermediation through its nonbank sector.

To lay the foundation for a strong and robust financial sector, the Government needs to launch broad-based financial and corporate governance reforms, including (i) strengthening the governance and enforcement capacity of the regulators, Securities and Exchange Commission (SEC) and Bangko Sentral ng Pilipinas (BSP); (ii) modernizing the securities market; (iii) introducing more transparency in market transactions; and (iv) encouraging enforcement of rules and regulations. These reforms are critical to meet the challenges of growing volatility from a weak stock exchange, competitive pressures from technological innovation, as well as globalization and integration of financial markets.

Objective and The Program will support the process of capital formation Scope through improved corporate governance in the nonbank financial services sector. The key components of Phase I are

(i) enhancing and strengthening the governance of SEC by (a) allowing SEC greater administrative, operational, and financial autonomy; and (b) enhancing monitoring and enforcement capacity; (ii) modernizing the governance and regulatory iii

structure of the Philippine Stock Exchange (PSE) by (a) developing arrangements for PSE to strengthen its governance during the transition period, (b) restructuring and demutualizing PSE; (c) enhancing self-regulatory organization (SRO) reporting, and (d) developing arrangements for effective regulation of PSE; (iii) strengthening market oversight, compliance, and enforcement by (a) developing market governance, (b) strengthening prudential regulation of nonbank financial institutions, (c) preventing misconduct and market abuse, and (d) improving financial management and governance by strengthening financial disclosure monitoring; and (iv) facilitating diversification and innovation in corporate financing by (a) developing a policy, regulatory, and taxation framework for the corporate bond market; and (b) enhancing institutional investors’ participation to augment market liquidity.

Phase II will consist of policy actions based on the Agenda for Phase II Dialogue. These actions, when agreed between the Government and ADB, may form the basis of future ADB assistance to the Government in the nonbank financial sector. The Agenda for Phase II Dialogue includes the following Core Topics

(i) implementing demutualization of PSE; (ii) strengthening market regulation; (iii) strengthening market governance and compliance; and (iv) facilitating diversification and innovation in corporate financing.

Classification Economic growth

Environmental Category C Assessment

The ADB Loan

Loan Amount A loan of $75 million from the Asian Development Bank’s and Terms (ADB’s) ordinary capital resources will be provided under ADB’s LIBOR-based lending facility. The loan will have a 15-year term, including a grace period of 3 years; an interest rate determined in accordance with ADB’s LIBOR-based lending facility, a commitment charge of 0.75 percent per annum, a front-end fee of 1.0 percent; and conversion options that may be exercised in accordance with the terms of the draft Loan Agreement, the Loan iv

Regulations, and ADB’s Conversion Guidelines; and other terms and conditions set forth in the draft Loan Agreement. The loan closing date is 31 December 2002.

Program Period The Phase I of the Program is three years (1998-2001). The loan and Tranching will be released in one tranche, which will be made available upon loan effectiveness.

Executing The Department of Finance (DOF) will be the Executing Agency Agency for the NFG Program and SEC will be the Implementing Agency. SEC will set up a coordinating committee headed by the Chairperson of SEC and comprising representatives from Bangko Sentral ng Pilipinas, Bureau of Treasury, DOF, National Economic and Development Authority, PSE, SEC, and the Capital Market Development Council that consists of members from business and industry associations. ADB will also be a member of this committee to oversee progress on Phase II of the reform program.

Procurement The loan proceeds will be used to finance the foreign exchange costs of items produced and procured in ADB member countries (other than items specified in the list of ineligible items and imports financed by other bilateral and multilateral sources). The Government will certify that the volume of eligible imports exceeds the amount of ADB’s projected disbursements under the loans for the given period. ADB reserves the right to audit the use of the loan proceeds and verify the accuracy of the Government’s certification.

Counterpart The Government will utilize local currency counterpart funds Funds generated by the loan to meet program expenditures and associated costs of reform and to help maintain current levels of social expenditures. The structural adjustment costs for Phase I stem from restructuring SEC, administrative reforms linked to computerization of SRO, monitoring systems in SEC and PSE, and demutualization costs already borne by SEC and PSE.

Technical Assistance The advisory TA of $1 million will strengthen market governance by developing (i) an effective SRO framework to address the potential conflicts of interest in PSE’s newly demutualized ownership structure; (ii) SEC capacity to investigate and enforce market rules; (iii) an efficient management information system and staff training in the use of these systems; and (iv) accounting and auditing skills and standards. The TA will be financed from the Asian Currency Crisis Support Facility funded by the Government of the Japan. It is estimated that about 22 person- months of international and 16 domestic consulting services will be required. All consultants will be engaged in accordance with ADB’s Guidelines on the Use of Consultants and other arrangements satisfactory to ADB for recruiting domestic consultants. v

Risks and Safeguards The Program faces four major risks. First, the widening fiscal deficit and growing nonperforming loans of the banking sector could disrupt macroeconomic stability or exacerbate banking sector fragility. Recognizing this, the new Government has indicated its resolve to adopt more fiscal dicpline and launch tax reforms to support macroeconomic stability. At the same time, the Government is taking steps to deal with the weaknesses of the banking sector.

Second, reforms in the nonbank financial sector PSE critically depend on the support of the private sector including the members of PSE. Efforts have been made to have wider consultations to evolve consensus among the different stakeholders and to take advance actions to ensure that demutualization of PSE is realized.

Third, effective Program implementation is dependent upon developing capacities across the nonbank financial sector. Increasing the skills of regulators, accountants, and auditors is necessary if regulations and standards are to be enforced and complied with. The Program has introduced a wide-ranging capacity building element in the TA to SEC. In addition, the Program supports the introduction of a more competitive salary structure for SEC to retain qualified staff to mitigate this risk.

Fourth, reliance on enactment of legislation has proven to be difficult in the context of the Philippines. The Program has focused on ensuring that current market regulations, if found satisfactory, are adequately enforced. If improvements in regulations are required, alternatives to legislative action will be explored through rules and administrative orders. In addition, up- front compliance on all actions requiring legislation was required to address possible delays in Program implementation. I. THE PROPOSAL

1. I submit for your approval the following Report and Recommendation on a proposed loan to the Republic of the Philippines for the Nonbank Financial Governance (NFG) Program. The report also describes proposed technical assistance for Strengthening Regulatory and Market Governance, and if the Board approves the proposed loan, I, acting under the authority delegated to me by the Board, shall approve the technical assistance.

II. INTRODUCTION

2. The Philippines withstood the Asian financial crisis well, but faced renewed and formidable challenges in 2000 as economic management and governance1 steadily deteriorated. Economic decision making came to a virtual standstill in late 2000 following public scrutiny of corruption scandals in both the banking sector and capital markets. Growing political uncertainty combined with stock market vulnerabilities led to a sharp decline in the peso and stock market indices to historic lows, and triggered slippages in fiscal deficit targets. Attempts to counteract the weakness in the exchange rate by monetary tightening led to high interest rates that generated more economic instability and uncertainty.

3. Nevertheless, the Philippines showed remarkable resilience in withstanding both the regional crisis of 1997 and the subsequent political turmoil that gripped the country throughout 2000. The new millenium, however, brings with it renewed economic promises and prospects. Supported by people power, the country witnessed its second peaceful democratic transition following the takeover by Vice President Gloria Macapagal-Arroyo of the office of the President on 20 January 2001. Rebuilding investor and public confidence in the economic and political system has been at the forefront of the President’s economic agenda. Recent political events have brought some degree of economic and financial stability. However, stock market vulnerabilities continue to reflect the underlying weakness in economic fundamentals, lack of investor confidence in a thin and weakly governed stock exchange, and the adverse effects of recent exuberance and turmoil in the world stock markets.

4. The primary challenge facing the new Government is to introduce effective economic and political governance and management. The new administration has been swift to recognize the urgency of the task and has indicated its resolve to rebuild the economy by (i) instilling macroeconomic discipline; (ii) developing strong and robust financial markets; (iii) refocusing on poverty reduction; and (iv) promoting a culture of rule of law, accountability, efficiency, and entrepreneurship.

5. The medium-term economic framework of the Government integrates the objectives of the Post-Program Monitoring agreement with the International Monetary Fund (IMF) finalized in April 2001. IMF had established a $1.4 billion standby credit facility under a Memorandum of Economic and Financial Policies in 1998. The Government was able to draw over $1 billion on this facility, but it waived the final tranche of approximately $336 million as it felt that it would not be able to meet the fiscal targets and structural reform benchmarks agreed upon with IMF. Currently, the Government is taking steps to curb the growth in the fiscal deficit within the Post- Program Monitoring framework of IMF.

6. Despite political disruptions, the new Government stated its commitment to stimulating growth by addressing long-term structural issues and constraints. This would, however, only be

1 Governance refer to accountability, predictability, participation, and transparency. 2 possible if it is able to launch an effective strategy for resource mobilization in both the public and private sectors. On the public sector side, the fiscal distress has called for renewed attention to reforms in domestic taxation. However, the private sector will need to meet the bulk of resource requirements through improved financial intermediation. Recognizing this, the Government launched several initiatives to support a stronger and more robust banking system and to broaden and deepen the capital markets since the onset of the crisis in late 1997. These measures have yielded mixed results.

7. Today, the Philippines has one of the most independent central banks, Bangko Sentral ng Pilipinas (BSP), in the region, and has developed an effective monetary management system. With the support of the Philippine Deposit Insurance Corporation (PDIC), BSP has led a complex and wide-scale bank-restructuring program over the past year. This has involved closure of one bank, merger of four of the larger banks into two banks, and merger of two smaller banks into the country’s largest bank. In addition, the Philippine National Bank (PNB) required P10 billion liquidity assistance from the PDIC in 2000. To enhance the soundness of the banking system, BSP has taken additional steps to (i) limit a bank’s transactional capacity; (ii) require regular reporting of delinquent and restructured loans; (iii) introduce higher statutory capital and bad loan provisioning; and (iv) require bank disclosure on interest rates, nonperforming loans (NPLs), and higher quality reporting standards, etc.

8. The financial markets were buffeted by the sharp withdrawal of capital from the Philippines, the subsequent peso depreciation, and the BW Resources2 scandal involving allegations of stock price manipulation by a number of brokers, followed by allegations of political interference in the Securities and Exchange Commission (SEC) investigations. These developments created an atmosphere that eroded both investor confidence and the gains achieved in financial markets in the mid-1990s. Market capitalization went from the 1996 precrisis level of P2,122 billion to P1,251 billion in 1997 before recovering to P2,578 billion by end-2000.

9. It is against this backdrop that the Government and the Asian Development Bank (ADB) agreed to broaden and deepen ADB’s involvement in the nonbank financial sector, complementing and building on the reforms initiated under the Capital Market Development Program (CMDP) loan in 1995.3 The proposed NFG Program will support broader and deeper reforms in the nonbank financial sector. With this objective, ADB approved TA4 to the nonbank financial sector in 1999. This TA complemented bilateral assistance primarily from the United States Agency for International Development (USAID).

10. The proposed NFG Program was formulated based on (i) lessons learned from implementing the CMDP, (ii) economic and sector work launched between 1998 and 2000, (iii) the findings and recommendations of the ADB TA (footnote 4), and (iv) the consensus in both ADB and the Government on the need to enhance financial market governance. Extensive policy dialogue has been maintained with the Government over the past two years. ADB fielded a Reconnaissance Mission in August 1999 and a Fact-Finding Mission5 in October 2000 to reach an understanding with the Government on the objectives and scope of the proposed Program. The development policy letter, the policy matrix, and the agenda for Phase II dialogue of the NFG Program are in Appendix 1. The program framework is in Appendix 2.

2 This company was renamed Fairmont Holdings, Inc. in 2000. 3 Loan 1363-PHI: Capital Market Development Program, for $150 million, approved on 22 August 1995. 4 TA 3245-PHI: Nonbank Financial Sector Development, for $2 million, approved on 25 August 1999. 5 The Mission comprised N. Chakwin, Mission Leader, Senior Financial Economist; A. Malmstrom, Financial Economist; and E. Chen, Young Professional. 3

III. THE MACROECONOMIC CONTEXT

A. Government Development Objectives, Strategy, and Plans

11. The Government’s economic strategy and plans, articulated in the revised New Medium- Term Philippine Development Plan: 2001-2004, advocate adoption of a sustainable development path anchored by economic growth with social equity. Stated objectives include reducing the incidence of poverty, improving employment rates, and stabilizing prices. To achieve these goals, a development program was launched to raise basic social indicators, improve access to basic services, and increase agricultural productivity and diversification. Complementing these efforts, the Government aims to establish a globally competitive industry sector based on further trade liberalization, and enhanced technology in the industrial environment.6 Adherence to a fiscal stabilization program is critical to allow for adequate growth in public investment and to avoid crowding out the private sector. Concurrently, the Government needs to revive private savings and investments by strengthening and diversifying the financial intermediation process and by promoting the expansion of equity and debt markets.

12. The Government adopted a broad-ranging privatization program starting in 1992. The objective was to generate revenue, stimulate capital markets, and introduce greater economic efficiency. Privatization proceeds fell significantly short of the P22 billion target in 2000. To generate resources, the Department of Finance (DOF) issued PROgress bonds in August 2000. These bonds allowed investors to swap the bonds for shares of companies, or the cash equivalent of state assets being privatized. The 5-year bonds have a fixed coupon rate of 13.9 percent per annum payable every quarter. Among the state corporations in which shares are being auctioned are Manila Electric Co. (Meralco), the Philippines National Construction Corp, the Philippines National Oil Co. – Energy Development Corp., IBC Channel 13, Food Terminal, Inc., Philippine Postal Corp., and the Philippine Phosphate Fertilizer Corp. In addition, ADB is assisting in privatizing the National Power Corporation. The proceeds from the privatization program will generate revenues to ease budgetary pressures (para. 22).

13. Economic recovery was notable in early 2000 after a significant slowdown in real gross domestic product (GDP) growth during 1997 and 1998. The impact of the regional financial crisis was compounded by a decline in agricultural production because of drought conditions accompanying El Niño and later the typhoons related to the La Niña phenomenon. To mitigate the shock, the Government adopted measures to improve liquidity management, stabilize the peso, and strengthen the financial system. Supporting the drive toward better economic management, the Government enacted critical pieces of legislation during 2000:

(i) Securities Regulation Code (SRC), which elevates the role and power of SEC– consistent with the proposed Program–in overseeing and regulating market activity; (ii) General Banking Act, which includes provisions to align rules and regulations with international standards and guidelines; (iii) Retail Trade Liberalization Act, which permits foreign ownership of local retail stores, with capital of more than $2.5 million; and (iv) Electronic Commerce Act, which provides a legal foundation for electronic transactions and introduces penalties for computer hacking and piracy. Implementing guidelines are being drafted with a view to incorporating guidelines for securities transactions and electronic banking.

6 TA 3345-PHI: Strengthen Export Competitiveness, for $1 million, approved on 17 December 1999. 4

14. In addition, the Government plans to (i) strengthen fiscal management by launching tax reforms and confining public expenditure, and (ii) stabilize prices, interest rates, and the peso. The banking sector, restructured in the early 1990s, initially appeared to weather the Asian financial crisis relatively well. However, persistent economic instability has resulted in deterioration in asset and portfolio quality, and stagnation in new lending and credit growth. The Government and BSP have taken a number of steps to encourage bank consolidation, raise minimum capital and provisioning requirements, and introduce a moratorium on bank branching and upgrading of licenses. Mergers have occurred or been announced between the PCI Bank and Equitable Banking Corporation, and Bank of the Philippine Islands and Far East Bank and Trust Company; and acquisition of Asian Bank and Philbanking Corporation by Global Bank, a subsidiary of Metrobank.

15. BSP has started a program to improve internal systems and procedures, and strengthen banking supervision practices. Under the new program, BSP introduced a systemic failure contingency plan, issued further guidelines for prompt corrective action, stepped up on-site inspections, and improved coordination between BSP and PDIC in resolving distressed banks. In addition, BSP is now monitoring bank groups on a consolidated basis and has strengthened early warning systems to detect banking weaknesses. SEC and BSP are working on a Memorandum of Understanding (MOU) to improve the monitoring of nonbank financial institutions (NBFIs), which are affiliates or subsidiaries of banks. Steps are under way to implement the new real time gross settlement (RTGS) system, which will facilitate central bank clearing and settlement of all payments. The RTGS system will support a true delivery versus payment system and thereby reduce risks in payment, clearing, and settlement. The final tests for the RTGS system are expected to be completed and the system to be fully on-line by the end of 2001.

16. The most far-reaching reform in the banking sector is the enactment of the General Banking Act 2000. This law (i) mandates banks to meet capital adequacy in line with international standards; (ii) allows foreign ownership of a local bank to be raised from 30 percent to 40 percent of the voting stock, and under certain conditions, up to a maximum of 100 percent; (iii) authorizes BSP to conduct regular investigations to determine whether a bank or its affiliates, are conducting business in an unsound manner; and (iv) restores the power of the Monetary Board to remove or suspend directors and officers involved in misconduct.

B. Recent Economic Performance and Prospects

17. A combination of factors affected economic performance in the Philippines during 2000. The most significant were the persistent political uncertainty, weak economic management, and regional vulnerabilities. Despite these disruptions, economic recovery continued as real GDP grew by 4.2 percent in 2000 compared with 3.7 percent in 1999. Economic growth in 2000 was supported by agricultural growth, boosted by favorable weather conditions, and a 5.6 percent rise in manufacturing. The industry sector, however, has remained sluggish due to a slowdown in construction.

18. The manufacturing sector continues to be plagued by weakening corporate profitability (declining by 25-40 percent in 2000) as a result of higher interest rates, import and energy costs, and lower demand. Philippine companies with foreign currency obligations have been facing steadily higher principal and interest payments in peso terms. These costs have hit company earnings and contributed to declines in the debt service capacity of corporations. As a result of the rise in operating costs and debt obligations, a number of companies filed requests with SEC for 5 relief from debt service obligations in 1999 and 2000. In addition, many companies postponed new projects, thus constraining industrial production and contributing to growth of unemployment.

19. The unemployment rate in the Philippines has averaged over 10 percent from 1999 to 2000. This is 2-3 times the rate in other countries of the Association of South East Asian Nations (ASEAN) during the same period. Although the unemployment rate reached 11.2 percent in 2000, employment generation was strong during the 1990s relative to neighboring ASEAN countries. However, job creation has not been fast enough to absorb labor and reduce unemployment, as the labor force continues to grow by about 2.5 percent annually. Rising productivity and stable manufacturing employment levels indicate that there has been little labor shedding as a result of the crisis and lingering economic problems. Maintaining higher growth levels, and keeping pace with the population growth will be pivotal to reducing unemployment in a long-term sustainable manner.

20. Performance in the real sector was overshadowed by the growing fiscal distress in 2000, as the national budget deficit reached P136 billion (3.9 percent of gross national product [GNP]) – more than double the IMF target of P62.5 billion (1.8 percent of GNP). Budgetary pressures continued throughout the year as tax revenues fell short of budget requirements. The budgetary shortfall was attributed to a weak tax base,7 poor collection systems and procedures, and the Government’s inability to realize the proceeds from the stalled privatization program (para. 12).8 Public spending was to some extent tightened. Total revenue/GNP fell by 3.3 from 1996 to 2000, while public spending/GNP rose by 0.4 over this period. To meet the budgetary financing gap, the Government borrowed from the domestic and overseas markets and drew down funds from the standby credit facility under an IMF program outlined in a 1998 Memorandum of Economic and Financial Policies. Budgetary pressures continued to make monetary management difficult as Government borrowings rose to 5.7 percent of GDP and induced interest rate pressures. The addition of new Government contingent liabilities indicates that debt service levels equivalent to 31 percent of budgetary expenditures will remain a Government concern.

21. The external current account surplus grew to $9 billion in 2000. This represents a 23 percent growth over the 1999 level and can principally be attributed to export growth, led by electronics (approximately 58 percent of exports). Additional factors include the slowdown in imports and weak domestic demand. Despite the buildup of the external current account surplus, the balance of payments position in 2000 was in deficit on an aggregate basis due to the capital account. A primary factor was the reemergence of a net outflow of portfolio equity investments ($335 million)9 slightly lower than the 1997 crisis-related outflows ($406 million). Net foreign direct investment was more stable recovering to $2.1 billion, 10 percent higher than 1999 levels. By year-end, it was evident that Government access to credit from multilateral and bilateral sources, as well as recourse to commercial credit had dwindled significantly during the year.

22. Banking sector problems have also compounded difficulties in sustaining economic recovery. Domestic commercial banks continued to weaken, as growth of bank deposits and credit declined. Banking sector NPLs more than doubled from 7.4 percent in 1998 to almost 20

7 Tax collection efficiency declined from 17 percent in 1997 to under 14 percent in 2000. 8 Almost 24 percent of the slippage in the budget deficit in 2000 occurred because of the nonrealization of privatization proceeds. 9 In 1996, portfolio equity investment was close to $2 billion. 6 percent in 2001.10 The steady decline in bank asset quality is attributable to a variety of factors: (i) interest pressures, (ii) more stringent reclassification of loans in the newly merged banks, and (iii) a slowdown in asset growth. In addition, the Government’s plan to privatize PNB11 has been delayed. This delay in restructuring PNB has resulted in deposit withdrawals and continuing growth in NPLs. To avert a crisis, the Government intervened to support the deteriorating balance sheet. Government support has involved liquidity assistance of P10 billion from PDIC and a P15 billion loan from BSP to purchase NPLs from PNB. The assistance constitutes the largest bailout in Philippines banking history and was provided as PNB represents 7 percent of banking sector assets. To reduce NPLs, the Government is considering a number of proposals, among them transferring NPLs to an asset management company or banks swapping debt for equity in corporations.

23. In the wake of the global slowdown, the Philippines like other regional economies is experiencing slower-than-expected growth. Investor confidence has not yet been restored and the peso has remained below P50=$1. As of October 2001, the central bank borrowing and lending rates have been reduced to 8.75 percent and 11 percent, respectively. Real GDP is projected to grow by 2.5-3.0 percent in 2001, given the lingering domestic uncertainties, weak external environment, and structural issues facing the economy. The main domestic challenge facing the Philippines is how to stop the deterioration in public finances and keep budgetary pressures within manageable limits. The Government budget for 2001 projects a deficit of around 4.0 percent. The fall in revenues over the past four years, together with peso depreciation, have increased public sector debt to almost 66 percent of GNP. While keeping control on the budget deficit, the Government plans to pursue a tight monetary policy to bring down the inflation rate. With the July year-on-year inflation rate reaching 6.8 percent (the year-end level for 2000), maintaining price stability may prove challenging in the second half of the year.

24. Strengthening the banking sector is critical, given that the NPLs of some domestic banks have surpassed BSP’s expected peak of 19-20 percent. Given the stress in the sector and the interest and exchange rate environment, commercial banks have maintained high capital adequacy ratios averaging over 15 percent.12 In addition, a few episodes over the past year of runs on bank deposit resulted in large withdrawals from several banks, indicating wavering depositor confidence in the banking system. Authorities were able to quickly contain the systemic risks posed by these withdrawals through a combination of liquidity support and new capital injections by existing owners. However, there is some risk that weak banks might require additional liquidity support and thereby complicate monetary policy.

25. The external sector is becoming more vulnerable, with the value of exports for the first eight months of 2001 declining by 13 percent. This follows growth of 9 percent in 2000 and 19 percent in 1999. This is especially important in the context of the Philippines where there is a high dependence on markets in the United States and Japan. Despite the rise in capital outflows, the Philippines does not face significant debt servicing pressures in the near future. Debt service payments are projected at 17 percent of exports of goods and services in 2001; reserves cover 260 percent of short-term debt (or 4.2 months of imports); and the rollover risk for interbank credit

10 The international banks nonperforming loans have remained steady at about 3 percent while those of domestic banks have continued to grow , averaging over 25 percent, and those of the Philippine National bank (PNB) over 30 percent. 11 This was a condition for disbursing the remaining tranches of the World Bank: Banking Sector Reform Loan, of $300 million, approved in 1998. The loan was cancelled because the rehabilitation of PNB will require a longer time and more sustained effort than were originally anticipated. 12 The capital adequacy ratio of two universal banks (one was PNB) has dipped below the statutory norm of 10 percent since end-2000 (although both have been above 8 percent). 7 lines appears limited, given that net foreign liabilities of private commercial banks have declined from $6 billion in 1997 to $3.5 billion in 2000. Finally, the Government’s commitment to improve the business climate was affirmed as it recently enacted the anti-money laundering law in line with the Financial Action Task Force 40 recommendations.

IV. THE SECTOR

A. Background and Recent Performance

1. Overview of the Nonbank Financial Sector

26. The nonbank financial sector is a major source of savings and supplier of funds to the private sector. NBFIs provide a wide range of financial services: lending, investing, or placement of equity and debt instruments. Almost 70 percent of nonbank financial sector assets are generated from contractual savings institutions and 30 percent from investment houses handling underwriting and money market operations, financing companies engaged in lending and leasing activities, and independent fund managers managing mutual funds.13 The nonbank financial sector includes securities brokers and dealers, financing companies, and investment houses (Table 1). NBFIs act in the capacity of a fiduciary managing the money of clients through investment companies (mutual funds) and pre-need companies. The assets of numerous (over 6,000) neighborhood lending investors and pawnshops account for less than 1 percent of financial sector assets. As many of these small businesses are affiliated with banks or financing companies, it is anticipated that they will face pressures to merge or liquidate assets. The SEC has already started to issue rules to consolidate lending investors.

Table 1: Selected Nonbank Financial Sector Participants (1998-2000)

Type of Entity Number Total Assets (P million) Securities Brokers/Dealers 168 113,297a Investment Houses 37 37,924a With Quasi Bank License 7 32,935a Mutual Fund Managers 20 6,129 Stock Funds 6 1,516 Balanced Funds 10 1,703 Bond Funds 4 2,909 Financing companies 177 55,352 With Quasi Bank License 7 13,720 Pre-need Companies 52 130,303 a Based on audited financial statements. Sources: Securities and Exchange Commission and Bangko Sentral ng Pilipinas.

13 At present, the country has over 7,000 nonbank financial institutions. 8

2. Regulatory Framework

27. SEC regulates the capital market, and licenses and supervises self-regulatory organizations (SROs)14 including Philippine Stock Exchange (PSE), the Philippine Central Depository, Inc. (PCDI), and the Securities Clearing Corporation of the Philippines (SCCP). SEC also oversees company registration and the conduct of market participants. BSP is also involved in supervising capital markets to the extent that bank subsidiaries and affiliates, such as investment houses and securities firms, operate in the capital market.

28. Established in 1936, SEC derives its mandate, powers, and broad authority to regulate and supervise corporations, investment firms, and the securities industry from SRC, Presidential Decree 902-A, the Corporation Code, Investment Houses Law, the Investment Company Act, and the Financing Company Act and other statutes (Appendix 3).15 Supported by these laws, SEC serves as a collegial body with a governing board consisting of a full-time chairperson that is the chief executive, and four commissioners who coordinate line responsibilities. The members of the Commission, appointed by the President of the Philippines for a seven-year term, decide regulatory, supervisory, and enforcement matters on the basis of majority vote.

29. BSP supervises all nonbank services offered by banks and quasi banks (QB)16 subsidiaries and affiliates and other NBFIs authorized to engage in QB functions and other fiduciary investment management operations. Since many NBFIs regulated by SEC are the subsidiaries or affiliates of banks, BSP and SEC need to develop more effective coordination in regulating and supervising of the nonbank financial sector.

3. Market Institutions

a. The Stock Exchange

30. The securities industry in the Philippines began with the opening of the Manila Stock Exchange in 1927 and later the Makati Stock Exchange in 1963. The Philippine securities market was the most active in Asia until the 1970s, but witnessed a setback subsequently due to political and economic problems. In 1994, the Manila and Makati Stock Exchanges were unified into the PSE (Appendix 4) to achieve uniform pricing of stocks and eliminate arbitrage. In the process, PSE’s two trading floors were linked electronically, enabling brokers and traders to execute orders and clear transactions within the day.

31. PSE is owned by its broker members, each of whom buys a seat entitling him/her to one vote at general meetings and to participate in its functions, services, and activities. A PSE seat is currently valued at P25 million, down from P80 million in 1996. A 15-member board of governors has traditionally overseen PSE whose administration is managed by the PSE president who is concurrently chief executive officer. Two board members, including the president, were required to be independent directors. Three additional independent directors joined the board in 1998 as a condition for obtaining a SRO license for PSE.

32. In the three years prior to the Asian financial crisis, PSE was able to raise, on the average, P35 billion in new capital through issues of equity securities. Despite a slowdown from

14 An SRO is an industry organization developed to enforce fair, ethical, and efficient practices on the industry. Its powers and responsibilities are complementary to the oversight regulator. 15 Appendix 5 contains the rules and regulations governing the nonbank financial sector. 16 A quasi bank license entitles a financial intermediary to borrow funds from more than 20 lenders at any time, for relending or related investment activity. BSP is no longer granting quasi bank licenses. 9

1993 to 1994 due to the Mexican crisis, PSE’s market capitalization grew steadily and reached over P2 trillion in 1996. The secondary equities market was also active: in 1996 it ranked fifth in terms of turnover compared with its regional comparators and the stock index increased steadily over the six-year period up to end-June 1997.

Table 2: Selected Stock Market Indicators

Item 1997 1998 1999 2000 Capitalization (billion pesos)a 1,251 1,374 1,938 2,578 (% gross domestic product) (51.6) (51.3) (64.7) (77.6) Philippines Composite Index 1,869 1,969 2,143 1,495 (Peso, % change previous period) (-41.1) (5.4) (8.8) (-30.3) ($, % change previous period) (-61.2) (8.3) (5.1) (-43.7) Average daily trading volume 7.8 1.2 3.8 2.6 (million shares) Number of listed companies 221 221 226 230 a All indicators are for end of period. Source: Philippines Stock Exchange.

33. The regional financial crisis hit PSE substantially (Table 2). Prices of shares of Philippine companies listed on PSE fell significantly in 1997. The falling stock market and resultant heavy selling of Philippine equity securities by foreign investors induced exchange rate pressures and affected the foreign currency positions of financial institutions in the Philippines. The PSE Composite Index declined 45.8 percent in peso terms from 3,448 on 3 February 1997 to 1,870 on 29 December 1997, and continued to fall during most of 1998, reaching an historic low of 1,082 on 11 September 1998. After partial recovery in late 1999 and early 2000, the PSE Composite Index continued to be quite volatile, declining to 1,534 on 30 June 2000. Stock market indicators steadily declined:

(i) Initial public offerings (IPOs) fell from P1 billion in 1998 to P756 million in 1999, and P560 million in 2000; and

(ii) Market capitalization increased steadily through the 1990s, peaking in 1996 at P2,122 billion. In 1997, market capitalization fell to P1,251 billion but recovered in late 2000 to P2,578 billion based on seven new listings, including the P9 billion IPO of Sunlife Financial Services, Inc., of Canada and an P8.5 billion offering of Philippines Deposit Receipts by Global Telecom.

34. PSE market capitalization is characterized by a high degree of concentration. The top 10 companies account for about 60 percent of market capitalization and the top 50 companies for over 90 percent. The remaining 180 companies are not regularly traded and, often, no current price quotes exist for their stocks. The Ayala Group of companies dominates the market accounting for about 20 percent of the market capitalization.

35. PSE operates two electronically linked exchange floors: Makati and Pasig (para. 30). Since November 1995, it has operated a single order-book using US MakTrade software to adopt the Unified Trading System. The system is considered efficient and transparent. PSE provides a computerized, exchange-based trading market in domestic ordinary shares, preferred shares, bonds, and warrants. The exchange trades 9:30 to 12:00 noon five days a week. Equities are by far the most actively traded instruments. The turnover was P659 billion end-2000, close to the 1996 level. 10

b. Securities Clearing Corporation of the Philippines

36. SCCP is a privately owned corporation authorized by SEC in 1998 to provide clearance and settlement services for trades executed on the PSE. SCCP is capitalized at P175 million, P50 million paid-up and P125 million callable capital. PSE owns 51 percent of SCCP shares and the remaining 49 percent are held by three Philippine commercial banks. Two of these banks are designated as settlement banks.

37. SCCP provides trade matching and confirmation, trade netting, settlement instructions, and a settlement guarantee for its members. The clearinghouse within PSE matches trades on trade day plus 1 (T+1) based on data downloaded from the unified trading system. Broker confirmations are recorded on T+2 based on returns from brokers to the clearinghouse. Disputed trades are resolved through amendment of trade details, buying in, unwinding, or other arrangements. Trades are netted on T+3 and brokers, the central depository, and the two settlement banks are notified by the clearinghouse of the net cash and securities position for payment or transfer. On T+3 the settlement banks book the necessary credits and debits in the cash settlement accounts of the brokers, and the brokers execute transfers of securities through transfer agents or directly to PCDI.

c. Philippine Central Depository, Inc.

38. SEC granted PCDI a license in December 1996. PCDI services the securities industry by providing securities safekeeping services and book entry settlement of trade. PCDI is a provider of information services to SCCP, and supports the needs of SCCP in carrying out its responsibilities for securities transfers and cash settlement. The PCDI system links PSE and SCCP, brokers, custodians, and settlement banks together under one information and accounting system. PSE and the Bankers Association of the Philippines each own 32 percent, the Financial Executives Institute of the Philippines and the Development Bank of the Philippines each own another 10 percent. Industry associations own the remainder of PCDI.

4. Key Market Participants

a. Brokers and Dealers

39. There are currently 184 securities brokers and dealers registered with SEC: of that number, 147 are active and 37 inactive. Of the active members, 120 are corporate members (of which 10 are subsidiaries or affiliates of banks) and 27 are individuals; 21 are foreign and 126 local. The assets of securities brokers and dealers grew from P4.8 billion to P11.6 billion from 1992 to 1996; however, the size and business of the securities industry remain small and volatile as prices of PSE-listed companies fell during the crisis period. The falling stock market and resultant heavy selling of Philippines equity securities by foreign investors exacerbated exchange rate pressures and affected the foreign currency positions and value of inventories of financial institutions in the Philippines. At PSE, the top 20 securities brokers and dealers account for about 90 percent of the business and most of the largest firms are foreign owned. However, the small stock brokerage firms whose volume and value of business are low have dominated the PSE board of directors, carrying disproportionate influence in managing and administering PSE. 11

b. Investment Houses

40. At present, there are 44 investment houses;17 7 of them have QB licenses. Investment houses are licensed by BSP; however, they register with SEC in order to perform their main function of underwriting. Over a five-year period ending in 1998, the assets of investment houses grew from P10 billion to P56 billion and stagnated at around this level due to the slowdown in underwriting and related capital market activities. Of the seven universal banks, four conduct underwriting activities through an investment house subsidiary or affiliate and three underwrite directly. This raises questions of what policies and procedures are in place to segregate bank assets and mitigate the underwriting risk. Even if banks are licensed as underwriters they must establish separate subsidiaries for the purpose of functioning as a PSE member securities broker- dealer. Hence, the three universal banks that do not have independent underwriting subsidiaries are not entitled to PSE membership. In addition to universal banks that play a role in underwriting, there are 38 commercial banks some of which may engage in underwriting and stock brokering through subsidiaries and affiliates. At present, there are 10 subsidiaries or affiliates of commercial banks that have PSE membership.

c. Financing Companies

41. Financing companies provide loans, mortgages, financial leases, and other forms of credit. There are 177 financing companies with 228 branch offices. Seven financing companies have QB licenses and are allowed to borrow funds by issuing negotiable money market instruments such as commercial papers. Of the 170 financing companies without a QB license, 19 are the subsidiaries or affiliates of commercial banks and 5 companies have dual licenses to operate as a finance company and an investment house. Assets of financing companies grew from P28.8 billion to P55.3 billion over 1992-2000. Non-QB financing companies contributed to this growth and accounted for 80 percent of the total financing companies assets, while QB financing companies assets stagnated at P8.7 billion as they faced difficulties raising funding from markets and their bank affiliates.

5. Nonbank Fiduciaries

a. Mutual Funds

42. The Philippines permits two classes of investment companies: (i) open-end funds (i.e., mutual funds) set up to continually offer new shares to the public, and (ii) closed-end funds that offer only a fixed number of shares determined at the time of the IPO. Closed-end funds are not redeemable at the option of the shareholder but rather trade like any other listed stock, with the price determined on the basis of supply and demand. Of the 20 mutual open-ended funds in the country, 6 are stock funds, 10 balanced funds, and 4 bond funds. Two mutual funds are sponsored by banks and accounted for about one third of the industry’s net assets of P3.3 billion as of end- 2000.

17 The larger investment houses act as underwriters and dealers in private money market instruments, government debt, listed equity securities, and private placement of debt and equity instruments. Under SEC regulations, PSE members may act as sales agents in the distribution of securities on behalf of universal banks or investment houses that underwrite securities. 12

b. Pre-Need Plans

43. The pre-need industry is the country’s predominant collective investment vehicle with over 200,000 sales agents throughout the Philippines. The industry has raised cumulative assets exceeding P130 billion as of end-1999. Pre-need plans have evolved from a financing adjunct of the funeral industry (memorial, burial, and cremation), to pension and education plans. The industry has moved from open-ended hedges against inflation to “fixed value” plans. Total sales amounted to P31.1 billion in 1999 and P36.1 billion in 2000, or an increase of 16 percent. Under the authority of the SRC, SEC will continue to regulate pre-need plans. The Pre- Need Code legislation that will upgrade the supervision and reporting requirements of pre-need companies is pending in Congress.

6. The Accounting and Auditing Profession

44. The Philippines maintains an elaborate legal, regulatory, and institutional framework to oversee the development and practice of the accounting and auditing professions. The Revised Accountancy Law of 1975 governs accounting and auditing professional standards, and the Professional Regulation Commission (PRC) regulates over 40 professions, including the accountancy profession. PRC is under the administrative supervision of the Civil Service Commission, an independent agency reporting to the Office of the President. PRC is responsible for formulating policies, rules, and regulations for professional practices including setting the minimum requirements for certified public accountants (CPA). In collaboration with the professional regulatory board for accounting, the Board of Accountancy (BOA), PRC conducts license examinations and periodic inspections to ensure enforcement and compliance with professional standards. PRC also issues and renews licenses for professionals, investigates and adjudicates complaints and cases against professionals, and supervises accredited professional organizations such as the Philippines Institute of Certified Public Accountants (PICPA). PRC and BOA are now positioning themselves to improve monitoring and enforcement of the quality and integrity of professional ethics, education, and standards, and to proactively participate in negotiations and implementation of the ASEAN Framework Agreement on Services, and the World Trade Organization-General Agreement on Trade in Services.

a. Board of Accounting

45. BOA comprises seven members who are nominated by PICPA and appointed by the President. In accordance with the Revised Accountancy Law of 1975 and subject to PRC approval, BOA is responsible for supervising and monitoring accountancy practices, developing rules and regulations, setting professional and ethical standards, administering the CPA examination, and issuing CPA certificates. BOA also investigates violations of the Revised Accountancy of Law 1975 and, after due process, may suspend, revoke, or reissue registration certificates. BOA’s key mandates are to (i) improve the curriculum for accountancy education and the CPA examination system, (ii) revise the accountancy code of ethics and regulations for foreign professionals, and (iii) resolve outstanding legal cases and obtain International Standards Organization certification.

46. To achieve these objectives, BOA implemented a coordinated work program with PICPA and other concerned bodies on revising the accountancy code of ethics, enhancing the accountancy curriculum, and developing programs that reflect technological advances in the accounting profession. The process of reviewing the Accountancy Law of 1975 and the Code of Ethics for possible amendments is continuing. 13

b. Professional Integration

47. PRC accredited PICPA in 1973 as the association responsible for integrating all Philippine CPAs by registering them as PICPA members. PRC has thus far registered 103,340 CPAs as of December 2000, but not all are active (i.e. fee-paying) members of PICPA. In 1999, PICPA launched a push for compulsory CPA membership in PICPA. CPAs who were not PICPA members were given until 31 July 2000 to renew their respective registration certificates or face its cancellation. Under PICPA rules, all persons whose names appear in PRC’s CPA Register should be members of PICPA. On this basis, failure to maintain membership in PICPA can be sufficient cause for PRC to revoke CPA’s registration certificate. PICPA further prepared a bill, recently presented to Congress, that requires compulsory membership of professionals in their respective accredited professional organizations.

B. Constraints and Issues

1. Weakness in SEC Structure and Governance

48. SEC has a broad and strategic mandate to regulate the securities market. It is, however, subject to oversight from DOF. Its rules and decisions can be subject to challenges in the courts. It lacks financial autonomy, which impacts on its flexibility to meet this mandate. SEC financing remains a major obstacle to effective market regulation and enforcement. Fees and charges collected by SEC (close to P1 billion in 1998) go to the Government’s general revenue budget. SEC is then given a budget allocation of around P140 million with salaries tied to the civil service scale. The resource constraints have limited SEC’s ability to modernize its internal systems and controls and to function as an effective regulator of the securities market.

49. Under the 1982 Revised Securities Act, SEC lacked a clear legal mandate and the human and financial resources to fully exercise its oversight powers and authorities over the capital market. The organizational structure of SEC was restricted and outdated, and encouraged overlapping administration and undersupervision of the securities markets. For instance, three departments handle surveillance, investigations, and enforcement but lack effective coordination among them. The Prosecutions and Enforcement Department took limited enforcement actions, while the Brokers and Exchanges Department, which grants broker licenses, was overseeing license cancellations or suspensions. The Money Market Operations Department, which monitored investment houses, also would initiate investigations. Besides legal impediments to reorganization, there was no legal protection for SEC staff acting to discharge their regulatory functions and powers as regulators. SEC governance standards were considerably short of the International Organization of Securities Commissions (IOSCO) Objectives and Principles for a securities regulator.18 Restructuring the organization, introducing information technology, and developing human resource capacity are critical for SEC to improve its market regulation.

50. Despite organizational shortcomings under the Revised Securities Act, SEC started drafting the rules for an effective regulatory framework for PSE to function as an SEC SRO. SEC needs to develop an MOU with PSE on specific aspects of market monitoring, particularly after PSE is demutualized. However, under the CMDP, PSE transformed its legal and regulatory framework to operate as an SRO, but there were no effective implementing rules and regulations (IRR) for the SRO. PSE has not fully developed its capacity to act as a frontline regulator for brokers, dealers, and the exchange and as an effective supervisor for listed

18 The full text of all IOSCO documents is available on its web site, www.IOSCO.org. 14 companies’ compliance with PSE regulations and other rules. In addition, SEC has not been effective in its market oversight role of PSE. SEC continued to operate and regulate PSE as its staff continued to exercise direct statutory and administrative controls rather than focus on broad market monitoring oversight. In implementing the full disclosure rules and SRO framework, SEC then developed an overly technical and backward-looking approach that prevented sufficient flexibility, and limited the creative development and nurturing PSE’s SRO responsibilities. Both PSE and SEC were unclear as to how SROs functioned, including the ways regulatory and oversight responsibilities would be shared. In view of these issues, effective implementation of PSE’s SRO status has been problematic. The SRO structure has created legal issues and contributed to a high degree of uncertainty about SEC’s mandate to enforce SRO rules and led to disputes between SEC and PSE.

51. SEC needs to reexamine its policy on PSE self-regulation. It needs to develop and publish a policy statement setting out oversight objectives and how SEC proposes to achieve them. In addition, SEC needs to build its staff skills in market surveillance and enforcement. Prior to reorganization, almost 65 percent of SEC staff were involved in company registration, while the remainder focused on SEC’s core activities of prudential regulation of financial services institutions under its jurisdiction and market conduct in the securities industry. The SEC culture needs to change so that the majority of staff resources are directly involved in SEC core activities while the remainder of the staff, about 20 percent, focus on company registration. To achieve this outcome SEC needs to take advantage of recent developments in information technology, and upgrade its monitoring and investigation capacity to allow it to analyze data sets in a relational and predictive way. Current record keeping and filing is not sufficient for adequate market regulation.

2. Weak PSE Governance and Regulation

52. The Philippines has been steadily increasing public ownership of companies through private and institutional investment and privatization of state-owned enterprises since the 1990s (para. 12), and it has facilitated growth in the equities market. However, the standards of corporate governance still remain weak. Under the CMDP, PSE introduced three additional independent directors (para. 30) on the board of PSE to strengthen governance, and supported the introduction of self-regulation.

53. PSE was established as a limited-liability company that concentrated on providing services and minimizing costs for its members, rather than being profit driven. Operating surpluses of PSE have been used to cover losses from any unlikely system failures, or directed toward improving systems and facilities, market development, and public awareness and investor education. PSE’s cooperative governance structure, where each member in the mutually owned company is accorded an equal vote regardless of market share or volume of business on PSE (para. 30), once served it well. It has, however, become more of a hindrance than a benefit. PSE governance and its ability to implement policies and regulation is affected by the dominance of the smaller brokers and dealers who are overrepresented on PSE’s board of directors.19 These smaller brokers have prevented listed companies and large players from having reasonable representation in market development and policy issues. The top 20 brokers accounting for 90 percent of business conducted on PSE (para. 39) have been trying to create a more professional culture at PSE. The large brokers are seeking improvements in market quality and integrity, better rules, and better enforcement. While the smaller brokers prefer more lax supervision, large brokers have supported close monitoring of market trading, strict

19 PCR: PHI 21223: Capital Market Development Program, August 2000. 15 supervision of capital adequacy rules, and implementation of delivery-versus-payment (DVP) in the settlement system. Small brokers see these new systems, procedures, and regulations as unnecessary costs and often as impediments to profitable trading. Effective implementation of these systems and procedures are required for PSE to become a member of the Federation Internationale des Bourses de Valeurs (FIBV).20 Without FIBV accreditation, foreign and institutional investment would be severely restricted.

54. SEC granted PSE a license to undertake self-regulation in 1998 (para. 27). However, implementation of the SRO structure has been difficult as SEC and PSE failed to agree on coregulation with shared responsibilities between the market regulator and the SRO. PSE’s SRO privileges were suspended in March 2000 due to PSE’s failure to maintain a satisfactory compliance and enforcement department for direct supervision and monitoring of brokers and dealers. PSE regained its SRO status in late 2000 when it reconstituted its compliance and enforcement division and guaranteed SEC that it will strengthen its market monitoring systems. More work needs to be done to ensure that the SRO framework is fully understood and operates as an efficient and cooperative system. An additional problem to effective rule enforcement is PSE’s listing and disclosure group and the compliance and surveillance group who do not have operational procedures for rule enforcement. As a result, the processes and decision-rules are not uniformly applied, leading to inconsistency and uncertainty and opportunities for market manipulation.

3. Inadequate Compliance by Market Participants and Weak Enforcement by SEC

55. Financial reporting and market transactions in the Philippines lack consistency in regulatory compliance, enforcement, and transparency. As a result, financial intermediaries performing the same functions are regulated and supervised under different standards. Market participants take advantage of the application of different standards and engage in regulatory arbitrage and market abuse. One of the major issues is the dichotomy between the regulation and supervision of the nonbank financial sector. While SEC regulates the nonbank financial sector, some NBFIs are supervised by BSP (para. 29). This structure has evolved as commercial banks expanded their operations to handle securities functions and businesses through subsidiaries or affiliates, and universal banks were licensed to underwrite securities. BSP’s role in supervising the underwriting activity of universal and commercial banks and SEC’s role in the rest of the securities market have created regulatory fragmentation and segmentation. Both agencies have different priorities as reflected in their respective policies, rules and regulations, and record keeping and reporting requirements for their institutions. Similar financial activities are regulated under different standards, resulting in uncertainties with respect to compliance, regulatory costs, and protection of the public. To address this problem, some regulators around the world have moved from an institutional to a functional approach toward regulation. Under this framework similar activities and products are regulated and supervised uniformly, even where regulation or supervision is provided by different institutions. SEC and BSP need to join efforts to provide more unified oversight and supervision of NBFIs and to ensure effective compliance with market rules and regulations.

56. Under the fragmented regulatory structure, NBFIs have not followed full and fair disclosure principles; company annual reports are incomplete, and the quality of information does not meet

20 FIBV, or the International Federation of Stock Exchanges, is the trade organization for regulated securities and derivative markets worldwide. It promotes the professional business development of financial markets, at national and international levels. 16

SEC reporting standards.21 Lack of compliance with financial reporting rules and regulations and with disclosure of significant subsidiaries or affiliates reflects SEC’s weak monitoring system. An insufficient level of market transparency and disclosure of company financial information has affected the efficiency and development of the capital markets in the Philippines. SEC does not have sufficient capacity in accounting and auditing, and monitoring off-market transactions; as a result, activities such as block trades have been inadequately regulated.

57. While PSE rules provide for block sales to be reported to the market, both compliance and the level of disclosure are often deficient. Block trades have been abused by some investors and have led to the recent allegations of unfair pricing, market manipulation, and abuse. The conduct of block trades in listed securities is permissible in many equity markets. It is recognized that permitting ownership in large parcels of shares reduces the average transaction cost of selling shares. However, since block sales are conducted in minimum sizes and its sales are outside the regular market of continuous bids and offers, these transactions tend to be nontransparent. More efficient mechanisms are required to ensure that price information from block trades is transferred to the market in a timely manner. The new provision in the tender offer rules effectively addresses the lack of pricing transparency of block sales by requiring wider dissemination of price information to the market. The new SEC rule also sets parameters to protect minority stock holders. Each block sale is now recorded by SEC.

58. This lack of transparency and enforcement manifested itself in a series of stock market scandals. In addition to the stock manipulation and insider-trading allegation of the BW Resources stock in early 2000, there have been price manipulation charges against brokers involved in trading the Reynolds Philippines Corp. stock. Mismanagement in Urbancorp Investment, Inc, and its parent company Urban Bank has also been noted. While the Reynolds Philippines Corp. price rigging allegations resulted in minor fines to several brokers, the investment house irregularities resulted in a run on Urban Bank deposits. BSP closed Urban Bank and SEC suspended the investment house license of Urbancorp Investment, Inc. Negotiations are under way for rehabilitating both the bank and investment house.

4. Lack of Diversification of Corporate Financing

59. Financial leveraging by corporations in the Philippines has been comparatively lower than in other East Asian economies. Lack of diversification in corporate financing, however, remains a problem since capital markets are thin, with little liquidity and depth. The limited diversity of financial instruments provides weak prospects for financing options and innovation. While there are 230 listed companies on PSE, so far only one corporate bond has been issued, two companies have issued warrants, and one company has a preferred stock listing. Corporate bonds and asset-backed securities each account for less than 1 percent of the outstanding value of all listed securities. Of the total securities registered with SEC, about 80 percent are common stock, while short- and medium-term commercial paper account for about 12 percent. Medium-term, variable rate, commercial paper with maturities up to five years is issued in lieu of fixed-term corporate bonds.

60. The money and debt market (Appendix 5) comprised (i) government securities including treasury bills (T-bills) with tenures of 91, 182, and 364; days and bonds and notes of longer tenure that are auctioned; and (ii) interbank call loans, promissory notes, repurchase agreements (repos), and commercial paper. The Government has been successful in launching

21 Recent surveys of the annual reports of 16 listed Philippine holding companies revealed that 75 percent of the companies did not present summarized information regarding the financial position of significant subsidiaries in 1997. 17 fixed rate issues with a maturity of as long as 20 years. With respect to private issues, some corporations have launched commercial paper issues of longer maturity. The insurance industry, the Social Security System, and Government Services Insurance System participate in the Government treasury auctions. Debt securities issues are mostly absorbed by commercial banks either for their own account or to finance short-term placements.

61. The main obstacle to debt market development is the high transaction costs, including the documentary stamp tax (DST). While the DST on secondary trading has directly contributed to slow development of the secondary market, lack of liquidity, no market makers, and thin volumes have resulted in little interest by investors. Another constraint has been inadequate market infrastructure for registration, clearance, and settlement, as well as investment limitations on institutional investors.

62. The issue of market liquidity is tied to the ability of an investor or market maker to fund inventory to buy and sell securities. In general for a bank, broker, or investment bank, equity inventory may be financed through (i) repos, or (ii) securities borrowing and lending activities. Fully collateralized repos (usually by Government securities) are securities that are normally exempt from reserve requirements, excessive capital charges, or burdensome transaction taxes, and are considered a cost-effective way for dealers and market makers to finance their inventories of Government and private securities. However, in the Philippines repos are classified as bank deposit substitutes; therefore, banks are required to hold reserves against their inventory. In addition, securities borrowing and lending are presently not allowed. As a result of these restrictions, the market is illiquid as there are no market makers who can at all times provide bid and offer prices for securities. If debt markets are to fully develop, the Government needs to address taxation and market liquidity concerns, including identifying prudentially sound ways of fostering liquidity.

5. Fragile Market Infrastructure

63. Under the CMDP loan, ADB supported the development of a clearing and settlement system and the establishment of a central depository institution (paras. 36-38). These institutions provide the basic infrastructure needed to create a modern market trading system (Appendix 6). SCCP is the equity clearing and settlement agency, and PCDI is the depository institution. SCCP, operating under a temporary license from SEC, is supported by an electronic data processing system, which is shared and owned by PCDI. It is the responsibility of SCCP to execute DVP settlement, maintain and administer a Clearing and Trade Guarantee Fund, and undertake system risk monitoring and management.

64. The smaller brokers and dealers have shown resistance to the implementation of DVP as it eliminates the “float” time between buying a security and transferring the money from a broker or dealer’s account. Under DVP, simultaneous transfer eliminates the risk of nondelivery of security or nonpayment of funds for a transaction. The real risk of nondelivery is broader market failure triggered by the unwinding of linked trades. SCCP, responsible for executing DVP, has encountered difficulty in meeting its objectives because of its ownership and governance structure and delays in development of the RTGS systems. Since July 2000, PSE with its majority shareholding has effectively taken control of SCCP, installing one of its own members as head of the institution.

65. Under SEC licensing requirements, SCCP is required to establish and maintain a Clearing and Trade Guarantee Fund. At present, PSE maintains a trust fund–currently about P186 million– for this purpose. A common rule of thumb is that such funds should be 5 percent 18 of daily unsettled trades. Given the sharp decline in the stock market, this fund appears adequate. However, when the market returns to precrisis levels, additional funds will be required to cover the risk of the higher volume of trades.

66. PCDI provides securities registration and safekeeping services through a book entry system, and gives SCCP information for clearing and cash settlement of trades. PCDI links PSE, SCCP, brokers, custodians, and settlement banks together under one information and accounting system. PSE has mandated that all trades executed on PSE be settled through PCDI. Currently, SCCP and PCDI operations are limited to the equity market. Furthermore, provisions in SRC for uncertified securities have potentially created uncertainties regarding the future role of PCDI. SRC defines the role of stock transfer agents (in place of PCDI) and commercial banks (in place of SCCP) to allow them to assume some of the functions of the present clearance and settlement and depository system. While it is unclear how these provisions will be implemented, it would be unusual for commercial banks to assume the risk exposure of equity clearing and settlement. However, with the imminent demutualization of PSE, issues concerning the clearing, settlement, and depository systems need to be explored with SEC and PSE.

6. Low-Quality Financial Reporting

67. The establishment, implementation, compliance, and enforcement of best practices in accounting and auditing, corporate governance, and securities markets standards are recommended means of enhancing transparency and information flows in emerging markets. Guidelines as developed by international standard setters will help the Philippines encourage high quality accounting and reporting arrangements consistent with international standards.

68. The weak monitoring of financial statements by SEC (para. 56) is compounded by reporting requirements of the Philippine Accounting Standards Council, which prescribes statements of financial accounting standards that are not consistent with international accounting standards (IAS). The accounting profession has adopted a wide range of policy choices for preparing financial statements; the quality of financial reporting for investors has therefore been affected.

Figure 1: Perceived Quality of Financial Accounting Systemsa

10

9

8

7

6

5 Quality of Financial Accounting Systems Accounting Financial of Quality

4 I M alaysia T hailand P hilippines Indonesia a Saudagaran, Ahahrokh and Joselito Diga. 2000. The Institutional Environment of Financial Reporting in ASEAN. Institutional Journal of Accounting. Vol 35(1): 1-26. The quality is rated from 1 (lowest) to 10 (highest). 19

69. Adopting IAS will (i) reduce the costs and efforts associated with standard setting, (ii) improve the credibility of Philippine financial reporting, (iii) provide access to a greater range of training materials, (iv) make Philippine CPA skills more transferable on the international market, and (v) align Philippine financial reporting standards with international standards and practices. Where an IAS does not address a certain country-specific arrangement, then specific national accounting standards can be adopted for country-specific financial arrangements.

70. Besides accounting, there has been weak monitoring of compliance with standard auditing practices. Philippine auditing practices differ substantially from international and regional guidelines and norms in four areas: (i) auditor appointment and dismissal, (ii) auditor independence, (iii) audit reporting procedures, and (iv) exposure of auditors to liability.

C. External Assistance to the Sector and Aid Agency Coordination

71. IMF provided a two-year standby credit to the Government of the Philippines, equivalent to SDR1,021 million (about $1,371 million) to support the government’s economic program from 1998-1999. The program addressed the dual goals of supporting Government liquidity during the Asian crisis while creating the conditions for sustained growth over the medium term. The standby program, scheduled for completion in June 2000, was extended until December 2000. This standby arrangement was allowed to lapse; however, the Government consented to regular IMF consultations to review the medium-term economic framework and the broad direction of structural reform under a post-program monitoring agreement.

72. Within this overall context, both the World Bank and ADB have been pursuing structural adjustment programs in the financial sector. The World Bank has supported banking sector restructuring and reforms, while ADB has focused on capital market growth and development. The World Bank’s Banking System Reform Project22 ($300 million) was co-financed by Japan Bank for International Cooperation (43.8 billion yen). This operation focused on strengthening banking regulation and supervision as well as developing a resolution framework for troubled banks and encouraging banking sector restructuring. Although the Government and World Bank decided to cancel the project in May 2001, banking sector reform is continuing. The World Bank has also conducted economic and sector work in the areas of pension reform, housing finance, and enterprise restructuring. Appendix 7 gives a detailed list of reforms implemented under this loan.

73. ADB involvement in the capital markets started with reforms under the CMDP. The CMDP focused on (i) consolidating the two stock exchanges, (ii) encouraging transparency and accountability through increased public disclosure of financial information, and (iii) building capacity and market confidence. Although the Government was in compliance with the core conditions of the CMDP loan, compliance with a number of other conditions tied to the release of the second tranche was delayed with the enactment of SRC. Although ADB and the Government agreed to cancel the second tranche,23 the CMDP was successfully completed following the passage of SRC in July 2000. ADB approved TA for $2 million in 1999 (footnote 4) to (i) restructure SEC, (ii) build the capacity of SEC staff, and (iii) strengthen the management information system (MIS).

22 The World Bank: Banking System Reform, Report No. P7235-PH, approved in November 1998. 23 IN.88-00: Capital Market Development Program Cancellation of Second Tranche, April 2000. 20

74. In addition to international financial institutions’ initiatives, USAID approved a large TA24 to (i) support enhancing the professionalization of PSE and a review of the business operations of the clearing and settlement system, (ii) draft the IRR for the SRC, and (iii) support the regulatory reform of the pre-need and investment advisory industries. The Canadian International Development Agency supported the Philippine Deposit Insurance Corporation25 and BSP in capacity building for supervision, and assisted SEC in drafting revisions of the Investment Company Act. The Australian Agency for International Development through its Philippine-Australian Governance Facility, provided advisory assistance to PSE for developing its demutualization plan.

75. With assistance from IMF, USAID, and World Bank, the Government has been developing legislation that will amend taxation laws to rationalize the DST and other taxes that have hampered financial sector transactions. ADB’s support for the nonbank financial sector complements and reinforces these aid agencies’ efforts to reform the financial sector.

D. ADB’s Operations and Strategy in the Sector

1. Country Strategy

76. ADB’s country operational strategy, which was revised in 1998, conforms closely to the Government’s new development priorities outlined under the new Medium-Term Philippine Development Plan approved in 2001 (para. 6). The strategy places increased importance on poverty reduction, social development, and improved governance. In particular, the strategy envisages ADB’s assistance program to concentrate on promoting equitable growth, better provision of basic social services such as health care and basic education, management and protection of the environment, and policies and programs to improve the country’s infrastructure, with emphasis on greater private sector participation. Through its sector focus, the strategy also addresses issues relevant to the currency turmoil, including capital market development.

77. The immediate challenge of economic management is to restore public confidence in the economy, while addressing the weaknesses in some of the economic fundamentals. ADB has identified four economic management priorities for the Philippines: (i) restoring fiscal credibility, (ii) strengthening governance, (iii) improving the savings rate, and (iv) containing population growth. To reflect these priorities, ADB has been changing the sector mix of its operational program, moving away from traditional infrastructure project financing, to support broad-based governance reforms, policy and institutional reforms in the agriculture and power sectors, and development of basic health, education, and other social services. Within the area of governance, ADB’s operational strategy and programs have focused on improving the transparency of public expenditures, preventing corruption, accelerating privatization and the restructuring of public sector utilities and other entities, decentralizing national government entities, and encouraging greater private sector participation. To broaden and deepen these governance initiatives, ADB’s strategy has emphasized strengthening governance of financial markets–a fundamental goal of the proposed Program.

24 The USAID project: Accelerating Growth, Investment, and Liberalization with Equity (AGILE) provided approximately $27.7 million from June 1998 to September 2001 for multisector assistance that covers financial sector, trade and industry. 25 ADB is also implementing TA 2971-PHI: Institutional Capacity Building of the Philippine Deposit Insurance Corporation, for $742,000, approved on 31 December 1997. 21

2. Sector Strategy

78. As seen in the recent Asian crisis, an economy that becomes more open and integrated with the global economy will be more vulnerable to external economic shocks, particularly if it exhibits high dependence on banks and has a weak regulatory framework for the financial sector.26 This underscores the need for developing strategies that can support broadening and diversifying the industry and financial sectors to allow for better risk mitigation and management. In addition, the Philippines needs to actively pursue reforms in the finance, corporate, trade and investment sectors if it is to remain competitive in the region.

79. To support the Philippines in these areas, the ADB’s sector strategy envisages a twofold approach involving support for (i) financial sector reforms, with particular focus on nonbank financial sector development; and (ii) industry and trade development with a focus on fostering greater competitiveness, including development of small and medium-size enterprises. In the financial sector, the primary emphasis of ADB’s sector strategy has been to help develop and diversify the nonbank financial sector to enable it to provide long-term funding and risk diversification avenues. To promote the development of the nonbank financial sector, ADB has emphasized restoring investor confidence by strengthening governance of the financial and corporate sectors at the regulator and market participant levels. To achieve this objective, ADB’s policy work has emphasized strengthening the powers of SEC and its governance structure to effectively enforce market regulations and conduct proper market surveillance. Simultaneously, emphasis is placed on improving governance by promoting greater transparency and disclosure in financial reporting, use of international accounting and auditing standards, and promoting impartial policy, regulation, and enforcement across institutions and markets. Appendix 8 gives the key reforms undertaken by the Government over the past 10 years.

V. THE PROGRAM

A. Rationale

80. The Asian crisis has highlighted the risks associated with vulnerable financial structures in a financially integrated world. The buildup of vulnerabilities stemmed from excessive reliance on bank financing, poor corporate and financial regulations and governance, including poor compliance with accounting and auditing standards, and inadequate disclosure. Governance and enforcement have been weak at the regulator, financial institutions, and corporate levels. The crisis has also revealed the risks of family and relationship-based corporate and financial structures. While the Philippines managed to avert the more serious effects of the Asian crisis, these same features also characterize its corporate and financial structures.

81. Like other countries in the region, corporations in the Philippines rely heavily on bank- based financing. Businesses are dominated by groups of companies controlled by a few shareholders, often members of the same family. High ownership concentration is typically both a result and a cause of weak corporate governance. Less than a quarter of the country’s largest companies are listed on PSE, and of these, two thirds or more of the stock is usually in the hands of the controlling group. Consequently, minority or “outside” shareholders are not involved in corporate decisions and small shareholders are bypassed because of the small “public float” offered by companies. This contributes to thin illiquid markets, volatile share prices,

26 Duncan, R. and S. Pollard. A Conceptual Framework for Designing a Country Poverty Reduction Strategy. Delivered at the Asia and Pacific Forum on Poverty: Reforming Polices and Institutions for Poverty Reduction, Manila, 5-9 February 2001. 22 and the potential for price manipulation by the large controlling group. The end result is that the relative scarcity of publicly traded shares limits overall access to capital market financing for a broad range of companies. Hence, companies have come to rely on bank financing, often from an affiliated bank or other related intermediary. While related party loans are guided by limits to directors, officers, shareholders, or related interests, intercorporate and intragroup lending raises issues of possible expropriation of capital that may eventually hurt the soundness of financial intermediaries. In this structure the incentives to improve governance and disclosure, at either financial institution or corporate level, are limited.

82. To rationalize the incentive framework, the Government will develop systems and procedures to increase the efficiency of corporate financing while strengthening corporate internal controls and improving standards of accounting, auditing, and financial reporting systems. In addition, effective rule enforcement will be placed at the top of the reform agenda.

83. Under the Program, the Philippines has started to lay the foundations for a strong and robust financial sector and institutions. The key pillars of the Program are (i) strengthening the governance and enforcement capacity of the regulators, SEC and BSP; (ii) modernizing the securities market; (iii) introducing more transparency in the market; and (iv) encouraging enforcement of rules and regulations. These reforms are critical to meet the challenges of a growing volatility from a weak stock exchange, competitive pressures from technological innovation, as well as globalization and integration of financial markets.

B. Objective and Scope

84. The Program will support the process of capital formation through improved corporate governance in the nonbank financial sector. The key components of the Program are

(i) enhancing and strengthening the governance of SEC by (a) allowing SEC greater administrative, operational, and financial autonomy; and (b) enhancing monitoring and enforcement capacity; (ii) modernizing the governance and regulatory structure of PSE by (a) developing arrangements for PSE to strengthen its governance during the transition period, (b) restructuring and demutualizing PSE, (c) enhancing SRO reporting, and (d) developing arrangements for effective regulation of PSE; (iii) strengthening market oversight, compliance, and enforcement by (a) developing market governance, (b) strengthening prudential regulation of NBFIs, (c) preventing misconduct and market abuse, and (d) improving financial management and governance by strengthening financial disclosure monitoring; and (iv) facilitating diversification and innovation of corporate financing by (a) developing a policy, regulatory, and taxation framework for the corporate bond market; and (b) enhancing institutional investors’ participation to augment market liquidity.

C. Policy Framework and Actions

85. Building on ADB’s extensive economic and sector work and policy dialogue over the last decade, the NFG Program provides a long-term approach and perspective for reforms in the nonbank financial sector. To capture this long-term perspective effectively, the NFG Program has been developed in two phases. 23

(i) Phase I, from 1998 to 2001, focused on guiding the transformation of the regulator (SEC) and the stock exchange (PSE). SEC is now empowered to deal more effectively with market governance, regulation, and enforcement. PSE has taken the initial steps toward adopting new corporate governance standards and business practices. To support these institutions in the implementation of their regulatory responsibilities, Phase I supported the strengthening of market regulations, increasing the transparency of market transactions, and encouraging greater compliance with rules and regulations. Simultaneously, Phase I reforms also promoted an environment that will encourage the development of new financing options and structures.

(ii) Phase II, 2002-2004, aims to broaden and deepen the policy framework and actions implemented under Phase I. These reforms will draw on the technical work sponsored by ADB under TA (para. 123-125), the results of the Financial Sector Assessment Program (FSAP) conducted jointly by IMF and the World Bank, and the extensive economic and sector work conducted by ADB. ADB has been participating in the Review of Standards and Codes with the World Bank in three areas: accounting and auditing, corporate governance, and corporate insolvency. The core topics of Phase II include (a) implementing demutualization of PSE; (b) strengthening market regulation; (c) strengthening market governance and compliance; and (d) facilitating diversification and innovation in corporate financing. These four themes will be the basis for continuing the policy dialogue on Phase II and critical to support greater SEC effectiveness and sustained reform in the nonbank financial services sector. The Government will augment this reform agenda, drawing on the recommendations of the FSAP, which will assess economic and financial sector vulnerabilities and identify priority issues and constraints facing different segments of the financial sector and their interrelationships.

86. Phase I consists of the 35 policy actions described in the policy matrix (Appendix 1). Phase II will follow the Agenda for Phase II Dialogue described in Appendix 1.

1. Phase I of the NFG Program

a. Enhance and Strengthen SEC Governance

87. SEC has undergone a number of changes throughout the 1990s. The first major effort to strengthen SEC was supported under the CMDP loan. Policy actions under this loan supported the initial steps to reorient the operations and systems within SEC from company registration and monitoring to capital market regulation. However, SEC was unable to fully adopt an effective regulatory culture as its structure, systems, and procedures were constrained under the Revised Securities Act. Recent scandals (para. 8) in the securities market forced the Government to take swift action and initiate deeper reforms. As part of Phase I, the Government enacted the SRC in July 2000. Under the SRC, articles in the Revised Securities Act, which prohibited SEC from restructuring its operations, were removed. SEC is now empowered to reorganize, streamline its structure and operations, self-finance, rationalize its staff incentive structure and upgrade its human resources, and oversee the SRO and the securities industry. These key amendments to the SRC supported SEC restructuring and reorganization. With support of ADB TA, SEC prepared its restructuring plan, adopted the new organizational structure, assessed its staffing and skills requirements, and developed new job descriptions. 24

88. The reorganization plan was developed in line with the IOSCO Objectives and Principles of Securities Regulation. IOSCO principles advocate establishing an appropriate balance between independence and accountability, clear regulatory objectives, and ensuring the resources to meet those objectives. Although SEC is still under the administrative authority of DOF, it has gained greater autonomy under the SRC. SEC can retain part of the funds that it raises and has been empowered to issue rules, impose sanctions, and regulate the securities market.

89. SEC established a reorganization committee headed by the chairperson and comprising the commissioners and department directors of SEC. Supported by TA (footnote 4), the committee recommended a full reorganization of SEC including the establishment of a new set of core operating departments: market regulation, corporation finance, enforcement, and compliance and inspection. In addition, specific support departments/offices/divisions were created, including the Office of the General Counsel, General Accountant, and an Investor Information and Publication Division. The restructuring plan includes a new salary structure for SEC staff comparable with that for BSP and other government financial institutions.

90. The Economic Coordinating Council endorsed a separation package for redundant staff as part of the restructuring plan. The retrenchment was voluntary and it was agreed that about half of the staff would no longer be required in the new organization. After the new job descriptions and skill requirements were developed, staff applied for the newly posted positions. A job placement service was established at SEC to assist the transition of interested staff to other Government agencies. Given the fair separation package and the transparent processes developed, staff retrenchment was accomplished with little disruption and loss of morale at SEC. Ultimately, 300 of 700 staff took the early retirement or a separation package costing approximately $6 million.27

91. Following agreement on the structure, core departments, and work flow within SEC, a staffing plan with job descriptions and skill requirements was developed. Salary scales of SEC were aligned with other comparable government agencies to attract and keep high-quality staff. Supporting the organizational restructuring, ADB TA developed a full-scale training program for newly recruited and retained staff to familiarize them with the SRC provisions and its IRR. The staff were trained using newly developed manuals on reporting rules for brokers and dealers, investigation practices for compliance and enforcement, and SRO and company reporting requirements.

92. In line with the Program, the Enforcement Department of SEC was entrusted with full powers to enforce and laws and regulations ensure compliance of all market participants. SEC further established processes for investigating potential legal infractions and taking action against market participants, issuers, and individuals that breach SRC and SEC regulations.

b. Modernize Governance and Regulatory Structure of PSE

93. Phase I supported the initial steps toward a major transformation of PSE to improve governance, and increase efficiency and compliance with rules and regulations. The Program supported restructuring PSE’s board of governors to include a majority of independent directors

27 The voluntary retirement package was developed based on years of service in addition to the usual civil services allowances for pension. Additional restructuring costs noted in para. 118 (i) include the cost of higher salaries, new information technology, and communication systems; the development and maintenance of a web site, public information office; and increased building and system security. 25 who represent the broader interests of the market. Of the 15 members on the board, PSE inducted 5 new representatives, bringing the nonmember representation to 8, including the PSE president. These nonmember directors were selected from academia, law firms, and industry and represent and protect the interests of investors and the general public.

94. In line with the program objectives, PSE conducted a study to examine the feasibility of converting the stock exchange from a mutual, or member-owned and -governed entity into a for- profit, shareholder-owned corporation. The study, completed in April 2001, recommended suitable options for the privatization, or demutualization, of PSE based on its business prospects, and a plan for a governance and regulatory framework within the SRO framework. Provisions in the SRC created some of the parameters for PSE demutualization. For example, under the SRC no shareholder in the demutualized exchange can hold more than 5 percent of shares and no group control over 20 percent unless SEC determines otherwise. This provision will ensure a diverse ownership structure for PSE. PSE has already taken the first step in the process by issuing 20 percent of PSE shares to its members. PSE is holding the remaining 80 percent for either direct placement with interested investors or eventual self-listing on the PSE.

c. Strengthen Market Oversight, Compliance, and Enforcement

95. Restoring investor confidence is a top priority of the Government. Phase I supported the implementation of higher standards of market oversight and transparency. Greater transparency and accountability were developed by introducing stricter reporting requirements for the SRO. This complied with the IRR developed to support the SRC provisions. SEC now has to review and monitor SRO reports regularly for timeliness and accuracy. In addition, the SRO should notify SEC of any investigation of a broker or stock being initiated by the SRO, at the same time that it notifies the PSE board of governors.

96. The Program supports increased transparency in securities market trading. This includes more effective and fuller disclosure of information that may impact on share prices. All listed companies are now required to have two, or 20 percent, independent members on their Board of Directors. The independent directors represent the public and minority shareholders’ interests and bring greater transparency and facilitate disclosure of company information to the public. To improve the efficiency and transparency of the pricing of equity stocks, the dissemination of price information from block sales was improved through increased market disclosure and stock offer requirements on block sales of stock. SEC also adopted rules for stronger beneficial ownership disclosure, including establishing a subregistry with the beneficial owner names listed under the stockbroker accounts at PDCI. SEC created an Office of General Accountant to improve the quality of information disclosed to the market; encourage greater transparency, public awareness, and dissemination of its own rules and regulations on its web site; and opened a public information office.

97. The IRR for the SRC addressed prudential concerns by requiring brokers and dealers to maintain adequate capital reserves in line with international standards. In addition, rules defining the requirements for market makers, the segregation of stockbrokers and dealers, and shorter settlement periods for all SEC fines and penalties were introduced under Phase I.

98. To fight fraud, manipulation, and deception in connection with the purchase and sale of securities whether in PSE transactions or outside the exchange, Phase I supported provisions in the SRC to broaden SEC’s enforcement powers. New standards and procedures were introduced for improved market monitoring and enforcement. In addition to establishing a separate department for compliance and enforcement, securities regulators are now protected 26 from prosecution when they act in good faith and within the legal powers conferred on SEC. In- house training programs were developed to build capacity and keep investigators up-to-date on market activity.

d. Facilitate Diversification and Innovation in Corporate Financing

99. There is a relatively active market in listed stocks; however, the market for corporate debt and other financial instruments is largely illiquid because of policy, regulatory, and taxation constraints. An adequate supply of equity and diversified debt products increases financing options and its risk management alternatives at the level of both financial institutions and corporations. Phase I supported Government initiatives to improve the environment for corporate financing. A high-level working group comprising regulators and market participants such as BSP, SEC, Bankers Association of the Philippines, Investment House Association of the Philippines, and other resource people developed a manual on debt origination and underwriting. SEC has already discussed the system modifications required for more transparent information through a subregistry system at the PCDI.

100. In addition, Phase I supported the liberalization of the insurance company investment code to allow greater participation of insurance companies in the market and improve risk management of funds while providing greater market liquidity. Phase I also supported expanding the possibilities of financing for market intermediaries and enhancing the role of sophisticated investors in line with international practice. This involves allowing financing companies and investment houses greater flexibility in meeting their funding requirements.

101. Phase I supported the thorough review of the PCDI systems and procedures, including the present certificate processing systems, business plan; an analysis of the current infrastructure and feasibility for corporate debt registry and trading; compliance with G-3028 and International Systems Security Association recommendations; and staff training requirements.

2. Phase II of the NFG Program

a. Implement Demutualization of PSE

102. Part of the efforts to restore investor confidence in the Philippines securities market will be demutualizing and privatizing PSE. This process has already started with the distribution of PSE shares to the members (para. 94), but further efforts are needed to improve PSE governance. Governance reform is instrumental to the future successful development of the capital market in the Philippines. The goal of demutualization is to facilitate PSE’s ability to respond to market changes, reduce transaction costs, augment resources for investment in newer technology to replace the outdated internal systems and trading platforms, and institute more professional management practices. Given these changes, the SRO framework will need to be strengthened.

103. SEC will work closely with PSE to ensure PSE’s smooth and effective transition from a nonprofit to a fully privatized, or demutualized, company. The transition involves distributing PSE shares to create a broad, diverse ownership structure. In this process, SEC and PSE will

28 The Group of Thirty, established in 1978, is a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia. It aims to deepen understanding of international economic and financial issues, to explore the international repercussions of decisions taken in the public and private sectors, and to examine the choices available to market practitioners and policymakers. 27 need to work together to evolve satisfactory governance and regulatory arrangements in line with good international practices. Full implementation of PSE demutualization will address governance concerns, increase the efficiency and transparency of market transactions, and improve compliance with regulations. These measures are expected to boost investor confidence and investment in the market.

104. In addition, there will be a need to enhance market monitoring and surveillance and ensure the transparency of the trading mechanism. Under Phase II, ADB will continue to work with PSE and SEC to ensure sound market regulatory practices in line with the demutualized structure of PSE. Ultimately, demutualization will lead to greater efficiency, cost savings, and a stock exchange more transparently managed in line with international best practices and sound corporate governance standards.

b. Strengthen Market Regulation

105. SEC is expected to develop greater capacity to enforce legislation and regulations and monitor financial reporting of market participants; it will require enhanced systems, skills upgrading, and standards training in accounting and auditing. SEC is expected to support more in-house capacity building and training of its staff in the use of information technology and management systems to increase staff efficiency. Specifically designed training modules developed under the Asia-Pacific Economic Cooperation (APEC) Finance Ministers: Financial Regulators Training Initiative will be introduced.29 Activity has already started to address some of the regulatory issues in the nonbank financial sector with an MOU between SEC and BSP. MOUs are planned for SEC and PSE, and SEC and the institutions that regulate the accounting profession.

106. In addition, SEC will take the lead in developing a strategy to deal with the direction of regulation of the nonbank financial sector in the Philippines. The policy framework must have a clear focus on raising regulatory effectiveness. One of the key requirements in meeting this objective is a consistent approach to regulating markets and market conduct. SEC is responsible for the prudential soundness of a subset of financial institutions including investment houses, financing companies, and the pre-need industry and mutual funds. It is also fully responsible for market conduct issues across the securities market. There are a number of regulatory models in the world, each with advantages. The Philippines needs to adopt a consistent approach to market regulation and should develop a strategy that will address these issues and recommend policy measures to strengthen nonbank financial markets. The results of the FSAP may provide additional insight into the concerns and vulnerabilities and inter-relationships in the financial sector.

c. Strengthen Market Governance and Compliance

107. Under Phase II, the Government is committed to improving financial management and governance by strengthening financial disclosure and monitoring. SEC will upgrade its capacity to improve both the quality and quantity of financial information disseminated to the public. This will involve introducing SEC procedures for routine checking of financial statements and audited reports and instituting a penalty system for auditing firms that do not qualify audit opinions or where financial disclosure information is inaccurate or incomplete.

29 The ADB web site has a list of activities conducted under this initiative. 28

108. The Government will support the review of the Revised Accountancy Law of 1975. After the review, amendments will be prepared to reflect improved governance and financial management standards. The amendments will refine arrangements accounting for setting standards in the Philippines. Additional amendments will be prepared to improve transparency and accountability in the auditing profession. The professional accounting bodies are supporting the adoption of IAS as agreed to by Government as a signatory to the IOSCO Objectives and Principles of Securities Regulation. Additional actions will be taken by Government to introduce IAS, enhance accounting standard setting, increase the accountability of professionals, and strengthen monitoring and compliance with auditing practices.

109. An equally important area is clearance and settlement and the depository infrastructure for the securities market. Systems and procedures need to be established such that the operations of clearance and settlement and the depository are transparent, efficient, and in line with international guidelines. Developing cost-efficient and transparent infrastructure for trading, clearance and settlement, depository and registry functions is critical for international market recognition and investor confidence. In addition, steps need to be taken to develop a scripless trading environment in accord with Group-30 recommendations. Specifications for corporate bond trading and registry functions are already under way. The Government is committed to maintaining international standards for clearing and settlement and recognizes that any changes to the present market infrastructure will be based on international standards and in accordance with the best interests of market development.

d. Facilitate Diversification and Innovation in Corporate Financing

110. The Government is supporting private sector efforts to improve financing alternatives for the corporate sector. Phase II will support the private sector in its efforts to develop a bond market exchange that will include corporate debt instruments. It is anticipated that this market will give companies greater access to long-term corporate financing. Greater efforts are also needed to eliminate tax policy distortions and create an enabling environment for trading corporate debt instruments. The Government will seek to rationalize the tax and regulatory structures on secondary trading of debt market instruments such that it will be economically viable and a liquid debt market will be possible. The corporate debt market needs to be revitalized by introducing regulations for corporate debt trading, upgrading market infrastructure for a corporate debt registry, and rationalizing the tax system including the elimination of DST on secondary trading.

D. Social and Environmental Issues

111. Appendix 9 gives the poverty impact assessment. The policy actions under the Program are fully consistent with the three components of ADB’s poverty reduction strategy, namely, pro- poor sustainable economic growth, good governance, and social development.30 Pro-poor sustainable economic growth is to be achieved through the Program’s focus on measures to increase investor confidence and restore the flow of much-needed investment capital to the Philippines. The Program will strengthen market governance by improving the regulation of competitive markets, restructuring the stock exchange allowing it to operate more efficiently, and improving the quality and quantity of reported and audited financial statements. In addition, the Program aims to rationalize distortions in the tax policy. These measures will expand economic opportunities by reversing policies that often protected and assisted large and influential

30 Fighting Poverty in Asia and the Pacific: The Poverty Reduction Strategy of The Asian Development Bank, approved on 9 November 1999. 29 firms or business groups. The Program will contribute to income generation and higher employment. PSE restructuring will allow it to provide special services for small and medium-size enterprises to source capital from the stock market. Access to longer-term equity capital has been a major constraint for small and medium-size enterprises.31

112. The Program will not have any direct and immediate environmental impacts. The likely environmental impacts are indirect and long-term, and most are positive (environmentally beneficial). Evaluation of the potential indirect environmental impacts of the policy matrix is in Appendix 10.

VI. THE PROPOSED LOAN

A. Amount of Loan and Source of Funds

113. The Republic of the Philippines has requested a loan of $75 million from ADB's ordinary capital resources to help finance the Program. The loan will have a 15-year term, including a grace period of 3 years; an interest rate determined in accordance with ADB's London interbank offered rate (LIBOR)-based lending facility; a commitment charge of 0.75 percent per annum, a front-end fee of 1.0 percent (the fee will be capitalized in the loan); conversion options that may be exercised in accordance with the terms of the draft Loan Agreement, the Loan Regulations, and ADB's Conversion Guidelines; and other terms and conditions set forth in the Loan Agreement. The Government has provided ADB with (i) reasons for the Republic of the Philippines' decision to borrow under ADB's LIBOR-based lending facility on the basis of these terms and conditions, and (ii) an undertaking that these choices were the Republic of the Philippines' own independent decision and not made in reliance on any communication or advice of ADB.

114. The size of the program loan was determined keeping in view the (i) estimated short- to medium-term costs of the reform program (in fiscal or balance-of-payment terms or both), (ii) strength of the reform package, and (iii) relative importance of the sector.

115. Total adjustment costs incurred under Phase I are estimated at about $55 million during the program period. They consist of

(i) SEC restructuring costs (about $15 million) including $6 million for staff retirement program; (ii) costs of administrative reforms linked to the computerization and reorganization of SRO monitoring systems in PSE and SEC, and the continuing cost of higher salaries at SEC (about $25 million); and (iii) demutualization costs already borne by SEC and PSE, including the costs of developing business plans, restructuring staffing at the exchange, development of new procedures for the SRO, development of new infrastructure for clearing and settlement, and SEC-related costs for increased staffing and developing a new regulatory framework for the demutualized exchange ($15 million).

116. The Program will play a key role in restoring investor confidence in the Philippines and attracting foreign investment. A secure investor framework includes maintaining a well- functioning stock exchange with good governance principles, and a transparent regulatory framework applying international standards. The impact of weak investor confidence can be

31 TA 3345 (footnote 6) is helping the development of small and medium-size enterprises sector issues. 30 seen directly in lost foreign investment. Over the past two years, foreign investment levels in the Philippines were less than one third of the 1997 levels and largely attributed to low investor confidence resulting from weak governance in the financial markets.

B. Interest, Maturity, and Utilization Period

117. The Borrower will be the Republic of the Philippines, and the interest rate will be determined in accordance with ADB’s LIBOR-based loan facility and with an amortization period of 15 years, including a grace period of 3 years. The loan closing date is 31 December 2002.

C. Implementation Arrangements

118. DOF will be the Executing Agency for the NFG program and SEC will be the Implementing Agency. SEC will set up a coordinating committee headed by the chairperson of SEC and comprising representatives from BSP, Bureau of Treasury, DOF, National Economic and Development Authority, PSE, SEC, and the Capital Market Development Council that comprises members from business and industry associations. ADB will also be a member of this committee to oversee progress in Phase II of the reform program.

D. Procurement and Disbursement

119. The loan proceeds will be used to finance the foreign exchange costs of items produced and procured in ADB member countries (other than the items specified in the list of ineligible items [Appendix 11] and imports financed by other bilateral and multilateral sources). The Government will certify that the volume of eligible imports exceeds the amount of ADB’s projected disbursements under the loan for the given period. ADB reserves the right to audit the use of the loan proceeds and verify the accuracy of the Government’s certification.

E. Counterpart Funds

120. The Government will utilize the local currency counterpart funds generated by the NFG loan to meet program expenditures and associated costs of reform and to help maintain current levels of social expenditures.

F. Monitoring and Tranching

121. The single tranche for Phase I is justified because of the

(i) substantive up-front compliance with 35 policy actions. These actions constitute a holistic Phase I component of the NFG Program focusing on the key issues of empowerment and reorganization of SEC, fundamental corporate governance reforms of PSE, and initiating steps to enhance the transparency of market intermediaries and strengthening prudential regulation;

(ii) evolving nature of Phase II. ADB and the Government have agreed on the Agenda for Phase II Dialogue and direction of the Program, but specific policy actions and the timetable for implementing Phase II will be developed by the Government in collaboration with ADB, incorporating the results of additional economic and sector work being sponsored by ADB and the completion of the FSAP; 31

(iii) uncertain global and regional financial market environment, which enhances the potential risks of financial contagion and requires flexibility in designing and prioritizing policy reforms in light of emerging developments and requirements;

(iv) complexities of the PSE demutualization process, which requires more lead time to ensure an adequate buildup of investor confidence for a possible IPO for PSE; and

(v) assessment of the capacities of the existing Implementing Agencies, which need support of the TA to implement the next phase of the Program.

122. The loan amount of $75 million will be released upon loan effectiveness. The conditions for release include 35 policy actions with which the Government has fully complied. An agenda for Phase II dialogue has been developed in collaboration with the Government to ensure sustainability and enhancement of reform efforts. The Government and ADB will jointly monitor the implementation of Phase II through semiannual reviews. These reviews, conducted with the coordinating committee, will assess the direction and pace of Phase II. To assist ADB reviews, the Government will provide relevant information through regular reporting on progress and impact of the policy reforms.

VII. THE TECHNICAL ASSISTANCE

123. The objective of the TA (Appendix 12) is to strengthen market governance by focusing on analytical and institutional support for the development of

(i) an effective SRO framework to address the potential conflicts of interest in PSE’s newly demutualized ownership structure; (ii) SEC’s capacity to investigate and enforce market regulations; (iii) an efficient MIS and staff training to effectively use the system; and (iv) skills and standards in accounting and auditing.

124. The TA is estimated to cost $1.43 million equivalent, of which $0.84 is the foreign exchange cost and $0.59 million equivalent is the local currency cost. ADB will finance $1 million equivalent to cover the entire foreign exchange cost and $0.16 million equivalent of the local currency cost. The TA will be financed on a grant basis from the Asian Currency Crisis Support Facility, funded by the Government of Japan. The Government will provide $0.43 million equivalent to finance counterpart staff, office facilities, and workshops. Appendix 13 presents the detailed cost estimates and financing plan.

125. SEC will be the Executing Agency. The TA will be implemented over a 12-month period starting January 2002 and ending in December 2002. It is estimated that the TA will require 38 person-months of consulting support: 22 from international consultants and 16 from domestic. All consultants will be selected in accordance with ADB’s Guidelines on the Use of Consultants and other arrangements satisfactory to ADB.

VIII. PROGRAM BENEFITS AND RISKS

A. Benefits

126. ADB’s long-standing support for capital market development, now expanded to cover the nonbank financial sector, is expected to assist the Philippines in developing vibrant, competitive, 32 and well-functioning financial markets. The Program’s focus on strengthening the governance of financial markets is expected to have wide-ranging and sustained benefits. The primary benefits of the Program are promoting financial market stability and restoring investor confidence. These objectives will be addressed through the implementation of reforms with the potential to broaden and diversify the markets and support capital formation by encouraging foreign investor participation in the domestic markets. Asset diversification away from the banking sector, especially given the current level of banking stress, will support more resilient domestic markets able to withstand exogenous shocks and currency contagion. Effectively dealing with financial crises will help the economy protect vulnerable groups, which fall below poverty lines during a crisis, as currency depreciation triggers unemployment and impacts disproportionately on lower income levels.

127. Another principal benefit of the Program is restoring investor confidence in the markets as SEC emerges as a strong regulator with highly skilled professional staff. Efficient and resilient financial and corporate sectors tend to be characterized by good governance. The Asian financial crisis revealed gaps in governance among regulators, financial institutions, and corporations. Developing market surveillance capacities at SEC will provide greater insight into market transactions and allow regulators to track market abuse and fraudulent activities. Penalties on market abuse will act as a deterrent to market manipulation and insider trading, which together have resulted in significant losses to investors. Better monitoring and reporting through a well-developed MIS will also improve SEC’s ability to make public the details on securities markets transactions and activities, and help investors feel more confident about the quality of market information.

128. Transforming PSE into a demutualized exchange will help PSE to remain competitive with modern infrastructure and new governance and regulatory structures, and improve performance and confidence in the exchange. Large companies are turning to Singapore and Hong Kong, China, rather than listing domestically. A modern, professional, and well-regulated exchange is likely to provide better prospects for companies to meet their financing needs, while protecting the interest of minority investors in the listed companies.

129. Developing market infrastructure by upgrading systems and procedures for posttrade processing will help increase efficiency and reduce transaction costs, and enhance market transparency and stability. One of the benefits of a better market infrastructure will be the establishment of a facility for the clearance and settlement and registry of corporate debt instruments. The corporate debt market is expected to provide much-needed capital to the corporate sector, while at the same time supporting financing and risk diversity.

130. Lastly, the Program will address one of the major deficiencies in the Philippines, poor financial accounting and auditing standards. As one of the cornerstones of governance, high- quality accounting and auditing practices provide the basis for establishing market integrity and credibility. Without professional standards in these areas, a disclosure-based regulatory system cannot protect the interests of the public. The Program’s emphasis on implementing IAS supports full and fair disclosure policies and is part of ADB’s efforts to implement international standards.

B. Risks

131. The Program faces four major risks. First, macroeconomic stability and a sound banking system are prerequisites for the development of capital markets and affiliated institutions. With the widening fiscal deficit and growing NPLs of the banking sector, macroeconomic stability could be disrupted or banking sector fragility may worsen. Recognizing this, the new 33

Government has indicated its resolve to adopt more fiscal discipline and launch tax reforms to support macroeconomic stability. At the same time, the Government is taking steps to deal with the weaknesses in the banking sector.

132. Second, the effective implementation of the fundamental reforms of PSE and segments of the nonbank financial sector depends critically on the support of the private sector including the members of PSE and other market intermediaries and participants. In the past, vested interests and small brokers resisted change and stalled market reforms of PSE. In the design of the Program, efforts were made for wider consultations to develop a consensus approach among the stakeholders. More significantly, the Program incorporates advance actions in specific areas where there is likely to be resistance, such as the demutualization of PSE. One critical advance action in Phase I is the development and approval by PSE of the demutualization plan. To foster better understanding of the demutualization process and disseminate information among market participants on the governance and regulatory implications of demutualization, ADB held a workshop on this topic in August 2001. The workshop was well attended with good participation from Philippine stakeholders.

133. Third, the effective implementation of the Program is contingent on developing capacities across SEC, PSE, and in the area of financial management. Increasing the skills of regulators, accountants, and auditors is necessary if regulations and standards are to be enforced and levels of compliance increased. It is difficult for public sector institutions to attract and retain staff with the desired skills and experience. The Program supports SEC adopting salary structures in line with BSP and Social Security System. In addition, SEC has been able rationalize its staffing levels and hire new better qualified professionals. ADB through its TA (footnote 4) and support from the APEC Finance Ministers: Financial Regulators Training Initiative, is training staff to develop capacities in different technical areas. This training is being institutionalized through the newly established Human Resources department.

134. Finally, one of the lessons learned from the CMDP was to avoid excessive reliance on the enactment of legislation that may make the implementation of policy actions unpredictable. The Program has focused on ensuring that current market regulations, if found satisfactory, are adequately enforced. The Program is all front loaded, including the enactment of legislation to ensure up front compliance and timely implementation. If improvements in regulations are required, alternatives to legislative action have been explored through rules and administrative orders.

135. In addition to the four risks noted, program loans to the Philippines have recently come under scrutiny due to delays in implementing four pending programs.32 It should, however, be noted that the performance of the Philippines on program loans has previously been credible. In total, the ADB has approved nine program loans to the Philippines. Four are ongoing and five have been completed. The program performance audit reports rated two of the completed program loans33 generally successful, with the tranches released in a timely manner and reforms well implemented.

32 Loan 1662-PHI: Power Sector Restructuring Program, for $300 million, approved on 16 December 1998; Loan 1663-PHI: Metro Manila Air Quality Improvement Sector Development Program, for $200 million, approved on 16 December 1998; Loan 1739-PHI: Grains Sector Development Program, for $100 million, approved on 24 April 2000; and Loan 1745-PHI: Pasig River Environmental Management and Rehabilitation Sector Development Program, for $100 million, approved on 20 July 2000. 33 PPA: PHI 17152: Fisheries Sector Program, December 1999; and PPA: PHI 0680: Agricultural Inputs Program, December 1987. 34

136. The remaining three completed program loans34 have been rated partially successful as the Government complied with all loan tranche release conditions, but experienced delays in program implementation due to lack of familiarity with ADB procurement procedures, shifting priorities among stakeholders, and policy actions related to the enactment of legislation.

137. More specifically, progress in implementing policy reforms in the four pending program loans (footnote 35) has been delayed because of reforms tied to the enactment of new legislation. The Government has made significant efforts to support all of the relevant legislation in Congress by identifying the legislation tied to ADB programs as priority legislation. These programs are expected to be completed despite some delays.

138. Under Phase I of the NFG Program, the Government enacted the SRC, with the SEC developing the IRR for the law. The risk of delays in Phase I was mitigated by early enactment of legislation. Phase II will require up-front compliance with policy actions. Therefore, the risk of delays in this Program is limited.

IX. ASSURANCES

139. The Government has assured ADB that (i) the policies adopted and actions taken prior to the date of the Loan Agreement, as described in the development policy letter, will continue in effect for the duration of the Program; and (ii) the Government, in collaboration with ADB, shall develop policy actions based on the Agenda for Phase II Dialogue to carry forward Phase II of the NFG Program. These actions, when agreed between the Government and ADB, may form the basis of future ADB assistance to the Government in the nonbank financial sector.

X. RECOMMENDATION

140. I am satisfied that the proposed loan would comply with the Articles of Agreement of ADB and recommend that the Board approve the loan of $75,000,000 to the Republic of the Philippines for the Nonbank Financial Governance Program from ADB’s ordinary capital resources, with interest to be determined in accordance with ADB's LIBOR-based loan facility, an amortization period of 15 years, including a grace period of 3 years, and such other terms and conditions as are substantially in accordance with those set forth in the draft Loan Agreement presented to the Board.

TADAO CHINO President

October 2001

34 PCR: PHI: 299: Forestry Sector Program, November 1994; PCR: PHI: 21223, Capital Market Development Program, August 2000, and PPA: PHI: 1046: Road and Road Transport Sector Program Loan, February 1995. 35

APPENDIXES

Number Title Page Cited on (page, para.)

1 Development Policy Letter, Policy Matrix, and 36 2, 10 Agenda for Phase II Dialogue for the Nonbank Financial Governance Program 2 Program Framework 47 2, 10 3 Main Acts and Regulations Governing Nonbank 52 8, 28 Financial Institutions 4 Philippine Stock Exchange 53 8, 30 5 The Debt Market in the Philippines 56 16, 60 6 Depository and Clearing and Settlement 58 17, 63 7 Banking Sector Reforms 63 19, 72 8 Significant Financial Sector Reforms 65 21, 79 9 Poverty Impact Assessment 67 28, 111 10 Environmental Impact Assessment 70 29, 112 11 Ineligible Items 71 30, 119 12 Outline Terms of Reference for Consultants 72 31, 123 13 Cost Estimates and Financing Plan for the Technical 75 31, 124 Assistance 36 Appendix 1, page 1

DEVELOPMENT POLICY LETTER

Mr. Tadao Chino President Asian Development Bank Manila, Philippines

Dear President Chino:

The Government of the Philippines is committed to promoting sustainable economic growth and enhancing social equity. To support the implementation of these policy goals, the Government is focusing on strengthening macroeconomic management. The budget deficit is being kept under control through tax reforms and rationalization of public spending and policies are being pursued to help maintain stability in interest rates, prices, and the exchange rate. The Government is adopting more aggressive policies to promote private investment and private savings. A major component of this is to develop a more robust and diversified financial system by promoting development of the nonbank financial services sector that has lagged behind the growth of the banking sector.

Development of nonbank financial services sector will help private sector meet its growing long-term investment requirements, reduce excessive reliance on banking financing, and provide an alternate source of funding and varied financial instruments. This will assist the corporate sector in its efforts to improve risk mitigation and management. The Government has launched a Nonbank Financial Governance (NFG) Program, which aims to restore investor confidence by strengthening the governance of the financial and corporate sectors at the regulator and market participant levels. The Government has implemented Phase I of the NFG Program from 1998 to 2001 and is now gearing itself to carry out Phase II over the next three years. The reforms under the NFG Program will help mobilize the country’s long-term funding requirements and assist in restoring investor confidence.

The centerpiece of the NFG Program - Phase I, was the restructuring of the Securities and Exchange Commission (SEC). This was achieved as a result of the Government’s enactment of the Securities Regulation Code (SRC) in July 2000. The SRC empowered the SEC and strengthened its governance structure to effectively enforce market regulations. The SRC contains provisions that facilitated greater administrative, operational, and financial flexibility that strengthened the governance of SEC.

In addition, Phase I supported modernization of the governance and regulatory structure of the Philippine Stock Exchange (PSE); strengthening market oversight, compliance and enforcement; and measures to facilitate diversification and innovation in corporate financing.

The Government has made progress in modernizing the governance of PSE. PSE’s Board of Directors (BOD) is now more in line with international standards after being reconstituted to include a 51 percent majority of independent directors from academia, law firms, and industry. These independent directors represent and protect the interests of investors and the general public. In addition, the Government has required PSE to change its ownership structure under the SRC. The previous mutual ownership structure had become outdated and no longer effectively served the needs of the public and the exchange members. The change 37 Appendix 1, page 2 from a mutual, nonprofit company, to a private stockholder-based structure should improve the efficiency and transparency of market transactions. The initial step in this process included the distribution of 20 percent of PSE shares to the stockbrokers.

The Government has also made progress in implementing greater governance in the market by increasing transparency, better disclosure and enforcement procedures. Under SRC regulations, all listed companies are now required to have two, or 20 percent, independent members on their BOD. The SEC has also created an Office of General Accountant to improve the quality of information disclosed to the market and encouraged greater transparency, public awareness, and dissemination of its own rules regulations on its web site and opened a public information office. SEC has also adopted rules for stronger beneficial ownership disclosure requirements and has enhanced market monitoring by establishing a separate department for compliance and enforcement, indemnification of securities regulators, and developing in-house training capacity to keep investigators up-to-date on market activity. The implementing rules and regulations for the SRC have addressed prudential concerns by requiring brokers and dealers to maintain adequate capital reserves in line with international standards.

Under Phase I, the Government has also taken steps to improve the environment for corporate financing. A high-level working group developed a manual on debt origination and underwriting. Resolutions have been adopted to liberalize investment guidelines to allow greater participation of insurance companies, which enhanced market liquidity. Discussions with the Philippine Central Depository, Inc., are under way for system modifications to provide more transparent information through a sub-registry system; and for it to act as the registrar and custodian for a corporate bond exchange.

The Government is committed to Phase II of the NFG Program that will build on and deepen the reforms initiated under Phase I. The Main emphasis of the Phase II reforms will be to:

(i) Carry forward and complete the process of PSE demutualization. To achieve this, SEC will work closely with PSE to ensure a smooth and effective transition of PSE from a nonprofit to a fully privatized, or demutualized, company. The transition includes a distribution of PSE shares to create a broad, diverse ownership structure. In this process, SEC and PSE will need to work together to evolve satisfactory governance and regulatory arrangements in line with good international practices. Full and effective implementation of demutualization of PSE will address governance concerns, increase the efficiency and transparency of market transactions, and improve compliance with regulations. It is expected that these measures will boost investor confidence and investment in the market.

(ii) Strengthen market regulation. The SEC is expected to strengthen its capacity to enforce legislation and regulations, and monitor financial reporting of market participants. This will require enhanced systems, skills upgrading, and training in accounting and auditing standards. SEC will further enhance its enforcement and market surveillance capacities and improve regulation and supervision of the nonbank financial sector. To facilitate this process, SEC is committed to supporting more in-house capacity building and training of its staff in the use of more information technology and management systems to increase staff efficiency. SEC will also develop a strategy to deal with the future policy direction of regulation of the nonbank financial sector. Activity has already been started to address some of the regulatory issues in the nonbank financial sector with an MOU between SEC and BSP, and MOUs planned for SEC and PSE, and SEC and the accounting profession. 38 Appendix 1, page 3

(iii) Strengthen market governance and compliance. The Government is committed to improving financial management and governance by strengthening financial disclosure and monitoring. The professional accounting bodies are supporting the adoption of international accounting standards as agreed to by Government as a signatory to the IOSCO Objectives and Principles of Securities Regulation. Development of cost-efficient and transparent infrastructure for trading, clearance and settlement, depository and registry functions is critical for international market recognition and investor confidence. The Government is committed to maintaining international standards for clearing and settlement and recognizes that any changes to the present market infrastructure will be based on international standards and in accordance with the best interests of market development. Steps need to be taken to develop a scripless trading environment in accord with Group-30 recommendations. Specifications for corporate bond trading and registry functions are already under way.

(iv) Facilitate diversification and innovation in corporate financing. The Government is committed to supporting private sector efforts to improve financing alternatives for the corporate sector. It is anticipated that broader access of companies to long-term corporate financing will support longer-term growth. Greater efforts are also needed to eliminate tax policy distortions and create an enabling environment for trading corporate debt instruments.

Substantial technical assistance has been sought from the Asian Development Bank (ADB) to strengthen market governance by (i) strengthening SEC’s role in setting and enforcing accounting and auditing standards and practices in line with international standards; (ii) developing the self-regulatory organization (SRO) framework for the securities market; (iii) strengthening SEC’s capacity to investigate and enforce market regulations; and (iv) enhancing management information systems to augment SEC’s capacity to investigate and enforce market regulations.

The Government has effectively implemented Phase I of the NFG Program with advisory support from ADB and is committed to pursue Phase II of the Program. The Government of the Philippines requests a Nonbank Financial Governance Program loan of $75 million and the associated technical assistance grant for Strengthening Regulatory and Market Governance. The Government will use the proceeds of the loan to meet the costs of structural adjustment of the NFG Program.

4 October 2001 39 Attachment 1, page1 ector. The (Done) (Done) (Done) (Done) July 2000 July 2000 August 2000 January 2001 Actions to be Completed by y g in line y determination y in salar y al protection while pursuin g , and define clear areas of responsibilit y , and provide SEC flexibilit y POLICY MATRIX FOR THE ulators, which allows them le g , and transparenc y and operations independentl NONBANK FINANCIAL GOVERNANCE PROGRAM (PHASE I) g anization plan that conforms to international best practices and keeps in view domestic g e its restructurin anize itself to increase efficienc g g by exempting its staff from the civil service pay scale with International Organization of Securities Commissions (IOSCO) guidelines (i) Reor (i) Rationalize SEC staffing level and induct new skills; (ii) Develop the required departments including effective enforcement and compliance; (ii) Begin partial self-financing, and (iii) Mana redundancies as well new skill requirements investigation and prosecution of market participants who violate regulations requirements. In addition, prepare a supportive human resource development plan for SEC and identif (iii) Support modernization of SEC systems, procedures, business rules, ethics, and discipline (i) (ii) (iii) enhancing and strengthening the governance of Securities Exchange Commission (SEC); modernizing governance and regulatory structure of the Philippine Stock Exchange (PSE); (iv) strengthening market governance, compliance, and enforcement; facilitating diversification and innovation in corporate financing. 2. SEC prepare a reor 1. Guarantee indemnification of market re 1. Enact Securities Regulation Code (SRC) legislation to empower SEC 3. Implement the SEC Reorganization Plan so as to I. Enhance and Strengthen the Governance of SEC A. Allow SEC greater administrative, operational, and financial flexibility B. Enhance monitoring and enforcement capacity Policy Actions Program Objective: To support the process of capital formation through improved corporate governance in nonbank financial s Program focuses on 40 Attachment 1, page2 (Done) (Done) (Done) (Done) (Done) (Done) (Done) July 2000 June 2001 June 2001 August 2000 January 2001 Actions to be February 2001 Completed by December 2000 y h the g overnance and g board who can adequatel g overnance structure throu g overnin g PSE and develop suitable options for g then PSE g es facin g and enforcement consistent with international best g in monitorin y capacit g to examine the issues and challen y in-house trainin g findings practices, and (i) Developin represent investor’s interest (i) Investigation findings by the SRO must be reported simultaneously to SEC and PSE Board, (ii) The PSE Board must notify SEC within 45 days on actions pursued by as a result of the investigation overseen by at least one independent Board member; furthermore: induction of no less than 51 percent nonbroker members on the (ii) Implement APEC Regulators Training Program standards to improve its effectiveness as a regulator procedures conform to IOSCO/Bank for International Settlements, and other international best practice monitoring of trading listed companies, and investigations conducted with respect hereto, semiannual reports on the number of newly listed issues, delisted/suspended issues and reasons therefor. regulatory framework demutualization of PSE based on its business prospects, and recommend a suitable 2. Self-regulatory organizations (SRO) must establish a separate audit, compliance and surveillance department 2. SEC to undertake an assessment of its enforcement powers and develop action plan in line with IOSCO 3. Assess SEC supervision practices for the nonbank financial sector and evaluate whether standards 4. Enhance capacity of enforcement by 1. SEC in accordance with SRC to issue directives stren 1. PSE to launch a stud 1. The SRO will submit monthly reports on capital adequacy of members, quarterly the results Policy Actions II. Modernize Governance and Regulatory Structure of PSE A. Develop arrangements for PSE to strengthen its governance during transition period B. Restructure and demutualize PSE C. Enhance SRO Reporting 41 Attachment 1, page3 (Done) (Done) (Done) (Done) (Done) (Done) (Done) (Done) July 2000 July 2000 July 2000 July 2000 July 2000 July 2000 Actions to be Completed by hts, g shareholder ri g overnment financial institution protectin g reporting requirement by a beneficial owner of security to security’s issuer, and (i) Beneficial ownership threshold definition be lowered from 10 percent to 5 with respect triggering (ii) Draft rules on mandatory tender offers for the protection of minority shareholders (iii) examinations and investigations started completed in the past month. within the past month. institutions and government-owned or -controlled corporations increase transparency, and improve reporting requirement 4. Revise the beneficial ownership rules to require 2. The SRO will submit to SEC its confidential examination calendar for the year before 15 January every year.3. The SRO will file timely (within 10 days from month’s end) monthly reports with SEC on its periodic July 2000 4. The SRO will file timely (within 10 days from month’s end) monthly summary findings of audits completed 1. SEC to develop regulatory framework ensure effective enforcement of PSE self-regulation 1. Draft an administrative order requiring the adoption and publication of a code ethics for government financial 2. Draft an administrative code of ethics for 3. Require all listed companies to have at least 2 independent (or 20 percent) board members July 2000 Policy Actions D. Develop arrangements for effective regulation of PSE III. Strengthen Market Oversight, Compliance, and Enforcement A. Develop market governance 42 Attachment 1, page4 (Done) (Done) (Done) (Done) (Done) (Done) (Done) (Done) July 2000 July 2000 March 2001 August 2000 January 2001 January 2001 Actions to be Completed by stems y information to g 100 million paid-up stems, (ii) business y s g nated market makers to maintain P (i) present certificate processin g g , Inc. includin y sis of the current infrastructure, and (iv) compliance with G-30 International S istration and resolution of external complaints for expeditious disposal simple cases or y g reference to the appropriate exchange department for an initial inquiry the public (ii) Establish a web site providing this information on an updated basis (iii) Create an Information Office in SEC to make rules and regulations available the public (iv) Before final adoption, have a public hearing of the proposed implementing rules and regulation for SRC (v) Continue to support the efforts of Capital Market Development Council in disseminatin (i) Undertakes investigations of all market malpractices and abuse Security Association recommendations. capital excluding the value of their stock exchange seats and trading rights for new broker entry (i) Compile and publish SRC implementing rules regulations update them on annual basis prudential management of risk re (ii) Facilitates plan, (iii) an anal 1. SEC to complete a thorough review and financial assessment of finance companies investment houses April 2001 3. Enact legislation to clarify SEC’s jurisdiction over the regulation of pre-need plans 5. Increase public awareness through dissemination of SEC rules and regulations 6. Review Philippine Central Depositor 2. Introduce a requirement for new brokers and desi 3. Introduce and monitor implementation of mark-to-market practices in line with international standards for 1. Create a central department in SEC that 2. Introduce 10-day settlement period for all fines and penalties levied on companies January 2001 Policy Actions B. Strengthen prudential regulation of nonbank financial institutions C. Prevent misconduct and market abuse 43 Attachment 1, page5 (Done) (Done) (Done) (Done) (Done) (Done) (Done) (Done) July 2000 June 2000 March 2001 March 2001 January 2001 Actions to be Completed by December 2000 December 2000 December 2000 liberalize y of qualified y or the Insurance g g allowin y tax treatment of public and g b y bonds which should allow Bureau of ulators to develop a manual for market y g h the creation of a cate g and equalizin g throu g 5,000 with 5 year-maturity, and list these securities in PSE, in financin y stem of penalties for corporations that breach financial disclosure to small denominated treasur y g ress that will facilitate financial autonom g roup of market participants and re reater flexibilit g g

g islative amendments to the insurance companies that will prudentiall g ress le g h-level workin g islation to allow g Commission to retain 1.5 percent of the premium tax collected by it Treasury to issue these bonds in denomination of P requirements participants on debt origination and underwriting private pension funds investment guidelines for insurance companies and allow these to be traded as regular Government securities institutional buyers 1. Create chief accounting position at SEC 2. SEC to develop an automatic s hi a 1. Establish 2. Approve the procedures pertainin 1. Submit to Con 2. Introduce amendments to Con 3. Draft bill to amend the tax code with objective of rationalizin le 4. Introduce Policy Actions D. Strengthen Financial Disclosure Monitoring IV. Facilitate Diversification and Innovation in Corporate Financing A. Develop a policy, regulatory, and taxation framework for corporate bond market B. Enhance institutional investors participation to augment market liquidity AGENDA FOR PHASE II DIALOGUE

Objectives Core Topics Monitoring Mechanisms Assumptions and Risks 1. Implement demutualization of Philippine Stock Exchange (PSE) (i) Increase investor • Diversify ownership structure either • Report on share distribution or initial • PSE commitment to reform confidence in PSE through private placement or public public offering on PSE and demutualization offering • Issue shares in PSE • SEC commitment to • Securities and Exchange Commission • SEC audit report on PSE's strengthen the self-regulatory (SEC) to audit implementation of PSE's surveillance and compliance system organization (SRO) SRO Surveillance and Compliance framework systems and procedures • PSE to • Reconstituted PSE committees • PSE commitment to become (i) reconstitute its compliance and • PSE revised rules to address a professional stock enforcement division, potential conflicts of interest in the exchange (ii) improve enforcement of its by-laws demutualized structure and regulations, • Implementation of new MIS to (iii) develop a management information facilitate data analyses and 44 system (MIS) for market investigations surveillance and on-site supervision • The use of scripless trading and system, and sub-accounts adopted, or name on (iv) enhance transparency in trading registry systems put in place mechanisms

(ii) Enhance SRO • SEC to issue joint policy statement with • Memorandum of Understanding • SRO framework may remain environment PSE on oversight and direct monitoring (MOU) between SEC and PSE on its weak due to lack of responsibilities in the SRO relationship respective roles in an SRO setting enforcement and political will. • Asian Development Bank (ADB) However, with a new review mission to evaluate ownership structure, this risk regulatory framework may be mitigated.

2. Strengthen market regulation (i) Augment SEC • Assessment report of enforcement • Action plan to improve effectiveness • Continued support in SEC Attachment 2,page1 enforcement capacities powers and supervisory practices as market regulator and Government for reforms and supervisory skills • Medium-term strategy for nonbank • Commission-approved medium-term in this area and practices regulation and supervision strategy • Adequate capacity in SEC to undertake reforms Objectives Core Topics Monitoring Mechanisms Assumptions and Risks (ii) Enhance monitoring • Upgrade information technology to • Report on MIS implementation and • Capacity and willingness to and surveillance improve MIS how systems have been effective use new systems will capacity improve.

3. Strengthen market governance and compliance (i) Improve the quality and • Introduce of SEC routine inspection • Procedures put in place for checking • Insufficient number of staff quantity of financial procedures for filed documents financial statements and numbers of trained with training to information disclosed statements checked per quarter effectively implement this type to the market • Adopt a penalty systems for fraudulent • A confidential inspection calendar of program. It may take a few or misleading information filed with SEC prepared yearly years to build capacity. • Institute random on-site inspections • Number of on-site inspections

(ii) Adopt international • Implement national training programs • Number of training programs run by • Issues of copyright still remains accounting standards with support of Board of Accountancy SEC, BOA, and PICPA an obstacle to adoption of IAS. (IAS) for private sector (BOA) and through the Philippine ADB and other international accounting and Institute of Certified Public Accountants organizations are currently auditing (PICPA) organization and with support lobbying this issue with IAS. of ADB technical assistance

• SEC Office of General Accountant to • Statements issued 45 issue statements on the adoption of IAS in consultation with BOA and PICPA • SEC, BOA, and PICPA to develop MOU • MOU endorsed by all parties on the use and enforcement responsibilities for enforcing IAS

(iii) Modernize the • BOA to review and propose • Amendments proposed for • Resistance to reform from accounting and amendments to the 1975 accounting Congressional debate practicing professionals. auditing framework law in line with international standards PICPA will have to be • Auditors to submit qualified audited • Number of audited financial instrumental in reform in this opinions with financial statements and statements with qualified auditor area. reports to SEC opinions • BOA to develop and endorse a code of • Adoption of the code of conduct conduct for auditors • All practicing accountants must become members of PICPA. Attachment 2,page2

(iv) Increase transparency • Implement scripless trading • SEC to issue rules and regulations for • PSE demutualization may lead in clearing and securities trading in a scripless to consolidation of market settlement of securities environment trading infrastructure as part of and depository • All market trading infrastructure must be • SEC assessment of compliance with the PSE holding company or functions developed in line with international international standards other similar arrangement. Objectives Core Topics Monitoring Mechanisms Assumptions and Risks standards Whatever ownership structure is adopted, it should be transparent and free of conflicts of interest.

(v) Increase public • SEC to disseminate information to the • Updated web site • SEC has the capacity to awareness of SEC public through web site, publications, • Regular and organized maintain the web site and has rules and regulations and press releases dissemination of information on SEC a commitment to sustaining rules, orders, and opinions public dissemination of information.

4. Facilitate diversification and innovation in corporate financing (i) Review taxation of • The Insurance Commission to submit • Submission to Congress of • Support is maintained in insurance industry proposed amendments to tax laws amendments to the Insurance Code Congress for the amendments to the Insurance Code and (ii) Enhance institutional • The Insurance Commission to submit to • Reports to ADB on recommendations taxation code. investors’ participation Congress proposed amendments to tax to bring the code in line with to augment market laws international standards

liquidity • Review operations and rules governing • Department of Finance and the 46 the Insurance Commission and Retirement Income Commission to participation of insurance companies in submit reports on the proposed the capital markets amendments to taxation of pension • Examine ways to prudently liberalize funds investment guidelines for insurance companies • Rationalize and equalize the tax treatment of public and private pension funds

(iii) Develop infrastructure • SEC to issue disclosure rules on • Disclosure rules issued by SEC • The corporate debt market has for corporate debt corporate debt in line with international been unable to develop trading practice despite efforts underway for • Establish fixed-income trading • Issue SRO rules the past 10 years. It is hoped counter/exchange and SRO to monitor • SEC recognizes and licenses the that the current efforts by the the market SRO. Bankers Association of the • Rationalize taxation on secondary trading • Exchange becomes operational. Philippines will be able to Attachment 2,page1 of debt instruments • Tax code amended finally produce a workable framework for corporate debt trading. 47 Appendix2, page1 export markets Philippines of the Government to reform in the nonbank financial sector reforms undertake reforms Macroeconomic stability Macroeconomic Sustained growth in key Political stability in the Sustained strong commitment Continued support in SEC for Adequate capacity in SEC to • • • • • • development review missions PSE turnover, and listings, number of initial public offerings, and nonbank financial institutions asset growth reduction of staff levels guarantee indemnification, while amendments to SRC are drafted assessments and/ or consultants reports evaluating conformity and regulations based on assessments Macroeconomic developments Macroeconomic reports Financial sector growth and Economic Asian Development Bank (ADB) Market developments in terms of Enactment of SRC Completed reorganization and Policy statement issued to ADB review mission to examine Issue and implement revised rules Implement training programs • • • • • • • • • • • PROGRAM FRAMEWORK increased participation of domestic companies in the equity and debt market Exchange (PSE) sector (SRC) to give SEC greater organizational flexibility and be self-funded become a more efficient entity regulators, which allows them legal protection in their professional capacity and develop an action plan in line with International Organization of Securities Commissions (IOSCO) standards evaluate whether standards and procedures conform to IOSCO/Bank for International Settlements, and other international best practice developing in-house training program, and implement APEC regulators training program Sustained growth of the economy and Increased participation of foreign investors Increased turnover at Philippine Stock More listings at PSE Number of initial public offerings Amount of assets in the nonbank financial Enact the Securities Regulation Code SEC to reorganize and rationalize Guarantee indemnification of market SEC to assess its enforcement powers, Assess SEC supervision practices and Enhance enforcement capacity by • • • • • • • • • • • • administrative, operational and financial flexibility and enforcement capacity Design Summary Performance Targets Monitoring Mechanisms Assumptions and Risks intermediation, and and improving investor protection. governance of Securities and Exchange Commission (SEC) (i) Allow SEC greater monitoring (ii) Enhance Goal To promote development of a vibrant and resilient nonbank financial sector that can adequately support economic growth Purpose To promote the development of the nonbank financial sector by governance, (i) strengthening efficiency, (ii) improving financial (iii) diversifying (iv) deepening capital formation Outputs 1. Enhance and strengthen 48 Appendix2, page2 and demutualization regulation of PSE to demutualization PSE commitment to reform SEC commitment to revise its Market conditions conducive • • • department established and mechanism for reporting findings to SEC established examination schedules to SEC regulatory framework Board composition altered Audit, compliance, and surveillance Demutualization of PSE Submission of required reports and ADB review mission to evaluate • • • • • percent nonbroker members on the governing board establish a separate audit, compliance, and surveillance department overseen by at least one independent Board member; furthermore: (i) Investigation findings by the SRO must be reported simultaneously to SEC and the PSE Board, (ii) PSE Board must notify SEC within 45 days on actions pursued by PSE as a result of the investigation findings. options for demutualization, and a suitable governance and regulatory framework capital adequacy of members, quarterly reports on the results of monitoring trading of listed companies, and investigations conducted with respect hereto, semiannual reports on the number of newly listed issues, delisted/suspended issues, and reasons therefore. confidential examination calendar for the year before 15 January every year. 10 days from month’s end) monthly reports on its periodic examinations and investigations started and completed in the past month. summary findings of end) monthly month’s past month. audits completed within the ensure effective regulation of a demutualized PSE that defines the roles and responsibilities of PSE SEC, respectively. In accordance with SRC, PSE to induct 51 Self-regulatory organizations (SRO) must PSE to prepare a study outlining the The SRO will submit monthly reports on The SRO will submit to SEC its The SRO will file with SEC timely (within SEC to develop a regulatory framework The SRO will file timely (within 10 days from • • • • • • • • for PSE to strengthen its governance during the transition period demutualize PSE reporting for effective supervision of PSE Design Summary Performance Targets Monitoring Mechanisms Assumptions and Risks regulatory structure of PSE arrangements (i) Develop (ii) Restructure and SRO (iii) Enhance arrangements (iv) Develop 2. Modernize governance and 49 Appendix2, page3 enhancing governance in government financial institutions Government support for • published ownership, and tender offers published on the SEC web site, and made available to the public via an information office assessment Administrative orders issued and Approved rule implemented Approved rules for beneficial All SEC rules and regulations to be ADB review mission to evaluate • • • • • h g this g ulations g ulation for g ulations available information to the g of the proposed g g rules and re g rules and re g ulations: (i) compile and publish SRC g implementin public and update them on annual basis, establish a web site providin (ii) information on an updated basis, create an Information Office in SEC to (iii) make SEC rules and re adoption and publication of a code ethics for government financial institutions and government-owned or controlled corporations institutions protecting shareholder rights, increase transparency, and improve reporting requirements 2 independent board members, or 20 percent of board members require (i) beneficial ownership threshold definition be lowered from 10 percent to 5 percent with respect to triggering reporting requirement by a beneficial owner of security to a security’s issuer; and (ii) draft rules on mandatory tender offers for the protection of minority shareholders. Inc.’s present processing systems, business plan, infrastructure, compliance with G-30 and International Systems Security Association recommendations, and assess staff training requirements to the public, (iv) before final adoption, to the public, (iv) have a public hearin continue to support the SRC, and (v) efforts of the Capital Market Development Council in disseminatin and implementin dissemination of SEC rules and re Drafting of administrative orders requiring Draft administrative order for government Require listed companies to have at least Revise the beneficial ownership rules to Increase public awareness throu Review Philippine Central Depository, • • • • • • governance Design Summary Performance Targets Monitoring Mechanisms Assumptions and Risks oversight, compliance, and enforcement market (i) Develop 3. Strengthen market 3. Strengthen 50 Appendix2, page4 SEC to upgrade and enforce prudential regulations, and enhance governance Continued commitment in • and functioning investigation department settlement period for fines and penalties assessment to P100 million denominated treasury bonds An established, adequately staffed SEC to implement a 10-day Enactment of the SRC General Accountant position created System developed and implemented Completed review and financial Paid-up capital requirement raised Manuals developed and produced Approval or rules pertaining to small ADB review mission to examine • • • • • • • • • • 5,000 e department for an ations of all market g g istration and resolution of external g 100 million paid-up capital excluding the malpractices and abuse, and (ii) facilitates malpractices and abuse, (ii) re initial inquiry fines and penalties levied on companies jurisdiction over the regulation of pre-need plans financial assessment of finance companies and investment houses and designated market makers to maintain P undertakes investi SEC penalties for corporations that breach financial disclosure requirements market participants and regulators to develop a manual for market participants on debt origination and underwriting denominated treasury bonds, make them reserve eligible, allow Bureau of Treasury to issue these in denomination of P complaints for expeditious disposal of simple cases or reference to the appropriate exchan value of their stock exchange seats and trading rights for new broker entry mark-to-market practices in line with international standards for prudential management of risk with a 5-year maturity, and list these on Introduce 10-day settlement period for all Enact legislation to clarify SEC’s SEC to complete a thorough review and Introduce a requirement for new brokers Create a central department in SEC that (i) Create General Accountant position at SEC to develop an automatic system of Establish a high-level working group of Approve procedures for small Introduce and monitor implementation of • • • • • • • • • • regulation of nonbank financial institutions and market abuse disclosure monitoring regulatory framework for the corporate debt market Design Summary Performance Targets Monitoring Mechanisms Assumptions and Risks (ii) Strengthen prudential (ii) Strengthen misconduct (iii) Prevent financial (iv) Strengthen innovation of corporate financing (i) Develop a policy and 4. Facilitate diversification and 51 Appendix2, page5 proposed amendments to the Insurance Code amendments to the Tax Code Support in Congress for the Support in Congress for • • legislative amendments for insurance companies Insurance Code that will allow the Insurance Commission to retain 1.5 percent of the premium tax collected by them developments pertaining to cash settled securities Submission to Congress of Introduce amendment to the Draft amendment to the tax code Introduce legislation to Congress • • • • insurance companies Issuance Commission public and private pension funds flexibility for financing companies and investment houses to meet their financing requirements Government of the Philippines to support the Nonbank Financial Governance Reform with implementation of reforms PSE, and trade as regular Government securities Liberalize investment guidelines for Facilitate financial autonomy for the Introduce legislation to allow greater Program loan of $75 million to the Technical assistance of $1 million to assist Rationalize and equalize the tax treatment of • • • • • • investors’ participation to augment market liquidity access of companies to finance Design Summary Performance Targets Monitoring Mechanisms Assumptions and Risks (ii) Enhance institutional (ii) Enhance broader (iii) Facilitate Inputs 52 Appendix 3

MAIN ACTS AND REGULATIONS GOVERNING NONBANK FINANCIAL INSTITUTIONS

Financial Licensing Regulatory Regulation Institutions Authority Authority Investment House PD 129 Investment House Act For QBs: SEC, BSP For QBs: SEC, BSP RA 7653 New Central Bank Act For NQBs: SEC For NQBs: SEC 1993 Manual of Regulation Securities Dealers SRC 2000 SEC SEC and Brokers RA 7653 New Central Bank Act 1993 SRC – Implementing Rules and Regulations Finance Companies RA 8556 Amended Finance For QBs: SEC, BSP For QBs: SEC, BSP (including Leasing Company Act 1998 For NQBs: SEC For NQBs: SEC Companies) Manual of Regulation RA 5980 Finance Company Act 1969 RA 7653 New Central Bank Act 1993 Investment RA 7653 New Central Bank Act SEC SEC Companies 1993 Investment Company Act Pawnshop PD 114 Pawnshop Regulation BSP BSP Act Manual of Regulation NBFIs subsidiaries RA 7653 New Central Bank Act n.a. BSP (only on of banks and quasi 1993 financial statements) banks SEC (for overall activities)

Securities-related RA 7653 New Central Bank Act BSP BSP, SEC (only on business of 1993 securities-related expanded RA 337 General Banking Act business) commercial banks Manual of Regulation Quasi-banking RA 7653 New Central Bank Act BSP BSP, SEC activities 1993 Manual of Regulation BSP = Bangko Sentral ng Pilipinas, NBFI = nonbank financial institutions, NQBs = non-quasi banks, PD = Presidential Decree, QBs = quasi banks, RA = Republic Act, SEC = Securities and Exchange Commission, SRC = Securities Regulation Code. 53 Appendix 4, page 1

PHILIPPINE STOCK EXCHANGE

1. The Philippine Stock Exchange (PSE) began operations in 1994 when the Manila and Makati Stock Exchanges merged. The Manila Stock Exchange had been in operation since 1927, while the Makati Stock Exchange opened in 1963. There are two trading floors, but these are electronically linked and thus operate as one floor. The two floors will be physically merged when the PSE moves to a new location in 2004.

2. PSE is a member-owned exchange, where each member has one vote at general meetings. It is a not-for-profit organization and all profits are reinvested in the exchange. At the end of 2000, the exchange had 148 domestic and 36 foreign broker members. The exchange is governed by a 15-member board that has a majority of nonmembers since September 2000 (Figure A6).

3. On 29 June 1998, the Securities and Exchange Commission (SEC) granted PSE self- regulatory status. As a self-regulatory organization (SRO), PSE is responsible for the frontline regulation of member firms and their trading. To gain SRO status, PSE had to establish a compliance and surveillance department. At the beginning of each year, PSE must submit an annual member audit plan to SEC, and each month reports of audits must be sent to SEC as well as a consolidated report on capital adequacy compliance by members. PSE lost its SRO status in April 2000 following the resignation of the staff in the compliance and surveillance department in conjunction with an insider trading case. The SRO status was restored in September 2000 when PSE again complied with the requirements for a SRO.

4. Most issues listed on the PSE are common stocks. These can be either Class A or Class B. Filipinos can own both classes, while foreigners can only buy Class B stocks. Preferred stocks can also be issued. These differ from common stocks in that preference is given to the holders of this stock over the holders of common stocks.

5. Trading is a fully automated auction market where buy and sell orders are prioritized by price and time. The broker, dealer, or sales representative must indicate whether the order is for the firm’s own account or for a client. Furthermore, it must be clear whether the order is for a domestic or foreign firm or client. Clearing and settlement are done by commercial banks in conjunction with the Philippine Central Depository, Inc. Stock certificates are immobilized through a book entry system, and settlement is done at T+4.

6. The fees for trading include brokers commission of a maximum 1.5 percent of the total transaction cost. In addition, transfer agents charge a transfer fee of P100 per stock, and value- added tax is added to this fee. A documentary stamp tax of P1.5 for every P200 par value of the stock transferred is levied. Sales of listed stocks is also subject to a transaction tax of 0.5 percent of the value of the transaction in lieu of a capital gains tax.

7. From 1991 to 2000, the number of listed companies increased from 161 to 230 (Table A6). Market capitalization in 1991 was P297.7 billion, which increased to a peak of P2,121.8 billion by 1996 before the Asian financial crisis began. At the end of 2000, market capitalization stood at P2,577.69 billion, thanks to the listing of two large insurance companies, Manulife and Sunlife. The share volume in billions of pesos grew from an average of 39.4 in 1991 to 659 in 2000. The turnover ratio increased from 17.2 percent in 1991 to 31.1 percent in 1998, and 83.88 percent in 1999. 54 Appendix 4, page 2

8. The composite index rose from 1,151.9 at the end of 1991 to 3,170.6 in 1996. After a rebound in 1999, the index fell considerably in 2000, following poor regional prospects and in response to political uncertainty in the Philippines. By the end of 2000, the index stood at 1,494.50.

9. It is estimated that the top 20 brokers account for about 90 percent of turnover, while the 4 top brokers alone account for 25 percent of turnover. Many of the small brokers account for less than 1 percent of turnover. As a result of the current ownership structure with one vote per member, the large brokers have to gain the support of small brokers to implement any changes at the exchange. This situation is about to change as PSE is mandated by law to demutualize by September 2001. It is yet to be determined how the demutualized PSE will be structured, but it will be a profit-oriented organization with more dispersed ownership, and where the ownership share determines the number of votes. Hence, the balance of power is likely to shift from small owners to large active owners. Demutualization will also affect SEC’s oversight function, and rules and regulations may have to be revised to suit a demutualized exchange.

Table A4: Philippine Stock Exchange

PSE Market Listed Share Volume Turnover Year Composite capitalization Companies (billion pesos) Ratio (%) Index (billion pesos) 1991 161 1,151.9 297.7 39.4 17.2 1992 170 1,256.2 391.2 77.0 22.4 1993 180 3,196.1 1,088.8 182.2 24.6 1994 189 2,785.8 1,386.5 364.3 29.4 1995 205 2,594.2 1,545.7 379.0 25.8 1996 216 3,170.6 2,121.8 668.8 36.5 1997 221 1,869.2 1,251.3 586.2 34.8 1998 222 1,968.8 1,373.7 408.7 31.1 1999 223 2,142.9 1,937.7 948.0 83.8 2000 230 1,494.5 2,577.7 659.0 56.5 Source: Philippine Stock Exchange. 55 Appendix 4, page 3

Figure A4: Philippine Stock Exchange Organization Chart

Committees Board of Members Governors

President CEO

Senior Vice President Chief Operating Officer

Vice President Vice President Asst. Vice President Vice President Vice President Listing & Disclosure Compliance and Automated Trading Finance and Business Development (Vacant) Surveillance Group Administration and Information

Market Movement Ayala Operations Product Evaluation Finance Monitoring Tektite Operations Development

Member Compliance Systems Market Processing Treasury Monitoring Development Development

Issuer Disclosure Legal Review and Network Accounting Corporate Monitoring Investigation Management Communications

Legal Review Technical Support Budget Research

Clearing and Administration Membership Affairs Settlement 56 Appendix 5, page 1

THE DEBT MARKET IN THE PHILIPPINES

A. Government Debt Securities

1. Government debt securities are either short-term treasury bills (T-bills), with maturities shorter than one year, or treasury bonds with maturities over one year. T-bills have tenors of 91, 182, or 364 days. T-bills with shorter tenors are called Cash Management Bills. Treasury bonds have 2-year, 5-year, 7-year, 10-year or 20-year maturity. One 20-year bond was issued in April 1997 and one 25-year bond in November 2000.

2. T-bills are auctioned every Monday, and bonds every second and fourth Tuesday of the month. The amount and maturities to be auctioned are announced to dealers three working days before the auction. It is done electronically through the Bridge Information System. Government securities eligible dealers (GSEDs) key in their bids before 1 pm on the day of the auction. The seven-member auction committee then reviews the bids and decides on awards. The interest rate is essentially market-determined.

3. The auction committee is made up of the secretary of the Department of Finance (DOF), treasurer, 2 deputy treasurers, assistant secretary from DOF, Securities and Exchange Commission (SEC) chairman, and Bangko Sentral ng Pilipinas (BSP) representative. The result is relayed back to the dealers through the automated debt auction processing system (ADAPS).

4. The dealers can make a maximum of seven competitive bids and one noncompetitive bid per tenor. A competitive bid is a tender to buy an amount of securities at a yield rate per annum that a GSED believes will wrest an award for the GSED by outbidding other dealers. A noncompetitive bid is a tender to buy a specified amount of Government securities without indicating any yield rate. The rate for non-competitive bids will be the weighted average yield rate of the competitive bids awarded at the same auction. Sixty percent are awarded to competitive bids and 40 percent to noncompetitive.

5. Auction awards are downloaded into the RoSS system (Registry of Scripless Securities) to register ownership. From the RoSS system, a trade report for settlement goes to BSP for cash settlements, and statement of securities goes to dealers.

6. There are 45 accredited dealers. The requirements to become a dealer include P100 million unimpaired capital and surplus account, meet all ratios prescribed for the industry, and be electronically linked to ADAPS and RoSS. Settlement in RoSS at the Bureau of Treasury is real time, while cash settlement is done at BSP, T+1.

7. The outstanding amount of government securities at the end of 1999 amounted to P986.7 billion. During 1999 a total of 239.3 billion pesos of government securities were issued. This figure includes 91-, 182- and 364-day T-bills, and bonds with maturities of 2, 5, 7, and 10 years.

8. Interest rates on 91-day bills have come down from an average of 10.19 percent in 1999, to an average of 8.9 percent during the first three quarters of 2000 (Figure A7).

9. Under the Small Investors Program, small denominations of treasury bonds with a five- year maturity and minimum face value of P5,000 were issued. The first issued in July 1999 amounted to P11.65 billion and the second in October 1999 to P18.6 billion. There are plans for listing and trading these bonds to make them a retail product, but the plans have yet to be implemented. 57 Appendix 5, page 2

B. Corporate Debt Securities

10. The corporate debt market consists of commercial papers and bonds. A majority of the shareholders must approve bond issues, whereas only board approval is required for commercial papers with less than seven years maturity. For commercial papers with longer maturity, two thirds of shareholders approval is needed.

11. Short-term commercial papers have dominated the market since they are cheaper than short-term bank loans, as reserve requirements are not extended to short-term papers. Long- term papers have become more common in the past few years due to stabilizing inflation. The average long-term tenor is 5-7 years. Until 1994, there was little interest in the debt market from corporations.

12. SEC requires credit ratings for corporate issues, bonds as well as commercial paper. Interest rates on commercial papers are usually based on T-bills plus a spread determined by perceived risk.

13. The secondary market in debt securities is largely inactive. There is no formalized listing and trading for debt securities. The PSE has developed listing rules for debt securities and SEC has approved these, but listing and trading have yet to take place.

Figure A5: Interest Rates on Treasury Bills (January 1999-June 2001)

18 16 14 12 91-day 10 8 182-day 6 364-day 4 2 0 n n n Apr Jul Oct Apr Jul Oct Apr

1999 Ja 2000 Ja 2001 Ja

Source: Bangko Sentral ng Pilipinas. 58 Appendix 6, page 1

DEPOSITORY AND CLEARING AND SETTLEMENT

A. The Philippine Central Depository, Inc.

1. The 1998 G-301 recommendations require each country to have an effective and fully developed central securities depository. In the Philippines, the Philippine Central Depository, Inc. (PCDI) was granted an operating license by the Securities and Exchange Commission (SEC) in December 1996 and commenced operations on 10 January 1997 (Table A8.1). Securities held at the PCDI are actually “immobilized” through the use of large, consolidated share certificates. These certificates are referred to as “jumbos” by the PCDI (an average 5,215 certificates went to the jumbo inventory in 2000). PCDI provides safe custody and securities settlement services for both debt and equity securities. Securities are lodged with PCDI and registered in the name of the PCDI Nominee Corporation as trustee.

2. Settlement of transactions is effected through debits and credits on the securities accounts of participants maintained by PCDI. The computerized book-entry system known as BES is currently adopted by PCDI to achieve the book entry transfers between buyers and sellers. PCDI currently handles the securities being actively traded on the Philippine Stock Exchange (PSE). PCDI also provides nominee services for distribution of information and benefit entitlements to participants, and bureau services through which participants make use of the computer facilities of PCDI for the back-office administration.

3. The securities that are eligible in the book-entry system of PCDI are equity securities (stocks listed in PSE) and debt securities (treasury bills and treasury bonds). However, PCDI currently has only equities on deposit. The system does have the capability to handle debt securities when the market is ready for such a service.

B. The Securities Clearing Corporation of the Philippines

4. The Securities Clearing Corporation of the Philippines (SCCP) is a privately owned corporation (Table A6.1). SEC authorized SCCP in 1998 to provide clearance and settlement services for trades executed on the PSE. The functions and services SCCP provides include implementing delivery-versus-payment (DVP), clearing and settling PSE trades, maintaining and administrating of the Clearing and Trade Guarantee Fund, and risk monitoring and management.

5. SCCP acts with three agencies to effect delivery of the securities and cash elements to the trading counterparties as specified in the trade contracts: (i) PSE – provides direct primary input of trade contracts as an electronic feed from PSE’s information system; (ii) PCDI – performs the book-entry transfer of securities from the seller to the buyer; (iii) settlement bank – performs the physical transfer of cash from the buyer to the seller.

6. The clearing and settlement process is supported by an electronic data processing system called FINTRACS, which is a joint venture with PCDI. SCCP guarantees a DVP settlement and has adopted a trade-for-trade settlement system for all the eligible trades.

1 The Group of Thirty, established in 1978, is a private, nonprofit, international body composed of very senior representatives of the private and public sectors and academia. It aims to deepen understanding of international economic and financial issues, to explore the international repercussions of decisions taken in the public and private sectors, and to examine the choices available to market practitioners and policymakers. 59 Appendix 6, page 2

Table A6.1: Overview of the Depository and Clearing & Settlement House

The Philippine Central Depository The Securities Clearing Corporation of Inc. (PCDI) the Philippines (SCCP) Ownership PCDI is a private sector company with SCCP is a privately owned institution public sector representation. Its organized as a clearance and settlement shareholders are Philippine Stock agency for the eligible trades executed in Exchange (PSE) (31.7%), Bankers the PSE. PSE holds 51% of the shares, with Association of the Philippines the remaining 49% held by Philippine (31.7%), FEIP (10%), Development commercial banks. Bank of the Philippines (10%), Investment Houses Association of the Philippines (6.56%), Social Security System (5%), and Citibank N.A. (5%).

Eligible PCDI participants include the member SCCP participants include member brokers Participants brokers of PSE, custodian banks, of PSE, settlement banks, and PCDI. insurance companies, registrars, Smaller members resisted the introduction banks, social security and other of this system as it eliminates the time government institutional investors. between rate of a security is sold and its delivery.

Authority The Revised Securities Act prohibits SCCP was authorized by SEC to provide any person from providing settlement clearance and settlement services. The services unless authorized by SEC to company submitted to SEC the draft rules do so. PCDI received its authorization and procedures which were subsequently as a depository and securities approved in November 1997. The current settlement organization in 1996; the provisional license expired on 31 PCDI Rules were written in 1997 and December 2000. were approved by SEC. PCDI’s ongoing operations are supervised by SEC under a temporary license. Functions of 1. Facilitates transfer of ownership 1. Establishes the liabilities between operation of stocks and funds, thereby member brokers (order matching and reducing settlement risks. confirmation). 2. Allows prompt distribution of stock 2. Synchronizes settlement of funds and and cash dividends as well as transfer of securities (issue payment interest and maturity payments, and transfer instructions on delivery- enabling beneficial owners to versus-payment basis). immediately realize the fruits of 3. Guarantees settlement of trades in the their investments. event of member default (maintains and 3. Provides for immediate updating administers the Clearing and Trade of portfolio records immediately Guarantee Fund). settling the seller’s and buyer’s 4. Imposes and administers risk legal liability. management systems to ensure 4. Supports scripless trading in the settlement (sets financial and Government debt market. administrative rules and monitors 5. Facilitates the process of pledging compliance with the rules by member securities. brokers). 6. Provides infrastructure to handle 5. Manages and administers the clearing peak volumes. and Trade Guarantee Fund. 7. Eliminates risks associated with physical certificates (i.e., lost certificates or forged signatures). 60 Appendix 6, page 3

C. Delivery-Versus-Payment System

7. Delivery versus payment (DVP) represents the simultaneous exchange of securities (the deliver side) and cash value (payment) to settle a transaction. DVP features the concept of a safe and efficient settlement system. This concept is also one of the G30 recommendations. As the term DVP itself implies, the concept contains two major parts: the delivery part and the payment part. The delivery part refers to the delivery of securities from a seller to a buyer, the payment part is the delivery of funds from the buyer to the seller. If there is a time lag between these two parts, one of the transaction’s counterparties will be exposed to the risk of the other party to complete delivery. Therefore, the goal of a sound DVP is to achieve a simultaneous exchange of securities and payment.

8. To achieve a DVP with high security and efficiency, two aspects of the transaction need to be considered. The settlement mechanism’s ability to move securities and funds positions at the same time is the first concern. The second is the quality of the payment that is exchanged. The exchanging security position by depositories is comparatively simple because depository controls the securities as well as the participant records, and is, thus, free to apply debits and credits to these accounts as necessary. However, the payment system is difficult to control. That is because both the clearing and settlement organizations (and their participants) may have access to a payment system for processing the required exchange of funds, but neither controls a market’s payment system. Therefore, the goal is to ensure that both payment and settlement of security position are “good.” Nevertheless, due to the dynamics between the clearing and settlement organizations and the payment system, this goal is not always reachable. The diverse characteristics of the market’s payment system result in various possibilities for achieving DVP.

9. The report from the Committee on Payment and Settlement System gives three broad structural approaches to achieving DVP:

(i) Model 1 - Simultaneous finality of securities transfer and cash transfer. Examples of model 1 systems include Euroclaer, Fedwire, and Cedel. This model is best in terms of risk control. (ii) Model 2 - Final transfer of securities prior to final cash transfer but against guarantee by reliable banks. An example of this is the Central Gilts Office in the United Kingdom. (iii) Model 3 - Provisional transfer of securities becomes final when final cash transfer is made. If the cash is not paid, the securities credit will be reversed. Finality is conditional on information as to the availability of funds for purposes of settlement.

Table A6.2: Chronology of the Implementation of DVP in PCDI and SCCP

Timetable Progress of Implementation January 1997 PCDI began operations (for securities settlement). December 1998 SCCP was given provisional license, DVP Model 2 was implemented – gross settlement for securities and net settlement for cash. July 2000 Modified Model 2 was implemented with advance deposit of securities to SCCP escrow account and advance deposit of cash. DVP = delivery-versus-payment, PCDI = Philippine Central Depository, Inc., SCCP = Securities Clearing Corporation of the Philippines. Source: Corporate Planning and Development Department, PCDI. 61 Appendix 6, page 4

D. Credit Accommodations to SCCP’s DVP Implementation

10. SCCP started implementing DVP or trade-for-trade settlement on 7 December 1998 (Table A6.2). However, PSE directed SCCP, by virtue of its majority ownership and controlling interest, to deviate from the prescribed manner of settlement. SCCP was mandated to incorporate various accommodations to its DVP implementation for broker members on a “trial run” basis: (i) if brokers deliver securities on T+3, they get paid at 9:00 am on T+4 when under approved SCCP rules they should be paid at 1:00 pm on T+4; (ii) brokers are given the privilege of drawing as early as 9:00 am their Net Due Broker amount or P5 million (whichever is less) prior to the delivery of the corresponding securities on T+4 at 11:00 am.

11. The credit accommodations greatly affected the fundamental principles of DVP trade-for- trade settlement. While the system strives to ensure a simultaneous exchange of cash for securities and vice-versa, the conditions imposed by PSE, which SCCP had no other choice but to accept, injected elements of risk, thereby making it ineffective. Thus, the two credit accommodations negated the DVP principle. Therefore, SCCP was directed by an SEC order to immediately stop extending credit accommodation to its participants and to strictly implement the DVP settlement. These credit accommodations were removed from SCCP on 30 June 1999.

E. Recommendations of G30 and 1995 ISSA Amendments

12. Table A6.3 summarizes PCDI’s compliance with the G30 recommendations and amendments to ISSA.

Table A6.3: Compliance of PCDI to Recommendations

Recommendation Implemented? Planned?

1.1 All comparisons of trades between direct market Yes participants (i.e. brokers, broker/ dealers and other exchange members) should be accomplished by T+0. 1.2 Matched trades should be linked to the settlement system. Yes 2. Indirect market participants (such as institutional investors Yes and other indirect trading counterparties) should achieve positive affirmation of trade details by T+1. 3.1 Each country should have in place an effective and fully Yes developed central securities depository, organized and managed to encourage the broadest possible direct and indirect industry participation. 3.2 The range of depository-eligible instruments should be as No 2001 wide as possible. 3.3 Immobilization or dematerialization of financial instruments Yes should be achieved to the utmost extent possible. 3.4 If several central securities depositories exist in the same market, they should operate under compatible rules and No practices, with the aim of reducing settlement risk and enabling efficient use of funds and available cross-collateral. 4.1 Study capability of trade netting system. Each market is No 2001 encouraged to reduce settlement risk by introducing either Real Time Gross Settlement or 62 Appendix 6, page 5

Recommendation Implemented? Planned?

4.2 a trade netting system that fully meets the “Lamfalussy- No No recommendation.” 5. DVP should be employed as the method of setting all Equities- Yes securities transactions. DVP is defined as follows: simultaneous, final, irrevocable, and immediately available exchange of securities and cash on a continuous basis throughout the day. 6.1 Payments associated with the settlement of securities Yes transactions and 6.2 the servicing of securities portfolios should be made Yes consistent across all instruments and markets by adopting the “same day” funds convention. 7.1 A “rolling settlement” system should be adopted by all Yes markets. 7.2 Final settlement should occur no later than T+3. Yes 8.1 Securities lending and borrowing should be encouraged as No Yes a method of expediting the settlement of securities transactions. 8.2 Existing regulatory and taxation barriers that inhibit the No Yes practice of lending and borrowing securities should be removed. 9.1 Each country should adopt the standard for securities No No messages developed by the International Organization of Standardization (ISO Standard 7775). 9.2 In particular, countries should adopt the International No No Standard Identification Numbering system for securities as defined in ISO Standard 6166. Source: 1995 Recommendation of International Systems Security Association and Philippine Central Depository, Inc.

G. Recommendations on the Operations of PCDI2

13. To address the current environment and in preparation for changes by SEC, PCDI should

(i) review and rewrite its rules to be more definitive about responsibilities and liabilities accepted by the depository and assigned to its members and even to SCCP,

(ii) establish a formal procedure documentation program that supports the management and staff in completing their daily responsibilities, and

(iii) develop and implement a more comprehensive business continuity plan that includes both technical and business operations. This plan should be reviewed and updated at least annually.

2 Hertel, S. 2000. Philippine Central Depository (PCD) Operations Review. AGILE report. PricewaterhouseCoopers, August 2000. 63 Appendix 7, page 1

BANKING SECTOR REFORMS

1. Under the World Bank Banking Sector Reform Loan (BSRL), $200 million was disbursed and two subsequent tranches of $200 million each were planned. The original closing date was 31 June 2001. The Government cancelled the loan on 23 May 2001. However, substantial progress was accomplished under this loan before it was cancelled. The table outlines the policy actions and how the Government implemented the reform under the BSRL.

Policy Action Implementation Second Tranche

1. External auditors to be placed under Implemented under Circular No. 179 issued 25 affirmative obligation to inform Bangko September 1998 Sentral ng Pilipinas (BSP) of factors that materially affect the soundness of financial institutions

Accreditation of external auditors Implemented under Circular No. 245 dated 19 May engaged by banks 2000

2. Supervision of 7 banking organizations on Consolidated examination of 17 banks completed: 2 in a consolidated basis and evaluation of 1998 and 15 in 1999, all reports of examination prudential norms on the risks of the entire released to banks. banking organization

3. Completion of supplementary on-site On-site examination of 51 banks ongoing as examinations of 51 banks in accordance mandated under Republic Act No. 7653 (The New with its program of intensified monitoring Central Bank Act), which provides that banks be of institutions at risk and imposition of examined at least once every 12 months. Corrective appropriate corrective actions actions incorporated in the report of examination released to banks. Special examination conducted in accordance with provision in BSP Charter.

4. Guidelines for corrective actions for banks Sanctions of increasing severity for banks’ failure to corresponding to their degree of capital meet minimum capital requirements, implemented deficiency under Circular No. 176 dated 7 September 1998.

Prompt corrective action implemented under Circular No. 181 dated 14 November 1998 to be implemented in tandem with Circular No. 176.

Guidelines for intervening and resolving Implemented under Circular-Letter dated 11 August insolvent and near-insolvent banks 1998 re: policy guidelines on resolving problem bank issues.

Implemented under Circular No. 172 dated 31 August 1998, as amended by Circular No. 237 dated 19 April 2000 re: merger and consolidation incentives.

Contingency plan to handle systemic Contingency plan to deal with bank crises (systemic or crises institutional) approved by Monetary Board under Resolution No. 206 dated 17 February 1999. 64 Appendix 7, page 2

Policy Action Implementation The revised plan was approved by the Monetary Board through Resolution No. 30 dated 7 January 2000.

5. The Government will have adopted an External audit completed in December 1999 and action plan, satisfactory to the World released in May 2000. Bank, to promote strategic investment in Philippine National Bank (PNB), including Price Waterhouse engaged to conduct valuation of (i) an in-depth audit of PNB by external PNB, which is to be completed. Rehabilitation and auditors, and (ii) development and privatization plan being developed. implementation of a course of action for strengthening PNB’s financial performance consistent with the findings of the abovementioned audit.

6. Maintenance of a sound macroeconomic Linked to International Monetary Fund (IMF) Post framework Program Monitoring. World Bank has accepted economic program recently agreed upon with IMF as compliance with the condition.

7. Protection of BSP and Philippine Deposit Included in the draft amendments to the Central Bank Insurance Corporation (PDIC) staff from and Philippine Deposit Insurance Corporation Acts. lawsuits brought against them Bill for resubmission during 12th Congress.

Third Tranche

1. Action plan and bidding rules satisfactory Rehabilitation and privatization plans being developed to World Bank for the private strategic investor to transfer management and control of PNB

2. BSP to put into effect disclosure requirements for listed and nonlisted banks

3. Amendments to Central Bank Act and For resubmission during 12th Congress PDIC Act 4. Supervise an additional 10 banks on a Consolidated examination of 17 banks completed: 2 in consolidated basis and evaluate 1998 and 15 in 1999; all reports of examination prudential norms for banking organization released to banks.

5. Maintenance of a sound macroeconomic Linked to IMF Post Program Monitoring. World Bank framework has accepted the economic program agreed upon with IMF as compliance with the condition. 65 Appendix 8, page 1

SIGNIFICANT FINANCIAL SECTOR REFORMS

1. Major changes occurred in the financial sector over the last 10 years as a result of Government and market initiatives to strengthen financial sector management, while at the same time liberalizing the sector’s operations. Significant policy measures relating to Asian Development Bank operations include the following:

(i) 1992. The Capital Market Development Council was established, comprising both Government and private sector practitioners. Its task is to recommend proposals for capital market development in an integrated and consistent manner, and implement consequential changes in Government policy. The Capital Market Development Council, along with the Capital Market Coordination Council composed of Government and representatives, which was set up in 1993, fully endorsed to the National Economic Development Authority and Department of Finance the capital market reform agenda contained in the Capital Market Development Program.

(ii) 1993. The central bank was restructured into Bangko Sentral ng Pilipinas (BSP), allowing for more focus on and improvement of monetary management. This led to lower inflation (18.7 percent in 1991 to around 9 percent average during 1994- 1996) and lower interest rates.

(iii) 1994. Unification of the Manila and Makati stock exchanges into the Philippine Stock Exchange (PSE). This led to a rapidly increasing stock market capitalization until the crisis.

(iv) 1995. The banking system was opened to foreign competitors through legislation passed in 1994 and in 1995. Ten foreign banks were licensed to open full service branches.

(v) 1995. BSP raised the minimum capital requirements for licensed commercial banks and adopted the Basle Committee norms on capital adequacy and income recognition.

(vi) 1995-1996. Securities and Exchange Commission (SEC) shifted its regulatory philosophy from a merit-based approach to full disclosure and enforcement.

(vii) 1996. Philippine Central Depository, Inc. (PCDI) and Securities Clearing Corporation of the Philippines (SCCP) were established. PCDI was fully operational by the end of 1996, and SCCP by the end of 1998.

(viii) 1995-1996. Amended laws and regulations governing financial, capital market and other related activities to liberalize the markets were presented to Congress (Securities Regulation and Enforcement Act, Revised Investment Company Act, Corporation Code, Financing Company Act, and Investment Houses Law).

(ix) 1998. Regulatory responsibilities were realigned along more functional lines such as giving SEC jurisdiction over all investment houses and finance companies not affiliated with banks. 66 Appendix 8, page 2

(x) 1998. SEC granted a self-regulatory organization license to PSE after PSE met the Federation Internationale des Bourses de Valeurs (FIBV) criteria and received accredited FIBV status.

(xi) 1999. BSP and SEC agreed to a memorandum of understanding to undertake information sharing in areas of overlapping jurisdiction.

(xii) 2000. The Securities Regulation Code was enacted, providing the foundation for deeper changes in capital market regulation. 67 Appendix 9, page 1

POVERTY IMPACT ASSESSMENT

1. Taken as a whole, the Nonbank Financial Governance (NFG) Program is poor-neutral in direct impact and indirectly pro-poor in supporting the three components of the Asian Development Bank’s poverty reduction strategy: pro-poor sustainable economic growth, good governance, and social development.1 Pro-poor sustainable economic growth is to be achieved through the Program’s focus on measures to increase investor confidence and restore the flow much-needed investment capital to the Philippines. This, in turn, will provide employment for young school leavers who comprise 30 percent of the labor force but 50 percent of the unemployed. Revitalizing the moribund labor market provides income-generating opportunities for the underemployed raising real wages of the working poor. The Program will strengthen market governance by improving regulation of competitive markets, restructuring the stock exchange and allowing it to operate more efficiently; and through improved transparency of the quality and quantity of reported and audited financial statements. In addition, the Program supports the rationalization of distortions related to taxation policy. These measures will expand economic opportunities by reversing policies that often provided protection and assistance to large and influential firms or business groups. The Program also supports the third pillar of the poverty reduction strategy of social development. Providing basic services such as water supply and sanitation requires investment with long-term payback horizons. The development of social protection programs such as pensions and other insurance schemes require long-term investment opportunities. A competitive capital market supports the expansion of basic social services and the system of social protection with private sector resources by matching the need for long-term money to the need for long-term investment opportunities.

2. The Program supports the Medium-Term Philippine Development Plan 2001-2004 (MTPDP) underscores the importance of macroeconomic stability for broad-based growth, comprehensive development, and governance as “crucial for success in the fight against poverty and high unemployment.”2 Although significant measures have been passed to strengthen the regulatory framework for capital market development, the chapter macroeconomic stability cites the need for continued reform to develop the capital market and improve corporate governance to increase domestic savings for higher investment without running into balance of payment and external debt problems. The MTPDP recognizes that the escape from poverty hinges on “agricultural modernization and rural industrialization,”3 which in turn will depend on a vibrant small and medium-size enterprise (SME) sector supported by appropriate policies and access to financing.4 Appropriate policies for sustainable development include those supporting a favorable business environment.5

3. The slowdown in growth contributed to the moribund state of the labor market. During 2000, unemployment reached record highs from already high levels earlier. One fifth of the labor force was underemployed, while real wages stagnated However, the failure of the labor market also contributed to low growth. The direct causes lie with macroeconomic, industrial, and labor market policies; while indirect causes include access to financial markets, especially for SMEs that would be direct beneficiaries of the Program.

4. Price shock and inflation has a greater impact on the poor than on the non-poor. The Asian crisis took its toll by increasing the proportion of the poor and increasing the depth of

1 Asian Development Bank. 1999. Fighting Poverty in Asia and the Pacific: The Poverty Reduction Strategy. 2 Medium-Term Philippine Development Plan (MTPDP) 2001-2004, 2001. Introduction and Overview Chapter. 3 MTPDP, Overview Chapter. 4 MTPDP, Industry and Services Chapter. 5 MTPDP, Governance Chapter. 68 Appendix 9, page 2 poverty. Between 1997 and 2000, the proportion of households below the poverty line increased from 31.8 to 34.2 percent, and those with incomes below the food threshold6 increased from 16.2 percent to 16.8 percent. Increased prudential standards and greater efforts to increase compliance, and enforcement with rules and regulations lead to a more robust system, thereby reducing its vulnerability to external shock as does greater reliance on domestic capital markets.

5. Fiscal realities constrain the expansion of basic public services. For example, one fifth of the population lacks access to safe water and one fourth lacks access to electricity. These and other public service investment areas with long-term financing needs such as schools, public health centers, feeder ports, and farm-to-market roads are the responsibility of municipal governments with limited local resources. Access to a well developed bond market will enable municipal governments to promote access of the poor to public goods and increase their productivity. Expansion of the system for social protection is constrained by the need for efficient and less risky alternatives to banks in providing long term funds. Strengthening the capacity of institutional investors deepens the security markets and enables the expansion of the social protection system and the provision of basic public infrastructure.

6. The Program addresses the requirements of the major actors in the capital market, which taken as a whole enable a well-regulated and efficient capital market. The only negative impact in the Program results from the streamlining of the Securities and Exchange Commission (SEC). Three hundred of SEC’s staff have voluntarily accepted a severance package that is above the legal requirements. They were relatively young and skilled and unlikely to find undue difficulties in locating other employment within the sector. A poverty impact matrix is shown for the combined Program as each component of the program contributes to the same outcome.

Table A9: Poverty Impact of the Program

Channel Indirect Macro Non-Poor Labor Increased access to capital Increased accountability and More investment funds flow markets leads to increased clarification of fiduciary into sectors, industries, and employment opportunities responsibilities reduce the countries with transparent for the skilled poor and possibility for market and efficient markets. The increased opportunities for manipulation, fraud, and potential impact on labor is income generation for the abuse. The cost of these directly correlated to unskilled poor financial crimes has a direct activity in the economy. impact on business Therefore, the greater the Job creation revitalizes confidence, future business confidence, the labor markets and can lead investment, and higher the potential for to increased real wages for consequently to labor labor absorption. the working poor. absorption.

Access for the More stable and Greater investor confidence Stability of the funding markets and predictable funding of leads to greater capital insurance sector liabilities services contractual saving formation increasing pool of provides a sounder basis schemes reduced funds for short term and for greater returns in the vulnerability to poverty for longer term investment insurance sector, including the working poor. life insurance.

6 The poverty line composes a food threshold plus and allowance for nonfood needs such as clothing, shelter, lighting, education, and health. 69 Appendix 9, page 3

Channel Indirect Macro Non-Poor Sustained expansion of Increased transparency and Enhanced disclosure and SMEs leads to an improved stability in financial markets more accurate financial tax base from business and increases the opportunities reporting in the market personal income, enabling for local government, pension including collective increased provision of plans, and insurance investment schemes such basic services for the poor. schemes matches the need as the pre-need industry for long term investment and will protect the smaller long term savings investors. instruments,

In turn, this enables expansion of the provision of public services to the poor and improves the reliability of the social protection system

Prices Capital market Increased prudential development leads to standards and greater efforts alternative sources and to increase compliance and more competitive of finance enforcement with rules and for SMEs leading to lower regulations lead to a more production costs and more robust system, thereby competitive prices reducing its vulnerability to external shock and price swings

Net Impact The direct impact of the Program is poor-neutral. The indirect impact is pro-poor.

Narrative The actions taken under the Program will lead to an efficient capital market where investors are informed and protected. This will diversify the range of financial instruments available to the public and private sector, reducing vulnerability to the banking sector and buffering from external shock. Increased access to financial markets by SMEs creates employment opportunities for skilled and unskilled labor and increased opportunities for small businesses. Increased transparency and stability in financial markets increase the opportunities for local government, pension plans, and insurance schemes matches the need for long term investment and long term savings instruments. This enables expansion of the provision of public services to the poor and improves the reliability of the social protection system. 70 Appendix 10

ENVIRONMENTAL IMPACT ASSESSMENT

1. The Program will not have any direct and immediate environmental impacts. The likely environmental impacts are indirect and long-term, and most them are positive (environmentally beneficial). In general, improved governance in the nonbank financial sector will improve regulation of competitive markets, increase transparency, and promote good enterprise governance. This, in turn, will optimize efficiency in the use of resources, including environmental resources. However, such optimization requires an appropriate environmental regulatory framework and enforcement.

Policy Actions Potential Environmental Impacts I. Enhance and Strengthen the Governance of (+) Increase efficiency in business operations, Securities and Exchange Commission (SEC) which, in general, will improve environmental A. Allow SEC greater administrative, operational, and management financial flexibility B. Enhance monitoring and enforcement capacity

II. Modernize Governance and Regulatory Structure (+) Ditto of Philippine Stock Exchange (PSE) A. Develop arrangements for PSE to strengthen its governance during the transition period B. Restructure and demutualize PSE C. Enhance self-regulatory organization reporting D. Develop arrangements for effective regulation of PSE III. Strengthen Market Oversight, Compliance, and (+) Ditto Enforcement A. Develop market governance B. Strengthen prudential regulation of nonbank financial institutions C. Prevent misconduct and market abuse

IV. Facilitate Diversification and Innovation in (?) Mixed results, depending on direction and Corporate Financing magnitude of tax and investments A. Develop a policy, regulatory, and taxation framework for corporate bond market B. Enhance institutional investors participation to augment market liquidity (+) = positive environmental impacts, (-) = negative environmental impacts, (?) = mixed/uncertain environmental impacts. 71 Appendix 11

INELIGIBLE ITEMS

1. The proceeds of the loan will be used to finance the foreign currency expenditures for the reasonable cost of imported goods required during implementation of the Program.

2. Notwithstanding the provision of para. 1, no withdrawals will be made for

(i) expenditures for goods included in the following Customs Coordination Council Nomenclature chapters or headings as designated by the Asian Development Bank (ADB) by notice to the Government;

Group Subgroup Description of Items

22 22.03-22.10 Alcoholic beverages

24 24.01 Tobacco, unmanufactured tobacco refuse;

24 24.02 Tobacco, manufactured (whether or not containing tobacco substitutes)

28 28.50-28.52 Radioactive and associated materials

71 71.01-71.04 Pearls; precious and semiprecious stones, unworked or worked

71 71.05-71.06 Jewelry of gold, silver, or platinum group metals (except watches and watch cases); goldsmiths’ or silversmiths’ wares (including set gems)

71 71.07-71.08 Gold, nonmonetary (excluding gold ores and concentrates)

84 84.59 Nuclear reactors and parts thereof, fuel elements (cartridges), nonirradiated for nuclear reactors

(ii) expenditures in the currency of the Borrower or of goods supplied from the territory of the Borrower;

(iii) payments made for expenditures incurred more than 180 days before the effectiveness date of the loan;

(iv) expenditures for goods supplied under a contract that any national or international financing institution or agency will have financed or agreed to finance, including any contract financed under any loans from ADB;

(v) expenditures for goods intended for a military or paramilitary purpose or for luxury consumption; and

(vi) expenditures for pesticides categorized as extremely hazardous or highly hazardous in Class 1a or 1b, respectively, of the World Health Organization’s Classification of Pesticides by Hazard and Guidelines to Classification. 72 Appendix 12, page 1

OUTLINE TERMS OF REFERENCE FOR CONSULTANTS

1. The objective of the technical assistance is to strengthen market governance by focusing on analytical and institutional support for the development of (i) an effective self-regulatory organization, (ii) Securities and Exchange Commission’s (SEC) capacity to investigate and enforce market regulations, (iii) an efficient management information system (MIS) and staff training to effectively use the system, and (iv) skills and standards in accounting and auditing.

2. A team of international and domestic consultants will be recruited to perform the tasks specified in the terms of reference.

A. International Consultants

1. Compliance and Enforcement Expert (5 person-months)

3. The consultant should have an advanced degree in economics, finance, or business and extensive experience in capital market development, particularly in regulation and supervision. The consultant should also be familiar with emerging markets. The responsibilities of the consultant will include the following:

(i) Assist the SEC with defining the roles and functions of SEC to allow a demutualized Philippine Stock Exchange (PSE) to operate independently without compromising SEC’s oversight;

(ii) develop a policy statement setting out oversight objectives of SEC and how SEC relates to cooperative market regulation with the PSE;

(iii) develop reporting requirements for a self-regulatory organization (SRO) that will enhance transparency and facilitate SEC’s oversight of SROs;

(iv) develop and execute training programs for SEC staff in market surveillance and monitoring, enforcement, and compliance in conformity with the laws, rules, and regulations in the Philippines and according to SEC’s mandate; and

(v) develop SEC’s monitoring and investigative capacity by installing necessary software to allow SEC to analyze large data sets in a relational and predictive way. This component will be undertaken together with the MIS expert.

2. MIS Expert–Systems (5 person-months)

4. The consultant should have preferably a degree in computer science and experience in developing MIS. In-depth knowledge of hardware and software is essential. The consultant will undertake the following:

(i) procure hardware and software and install MIS for compliance monitoring and evaluation system in SEC and licensing system in the Insurance Commission (IC) as developed under previous technical assistance;

(ii) ensure that hardware and software maintenance agreements are signed in connection with hardware and software procurement; 73 Appendix 12, page 2

(iii) develop and implement business disaster and recovery plans for the MIS;

(iv) train SEC and IC staff in using the MIS effectively; and

(v) train SEC and IC technical staff in maintaining the MIS.

3. Accountant, Organization, and Training Specialist (7 person-months)

5. The consultant should be a certified public accountant (CPA) or chartered accountant or have an equivalent certification, with extensive experience in accounting and international accounting standards and procedures. The consultant must also have in-depth knowledge of and experience in CPA examinations and training. The responsibilities include the following:

(i) clarify the organizational roles and responsibilities of SEC, Board of Accountancy (BOA), Professional Regulation Commission (PRC), and Philippine Institute of Certified Public Accountants (PICPA). This will include (a) analyzing and identifying role overlaps among PRC, SEC, BOA, and PICPA; (b) negotiating the optimal organizational assignment of these roles; and (c) preparing Memoranda of Agreement (MOA) between SEC, BOA, and PRC, detailing each organization’s role in licensing, registering, regulating, and enforcing regulations for the profession, including procedures for filing administrative charges against CPAs violating relevant laws;

(ii) strengthen the organization of the accountancy profession, which will involve (a) examining BOA’s regulatory role; (b) identifying the resource requirements and processes necessary for BOA to effectively undertake this role; (c) examining revenue collection by and distribution to PRC, SEC, BOA, and PICPA; (d) recommending enhanced collection and distribution arrangements; and (e) designing and developing a web site for BOA;

(iii) develop an action plan to reform the CPA exam procedures, including (a) design options for examination systems; (b) establishing a database of examination questions adapted to the Philippines; (c) examining the feasibility of and options for developing an on-line examination system; and suitable examination software; and (d) identifying necessary changes to management procedures for implementing of the action plan; and

(iv) facilitate the introduction of international accounting standards (IAS) by (a) preparing educational materials on IAS; (b) developing training courses on the application of IAS for CPAs; and (c) in collaboration with PICPA, training trainers in these educational materials and courses, and using PICPA’s network to spread the training nationwide.

4. Accountant, Accounting, and Auditing Standards and Practices Specialist (5 person-months)

6. The consultant should have a CPA or equivalent certification, and extensive experience in international accounting and auditing standards and practices. The responsibilities will include the following: 74 Appendix 12, page 3

(i) work together with the General Accountant of SEC, BOA, and PRC to review the Revised Accountancy Law of 1975, and identify areas where amendments are needed to modernize the law, and allow for introduction of IAS;

(ii) prepare amendments to the Revised Accountancy Law of 1975 that define the rules for auditor appointment and dismissal, auditor independence, audit reporting procedures, and exposure of auditors to liability; and

(iii) assist training SEC staff in implementing auditing and evaluating audited financial statements of listed companies and NBFIs for compliance to SEC disclosure rules and regulations.

B. Domestic Consultants

1. MIS Experts (2 persons, 5 person-months each)

7. The consultants should have a degree in computer science and experience with MIS. The consultants will support the international consultant in installing hardware and software and training SEC and IC staff.

2. Web Site Developer (2 person-months)

8. The consultant will work with the international accountant and BOA and develop a web site for BOA members containing necessary information and that is user-friendly, and train BOA staff to update and maintain the web site.

3. Accountant (4 person-months)

9. The consultant will work with the international expert and assist with the IAS component, particularly with (i) preparing educational materials on IAS; (ii) offering training courses on the application of IAS; and (iii) organizing seminars to pilot educational materials. The consultant will also assist the international expert with reviewing the Revised Accountancy Law and preparing amendments to the law.

C. Implementation Arrangements and Reporting Requirements

10. SEC will be the Executing Agency. For the components relating to accounting and auditing, a steering committee chaired by SEC with members from ADB, SEC, PRC, BOA, and PICPA will be formed to oversee the project. The MIS and compliance components will be overseen jointly by SEC and Asian Development Bank (ADB), and IC and ADB, respectively.

11. The team will provide ADB with an inception report within one month, detailing the proposed work schedule, major tasks, and initial progress. In addition, the team will submit monthly progress reports on key developments. A draft final report will be submitted to ADB four weeks before the physical completion of the technical assistance. Copies of training materials will be submitted to ADB as well. Each member of the steering committee will also receive copies of the reports.

12. All reports will be submitted in both hard and soft copies. 75 Appendix 13

COST ESTIMATES AND FINANCING PLAN FOR THE TECHNICAL ASSISTANCE ($'000)

Foreign Local Total Item Exchange Currency Cost A. Asian Development Bank Financinga 1. Consultants a. Remuneration and Per Diem i. International Consultants 550.0 0.0 550.0 ii. Domestic Consultants 0.0 80.0 80.0 b. International Travel 30.0 0.0 30.0 c. Reports and Communications 5.0 5.0 10.0 2. Equipment 150.0 0.0 150.0 3. Training, Seminars, and Material 0.0 30.0 30.0 4. Miscellaneous Administration and 5.0 5.0 10.0 Support Costs 5. Transportation 0.0 10.0 10.0 6. Contingencies 100.0 30.0 130.0 Subtotal (A) 840.0 160.0 1,000.0

B. Government Financing

1. Office Accommodation 0.0 130.0 130.0 2. Secretarial Support 60.0 60.0 3. Remuneration and Per Diem 0.0 70.0 70.0 of Counterpart Staff 4. Communications 0.0 20.0 20.0 5. Training 0.0 40.0 40.0 6. Contingencies 0.0 110.0 110.0 Subtotal (B) 0.0 430.0 430.0 Total 840.0 590.0 1,430.0 a The technical assistance will be financed on a grant basis from the Asian Currency Crisis Support Facility and funded by the Government of Japan. Source: ADB estimates.