A review of the Financial Stability Report 2023

The annual Financial Stability Report (FSR) was launched on Feb. 13 at the BSP assembly hall under the auspices of the Financial Stability Coordination Council (FSCC), which consists of the BSP, which serves as the chair of the council, the Department of Finance (DoF), the Insurance Commission (IC), the Philippine Deposit Insurance Corp. (PDIC), and the Securities and Exchange Commission (SEC). The FSCC first convened in 2011, and its organization was institutionalized through Executive Order No. 144 under the Duterte administration.

In his opening remarks, Mr. Remolona said the FSR is “not a technical report, but a thematic narrative.” He also encouraged participants and stakeholders to get engaged in a continuing dialogue with the BSP and the FSCC about the elements of systemic risks that may be developing or are not yet visible.

The report was prepared by the Office of Systemic Risk Management (OSRM), headed by Senior Assistant Governor Johnny Noe E. Ravalo.*

The 2023 FSR consists of three chapters. The first chapter on macro environment is a review of global developments and the domestic economy. Most market participants are already familiar with the “recession that did not happen” in the major economies, despite the very strong consensus, even unusual unanimity, among economists and analysts of the major global financial market players.

In January last year, this author downloaded the economic and market forecasts of 13 major houses which predicted a certain recession in the US, and a “very likely” recession in Europe. In alphabetical order, these were — Apollo Global, Blackrock (world’s largest fund manager), BNP Paribas, BNY Mellon, Deutsche Bank, Citigroup, Credit Suisse, Fidelity, Goldman Sachs, HSBC, ING, JP Morgan, and Wells Fargo. The actual results confounded all predictions, and led The Economist magazine to ask, “how could so many be so wrong?”

The second chapter covered Financial Markets risks, starting with an overview of the global story, a discussion on the US dollar as a vehicle for interconnectedness, capital markets, and the local banking system.

The third chapter discussed “Understanding systemic risks” and “Moving forward into 2024.”

HOW SIMILAR TO PREVIOUS REPORTS, HOW DIFFERENT

The 2023 FSR has the same basic coverage as the previous year’s FSR with the three main themes on general macro environment, financial market risks, and interconnected risks. The 2023 report paid particular attention to the methodology of measuring liquidity risks as a critical component of a corporate health index. This is somewhat similar to the credit risk rating framework of credit rating agencies, albeit with a narrower focus on the so-called liquidity-seeking firms (LSFs).

While Mr. Remolona noted that the FSR is not a technical report but a thematic narrative, the report essayed a technical discussion on the fine details of the six parameters that make up the corporate health index beyond the usual indicators or Interest Coverage Ratio (ICR) and Earnings Before Interest and Taxes (EBIT) — short-term liquidity, cash ratio, unlevered free cash flow to short-term debt and probability of default. The approach gets even more esoteric with the discussion on normalizing data for better comparability via a Winsorized approach for handling extreme data points.

The report further extends the analysis of the LSFs corporate health index by using data at the firm level aggregated in a massive database to derive system-level indicators of liquidity stress. As the 2008 Global Financial Crisis showed, financial institutions and firms that are illiquid long enough become insolvent at some point. This phenomenon was sought to be captured in the Vercelli Liquidity-Solvency model.

On top of the Vercelli model, the report attempted to document the transmission of contagion effects from individual firms and from financial institutions to non-financial institutions, starting from separate layers of contagion. It also modeled the simultaneous effects of the stress on the system via a multi-level contagion map. This is substantive work to come up with an impressive framework in attempting to make sense of and identify trends that, hopefully, will prove its utility in the near future.

The extended discussion on measures of liquidity risks and corresponding contagion and network effects highlights key lessons — that liquidity is not about the size of the balance sheet as demonstrated in the rapid collapse of Silicon Valley Bank (SVB) in March 2023. The CEO of SVB notably lobbied strongly for SVB to be exempted from the rigorous rules of Sarbanes-Oxley on the grounds that at less than $200 billion in assets, it did not fall in the “too big to fail category.” In addition, sufficient capital is necessary but not sufficient to stave off collapse or ward off systemic consequences. Liquidity is key.

The financial markets section reiterated the obvious role of the US Dollar as a vehicle of interconnectedness, given its continuing role as a major reserve currency and primary currency for international trade. The erosion of the US dollar’s dominance in international trade finance has been well documented in the two years following the creative adjustments of various players to circumvent the US sanctions on Russia, but predictions about the tectonic shift towards the “dedollarization” of the global economy still seems to be premature.

The FSR discussion on capital flows highlighted the fact the funding of corporate needs in the Philippines still relies mainly on bank financing compared to the stock and bond markets. This is in stark contrast to the US and other Western markets with greater reliance on more developed capital markets. The continued reliance on bank funding is explained by the barrier to corporates of a higher threshold of information requirements to access the bond and stock markets.

Having a deeper capital market is obviously a desideratum, and “there is no doubt that a well-functioning capital market can only be beneficial.” This view, however, is tempered by a famous

statement by former Fed Chair Alan Greenspan that a “spare tire (the capital markets) is not necessary if we are sure that none of the running tires (rapid growth, available bank credit, low NPLs) will suffer a flat.” The net take away is that the funding requirements for economic growth are sufficiently provided meantime, although it is acknowledged that there is a lot of room for capital markets to fund incremental growth.

The report notes that the real estate or property sector is also monitored mainly because it is a barometer of economic activity. The real estate cycle of expansion, slowdown, recession, and recovery is mainly reflected in price trends as an indirect indicator of demand. However, the sector’s connection to the overall financial risk picture is not clearly spelled out.

Despite the surprises of 2023, the report concluded that the economy and markets appear to be in a “risk on” mode, market speak for an optimistic outlook driving market behavior. This trend of whether the market is in a risk-on or risk-off mode is reflected in the changes in the slope of the yield curve (two-year and five-year treasury yields). An inverted yield curve (where short-term rates are higher than longer-term) is considered a leading indicator of probable recession, coupled with a forecast of the price trends in the equities (stock) market which incorporates the expectation of corporate profits.

The report concluded that while a “risk on” environment presents opportunities, it is best to be ready for what BSP Governor Remolona refers to as the “risks of rosy scenarios,” and not fall into a trap of irrational exuberance. A proactive stance is needed, with a structured approach to systemic risk management.

*Link to full report here: FSR2023.pdf (bsp.gov.ph)

ALEXANDER C. ESCUCHA is president of the Institute for Development and Econometric Analysis, Inc. (IDEA), and chairman of the UP Visayas Foundation, Inc. (UPVFI). He is a fellow of the Foundation for Economic Freedom (FEF) and a past president of the Philippine Economic Society (PES). He wrote the Handbook on the Overview of the Banking Industry for the Bankers Association of the Philippines’ 60th anniversary in 2014. He is an international resource director of The Asian Banker (Singapore). alex.escucha @gmail.com