Financial Fragility

UNIVERSITY OF ASIA AND THE PACIFIC
A STUDY ON THE FINANCIAL FRAGILITY

OF PHILIPPINE UNIVERSAL AND COMMERCIAL BANKS
A Sector Analysis Paper

Presented to the
Faculty of the School of Economics
University of Asia and the Pacific
In Partial Fulfillment
of the Requirements for
Research Seminar II
Mentor:
Ms. Jovi C. Dacanay
Authors:
William Charles B. Galvez
Ren Matthew B. Lee
Raphael Angelo G. Salvador
SY 2014 2015
TABLE OF CONTENTS
Page
List of Tables v
List of Figures vi
List of Acronyms vii
Executive Summary viii
CHAPTER
I INTRODUCTION
A. Background of the Study 1
B. Statement of the Problem 3
C. Objectives of the Study 3
D. Significance of the Study 4
E. Scope and Limitations 6
F. Definition of Terms 7
II REVIEW OF RELATED LITERATURE

A. Financial Fragility, Financial Sector, and Economic
9
Growth
THEORETICAL FRAMEWORK, CONCEPTUAL

III FRAMEWORK, AND EMPIRICAL
METHODOLOGY
A. Theoretical Framework 16
B. Conceptual Framework 26
C. Empirical Methodology 27
PRESENTATION, INTERPRETATION, AND

IV
ANALYSIS OF DATA
A. Confirming the Presence of Financial Fragility among
37
UKBs
B. Effect of Financial Fragility to the UKBs
52
Profitability
C. Evaluating Impact of the Profitability of the Universal
60
and Commercial Banks to the Macroeconomy
SUMMARY, CONCLUSIONS, AND

V
RECOMMENDATIONS
A. Summary 68
B. Conclusions 71
C. Recommendations 74
APPENDIX
iii
A. Regression Results (Effect of Financial Fragility to
77
the UKBs Profitability, 2000Q1 to 2014Q4)
B. Regression Results (Effect of Financial Fragility to
78
the UKBs Profitability, 2000Q1 to 2009Q1)
C. Regression Results (Effect of Financial Fragility to
79
the UKBs Profitability, 2009Q1 to 2014Q14
D. Regression Results (Effect of Profitability of Banks to
the Gross Value Added of the Industry, 2000Q1 to 80
2014Q4)
E. Regression Results (Effect of Profitability of Banks to
2009Q1)
F. Regression Results (Effect of Profitability of Banks to
2014Q4)
BIBLIOGRAPHY 84
iv
LIST OF TABLES
Table Page
Variables used for the Theoretical Framework and Empirical

1 36
Methodology
2 Risk Premium from 1999Q1 to 2011Q4 and 2012Q1 to 2014Q4 50
Regression Results (Effect of Financial Fragility to the UKBs
3 52
Profitability, 2000Q1 to 2014Q4)
Regression Results (Effect of Financial Fragility to the UKBs
4 57
Profitability, 2000Q1 to 2009Q4 and 2009Q1 to 2014Q4)
Regression Results (Effect of Profitability of Banks to the Gross
5 61
Value Added of the Industry, 2000Q1 to 2014Q4)
Regression Results (Effect of Profitability of Banks to the Gross
6 Value Added of the Industry, 2000Q1 to 2009Q4 and 2009Q1 to 64
2014Q4)
v
LIST OF FIGURES
Figure Page
1 Equilibrium Level IS-LM & the Real Sector 18

2 Market for Loanable Funds 19
3 Industry on the saddle path 24
4 Conceptual Framework of the Study 26
5 Conceptual Map of the Empirical Methodology 35
Non-performing Loans Ratio (NPLR) of UKBs, First Quarter of
6
1999 to Fourth Quarter of 2014 38
Non-performing Loans and Gross Total Loans for UKBs, First 38
7
Quarter 1999 to Fourth Quarter 2014
Allowances for Credit Losses (ACL) for UKBs, First Quarter of
8 39
1999 to Fourth Quarter of 2014
Figure 8. Return on Assets (ROA) of UKBs, First Quarter of
9 40
1999 to Fourth Quarter of 2014
Cost-to-Income Ratio (CIR) of UKBs, First Quarter of 1999 to
10 41
Fourth Quarter of 2014
Gross Value Added of the Financial Intermediaries (FINGVA)
11 specifically Banking Institutions, First Quarter of 1999 to Fourth 42
Quarter of 2014
Non-performing Loans Ratio of ASEAN 5 (Indonesia, Malaysia,
12 43
Philippines, Singapore, and Thailand), 1999 to 2013
Comparison of Inflation Rate and Interest Rate of the
13 46
Philippines, 1999 to 2014
Scatterplot of Interest Rate and Inflation Rate and Real Total
14 47
Loans Universal and Commercial Banks
Scatterplots of Interest Rate, Return on Assets (ROA) and Real
15 49
Total Loans
16 Real Total Loans, Philippines 1999 to 2014 51
Actual, Fitted and Residual Graphs of ROA from 2000Q1 to
17 56
2014Q4
18 59
2009Q4
19 60
2014Q4
Actual, Fitted and Residual Graphs of FINGVA from 2000Q1 to
20 63
2014Q4
21 67
2009Q4
22 67
2014Q4
vi
LIST OF ACRONYMS
ACL Allowance for Credit Losses

ARCH Auto Regressive Conditional Heteroskedasticity
BSP Bangko Sentral ng Pilipinas
GDP Gross Domestic Product
GVA Gross Value Added
IMF International Monetary Fund
MECBD Monetary Equilibrium with Commercial Banks and
Defaults
NPAGA Non-Performing Assets to Gross Assets
NPL Non-Performing Loans
NPLR Non-Performing Loans Ratio
PNPL Provisions to Non-Performing Loans
ROA Return on Assets
UKB Universal and Commercial Banks
vii
EXECUTIVE SUMMARY
The research dwells on the impact of financial fragility of Philippine
Universal and Commercial Banks to their profitability and contribution to the
macroeconomy. It seeks to confirm the existence of financial fragility in the major
segment of Philippine Banking Sector and to determine the behavior of the banks
in response to the fragility, which consequently affects their performance in the
sector and in the whole economy.
The study takes into account the concept of credit risk and credit rationing
to further understand financial fragility. With these principles, the necessary
procedures to be taken were identified to answer the objectives of the study.
Looking through certain macroeconomic and bank-level data helped in verifying
the presence of fragility and utilizing the appropriate econometric tool were done
to come up with significant findings and computations in giving answers to the
study.
The results in the study show interesting conclusions about the financial
fragility in the Philippines. Basically, banks take into account the presence of
fragility, as indicated by non-performing loans, in the Philippine Financial System
through their monitoring system. In their consideration of financial fragility,
banks employ certain strategies and techniques in order to maintain a certain level
of fragility. Aside from their monitoring scheme, the profitability level banks
want to achieve are attained through other means to generate income like external
risk financing. Moreover, these other means of earning profits are being reflected
viii
in the contribution of the sector to the macroeconomy, through its gross value
added.
With the findings of the study, the researchers suggest undertaking further
studies on financial fragility by incorporating other bank-level indicators such as
risk assets and capital measures, which are significant elements when it comes to
banking stability. Banks may also focus on further assessing or screening their
existing and potential borrowers to further mitigate the risks connected to
financial fragility.
ix
CHAPTER I
INTRODUCTION
A. Background of the Study
For the past years, the Philippine Banking System has undergone different
developments and challenges, which define its current status today. The changes
that it experience mainly depends on the economic events, locally and
internationally. Some of these events, which may be considered as key drivers for
the changes and developments in the banking system, include the Asian Financial
Crisis and Financial Liberalization. The experience on the Asian Financial Crisis
made the country, alongside with its ASEAN neighbors to come up with policy
reforms and economic changes that will strengthen the banking system for better
management and for lesser vulnerability. 1 At the same time, the financial
liberalization led banks in this part of the world to achieve steady progress since
the year 2000 and to aim greater capital accumulation, among other
consequences.2
As the Philippine banking system continuous to become more complex
due to different societal events, one of the pressing concerns of banks in
developing countries nowadays is financial instability. Financial instability refers
to the inability of the financial system to perform its essential function of
channeling funds to those individuals or firms that have productive investment

1
Gochoco-Bautista, Ma. Socorro. "The Past Performance of the Philippine Banking Sector and
Challenges in the Postcrisis Period." Asian Development Bank 30-73
2
Guinigundo, Diwa. "The Philippine Financial System: issues and challenges."
1
opportunities thereby causing the economy to operate inefficiently and hampering
growth in the economy. Thus, since in the present, the dichotomy between the
financial sector and real sector has already been removed, that is, a failure in the
financial system can directly cause adverse effect on the real sector which can
cause recessions, (as given in the U.S. Financial Crisis of 2008, etc.) it is very
relevant and timely to study financial instability. Hence, this paper seeks to
examine the concept of financial fragility to reflect the instability of the Philippine
financial sector since financial fragility is an indicator of the vulnerability of
financial system to external shocks3. Thus, the underlying concept that serves as
the foundation of the research is financial fragility. In fact, the study underscores
the relevance of the concept of financial fragility in measuring the current footing
of universal banks in the Philippines relative to its resiliency against external
shocks. Since in a developing country, as what Freixas and Rochet claim, where
the financial institution is not fully developed, the measurement of financial
fragility is fitting to assess the financial stability of banks and the borrowers,
which could be susceptible to financial failures and bank crisis.4
In addition, this paper tackles the efficiency of the universal banks in
relation to the concept of financial fragility. Especially since, determining banks
efficiency is important to be taken into consideration nowadays as the Philippine
financial sector face tighter competition with the entry of foreign banks in the
country because of greater exposure to globalization. This is also significant since

3
International Monetary Fund (1998), Chapter IV: Financial crises: characteristics and
vulnerability, World Economic Outlook, Washington DC
4
Freixas, Xavier, and Jean-Charles Rochet. Microeconomics of Banking. 2nd. Cambridge,
Massachusetts: Massachusetts Institute of Technology, 2008.
2
banking efficiency could help in determining the banks financial stability or
fragility.
Thus, having a better understanding of how stable or fragile the banks are
in the Philippines should help determine its vulnerability to different economic
challenges or shocks in the future. Consequently, having a deeper knowledge of
unstable financial system is very vital to the Philippine economy because it will
serve as a precursor for the government to employ prudent crisis management,
prevention, and regulation of the financial system.
B. Statement of the Problem
The research study will endeavor to answer the main question: How is the
banking sectors profitability and contribution to the macroeconomy affected by
financial fragility in the Philippine Financial Sector?
C. Objectives of the Study
At the end of the study, the researchers would like to:
1. Verify the presence of financial fragility in the universal and commercial
banks (UKBs) in the Philippines through different indicators.
2. Determine the effect of financial fragility to the profitability of banks
through the appropriate econometric tool.
3. Assess the influence of financial fragility and profitability of UKBs in the
Philippines to the contribution of the sector to the economy.
3
D. Significance of the Study
The study presents several importance to the Philippine economy,
especially to the Philippine banking system and monetary sector for more well
informed and sound decision-making among firm owners, policymakers, investors
and other stakeholders. Primarily, the research study is significant because it deals
with banks which function as one of the main engines that spur economic activity
in a country. More specifically, this research study deals with universal banks,
which offer extensive financial services of both commercial and investment
banks.5
Moreover, this study is relevant primarily because it aims to give an
assessment of the current situation of the Philippine universal banks concerning,
credit rationing, fragility, capitalization, and efficiency from 1999 to 2014. The
study will be highly relevant in the domestic economic sphere since it will
endeavor to verify the existence of financial fragility and credit rationing which
can all be contributory to the worsening or easing of financial vulnerability of
Philippine universal banks relative to external shocks. Thus, it will also shed light
as to how banks profit despite the existence of such financial fragility. Hence, this
study will largely be beneficial to the bank owners and managers, investors, and
policymakers.
This is essentially important among bank owners and managers as they
will be better equipped to assess the performance of their banks to help them
better shape up to make their financial firms more stable and stronger amidst

5
Ng, Thiam Hee. "Asian Development Blog." Banking Integration in ASEAN Gathers pace.
August 29, 2014. Accessed December 11, 2014.
4
different economic circumstances. Specifically, the study will help enlighten bank
owners and managers concerning the presence of financial fragility, its indicators
and its implications to the financial system. That is to say, determining the
intensity of the adverse effects of the indicators will also contribute to identifying
which of those indicators the bank owners and managers should focus more on
curbing in order to avoid a financial crisis.6 Thus, the paper should give an idea as
to how bank owners and managers can stabilize their banks to avoid any
unfortunate financial meltdowns ahead as well as earn enough profits to sustain
the stable financial system.
In addition, this study may provide the policymakers, specifically the
Bangko Sentral ng Pilipinas (BSP), an idea of the current footing of Philippine
universal banks in terms of financial vulnerability to crisis, capitalization, and
efficiency. Moreover, some indicators of financial fragility will be examined and
thus it should help BSP to be more informed for more effective monetary policy
regulation and prevention. Thus, this enables the policy makers to have a more
accurate measure of the progress/decline of Philippine universal banks, which
could result in possible policy changes or improvements to the current governing
banking policies for the betterment of the industry thereafter.
For the investors, this study will provide information on the vulnerability
of Philippine universal banks to bank crisis in the present. Thus, it will give them
a better assessment on the level of risks on their investment ventures into the

6
Mullineux, Andrew, and Victor Murinde. Handbook of International Banking. Northhampton,
Massachusetts: Edward Elgar Publishing Limited, 2003.
5
Philippine banking industry. The paper shall also serve to be useful, as it would
help them make sound financial and investment decisions.
E. Scope and Limitations
This research study will focus on verifying the existence of financial
fragility in the Philippine financial system and how UKBs cope up in terms of
maintaining profitability to keep the financial system afloat. Hence, such
endeavor shall be accomplished by looking at the performance of the UKBs from
1999 to 2014 together with the use of appropriate economic tools. Moreover, this
time period was chosen as a way of capturing the significant financial
undertakings such as recessions as well as monetary policy changes in the
financial system at large. In addition, the researchers selected UKBs since these
banks take majority of the share for the banking sector, showing their very
significant influence to the sector. Thus, other types of banks present in the
country will not be discussed. Moreover, greater focus will be given on the
behavior of UKBs as to how they maintain their profitability amidst the presence
of fragility in the system. Consequently, the measures employed by UKBs as to
how they are able sustain their profitability will be given as much focus in the
study. In addition, the corresponding implications such measures by UKBs, and
how it affects the performance of the Philippine financial sector will be covered.
6
F. Definition of Terms
1. Broad Lending Channel - This channel takes into account the role of the
banking system in a context of asymmetric information. Thus, it considers
the external finance premium, defined as the wedge between the cost of
funds raised externally and the opportunity cost of internal funds, as an
essential key in the understanding of the transmission mechanism.
2. Collateral Constraints It occurs when the collaterals offered by
borrowers to banks tend to be inconvertible to cash.
3. Commercial banks - A financial institution that provides services, such as
accepting deposits, giving business loans and auto loans, mortgage
lending, and basic investment products like savings accounts and
certificates of deposits.
4. Credit Rationing It occurs whenever some borrowers demand for credit
is turned down, even if this borrower is willing to pay all the price and
non-price elements of the loan contract.
5. Deposits A transaction involving a transfer of funds to another party for
safekeeping.
6. Bank Efficiency Ratio It is a measure of a bank's overhead as a
percentage of its revenue
7. Financial Fragility the financial system's susceptibility to large-scale
financial crises caused by small, routine economic shocks. When
substantial default of a number of households and banks (i.e. a liquidity
crisis), without necessarily becoming bankrupt, occurs and the aggregate
7
profitability of the banking sector decreases significantly (ie a banking
crisis).
8. Inflation The rate at which the general level of prices for goods and
services is rising, and, subsequently, purchasing power is falling.
9. Interest Rate - The amount charged, expressed as a percentage
of principal, by a lender to a borrower for the use of assets.
10. Loans It is generally the act of giving money, property or other material
goods to another party in exchange for future repayment of the principal
amount along with interest or other finance charges.
11. Non-performing Assets - A debt obligation where the borrower has not
paid any previously agreed upon interest and principal repayments to the
designated lender for an extended period of time.
12. Non-performing Loans A sum of borrowed money upon which the
debtor has not made his or her scheduled payments for at least 90 days or
loans that is either in default or close to being in default.
13. Return on Assets An indicator of how profitable a company is relative to
its total assets.
14. Risk Premium - The return in excess of the risk-free rate of return that an
investment is expected to yield.
15. Total Assets The sum of current and long-term assets owned by
a person, company, or other entity.
16. Universal Bank - A banking system in which banks provide a wide variety
of financial services, including both commercial and investment services.
8
CHAPTER II
REVIEW OF RELATED LITERATURE
Different studies and literatures have been written regarding the
phenomenon of financial fragility. Hence, the studies and literatures found, which
are related to the study have provided ideas that aided in the formulation of
research objectives.
A. Financial Fragility, Financial Sector, and Economic Growth
According to Tsomocos7, the recent major financial crises such as, Japans
liquidity trap throughout the 1990s, United Kingdom in the early 1990s, Mexican
financial Crisis in 1995, East Asia in 1997, US 2008 Financial crisis have evoked
renewed interest in studying financial instability. Its origins, propagation
mechanisms, macroeconomic consequences and ultimately its containment are
some of the issues that have recently attracted attention. Furthermore, according
to International Monetary Fund (IMF) report (World Economic Outlook 1998)
while external events may contribute to or precipitate a crisis, a countrys
vulnerability to a crisis depends on domestic economic conditions and policies,
such as, over-borrowing for unproductive uses, a fragile financial sector, or an
inflexible exchange rate system. Thus, according to the IMF report, it is clear that
a financial fragility of the banking sector is an indicator of vulnerability of the

7
Tsomocos, Dmitrius. Equilibrium Analysis, Banking, Contagion and Financial Fragility. Bank
of England Working Paper No. 175. 2003.
http://www.bankofengland.co.uk/archive/Documents/historicpubs/workingpapers/2003/wp175.pdf
(Accessed January 28, 2015.
9
financial sector to financial crisis. Thus, in relation to that, Tsomocos discussed
the same concept namely financial fragility in his paper, and characterized it as,
having the aggregate profitability of the financial sector diminished significantly
over time without necessarily having the borrowers at bankruptcy.
Moreover, Freixas and Rochet8 claims, where the financial institution is
not fully developed, the measurement of financial fragility is fitting to assess the
financial stability of banks and the borrowers, which could be susceptible to
financial failures. In line with this, Lagunoff, and Schreft define financial fragility
as the financial system's susceptibility to large-scale financial crises caused by
small, routine economic shocks. Bernanke and Gertler describes a financially
fragile situation as having a substantial underinvestment, misallocation of
investment resources, and possibly even a complete investment collapse in an
economy due to a very weak balance sheets of the banks. Hence, a weak balance
sheet of the banks entails more collection of non-performing loans than
performing loans, given that, loans is the main product of financial institutions in
developing countries.
As Bernanke and Gertler suggest, financially fragile situation is one where
in the borrower or investor has low wealth or net worth relative to the size of his
project that is assumed to be financed by the bank and such situation leads to high
agency costs and to poor performance in the investment sector and the economy.
The lesser the borrowers net worth relative to his project is, the lesser likely he
can contribute to the funding of his investment project which consequently put the

8
10
banks in a fragile situation. For that reason, financial fragility can be represented
by high level of accumulation of non-performing loans presumably from such
investors with low net worth relative to their investment projects.
Furthermore, financial fragility among banks, in the case of the study
universal banks, can affect how the real sector relates to the financial sector. The
real sector makes use of these financial institutions and intermediations for safe-
keeping, which will be influenced by how these banks perform in their operations.
For instance, if a bank is known to have a huge amount of non-performing loans,
which may be a cause for its vulnerability to a default or bankruptcy, firms from
the real sector will not invest or utilize such bank for their transactions.
In line with that, Minsky, as cited by Tymoigne, defined financial fragility
as the robustness or fragility of the financial system depends upon the size and
strengths of margins of safety and the likelihood that initial disturbances are
amplified. Initial disturbances come from defaults, rising interest rates,
disruption in refinancing sources, a natural disaster, or any other shocks that
affect either the cash inflow or cash outflow of an economic unit.9 The economy,
especially financial institutions like banks, will be vulnerable with these
disturbances if they have small asset size or if they are accumulating high level of
non-performing loans, thus making them inefficient. Hassan, Chan and Karim10,
found out that higher accumulation of non-performing loans reduces the
efficiency of banks. Hence, it presented data that affirms how high level of

9
Tymoigne, ric. "Measuring Macroprudential Risk through Financial Fragility: A Minskyan
Approach." (Levy Economics institute) April 2012.
10
Karim, Mohd, Sok-Gee Chan, and Sallahudin Hassan. "Bank Efficiency and Non-Performing
Loans: Evidence from Malaysia and Singapore." Prague Economic Papers 2 (2010): 118-32.
11
accumulation of non-performing loans eroded capital of Malaysian and
Singaporean banks during the Asian crisis, which curbed growth and innovation
for such consequently. Thus, one begs the question just how high accumulation of
non-performing loans affects the efficiency of banks? Hassan et. al. claim that
high-level accumulation of NPL incurs additional operating costs for the banks.11
That is to say, there would be additional costs such as additional monitoring of
the delinquent borrowers and the value of their collateral, the expense of
analyzing and negotiating possible workout arrangements, the cost of seizing,
maintaining, and eventually disposing of collateral if default later occurs, and the
diversion of senior management attention away from solving other operational
problems. In other words, by measuring the level of accumulation of non-
performing loans (NPL) relative to Return on Assets (ROA), it will facilitate for
the determination of the fragility or stability of universal banks in the Philippines,
as the measurement of NPL will give an idea as to how much of the banks
products namely the loans, has become inefficient or non-performing.
Furthermore, the aforementioned disturbances may be attributed to the
imperfections in the financial markets like asymmetric information, which can
eventually lead to inefficient channeling of resources to investment. 12 The
inefficiency present may affect the aggregate macroeconomic activity.
Bernanke and Gertler, as cited by Freixas and Rochet, came up with a
model and related it to one-good in one-period general equilibrium model with an

11
Ibid.
12
12
infinite number of risk natural agents.13 Financial fragility is very much related to
the financial structure existing in the economy. Thus, a strong and solid financial
structure may become firm and may be able to keep itself away from the fragility.
This is where the idea on efficiency comes in. A strong financial structure may be
characterized by good quality of financial services that would lead to a higher rate
of growth. In this case, higher banking efficiency, which may significantly be
attributed to services, lead to its better performance and eventually lead to
economic growth.14
In recent years, a growing literature has explored the role of finance for
economic growth. Indeed many would assert that the financial institutions have a
huge positive effect on the growth of an economy. Evidently, such is the case in
the United States, where the financial system is critical to the functioning of the
economy as a whole and that banks are central to the financial system15. Hence, in
the same study they also claim that, financial institution not only provides
substantial employment to the U.S. economy but also serves its vital purpose
namely credit provision, which stimulates the economy. For instance, financial
institution enables credit provision which means that it allows businesses to invest
beyond their cash on hand, allows for households to purchase homes without
shelling out the entire cost in advance, both of which fuels private investment
spending and consumption in the economy. Financial institution also through its
credit provision enables government to smooth out their spending by mitigating

13
Ibid.
14
Ibid.
15
Baily, Martin Neil, and Douglas J. Eliott. "The Role of Finance in the Economy: Implications
for Structural Reform of the Financial Sector." (The Brookings Institution) July 2013.
13
cyclical pattern of tax revenues and to invest in infrastructure projects, which also
fuels Gross Domestic Product (GDP) of an economy. Moreover, different cross-
country studies provided convincing evidence. For example, King and Levine
employ data on 77 countries over the period 1960-1989, to document that the
level of financial development really determines long-run economic growth,
capital accumulation, and productivity growth.16 Levine and Zervos, as stated by
Cheng and Degryse, refine this and find that initial stock market liquidity and
banking development are both positively correlated with future rates of economic
and productivity growth in a sample of 42 countries over the period 1976-1993.17
Moreover, finance spurs economic growth, as the case in China, which shows that
even in a country with high growth rate, financial institution still fuels the growth
of the economy significantly.18 Cheng and Degryse employed data of 27 Chinese
provinces over the period 1995-2003, to study whether two different types of
institutions, banks and non-bank financial institutions have a significantly impact
on local economic growth. Thus, the findings show that banks outperform non-
bank financial institution and only bank loans exert a statistically and
economically significant positive impact on local economic growth, which
becomes more pronounced when the banking sector is less concentrated.19 Hence,
it can be established that financial institution drives up economic growth in the
economy and hence a positive correlation between economic growth and financial

16
King, R.G., and R. Levine. "Finance and Growth: Schumpeter Might Be Right." Quarterly
Journal of Economics, 1993.
17
Levine, R., and S. Zervos. "Stocks, Markets, Banks and Economic Growth." American
Economic Review 88 (1998): 537-558.
18
Cheng, Xiaoqiang, and Hans Degryse. "The Impact of Bank and Non-Bank Financial
Institutions on Local Economic Growth in China."
19
Ibid.
14
institution can be observed as evident in the discussion above. On the other hand,
it can be deduced that a financial instability should have an accordingly negative
implication on the economy to reinforce the established positive correlation
between economic growth and financial institution. Thus, according to a study by
Hakkio and Davig, financial instability recently pushed the U.S. economy into its
most severe recession since the Great Depression and that the experience of the
US and other countries has shown that businesses and households often pull back
on new investments and purchases in response to the tighter credit conditions and
greater uncertainty caused by financial stress. They also found out that over the
last two decades, increases in financial instability have had a much stronger effect
on the real economy. Thus, they came to the conclusion that when financial
instability is low, financial markets operate smoothly which once again affirms
the positive correlation between economic growth and the financial institution.20

20
Davig, Troy, and Craig Hakkio. "What Is the Effect of Financial Stress on Economic Activity?"
(Federal Reserve Bank of Kansas City) 36-62.
15
CHAPTER III
THEORETICAL FRAMEWORK, CONCEPTUAL FRAMEWORK AND
EMPIRICAL METHODOLOGY
A. Theoretical Framework
This particular study on the Philippine Financial Sector is founded on the
concept of Financial Fragility. Various attempts have been made in order to
clearly explain the theory. However, the study utilizes Tsomocos understanding
of the concept since it applies to the financial system in the country. Tsomocos
definition of financial fragility is as follows: When substantial default of a
number of households and banks (ie a liquidity crisis), without necessarily
becoming bankrupt, occurs and the aggregate profitability of the banking sector
decreases significantly (ie a banking crisis). He discussed that, amidst the
presence of a considerable amount of defaults in the economy, monetary
equilibrium with commercial banks and default (MECBD) exists. In this case,
financial fragility in the financial sector is present along with orderly functioning
markets, characterized by banks sustaining themselves through gains from trade
in the economy or profit generation but not at the maximum level. The presence
of an inactive and an incomplete asset markets structure is also considered in this
model. Mishkin, as cited by Tsomocos, also provided a concept of fragility,
which goes, Financial instability occurs when shocks to the financial system
16
interfere with information flows so that the financial system can no longer do its
job of channeling funds to those with productive investment opportunities.21
Banks resort to the concept of credit rationing to take into consideration
financial fragility. Credit rationing refers to the situation where banks control the
amount of loans firms or individuals, depending on their creditworthiness,
through higher or lower interest rates. With credit rationing, at least two
equilibrium lending rates are provided to borrowers to address the amount of
loans they are willing to pay and their assumed paying capacity by the banks. This
serves as a banking measure, which foresees the possibility of defaults among
borrowers. No single equilibrium rate is implemented since borrowers have
different needs and ability to pay and a positive residual demand at R > R1 will
occur, which will decrease the level of profitability of banks.22 Figure 2 shows the
market for the loanable funds, depicting credit rationing among banks. Arnold and
Riley (2009) tested the possibility of credit rationing in the Stiglitz-Weiss Model,
as shown in Figure 2 below.
The MECBD is an equilibrium level that is not at full-employment and
Pareto optimal given the conditions it possesses. Thus, this equilibrium level is
dissimilar to the Neoclassical Model showing full-employment and that is Pareto-
optimal, as presented in Figure 1. In this model, the interest rate mechanism
works in a set-up with perfect information. The real sector experiences full

21
Tsomocos, Dmitrius. Equilibrium Analysis, Banking, Contagion and Financial Fragility. Bank
of England Working Paper No. 175. 2003.
http://www.bankofengland.co.uk/archive/Documents/historicpubs/workingpapers/2003/wp175.pdf
(Accessed January 28, 2015.
22
Arnold, L. & J.G. Riley. On the Possibility of Credit Rationing in the Stiglitz-Weiss Model.
American Economic Association. 99, no. 5 (2009): 2012-2021. Accessed March 20, 2015.
17
employment, wherein the price of goods is equal to the marginal rate of
substitution and marginal rate of technical substitution.
Figure 1. Equilibrium Level IS-LM & the Real Sector
Source: Kronovich, R. Slides for Chapter 3 of Macroeconomics

From Mankiw, G. Macroeconomics. 7th edition, 2010
This level of equilibrium in MECBD is described wherein the industry is
on a saddle path as shown in Figure 3, adapted from Romer (2012).
18
Figure 2. Market for Loanable Funds
R3
R1
r = V(R1)
R2
V(R2)
G( (R2))
Source: Arnold, L. & J.G. Riley (2009), On the Possibility of Credit Rationing in the
Stiglitz-Weiss Model
In the figure above, it can be seen that with credit rationing, banks do not
lend at a single rate, V(R). The lowest loan rate is V(R2) and is loaned only to
firms having an expected level of capital of G( (R2)). If the interest rate
mechanism would have prevailed under the assumption of perfect information, a
lower level of expected capital would have been required by banks, which is the
level of expected level of capital intersecting the liquidity preference line.23 With
credit rationing practiced across the entire financial system, a higher interest rate,
V(R1), is charged by banks to some firms, the same interest rate is charged to
firms with a higher level of aggregate capital stock. Note that this interest rate is
charged whether the economy is at a low or high level of aggregate capital stock.
Despite efforts to rigorously monitor the credit standing and history of borrowers,
the financial system faces loan defaults depleting their supply of loanable funds.

23
Ibid.
19
Banks resort to external financing, which are charged a risk premium. This
explains why banks have to resort to lending at a higher than equilibrium interest
rate. At a loan rate of V(R2), banks can expect high level of returns to borrowers
who end up winners resulting to a much higher level of expected capital revenue,
or, if borrowers end up losers, banks would expect a lower level of capital
revenue.
The theoretical formulation of Arnold and Riley (2009) is achieved
through capital adjustments resulting to equilibrium that is non-Pareto optimal. It
is therefore important to understand how banks adjust their loanable funds at the
appropriate interest rate. They have to make sure that profits (i.e. marginal
revenue of capital) are attained. Using the loanable funds given by banks, as
indicator of capital, banks either become stringent or lax as to the amount of
loanable funds. They can lend to borrowers in a situation wherein borrowers use
collateral, working as an indicator of their capacity to repay their loans.
In this context, we are relating K (loanable funds) with the interest rate
charged to borrowers as one proxy for the real interest rate. The dynamic path of
K as is used in this paper can explain the behavior of bank lending.
The dynamic path of capital, also termed as Tobins q, as is used in this
paper is based on Romer (2012). The basis for the optimal level of the marginal
revenue of capital at any period t [(K(t))] is equal to the user cost of capital. The
marginal revenue of capital refers to the left hand side of Equation 1. The user
cost of capital, referring to the right hand side of the equation 1, would depend on
the manner in which the present value of capital fluctuates or oscillates from the
20
stable combination of capital stock and returns from capital. The present value of
capital would depend on the interest rate charged by banks, and, the returns to
capital would be indicated by profits.
(()) = () () (1)
In the context of banks with credit rationing, the present value of profits
(q), will determine its investment decisions in the future, which will affect its
profitability. Given its financial resources at present, the banks will move or will
adjust its loans and risk premium or the raise to its interest rates to eventually
attain the certain level of bank performance it wants to achieve. This appears to be
part of the banks monitoring scheme of loans and external risk financing.
In attaining a certain level of profitability, banks take into account
uncertainty as described by the equation below, that is, the expected change of the
present value of capital with respect to time is equal to the real revenue of the firm
less the marginal revenue of capital.
= (2)
Where:
r real interest rate
q(t) present value of capital
(K(t)) marginal revenue of capital
expected change of the present value of
capital
This equation describes the pathway present value of capital across a time
period t, taking into account fluctuations in prices and the various adjustment
processes happening in the monetary sector.
21
In a financial system, where credit rationing is system-wide, it is important
now to model why an equilibrium level of interest rate is achieved despite having
two types of borrowers (i.e. those who can and cannot repay).
Given the aggregate quantity of capital, K (also called initial endowments
of banks), and q is its present value, the unique equilibrium level is attained, when
changes in the aggregate level of capital through time, moves along a certain
level of q that produces a stable path, and moves up to the point so that the rate
of change of = 0. These are areas II and IV of Figure 3. The figure below
shows the Ramsey model, in which, there is a unique level of q such that K and q
converge to the point where they are stable (Point E in the diagram). The
disequilibrium portions of the path of = (t) are as follows. If q starts below
point E, for example, q < 1, and is in area III, the industryin the case, banking
sectoreventually crosses into the region where both K and q are falling, and
they then continue to fall indefinitely. In other words during periods of
macroeconomic uncertainty, when the present value capital is below its initial
value, and the company is experiencing a depletion of capital stock, it is likely
that firms do not borrow and invest, return on assets are maintained at very low
levels. This event would not allow a firm to repay its loans, eventually causing
them to default. Similarly, if q starts higher than point E, for example, q > 1, and
is in area I, the industry eventually moves into the region where both K and q are
rising and remains there. In other words during periods of macroeconomic
uncertainty, when the present value of capital is much higher than its initial value
and the company is increasing its capital stock, it is likely that firms borrow and
22
invest in such a way that return on assets are maintained at high levels. This event
causes fluctuations and volatilities in the companys present value of capital. In
area II, the present value of K is higher than its initial value where q > 1 but
depletion of capital stock is being experienced by the industry. This will lead the
firms in this area to borrow in order to equalize of the depleted capital stock
maintain the desired return on assets. Hence, in periods of macroeconomic
uncertainty, when the present value of capital is above its initial value but the
firms experience capital stock depletion, loans and investments will be made to be
address the depletion of capital stock and to be in the equilibrium level in the
long-run. With area IV in which q < 1, the present value of K is lower than its
initial value. However, its capital stock is increasing. In this case, the industry
might want to borrow less to keep the level of return on assets it actually
experiencing. Therefore, at times when the initial value of capital is greater than
the present value along with the increase in capital stock of the firm, lesser
borrowings and investments have to be done to sustain the certain level of return
on assets and to avoid going beyond the targeted return on assets.
23
Figure 3. Industry on the saddle path
II
IV
III
Source: Romer, David (2012). Advanced Macroeconomics. 4th Edition
In other words, the stable path of the changes in the present value of
capital occurs when the company is experiencing an increase in capital stock but
the present value of capital is below its initial level, as in area IV. In this case,
companies will borrow less. In another case, from which the company can borrow
more, the company is decreasing its capital stock but the present value of capital
is increasing as in area II. Both these instances will allow the marginal revenue of
capital, as indicated by ROA to stabilize at a certain level.
In relation to the bank, a certain level or bandwidth of ROA is targeted by
banks to sustain the operations. It does not require having a level of profitability
that is beyond the certain range it follows. This also means that banks just allow a
certain level of loans due to the possibility of defaults and do not engage in
24
allowing a high amount of loans even if these are assured to be performing and its
borrowers are creditworthy. At the same time, banks do not prefer a lower amount
of loans since this might weaken the banking profitability and performance.
Banks try to make sure that they are moving towards an equilibrium level.
Equilibrium level is measured through the return on assets or the marginal
revenue of capital ((K(t)). To be able to have the certain level of profitability to
achieve equilibrium, firms, and banks in this case, consider the Tobins q. Romer
stated that:
Our analysis of the firms maximization problem implies that q

summarizes all information about the future that is relevant to a
firms investment decision. [The] q shows how an additional
dollar of capital affects the present value of profits. Thus the firm
wants to increase its capital stock if q is high and reduce it if q is
low; the firm does not need to know anything about the future
other than the information that is summarized in q in order to
make this decision.24
In relation to achieving profitability, banks make sure that their
investment, through the external risk financing, holds a greater value more than its
cost. This is described by Romers analysis below:
Our analysis so far appears to imply that uncertainty has no

effect on investment: firms invest as long as the value of new
capital exceeds the cost of acquiring it, and the value of that
capital depends only on its expected payoffs. But this analysis
neglects the fact that it is not quite correct to assume that there is
exogenous uncertainty about the future values of (K). Since the
path of K is determined within the model, what can be taken as
exogenous is uncertainty about the position of the () function;
the combination of that uncertainty and firms behavior then
determines uncertainty about the values of (K).

24
Romer, David. "Investment." In Advanced Macroeconomics. New York: McGraw-Hill
Companies, 1996.
25
In this case, banks appear to achieve its future profitability by making sure
that it is incorporating the necessary factors like the value of its marginal return of
capital (ROA) and the user costs. Unless certain unexpected factors arise, the
banks follow this principle to attain the profitability they are expected to attain.
B. Conceptual Framework
To have a better understanding of the theoretical framework, the figure
below presents the conceptual framework. This will serve as a guide through the
course of the research study.
The figure below presents the theoretical framework and its relation to the
banking sector. This is going to be verified through certain empirical models.
Specifically, through certain indicators from the Philippine UKBs, the researchers
will be able to identify the presence of financial fragility and how it affects the
profitability of the banks and its effect on the macroeconomy.
Figure 4. Conceptual Framework of the Study
26
C. Empirical Methodology
To be able to answer the research objectives, several tools will be used.
The theoretical framework will also be confirmed within the context of the study,
specifically in the Philippine UKBs setting.
Several underlying principles must also be taken into account to better
understand the scenario of financial fragility, which serve as factors affecting this
phenomenon. Since defaults are considered as a given, the risks connected to it
are also noted specifically credit risk. This is the type of risk associated with the
loss incurred due to the inability of a borrower to pay a loan or its obligations.
Increasing the level of this risk makes a system more financially fragile and the
inability to control the risk can lead to the failure of the whole banking system.
Banks also make use of collaterals to prevent defaults among households and
banks. However, instances occur when the collaterals offered tend to be
inconvertible to cash, which refers to collateral constraints. This situation
stagnates the banking liquidity, which may lead to a liquidity trap and ultimately
increasing financial fragility. Moreover, the level of efficiency is negatively
related to non-performing loans, which indicates fragility. Cajueiro, Craveiro and
Tabak concluded financial fragility is that that there are strong evidences that a
low cost efficiency may result in greater vulnerability, given that such bad
performance should be related to an increase in the system credit risk25.
The researchers collected data of the UKBs from the BSP. The data
obtained were needed in order to answer the three main objectives of the study.

25
Tabak, B., Giovana L. C. and Daniel O. C. Bank Efficiency and Default in Brazil: Causality
Tests. Banco Central do Brasil Working Paper Series No. 253. 2011
27
To be more specific, quarterly data from 1999 to 2014 were gathered, providing
64 observations for the following variables: return on assets (ROA), non-
performing loans ratio (NPLR), allowance for credit losses (ACL), cost-to-income
ratio (CIR), non-performing assets to gross assets (NPAGA), real GDP, inflation
rate, and gross value added (GVA) of the banking institutions under financial
intermediaries.
To identify how financial fragility is present in the Philippines,
determining the level of certain variables namely, return on assets, non-
performing loans ratio, allowance for credit losses, cost-to-income ratio, non-
performing assets to gross assets, and gross value added of the banking
institutions from 1999 to 2014 must be done. The trends of these variables will be
analyzed through line graphs in order to determine the existing of financial
fragility in the Philippines. This will also prove that the Philippines is in a state of
MECBD. These data will also be compared to those of Indonesia, Malaysia,
Singapore and Thailand to compare the level of fragility in the Philippines and to
see the difference in the development of the financial sector.
In answering the second objective, multiple regression analysis will be
used in order to identify how the return on assets, the measure of profitability of
the UKBs, move given the variables included in the model. This is based on the
study of Toby (2009) on profitability. Tobys study on the profitability of banks
took into consideration financial fragility, indicated by NPL. In a more in-depth
understanding, Toby tried to relate profitability, indicated by ROA, to NPLR and
the provisions to non-performing loans (PNPL) through an empirical
28
methodology, specifically an estimation of a multiple regression model.
Interestingly, the study found out that growth of NPLR is less than the growth of
the ROA. This finding shows that banks have taken into account this risk in
targeting a specific ROA. To achieve their target ROA, adjusting the level of
provisions is significant given the NPLR these banks expect to obtain in a
particular time period.26 This is the basis of the one of the objectives of the study.
For the study, Equation 3 below is used to explain the behavior of the
banks ROA. To explain the behavior of the return on assets, bank-level indicators
and several macroeconomic variables namely real GDP and interest rate were
utilized. This will determine whether the marginal revenue of capital, as indicated
by the ROA, in the theoretical framework moves towards the equilibrium level
depending on how banks ROA behave, in anticipation of Financial Fragility.
= (, , , , , , ) (3)
Where:
ROA Return on Assets
REALGDP Real Value of the Gross Domestic Product
INTERESTRATE Interest Rate
CIR Cost-to-Income Ratio
NPLR Non-performing Loans Ratio
ACL Allowance for Credit Losses
NPAGA Non-performing Assets to Gross Assets
In connection to this, Tobys conclusion confirms Bernanke and Gertlers
concept of Financial Fragility. The idea that banks have considered some
borrowers will default is a signal of their awareness of financial instability. This is

26
Toby, Adolphus. Modelling Financial Fragility and Bank Profitability in an International
Context. International Journal of Business Insights and Transformation. August 2011-September
2011, Vol. 4, Issue 2.
29
based on the perception of financial fragility of Bernanke and Gertler, which
refers to a situation to be one in which potential borrowers (those with the
greatest access to productive investment projects, or with the greatest
entrepreneurial skills) have low wealth relative to the sizes of their projects.
They end up incurring higher agency costs, which may lead to a poor
performance in the investment sector and the economy. Poor functioning may
also occur due to the defaults since these occurrences decrease the liquidity and
level of free cash flow in the firm. They also described a financially fragile
situation as having a substantial underinvestment, misallocation of investment
resources, and possibly even a complete investment collapse in an economy due
to a very weak balance sheets of the banks. Hence, a weak balance sheet of the
banks entails more collection of non-performing loans than performing loans,
given that, loans is the main product of financial institutions in developing
countries. 27 Banks have to adjust their operations and their strategies to maintain
a certain level of profitability for a stable financial performance.
Therefore, the researchers believe that banks take into account credit risk,
indicated by non-performing loans, in monitoring the movement of their ROA in
order to maintain a certain level of profitability.
The researchers will utilize the Auto Regressive Conditional
Heteroskedasticity (ARCH) given the behavior of the ROA, classified as a time-
series data. This will aid in interpreting the variables in the variance equation
including the volatility, leverage effect and the long-run variance, particularly its

27
Bernanke, Ben. "Financial Fragility and Economic Performance." The Quarterly Journal of
Economics 105, no. 1 (1990): 87-114. Accessed January 28, 2015.
30
significance to the model. Leverage assesses the tail of the distribution of the
variable. This will indicate if a fat tail in the overall distribution exists showing
that the variables affecting the volatility of the return on assets will remain and
will not vanish in a short period of time. The ARCH is used to ensure that the
heteroskedasticity will be corrected.
Three multiple regression models will be done. The difference of the
models lies in the time period. The first will include data from 2000Q1 to
2014Q4. The second model will contain data points from 2000Q1 to 2009Q1. The
third one will comprise data from 2009Q1 to 2014Q4. The division for the second
and third will be done to have closer look and analysis before and after the global
financial crisis.
The third objective will be answered through multiple regression analysis,
as well. This will be done by designing a model where the GVA of the Banking
Sector will be used as the dependent variable while having the forecasted return
on assets, which incorporated all the other variables as used in the second
objective, and the dependent variable itself, the GVA of the Banking Sector, as
independent variables. Equation 4 below is used for the third objective:
= (, , , ) (4)
Where:
FINGVA Gross Value Added of the Banking Institutions
under the Financial Intermediaries
ROAF Forecasted Return on Assets
31
Similar to objective two, ARCH will be employed in the multiple
regression analysis to measure autocorrelation, leverage and cyclicality. This will
also correct the model if it is heteroskedastic. The evaluation of heteroskedasticity
will also be determined through the significance or insignificance of the variables
present in the variance equation. This will also aid in determining what variable
and its time period significantly impact the behavior the Banking Sectors GVA.
Three models will be made having the similar time period as those in the
second objective specifically, data points from 2000Q2 to 2014Q4, from 2000Q2
to 2009Q1, and from 2009Q2 to 2014Q4. This will provide a better understanding
and analysis of the models before and after the global financial crisis.
There are several concepts considered for the formulation of the equation
above. This is firmly based on the theoretical framework in relation to other
studies on financial fragility. The concept of financial fragility may be connected
to the interaction between the financial sector and real sector. It is evident that
banks major market comes from the real sector, particularly firms and individuals
who run businesses and need loans for their capital and business operations. The
assumption of banks having some borrowers who will end up defaulting has been
incorporated in the interaction, which creates the notion of developing a highly
monitored financing on the side of the banks as discussed by Tirole and
Holmstrm. Furthermore, members of the real sector are not sure of where to
borrow because of their perception that banks have uncertainties whether to let
them borrow or not depending on the status of their capitalization. Tirole and
Holmstrm mentioned about all types of capital tighteninga credit crunch, a
32
collateral squeeze, and a saving squeezehit poorly capitalized firms the
hardest which may be the case with firms in the real sector, affecting its
interaction with the banks of the financial sector and eventually the economy as a
whole. In terms of saving, firms in the real sector are also wary as to where to
invest or to put in their money among the banks knowing the threat of banking
instability. This interaction between the two important sectors with firms that
experience capital constraints has an effect to the investments, interest rates and
intensity of monitoring, making an effect to the whole economy.28
Not only do banks turn to the adjustment of their provisions to attain a
certain level of ROA and to resolve liquidity traps. Banks also consider other
sources of profits to sustain a satisfying financial performance. Banks employ a
broad lending channel, which considers the banking systems function, in the
context of asymmetric information, a characteristic of a financial fragile financial
system. This channel incorporates external finance premium, which is defined by
Freixas and Rochet, as the wedge between the cost of funds raised externally and
the opportunity cost of internal funds, as an essential key in the understanding of
the transmission mechanism. This describes the investment activity and
performance of a bank provided that bank lending has been limited due to some
liquidity shortages. This also occurs when the interest channel has already been

28
Jean, Tirole and Bengt Holmstrm. "Financial Intermediation, Loanable Funds, and the Real
Sector." The Quarterly Journal of Economics 112, no. 3 (1997): 663-91. Accessed March 15,
2015.
33
explored and has been seen to be not enough. In this way, banks utilize the broad
lending channel made possible through other means of financing like securities.29
Thus, the authors thought that the gross value added of the banking sector
under the financial intermediaries have incorporated financial fragility and the
measures done by banks, indicated by risk premium, to maintain a certain level of
profitability, making the whole sector to expand.
Provided this understanding of Financial Fragility, the Philippine
Financial Sector appears to be at the state of MECBD. UKBs in the country have
existing defaults indicated by their non-performing loans but manage to achieve a
profitability level sufficient to survive. Hence, the banking system can be noted to
be financial fragile. This means that an equilibrium level is reached but inefficient
since the banks are not operating at its maximum level where maximum profits
are met. Principles that affect fragility as mentioned above namely credit risk,
collateral constraints and efficiency are also visible in the Philippine set-up. These
banks take the aforementioned factors as a given on how they operate as a
business knowing that this will affect their profitability. At the same time,
financial fragility is applicable to the Philippines whose financial system is still
developing along with its different sectors. In this study, it is important to look at
how much financial fragility affects the performance of the Philippine banking
industry, especially the UKBs.

29
34
In this regard, the researchers came to the general hypothesis that the
Philippine UKBs monitor credit risk to maintain a certain level of profitability,
which eventually leads to a positive impact to the macroeconomy.
Figure 5 shows how the empirical methodology will be undertaken. In
addition, to summarize the variables used in the empirical methodology and the
theoretical framework. Table 1 presents the model for the framework and the
equivalent variables used for the methodology.
Figure 5. Conceptual Map of the Empirical Methodology
Philippine Universal
and Commercial
Banks
Bank-level data Macroeconomic

data
Identifying how is Effect of Financial Impact of the

Financial Fragility Fragility to the Profitability of the
present among the Industrys Universal and
universal and Profitability Commercial Banks to
commercial banks the Macroeconomy
Determining
Financial Fragilitys
impact to the
Philippine Universal
Conclusion and
Policy
35
Table 1. Variables used for the Theoretical Framework and Empirical Methodology
=
Theoretical
Meaning Variables References
Framework
Marginal revenue of Return on Assets
(()) Toby (2011)
capital (ROA)
Present value of Arnold & Riley
() Real Total Loans
capital (2009)
Risk Premium
Freixas & Rochet
(Variable for Broad
(2009)
Lending Channel)
Cost-to-Income Ratio
Tabak, et. al (2011)
(Efficiency Ratio)
Bank Lending Rate Arnold & Riley
Expected change in (Interest Rate) (2009)
present value of Toby (2011),
Non-Performing
capital Bernanke & Gertler
Loans Ratio (NPLR)
(1990)
Non-Performing
Freixas & Rochet
Assets to Gross
(2009)
Assets (NPAGA)
Allowance for Credit
Toby (2011)
Losses (ACL)
Note: Blue font variables that indicate the behavior of banks of how they deal with credit
rationing.
The macroeconomic variables, namely Real GDP and GVA of the Banking Sector
(FINGVA) in the model are not included in the table since they are treated to be exogenous to the
model.
36
CHAPTER IV
PRESENTATION, INTERPRETATION, AND ANALYSIS OF DATA
A. Confirming the Presence of Financial Fragility among UKBs
This portion answers the first objective of the study. Different
macroeconomic and bank-level indicators must be looked at to assess the level of
financial fragility in the Philippines. These will show how fragile the financial
sector, as indicated by NPLR, in the Philippines is and how does it relate to the
whole economy. Trends among the variables will also be seen to determine how is
the Philippines doing in terms of this aspect.
Figure 6 shows the level and the trend of ratio non-performing loans to the
total loans of the Philippines Universal banks over the time-period of 1999 to
2014. The table shows that over the years, the NPLR of the country have been
declining from an average ratio level of 0.132 in 1999 to 0.021 in 2014. This
shows that the percentage of the non-performing loans to the total loans have
decreased through time.
37
Figure 6. Non-performing Loans Ratio (NPLR) of UKBs, First Quarter of 1999 to
Non-performing Loans Ratio (NPLR)

0.2
NPLR
0.15
0.1
0.05
0
1999 Q1
1999 Q4
2000 Q3
2001 Q2
2002 Q1
2002 Q4
2003 Q3
2004 Q2
2005 Q1
2005 Q4
2006 Q3
2007 Q2
2008 Q1
2008 Q4
2009 Q3
2010 Q2
2011 Q1
2011 Q4
2012 Q3
2013 Q2
2014 Q1
2014 Q4
Source of Basic Data: Bangko Sentral ng Pilipinas (BSP)
The rising level of loans have caused the declining NPLR since it is more
than the growth of non-performing loans, as shown in Figure 7.
Figure 7. Non-performing Loans and Gross Total Loans for UKBs, First Quarter
1999 to Fourth Quarter 2014
3E+12
Non-performing Loans
2.5E+12
Gross Total Loans
2E+12
in Php
1.5E+12
1E+12
5E+11
0
1999Q1
1999Q4
2000Q3
2001Q2
2002Q1
2002Q4
2003Q3
2004Q2
2005Q1
2005Q4
2006Q3
2007Q2
2008Q1
2008Q4
2009Q3
2010Q2
2011Q1
2011Q4
2012Q3
2013Q2
2014Q1
2014Q4
In addition, Figure 8 displays the trend of ACL of the UKBs. It shows a
relatively increasing level of ACL of the countrys UKBs over the time-period
1999 to 2014. This entails banks allowances or provisions for a buffer against
38
non-performing loans to avert any instances of financial collapse due to non-
performing loans. For that reason, it can be said that the Philippine UKBs have an
increasing trend in terms of its allowance for non-performing loans through the
time-period 1999 to 2003.
Figure 8. Allowances for Credit Losses (ACL) for UKBs, First Quarter of 1999 to
Allowances for Credit Losses (ACL)

160
140
120
in Php billion
100
80
60
40
ACL
20
0
1999 Q1
1999 Q4
2000 Q3
2001 Q2
2002 Q1
2002 Q4
2003 Q3
2004 Q2
2005 Q1
2005 Q4
2006 Q3
2007 Q2
2008 Q1
2008 Q4
2009 Q3
2010 Q2
2011 Q1
2011 Q4
2012 Q3
2013 Q2
2014 Q1
2014 Q4
In terms of the UKBs profitability, the countrys UKBs have significantly
increased since the first quarter of 1999. An upward trend may be observed,
connoting positive information for the Philippines UKBs. Figure 9 shows the
level and the trend of return on assets of UKBs throughout the time period 1999
to 2014. Thus, UKBs have climbed in terms of using its assets to earn more
profits.
39
Figure 9. Return on Assets (ROA) of UKBs, First Quarter of 1999 to Fourth
Quarter of 2014
Return on Assets (ROA)
0.025
ROA
0.02
0.015
0.01
0.005
0
1999 Q1
1999 Q4
2000 Q3
2001 Q2
2002 Q1
2002 Q4
2003 Q3
2004 Q2
2005 Q1
2005 Q4
2006 Q3
2007 Q2
2008 Q1
2008 Q4
2009 Q3
2010 Q2
2011 Q1
2011 Q4
2012 Q3
2013 Q2
2014 Q1
2014 Q4
Moreover, Figure 10 shows the level and trend of the CIR of the
Philippine UKBs from 1999 to 2014. The table below shows that the CIRs of the
Philippine UKBs are settling on a relatively stable level at 0.79 (highest) to 0.56
(lowest) ratio level. However, despite that, the table clearly illustrates that it is on
a slightly downward trend. Hence, this ratio is used in this paper to signify the
level of efficiency of Philippine UKBs as it measures how banks costs are
changing relative to income. For that reason, the level of efficiency of Philippine
UKBs, as evident in the graph, has not improved to a significant level since 1999;
however, the fact that there is a slight downward trend as depicted in the graph,
can be attributed to the incremental improvements in the level of efficiency of
Philippine UKBs.
40
Figure 10. Cost-to-Income Ratio (CIR) of UKBs, First Quarter of 1999 to Fourth
Quarter of 2014
Cost-to-Income Ratio (CIR)

0.90
0.80
0.70
0.60
0.50
0.40
0.30
0.20
0.10 CIR
0.00
1999Q1
1999Q4
2000Q3
2001Q2
2002Q1
2002Q4
2003Q3
2004Q2
2005Q1
2005Q4
2006Q3
2007Q2
2008Q1
2008Q4
2009Q3
2010Q2
2011Q1
2011Q4
2012Q3
2013Q2
2014Q1
2014Q4
Source of Basic Data: Bangko Sentral ng Pilipinas
Figure 11 shows the level and trend of Gross Value Added of the Banking
Institutions (FINGVA) to the Gross Domestic Product. The figure below shows
that the level of GVA to the entire economy is increasing since 1999 to 2014. This
presents how the sector increased and expanded its contribution to the
macroeconomy. This upward trend may persists given more economic activities
will occur in the near future brought about by the ASEAN integration, mainly
characterized by more inflow of goods and services in the country.
41
Figure 11. Gross Value Added of the Financial Intermediaries (FINGVA)
specifically Banking Institutions, First Quarter of 1999 to Fourth Quarter of 2014
Gross Value Added of the Banking Institutions under

Financial Intermediaries (FINGVA)
7E+10
6E+10
5E+10
4E+10
3E+10
FINGVA
2E+10
1E+10
0
1999 Q1
1999 Q4
2000 Q3
2001 Q2
2002 Q1
2002 Q4
2003 Q3
2004 Q2
2005 Q1
2005 Q4
2006 Q3
2007 Q2
2008 Q1
2008 Q4
2009 Q3
2010 Q2
2011 Q1
2011 Q4
2012 Q3
2013 Q2
2014 Q1
2014 Q4
Source of Basic Data: Bangko Sentral ng Pilipinas
In a regional scale, ASEAN 5 experiences a generally decreasing trend of
NPLR. The Philippines lies almost at the same level of NPLRs with the other
members of the ASEAN 5. But in 2014, the Philippines has the highest level of
non-performing loans among the ASEAN 5 in 2013. This indicates that more of
the borrowers in the country end up defaulting compared to those in Indonesia,
Malaysia, Singapore and Thailand. Figure 12 below shows that the trend of NPLR
in the ASEAN 5, which shows that Philippines went higher over other countries,
especially from 2003 to 2005 and in 2013.
42
Figure 12. Non-performing Loans Ratio of ASEAN 5 (Indonesia, Malaysia,
Philippines, Singapore, and Thailand), 1999 to 2013
Non-Performing Loans Ratio of ASEAN 5, 1999 to 2014

45.00
Bank Non-Performing Loans to Total Loans (%)

40.00
35.00
30.00 Indonesia
25.00 Malaysia
20.00 Singapore
15.00 Thailand
10.00 Philippines
5.00
0.00
1999
2000
2001
2002
2003
2005
2006
2008
2009
2010
2011
2012
2013
2004
2007
Source of Basic Data: World Bank
In summary, the Philippine Financial Sector appears to be at the state of
MECBD. UKBs in the country have existing defaults indicated by the existence
of non-performing loans, as shown in Figure 6, but manage to achieve a
profitability level sufficient to maintain a certain level of ROA, indicated in
Figure 9. The first idea is in line with Tobys study, wherein he defined financial
fragility as the excessive build up of non-performing loans in the total loans
portfolio coupled with insufficient loan loss provisions. For that reason, financial
fragility exists in the Philippine Financial Sector as evident in the existence of
NPL and upward trend of ACL of UKBs, shown in Figures 7 and 8. It is
consistent with Tobys findings that the existence of non-performing loans is
43
indicative of existing defaults in the banks30, and as such, it triggers credit risks
and consequently financial fragility, which contributes to the instability of
financial system in the economy. Thus, despite the presence of financial fragility,
the Philippine Financial Sector is making improvements in its level of
profitability as evident in the increase in its ROA, CIR and GVA, presented in
Figures 9, 10 and 11.
In addition, it is noteworthy that NPL have been decreasing, when ROA
has been increasing from 1999 to 2014. Hence, it confirms the findings of Toby
that when growth of NPLR is less than the growth of the ROA, banks engage in
targeting a specific level of ROA. Hence, it begs the question, how do banks
despite the existence of fragility still manage to earn profits?
Firstly, banks bolster their level of provisions to non-performing loans or
ACL as evident in Figure 8. Thus, it is in line with Tobys study that is, to achieve
their target ROA, adjusting the level of provisions is significant given the NPLR
these banks expect to obtain in a particular time period.31 In other words, the
upward trend in the ACL throughout the years can signify UKBs behavior of
investing more and more on putting up buffers against possibly growing non-
performing loans to avoid financial instability. In other words, it signifies the
growing awareness of banks towards the existence of financial fragility, which
explains their behavior of boosting their ACL despite the reduction in the NPL
ratio. Therefore, it also affirms with the theory of Bernanke and Gertlers

30
Charles Goodhart. A Model to Analyze Financial Fragility. Financial Stability Review. June
2005. http://www.bankofengland.co.uk/publications/Documents/fsr/2005/fsr18art7.pdf (Accessed
on February 8, 2015).
31
Toby, Adolphus. Modelling Financial Fragility and Bank Profitability in an International
Context. International Journal of Business Insights and Transformation. August 2011-September
2011, Vol. 4, Issue 2.
44
regarding Financial Fragility, that is, banks have already considered some
borrowers will default, thus it is a signal of their awareness of financial instability.
In addition, it is also in line with Tobys theory that banks increase their
provisions for credit losses to counter fragility as caused by an excessive build up
of non-performing loans, which can be detrimental to the financial sector.
Furthermore, Figure 12 shows the ASEAN 5 countries all experiencing
decreasing levels of non-performing loans with the Philippines having the highest
level of NPLR in 2013. However, the downward trend in the NPL do not signify a
substantial decline in credit riskiness and consequently, financial fragility in the
UKBs but rather attributed to an expanding profitability of the financial sector
since NPLR is a ratio and total loan portfolio is the denominator. In other words,
financial fragility still exist in the financial sector via the existence of NPL, but
because of the significant increase in the ROA and GVA as well as incremental
improvements in efficiency. As a result, the non-performing loans ratio will
decline alongside the increase in GVA and ROA over the years. It confirms the
theory of Ponce in his study of Spanish financial sector, that is, the size of the
bank's loan portfolio on its balance sheet have a positive correlation with the level
of its profitability as measured both by ROA and by ROE. In effect, the banks are
investing more and more on provisions to non-performing loans to counter a
possible financial instability caused by excessive amount of non-performing
loans and insufficient loan reserves32.
Moreover, another reason as to why UKBs can maintain its profitability
despite the existence of financial fragility as indicated by NPL, is through the

32
Ibid.
45
concept of external finance premium as evident in the large risk premium
clearly present in Figure 13.
Figure 13. Comparison of Inflation Rate and Interest Rate of the Philippines,
Comparison of Inflation Rate
1999 and Interest Rate (1999-2014)
to 2014
.14 .14
.12 .12
.10 .10
.08 .08
.06 .06
.04 .04
.02 .02
.00 .00
2000 2002 2004 2006 2008 2010 2012 2014
Interest Rate Inflation Rate

Source: Bangko Sentral ng Pilipinas (BSP)
Hence, Freixas and Rochet define risk premium, as the wedge between
the cost of funds raised externally and the opportunity cost of internal funds or in
other words the difference between real interest rates and inflation rates. Thus, in
Figure 13, from 1999 to 2014 the level of interest rates have always been above
the level of inflation rate which signifies that UKBs are charging their borrowers
with higher interest rate relative to inflation over the years.
Interestingly, in Figure 14, by using a scatterplot, the relationship of the
interest rate with inflation rate becomes more pronounced at any given time
46
period. That is to say, the trend line for both real interest rate and inflation rate
reveal the prevailing gap between the two variables over the years.
Figure 14. Scatterplot of Interest Rate and Inflation Rate and Real Total Loans
Universal and Commercial Banks
Source: Bangko Sentral ng Pilipinas
At any given period of time within the time period under study, the level
of real interest rates charged by the banks to the borrowers has always been way
above the inflation rate for instance, in the first quarter of 2000, the real interest
rate was recorded at 10% (.10345) when inflation rate was only 2.5% (.025).
Neoclassical Macroeconomics suggests that the interest rate charged by
banks should be close to the inflation rate since in the Fisher equation, nominal
interest rate, takes into account inflation. However in the case of UKBs, despite
the easing and stability of inflation rates following a few years after the inflation
47
targeting policy of BSP in 200233, banks still charge higher interest rates as
proven in Figure 13. Hence, in order to have a full understanding as to why UKBs
resort to risk premium, the concept of credit rationing must be take into
consideration.
Figure 16 reveals that real total loans are increasing throughout the time
period under study. Hence, in the study, real total loans is used as an indicator for
credit rationing or as defined by Arnold and Riley, which refers to the situation
where banks control the amount of loans firms or individuals, depending on their
creditworthiness, through higher or lower interest rates. With credit rationing, at
least two equilibrium lending rates are provided to borrowers to address the
amount of loans they are willing to pay and their assumed paying capacity by the
banks. This serves as a banking measure, which foresees the possibility of
defaults among borrowers. For that reason, UKBs do not lend at a single rate,
which is at a lower level compared to how much it usually give as loan rate. In
this case, there will be a certain a difference with the actual equilibrium loan rates
against the supposed loan rate. This may present how the banks earn through the
risk premium or the increment with the loan rates, despite the possibility of
defaults on the borrowers hence, amidst financial fragility. Thus, it affirms the
theory of Freixas and Rochet that banks also consider other sources of profits to
sustain a satisfying financial performance namely in the form of external finance
premium. The authors claim that banks employ external finance premium, as
incorporated in their broad lending activity, which is describes as the investment
activity and performance of a bank made possible through other means of

33
Bangko Sentral ng Pilipinas (BSP). Inflation Targeting. Accessed on March 23, 2015
48
financing like securities,34 provided that bank lending has been limited due to
liquidity shortages, credit constraints, failure of interest rates to bring equilibrium
etc. In effect, clearly, because of financial fragility, UKBs are resorting to external
finance premium and shoulder external financing to cope with financial fragility.
That is to say, banks have to charge higher interest rates despite relatively low
inflation rates, in order to profit in a sufficient level, that is, earning profit margin
that is enough to cover their external finance premiums (e.g. investments in
securities, bonds from abroad, etc.) as well as enough to sustain a certain target
level of Return on Assets.
Figure 15. Scatterplots of Interest Rate, Return on Assets (ROA)

and Real Total Loans
Scatterplots of Interest Rate, Return-on-Assets (ROA) and Real Total Loans
00 0 0 00 00
0 00
00 00 00 00 00
000 0 00 00 0 00
0 0 00 00 70
0
15 18 21 24 2
ROA REALTOTALLOANS
0.14
0.13
0.12
Interest Rate
0.11
0.10
0.09
0.08
0.07
0.06
0.05
00 05 10 15 20
0.0 0. 0 0. 0 0.0 0 .0

34
49
Moreover, it is noteworthy that starting 2012, the interest rates charged by
banks are becoming less tight, as shown in Figure 13. In this case, the gap
between interest rate and inflation rate are shrinking. For instance, the average
interest rate for all quarters of 2012 to 2014 is only at 5.60% and inflation rate on
average for the same time period is 3.28%, which makes up for a roughly 2% on
average risk premium. Hence, it is lower than the average risk premium in 1999 to
2011, which is recorded at roughly 4%, presented in Table 2. For that reason, the
authors could only infer that it could be because starting 2012 onwards, borrowers
are able to pay back their loans and thus minimize the need for banks to resort
much to external finance premiums as evident in the decreasing trend of non-
performing loans and the shrinking gap of risk premiums, presented in Figure 13.
Table 2. Risk Premium from 1999Q1 to 2011Q4 and 2012Q1 to 2014Q4

1999 Q1 to 2011 Q4 2012 Q1 2014 Q4
Interest Rate 9.48% 5.62%
Inflation Rate 5.10% 3.29%
Average Risk Premium 4.38% 2.33%
Source: Authors estimates
Lastly, in Figure 14, it is interesting to note that the scatter plots for
interest rate relative to ROA and interest rate relative to real total loans reveal
important insights. That is, UKBs interest rates are stabilizing at a lower rate and
are coupled with higher ROA and greater real total loans. Hence, it reinforces the
earlier claim of the researchers that starting 2012, UKBs have been stabilizing
their interest rates, which could be due to the repayment behavior of borrowers for
the recent years (2012 onwards) and in effect as seen in Figure 14, real total loans
and return on assets are increasing as well.
50
Moreover, Arnold and Riley, add that credit rationing is being considered
to be system-wide, which may lead to the upsurge or down surge of loans, which
depends on the quality of borrowers. Thus an increase in real total loans as
evident in Figure 15 signifies that banks are getting upsurge of loans from mostly
large firms. According to Romer, large firms borrow larger amount of loans after
a monetary tightening, which took place in 2012 as demonstrated by gradual
easing of interest rates charged by UKBs, shown in Table 2 and also large firms
are able to access outside financing because they are the ones in need of large
capital for massive investment projects.
Figure 16. Real Total Loans, 1999 to 2014

Real Total Loans (Base Year: 2000)
2,800,000,000
2,600,000,000
2,400,000,000
2,200,000,000
2,000,000,000
1,800,000,000
1,600,000,000
1,400,000,000
1,200,000,000
2000 2002 2004 2006 2008 2010 2012 2014
51
B. Effect of Financial Fragility to the UKBs Profitability
To determine the effect of financial fragility to the profitability of the
UKBs, which is the second objective of the paper, several models and graphs is
analyzed.
The model used to answer the second objective incorporated ROA, which
is the measure of the UKBs profitability, together with some macroeconomic
variables namely real GDP and interest rate and bank-level indicators namely
cost-to-income ratio, allowance for credit losses, non-performing loans and non-
performing assets to gross assets. Non-performing loans and non-performing
assets included indicating financial fragility. Table 3 presents the regression
results to determine the effect of financial fragility to the profitability of banks
using ARCH.
Table 3. Regression Results (Effect of Financial Fragility to the UKBs

Profitability, 2000Q1 to 2014Q4)
Variable Coefficient P-Value
C 0.033517 0.0000***
REALGDP -5.81E-15 0.0003***
INTERESTRATE(-2) -0.051106 0.0003***
CIR -0.029087 0.0000***
ACL(-1) -2.36E-05 0.2840
NPLR(-1) -0.017183 0.3750
NPAGA(-1) 0.132347 0.0002***
ROA(-1) 0.413084 0.0000***
ACL(-4) 0.000117 0.0001***
NPLR(-4) -0.046343 0.0300**
ROA(-4) -0.259667 0.0000***
NPAGA(-4) -0.109974 0.0161**
Adjusted R2 0.962851
Volatility 0.010000 0.9633
Leverage Effect 0.010000 0.9675
Long Run Conditional
0.010000 0.9993
Variance
52
In this model, majority of the bank-level indicators are significant to the
return on assets of the UKBs. Particularly, the NPAGA and ROA of the past
quarter, the ACL, NPLR, ROA and NPAGA are all significant at all levels except
for the NPLR of the previous year, which is also significant at 5% and 10%.
When it comes to the ROA, it implies that for every unit increase in the
ROA using the last quarter as the reference results to 0.41 increase in the current
ROA. This presents how UKBs take into account their profitability the previous
quarter in determining their profitability ratio for the current quarter. This
indicates that they make decisions based on how they performed the previous
quarter to be able to sustain a certain level of profitability during the current
quarter. At the same time, the ROA of the previous year appears to have a
negative effect on the current ROA. This might indicate that banks just try to
achieve a certain level of equilibrium and do not exceed the bandwidth of ROA
that they are targeting. This shows that since they appear to be achieving a higher
ROA at this time, they would not exert much effort to have a greater ROA to be
able to maintain their level of profitability.
The macroeconomic variables have inverse relationship with the ROA.
Real GDP and Interest Rate are significant at 1%, 5% and 10% and moves in an
opposite direction with ROA at a very minute level of coefficient. The negative
coefficient for the real GDP is not the expected sign since the real GDP should go
along with Return on Assets. However, Kanwal and Nadeem (2013) considered
the real GDP to be having either a positive or negative as expected sign when they
did a study on the impact of macroeconomic variables to the profitability of listed
53
commercial banks in Pakistan.35 As stated in their study, the opposing result may
be due to some external factors such as information asymmetry or the lack of
information of the consumers to the countrys economic changes. The negative
coefficient for the interest rate indicates that a higher interest rate decreases the
demand for the products that the UKBs offer, particularly loans, since the cost of
borrowing is higher. In addition, the interest rate in the past two quarters plays a
role in the determination of the ROA at present.
CIR, the efficiency ratio, possesses a negative relationship with ROA.
This means that a higher ratio, indicating higher level of inefficiency, deteriorates
the higher level of ROA. In this way, UKBs would like to improve their
efficiency level, in which they yield the most output given the least costs they can
incur.
Mixed effects depending on the time period may be observed as regards
the NPLR and NPAGA. With reference to the previous quarter, NPLR appeared
to be insignificant in determining the ROA of the current quarter. Surprisingly,
NPAGA of the previous quarter moves together with the ROA. It indicates that a
higher NPAGA leads to a higher ROA, which is in contrary as to how these two
variables relate with each other. Going back four quarters or a year before the
current quarter, NPLR and NPAGA both carry negative relationships with the
banks profitability ratio for the current quarter. This shows that UKBs take note
more of the NPLR and NPAGA, which are its indicator of credit risk and
collateral constraints than the ones of the previous quarter. In addition, seeing that

35
Kanwal, Sara, and Muhammad Nadeem. "The Impact of Macroeconomic Variables on the
Profitability of Listed Commercial Banks in Pakistan." European Journal of Business and Social
Sciences 2, no. 9 (2013): 186-201. Accessed March 30, 2015. http://www.ejbss.com/recent.aspx.
54
NPLR is insignificant for the previous quarter while being substantial for the last
year in identifying its ROA shows that banks gauge more their performance with
the previous years more than that of the previous quarter. This affects their
provisioning of loans and how they are going to sustain their target level of
profitability. Having the NPAGAs obtain different directions at two time periods
present an interesting finding. This can show that this variable can either
contribute to the decrease or increase of the banks ROA.
The result of the model is noteworthy because of its adjusted R2 of
0.962851. This means that 96.29% of the movement of the ROA is explained by
the factors included in the model as independent variables. Having the indicators
for fragility, observed to be significant, part of the model indicate that UKBs take
into account the presence of these non-performing loans and non-performing
assets in terms of their decision-making especially in identifying their desired
level of profitability. This confirms the idea that the Philippines is in a state of
MECBD, in which banks adjust to the potential losses through loans and
collaterals obtained.
Using the model, it has been found out that volatility, leverage effect and
long-run conditional variance are insignificant. This indicates that the model is
already corrected.
Figure 17 shows the graph for the actual, fitted and residual of the model.
From 2000 to 2014, certain trend points were similar for the actual and fitted.
There were some portions were in the residuals exceeded -0.001 to 0.001,
particularly in Q1 of 2013. This means that the fitted ROA is not completely
55
captured by the actual ROA, meaning that there are other factors affecting the
dependent variable aside from those included in the model.
Figure 17. Actual, Fitted and Residual Graphs of ROA from 2000Q1 to 2014Q4
Dividing the time periods from 2000 to 2009 and 2009 to 2014 will
provide a clearer picture of the effect of fragility to the profitability of the UKBs
between the two-time period basically before and after the global financial crisis.
Same regressand and regressors were utilized in the model.
56
Table 4. Regression Results (Effect of Financial Fragility to the UKBs
Profitability, 2000Q1 to 2009Q1 and 2009Q1 to 2014Q4)
2000Q1 to 2009Q1 2009Q1 to 2014Q4
Variables
Coefficient P-Value Coefficient P-Value
C 0.027913 0.0000*** 0.080462 0.0000***
REALGDP -2.85E-15 0.1237 -2.02E-15 0.1953
INTERESTRATE(-2) -0.040578 0.0067*** -0.046832 0.2635
CIR -0.027021 0.0000*** -0.060936 0.0000***
ACL(-1) -2.30E-05 0.4452 -0.000313 0.0000***
NPLR(-1) -0.009882 0.7193 -0.545466 0.0000***
NPAGA(-1) 0.108970 0.0074*** 0.634447 0.0006***
ROA(-1) 0.421986 0.0000*** 0.501462 0.0002***
ACL(-4) 0.000109 0.0004*** 9.54E-05 0.2748
NPLR(-4) -0.043437 0.0837* 0.187178 0.2276
ROA(-4) -0.278294 0.0016*** 0.176864 0.0252
NPAGA(-4) -0.089674 0.0895* -0.420231 0.0223
Adjusted R2 0.963339 0.958000
Volatility 0.010000 0.9743 0.010000 0.9785
Leverage Effect 0.010000 0.9465 0.010000 0.9580
Long Run
0.010000 0.9962 0.010000 0.9965
Conditional Variance
Some similarities and several differences may be observed with the two
models estimated. The CIR and the ROA were consistent in both periods in terms
of its significance and relationship with the current ROA. The current CIR
consistently possessed an inverse relationship with the ROA. The consistency of
CIR to have a negative relationship with ROA shows that a greater level of
efficiency certainly contributes to a better ROA. At the same time, inefficiency
leads to the weakening or decline of ROA. In this regard, banks should have
strategies on improving efficiency. Moreover, the ROA of the previous quarter
always act positively with the current ROA. This signifies that banks regard the
previous quarters ROA as an important factor to the outcome of the incoming
ROA. Another significant variable is the NPAGA. In both periods, it has
constantly provided a positive relationship with the ROA. This finding appears to
57
be interesting since non-performing assets stagnates the usefulness of an asset
but it contributes to the improvement of the ROA. This can give a signal that
despite banks might have non-performing assets other means of profit or other
sources of revenue are looked for like other investments.
Some variables were seen to be significant in the pre-financial crisis but
insignificant after the peak of the financial crisis and vice versa. The interest rate
was regarded as significant for the ROA in 2000 to 2009. The ACL and NPLR
with a lag of four quarters or of one year is seen to be significant in determining
the ROA from 2000 to 2009 only. After the peak of the financial crisis (from 2009
to 2014), to measure the current ROA, the ACL and the NPLR of the previous
quarter and the ROA of the year before are being looked at more than those of the
previous year. This may be explained by the idea that UKBs are keen in keeping
track of their NPLR and ACL per quarter. It is also worth noting this time that
ACL with one-quarter lag performs negatively related to the ROA. Furthermore,
the NPAGA of the previous year is already significant in figuring out the current
ROA. Generally, this may show the changing behavior of UKBs in monitoring
their NPLR and NPAGA. There is a possibility that they try to consider NPLR of
the previous quarter more at present compared to before, probably to be able to
avoid more defaults despite allotting a specific amount of provisions for these to
keep liquidity stable or keep the money flowing in and out of the firm. This may
be a way for them to become more aware of their finances to know immediately
what strategy to employ in sustaining a certain level of profitability.
58
The ROA a year before is also taken into consideration in determining the
current profitability of banks. However, between the two-time periods changed.
ROA four quarters ago initially moves at the opposite direction from 2000 to
2009 but this variable already moves together to know the current ROA. This also
may show the small changes being observed with the variable.
The adjusted R2 before and after the peak of the Financial Crisis are
0.963339 and 0.958000, respectively. The adjusted R2s obtained for the both
periods show that the models are robust, indicating that the ROA is almost 100%
being explained by the independent variables included in the model.
Figure 18 presents the actual, fitted and residual of the model for 2000Q1
to 2009Q4. More volatility may be observed from the actual more than the fitted.
59
Figure 19 below presents the trend for the actual, fitted and residual for the
model from 2009Q1 to 2014Q4. Compared to the previous figure, representing an
earlier time period, the model is more fitted in which many points in the actual
are hitting the fitted line. This may show that UKBs in the latter years are more
equipped in getting their desired ROAs. They were able to control the movement
of their ROA in line with their targets but still having small amounts of
discrepancies.
C. Evaluating Impact of the Profitability of the Universal and Commercial Banks

to the Macroeconomy
The third objective, which focuses on assessing the impact of the
profitability of UKBs to the whole sector, is going to be tackled. The model used
to answer the third objective incorporated Gross Value Added of the Financial
60
Sector of the current year (FINGVA), which is an indicator of the effect of
financial sector on the macroeconomy. ROA, GVA of the previous year, real total
loans and risk premium are regressed against GVA of the current year to be able
to determine the effects of the banking institutions profitability (ROA), its GVA
the previous year, credit rationing and risk premium on the macroeconomy. Table
5 presents the regression results to determine the effect of ROA, GVA, real total
loans and risk premium on the macroeconomy using ARCH.
Table 5. Regression Results (Effect of Profitability of Banks to the Gross Value

Added of the Industry, 2000Q1 to 2014Q4)
Variables Coefficients P-Value
ROAF(-1) 2.24E+11 0.00018***
FINGVA(-4) 1.024222 0.0000***
REALTOTALLOANS -0.255751 0.7835
RiskPremium 8.82E+09 0.3093
2
Adjusted R 0.980807
Volatility 0.837282 0.0369
Leverage 0.117740 0.5930
0.896961 0.0000
Variance
Source: Authors Estimates
In the regressed model for UKBs from 1999 to 2014, results show that
both Return on Assets and GVA of the previous year are significant at 1%, 5%
and 10%. However, Real Total Loans and Risk Premium are insignificant. Thus,
the probabilities of both ROA and GVA previous year suggest that all variables
from second quarter of 2000 to fourth quarter of 2014 significantly explain the
behavior of current year GVA. The result of the model is noteworthy because of
its adjusted r-squared of 0.980807. It implies that 98.08% of the movement of the
current year GVA is explained by the ROA and previous year GVA, however this
61
is not the case for the other two variables that are insignificant in the model
namely, Risk Premium and Real Total Loans.
Moreover, all significant independent variables carry a positive
relationship relative to the dependent variable that is, current year GVA. In other
words, as ROA or the level of profitability increases, the current level of GVA
should also increase as a result. Secondly, the behavior of the banks towards GVA
is dominated by monitoring of previous years performance as evident in the
significance of previous year GVA to current GVA. For that reason, the higher
the previous year GVA is, then the higher, the forecasted GVA banks will set for
the current year since it is always better off for banks to aim to expand the
financial sector for its gross value added to be more significant contributor to the
Gross domestic product in the country. Furthermore, the Financial GVA of the
previous year has the most significant influence on the current year GVA, which
means for every increase in the previous year GVA, it results in a 1.0013 unit-
increase on the current year GVA. This underscores the behavior of the banking
institutions, that is, these banks take into account the previous year GVA
performance relative to the macroeconomy in determining their projection for
their current year GVA that should be at the level greater than the previous
growth rates. Hence, banks would aim to increase their gross value added to the
economy because doing so entails expanding and improving the financial sector
as well to be less vulnerable to financial fragility. Thus, it supports the theory of
Freixas and Rochet that, a strong and solid financial structure may become firm
and may be able to keep itself away from the fragility because it is characterized
62
by good quality of financial services and higher banking efficiency, which leads
to a higher growth for the sector, and eventually contribute to economic growth.
Using the model, it has been found out that volatility, leverage effect and
long-run conditional variance are insignificant which indicates that the model is
homoskedastic.
Figure 20. Actual, Fitted and Residual Graphs of FINGVA

from 2000Q1 to 2014Q4
The researchers split the observations into two, with 2009 as the breaking
point since in 2009 the global financial crisis adversely affected the global
economy. Moreover dividing the time periods from 2000 to 2009 and 2009 to
2014 will be more effective for the researcher to capture fully significant effects
of ROA and previous year GVA, Real Total Loans and Risk Premium on current
GVA just before and after the financial crisis. Same regressand and regressors
were utilized in the model.
63
Table 6. Regression Results (Effect of Profitability of Banks to the Gross Value
Added of the Industry, 2000Q1 to 2009Q4 and 2009Q1 to 2014Q4)
2000 Q1 to 2009 Q4 2009 Q1 to 2014 Q4
Coefficient P - Value Coefficient P - Value
ROAF(-1) 1.92E+11 0.0056*** 1.38E+11 0.1497
FINGVA(-4) 0.971708 0.0000*** 1.087047 0.0000***
REALTOTALLOANS -12.63525 0.0002*** 2.092550 0.0935*
RiskPremium -1.18E+10 0.1464 1.06E+11 0.0134**
Adjusted R-squared 0.968593 0.913198
Volatility 0.493832 0.4020 -2.560773 0.0132
Leverage 0.299918 0.4154 -1.731494 0.0097
Variance 0.822387 0.0000 0.329143 0.4726
A lot of similarities and differences can be observed in the models
estimated namely, all variables in both time periods still carry the same positive
relationship the dependent variable. For both models, the previous year quarterly
GVA remains significant at 1%, 5% and 10%. Thus, the probabilities of the
variables suggest that all previous year GVA variables from 2000 to 2014
significantly explain the behavior of current year GVA. That is to say, even with
the split of the time period, the previous GVA is still significant in explaining the
effects of GVA on the macro economy. Hence, it can be deduced that the banks
make decisions based their monitoring on how they performed the previous
quarter in terms of GVA, to be able to come up with a certain greater level of
current GVA for the improvement of the financial sector. It is in line with
Holmstrms and Tiroles Theory, that banks through a strong and large capital
base with highly monitored finance becomes financially stable and it can lead to
higher rate of growth for the financial sector. Hence, they add that strongly
capitalized banks becomes less vulnerable to risks, threats or shocks such as
capital tightening like credit crunch, collateral squeeze and savings squeeze. In
64
other words as banks expand their current GVA by monitoring practices, the more
it becomes strongly capitalized to withstand fragility and shocks and thereby keep
the financial sector stable.
Furthermore, in 2000 to 2009, 96.8% of the movement of the current year
GVA is explained by the previous GVA in the model. In 2009 to 2014, the
previous year GVA remain to be the most significant independent variable in the
model as it can explain 91.3% of the current GVA. The more interesting change
after the split of the time period is that of Risk Premium and Real Total Loans.
Risk Premium and Real Total Loans are two independent variables, which used to
be insignificant in the model prior to the split of the period. Thus, after the
researchers split the observation, both real total loans and risk premium became
significant for both 2000Q1 to 2009Q1 and 2009Q1 to 2014Q4. For instance, real
total loans, which are an indicator for credit rationing, become significant at both
10% and 5% in 2000Q1 to 2009Q1. However, for risk premium assets, it becomes
significant at 5% and 10% in 2009Q1 to 2014Q4. However, surprisingly, in
2000Q1 to 2009Q1, both risk premium and real total loans carry a negative signs,
which in economic theory should not be the case. For instance, for real total loans
which is an indicator for credit rationing, should carry a positive sign because as
banks increase their real total loans, it is tantamount to an upsurge in less risky
loans, which made possible only by credit rationing. In other words, UKBs are
controlling the amount of loans they give and they lend at different interest rate
level to different borrowers depending on their credit worthiness and ability pay36

36
Arnold, L. & J.G. Riley. On the Possibility of Credit Rationing in the Stiglitz-Weiss Model.
American Economic Association. 99, no. 5 (2009): 2012-2021. Accessed March 20, 2015.
65
to minimize instances of defaults. Furthermore, risk premium should carry a
positive result because it is another form of financing for UKBs in order for them
to maintain their target ROA level despite the presence of financial fragility in the
financial system. Thus, banks have to charge higher interest rates despite
relatively low inflation rates, in order to profit in a sufficient level, enough to
sustain a certain target level of ROA. Nonetheless, since in 2009 to 2014, both
variables are significant, and they carry positive signs which conforms with
economic theory, it can be said that for every one unit increase in real total loans
as well as one unit increase in external risk financing, it should merit a
corresponding 2.09 and 1.06E+11 units increase in the current year GVA of the
financial sector. Hence, the financial sector profits from UKBs utilization of
external risk premium and credit rationing.
Thus, UKBs ways of monitoring of previous year GVA performance, risk
premium and credit rationing are direct measures to remain profitable and sustain
their target ROA level despite the presence of fragility in the financial sector.
Moreover, when looking at the graph of the split periods shown in Figure
21, it shows that, from 2000 to 2009, previous year GVA and ROA are able to
capture and explain significantly the behavior of the current GVA. However, in
Figure 22, it shows that ROA and previous year GVA seem to be no longer
capable of fully capturing the behavior of the current GVA.
66
Figure 21. Actual, Fitted and Residual Graphs of FINGVA
from 2000Q1 to 2009Q4
Figure 22. Actual, Fitted and Residual Graphs of FINGVA from 2009Q1 to
2014Q4
67
CHAPTER V
SUMMARY, CONCLUSIONS, AND RECOMMENDATIONS
A. Summary
In examining how the banking industrys profitability and contribution to
the macroeconomy is affected by financial fragility in the Philippine Financial
Sector, several aims were answered, which primarily looked into several variables
namely non-performing loans ratio, non-performing assets to gross assets, cost-to-
income ratio, return on assets, gross value added of the banking institutions as
part of financial intermediaries, interest rate, and real GDP.
The assessment was based on the existing concept on Financial Fragility,
particularly the model designed by Tsomocos, which focuses on the concept of
monetary equilibrium with commercial banks and defaults. This connects to the
idea that banks, specifically universal and commercial banks (which are the focus
of the study), have anticipated the fact that there are potential borrowers who will
not be able to pay their loans due to certain constraints that they will encounter
and that their collaterals will not be utilized since these are not earning or are
inconvertible to cash. This affects how the banks decide on their operations in
order to attain their targets on their performance, especially on the level of
profitability they would want to achieve.
In this study, the evaluation began by determining the existing of financial
fragility through some variables such as non-performing loans, allowances for
credit losses and non-performing assets. It was seen that there is a level of
68
fragility given the presence of non-performing loans and non-performing assets,
despite at a decline ratio level. The data also reveal an upward trend in the ACL
of universal and commercial banks from 1999 to 2014, which can signify banks
behavior of investing more and more on putting up buffers against possibly
growing non-performing loans to avoid financial instability. In addition, all the
ASEAN 5 countries are experiencing falling levels of non-performing loans with
the Philippines having the highest level of NPLR in 2013. However, findings
reveal that the downward trend in the non-performing loans do not signify a
substantial decline in credit riskiness and consequently, financial fragility in the
UKBs but rather attributed to an expanding profitability of the financial sector as
GVA and ROA all went up from 1999 to 2014.
After employing multiple regression analysis in answering some of the
objectives, the empirical findings indicate that financial fragility exist in the
banking sector as banks already incorporated potential defaults in their loans
services, thereby, they established a buffer against circumstances through the
presence of provisions to non-performing loans. Hence, the existence of non-
performing loans is indicative of existing defaults in the banks, and as such, it
triggers credit risks and consequently financial fragility, which contributes to the
instability of financial system in the economy.
Furthermore, in order to concretely determine how financial fragility
affects profitability of the UKBs and its contribution to the macroeconomy,
multiple regression analysis was applied to estimate the model and to identify the
behavior of the UKBs in terms of how they aim a certain level of profitability
69
despite the presence of financial fragility. This was done by taking ROA as the
dependent variable while having some macroeconomic variables namely real
GDP and interest rate, and bank-level indicators including cost-to-income ratio,
and financial fragility and credit risk indicators namely, allowance for credit
losses, non-performing loans and non-performing assets to gross assets. Since
time-series data was used, the appropriate econometric tool was utilized
particularly ARCH to arrive at valuable and interesting results.
When it comes to the influence of financial fragility and profitability of
UKBs to the macroeconomy, the same process was employed. However, with
Gross Value Added of the financial sector (FINGVA) as the dependent variable
and the GVA itself and the forecasted ROA as the independent variables. In this
case, the empirical results reveal that UKBs have been increasing their capital
base over the period 1999 to 2014 by means of the monitoring behavior among
banks. Monitoring behavior of banks play a key role in determining their profit
level as well as lessening the level of financial fragility in the financial sector.
That is to say, both previous quarter ROA and previous year GVA posted highest
significance when regressed against current ROA and current GVA. Hence, it
explains how UKBs take into account their profitability in the previous
quarter/year in determining their profitability ratio for the current quarter. This
indicates that UKBs make decisions based on how they performed the previous
quarter to be able to sustain a certain level of profitability for the current quarter.
70
B. Conclusion
The universal and commercial banks in the Philippines experience
financial fragility, which affects the overall performance of the banks and their
contribution to the economy. Primarily, these banks awareness of the financial
fragility is made visible by their implementation of credit rationing and their
understanding of credit risk. These banks consider these factors in making
decisions since these elements influence their performance.
The presence of financial fragility in the Philippines, specifically for
universal and commercial banks, is observed through the non-performing loans.
These indicators play significant roles in affecting the fragility in the financial
sector, which eventually holds an influence to the profitability of the banks and its
contribution to the whole economy. Despite the fact of the presence of such
economic phenomenon, a positive note may be realized since the trend for these
indicators have practically declined since 1999. This may be due to the fact that
different changes and developments have occurred since 1999, which partly
remedied the vulnerabilities present in the domestic financial system. Moreover,
the falling of the ratio, specifically for non-performing loans, is due to the
expansion of the total amount of loans. Although the non-performing loans have
also been increasing through time, the rate of growth of the total loans is faster. At
the same time, this may be due to the expansion of the financial sector, in terms of
its resources and output as seen from the significant growth of the gross value
added of the banking institutions under financial intermediaries.
71
Banks see that there are potential borrowers who will not be able to pay
their loans and there are also some who will provide collaterals, which will not be
useful, in case they will default. Given this anticipation, banks execute certain
measures and actions in order to not make these constraints affect the certain level
of profitability they want to achieve in order to sustain the business. Empirically
speaking, through an ARCH model, these banks incorporate their non-performing
loans, and non-performing assets along with its return on assets and allowances
for credit losses for the past four quarters or for the past year to determine their
return on assets or their profitability. These variables in that certain time period
appeared to be significant more than any quarters. This shows how banks monitor
the level of credit risk and collateral constraints to know how to target their
desired level of profitability. This aimed level of financial performance is also a
level that will keep the banks sustain the business at a reasonable amount of
returns but not that which is more than what has been usually targeted.
With regard non-performing assets, a direct relationship may be observed
based on the model. This finding is not in line with the norm knowing that these
types of assets do not improve the return of the assets. However, this may be an
indicator of banks to determine alternative sources of profit-earning assets.
Monitoring the level of non-performing assets as a percentage of gross assets can
trigger UKBs to invest in other assets, which might be risky but have high returns.
Furthermore, since banks anticipate financial fragility in their operations
to reach a certain level of profitability, certain effects may also reach the banks
contributions to the macroeconomy. This may be observed in the effect of the
72
return on assets to the gross value added of the banking institutions. The GVA of
the banking institutions is affected by the factors coming from itself and from the
ROA of the UKBs. This shows that the UKBs ROA, which have included the
fact that there is financial fragility through the non-performing loans and non-
performing assets, directly affects the growth or decline of the GVA since these
variables possess a positive relationship. More specifically, the ROA of the
previous quarter appeared to have more impact to the movement of the GVA
more than the ROAs in other quarter. In a sense, this can show how credit risk
and collateral constraints affect the growth of the GVA. This may also show that a
higher level of non-performing loans and non-performing assets may hurt the
level of GVA at a particular time period. The external risk financing through the
risk premium is also being reflected in the GVA and not in the ROA. This shows
that the whole gross value added of the banking institutions is being positively
affected by the risk premium to better sustain its level of profitability.
Indeed, financial fragility clearly persists in the Philippine Financial
System through the level of non-performing loans and non-performing assets,
indicating credit risk and collateral constraints. Given this situation, it is evident
through the models made that banks monitor and take these elements into account
in order to maintain a certain level of profitability. From 1999 to 2014, the level
of profitability, indicated by ROA, has only improved minimally. It fairly stayed
at a certain level with certain level of improvement. This can show that banks,
UKBs in particular, are working in simply maintaining a certain level of
profitability. This can be affected by the business, especially from the real sector,
73
engaging into financial transactions, specifically borrowing and saving activities.
At the same time, this can be due to the low penetration level of household
owning deposit and saving accounts across the country. In fact, there were only
6,738 deposit accounts per 10,000 adults in the country in 2013. This figure is
lower compared to other countries namely Kenya, Malaysia, Mexico, Peru and
Thailand.37
C. Recommendations
Several developments based on recommendations may be done in order to
have a deeper understanding about Financial Fragility in the Philippines. Different
recommendations after this study have come up to improve the research process
regarding the topic for more validity and soundness.
Banks may look into the profiles of borrowers with non-performing loans
for better monitoring and screening processes. To increase profitability, banks
may also try to explore untapped markets with potential creditworthiness.
In the study, the efficiency level of banks appeared to have an important
factor in determining the level of profitability of the UKBs. However, the
efficiency ratio used is only based on the cost and income of the UKBs, which
might not be accurate as other efficiency measures, which are obtained by using
other variables and econometric models. In this regard, it might seem important to
employ more accurate and specific econometric models in determining
efficiencies of the banks. To be more specifically, exploring the cost and profit

37
Bangko Sentral ng Pilipinas (BSP). Report on the State of Financial Inclusion in the
Philippines. 2013
74
efficiency of UKBs through other empirical methodologies under the same time
period in this study would be interesting and beneficial in order to give a fuller
picture of the profitability of these banks. Since having a rating system on cost
and profit efficiency can curb information asymmetry and as such, it will help
UKBs assess their level of profitability better and constrain the level of fragility to
avoid meltdowns in the financial sector.
Since profitability in the midst of financial fragility is being looked at,
including the other profitability measures and sources may be a good idea to have
a fuller view of the subject matter. It would be possible to look into products or
services that banks offer at the same time investments they make, which can have
an effect on the level of profitability and a relationship with financial fragility.
Specifically, in further studies, risk assets may be included in the model along
with other capital measures of banks since these elements are also significant in
looking into the credit riskiness of banks and the whole financial system.
The scope of the study may also be broaden to assess the whole financial
system of the Philippines by including not only UKBs but also other types such as
rural banks, cooperative and thrift banks. This will also determine the significance
of these banks to the whole financial system and on the concept of financial
fragility.
Another recommendation is the inclusion of a cross-country comparison
among ASEAN member countries, knowing that the country is the midst of the
ASEAN economic integration. This can be an essential factor to the study to
determine how the country fair in this aspect relative to its neighbors. This can
75
pose interesting and worth-keeping conclusions, which can help the countrys
have better strategies for growth and competitiveness in the ASEAN region. This
will also help evaluate the impact of financial fragility in the different countries,
especially on the banks profitability. In this way, different findings may arise
especially on the factors that affect the level of profitability among banks in
different countries. This will also show if banks in other countries behave
similarly with the banks in the Philippines or not.
76
APPENDIX A
Regression Results (Effect of Financial Fragility to the UKBs Profitability,

2000Q1 to 2014Q4)
Dependent Variable: ROA

Method: ML - ARCH (Marquardt) - Normal distribution
Date: 03/30/15 Time: 09:19
Sample (adjusted): 2000Q1 2014Q4
Included observations: 60 after adjustments
Convergence achieved after 3 iterations
Bollerslev-Wooldridge robust standard errors & covariance
Presample variance: backcast (parameter = 0.7)
LOG(GARCH) = C(13) + C(14)*ABS(RESID(-
1)/@SQRT(GARCH(-1))) +
C(15)*RESID(-1)/@SQRT(GARCH(-1)) +
C(16)*LOG(GARCH(-1))
Variable Coefficient Std. Error z-Statistic Prob.
C 0.033517 0.005849 5.730429 0.0000

REALGDP -5.81E-15 1.59E-15 -3.649375 0.0003
INTERESTRATE(-2) -0.051106 0.013971 -3.657936 0.0003
CIR -0.029087 0.005877 -4.948892 0.0000
ACL(-1) -2.36E-05 2.21E-05 -1.071368 0.2840
NPLR(-1) -0.017183 0.019369 -0.887138 0.3750
NPAGA(-1) 0.132347 0.036097 3.666402 0.0002
ROA(-1) 0.413084 0.074027 5.580181 0.0000
ACL(-4) 0.000117 2.92E-05 4.028163 0.0001
NPLR(-4) -0.046343 0.021362 -2.169450 0.0300
ROA(-4) -0.259667 0.058753 -4.419637 0.0000
NPAGA(-4) -0.109974 0.045698 -2.406550 0.0161
Variance Equation
C(13) -14.41351 160.2249 -0.089958 0.9283

C(14) 0.010000 0.217114 0.046059 0.9633
C(15) 0.010000 0.245195 0.040784 0.9675
C(16) 0.010000 11.02616 0.000907 0.9993
R-squared 0.969777 Mean dependent var 0.011288

Adjusted R-squared 0.962851 S.D. dependent var 0.004302
S.E. of regression 0.000829 Akaike info criterion -11.03259
Sum squared resid 3.30E-05 Schwarz criterion -10.47410
Log likelihood 346.9776 Hannan-Quinn criter. -10.81413
Durbin-Watson stat 1.493545
77
APPENDIX B

2000Q1 to 2009Q1)

Date: 03/30/15 Time: 09:14
Convergence achieved after 1 iteration
C 0.027913 0.005079 5.496131 0.0000

REALGDP -2.85E-15 1.85E-15 -1.539510 0.1237
INTERESTRATE(-2) -0.040578 0.014952 -2.713804 0.0067
CIR -0.027021 0.005386 -5.017057 0.0000
ACL(-1) -2.30E-05 3.01E-05 -0.763518 0.4452
NPLR(-1) -0.009882 0.027493 -0.359435 0.7193
NPAGA(-1) 0.108970 0.040674 2.679108 0.0074
ROA(-1) 0.421986 0.075776 5.568850 0.0000
ACL(-4) 0.000109 3.10E-05 3.513478 0.0004
NPLR(-4) -0.043437 0.025115 -1.729536 0.0837
ROA(-4) -0.278294 0.087953 -3.164134 0.0016
NPAGA(-4) -0.089674 0.052808 -1.698100 0.0895
Variance Equation
C(13) -14.89313 31.43620 -0.473757 0.6357

C(14) 0.010000 0.310524 0.032204 0.9743
C(15) 0.010000 0.148960 0.067132 0.9465
C(16) 0.010000 2.099451 0.004763 0.9962

78
APPENDIX C

2009Q1 to 2014Q14

Date: 03/30/15 Time: 09:13
Convergence achieved after 1 iteration
C 0.080462 0.013330 6.036306 0.0000

REALGDP -2.02E-15 1.56E-15 -1.295077 0.1953
INTERESTRATE(-2) -0.046832 0.041886 -1.118082 0.2635
CIR -0.060936 0.005164 -11.80068 0.0000
ACL(-1) -0.000313 7.65E-05 -4.090764 0.0000
NPLR(-1) -0.545466 0.100887 -5.406713 0.0000
NPAGA(-1) 0.634447 0.183832 3.451231 0.0006
ROA(-1) 0.501462 0.136624 3.670380 0.0002
ACL(-4) 9.54E-05 8.74E-05 1.092108 0.2748
NPLR(-4) 0.187178 0.155137 1.206533 0.2276
ROA(-4) 0.176864 0.079007 2.238593 0.0252
NPAGA(-4) -0.420231 0.183864 -2.285557 0.0223
Variance Equation
C(13) -15.46257 35.93652 -0.430275 0.6670

C(14) 0.010000 0.370752 0.026972 0.9785
C(15) 0.010000 0.189696 0.052716 0.9580
C(16) 0.010000 2.311244 0.004327 0.9965

79
APPENDIX D
Regression Results (Effect of Profitability of Banks to the Gross Value Added

of the Industry, 2000Q1 to 2014Q4)
Dependent Variable: FINGVA

Method: ML - ARCH
Date: 03/22/15 Time: 23:19
LOG(GARCH) = C(6) + C(7)*ABS(RESID(-1)/@SQRT(GARCH(-
1))) + C(8)
*RESID(-1)/@SQRT(GARCH(-1)) + C(9)*LOG(GARCH(-1))
C -6.37E+08 1.49E+09 -0.426750 0.6696

ROAF(-1) 2.24E+11 5.63E+10 3.987240 0.0001
FINGVA(-4) 1.024222 0.024037 42.61051 0.0000
REALTOTALLOANS -0.255751 0.930666 -0.274804 0.7835
RISKPREMIUM 8.82E+09 8.67E+09 1.016607 0.3093
Variance Equation
C(6) 3.688978 4.854307 0.759939 0.4473

C(7) 0.837282 0.401249 2.086690 0.0369
C(8) 0.117740 0.220293 0.534471 0.5930
C(9) 0.896961 0.114136 7.858706 0.0000
R-squared 0.982131 Mean dependent var 3.44E+10

Adjusted R-squared 0.980807 S.D. dependent var 1.28E+10
S.E. of regression 1.78E+09 Akaike info criterion 45.34513
Sum squared resid 1.71E+20 Schwarz criterion 45.66204
Log likelihood -1328.681 Hannan-Quinn criter. 45.46884
80
APPENDIX E


Method: ML - ARCH
Date: 03/22/15 Time: 23:18
1))) + C(8)
C 2.03E+10 5.58E+09 3.631771 0.0003

ROAF1(-1) 1.92E+11 6.94E+10 2.768620 0.0056
FINGVA(-4) 0.971708 0.041117 23.63295 0.0000
REALTOTALLOANS -12.63525 3.382850 -3.735091 0.0002
RISKPREMIUM -1.18E+10 8.12E+09 -1.452273 0.1464
Variance Equation
C(6) 6.991215 7.489972 0.933410 0.3506

C(7) 0.493832 0.589223 0.838108 0.4020
C(8) 0.299918 0.368289 0.814353 0.4154
C(9) 0.822387 0.183780 4.474854 0.0000

81
APPENDIX F


Method: ML - ARCH
Date: 03/22/15 Time: 23:19
1))) + C(8)
C -9.38E+09 5.06E+09 -1.853121 0.0639

ROAF2(-1) 1.38E+11 9.57E+10 1.440420 0.1497
FINGVA(-4) 1.087047 0.060142 18.07477 0.0000
REALTOTALLOANS 2.092550 1.247527 1.677358 0.0935
RISKPREMIUM 1.06E+11 4.30E+10 2.471733 0.0134
Variance Equation
C(6) 30.18277 20.42643 1.477633 0.1395

C(7) -2.560773 1.033168 -2.478565 0.0132
C(8) -1.731494 0.669339 -2.586870 0.0097
C(9) 0.329143 0.458232 0.718288 0.4726

82
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Financial Fragility

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Financial Fragility

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UNIVERSITY OF ASIA AND THE PACIFIC

A STUDY ON THE FINANCIAL FRAGILITY

A Sector Analysis Paper

Executive Summary viii

II REVIEW OF RELATED LITERATURE

THEORETICAL FRAMEWORK, CONCEPTUAL

PRESENTATION, INTERPRETATION, AND

SUMMARY, CONCLUSIONS, AND

Variables used for the Theoretical Framework and Empirical

1 Equilibrium Level IS-LM & the Real Sector 18

ACL Allowance for Credit Losses

The research dwells on the impact of financial fragility of Philippine

Universal and Commercial Banks to their profitability and contribution to the

macroeconomy. It seeks to confirm the existence of financial fragility in the major

in response to the fragility, which consequently affects their performance in the

sector and in the whole economy.

to further understand financial fragility. With these principles, the necessary

procedures to be taken were identified to answer the objectives of the study.

Looking through certain macroeconomic and bank-level data helped in verifying

to come up with significant findings and computations in giving answers to the

fragility, as indicated by non-performing loans, in the Philippine Financial System

through their monitoring system. In their consideration of financial fragility,

studies on financial fragility by incorporating other bank-level indicators such as

existing and potential borrowers to further mitigate the risks connected to

A. Background of the Study

that it experience mainly depends on the economic events, locally and

As the Philippine banking system continuous to become more complex

due to different societal events, one of the pressing concerns of banks in

developing countries nowadays is financial instability. Financial instability refers

to the inability of the financial system to perform its essential function of

channeling funds to those individuals or firms that have productive investment

financial sector since financial fragility is an indicator of the vulnerability of

of universal banks in the Philippines relative to its resiliency against external

the financial institution is not fully developed, the measurement of financial

which could be susceptible to financial failures and bank crisis.4

In addition, this paper tackles the efficiency of the universal banks in

relation to the concept of financial fragility. Especially since, determining banks

efficiency is important to be taken into consideration nowadays as the Philippine

country because of greater exposure to globalization. This is also significant since

in the Philippines should help determine its vulnerability to different economic

challenges or shocks in the future. Consequently, having a deeper knowledge of

serve as a precursor for the government to employ prudent crisis management,

prevention, and regulation of the financial system.

B. Statement of the Problem

banking sectors profitability and contribution to the macroeconomy affected by

financial fragility in the Philippine Financial Sector?

C. Objectives of the Study

At the end of the study, the researchers would like to:

1. Verify the presence of financial fragility in the universal and commercial

banks (UKBs) in the Philippines through different indicators.

2. Determine the effect of financial fragility to the profitability of banks

through the appropriate econometric tool.

3. Assess the influence of financial fragility and profitability of UKBs in the

Philippines to the contribution of the sector to the economy.

The study presents several importance to the Philippine economy,

informed and sound decision-making among firm owners, policymakers, investors

which offer extensive financial services of both commercial and investment

Moreover, this study is relevant primarily because it aims to give an

assessment of the current situation of the Philippine universal banks concerning,

can all be contributory to the worsening or easing of financial vulnerability of

This is essentially important among bank owners and managers as they

unfortunate financial meltdowns ahead as well as earn enough profits to sustain

the stable financial system.

In addition, this study may provide the policymakers, specifically the