Basel III capital standards were implemented in the Philippines beginning in 2014, earlier than other countries. This led Philippine banks to raise capital through various means in 2014. While the largest banks already had strong capital positions, other banks saw their capital ratios decline by around 200 basis points on average after Basel III took effect, in line with expectations. From 2010 to 2018, GDP growth remained steady around 6-8% despite changes to capital levels, contrasting predictions that growth may decline. However, returns on equity declined noticeably across big banks during this period, converging to around 8-10% for most, suggesting Basel III may have compressed bank profitability as expected by research.

1. Basel III and ROE in the Philippines
Basel III
The year 2019 is not just the end of a decade (arguably!) but also the culmination of the Basel
III Accord phase-in arrangements for capital adequacy and liquidity standards. Recall that
during 2012-2013, in response to the global financial crisis of 2008-2009, the Basel Committee
on Banking Supervision (BCBS) released a reform package with the goal of increasing the
safety of the financial sector. The creation of Basel III standards introduced new measures such
as the leverage ratio, capital strengthening tools such as capital conservation buffer, changes in
Common Equity Tier 1 (CET1) composition and higher capital requirements as well as new
standardized measures for liquidity risk management.
In the Philippines, the Bangko Sentral ng Pilipinas (BSP) released Circular No. 781 early in
2013 adopting the new Basel III framework for universal and commercial banks (U/KB’s). While
the BCBS version provided for a phased implementation of the reforms, the BSP adopted the
capital adequacy standards in full earlier than the rest of the world beginning January 1, 2014.
This is with the view that the domestic banking industry has strong capital position and that the
BSP believes that a deferred or phased approach may only lead to market uncertainty1
. Other
ASEAN countries such as Singapore, Malaysia and Thailand elected to follow the phased
implementation.
Looking back at the past decade, we saw a period of transition to the reforms made by Basel III.
Let’s have a quick trip down memory lane and see what happened along the way.
Capital and Banking Profitability
Capital
Before the full implementation of the Basel III framework, various industry research materials
discussed its impact such as capital shortfalls, operational challenges, necessary increases in
short-term liquidity and long-term funding needs. However, return on equity (ROE) stood out as
one important consideration for the transition in view of the need to raise additional capital.
Mckinsey & Company, through its seminal Mckinsey Working Papers on Risk, wrote a research
entitled Basel III and European banking: Its impact, how banks might respond, and the
challenges of implementation. In this paper, we had a glimpse what’s in store for banks in
Europe and in the US. The Mckinsey paper posited that ROE’s will decline by about 4
percentage points in Europe and 3 percentage points in the US. The impact on ROE is driven
by higher capital requirements and the liquidity requirements under the new liquidity coverage
ratio (LCR) and the net stable funding ratio (NSFR) measures. While the banking sector is
essentially tied-up to the economic cycle, policy changes are expected to have a substantial
effect on the profitability of the industry.
1
BSP Memorandum No. M-2013-008 dated March 5, 2013

2. As the BSP posed in its justification for the early roll-out of the capital adequacy portion of the
Basel III framework, the Philippine banking system has strong capital position owing mainly to
higher capital adequacy standards employed even during the Basel II era. We witnessed a
variety of capital-raising exercises during 2014 which includes equity offerings (through rights
issuance) and flotation of tier 2 capital instruments.
Figure 1 shows the three biggest privately-owned banks2
had significant headroom in capital
prior to the implementation of the new capital adequacy standards. Following the Basel III
implementation in 2014, we saw no distinct or discernible pattern of increase or decrease in the
CAR of the “big 3” banks as opposed to the bigger U/KB group which manifested about 200
basis points (bps) decline in capital between pre- and post-implementation.
Figure 1.
This decline can be partly attributed to the capital quality changes resulting to the derecognition
of certain capital instruments and regulatory adjustments to the CET1. We see more apparent
cases of decline in CAR’s for the next three big banks.
2
The largest privately-owned banks by total assets as of September 2019 are as follows: BDO Unibank, Inc. (BDO),
Metropolitan Bank and Trust Company (MBT) and Bank of the Philippine Islands (BPI). The next three largest
privately-owned banks are Philippine National Bank (PNB), China Banking Corporation (CHIB) and Security Bank
Corporation (SECB).

3. Figure 2 features the next three big banks in the U/KB group. The next three big U/KB’s have it
the other way around. Post-implementation capital ratios have declined by about 200 bps
consistent with the trajectory of the whole U/KB group. PNB, China Bank and Security Bank
were running an average of about 17% in total capital before Basel III which is about 300 bps
higher than their peers in the top 3. However, post-implementation and until 2018, the
differences are almost negligible.
Figure 2.
It is noticeable as well that the average post-implementation CAR’s of the smaller banks,
excluding Security Bank, have converged towards the average of their peers in the “big 3” which
is about 13.5%. While we have not further examined whether the convergence was a result of
individual strategies (e.g. timing of capital raising, different capital deployment strategies –
target market, etc.) or whether the Basel III implementation has leveled the capital use and
capital formation activities of banks, we note that the overall decline in the U/KB group is
consistent with the expectations of a “restructured” balance sheet in the banking sector.
Domestic growth and credit environment
Before diving deeper into the individual ROE’s of the big banks, let us refresh our perspective of
the domestic credit environment during 2010 to 2018. While the period had several instances of
policy rate changes to address brewing inflation, we saw no major domestic, regional or global
event that caused significant challenges in the Philippines financial system. The period saw

4. some changes in the BSP for open market operations3
and fiscal policy changes through a tax
reform package4
. GDP growth settled within the 6%-8% band while seeing a significant rise in
lending activity with year-on-year loan growth averaging 17% during 2017-2018 from about
8.5% at the start of the decade.
Figure 3.
We note the sustained levels of GDP growth as well as the robust loan growth notwithstanding
changes in the banking sector’s capital landscape. This appears to be in contrast with early
forecasts that a potential decline in GDP growth is expected as a result of higher capital
requirements and the consequent increased lending spreads5
.
ROE
Return on equity (ROE) is another story. From what we’ve seen in the Mckinsey paper, the
required fresh capital and funding shift are the major drivers of the potential decline in ROE’s.
We recognize, however, the Philippine banking system has significant capital headroom prior to
the implementation of the revised capital adequacy standards. We believe that this condition
specific to the Philippines should temper the overall impact on profitability.
3
The BSP introduced the interest rate corridor framework which is a system for guiding short-term market interest
rates towards the intended policy rates which is typically in between the ceiling and floor bands. Under the
framework, the old corridor structure is replaced by the use of overnight lending facility and overnight deposit facility.
4
The TRAIN Law provides a comprehensive package of reforms in personal income tax, estate tax, donor’s tax,
value-added tax (VAT), stamp taxes and excise tax on certain products.
5
Philippine banks have more informal risk-based lending which is primarily “relationship-driven” rather than using
calculated “formula-driven” spreads.

5. Looking roughly at the 2010-2018 data, Figure 4 shows a notable decline in ROE across the
subject banks and the U/KB group.
Figure 4.
There appears to be a return compression converging towards around 8%-10% even for
Security Bank which earlier reported a whopping 35% ROE during 2010 in a period where every
other big bank reported less than 20% ROE’s. We observed that the convergence in ROE’s
followed the same path as the convergence in CAR’s at around 13%-15% manifesting towards
the end of 2018. This supposed eventual convergence for big banks poses a question on
whether Basel III capital adequacy standards has such strong power to pull big banks towards
similar profitability levels.
Tying it all up
We observed domestic universal and commercial banks were able to meet the required
minimum capital following the implementation of the Basel III framework. We believe that higher
capital standards and a simplified approach to capital raising contributed to the robustness of
the balance sheets of the big banks. This strength consequently allowed the big banks to
transition smoothly to the new framework. ROE’s have noticeably declined notwithstanding
consistent GDP growth above 6% and increased loan growth. Wrapping up 2019, we will see
more tools going into the “standard in force” which will then give us more insights in the future
as to how the reforms of the past have served the banking industry and the economy.