CAPITAL MARKETS

INTRODUCTION

The previous chapter discussed that the role of financial intermediaries is to make the
needs of surplus units and deficit units meet.Financial intermediaries are the bridges that
enable meeting of investors or surplus units and borrowers or deficit units.Financial
intermediaries are also instrumental in bringing about the different types of financiall
instruments or securities that we find in the financial markets.
The National Statistical Coordination Board of the Philippine Statistics Authority (PSA)
reports that the national accounts of the Philippines highlight financial intermediation.Tables 2
and 3 show the annual gross value added in the financial intermediation by industry group in
the Philippines for the years 2013 and 2014 and their corresponding growth rates.

Table 2: Gross Value Added in Financial Intermediation by Industry Group (2013 and 2014
Annual at Constant 2000 Prices)

Annual Increas Growth

Industry/Industry Group
2013 2014 e/ Rata
Decrea
se

1.Banking Institutions 213,25 229,94 16,69 7.83

1 5 4 %

2.Non-bank Financial Intermediation 156,90 168,24 11,34 7.23

5 8 3 %

3.Insurance 83,18 89,33 6,15 7.40

3 8 5 %

4.Activities Auxiliary to Financial 27,34 27,95 60 2.23

Intermediation 4 3 9 %

Gross Value Added in Financial Intermediation 480,68 515,48 34,80 7.24

3 4 1 %

Table 2 shows that all sectors of the industry group(financial intermediationl experienced
growth-7.83%for banking institutions,7.23%for non-bank financial intermediation,7.40%for
insurance,and 2.23%for activities auxiliary to financial intermediation.The
total gross value added in financial intermediation experienced a 7.24% overall
growth rate.
 Table 3 shows the gross value added growth rates in financial intermediation by
industry group for the year 2012 compared to 2013,and for the year 2013 compared to
2014.

Table 3;Gross Value Added in Financial Intermediation by Industry Group(Annual 2012

Compared to 2013 and 2013 Compared to 2014)

Annual
Industry/industry Group
2012-2013 2013-2014

1.Banking Institutions 15.4 12.3

% %

2.Non-bank Financial Intermediation 14.3 11.7

% %

3.Insurance 20.0 11.9

% %

4.Activities Auxiliary to Financial Intermediation 16.5 6.5

% %

Gross Value Added in Financial Intermediation 15.9 11.7

% %

Table 3 shows that banking institutions grew by 15.4%in 2013 and 12.3%in
2014;non. kank financial intermediation grew bv 14.3%in 2013 and 11.7%in
2014.Insurance grew bv 30%in 2013 and 11.9%in 2014.Activities auxiliary to financial
intermediation grew by 16.5% in2013 and 6.5%in 2014.However,this also shows that
the growth rates in 2013 were higher than in 2014.Overall,the industry grew
15.9%in 2013 and 11.7%in 2014.

in this chapter,the students will learn how deficit units,savings units,and

intermediaries interplay in the business world.Financial intermediation and the
role of the different fnancial intermediaries play in the business world will be
discussed.Similarly,the role that avings units and deficit units play in the economv
will be explored.Students will also learn what disintermediation is,how it takes
place.and its effect on financial intermediaries. Furthermore,mismatching of
securities and how it works to the advantage and disadvantage of financial
intermediaries will be explained.In addition,the different types of risks faced bv fnancial
intermediaries and investors will be discussed.Bank supervision and bank regulation will be
explained and differentiated,and how the CAMELS rating is applied relative to bank
supervision and regulation.

FINANCIAL INTERMEDIARIES:DEFINITION

Financial intermediaries are the financial institutions that act as a bridge between
investors or savers(surplus units or SUs)and borrowers or security issuers(deficit units
or DUs).They may simply act as a bridge between deficit units and surplus units without
owning the securities issued by the deficit units.However,they can transfer them directly tol
the surplus units or investors,just like market specialists or brokers,or in certain instances,
like investment banks/merchant banks which underwrite certain original issues.Generally,
financial intermediaries buy the securities issued by the deficit units for their own account.
What they do is issue their own financial instruments called secondary securities,which they
sell directly to investors or surplus units.Financial intermediaries can therefore either help sell
the primary securities issued by the original issuers or issue their own financial instruments as
secondary securities.

A bank gets deposits from the depositors.In this case,the depositor is the lender and
the bank is the borrower.Original borrowers issue primary securities.In this case,the primary
security is the deposit account,that is,the checking account.The check (primary security)is
an asset (e.g.,marketable securities)that the buyer of the security can use to pay his account.
The bank depositor who bought the primary security can now use it-in this case,the check-
to pay his account,if the lender is willing to accept the check.This is the same with the buyers
of marketable securities who can sell their marketable securities or use them to pay his
account if the lender to the owner of the securities is willing to accept them as payment.

The bank,as a financial intermediary,can create secondary securities

that it can sell.It can pool deposits to avail a bigger amount that can be
transformed or created into a secondary Security like loans.commercial
papers,or negotiable certificate of deposits.which they can |sel to
interested investors or simply lend accumulated deposits to borrowers
as a loan.The |asset transformation role of financial intermediaries is
clearly seen through their issuance of secondary securities.The
primary securities they buy are transformed into secondary securities
that they issue.

Commercial papers (CPs)or negotiable certificates of

deposits(NCDs)that a bank issues are secondary securities.Loan is a
secondary security.The primary security (check or checking account)is now
transformed into a secondary security (CPs or NCDs).Borrowers do not
need to contact the savers directly.In the process,banks earn through the
interest spread between what these banks pay to depositors as interest and
the interest that these banks charge to their borrowers,For example,a bank
gives 6%interest to depositors,but charges the borrowers. 12%.The
spread is 6%,which is the difference between the two rates (12%-
6%=6%).

Asidefrom pension funds,which are usuallyissued byinsurance

companies,otherfinancial intermediaries issue securities as
NCDs,MMMFs,MMDAs,mortgage-backed securities,and the like.Financial
intermediaries have brought into existence several of the financial products
or securities now available in the financial markets.Financial
intermediaries are generallv large and have economies of scale in terms
of operation,and specifically,in analyzing the creditworthiness of borrowers
to ensure that securities issued by these borrowers are worth investing
into or purchasing for the buyers/investors.As Weston and
Brigham(1993)stated:

A system of specialized intermediaries can enable savings to do more than just

draw interest.For example,individuals can put money in banks and get both
interest income and a convenient way of making payments(checking),or put
money into life insurance companies and get both interest income and protection
for their beneficiaries.

Financial intermediaries do not only sell securities issued by other

companies;they also issue their own securities to raise funds to purchase securities of other
corporations they wish to buy either as their own investment or for resale in
cases where selling them will give them better profits.These secondary securities issued by
financial intermediaries include savings deposits,life insurance
policies,MMMFs,pensions,and pre-need plans,etc.Financial intermediaries use
these secondary securities to attract funds from surplus units,the same funds
they use to buy the primary securities issued by deficit units.

Financial intermediaries are different from other businesses in that their

assets and liabilities are overwhelmingly financial.They have very small amounts
of tangible assets.This is because intermediaries simply move funds from one
sector to another (Bodie et al.1995). Compared with non-financial firms,the
deposits they accept from both financial and non financial firms are their
liabilities while these deposits are the assets of the non-financial and financial firms
doing the deposit.The loans the depository institutions grant to non-financial and financial
Assets Liabilities &
firms are the assetsEquity
of the depository institutions,which are,in turn,the liabilities of
the Loans
borrower non-financial
Deposits and financial firms.This is Liabilities
Assets explained & further bv the
Equity
following illustration:
Deposits Loans

Depository Institutions Non Financial/Other

Financial Institutions

In short,the deposits made by the non-financial and financial

institutions are their assets and these deposits they place with the
depository institutions become the liabilities of the depository
institutions.On the other hand,the loans that the depository
institutions grant the non-financial and financial institutions are the
assets of the depository institutions and the liabilities of the non-
financial and other financial institutions.

DIRECT AND INDIRECT FINANCE

A borrower-lender relationship is the tvpical direct finance

relationship or transaction.A hank and a bank depositor are engaged in
direct finance;similarly,a bank and a bank borrower are engaged in
direct finance.If you borrow money from your aunt,that is direct
finance. An incorporator buying shares from the issuing corporation
also engages in direct finance. There is no need for any financial
intermediary.The checking account,savings account,or time deposit
certificate is originally issued by the bank to the depositor that acts as
the buyer of the security.The depositor“pays”for the
checking,savings,or time certificate of deposit issued by the
bank.The claims arising from a direct finance transaction,in our
example:the deposit,loan,and stock,are all primary or direct
securities.A direct security/primary security flows directly from the
borrowing unit to the lending or investing unit.
 Likewise,when someone or a company borrows from a bank,he or
the company issues apromissory note,which is the primary security for
the funds given by the bank in exchange. In essence,the borrower
"sells"his promissory note and he is "paid"by the bank through the
funds given to him that he borrowed.The relationship between the
borrower and the bank is direct,hence,direct finance.However,the
relationship between the depositors,where the funds lent to
borrowers came from,and the borrower from the bank,is indirect
finance.The borrowers do not even know who the depositors are.

Figure 13 shows direct finance without the use of a market specialist.

Direct/Primary Security
Investors
(Surplus Units)
Units) Fund Bank,Depositors,
Borrowers (Deficit Corporations
Banks,Borrowers,
lssuing Corps.

Figure 14 shows direct finance using a market specialist as a transfer agent

like brokers. The primary or direct security goes directly from the
issuer/borrower to the investor/saver. This is exactlv what Kidwell et al.
(2013)explained when they said that direct financing is one "where funds flow
directly through financial markets."The market specialist still transfers the original
issue/primary security (same issue issued by the issuing company),which is the
direct securitv.and does not create a new or secondary issue.These financial
institutions that channel funds directlv to deficit units from the surplus units but
do not issue their own financial instruments or securities are called market
specialists.Direct securities or primary securities such as stocks and bonds
sold in the open market through market specialists are termed as open
market securities. Market specialists are a special type of
financial Intermediary in the sense that they provide the
connection between surplus and deficit units but do not issue
their own securities.Market specialists help move funds
through financial markets.A market specialist does not acquire the
securities that he helps to sell. For instance,a broker who is a market
specialist,simply facilitates the sale of original or primary security issued by
corporations by looking for investors wlling to buy the securities.They
 simply find buyers for the primary/original securities and thev are paid
commissions.

Indirect finance is like the relationship between the depositor of a bank and the

borrowers of the same bank.The funds lent to the borrowers came from the deposits of
the banks depositors.The relationship between the bank and the depositors is direct like
the relationship between the bank and the borrowers,while that between the depositors
and the borrowers is indirect and therefore,indirect finance.The foregoing relationships are
illustrated in Figure 15.

Another transaction that involves indirect finance is the use of a

middleman or an intermediary,which generally happens in the secondary
financial market.When intermediaries pool deposits and transform them into
secondary securities which they sell to investors,it is called indirect
finance.That is exactly what banks do when they pool deposits and then grant
loans to borrowers.

CHANGING NATURE OF FINANCIAL INTERMEDIARIES

 Financial intermediaries have changed over time not only in structure but also in its
functions.Old simple financial intermediaries.which specialized in a single function like getting
Aeposits and granting loans,had become complex in structure with different departments
performing several specialized functions.

The Old Financial Environment

Thomas (1997)described the changing nature of financial intermediation.According to

him.the US Congress,after the Great Depression of the 1930s,devised a host of measures to
promote a highly specialized financial svstem.Banks were set up to take in deposits and grant
onlv short-term loans.Creation of branches was limited and interest rates were duly regulated.
Thrift institutions,to protect banks,were prohibited to grant consumer and commercial loans
and issue checking accounts and were forced to specialize in long-term fixed-rate mortgages.
life insurance companies were allowed onlv to issue policies and purchase corporate bonds.
not stocks.In 1933,the Banking Act of 1933(Glass Steagall Act)separated commercial and
investment banking.Commercial banks were no longer allowed to underwrite corporate
stocks and bonds,which function became the dominion of investment banks,and thev
were not allowed to hold common stocks in their investment portfolios.On the other hand.
investment banks were not allowed to accept household deposits or grant commercial loans,
which became the domain of commercial banks.Financial institutions therefore became highly
specialized.Households can no longer go to one financial institution and transact all their
businesses there.They have to go to banks to open checking accounts,go to an insurance
company to purchase insurance policies,go to a thrift institution to mortgage their house
and lot,etc.Companies who issue stocks and bonds have to go to an investment bank for
underwriting of their issues and go to a commercial bank for a loan.Severe restrictions were
placed on the portfolios of depository institutions,especially thrifts.This was known as the old
financial environment (OFE).

The New Financial Environment

OFE began to change in the mid-1970s when the increase in market rates of interest
accompanied by high and rising rates of inflation clashed with the existing
regulatory structures.The Hadiimichalakises(1995)described the new financial
environment as being characterized bv market-determined or deregulated rates on
assets and liabilities of financial intermediaries and bv greater homogeneity among
financial institutions,which emerged in the 1980s.Financial institutions can now
perform various financial functions,which enable households and companies to go to a
single financial institution to transact various financial businesses.Thereupon emerged
the new financial environment (NFE)characterized by financial innovations.New
practices and new products emerged.Laws,regulations, institutional
arrangements,and technological innovations were introduced.These innovations Sprung
from attempts bv households,firms,and banks to circumvent existing regulations to
maximize profit/wealth.The governments were left with no other choice but to simply
protect the health of their respective economic and financial systems.The
Hadjimichalakises (1995) pined that the proximate cause for the demise of the regulated
deposit rates in the 1930s until the early 1970s was the high and rising rate of inflation
in the late 1960s,the 1970s
and the early 1980s.According to them,inflation rate rose from 4.7%in 1972
to 9.7%(an increase of 5%)in 1981(in a span of 9 years).This inflation rate
embedded in the double.
digit rate of interest pushed interest rates to go up.As the spread between deposit
rates and interest rates widened,wealthy households and firms withdrew their
funds from the regular. rate deposit accounts and placed them in higher-earning financial
instruments like T-bills. which pay market-determined rates.Small savers were
unable to take advantage of these financial instruments because of
denominations they could not afford.The outflow of fundsl from financial
intermediaries is termed disintermediation,which plagued the depository
institutions,especially thrifts.Moreover,financial technology developed and
paved the wav for those who can afford said technology to circumvent existing
regulatory structures.As such. the old structures became less effective and less
useful,and ultimately became obsolete.

In the early 1970s,MMMFs were first introduced and households and small
businesses began to have access to a saving tool better than deposits.In
1977,Merrill Lynch created the cash management account (CMA)by combining
MMMF features with securities account and credit line(Hadjimichalakises
1995).CMA is an MMMF in which deposited funds can be used to purchase
securities or can be withdrawn bv check or credit card.It has no limit on the
number of checks that can be issued against the account or the size of the
check.Credit cards
also grew secondary to advances in computer technology,making it profitable for
banks to mass market the same.Private pension funds and state and local
government retirement funds also grew.This dramatic increase in pension funds
and mutual funds hurt commercial banks, thrift institutions,and investment banks
benefiting life insurance companies,which moved into management of pension
 fund assets.It also raised interest rates on deposit to prevent withdrawal of
deposits,boosted the commercial paper market,and allowed small businesses to
borrow from finance companies which,in turn,issue commercial papers to obtain
loanable funds.It also increased the demand for high-yielding mortgage-backed
securities that led to the securitization of consumer loans in the mid-1980s
(Thomas 1997).Securitization means loans made by banks and finance
companies were transformed into securities sold in large blocks.

In the advent of the new financial environment,credit cards replaced

money in the wallets of individuals and business executives.Even companies
opened their own credit card accounts.Corporate credit cards are a distinct group
within the greater credit card universe, separate from both personal and small
business credit cards.Companies may provide their employees with corporate
cards for the payment of approved,business-related expenses, most often
travel-related.Usually issued in the company's name,corporate cards also display
the name of the individual employee cardholder.Unlike personal and small
business cards, corporate credit cards are offered by only a few
issuers,Corporate credit card accounts are generally established by businesses
using a banking relationship or via deal negotiated directly with a card issuer.In
developing such relationship,the company's credit is considered,iust as an
individual's credit is considered when applying for a consumer credit card.When it
comes to payment,corporate cards fall into two categories:individual payment
cards and company payment cards.Employees who are issued an individual
payment card are responsible for submitting their own expense reports based on
company policy and paying the issuer directly for any changes. With company-
payment cards, the employer picks up the tab for all company-sanctioned charges. The
employeee may still pay the issuer directly for any unapproved or personal charge.
(Creditcards.com)

CLASSIFICATION OF FINANCIAL INTERMEDIARIES

Financial intermediaries varied but they have one comon characteristic. All of the
issue secondary securities to be able to purchase primary securities issued by deficit units.
They can however be grouped into basic categories:

1. Depository institutions

2. Non-depository institutions

DEPOSITORY INSTITUTIONS
 Depository institutions, as the name implies, refer to financial institutions that accept
deposits from surplus units. They issue checking or current accouts/demand deposits,
savings, time deposits, and help depositors with money market placements. Current or
checking accounts can be withdrawn by issuing checks. Most current accounts do not
earn inerest, although due to competition, ther are now banks offering interest on these
checking or current accounts. These are called NOW accounts. Savings account ca be
withdrawn by using passbooks given by the bank to the depositors when they initially
make their deposits. All the deposits and withdrawals are recorded in the same passbook.
It also details the interest earned and any taxes or charges deducted from the account.
Time deposits refer to deposits that have maturity, likr 30 days, 60 days, 180 days, or one
year. These deposits may not be withdrawn without penalty prior to maturity, but they earn
more interest than the savings account. Time deposits are evidenced by certificates of
deposits; however, these are not the negotiable CDs bought and sold in the open markets.
These banks or depository institutions help the depositors if the depositors want to ean
more than time deposits, and do the more risky money market placements.

These depository institutions pool the deposits of the depositors and lend the
pooled funds to deficit units or purchase securities. The dposits hat depository institutions
issue are free of risk as the amount f deposit or principal does not fluctuate like stocks and
bonds. Deposits are not only reduced if the depositor makes withdrawals or if there are
certain bank charges, like in cases when deposits go below the allowed minimum balance.
The deposits placed in these institutions, genrally, can be withdrawn on demand or in
certain cases only a short notice (if the amount to be withdrawn is too large). Individuals
and business companies are epositors and they are also borrowers.

Depository institutions include:

1) Commercial Banks

a. Ordinary commercial banks

b. Expanded commercial or universal banks

2) Thrift banks

A. Savings and mortgage banks

b. Savings and loan associations

c. Private development banks

d. Microfinance thrift banks

 e. Credit unions

3) Rural banks

Commercial Banks

Commercial banks are perhaps the biggest of the depository

institutions,Universal and commercial banks represent the largest single group of
financial institutions,resource-wise,in the country.They could have been the pioneers in
financial intermediation.

Ordinary commercial banks perform the more simple functions of accepting deposits and
granting loans.They do not do investment functions.Traditionally,commercial banks
grant only short-term loans.These loans were originally extended to merchants for the
transport of their goods in both the domestic and international markets,as well as to
finance the holdingof inventories during the brief period required for their sale.As the
industry developed and grew. producers became the clients of commercial
banks.Today,commercial banks are the largest lenders in commercial and industrial
loans,They supply funds to traders,manufacturers, industries,governments,and
other financial institutions,Liabilities of commercial banks and commercial banks
alone (except smaller savings and depository institutions)circulate as
money.Commercial banks have the power to create and destroy money through their
savings and loan operations (Fajardo et al,1994).Money does not only refer to currency
and coins but also includes checking/current accounts or demand deposits,regular
savings accounts,and small time deposits.Bank credit also increases money supply.

For instance,someone deposited P1,000 in the bank.The bank puts 8%as reserve
and is therefore able to lend the remaining 92%orP920.The borrower puts the P920 in
the bank The reserve is 8%leaving P846 available for lending.Another borrower puts
846 borrowed in the bank.The reserve is 8%leaving P778 available for lending.This
will continue almost endlessly.Just at this point,the P1,000 has grown
into:P1,000+P920+P846+P778=P3,544. That is how banks create money through its
lending operation.

In 1980,the financial reforms in the Philippines saw the creation of what is now known

as"universal banks"(Fajardo et al.1994).Universal banks or expanded commercial

banks are a combination of commercial banks and an investment house.They
perform expanded commercial banking functions(domestic and international) and underwriting
functions of an investment house.They offer the widest variety of banking services
among financial institutions.In addition to the function of an ordinary commercial
bank,universal banks are also authorized to engage in underwriting and other functions
of investment houses and invest in equities of non-allied undertakings.In
addition,they render financial services,payment processing,securities
transactions,underwriting(like merchant banks),and financial analysis.

The functions of an investment house may be done by the commercial bank:

(1)in. house by establishing a department for the purpose or by (2)the establishment of a
subsidiary which will do the investment function.As an investment house,however,they
cannot go into ather finance companies business,such as leasing.As an investment
house,they can only do underwriting of securities,securities dealership,and equity
investment.The minimum paid-in rapitalof a universal bank is P1.5 billion.Some
commercial and universal banks have become elobal.
in its website,Thismatter.com expounded on commercial banks citing the following:

The primary business of commercial banks is to serve businesses,although with banking

deregulation,they have entered into the consumer business as well.Commercial banks
provide the widest variety of banking services.In addition to savings accounts,checking
services,consumer loans,commercial and industrial (C&l)loans,and credit
cards, commercial banks may also offer trust services,trade financing,investment
banking, and management for corporations,governments and their
agencies,and treasury
services.Community banks,however,are smaller commercial banks with assets of
less than $1 billion that generally serve their immediate community of consumers
and smalll businesses.Community banks are often called regional and super-
regional banks that cover a much wider geographic area and usually have assets in
the hundreds of billions of dollars.They have many branches that extend into
several states and many ATMs at convenient locations throughout their
area.Global banks also offer international services such as letters of credit and
currency exchange.These larger banks use short- term borrowing,also the most
numerous by a large margin.Some commercial banks borrow in the money
markets to supplement their deposits and often requlre loans from the smaller
community banks.These correspondent banks have accounts at the larger
banks,which facilitate the frequent transfers of funds with the big banks.Some
banks- money center banks-borrow for their funding instead of relying on
deposits.However, the recent credit crisis has forced money center banks to become depository
institutions because they could not sell their commercial paper or bonds in financial
markets that have been greatly diminished by investors'fear of defaults.
 According to Investorwords.com,universal banking is a system of banking where
banks are allowed to provide a variety of services to their customers.In universal
banking,banks are not limited to just loans,checking and savings accounts,and other
similar activities,but are allowed to offer investment services as well
(Investorwords.com).Also,Thefreedictionary.com defined "universal banking"as banking
services that include savings,loans,and investments. Universal banking combines both
commercial banking and investment banking.The term universal banking is more
common in Europe than in the US because of stricter regulation of American banks.
(Thefreedictionary.com)

Deposits are a significant part of the money supply of a country.Commercial

banks play a key role in using these deposits as do other depository institutions in
the economic development of the country.Also,being in direct contact with the central
bank of the country, they receive all regulations and monetary policies of the central bank,which
governs the financial svstem in the country.As such,they disseminate these regulations
and policies to their depositors.Just like any otherfinancial intermediaries,they
mismatch maturities creating new instruments/securities in the process-making available
to even small depositors a variety of securities/instruments as saving tools.Mismatching of
securities means that they can turn short-term instruments like deposits into long-term
securities like bonds or long-term loans.

While deposits form a major part of commercial banks'liabilities or source of funding.

commercial banks also have other non-deposit sources of funds,such as subordinated notesl
and debentures.Their loans,on the other hand,are a mixture of consumer loans,commerciall
loans,real estate loans,and even international loans.Traditionally,commercial banks werel
the only depository institutions allowed by law to offer transaction services by providing al
financial instrument-demand deposits(better known as checking accounts)-that serve as a
medium of exchange.Historically,commercial banks served the financial needs of commerce
by providing a substantial portion of short-term credit to non-financial businesses providing
the bulk of the money in the form of checking accounts (Hadjimichalakises 1995).

Commercial banks,like some other smaller depositoryinstitutions,have several branches

in the different parts of the country.These enable them to reach a broader base and help the
country in its economic development.Nationwide branching is common among commercial
banks and this has helped not only the country,in general but also the communities where
these branches are located,in particular.

Forming a significant part of the financial system of any country,banks are regulated
by the central bank and the government to protect against any disruption in the provision of
 their services and to protect the cost that will be imposed on the economy.However,they
are regulated separately from savings institutions and credit unions.

Bank supervision and bank regulation are essential for the maintenance of a balanced
financial system.Bank supervision deals with ensuring the soundness and safety of banks.
Bank regulation consists of the administration of laws in the form of rules and
regulations that govern the conduct of banking and the structure of the banking
industry.There are bank regulations that govern the establishment of a certain bank
in a certain location.There are also bank regulations that govern mergers or
acquisitions affecting banks.Banks and other financial institutions are supervised and
regulated to ensure they engage in healthy practices to maintain a healthy financial
system.They are supervised and regulated to ensure they perform their functions to
benefit not only their own organizations,but also the people they serve,in
particular,and the economy and the country,in general.

The Philippine Deposit Insurance Corporation insures the deposits in the

depository institutions,including commercial banks to help depositors have peace of
mind knowing that their deposits are insured and therefore,safe in the banks.PDIC
helps in maintaining a healthy financial system in the Philippines.

Regulatory agencies in the Philippines include the Bangko Sentral ng Pilipinas,Securities

and Exchange Commission,Bureau of Internal Revenue,and the provincial,city.or
locall governments.Onsite reviews are at times made to ensure the healthy
operations of these depository institutions.

Prior to 1994,the MACRO rating was used by regulatory agencies to gauge

credit standing of banks:
M Management

A Asset quality
C Capital adequacy

R Risk management

O Operating results

in 1994,the Hadjimichalakises (1995)identified the CAMELS rating:

c Capital adequacy
A Asset quality

M Management

E Earnings
 L. Liquidity

S Sensitivity to risk

The CAMELS rating aims to determine a bank's overall condition and identify its
strengths and weaknesses financially,operationally,and managerially.Each element is
assigned a numerical rating based on the five key components (Pdf.usaid.gov).The
CAMELS rating is a comprehensive rating with one signifying the best rating and five
the lowest.It provides an early warning signal to prevent a collapse.A rating of one
means most stable,two or three are average suggesting supervisory attention,and four
or five for below average signaling a problem bank.