The International Monetary Fund has warned the Philippine government that the economy faces a risk that a “highly-leveraged conglomerate”, or one part of it, would default on its “foreign obligations and/or domestic loans”.

“With a handful of large conglomerates following broadly similar business models, and bank exposure to them equivalent to a sizeable share of total capital, systemic risks are heightened, “ the IMF explained in its Country Report No. 12/102, or its staff report for the 2013 Article IV Consultation with the Philippine government dated April 2013. (Each member country of the IMF is required to provide data to and consult with the Fund’s staff regarding its economic situation and policies as provided for in Article IV of its Articles of Agreement.)

It outlined the scenario that could unravel as a result of a default by this “highly leveraged conglomerate”:

• “Loans to the entire group are written down, causing a major reduction of bank capital. Reduced bank capital would create a domestic credit crunch.”

• “Concerns arise about the profitability and liquidity of other major conglomerates, raising their funding costs. “

While the IMF listed the default risk in its “Risk Assessment Matrix” in the report’s appendix as “low”, it appears to be deliberately underemphasizing the problem in that manner, since the concern is raised in several parts of the document’s main body.

After explaining the risk the country faces on the “external (international) side”, it noted in the part on risks “on the domestic side”:

“Debt-servicing problems at a domestic conglomerate could lead to sharply higher funding costs, undercapitalized banks, and a domestic credit crunch that pulls down growth sharply given the relatively concentrated loan portfolios of many banks. “

What the IMF was actually describing in its technocratic language was a scenario of financial panic if the “highly-leveraged conglomerate” fails to service its loans: Banks would pull back on their loan exposures to corporations, and demand high interest rates for their credits. Interest rates for the entire country would rise.

The IMF report noted that the Bangko Sentral ng Pilipinas’ “recently-strengthened governance requirements” for banks had disclosed that they have “large exposures to consolidated clients.”

Because of these new data, the BSP has been preparing so-called “conglomerate maps”. I was told by my BSP sources, that these “maps” represent its investigations to penetrate the “corporate layering” done by several conglomerates to evade banking regulations on the single-borrowers limit (SBL).

The SBL regulation, according to the General Banking Act of 2000, requires that “loans extended by a bank to any person, partnership, association, corporation or other entity shall at no time exceed 20 percent [raised to 25 percent in subsequent years] of the net worth of such bank. The basis for determining compliance with the single borrower limit is the total credit commitment of the bank to the borrower.” The SBL limit was designed to prevent banks from building up loans to a single borrower so much that its default would ruin the financial institution.

“It’s been quite obvious that this conglomerate, which has been expanding too rapidly is doing so through huge bank loans, and we can’t figure out how it is complying with the SBL,” a source said.

“The conglomerate maps may reveal larger exposures to individual related borrowers than previously recognized and (higher) than permitted ceilings,” the IMF report noted.

The IMF explained: “The earlier relaxation of the single borrower limit for petroleum purchases and PPP financing further expands conglomerates’ access to credit, reinforcing risks and the economy’s already concentrated ownership structure.”

With regards to the petroleum purchases, the IMF was referring to BSP Circular No. 711 of February 2011, which increased the SBL to 40 percent of a bank’s or financial institution’s net worth, if loans, credit accommodations, and guarantees to finance oil importations for the market are included. For “PPP purchases” the IMF was referring to the earlier BSP Circular No. 700 of December 2010, which set up a separate cap of 25 percent of a bank’s or financial institution’s net worth for loans, credit accommodations and guarantees related to infrastructure or development projects under the government’s Public-Private Partnership Program.

The IMF reportedly has raised the issue that even if the aim of the raising of the SBL may be laudable (for ensuring oil supply and infrastructure development) it would have the same result for a bank: its overexposure to a conglomerate would endanger the bank’s viability in case that conglomerate defaults.

The IMF also asked the BSP to investigate if such loans reported as for oil purchases or for PPP projects were being actually diverted for the conglomerates’ expansion into other ventures not covered by the new limits.

To mitigate the risks of banks’ overexposures to conglomerates, the IMF told the BSP:

“It is therefore advised to begin to roll back all SBLs (defined to encompass affiliated entities) to the standard 25 percent through effective sunset clauses and, where a consolidated borrower exceeds applicable limits, require banks to develop—and agree with borrowers—credible plans for timely reduction of excessive exposures. Specific provisions should also be applied in proportion to the SBL breach, consistent with the Basel Committee’s pronouncements.”

The IMF’s “Philippines: Risk Assessment Matrix” had three items in its “Recommended Policy Response” for the risk posed by the “default by a highly-leveraged conglomerate”:

• “The BSP should proactively roll back banks’ single borrower limits, underpinned by credible agreements between the banks and the conglomerate.

• In case of default, rapidly recapitalize banks to prevent disruptive contraction of credit.

• Avoid regulatory forbearance at banks and fiscal transfers to the affected conglomerate.”

That last item is a diplomatic way of saying: “Don’t be lenient on that conglomerate. Throw your books at it.”

On Wednesday: The IMF’s other warning: on the real estate boom.