Chapter 5: The Banko Sentral ng Pilipinas

Overview of the Bank Sentral ng Pilipinas

The Bangko Sentral ng Pilipinas (BSP) is the central bank of the Republic of the Philippines. It was
established on 3 July 1993 pursuant to the provisions of the 1987 Philippine Constitution and the New
Central Bank Act of 1993. The BSP took over from the Central Bank of Philippines, which was established
on 3 January 1949, as the country’s central monetary authority. The BSP enjoys fiscal and administrative
autonomy from the National Government in the pursuit of its mandated responsibilities.

Creation of BSP

A group of Filipinos had conceptualized a central bank for the Philippines as early as 1933. It came up
with the rudiments of a bill for the establishment of a central bank for the country after a careful study
of the economic provisions of the Hare-Hawes Cutting bill, the Philippine independence bill approved by
the US Congress.

During the Commonwealth period (1935-1941), the discussion about a Philippine central bank that
would promote price stability and economic growth continued. The country’s monetary system then
was administered by the Department of Finance and the National Treasury. The Philippines was on the
exchange standard using the US dollar—which was backed by 100 percent gold reserve—as the
standard currency.

In 1939, as required by the Tydings-McDuffie Act, the Philippine legislature passed a law establishing a
central bank. As it was a monetary law, it required the approval of the United States president.
However, President Franklin D. Roosevelt disapproved it due to strong opposition from vested interests.
A second law was passed in 1944 during the Japanese occupation, but the arrival of the American
liberalization forces aborted its implementation.

Shortly after President Manuel Roxas assumed office in 1946, he instructed then Finance Secretary
Miguel Cuaderno, Sr. to draw up a charter for a central bank. The establishment of a monetary authority
became imperative a year later as a result of the findings of the Joint Philippine-American Finance
Commission chaired by Mr. Cuaderno. The Commission, which studied Philippine financial, monetary
and fiscal problems in 1947, recommended a shift from the dollar exchange standard to a managed
currency system. A central bank was necessary to implement the proposed shift to the new system.

Immediately, the Central Bank Council, which was created by President Manuel Roxas to prepare the
charter of a proposed monetary authority, produced a draft. It was submitted to Congress in
February1948. By June of the same year, the newly-proclaimed President Elpidio Quirino, who
succeeded President Roxas, affixed his signature on Republic Act No. 265, the Central Bank Act of 1948.
The establishment of the Central Bank of the Philippines was a definite step toward national
sovereignty. Over the years, changes were introduced to make the charter more responsive to the
needs of the economy. On 29 November 1972, Presidential Decree No. 72 adopted the

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recommendations of the Joint IMF-CB Banking Survey Commission which made a study of the Philippine
banking system. The Commission proposed a program designed to ensure the system’s soundness and
healthy growth. Its most important recommendations were related to the objectives of the Central
Bank, its policy-making structures, scope of its authority and procedures for dealing with problem
financial institutions.

Subsequent changes sought to enhance the capability of the Central Bank, in the light of a developing
economy, to enforce banking laws and regulations and to respond to emerging central banking issues.
Thus, in the 1973 Constitution, the National Assembly was mandated to establish an independent
central monetary authority. Later, PD 1801 designated the Central Bank of the Philippines as the central
monetary authority (CMA). Years later, the 1987 Constitution adopted the provisions on the CMA from
the 1973 Constitution that were aimed essentially at establishing an independent monetary authority
through increased capitalization and greater private sector representation in the Monetary Board.

The administration that followed the transition government of President Corazon C. Aquino saw the
turning of another chapter in Philippine central banking. In accordance with a provision in the 1987
Constitution, President Fidel V. Ramos signed into law Republic Act No. 7653, the New Central Bank Act,
on 14 June 1993. The law provides for the establishment of an independent monetary authority to be
known as the Bangko Sentral ng Pilipinas, with the maintenance of price stability explicitly stated as its
primary objective. This objective was only implied in the old Central Bank charter. The law also gives the
Bangko Sentral fiscal and administrative autonomy which the old Central Bank did not have. On 3 July
1993, the New Central Bank Act took effect.

The BSP Vision

The BSP aims to be recognized globally as the monetary authority and primary financial system
supervisor that supports a strong economy and promotes a high quality of life for all Filipinos.

The BSP Mission

To promote and maintain price stability, a strong financial system, and a safe and efficient payments and
settlements system conducive to a sustainable and inclusive growth of the economy.

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Logo of BSP

The new BSP logo is a perfect round shape in blue that features three gold stars and a stylized Philippine
eagle rendered in white strokes. These main elements are framed on the left side with the text
inscription “Bangko Sentral ng Pilipinas” underscored by a gold line drawn in half circle. The right side
remains open, signifying freedom, openness, and readiness of the BSP, as represented by the Philippine
eagle, to soar and fly toward its goal. Putting all these elements together is a solid blue background to
signify stability.

Principal Elements:

1. The Philippine Eagle, our national bird, is the world’s largest eagle and is a symbol of strength, clear
vision and freedom, the qualities we aspire for as a central bank.

2. The three stars represent the three pillars of central banking: price stability, stable banking system,
and a safe and reliable payments system. It may also be interpreted as a geographical representation of
BSP’s equal concern for the impact of its policies and programs on all Filipinos, whether they are in
Luzon, Visayas or Mindanao.

Colors

1. The blue background signifies stability.

2. The stars are rendered in gold to symbolize wisdom, wealth, idealism, and high quality.

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3. The white color of the eagle and the text for BSP represents purity, neutrality, and mental clarity.

Font or Type Face

Non-serif, bold for “BANGKO SENTRAL NG PILIPINAS” to suggest solidity, strength, and stability. The use
of non-serif fonts characterized by clean lines portrays the no-nonsense professional manner of doing
business at the BSP.

Shape

Round shape to symbolize the continuing and unending quest to become an excellent monetary
authority committed to improve the quality of life of Filipinos. This round shape is also evocative of our
coins, the basic units of our currency.

The Balance Sheet

BANGKO SENTRAL NG PILIPINAS

BALANCE SHEETS

December 31, 2018 and 2017

(In Philippine Peso)

Note 2018 2017

(as restated)
ASSETS

FOREIGN CURRENCY FINANCIAL ASSETS 2.7/2.8.3/2.9

International reserves
Deposits with foreign banks 6 1,123,248,162,540 831,774,930,689
Other cash balances 7 1,131,822,894 233,178,718
Investment securities 8 2,134,396,095,054 2,719,308,711,490
Foreign securities purchased under
agreements 9 388,368,175,329 25,521,651,156
to resell 10 2,111,092,664 2,687,564,509
Loan to International Monetary Fund 11 428,575,278,987 416,509,798,557
Gold
International Monetary Fund special drawing 12 62,332,053,326 60,560,217,620
Rights

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Gross international reserves 4,140,162,680,794 4,056,596,052,739

Other foreign currency receivables 14 93,407,616,337 91,737,573,734

Non-international reserve foreign currency 38 33,255,679 32,471,204
Derivative instruments in a net gain/
(loss) position 2.8.3/2.19 52,562,590 95,503,927
Total foreign currency financial assets 4,233,656,115,400 4,148,461,601,604

LOCAL CURRENCY FINANCIAL ASSETS 2.9

Investment securities 15 223,298,756,824 224,616,052,975
Loans and advances (net) 13 277,505,654,368 187,418,147,176
Due from administrator of funds 2.22.1 to 4; 30,583,503,441 30,629,080,185
2.23.1 to 5;
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Other receivables (net) 14 33,092,816,225 20,495,024,262
Total local currency financial assets 564,480,730,858 463,158,304,598
Total financial assets 4,798,136,846,258 4,611,619,906,202

OTHER ASSETS
Acquired assets held for sale (net) 2.11/17 152,911,842 51,270,390
Investment property (net) 2.12/18 13,874,714,761 15,164,218,665
Bank premises, furniture, fixtures and
equipment (net) 2.13/19 23,725,039,436 23,089,504,608
Intangible assets (net) 2.14/20 234,255,304 217,016,705
Inventories (net) 2.16/21 10,689,227,749 8,046,770,622
Property dividend to NG 27.a 285,214,339 285,214,339
Deferred tax assets 2.29/40.2 2,655,842,837 6,147,803,403
Miscellaneous assets 22 1,537,314,241 2,270,946,451
Total other assets 53,154,520,509 55,272,745,183

TOTAL ASSETS 4,851,291,366,767 4,666,892,651,385

Note 2018 2017

(as restated)
LIABILITIES AND CAPITAL

FOREIGN CURRENCY FINANCIAL LIABILITIES 2.7/2.8.3/2.18

Short-term deposits 23 94,492,769,739 16,101,750,255
Loans payable 24 3 0,358,818 30,448,468
Bonds payable 25 26,290,224,840 24,986,493,216
Allocation of International Monetary

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 Fund special drawing rights 26 61,368,543,843 59,856,929,020
Other liabilities 27 5 ,644,763,050 6,387,959,404
Total foreign currency financial liabilities 187,826,660,290 107,363,580,363

LOCAL CURRENCY FINANCIAL LIABILITIES 2.18

Government deposits 28.a 76,704,188,049 311,708,438,631
Deposits of banks and quasi banks 28.b 1,882,212,579,334 1,902,087,916,172
Deposits of International Monetary Fund
and other financial institutions 28.c 122,832,915,784 115,052,829,070
Securities sold under agreements to
repurchase 2.20.2 300,986,093,187 305,057,187,465
Term deposit account 2.20.4 69,195,712,862 100,957,502,580
Overnight deposit account 2.20.3 58,643,762,312 85,472,352,969
Total local currency financial liabilities 2,510,575,251,528 2,820,336,226,887
Total financial liabilities 2,698,401,911,818 2,927,699,807,250

OTHER LIABILITIES
Currency in circulation 2.21/29 1,490,240,285,960 1,267,269,736,898
Retirement benefits obligation 2.22/27 2,962,060,302 2,998,141,788
Miscellaneous liabilities 27 7,818,029,509 6,231,040,535
Dividend payable 2.28/27.a 449,345,216 449,345,216
Deferred tax liability 2.29 8 ,943,093 7,444,379
Revaluation of foreign currency accounts 2.8.3/30 534,976,388,056 381,544,827,570
Total other liabilities 2,036,455,052,136 1,658,500,536,386
TOTAL LIABILITIES 4,734,856,963,954 4,586,200,343,636

CAPITAL ACCOUNTS
Capital 31.a 50,000,000,000 50,000,000,000
Surplus/(deficit) 31.b (9,276,999,393) (45,604,257,360)
Unrealized losses on investments in
government securities 31.c (1,807,783,041) (1,324,097,853)
Capital reserves 2.23/31 77,519,185,247 77,620,662,962
TOTAL CAPITAL ACCOUNTS 116,434,402,813 4,666,892,651,385

TOTAL LIABILITIES AND CAPITAL ACCOUNTS 4,851,291,366,767 4,666,892,651,385

Monetary Policy

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The primary objective of BSP's monetary policy is to promote a low and stable inflation conducive to a
balanced and sustainable economic growth. The adoption of inflation targeting framework for monetary
policy in January 2002 is aimed at achieving this objective.

August 8,2019, The Monetary Board decided to cut the interest rate on the BSP’s overnight reverse
repurchase (RRP) facility by 25 basis points (bps) to 4.25 percent. Accordingly, the interest rates on the
overnight deposit and lending facilities were reduced to 3.75 percent and 4.75 percent, respectively.

Overview of Functions and Operations

Objectives

The BSP’s primary objective is to maintain price stability conducive to a balanced and sustainable
economic growth. The BSP also aims to promote and preserve monetary stability and the convertibility
of the national currency.

Responsibilities

The BSP provides policy directions in the areas of money, banking and credit. It supervises operations of
banks and exercises regulatory powers over non-bank financial institutions with quasi-banking functions.

Under the New Central Bank Act, the BSP performs the following functions, all of which relate to its
status as the Republic’s central monetary authority.

1.Liquidity Management. The BSP formulates and implements monetary policy aimed at influencing
money supply consistent with its primary objective to maintain price stability.

2.Currency issue. The BSP has the exclusive power to issue the national currency. All notes and coins
issued by the BSP are fully guaranteed by the Government and are considered legal tender for all private
and public debts.

3.Lender of last resort. The BSP extends discounts, loans and advances to banking institutions for
liquidity purposes.

4.Financial Supervision. The BSP supervises banks and exercises regulatory powers over non-bank
institutions performing quasi-banking functions.

5.Management of foreign currency reserves. The BSP seeks to maintain sufficient international reserves
to meet any foreseeable net demands for foreign currencies in order to preserve the international
stability and convertibility of the Philippine peso.

6.Determination of exchange rate policy. The BSP determines the exchange rate policy of the
Philippines. Currently, the BSP adheres to a market-oriented foreign exchange rate policy such that the
role of Bangko Sentral is principally to ensure orderly conditions in the market.

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7.Other activities. The BSP functions as the banker, financial advisor and official depository of the
Government, its political subdivisions and instrumentalities and government-owned and -controlled
corporations.

The Monetary Board

The powers and function of Bangko Sentral are exercised by its Monetary Board, which has seven
members appointed by the President of the Philippines. Under the New Central Bank Act, one of the
government sector members of the Monetary Board must also be a member of the Cabinet designated
by the President.

The New Central Bank Act establishes certain qualifications for the members of the Monetary Board and
also prohibits members from holding certain positions with other governmental agencies and private
institutions that may give rise to conflicts of interest. With the exception of the members of the Cabinet,
the Governor and the other members of the Monetary Board serve terms of six years and may only be
removed for cause.

The Monetary Board meets at least once a week. The Board may be called to a meeting by the Governor
of the Bangko Sentral or by two (2) other members of the Board. Usually, the Board meets every
Thursday but on some occasions, it convenes to discuss urgent issues.

In the exercise of its authority, the Monetary Board shall:

1. Issue rules and regulations it considers necessary for the effective discharge of the responsibilities
and exercise of the powers vested upon the Monetary Board and the Bangko Sentral;

2. Direct the management, operations, and administration of the Bangko Sentral, reorganize its
personnel, and issue such rules and regulations as it may deem necessary or convenient for this
purpose. The legal units of the Bangko Sentral shall be under the exclusive supervision and control of the
Monetary Board;

3. Establish a human resource management system which shall govern the selection, hiring,
appointment, transfer, promotion, or dismissal of all personnel. Such system shall aim to establish
professionalism and excellence at all levels of the Bangko Sentral in accordance with sound principles of
management.

4. A compensation structure, based on job evaluation studies and wage surveys subject to the Board's
approval, shall be instituted as an integral component of the Bangko Sentral's human resource
development program.

5. On the recommendation of the Governor, appoint, fix the remunerations and other emoluments, and
remove personnel of the Bangko Sentral, subject to pertinent civil service laws: Provided, That the
Monetary Board shall have exclusive and final authority to promote, transfer, assign, or reassign
personnel of the Bangko Sentral and these personnel actions are deemed made in the interest of the
service and not disciplinary: Provided, further, That the Monetary Board may delegate such authority to
the Governor under such guidelines as it may determine;

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6. Adopt an annual budget for and authorize such expenditures by the Bangko Sentral in the interest of
the effective administration and operations of the Bangko Sentral in accordance with applicable laws
and regulations; and

7. Indemnify its members and other officials of the Bangko Sentral, including personnel of the
departments performing supervision and examination functions against all costs and expenses
reasonably incurred by such persons in connection with any civil or criminal action, suit or proceedings
to which he may be, or is, made a party by reason of the performance of his functions or duties, unless
he is finally adjudged in such action or proceeding to be liable for negligence or misconduct.

Other Power:
- Promotes price stability to keep inflation low
- Supervise all banks it monitors and examine the operation of banks and quasi banks all over the
country
- Manages international reserve, it seeks to maintain sufficient international reserves to meet any
foreseeable net demands for foreign currencies in order to preserve the international stability and
convertibility of the Philippine peso.
- Only agency that can issue Philippines bank notes and coins

BSP Notes and Coins - Overview

The BSP has the exclusive power and authority to issue the national currency. BSP’s notes and coins are
issued against, and in amounts not exceeding, the assets of the BSP. All notes and coins issued by the
BSP are fully guaranteed by the government and are considered legal tender for all private and public
debts.

Old peso bill can no longer be exchange for the new design series, as the Banko Sentral ng Pilipinas sticks
on its June 30 2017 deadline. The old bank on loss their value, the deadline is originally set on Jan 1 2017
but extended tice due to public request. The new generation currency has replaced the old peso bill
release in 1985, this is the BSP’s ways to protect the currency for counter fits.

The Governor

Pursuant to Republic Act No. 7653 (The New Central Bank Act), the Governor shall be the chief executive
officer of the Bangko Sentral. His powers and duties shall be to:

1. Prepare the agenda for the meetings of the Monetary Board and to submit for the consideration of
the Board the policies and measures that he believes to be necessary to carry out the purposes and
provisions of said Act;

2. Execute and administer the policies and measures approved by the Monetary Board;

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3. Direct and supervise the operations and internal administration of the Bangko Sentral. The Governor
may delegate certain of his administrative responsibilities to other officers or may assign specific tasks or
responsibilities to any full-time member of the Monetary Board without additional remuneration or
allowance whenever he may deem fit or subject to such rules and regulations as the Monetary Board
may prescribe;

4. Appoint and fix the remunerations and other emoluments of personnel below the rank of a
department head in accordance with the position and compensation plans approved by the Monetary
Board, as well as to impose disciplinary measures upon personnel of the Bangko Sentral, subject to the
provisions of Section 15(c) of said Act: Provided, That removal of personnel shall be with the approval of
the Monetary Board;

5. Render opinions, decisions, or rulings, which shall be final and executory until reversed or modified by
the Monetary Board, on matters regarding application or enforcement of laws pertaining to institutions
supervised by the Bangko Sentral and laws pertaining to quasi-banks, as well as regulations, policies or
instructions issued by the Monetary Board, and the implementation thereof; and

6. Exercise such other powers as may be vested in him by the Monetary Board.

The Governor of the Bangko Sentral shall be the principal representative of the Monetary Board and of
the Bangko Sentral and, in such capacity and in accordance with the instructions of the Monetary Board,
he shall be empowered to:

1. Represent the Monetary Board and the Bangko Sentral in all dealings with other offices, agencies and
instrumentalities of the Government, and all other persons or entities, public or private, whether
domestic, foreign or international;

2. Sign contracts entered into by the Bangko Sentral, notes and securities issued by the Bangko Sentral,
all reports, balance sheets, profit and loss statements, correspondence, and other documents of the
Bangko Sentral;

3. Represent the Bangko Sentral, either personally or through counsel, including private counsel, as
may be authorized by the Monetary Board, in any legal proceedings, action or specialized legal studies;
and

4. Delegate his power to represent the Bangko Sentral, to other officers upon his own responsibility:
Provided, however, That in order to preserve the integrity and the prestige of his office, the Governor of
the Bangko Sentral may choose not to participate in preliminary discussions with any multilateral
banking or financial institution on any negotiations for the Government within or outside the
Philippines. During the negotiations, he may instead be represented by a permanent negotiator.

What is Money Supply?

The money supply is the entire stock of currency and other liquid instruments circulating in a country's
economy as of a particular time. The money supply can include cash, coins, and balances held in

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checking and savings accounts, and other near money substitutes. Economists analyze the money supply
as a key variable to understanding the macroeconomy and guiding macroeconomic policy.

5.5 BSP CONTROL OF THE MONEY SUPPLY

Monetary Operations
Monetary operations refer to the buying/selling of government securities, lending/borrowing against
underlying assets as collateral, acceptance of fixed-term deposits, foreign exchange swaps, and the use
of other monetary instruments of the Bangko Sentral aimed at influencing the underlying demand and
supply conditions for central bank money.

On 3 June 2016, the BSP formally adopted an interest rate corridor (IRC) system as a framework for
conducting its monetary operations. The IRC is a system for guiding short-term market rates towards the
BSP policy interest rate which is the overnight reverse repurchase (RRP) rate.  It consists of a rate at
which the central bank (CB) lends to banks (typically an overnight lending rate) and a rate at which it
takes deposits from them (deposit rate). In a standard corridor, the lending rate will be above the CB
target/policy rate (thereby forming an upper bound for short-term market rates), and the deposit rate
will be below the CB policy rate (thereby forming the lower bound).

1. Open Market Operations (OMO)

Reverse Repurchase/Repurchase transactions
In a repurchase transaction, the BSP buys government securities (GS) from a bank with a
commitment to sell them back at a specified future date at a predetermined rate, resulting in an
expansionary effect on liquidity. Conversely, in a reverse repurchase (RRP) operation, the BSP also acts
as the seller of GS and the bank’s payment to the BSP has a contractionary effect on liquidity.

Outright purchases and sales of securities

An outright contract involves direct purchase/sale of government securities by the BSP
from/to the market for the purpose of increasing/decreasing money supply on a more permanent basis.
In such a transaction, the parties do not commit to reverse the transaction in the future, creating a more
permanent effect on the banking system’s level of money supply.

Foreign exchange swaps

Foreign exchange swaps refer to transactions involving the actual exchange of two currencies
(principal amount only) on a specific date at a rate agreed on the deal date (the first leg), and a
reverse exchange of the same two currencies at a date further in the future (the second leg) at a
rate (different from the rate applied to the first leg) agreed on deal date.

2. Acceptance of term deposits

The BSP, like other central banks, offers term deposits as one of the monetary tools to absorb liquidity.
In November 1998, the BSP offered the Special Deposit Accounts (SDA) to banks and later expanded the
access in April 2007 to trust entities of banks and non-bank financial institutions. With the adoption of
the IRC system in 2016, the SDA facility was replaced by the term deposit facility (TDF).

Term Deposit Facility (TDF)

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 The TDF is a liquidity absorption facility used by the BSP for active liquidity management.
Counterparties are asked to submit bids (volume and rate) for term placements with the BSP.
Currently, the BSP offers three tenors—seven, 14, and 28 days—in term deposit auction.

3. Standing Liquidity Facilities

The BSP offers standing liquidity (lending and deposit) windows to provide or absorb liquidity at the
initiative of the counterparty. These standing overnight facilities are available on demand to qualified
counterparties during BSP business hours. The two standing facilities that form the upper and lower
bound of the corridor are set at ± 50 basis points (bps) around the policy rate (the overnight RRP rate
under the new IRC structure).

Overnight Deposit Facility

The standing overnight deposit facility will absorb any residual system liquidity to prevent
market interest rates from falling below the corridor. Interest rate for the O/N deposit facility is
the RRP rate minus 50 bps (0.50 percentage point). The interest rate for the O/N deposit facility
serves as a floor for the O/N interbank rate.

Overnight Lending Facility

The standing overnight lending facility provides collateralized overnight funding to BSP
counterparties to clear end-of-day imbalances. Interest rate for the O/N lending facility is
the RRP rate plus 50 bps (0.50 percentage point). The interest rate for the O/N lending facility
serves as a ceiling for the O/N interbank rate.

OPEN MARKET OPERATIONS (OMO)

OMO is a monetary tool which involves the BSP publicly buying or selling government securities from
banks and financial institutions in order to expand or contract the supply of money. By controlling the
money supply, the BSP is able to exert some influence on the prices of goods and services and achieve
its inflation objectives.

When the BSP buys securities, it pays for them by directly crediting its counterparty’s Demand Deposit
Account that is being maintained with the BSP. Effectively, the transaction increases the buyer’s level of
reserves and on an aggregate level, expands the system’s money supply. Conversely, when the BSP sells
the securities, the buyer’s payment (via direct debit against the buyer’s Demand Deposit Account with
the BSP) reduces his reserve account causing money supply to contract.

In conducting OMO, the BSP uses two instruments: (1) repurchase (repo)/reverse repurchase (reverse
repo) agreements and (2) outright purchases and sales of securities.

 Repurchase (repo) / reverse repurchase (reverse repo) agreements. The BSP purchases

government securities from a bank with a commitment to sell it back at a specified future date
at a predetermined rate. In effect, a repo transaction expands the level of money supply as it
increases the bank’s level of reserves. Under a reverse repo, the BSP acts as the seller of
government securities, thus, the bank’s payment reduces its reserve account resulting in a

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 contraction in the system’s money supply. For both repos, the BSP can only affect the level of
money supply temporarily, given that the parties involved commit to reverse the transaction at
an agreed future date. At present, the BSP enters into repo agreements for a minimum of one
(1) day (overnight) for both repos and a maximum of 91 days and 364 days for repo and reverse
repo agreements, respectively.

 Outright purchases and sales of securities.  An outright contract involves direct purchase/sale of
government security by the BSP from/to the market for the purpose of increasing/decreasing
money supply on a more permanent basis. In such a transaction, the parties do not commit to
reverse the transaction in the future, creating a more permanent effect on the banking system’s
level of money supply.

The BSP may also use other monetary policy tools such as reserve requirements and rediscounting to
expand or contract money supply. The BSP may also grant loans and advances to banking institutions to
influence the volume of credit consistent with the objective of price stability. In addition, the BSP can
employ moral suasion as a last resort when existing market mechanisms cannot adequately and
promptly ensure the attainment of specific monetary objectives.

Advantages of Open Market Operations

However, among the tools available to the BSP, OMO offers advantages and continues to be the most
practical tool for the following reasons:

 First, it works within the BSP’s initiative and control. Having the authority to steer market
interest rates, the BSP can influence money supply by changing the monetary policy rates.
Consequently, OMO gives the BSP greater flexibility in terms of the amount and timing of
intervention.

 Secondly, it is fast to implement and gives quick results. Any change in the policy rates is readily
implemented, i.e., on the same day that the Monetary Board makes the resolution. Thus, any
effect on the market is evident right after the overnight trading for the day.

Why the Quantity of Money Matters

The quantity of money circulating in an economy affects both micro and macroeconomic trends. At the
micro level, a large supply of free and easy money means more personal spending. Individuals also have
an easier time getting loans such as personal loans, car loans, or home mortgages. 
At the macroeconomic level, the amount of money circulating in an economy affects things like gross
domestic product, overall growth, interest rates, and unemployment rates. The central banks tend to
control the quantity of money in circulation to achieve economic objectives and affect monetary policy.

Central Banks Set the Reserve Requirement

One of the basic methods used by all central banks to control the quantity of money in an economy is
the reserve requirement. As a rule, central banks mandate depository institutions to keep a certain
amount of funds in reserve against the amount of net transaction accounts. Thus a certain amount is
kept in reserve, and this does not enter circulation. Say the central bank has set the reserve requirement
at 9%. If a commercial bank has total deposits of $100 million, it must then set aside $9 million to satisfy
the reserve requirement. It can put the remaining $91 million into circulation. 

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When the central bank wants more money circulating into the economy, it can reduce the reserve
requirement. This means the bank can lend out more money. If it wants to reduce the amount of money
in the economy, it can increase the reserve requirement. This means that banks have less money to lend
out and will thus be pickier about issuing loans. 

Central Banks Influence Interest Rates

In most cases, a central bank cannot directly set interest rates for loans such as mortgages, auto loans,
or personal loans. However, the central bank does have certain tools to push interest rates towards
desired levels. For example, the central bank holds the key to the policy rate—this is the rate at which
commercial banks get to borrow from the central bank. When banks get to borrow from the central
bank at a lower rate, they pass these savings on by reducing the cost of loans to its customers. Lower
interest rates tend to increase borrowing, and this means the quantity of money in circulation increases.

Central Banks Engage in Open Market Operations

Central banks affect the quantity of money in circulation by buying or selling government
securities through the process known as open market operations (OMO). When a central bank is looking
to increase the quantity of money in circulation, it purchases government securities from commercial
banks and institutions. This frees up bank assets—they now have more cash to loan. This is a part of an
expansionary or easing monetary policy which brings down the interest rate in the economy. The
opposite is done in a case where money needs to taken out from the system. In the United States, the
Federal Reserve uses open market operations to reach a targeted federal funds rate. The federal
funds rate is the interest rate at which banks and institutions lend money to each other overnight. Each
lending-borrowing pair negotiates their own rate, and the average of these is the federal funds rate. The
federal funds rate, in turn, affects every other interest rate. Open market operations are a widely used
instrument as they are flexible, easy to use, and effective.

Central Banks Introduce a Quantitative Easing Program

In dire economic times, central banks can take open market operations a step further and institute a
program of quantitative easing. Under quantitative easing, central banks create money and use it to buy
up assets and securities such as government bonds. This money enters into the banking system as it is
received as payment for the assets purchased by the central bank. The bank reserves swell up by that
amount, which encourages banks to give out more loans, it further helps to lower long-term interest
rates and encourage investment.

References:

http://www.bsp.gov.ph/about/overview.asp

http://www.bsp.gov.ph/about/history.asp

http://www.bsp.gov.ph/about/vision.asp

http://www.bsp.gov.ph/about/2018FS/Balance%20Sheet.pdf

http://www.bsp.gov.ph/about/governance_pro.asp

Video:

https://www.youtube.com/watch?v=5yv1QCkCUpY

14
https://www.youtube.com/watch?v=TBpiF2UcWUw

News:

https://business.inquirer.net/232284/bsp-stop-exchanging-old-peso-bills-new-ones-june-30

Case Study:

http://www.bsp.gov.ph/downloads/Publications/2018/IR1qtr_2018.pdf

CHAPTER 6: Deposit Expansion and Money Supply

Reserve and Deposit Transfer

The New Central Bank Act (RA 7653)
ARTICLE VII - BANK RESERVES

SECTION 94. Reserve Requirements. — In order to control the volume of money created by the credit
operations of the banking system, all banks operating in the Philippines shall be required to maintain
reserves against their deposit liabilities: Provided, That the Monetary Board may, at its discretion, also
require all banks and/or quasi-banks to maintain reserves against funds held in trust and liabilities for
deposit substitutes as defined in this Act. The required reserves of each bank shall be proportional to the
volume of its deposit liabilities and shall ordinarily take the form of a deposit in the Bangko Sentral.
Reserve requirements shall be applied to all banks of the same category uniformly and without
discrimination.

Reserves against deposit substitutes, if imposed, shall be determined in the same manner as provided
for reserve requirements against regular bank deposits, with respect to the imposition, increase, and
computation of reserves.

The Monetary Board may exempt from reserve requirements deposits and deposit substitutes with
remaining maturities of two (2) years or more, as well as interbank borrowings.

Since the requirement to maintain bank reserves is imposed primarily to control the volume of money,
the Bangko Sentral shall not pay interest on the reserves maintained with it unless the Monetary Board
decides otherwise as warranted by circumstances.

SECTION 95. Definition of Deposit Substitutes. — The term "deposit substitutes" is defined as an
alternative form of obtaining funds from the public, other than deposits, through the issuance,
endorsement, or acceptance of debt instruments for the borrower's own account, for the purpose of
relending or purchasing of receivables and other obligations. These instruments may include, but need
not be limited to, banker’s acceptances, promissory notes, participations, certificates of assignment and
similar instruments with recourse, and repurchase agreements. The Monetary Board shall determine
what specific instruments shall be considered as deposit substitutes for the purposes of Section 94 of
this Act: Provided, however, That deposit substitutes of commercial, industrial and other non-financial
companies for the limited purpose of financing their own needs or the needs of their agents or dealers
shall not be covered by the provisions of Section 94 of this Act.

15
SECTION 96. Required Reserves Against Peso Deposits. — The Monetary Board may fix and, when it
deems necessary, alter the minimum reserve ratios to peso deposits, as well as to deposit substitutes,
which each bank and/or quasi-bank may maintain, and such ratio shall be applied uniformly to all banks
of the same category as well as to quasi-banks.

SECTION 97. Required Reserves Against Foreign Currency Deposits. — The Monetary Board is similarly
authorized to prescribe and modify the minimum reserve ratios applicable to deposits denominated in
foreign currencies.

SECTION 98. Reserves Against Unused Balances of Overdraft Lines. — In order to facilitate Bangko
Sentral control over the volume of bank credit, the Monetary Board may establish minimum reserve
requirements for unused balances of overdraft lines.

The powers of the Monetary Board to prescribe and modify reserve requirements against unused
balances of overdraft lines shall be the same as its powers with respect to reserve requirements against
demand deposits.

SECTION 99. Increase in Reserve Requirements. — Whenever in the opinion of the Monetary Board it
becomes necessary to increase reserve requirements against existing liabilities, the increase shall be
made in a gradual manner and shall not exceed four percentage points in any thirty-day period. Banks
and other affected financial institutions shall be notified reasonably in advance of the date on which
such increase is to become effective.

SECTION 100. Computation on Reserves. — The reserve position of each bank or quasi-bank shall be
calculated daily on the basis of the amount, at the close of business for the day, of the institution's
reserves and the amount of its liability accounts against which reserves are required to be maintained:
Provided, That with reference to holidays or non-banking days, the reserve position as calculated at the
close of the business day immediately preceding such holidays and non-banking days shall apply on such
days.

For the purpose of computing the reserve position of each bank or quasi-bank, its principal office in the
Philippines and all its branches and agencies located therein shall be considered as a single unit.

SECTION 101. Reserve Deficiencies. — Whenever the reserve position of any bank or quasi-bank,
computed in the manner specified in the preceding section of this Act, is below the required minimum,
the bank or quasi-bank shall pay the Bangko Sentral one-tenth of one percent (1/10 of 1%) per day on
the amount of the deficiency or the prevailing ninety-one-day treasury bill rate plus three percentage
points, whichever is higher: Provided, however, That banks and quasi-banks shall ordinarily be permitted
to offset any reserve deficiency occurring on one or more days of the week with any excess reserves
which they may hold on other days of the same week and shall be required to pay the penalty only on
the average daily deficiency during the week. In cases of abuse, the Monetary Board may deny any bank
or quasi-bank the privilege of offsetting reserve deficiencies in the aforesaid manner.

If a bank or quasi-bank chronically has a reserve deficiency, the Monetary Board may limit or prohibit
the making of new loans or investments by the institution and may require that part or all of the net
profits of the institution be assigned to surplus.

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The Monetary Board may modify or set aside the reserve deficiency penalties provided in this section,
for part or the entire period of a strike or lockout affecting a bank or a quasi-bank as defined in the
Labor Code, or of a national emergency affecting operations of banks or quasi-banks. The Monetary
Board may also modify or set aside reserved deficiency penalties for rehabilitation program of a bank.

SECTION 102. Interbank Settlement. — The Bangko Sentral shall establish facilities for interbank clearing
under such rules and regulations as the Monetary Board may prescribe: Provided, That the Bangko
Sentral may charge administrative and other fees for the maintenance of such facilities.

The deposit reserves maintained by the banks in the Bangko Sentral in accordance with the provisions of
Section 94 of this Act shall serve as basis for the clearing of checks and the settlement of interbank
balances, subject to such rules and regulations as the Monetary Board may issue with respect to such
operations: Provided, That any bank which incurs on overdrawing in its deposit account with the Bangko
Sentral shall fully cover said overdraft, including interest thereon at a rate equivalent to one-tenth of
one percent (1/10 of 1%) per day or the prevailing ninety-one-day treasury bill rate plus three
percentage points, whichever is higher, not later than the next clearing day: Provided, further, That
settlement of clearing balances shall not be effected for any account which continues to be overdrawn
for five (5) consecutive banking days until such time as the overdrawing is fully covered or otherwise
converted into an emergency loan or advance pursuant to the provisions of Section 84 of this Act:
Provided, finally, That the appropriate clearing office shall be officially notified of banks with overdrawn
balances. Banks with existing overdrafts with the Bangko Sentral as of the effectivity of this Act shall,
within such period as may be prescribed by the Monetary Board, either convert the overdraft into an
emergency loan or advance with a plan of payment, or settle such overdrafts, and that, upon failure to
so comply herewith, the Bangko Sentral shall take such action against the bank as may be warranted
under this Act.

SECTION 103. Exemption from Attachment and Other Purposes. — Deposits maintained by banks with
the Bangko Sentral as part of their reserve requirements shall be exempt from attachment,
garnishments, or any other order or process of any court, government agency or any other
administrative body issued to satisfy the claim of a party other than the Government, or its political
subdivisions or instrumentalities.

What Is a Bank Reserve?

A bank reserve is the currency deposit that is not lent out to the bank's clients. A small fraction of the
total deposits is held internally by the bank in cash vaults or deposited with the central bank. Minimum
reserve requirements are established by central banks in order to ensure that the financial institutions
will be able to provide clients with cash upon request.

How Bank Reserves Work

Bank reserves are typically held by financial institutions to avoid bank runs and have sufficient cash on
hand, should an unexpected and large withdrawal request come up. Bank reserves are divided into
required reserves and excess reserves. Because of the banking industry's importance to the economy,
national authorities regulate banks by obligating them to hold a certain amount of required reserves
with central banks.

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Excess reserves represent any vault cash that banks hold that is in excess of the required reserves
amount. Banks typically have a low incentive to maintain excess reserves because cash earns the rate of
return of zero and can lose value over time due to inflation. Thus, under normal circumstances, banks
minimize their excess reserves and lend out money to clients rather than holding cash in their vaults.
Bank reserves decrease during periods of economic expansion and increase during recessions.

BSP’s CONTROL OF THE DEPOSIT EXPANSION

Deposit Expansion 

·       The definitive factor that allows banks to create deposits/money is our fractional reserve system

·       Whenever cash is deposited into a bank, this leads to an increase in that banks reserves as well as
an increase in deposits, but does not increase the money supply—only changes its composition
(exchanging deposits for currency)

·       While an individual bank can make loans and create deposits only to the extent (on a dollar-per-
dollar basis) that it has excess reserves [Note: total reserves less required reserves equals excess
reserves], the banking system can create deposits equal to some multiple of its excess reserves.  The
magnitude of that multiple is expressed as the money multiplier.

·       The maximum value for the money multiplier is equal to the reciprocal of the reserve (requirement)
ratio, so that
 
                    M = 1 / r r
 
                    where    M  =   the money multiplier
                                  r r  =    the reserve (requirement) ratio
 
·       By raising reserve requirements, the Federal Reserve is able to reduce the size of the money
multiplier.  Conversely, whenever the Fed lowers reserve requirements, that increases the size of the
money multiplier.
 
·       To the extent that banks hold excess reserves and/or the public holds currency (as opposed to
holding its money balances in the form of checkable deposits), the size of the money multiplier is
reduced.  The public’s currency holdings (i.e., currency drain) constitute the largest single factor
reducing the size of the money multiplier

·       Just as money is created whenever banks make loans, money is uncreated/destroyed when bank
loans are repaid

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·       The money multiplier applies to money destruction as well as to money creation
 
 
 
 
 

Factors affecting Deposit Expansion

1. Savings interest rate

One of the most effective factors for deciding to deposit in banking system is the interest rate
(Mohammad and Mhadi, 2010). Harald and Heiko (2009), also mentioned interest as one of the
determining factor for commercial banks deposits. Philip (1968), also states that the offering of
attractive interest rate on bank deposits may be considered to have had a beneficial effect. Moreover,
Mustafa and Sayera (2009) said that low deposit rates are discouraging saving mobilization. Bhatt
(1970), said that the banking system is unlikely to be able to meet the demand for bank credit unless
concerted policy is pursued to raise the rate of saving generally and the rate of saving in the form of
deposits in particular.

Deposit interest rate can be defined as the reward or profit have been paid to depositors with respected
to their deposited money. This reward is for sacrificing present consumption for the future consumption
(Garo, 2015). Keynes defines the interest rate as the reward for parting from liquidity. However, there is
a question as why there should be a reward or interest payment for sacrificing liquidity. This question
can only be solved by considering the benefits of hoarding money at hand. Money is considered as a
perfect liquidity asset. Money can be exchanged for goods and services anytime, anywhere in order to
fulfill their needs and wants. Also, when they hoard money, they can recuperate them for unforeseen
circumstances. Moreover, when people keep money in another source of asset there will be a risk
associate with that. These factors emphasize that people can be benefited through hoarding money.
However, if they deposit money they have to sacrifice these benefits. Interest is paid as a reward for
these sacrifices (Hettiarachchi, 2005). According to classical economists, they accounted that there is a
positive relationship between interest rate and the number of savings.

Economists, mainly conventional economists, believe that depositors are decided to deposit their
money in banks because of the opportunity cost of holding cash in hand is high when the interest rate is
also high (Athukorala and Sen, 2003). This can easily be explained by the utility maximization (cost
minimization) premise, as a depositor will choose an action that will maximize their welfare or
satisfaction. As to Richard (1971), regulation of the commercial banking industry affects the returns that
expected by depositors. That is although deposits are the source for profit of banks it is influenced by
regulation of the country. Accordingly, the higher profit rate on demand deposits is the result of the
prohibition against the payment of interest on these deposits. Therefore, depositors are motivated by
returns. Using an adaptive expectation model, it is founded that depositors are indeed motivated by

19
returns in Malaysia (Erna and Ekki, 2004). On the other hand, Erna and Ekki (2004) state that Gafoor
(2003) shows that the rate of interest does not have influence on the volume of the deposits.

2. Security

Security of the bank is a much-concerned factor affecting for deposit mobilization. When a bank has high
security adoptions they can attract more deposits. In recent times, many banks address the issues and
risks related to deposits by adopting, deposit insurance scheme. This movement can be witness
nowadays in each country. This insurance scheme signals the depositors that their deposits are
protected in the event of bank failure (Samuel, 2015).
People save money in the banks because they believe banks are the most efficient caretakers of their
short term and long term savings. Therefore, banks should be more provident and careful on the funds
when they do their business activities since banks use savings as their capital to carry on the business
(Samarasiri, 2014). Hence deposits are the oxygen for banks (Garo, 2015). Therefore, it is must to
maintain security of people’s deposits in order to get a good reputation and well-establishment of banks
among public (Samarasiri, 2014).
However according to the study on safeguarding the banks; the challenging role of the security manager
carried out by Wan (2016), he indicates that even though traditional banks prioritized their security
requirements to protect its physical assets as cash, after the technology greatly intervene to banking
activities, present banks face many serious security issues than the past.

McNeal (2014), studies the security management of deposit taking institutions by considering 157
deposit taking institutions in Washington. The study identifies that, 75% of institutes manage their
system internally and also 90% majority of institutes follow up five pillars of avoiding security threat
related to banking technology, namely (1) a written security policy, (2) Security awareness education (3)
risk management and cyber risks, (4) information security audits and (5) incident monitoring and
reporting. Also, most banks use diversified security technologies as anti-virus, spy ware, mal ware
detection, intrusion prevention. Furthermore, banks allocate more share in their budget to ensure
system security. Therefore, according to McNeal (2014), these adoptions are finally enable a secured
banking environment and attract more deposits as a result of that.]

3. Branch expansion

There is a relationship between branch expansion of banks and deposit growth of banks (Banqui, 1987).
Banks make their expansion decisions based on level of competition, deposit potential, regional income
and development of infrastructure (roads). However, since deposit mobilization is the main role of
banks, branch expansion also decided on the level of deposit mobilization (Samuel, 2014). According to
the study ofBhattacherjee (2012), reveal that branch expansion is a significant factor affecting for
deposit mobilization.
Murthy and Haresh (1991), explains how branch expansion determines the deposit mobilization. Among
many factors affecting for deposit mobilization, to deposit money in a bank depositors first take into
consider location of branch (whether bank is rural, urban or semi-rural) and second, they consider the
region of bank belongs. The study further reveals that regions with high income earners and abundant
of branches have high deposits per branch while regions with low income earners and also associate
with low spread of branches denote low amount of deposits. This study has been concluded by deciding
branch expansion is the most effective factor for deposit mobilization]

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4. Bank image

Customers select a bank to deposit their money based on several determinants as attractiveness of the
deposit interest rate, attractive adverting on mass media, minimum loan conditions and also sometimes
customers assumed that state-owned banks are more reliable than the private banks. Moreover, some
customers assume that when banks have wide branch network then that bank is good for their deposits.
Although all the aforementioned factors are important when depositing money, among them bank
image is the most important factor of choosing a secured place to deposit valuable deposits of
customers. Bank image can be determined through the financial business and the management
information about the business activities of the bank. Therefore, one of the most significant factor
affecting for deposit mobilization is bank image. Since customers always expect a secured place for their
deposits, most of the time they tend to deposit money in the institutions or banks which have a positive
image (Samarasiri, 2014).

According to Telatela (2013), bank image is determined by the reliability, responsiveness, assurance and
empathy. Savers are always nosy about the safety of their funds, recurring cases of forgeries, theft and
bankruptcies occurred. Therefore, they always deposit more money in banks which have good bank
image.]

5. Services

It is known that banks are service oriented organizations and the service delivery can affect all the
activities that a bank perform. According to Khalily (1987), indicates that Mckinnon and Shaw have
largely concentrated on two variables affecting for deposit mobilization in their models in which services
to customers considered as a significant and positively related to each other.

The study by Goiteom (2011), on the bank selection decisions customers more emphasize on factors
such as convenience, service provision, employers influence and bank image. Therefore, banks should
consider these factors when implementing their market strategies to absorb more deposits.]

Generally, banks are providing services but competition among banks are determined by the quality of
the banking services. According to Khalily (1987), there should be strategy requires as policy and
procedural changes, development of innovative programs and improvement in the quality of services
provided to the depositors. Furthermore, the quality of banking services mainly depends on several
factors as, Branching Policy: The expansion of banking facilities is the key factor for deposit mobilization
and when providing facilities accessibility is the most important factor, Innovative approaches, Interest
rate policy, more incentives to depositors, more incentives to bank employee when achieving targets on
deposit mobilization, Training for bank employees and Expansion of infrastructure.

However similar studies have carried out by Hooman et al. (2016), regarding the factors affecting for
quality of services. The phenomenon of quality of banking services can be obtained only by ensuring the
quality of e-banking services, employee’s competence and skills, reliability of the banking system, an
impeccability banking system integrity and accountability measurements are the effective factors that
make the quality service.

According to Iswary (2015), there is a close relationship between banking services and customer
awareness. These two variables should be integrated with each other to have high deposit mobilization.

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However, by considering modern banking services, the study indicates that, banks need to constantly
look for innovative services which offer convenience of transacting from anywhere, anytime. Demands
and expectations of the customers are fast growing. Therefore, banks should be able to achieve these
rapid growing customer needs to attract more customers since banks operate in the oligopolistic market
structure. Therefore, interdependency among banks are high, this will create customers to shift from
one bank to the other bank easily. Therefore, innovative and timely services are much needed to
achieve high amount of deposits but without proper awareness programs it is inevitable.
Maharana et al. (2015) also carried out a study similar to the study of Iswary (2015), showing out that
deposit mobilization is affected by innovative banking services. Thus, computer based banking services
like ATM encourage customers to deposit more money since the transaction cost is very low.]

6. Awareness and Public Preference

Awareness is a social component which increases the collective consciousness among the people and
generates confidence in the industrial to face problems confidently. However, the success of the banks
depends on to which extent people in the particular country aware about the banking activities. When
considering about the deposit mobilization, customer awareness is a key element to absorb high
amount of deposits. Customer awareness about the services depends upon many factors such as return
on investments, promptness, care, security, convenience, growth, flexibility etc. hence integral part of
banks is deposit mobilization, therefore banks should pay attention to attract more deposits by giving
knowledge and promoting them (Kanthi, Singu, 2015).

According to Banqui et al. (1987), some analysts argue that demand for deposits influenced by
education level and awareness of customers related to banking activities. Moreover, according to the
study done by Banqui it considers the awareness as the factor affecting for deposit mobilization and
concluded as it has significant and positive impact on deposit mobilization.

“Determinants of Deposit Mobilization and related Costs”, the study carried out by Garo (2015), reveals
that customer awareness is highly associates with the deposit mobilization by performing regression
analysis.
According to Ishak, Faridah and Zabil. (2012), develop a model which indicates the behaviour of
customers regarding the banking activities.

According to Banqui et al.(1987) also indicates that among so many factors affecting for deposit
mobilization, consumer awareness is crucial factor. According to Hakimuddin (2012) some factors that
emphasize the need of making consumer aware in order to achieve maximum satisfaction as protection,
against exploitation, control over adverse selection, motivate people for savings, knowledge to handle
problems, and finally to construct healthy society, customers are to be awaked by the banks because
customers have right to safety, informed, choose, information and redressed.

According to the study “Cognizing customer awareness and perception of Islamic banking products in
Pakistan” done by Masood et al. (2014), most customers are not aware of Islamic banking products and
the study suggests providing awareness to customers by doing seminars and adopting strategies.
Moreover, they find that, most of the bank customers are only aware of the savings deposit. However,

22
an important aspect identified by these authors is even some bankers also do not have the appropriate
and timely knowledge on bank deposits and bank products.

According to the Ryan (2011), when creating customer awareness relating to deposits, brand position
and brand promise is two most important terms to be considered by banks. Brand position is the place
of banks that occupies in the customer’s mind while the bank promise is the place banks are intended to
build up in customers’ minds after implementing any awareness campaign. When designing awareness
strategies there are some important dimensions to be considered as they should be low cost and high
quality (Pull-marketing strategy). Advertisements and seminars should be powerful and simple, also
social Medias and high popularized Medias should be selected in order to attract more people to deposit
more money in their banks.

According to Khalily (1987), as per the rural people have more knowledge on the banking and banking
services, they develop confidence in bank deposits. This is expected to increase demand for deposits.]

Money Velocity and the Economy

A key feature of the financial crisis was a massive fall in the velocity of money. But what exactly is
“money velocity”? By definition, V=PY/M. In English: Velocity=Nominal Income divided by the Money
Supply. When asked for some intuition, economists often respond that velocity is the “average
turnover” of a dollar. A velocity of 2, for example, means that the average dollar gets spent twice per
year. Except in a world without resale, however, this explanation is incorrect. Suppose all new
production ceased. Money would still “turnover” as assets change hands, but nominal income would be
zero – and velocity would be too.

There is a better way to explain velocity Velocity is the inverse of the percentage of income that people
keep in the form of money. If nominal income is $100B and the money supply is $10B, then velocity is
10 – which means that average money holdings equal 10% of annual income.

Velocity is therefore essentially a measure of income-adjusted money demanded. The higher velocity,
the lower income-adjusted money demand. When velocity plummets, as in 2008, this means that
income-adjusted money demand has spiked.

For every monetary aggregate, there is a corresponding velocity. Velocity of the monetary base might
equal 100, indicating that people hold 1% of their annual income in (cash plus reserves). Velocity of M3
might equal 2, indicating that people hold 50% of their annual income in (cash plus reserves plus
checkings plus savings plus whatever). Usually the various velocities move in tandem, but they don’t
have to.

Pedagogically, the best feature is that you can calculate person-specific velocities. If a student has
annual income of $10,000, and on average holds $2000 in cash plus checking, then his corresponding
velocity for M1 equals 5. You can then ask the student questions like: What would happen to your
velocity if interest rates fell? If credit cards became more widely available? If you suddenly got nervous
about your financial security?

Once the student gets the microeconomics of his own velocity, it’s a lot easier to grasp the
macroeconomics of velocity. There’s just one crucial intellectual bridge to cross: An individual can

23
reduce his personal velocity simply by increasing his money holdings; for people in general to reduce
velocity, in contrast, there has to be a corresponding change in nominal income (unless, of course, the
quantity of money changes). So if the average person decides he’d rather hold 40% of his income in the
form of cash rather than 20%, and everything else stays the same, the nominal income of the economy
has to halve.

There are differing views among economists as to whether the velocity of money is a useful indicator of
the health of an economy or, more specifically, inflationary pressures. The "monetarists" who subscribe
to the quantity theory of money argue that money velocity should be stable absent changing
expectations, but a change in money supply can alter expectations and therefore money velocity and
inflation. For example, an increase in the money supply should theoretically lead to a commensurate
increase in prices because there is more money chasing the same level of goods and services in the
economy. The opposite should happen with a decrease in money supply. Critics, on the other hand,
argue that in the short term, the velocity of money is highly variable, and prices are resistant to change,
resulting in a weak and indirect link between money supply and inflation.

REFERENCES:

https://www.google.com/url?
sa=t&source=web&rct=j&url=https://www.econjournals.com/index.php/irmm/article/download/5887/
pdf&ved=2ahUKEwig0LOG1brkAhVXfd4KHWLYATkQFjALegQIAxAB&usg=AOvVaw0Jn4yclr726lJR6NB6rA
d1&cshid=1567720350808

https://www.econlib.org/archives/2009/11/what_is_money_v.html

https://www.investopedia.com/terms/v/velocity.asp

http://faculty.tamuc.edu/dfunderburk/231/notes/DepositExpansion.htm

http://www.bsp.gov.ph/moperations/moperations.asp

http://www.bsp.gov.ph/bspnotes/curr_faqs.asp

VIDEO:

https://www.youtube.com/watch?v=JG5c8nhR3LE

https://www.youtube.com/watch?v=_LPh72gx6GE

https://www.youtube.com/watch?v=t3413csxEtI

NEWS:

https://news.abs-cbn.com/business/07/05/19/bank-loans-money-supply-growth-slows-in-may-bangko-
sentral

CASE STUDY/RESEARCH:

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http://www.scienpress.com/upload/jafb/vol%202_4_8.pdf

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