A recent news report noted how Philippine banks allocated 4.63% of their total loan portfolio towards lending for small businesses, falling short of the lending quota of 10%. Only rural banks met the quota with lending of 16.18% to micro and small and 8.26% to medium enterprises.
Ironically, with the regulatory environment increasingly focused on prudence and compliance, the future of small banks in the Philippines stands at a critical juncture. Rural and thrift banks — long essential conduits of credit for micro, small, and medium enterprises (MSMEs) — are now squeezed by escalating regulatory demands on anti-money laundering (AML), cybersecurity, and sustainability disclosures.
While these regulations aim to strengthen the financial system, there is growing concern that they are imposing disproportionate burdens on smaller institutions. This, in turn, discourages lending to the very sectors we seek to empower.
The numbers tell a sobering story. From over 800 rural banks in the early 2000s, fewer than 400 remain today. Mergers, closures, and failures to meet evolving standards have driven a steady contraction. Many rural banks, often family-owned and deeply rooted in local communities, find it increasingly difficult to absorb the costs of compliance or meet growing digital and capital requirements.
Yet these institutions play a vital role in serving MSMEs, farmers, and low-income communities — segments that large commercial banks often overlook. Their deep local knowledge and personalized service models address the needs of clients who may not fit neatly into conventional credit assessment frameworks.
The regulatory treatment of MSME lending needs critical review. Regulators, understandably, aim to promote sound credit standards. But applying corporate loan evaluation criteria such as reliance on audited financials, rigid debt-service ratios, and formal collateral to MSMEs is often impractical. Most MSMEs operate with informal records, fluctuating cash flows, and blended personal-business finances. Many are viable and resilient but lack the documentation required by traditional credit screens.
Even more concerning are provisioning rules. Delayed payments — common in seasonal businesses like agriculture or informal retail — can trigger immediate loan reclassification and heavy loss provisioning, even if the loan is ultimately repaid in full. This is not risk management; it is risk mischaracterization. The absence of collateral is often penalized. These blanket rules may shield financial institutions from latent risk, but they also disincentivize MSME lending altogether.
What’s needed is not deregulation but proportional regulation — compliance requirements tailored to the size, risk profile, and operational realities of the institution.
This approach is already practiced elsewhere. In the European Union, the principle of proportionality enables smaller institutions to comply with prudential standards in simplified ways. The Basel Committee similarly advocates differentiated application of global rules for smaller, non-systemic banks.
In the Philippine context, allowing more credit discretion in MSME lending, especially for banks with strong local knowledge and sound risk management, could strike a healthier balance. Banks should not be penalized for exercising credit judgment, particularly when a client’s creditworthiness is better assessed through character, cash flow, and relationship history rather than formal paperwork.
A few policy shifts could help realign incentives:
1. Enhance proportional supervision for rural and thrift banks, building on the Bangko Sentral ng Pilipinas’ (BSP) Rural Bank Strengthening Program. Compliance requirements can be scaled appropriately without compromising system integrity.
2. Reform provisioning frameworks to distinguish between chronic nonperformance and temporary payment delays. A more nuanced approach would help prevent unnecessary capital erosion and unlock greater MSME lending.
3. Encourage alternative credit scoring models that use behavioral and transactional data, mobile usage, or payment histories as proxies for creditworthiness.
4. Support digital transformation via shared services or cloud-based compliance platforms for small banks. Many lack the scale to invest in IT infrastructure on their own.
5. Expand public guarantee schemes to absorb some of the credit risks associated with MSME lending, allowing banks to lend more without undue capital strain.
The question is not whether regulation is necessary — it is — but whether regulations are sufficiently tailored to on-the-ground realities. For many MSMEs, access to credit remains a daily challenge. For small banks, the choice increasingly lies between survival and closure, not due to poor lending practices, but because they struggle to meet standards designed for larger institutions.
If we want to empower MSMEs — the backbone of the Philippine economy — we must also empower the banks that serve them. This means crafting policies that reward prudence while allowing room for credit judgment. It means regulating with both rigor and empathy.
The BSP, in its submission to the World Bank, has described how it applies proportional supervision based on a financial institution’s risk profile and systemic importance. The BSP segments banks according to their business model and risk profile as either “simple” or “complex.” Universal and commercial banks are automatically classified as complex. Thrift banks, rural banks, and cooperative banks can also be deemed complex if they meet at least three of the following criteria: total assets of at least P6 billion; extensive branch network; provision of nontraditional financial products; adoption of non-conventional business models; or an aggressive risk appetite.
The BSP has adopted a segmented Basel regulatory framework and differentiated liquidity metrics to support proportionality. These measures aim to ensure the continuing soundness and stability of the banking system, ensure regulatory and business alignment, efficiently allocate supervisory resources, and promote broad-based growth and innovation.
This conceptual framework deserves recognition. However, given the characteristics of the Philippine banking landscape, is the plain dichotomy between simple and complex sufficient? Shouldn’t there be a finer tiering approach? Are the differentiated measures being consistently applied on the ground?
We must not regulate small banks out of existence. Instead, we should provide them the space to grow, digitize, and innovate, so they can continue doing what they do best: lending to those who need it most.
The views expressed herein are his own and do not necessarily reflect the opinion of his office as well as FINEX.
Benel Dela Paz Lagua was previously EVP and Chief Development Officer at the Development Bank of the Philippines. He is an active FINEX member and an advocate of risk-based lending for SMEs. Today, he is independent director in progressive banks and in some NGOs.
