Fitch Ratings has observed a further strengthening in the financial health of local banks in the past 18 months due to better asset quality and higher capital.

Banks decided to retain earnings thus the increase in capital.

Fitch said earnings may come under pressure.

The banks asset quality improved after banks sold performing loans (NPLs) and foreclosed properties. It also helped that property prices had risen further hiking valuation of foreclosed assets.

Most banks have satisfactorily provided for NPLs, particularly given that deterioration in loan quality is unlikely, owing to limited loan growth in recent years and a generally benign economic outlook.

Provisioning for foreclosed properties, however, remains low.

While property prices have been rising for high-quality commercial office space and higher-end residences, price growth has not been so great in other markets, where much of the banks’ assets lie.

In addition, many banks still maintain a significant amount of other assets that are either impaired or of questionable value, including deferred losses (on the sale of NPLs and foreclosed properties), subordinated debt issued by SPVs that purchased such NPLs and foreclosed properties, goodwill, and deferred tax assets.

During 2006/H107, many banks raised common and/or hybrid capital as well as subordinated debt, thanks to the buoyant equity and debt markets. Capital grew even more so through the retention of good earnings as well as unrealized gains on securities holdings. Notwithstanding these favorable developments, asset quality remains a key challenge for a number of banks, and some weaker banks may necessitate additional capital raisings.

In terms of profitability, while the banks’ margins remain high, they have been decreasing as a result of rising competition and a declining interest rate environment.

Most banks, however, continued to make substantial gains on their large holdings of long-term, fixed rate government papers. The banks also generate considerable fee income from various services and products, especially overseas remittances and trust sales.

Yet costs - albeit gradually declining - remain very high, partly due to the banks’ relatively small size by assets, widespread branch networks (given the geography of the Philippines) as well as inefficiency and a lack of automation. Fitch expects that earnings are likely to come under some pressure given the steepening yield curve. This may well cause margins to fall somewhat, and trading gains to diminish, or turn negative. Margin pressure at the bigger banks, however, should be somewhat offset by the central bank’s move in July 2007 towards paying a flat 6% per year.