When does regulatory relief become regulatory risk? Lessons from the BSP’s response to the Iran conflict

Every major financial crisis reshapes central banking.

The Asian Financial Crisis transformed exchange-rate management and reserve policy. The Global Financial Crisis elevated financial stability alongside price stability as a core objective of central banks. The COVID-19 pandemic expanded the supervisory toolkit through extraordinary liquidity support, regulatory flexibility, and crisis interventions.

The recent conflict involving Iran may become another important milestone, not because of the immediate consequences for the Philippine economy, but because it raises a more fundamental question: How far should a central bank go in protecting the financial system from external shocks before regulatory flexibility itself becomes a source of financial risk?

That question lies at the heart of the Bangko Sentral ng Pilipinas’ (BSP) recent package of regulatory relief measures.

The issue is therefore larger than one memorandum. It concerns the evolving philosophy of prudential supervision itself.

BEYOND MONETARY POLICY
On June 19, the BSP issued Memorandum No. M-2026-027 granting banks and quasi-banks temporary regulatory relief on unrealized mark-to-market losses arising from peso-denominated government securities classified as Financial Assets at Fair Value through Other Comprehensive Income (FVOCI).

The measure allows these institutions to temporarily not recognize excess unrealized losses, also known as paper losses, on FVOCI peso government securities in computing their capital adequacy ratio (CAR) and common equity tier 1 (CET-1) ratio for a period of nine months. This flexibility therefore allows the exclusion of these valuation losses from being deducted from regulatory capital during the relief period. Earlier supervisory measures including loan restructuring, borrower relief, regulatory forbearance on loan classification, rediscounting support, operational flexibility, and reduced digital payment fees had already been introduced following the President’s declaration of a State of National Energy Emergency.

Taken together, these measures signal an important development in Philippine central banking.

Rather than relying solely on monetary policy to respond to a geopolitical shock, the supervisory framework employed a combination of monetary, macroprudential, and supervisory instruments to preserve financial intermediation and limit the transmission of market volatility into the banking system.

Does this represent prudent innovation or excessive regulatory accommodation?

A NEW PHILOSOPHY OF PRUDENTIAL SUPERVISION
Modern prudential regulation no longer operates under the assumption that supervisory rules should remain mechanically unchanged regardless of economic conditions.

Following the Global Financial Crisis, regulators have increasingly recognized that excessively rigid application of prudential standards during periods of severe stress may unintentionally amplify financial instability. Temporary market losses can force unnecessary deleveraging, constrain credit, and reinforce economic downturns.

Consequently, supervisory policy has gradually become more countercyclical. The objective is not to weaken regulation but to prevent regulation itself from becoming procyclical.

Viewed from this perspective, temporary regulatory relief is neither extraordinary nor inherently inappropriate. The more relevant question is whether its design remains consistent with the fundamental principles of prudential supervision.

FOUR TESTS OF SOUND SUPERVISORY POLICY
Any exercise of regulatory discretion should be evaluated against four interrelated principles.

The first is necessity. Extraordinary supervisory intervention should respond to genuine systemic risk rather than isolated institutional weaknesses. The Iran conflict undeniably generated heightened uncertainty through higher energy prices, rising inflation expectations, increased bond yields, and financial market volatility. The supervisory concern, therefore, was not the solvency of individual banks but the potential transmission of external shocks into domestic financial conditions.

The second is proportionality. Temporary relief should remain narrowly targeted, transparent, and time-bound. Broad or open-ended regulatory accommodation risks distorting market incentives. The BSP’s memorandum incorporates several safeguards including defined eligibility, reporting requirements, and a fixed period of applicability. Whether those safeguards ultimately prove sufficient remains an open supervisory question rather than a settled conclusion.

The third is consistency. Every supervisory measure should reinforce, rather than dilute, the objective of preserving financial resilience. This aspect warrants closer examination. Some media reports indicate that an earlier draft of the memorandum contemplated temporary restrictions on cash dividend declarations by institutions availing themselves of regulatory relief, but the restriction did not appear in the final version.

From a prudential standpoint, this reported omission deserves careful scrutiny.

The purpose of regulatory capital is to absorb unexpected losses. If temporary regulatory accommodation is granted because unrealized losses reduce regulatory capital, allowing simultaneous distributions of capital to shareholders appears difficult to reconcile with the broader objective of capital preservation. International supervisory practice increasingly recognizes that capital relief and capital conservation should operate together, particularly during periods of elevated uncertainty. In the Philippine case, the BSP’s existing requirements for dividend declaration by banks will continue to be enforced.

The fourth, and perhaps most important, principle is exit strategy. Every emergency measure should contain a credible pathway back to normal supervisory standards. Temporary flexibility that lacks a clearly defined exit risks becoming a permanent feature of the regulatory landscape. Again, in the Philippine case, the BSP is explicit that this relief policy will be subject to clear end date, that full recognition of unrealized losses will have to be done by January 2027.

MOODY’S RAISES AN IMPORTANT WARNING
Recent commentary by Moody’s Ratings described the BSP’s capital relief as “credit negative.” The concern is not that Philippine banks have suddenly become weaker institutions. Rather, temporary exclusion of unrealized losses from regulatory capital may reduce transparency by making capital ratios appear stronger than they would under the normal prudential framework.

Other commentators have raised a related concern. If supervisory accommodation becomes readily available during periods of market stress, banks may gradually expect similar relief during future crises, thereby weakening incentives for prudent risk management.

These observations should not be dismissed as opposition to regulatory intervention.

Instead, they highlight the central dilemma confronting modern prudential supervision: preserving financial stability without diminishing market discipline.

WHEN DOES MORAL HAZARD BEGIN?
The current debate has often been framed as though moral hazard begins the moment regulatory relief is granted.

That proposition is too simplistic.

Financial regulation is as much about shaping expectations as it is about enforcing rules.

Moral hazard does not arise merely because regulators intervene during extraordinary circumstances. It emerges when supervised institutions begin incorporating future regulatory accommodation into present-day business decisions.

Once banks expect future supervisory relief whenever geopolitical shocks, interest-rate volatility, or market disruptions occur, incentives inevitably change. Capital planning becomes less conservative. Interest-rate risk may receive less attention. Liquidity management may become less rigorous. Prudential regulation gradually ceases to discipline risk and instead begins to subsidize it.

The danger therefore lies not in temporary regulatory flexibility but in regulatory dependence.

That distinction is critical.

A one-time response to an extraordinary geopolitical event differs fundamentally from repeated interventions that transform emergency supervisory measures into implicit guarantees.

THE REAL TEST OF CENTRAL BANK CREDIBILITY
The debate surrounding the BSP’s regulatory relief extends far beyond a single memorandum or a single geopolitical crisis. It raises a more enduring question about the future of prudential supervision in an increasingly uncertain world.

Modern central banks are no longer judged solely by their ability to maintain price stability. They are equally expected to preserve financial stability, sustain confidence in the banking system, and ensure the continuous flow of credit during periods of exceptional stress. These responsibilities inevitably require greater supervisory discretion than in previous decades.

Yet every expansion of regulatory discretion carries a corresponding responsibility to preserve the credibility of the supervisory framework itself.

Acting too late may allow temporary market dislocations to evolve into systemic instability. Acting too readily risks weakening market discipline and encouraging expectations of future regulatory accommodation.

The challenge, therefore, is not whether regulatory relief should ever be granted. There will be circumstances when extraordinary intervention is both necessary and justified. The more difficult question is whether such intervention remains rule-based, transparent, proportionate, internally consistent, and accompanied by a credible exit strategy.

Financial stability and market discipline are not competing objectives. In the long run, each ultimately depends upon the other. A central bank strengthens its credibility not merely by demonstrating the capacity to intervene during periods of stress, but by showing equal resolve in restoring the full discipline of prudential regulation once that stress has passed.

Ultimately, the success of the BSP’s response to the Iran conflict will not be measured simply by whether it softened the immediate impact of market volatility. It will be judged by whether the supervisory framework emerges with both financial stability and institutional credibility intact.

Diwa C. Guinigundo is the former deputy governor for the Monetary and Economics Sector, the Bangko Sentral ng Pilipinas (BSP). He served the BSP for 41 years. In 2001-2003, he was alternate executive director at the International Monetary Fund in Washington, DC. He is the senior pastor of the Fullness of Christ International Ministries in Mandaluyong.