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AN ANALYSIS ON THE INCIDENCE OF EXCESS RESERVES: CASE OF THE PHILIPPINESA Thesis Presented to the Philippine Economics SocietyByPolintan, Felipe T. Jr.Poquiz, Jasmin S.Simon, Justin G.October 2013ABSTRACTExcess Reserves are still an important part of the central banks’ monetary instrument via reserve requirement and open market operation. Hence this paper provides an analysis on the behavior of excess reserves for policy implications and its impact to the financial system. It could also help the thrift banks to evaluate their reserve management. This study focused on the behavior of thrift banks’ excess reserves from 1990 to 2010. Primarily, the reason why banks hold excess reserves is to provide a buffer against uncertainty. Since the timeline covers two crises that affected the Philippines, the Asian and Global Financial Crisis, one of the objectives of this paper is to know how thrift banks responded to the credit crunches. Additionally, interest rates specifically 91-day Treasury Bills rate was used as an opportunity cost of holding excess reserves. Finally, the researchers used demand deposit to further observe banks’ level of excess reserves as adapted in the model of Dow (2001).A regression analysis was used to test the short-run effects of excess reserves against the three explanatory variables. Demand deposit and crisis are presumed to have a positive relationship, while interest rates to be negatively correlated with excess reserves. The results confirm the hypothesis of demand deposit. However, the same was not true in the case of interest rate. This paper also found different banking behaviors from the two crises. Extensive studies about excess reserves in the Philippines are strongly suggested since there had been lack of support and evidences noticed in the case of this country. The researchers suggest that the central bank would make data on excess reserves on daily basis to be publicly available since most of the literature provides a detailed study on that. Furthermore, this could help banks to determine whether they are maximizing profitability or having enough buffers in case of shocks.Key words: Excess Reserves, Demand Deposits, 91-Day Treasury Bills Rate, Asian Financial Crisis, Global Financial CrisisTABLE OF CONTENTSPageTitle1Abstract2Table of Contents3List of Tables4List of Figures4CHAPTER 1 INTRODUCTION5Key Issues/Trends5Objectives of the Study8Significance of the Study8CHAPTER 2 REVIEW OF RELATED LITERATURE9Synthesis23Simulacrum24CHAPTER 3RESEARCH METHODS25Research Design25Data Gathering Procedure26Data Analysis26CHAPTER 4 DATA PRESENTATION AND ANALYSIS29Data Presentation29Results and Findings30CHAPTER 5CONCLUSIONS AND RECOMMENDATIONS38Conclusions38Recommendations41REFERENCES43APPENDICES46ABOUT THE AUTHORS55LIST OF TABLESTable 1: Regression Analysis25Table 2: Ramsey RESET43LIST OF FIGURESFigure 1: Simulacrum20Figure 2: Scatterplot42An Analysis on the Incidence of Excess Reserves: Case of the PhilippinesFelipe T. Polintan Jr., Jasmin S. Poquiz, Justin G. SimonIntroductionFinancial crises have always been a great threat to different economies. Two of the most recent crises faced by the Philippines were the Asian Financial Crisis and Global Financial Crisis. According to Asian Development Bank (ADB), Asian Financial Crisis of 1997 had significant detrimental effects on a number of neighboring countries of the Philippines and other economies that caused a slow growth performance. Moreover, according to Aslam (2012), one of the major factors that contributed to the Asian Financial Crisis was the inflow of Foreign Portfolio Investment (FPI) from different countries in stocks and great amount of short term intra-bank loans. When these portfolio investments penetrate the banking system, it gives pressure to the domestic expenditure and increases the current account deficit. And its outflow can decrease asset prices, interest rates, lower the value of local currency and it results in liquidity problems in the banking sector.Another point of view given by Corsetti et. al., (1999), was that the Asian Financial Crisis rooted mainly from the moral hazard problem of different industries. For some institutions, it was seemed to be rampant because government gave guarantees to private projects like direct subsidies and supporting policies that directed credit to favor the firms and other industries. This was because the government would like to induce higher output from firms to have high rates of economic growth. These supports given by the government made the firms to be more complacent thus overlooked the costs and riskiness of investment projects. The core implication of this problem was that a pressure to profitability does not encourage institutions to be more cautious in lending and to follow financial strategies reducing the overall riskiness of their portfolios. On the other hand, the Global Financial Crisis was caused by housing bubble in United States which peaked in 2007. It was caused by the values of securities tied to U.S. real estate pricing to fall, damaging financial institutions worldwide (Shahrokhi, 2011). Also, Cook (2011) strongly argued that this sub-prime crisis was actually the greatest money and credit excess in the history of the world. Gorton (2010) however argued that that there was banking panic on August 2007. Depositors rushed to banks and demanded their money back. But banks were not able to suffice these demands immediately since they have lent the money out already or they had it for long-term bonds. To honor these demands, banks must sell assets but only the Federal Reserve had the capability to buy the assets. It only proved that housing bubble led banks to hold illiquid assets thus they were not able to suffice the demands of the depositors.In addition, Aslam (2012) stated that the U.S. economic crisis was consisted by the boom-bust-cycles in the stock market, housing market and financial market. The crisis in the stock market spilled over not only to technology related industries but also in automobile, electronics and other manufacturers. In the late 2007 the subprime mortgage defaults contributed partly to the increase in unemployment in the United States. The emergence of cheap money and low interest rates worsen the sub-prime crisis. Low interest rates attracted property sectors to increase the demand for credit. Property loans of mortgage loans were repackaged and sold in form of securities. The main purpose of securitization of loans was to increase bank liquidity in order to meet the demand from the household sector.One of the most remarkable factors in the banking system that had been noticed and talked about by a lot of Western researchers was the excess reserves. Notice that in the global financial crisis, the United States significantly increased their level of excess reserves. Keister and McAndrews, (2009) pointed out that in the U.S., their excess reserves rose from $45 billion to $900 billion by January 2009. A lot of analysts saw the surge in excess reserves as an alarming development in the banking system. This simply emphasized that during crisis, instead banks lend funds out to the households, firms and other banks, and they were hoarding it and put it in their reserves. Other observers saw the hoarding of excess reserves as a sign that the mechanisms implemented by the Federal Reserve during the crisis have been ineffective. Instead of restoring the flow of credits, the money that the Fed has lent to banks since September 2008 is in the banks’ reserves. In addition, it was also been identified by Edlin and Jaffee (2009) that excess reserves were the problem behind the continuing credit crunch.Talasli (2010) stated that uncertainty increases the level of excess reserves. Since the Philippines has also been affected by the two great uncertainties: Asian Financial Crisis (Nagayasu, 2001) and financial crisis of 2007 (Rodgers et al., 2012), this paper examined the behavior of thrift banks on how they manage their excess reserves during the crises and in normal times.Moreover, this paper adapted the model of Dow (2001) and included only the demand deposit and interest rate as an opportunity cost of holding excess reserves to give precise analysis on the behavior of thrift banks toward their reserve management. The researchers however excluded the other explanatory variables from Dow such as the required reserve balances and the demand factor observed by the open market desk in the U.S. since they were not part of this study.Knowing how these factors: demand deposits, opportunity cost of holding excess reserves (interest rates) and uncertainties (Asian and Global Financial Crises) affect the level of excess reserves, can help the thrift banks to evaluate their reserve management as well as the Bangko Sentral ng Pilipinas in implementing monetary policies. This could also help future researches about reserves since this will be the first study of excess reserves in the Philippine setting. Furthermore, it is important to take note and not to be confused that this paper only discussed the fractional reserves of banks and not the gross international reserves of the country as a whole, which includes foreign currencies and gold reserves. The data on excess reserves was confined only from thrift banks which exclude other types of banks such as commercial and universal banks. For the reason that the current literature on excess reserves was more focused on big depository institutions (DIs) such as the commercial universal banks, this paper however wanted to explore the situation of small DIs such as thrift banks because thrift banks have a relatively small capital and therefore more prone uncertainty risks. Review of Related LiteratureBank ReservesUnder the fractional reserve system, each deposit made to the depository institutions are subjected to a legal requirement which individual banks have to comply with. Bank reserves are funds which are kept by banks, in order to meet the central bank’s statutory reserve requirement. Similar to the United States, these reserves can be held either as cash balances in individual banks’ vaults or deposits in the central bank. Reserves subject to the legal requirement are known as required while the additional reserves are called excess (Taufemback et al., 2012). Management on the supply of reserve balances is important in the operation of U.S. monetary policy (Judson et al., 2011).The main monetary instrument applicable for maintaining a level of reserve is the manipulation of the reserve requirements by the central bank. Faig et al., (2008) and Jalbert et al., (2010) both researchers justify the use of reserve requirements as a channel to regulate the money supply in order to stimulate the economy. Lown (2003) considers reserve requirement as “tax” on banks for holding reserves which are not interest earning. In this case, banks prefer to have low reserve requirements in order to free more funds for and invest them into earning assets.In the banking literature, reserves have been considered as an instrument to manage the risk of facing uncertainty of withdrawals from depositors (Faig et al., 2008). In the case of extreme uncertainty, a central bank may opt to use reserve requirement to strengthen the health and stability of financial institutions during an economic downturn or crisis (Jalbert et al., 2010). Excess Reserves The Reserve Position Doctrine (RPD) as a monetary policy deals with the manipulation of the level of excess reserves via open market operations. Although most banks now are shifting away from RPD and adopting interest rate targeting, there is still an ample space in the textbooks about it which is popularly known as the money multiplier. In the European Central Bank (ECB), excess reserves are still used as the framework in their monetary policy (Bindseil et al., 2006).Excess reserves are the incidental accumulation of liquid reserves held by banks. Although there are some banks which prefer to hold more reserves more than what is required to satisfy unexpected withdrawals (Agenor et al., 2004) from depositors or which we will consider as uncertainty. Whenever a bank fails to meet the legal requirement they are penalized by the central bank. To avoid overdraft or penalties on reserve deficiencies, banks wanted to hold more reserve balances. Likewise, more excess reserves provides less risk for bankruptcy in case of bank runs but it provides an opportunity cost of lower profits because of reduced loanable funds (Taufemback, 2012).This was also supported by Ashcraft (2011) that excess reserves are held because either no bank can trade after payments shocks occur, payments shocks are withdrawn from the banking system, or there are autonomous shocks to the supply of reserves held by banks that the Fed does not fully offset. Reserve balances are used by banks to meet legal requirement and to settle payments, if they fall short on liquidity they may opt to borrow in the interbank market and lend excess, if they have any to other banks who are overdraft (Fullwiler, 2006).According to Cargill (2006), banks hold excess reserves because of the fear of bank runs as learning from their experience in the Great Depression of 1930 – 1933. Also, there has been an excessive supply of reserve balance in the credit crunch of 2008 and it continued to be remarkably high as compared to previous levels (Judson et al., 2011). But contrary to the arguments above, banks minimize excess balances holdings as stated since they earn no interest (Demiralp, 2005). Dow (2001) stated that banks want to hold reserves to avoid overdraft or reserve deficiency penalties on their account at the central bank when facing uncertain flows of funds.Demand Deposits Dow (2001) used demand deposit in his model to determine the level of excess reserves. He stated that excess reserves have increased with the growth of deposits. Truly, the findings of his paper showed that an increase of deposit of $1 billion corresponds to an additional $3 million of excess reserves. Moreover, Lown et al., (2003) said that the possibility of reserve drains really depends on the demand deposit losses as well as for time deposits. They then concluded in their work that deposits were really used by banks to determine their reserve position.Ogawa (2007) supported through his estimation results that deposits exerted a significantly positive effect on reserve holdings. However, he did not emphasized much on deposits rather more on the financial health of the banks and the interest rates set by the central bank.Skeie (2008) added to the literature that through his model large withdrawals of demand deposits can exhaust banks’ excess reserves. Further, he also emphasized on demand deposits’ effect on banks’ liquidty and bank run. He stated in his study that the central bank creates a fiat currency that it uses to buy and sell goods and services at a fixed price. In his study he measured demand deposits in real terms and currency in circulation withdrawals rather than nominal terms of those that is based on the fiat currency. He used it to know how those variables affect excess reserves or liquidity that in turn cause bank runs and liquidity crises. He added that literature provides that bank runs are caused by withdrawals of demand deposits payable in real goods that exhausts in the banking system a fixed reserve of goods. The framework describes a traditional bank run in US and recently developing countries where it is based on currency in circulation withdrawals. In contrast, large withdrawals usually are in electronic payments of inside money without affecting a depletion of a scarce reserve from the banking system. Furthermore, Skeie (2008) included in his study that in a closed economy with no central bank intervention or in the absence of regulation and other policy influence, bank reserves are not exhausted from the banking system unless currency is withdrawn and stored outside of the system.Skeie (2008) also included in his study that large withdrawals drain excess liquidity and liquidity reserves present in the banking system. He added that regardless of the trigger, depletion of fixed liquid real goods reserve present to be paid out from the system of banking is caused by excessive withdrawals. To provide to these short term payouts, long term investments have to inefficiently liquidate. Because of this inefficiency, all depositors will try to withdraw immediately knowing that bank will not be able to pay all future withdrawals. A bank run in a real deposits framework will still happen even if the bank is fundamentally solvent for the reason that the liquidity structure of short term liabilities and long term assets are fragile.Teles and Zhou (2005) added that retail sweep programs that reclassify demand deposits to savings account affect the exhaustion of reserve balances. He added that since 1994, banks reclassify back their demand deposit accounts when its low from their previous reclassification of demand deposits balances above a certain level. For these reason, the study found out that the portion reclassified in the demand deposits led to the avoidance of reserve requirements and holdings of reserves by banks. The study of Duca and VanHoose (2004) emphasized that the recent increasing swept demand deposit balances led to a weaker link between demand deposit and liquidity. In effect, their paper stated that adjustments in M1 would be optimal so that monetary policies can consider these swept balances and for banks to hold the optimal reserve requirements.In the study made by Dutknowsky and VanHoose (2011), they focus on how demand deposit sweeping can affect the excess reserve holdings. They added that the excess reserve holdings of banks make uniformly less responsive to exogenous changes in interest on loans or reserves, required reserve ratio, bank deposits, or equity because of swept demand deposits. They supported these findings through the study of that Anderson and Rasche (2001), which stated that sweeping decreased required reserves.In addition, Baoteng (2013) further explained in their study on reserves of China that deposit shortage, reserve adjustment cost, reserve inventory cost and reserve readiness for rent-seeking opportunity would trigger the need for banks to hold excess reserves. They also found out in their work that the fail in deposits led to the reduction in credit supply. They explained that this was because banks face higher external finance cost to substitute deposits thus banks’ lending channel occurred via the money multiplier mechanism in China. They added that the shift of excess reserves to precautionary category led the involutary excess reserves to fall. This led to decreases in demand deposits that also led banks to face market frictions in substituting deposit shortfall with other non-reservable liabilities that cause them to reduce lending. With this, it is likely that banks would be less responsive to tightnening monetary policy if they hold larger involuntary excess reserves. They added that this is in contrast to banks in emerging market economies. Further, these involutary excess reserves can buffer for the effects of monetary policy shocks. In addition, a pivotal role can be played in bak lending behavior of banks in monetary policy effectiveness and transmission mechanism to excess reserves beyond precautionary levels. They supported their findings through the study of Acharya and Naqvi, (2012), which stated that exacerbate risk-taking behavior and aggressive bank lending can result from significant amount of involuntary excess reserves that showed a low probability of liquidity shortage.H1: Demand deposit has a direct relationship to the level of excess reserves.91-Day Treasury Bills RateDow (2001) observed the demand of excess reserves from 13 large banks using one-month Treasury Bills rate as an opportunity cost. His finding is that an increase in the Treasury bill rate tends to decrease excess reserves by $150 million. Bindseil et al. (2006) said, in support of the proposition of Dow, that if there is an increase in the level of interest rates, there will also be a decrease in the level of excess reserves. He revealed that a deposit institution with an interest rate of 2.25%, the opportunity cost and in this case loss of all banks in the euro area to be around €15 million per year, and a slightly lower loss of €100,000 for individual banks.In the case of Japan, Ogawa (2007) examined a panel data on Japanese banks in the period of 1991 to 2002. He found that the optimal demand for excess reserves is a decreasing function of short-term interest rate or call rate. The results of his study confirm that there is a significant impact between interest rate as well as banks’ financial health on the demand of banks’ reserves. In quantitative terms, he observed that an increase of .25% in the call loan rate contracted the aggregate excess reserves by 55–70%.Whitesell (2006) also recognizes interest corridor as an opportunity cost in holding reserve balance (hence excess reserves). Agenor et al., (2010) identifies the bond rate as the opportunity cost of excess reserves which also implies a negative relationship. In his model, he considers the optimal holding of reserves balances are determined by the following cost minimization dilemma, in which the bank must balance against the opportunity cost of holding reserves.Likewise, Marquez et al., (2013) included in his model repo rate, Eurodollar rate and discount rate to have an inverse relation with excess reserves. He anticipated that if the increase of short-term interest rates rises faster than the increase in deposit rates, then the opportunity cost in maintaining reserve balances increases as well.According to Lown (2003), there is no significant difference between required and excess reserves in terms of practicality for the reason that banks treat them for the same purpose. Discussions in his paper stated that in 1873 to 1929 and after 1953 banks had lower reserve requirements which followed the increases in interest rates. The findings of his paper suggest an inverse function between interest rates and reserve requirement and therefore to excess reserves as well.?However, Keister et al., (2006) noted that if the central bank began paying interest on reserves equal to the market interest rates then it removes the opportunity of cost of holding reserves. Thus, the researchers formulated the hypothesis of 91-day Treasury bills rate as an inverse function or an opportunity cost to excess reserves.H2: 91-treasury Bills rate has an inverse relationship to the level of excess reserves.CrisisMitchelle (1941) viewed financial crises as when depositors have the grounds to believe that the economy in the near future looks poor. With that said, the depositors would anticipate that future loan defaults will make it impossible for the bank to repay their deposits thus they will withdraw their money now.There are two traditional ways of understanding crises. The first is that crises result from panics. Secondly, crises arise because of fundamental causes from the business cycle. Friedman and Shwartz (1963) and Kindleberger (1978) argued as well that banking crises were resulted from panics and that most banks closed because they were illiquid rather than being insolvent.Financial systems have been so interconnected wherein the differences between banks and non-bank institutions have been blurred by rapid development of off-balance-sheet activities, credit derivatives and various non-bank financial intermediaries. Thus, once a large bank is near the cliff of collapsing, the whole system would be hurt thru spillover effects and negative externalities which could trigger systematic crisis (Mingkang, 2011).Talasli (2010) emphasized in his work that the uncertainties in the economy or banking system of Turkey would lead to an increase in the level of excess reserves. He included dummy variables that captured the effect of some liquidity shocks like quarter ends, public and religious holidays, when the increase in the volume of currency in circulation causes negative liquidity shock, tax payments, treasury auction settlement days and salary payments. These were the days of high payments of flows through banks’ reserve accounts and therefore represented as an uncertainty. In addition, he also put stressed that the increased distress in the global money markets after Lehman’s collapse caused Turkish banks to demand high levels of excess reserves. Moreover, Judson et al. (2011) supported the work of Talasli that demand for excess reserves depended critically on uncertainty of flows in and out of reserve accounts (Judson and Klee, 2011).This uncertainty was further explained by Agenor, Aizenman and Hoffmaister (2004). They said that the increased incidence of rationing may take the form of increases in excess reserve holdings motivated by higher perceived uncertainty or risk of default. And they further emphasized that greater volatility of deposits and increased riskiness of lending may also prompt banks to hold higher levels of precautionary excess reserves.Cukierman (2013) explained in his work that a dramatic increase in the amount of excess reserves occured in the United States during the global financial crisis. The annual long-term normal rate increase between January 1999 and August 2008 is about half a percent. After the Lehman event and up to april 2011, the anual rate accelerated to 100% that showed the rush of US Banks to accumulate reserves after September 2008. And at the end of August 2008, he emphasized that the total banking reserves stood at about $ 46 billion and just a year later, it increased by eighteen times larger.Krishnamurthy (2011) added that there is also a heightened demand for reserves during crisis. Krishnamurthy also noted that the Federal Reserve’s policy tools were less effective during such. The interbank market for liquidity is also widely thought to have functioned poorly during some of the most stressed periods of the financial crisis in 2007 and 2008. Liquidity, demand and hoarding phenomenon was rampant across many market suggests that broad factors were at work during the crisis. Haan and End (2013) also had the same findings with that of the works above. They found out that crisis had negatively affected liquid asset holdings against liquid liabilities. This reflected the fact that the level of demand deposits was relatively unaffected during the crisis. They explained as well that it could also be that the extended liquidity support by their central bank might have been an incentive for banks to reduce their liquidity buffers.Contrary to the literature above, Murta and Garcia (2010) did not find any significance in the existence of a crisis with the level of excess reserves. They strongly argued that they did not find evidence of changes in the demand for excess reserves by European banks after of the beginning of the subprime credit crisis. However, he also added that through ECB’s implementation of several measures, the crisis was softened in the money markets. Thus, their study strongly contributed to the understanding that, in a banking sector where the central bank contributes to minimize the impact of a crisis that affects the operations of the banks and contributes to the reduction of uncertainty, the credit institutions must rather focus on the cost of obtaining reserves in order to minimize its level.Asian Financial CrisisInitially, the depreciation of Thai Baht lead to the financial crisis experienced by Southeast Asia and East Asia during 1997 – 1998 and soon reached other economies because of financial contagion. In the beginning of the crisis, Thailand was already experiencing debt crisis which was worsened by the depreciation of Thai Baht. The crisis rooted from fast growth of inflow on speculative cash to the Southeast Asia that resulted to the increase of asset prices and blown up asset markets. Speculative cash inflows were attracted by open minded economists in the region. When the investors got knowledgeable of the risks involved in their investments, they immediately withdrew their money, resulting to Southeast Asian economies to be pressured and drove them deeper into crisis. (Havertz, 2012)During the Asian financial crisis, there was an uncontrolled fluctuation in the interest rates, asset prices and exchange rates. There was an increase in the non-performing loans (NPL) because of very high interest rates which lead to corporate failure. Over-lending of banks, financial deregulation, weak banking supervision and cronyism were the other factors which were identified to have caused the crisis (Aslam, 2012). One of the root causes of Asian financial crisis was the moral hazard problem. To explain, insurance scheme is needed in the banking system but it creates this so called moral hazard problem. This moral hazard problem has been even more complicated by the development of financial systems. The banking system for example has shifted from a credit culture to an equity culture –the income of banks have shifted from simply providing loans to securing them and the funding of banks has changed to capital markets, that relies mainly on others foreign investments resulting to large amount of embedded leverage (Hoflich, 2011).Global Financial CrisisTo derive money from lending activities, banks issued more securities. As a result, new financial instruments known as money market derivatives were created and traded in an unstructured and unregulated market i.e. over-the-counter (OTC). Because it is new to the market, leveraging in these financial instruments has increased and the government and market do not understand the kinds of risks and what would these entail in the economy. Further, these financial instruments lack transparency. These results to government and market’s inability to accurately determine the value and volume of these derivatives traded over-the-counter. The foremost buyers of financial instruments are investment banks and other financial institutions with excessive idle funds.The too big to fail (TBTF) problem rooted from the excessive risks taken by large banks. These risks allow large banks to externalize their costs thus pressuring the government to bail out failing lenders. With that said, the focus should be in the part of the regulators. They should monitor the risky investments made by the large banks or they should make advance measures to supervise the high risk large banks. Large banks significantly contributed to the existence of the global financial crisis.H3: Crisis has a direct relationship to the level of excess reserves.Liquidity One of the main issues being discussed in this paper was the liquidity. Banks have liquid liabilities and illiquid assets. They borrow short and lend long. This makes banks vulnerable to sudden demands for liquidity or the so called bank runs. Individuals have preferences for liquidity but the most profitable investment takes a long time to pay.One observation during the financial crisis was the problem in liquidity. Problems like balance sheet constraints, poor transparency regarding potential losses and concerns about concerns about counter party risk contributed to an illiquid financial market. Another problem in the liquidity management was the unwillingness of largest financial institutions to lend to each other because they are concerned about the solvency risk and the opaqueness of firms. (Rosengren and Werkema, 2011)Liquidity lock described as extreme risk aversion by many financial institutions that lead to continuous accumulation of illiquid assets. These institutions feared that they would not be able to sell assets in time without steep discounts.The dilemma is that depositors or consumers do not have a clear knowledge of the timing of their consumption in the inception of investment decisions. If a depositor put his investment on short-term asset and that he needs his funds in a later date, the depositor will regret that he did not put it in higher- yielding long-term asset that would maximize his income. If, on the other hand, a depositor put his investment on long-term-asset and that he needs his funds in an earlier date, he will have no funds to support his consumption and will regret not putting it in short-term asset. Even if the depositor invests in a combination of the two asset, the depositor will still regret with positive probability. This mismatch of asset maturity and time preferences is the problem that banks must find solution.On the other hand, liquidity has a key role in determining asset prices. The supply of liquidity is determined by banks’ initial portfolio choices. Nevertheless, small uncertainties to the demand for liquidity cause a collapse in asset prices. Once supply of liquidity is fixed by banks’ portfolio decisions, shocks to the demand for liquidity can result to asset-price volatility and default. In the short run, supply of liquidity is fixed. Moreover, in the absence of default, the demand for liquidity in the short run is perfectly inelastic. If the banks’ supply of liquidity is enough to satisfy the depositors’ demand when preference for liquidity is high, thus, there should be an excess supply of liquidity when their preference is low. A low interest rate would imply that asset prices are correspondingly high. However, asset prices cannot be high in all states for then short asset would be dominated and therefore, no one would want to hold it. Basically, in the absence of default, there will be price volatility. This argument does not require large shocks or uncertainties to liquidity demand.SynthesisAfter all the reviews made, the researchers have found out that there is lacking of journals from the Philippines which could support the topic of this paper. All of the reviews were from the journals of other countries such as U.S and other European Countries. With that, the researchers considered this as a gap and decided to adapt the models of these researchers and apply it to the Philippine setting. But it is important to take note that the models are modified base on the financial, economic and existing policies in the country as well as the availability of data from the central bank. The works of Dow (2001), Lown et al., (2002), Ogawa (2007), Skeie (2008), Duca et al., (2004), Dutkknowsky et al., (2011), Teles et al., (2005), and Baoteng et al., (2013) all observed the level of demand deposits and excess reserves. All studies proved a significant positive relationship between the level of demand deposits and excess reserves. The work of Dow (2001) focused its study on the US setting. The study of Lown et al., (2002) emphasized reserve drain on time deposits and demand deposits. Ogawa (2007) noted the effect of the two variables to interest rate and financial health. The paper of Skeie (2008) highlighted the effect of the two variables in bank’s liquidity and how large withdrawals affect demand deposits and excess reserves. Works of Teles et al., (2005), Duca et al., (2004), and Dutkknowsky et al., (2011) focused on the effect of retail sweep programs to demand deposits and excess reserves. Baoten et al., (2013) highlighted how the money multiplier effect in China was affected by the excess reserve and demand deposits and noted that the deposit shortage, reserve adjustment cost, reserve inventory cost and reserve readiness for rent-seeking opportunity triggers excess reserve holdings.The works of Dow (2001) in the U.S., Bindseil et al., (2006) in the Euro area and Ogawa (2007) in Japan are similar when they observed the behaviour of excess reserves and interest rates. Both papers proved the inverse relationship between the two variables. Whitesell (2006) as well as Agenor et al., (2010) identified interest rates as the opportunity cost of holding more excess reserves which also supports the negative relationship as stated by the previous authors. Marquez et al., (2013) included in his model repo rate, Eurodollar rate and discount rate to have an inverse relation with excess reserves. Lown (2003) proved that interest rate is negatively correlated with required reserves which also translates to excess reserves. Keister et al., (2006) said that if ever the central bank equates the interest rate paid on reserves and market interest rate, then there will be no opportunity cost faced by the banks. Thus, the researchers formulated the hypothesis of 91-day Treasury bills rate as an inverse function to excess reserves.Talasli (2010), Haan and End (2013), Krishnamurthy (2011), Cukierman (2013), Agenor et. al. (2004) and Judson et. al. (2011) found out that crisis also affect the level of excess reserves. However, Marta and Garcia (2010) did not find any significance in the existence of crisis to level of excess reserves in the European area. Thus, the study would like to find out if crisis is significant in the Philippines in determining the level of excess reserves. The related literature and studies have almost similar insights and facts gathered about the subject matter. The current study as compared to the related literatures and studies do have almost same goals or objectives in determining the effects of t-bills rate, demand deposits and crisis to the demand for excess reserves of the banks. The researchers understood that this study is going to be very significant in contributing to the pool of information about the behavior of banks in the Philippines with regards to their demand for excess reserves. This research is believed to be a guide for other future researches and the results of this paper can be used by the authorities to make monetary policies.An Analysis on the Incidence of Excess Reserves: Case of the PhilippinesFigure 1. Research Simulacrum266700251460Demand DepositsDemand Deposits266700146304091-day Treasury Bills Rate91-day Treasury Bills Rates27597103175(+)00(+)331321639584002008505431802759710113089(-)00(-)4397375320040Excess ReservesExcess Reserves1993265809333321380160935026670068885Asian Financial CrisisAsian Financial Crisis2007870307258283083010160(+)00(+)102808605245745(+)00(+)26670015240Global Financial CrisisGlobal Financial Crisis201104521272510Research MethodResearch DesignThe study used quantitative approach and time-series data. The study considered quantitative approach since the data used were about the reserves of the banking system and the factors that affect them, which both were in terms of peso and percentage. The study used time-series data because excess reserves of the thrift banks and 91-day treasury bills rate of the country are all available in monthly terms and the impact of Asian Financial Crisis of 1997-1998 and Global Financial Crisis of 2007-2008. The researchers wanted to find out if a change in each explanatory variable would cause a significant change to the dependent variable.The research was a national study because it covered all the thrift banks of the Philippines. This also covered the data from 1990 to 2010 monthly. The rationale of choosing the period was that the researchers would want to know the behavior of the banks toward their excess reserves from the beginning, development and aftermath of the financial crises. The researchers used the Consumer Price Index (CPI) to deflate the quantitative variables in the model and used the CPI in 2006 as the base year, which is the current base year set by the National Statistical Coordination Board (NSCB). The deflation of the quantitative variables made them more comparable since from nominal terms, they were converted to real terms that excluded the effects of inflation and other noise related to data being in nominal terms.The research used two binary dummy variables to represent the two crises, namely the presence of the Asian Financial Crisis and the presence of Global Financial Crisis. For the two binary dummy variables, 0 represented the absence of the crisis and 1 represented the presence of the crisis. The research used the Ordinary Least Squares (OLS) method to test the magnitude, and the effects of each explanatory variable to the dependent variable. To interpret the model, the researchers will use the following tests: Student’s t-test and Analysis of Variance F-test to test the significance of the explanatory variables and the significance of the model.Data Collection Procedure The data needed were excess reserves, demand deposits and 91-day treasury bills rates. All the data were available and gathered from the database of the Economic and Financial Learning Center of the Banko Sentral ng Pilipinas. Data AnalysisThe purpose of this section was to develop an empirical model that can examine the effects of change in demand deposit, treasury bills rates, the Asian Financial Crisis, and the Global Financial Crisis on the level of excess reserves. Dow (2001) did a research on the demand of excess reserves on which he specify four variables that affects the excess reserves. These variables are opportunity cost of holding excess reserves (overnight interest rates), level of transaction deposits, level of required reserve balances, and the demand factor observed by the desk. Using these variables, Dow (2001) demonstrates that through these variables an estimable equation can be generated. Furthermore, the model that he used was parsimonious and testable. A number of problems arose from this research approach. Among these were errors in measurement and multicollinearity associated with demographic data. Despite these potential problems, there must be some starting point for empirical research into the process by which business knowledge is learned.The choice as to what demographic variables to include in the model presented several difficulties. The researchers adapted the model of Dow (2001) only that the researchers dropped the demand factor observed by the desk. Instead of having the level of required reserve balances, the reseachers replaced it with the Asian Financial Crisis and Global Financial Crisis factor to lessen the possibility of multicollinearity in the model, specifically the multicollinearity between deposits and required reserve balances. While other authors have found a significant relationship between excess reserves and the following variables: penalty rate, interest spread, overnight call loan rate and interbank call loan rate, sweep accounts, level of loans, cost of borrowing, and interbank market, the terms were not significant in this study. Inclusion of these variables into the model increased the possibility of multicollinearity among variables, increased the noise in the model rather than fit, and deviates from the objective of the study. For these reasons they were not included in the model.The model developed to analyze the level of excess reserves relied on a the effects of change in demand deposit, 91-day treasury bills rates and the Sub-Prime and Global Financial Crisis, which can be represented by an equation of the form:(Eq.1) ExRes= β0 + β1LogDemDep + β2DLogTBillst +β2DLogTBillst-1+ DAsian+DGlobal+ εwhere ExRes measures the level of excess reserves, β0 as the value of the level of excess reserves without the effects of other variables, DemDep as the level of demand deposits, TBills as the treasury bills rate in the market, DAsian as a dummy variable to indicate the effect of the Asian Financial Crisis, DGlobal as a dummy variable to indicate the effect of the Global Financial Crisis, and ε as the residual term.The model measured the level of excess reserves as the difference of the actual reserve holdings of thrift banks, which includes cash in bank’s vault, deposit balance with BSP, eligible domestic securities, eligible foreign securities, and government securities under repurchase agreements and the required reserve balances the banks must hold, which includes statutory or regular reserves and liquidity reserves. The level of demand deposits was measured by the actual amount of checkable deposits thrift bank holds. Both excess reserves and demand deposits were measured in million pesos.The model used a semi-log functional form because of the established relationship of the explanatory variables to the explained variable. The model included a time lag of 1 for 91-day treasury bills rate to take into account the maturity of the treasury bills. The model used the first difference for the treasury bills rate to account the usual volatility of interest rates and to make the variable stationary.Data Presentation and AnalysisRegression OutputDependent Variable: EXRESMethod: Least SquaresSample (adjusted): 3 252Included observations: 250 after adjustmentsVariableCoefficientStd. Errort-StatisticProb.??C-2316.240546.7068-4.2367130.0000LOG(DEMDEP)312.588760.493445.1673170.0000DLOG(TBILLS)-393.7842546.4726-0.7205930.4718ASIAN-807.2772237.5003-3.3990580.0008GLOBAL999.6082307.42103.2515940.0013DLOG(TBILLS(-1))1453.029683.57272.1256390.0345R-squared0.218500????Mean dependent var476.4656Adjusted R-squared0.202486????S.D. dependent var1081.417S.E. of regression965.7445????Akaike info criterion16.60738Sum squared resid2.28E+08????Schwarz criterion16.69190Log likelihood-2069.923????Hannan-Quinn criter.16.64140F-statistic13.64405????Durbin-Watson stat1.714698Prob(F-statistic)0.000000Table 1InterpretationBased on the regression system, the total excess reserves of thrift banks in the Philippines would contract by 2316.240 pesos (in millions) in the absence of demand deposit, 91-day Treasury Bills rate and crises. The excess reserves would increase by 312.5887 pesos (in millions) for every one percentage increase in the demand deposit. While treasury bills rate is insignificant at level, it is significant after by lagging it by 1. The excess reserves would then increase by 1453.029 pesos (in millions) for one percentage point increase in treasury bills rate.Since the data range is from 1990 to 2010, two financial crises were captured namely the Asian Financial Crisis and the Global Financial Crisis. During the Asian Financial Crisis, thrift banks significantly decrease their excess reserves by 807.2772 pesos (in millions).While in the Global Financial Crisis, thrift banks significantly increased their excess reserves by 999.6082 pesos (in millions).AnalysisDemand DepositThe result obtained from the regression shows that the demand deposit is significant at t- Statistic Probability of 0.0000 which is less than α, level of significance of 0.05 and it has a positive relationship with excess reserves. A percentage increase in demand deposit would lead to an increase of 312.5887 pesos (in millions) in the excess reserves. This is consistent with the hypothesis of the researchers and from the works of Dow (2001); Lown et al., (2003); Ogawa (2007); Skeie (2008); Duca et al., (2004); Dutknowsky et al., (2011); Anderson et al., (2001); Boateng (2013).Demand deposits are subjected to statutory requirement set by the Bangko Sentral ng Pilipinas (BSP). A portion of the reserves are kept inside the vaults of the individual thrift banks and the remaining is deposited at the BSP. It is logical to say that as the demand deposit increases, there will also be an increase in the excess reserves since there will be more available reserves that can be held. The monetary base is composed of the money supply plus the total reserves. Excess reserves are also part of the monetary base but since it is part of the reserve, it cannot be loaned out by the banks thus, it is not part of the money in circulation. If there are more excess reserves, it means that there are more money that are kept in the banks’ vaults or in the BSP’, therefore, there is less money that can be loaned and less currency in circulation.However, in the context of thrift banks, thrift banks have relatively significant lower reserve requirements compared to expanded commercial banks and commercial banks due to their relatively lower capital. With this, it is also logical to say that the accumulation of excess reserves would make their demand deposit accounts secured as those of demand deposit accounts with expanded commercial banks and commercial banks. Furthermore, accumulation of excess reserves would not only make the thrift banks to make their demand deposits security to bank systemic shocks but also it would give them interest income due to the interest given by BSP to excess reserves. Because of these benefits to thrift banks in just one financial instrument, these would give them more incentive to accumulate excess reserves as demand deposit increases.It is also logical to say that as demand deposit increases, so as the degree of uncertainty related to withdrawal of depositors increases. Since these demand deposit accounts can be withdrawn anytime it gives relatively higher degree of uncertainty compared to other deposit accounts maintained in banks. If this degree of uncertainty would not be lessened, it would cripple the banks’ ability to optimize their investment and loans. This effect would be greater in the case of thrift banks since thrift banks have relatively lower capital compared to expanded commercial banks and commercial banks and because of that thrift banks have more incentive to optimize their investment and loans to extract more profit in those financial instruments for them to be able to compete with all other banks with relatively higher capital. One way for thrift banks to reduce this increase in uncertainty related to increases to demand deposit is to maximize the accumulation of excess reserves. For the reason that increases in accumulation of excess reserves would give relatively lower degree of uncertainty and risk compared to other investment instruments and give out loans but will yield the relatively greater interest income. Furthermore, because of accumulation of excess reserves would give relatively lower uncertainty risks thrift banks would have greater incentive for them to hold reserves. Because of these reasons, an increase of demand deposits will also increase excess reserves.91-Day Treasury Bills RateBased on the regression system, treasury bills rate at level is insignificant at t- Statistic Probability of 0.4718 which is greater than α, level of significance of 0.05. But at lagged 1 of the treasury bills rate, it has been found to be significant at the t- Statistic Probability of 0.0345 which is less than α. A percentage increase in the treasury bills rate would increase the level of excess reserves by 1453.029 pesos (in millions). This is a contradicting result to the hypothesis of the researchers of a negative relationship between excess reserves and the treasury bills rate and also to the works of Dow (2001); Bindseil et al., (2006); Ogawa (2007); Whitesell (2006); Agenor et al., (2010); Marquez et al., (2013); Keister et al., (2006); and Lown et al., (2003).The lagged term of 1 signifies that the thrift banks will not immediately respond to a change in the treasury bills rate until a month after its official release. This may be explained by the treasury bills rate used in the model which is the 91-day Treasury Bills rate. Since, its maturity is three months after its purchase, the change in the treasury bills rate will not affect the treasury bills purchased previously. Thus, purchasing treasury bills requires proper timing and forecast of a change in its rate before a bank would invest on new treasury bills.To appropriate funds a period of time before purchasing a treasury bills would not be optimal since the funds allocated will be idle and hence will not earn interest or will not increase the capital or assets of a bank. It would then be a wise option for banks to put it on reserves to at least earn interest, assuming these funds are the excess funds after all the banking operation. It is in BSP’s discretion on whether they will put a 4% interest per annum on statutory reserve but only up to 40% of the total level of statutory reserves and the other option is given to thrift banks to shift their reserves to liquidity reserves which are in form of market-yielding bonds purchased directly in BSP. The whole balance of thrift banks in liquidity reserves will be given half of the market interest rate of the prevailing government securities which is the treasury bills rate. However, in 2006, BSP amend its policy of instead of banks purchasing market-yielding bonds, they will instead deposit directly to BSP. This is in form of Reserve Depository Accounts (RDA). These RDAs are short-term deposits and may be in form of 3, 6 and 12 month term deposit. These deposits have interest rates of half of the prevailing government securities.Furthermore, according to Hornstein (2010), “if the federal funds rate is below the penalty rate but above the interest rate paid on reserves, then the forgone interest income represents an opportunity cost to holding reserve balances. However, if the federal funds rate is equal to the interest on reserves, then there is no opportunity cost to holding reserves and the demand for excess reserves becomes infinitely elastic” that is in the case of the United States. In the Philippine setting, considering the mechanism provided by Hornstein (2010), if the interbank call loan rate and overnight rate, which is also the reference for treasury bills rate, is less than the penalty rate set by the BSP and the interest on reserves then there will be no opportunity cost, but rather banks would prefer to place it on reserves because of the fear of overdraft and higher interest income. Since the interest paid on statutory reserves is at 4% per annum, it is greater than the usual interest rate provided by the treasury bills. It does not motivate banks to invest on treasury bills and would rather prefer placing it in reserves since the opportunity cost of these funds not placing in excess reserves is greater than when it is placed in excess reserves.However, it is also logical to say that one reason why the response in excess reserves of thrift banks comes after only a month after a change in 91-day treasury bills rate is that thrift banks have in their investment portfolios treasury bills with different time of maturity. 91-day treasury bills purchased in different months would significantly affect the decision of thrift banks to invest or accumulate excess reserves given their relatively lower capital. This is for the reason that these treasury bills would also qualify as conforming to the reserve requirement set by BSP under their liquidity reserve policy. Furthermore, since they have lower capital they would still wait for a certain number of treasury bills to mature to get their interest income and their funds for them to use it in their operations. Since a change in treasury bills rate would reflect on the interest on reserves, it would also affect the decisions of thrift banks to invest in excess reserves. It may be noted that the more the variation in maturity in thrift banks’ current 91-day treasury bills, the more the thrift banks would delay their operations and holding of excess reserves.In addition, in the context of thrift banks, there will be greater incentive to find the optimal combination of treasury bills and other investment channels and accumulation of excess reserves due to their relatively lower capital compared to other banks. Since thrift banks have relatively lower capital they have greater incentive to manage their opportunity costs and benefits regarding their investment portfolios. It is logical to say that one reason why the response in excess reserves of thrift banks comes after only a month after a change in 91-day treasury bills rate is that they want to maximize their investment decisions through comparing prevailing treasury bills rate, previous treasury bills rate, and average treasury bills rate. Furthermore, if the change in treasury bills rate, which is the difference of the prevailing treasury bills rate and previous treasury bills rate, would be relatively lower than the average treasury bills rate thrift banks would rationally put their funds in other financial instruments rather than the treasury bills rate. This is for the reason that the marginal change in treasury bills would not be enough to compensate for the opportunity costs the thrift banks would incur if they will invest in treasury bills. In effect, since interest on reserves are based also on treasury bills thrift banks will also do the same which is to not anymore hold excess reserves. In the context of assessing risks, if the interest on excess reserves, which are based in treasury bills rate, would give a lower interest income compared to the income other financial instruments would give but with higher risks, it would affect the thrift banks decision on to optimize the income return from investments and risks related to those financial instruments. Because of these reasons, and increase in 91-day treasury bills rate would increase excess reserves a month after the change in 91-day treasury bills rate.CrisesUncertainty is one of the main reasons why banks are motivated to hold reserves. Furthermore, anticipation of a great uncertainty would entail having to hold reserves greater than what is required to absorb its effect to the financial system. In the case of the Philippines, there are two major financial crises namely, the Asian Financial Crisis (1997 – 1998) and the Global Financial Crisis (2007 – 2008). The researchers isolated the two crises and observed the behavior of the banks’ excess reserves on the separate crises.Asian Financial CrisisThe regression system analyzes that the Asian Financial Crisis is significant at t- Statistic Probability of 0.0008 which is less than α, level of significance of 0.05 and negatively related to the level of excess reserves. The presence of Asian Financial Crisis contracted the level of excess reserves to 807.2772 pesos (in millions). The result is inconsistent with the hypothesis of the study and to the works of Krishnamurthy (2011); Judson et. al., (2011); Agenor et. al., (2004); Bech et. al., (2011); Cukierman (2013); Haan et al., (2013); and Talasli (2010). that an existence of crisis varies positively with excess reserves. The result implies that during the Asian Financial Crisis, instead of hoarding a massive level of excess reserve, thrift banks did not constrain the liquidity of the financial system. This follows the advice by the Fed that a large increase of excess reserves during a crisis will be ineffective (Keister et. al, 2009) in resolving the credit crunch. The Asian Financial crisis was mostly centered on the structural factors and not mainly in the interbank system. Thus, the accumulation of excess reserves was not an option considered by thrift banks.Global Financial CrisisThe results of the regression system analyzes that the Global Financial Crisis is significant at t- Statistic Probability of 0.0013 which is less than α, level of significance of 0.05 and has a positive relationship with the level of excess reserves. It has been found out that the presence of Global Financial Crisis increased the level of excess reserves by 999.6082 pesos (in millions). The result is consistent with the hypothesis and to the works of Krishnamurthy (2011); Judson et. al., (2011); Agenor et. al., (2004); Bech et. al., (2011); Cukierman (2013); Haan et al., (2013); and Talasli (2010).Contrary to the effect of Asian Financial Crisis to the level of excess reserves, the Global Financial Crisis gave more pressure to the banks to hoard more reserves. This may be explained because thrift banks, which are relatively smaller than universal and commercial banks, is more prone to defaults and loss on investments. Further, since universal and commercial are large financial institutions, thrift banks prepared for unexpected spillover effect of these universal and commercial banks to the whole financial system of the Philippines. It can be observed that there is an increasing trend in the level of the demand deposits. This further explains and signifies that the level of excess reserves and demand deposit are positively related. Since there are more demand deposits, more reserves can be accumulated. This accumulation of reserves provides a buffer against overdraft that could lead to penalty payments to BSP. These extreme risk aversions by banks lead to liquidity lock (Hoflich, 2011).Since reserves provided more secured interest income other than available form of investment during a crisis, it places small banks, like thrift banks, into a less risky position. And since thrift banks have a limited capital, their decisions should have minimal repercussions.Conclusions and RecommendationsThis study examined the behavior of thrift banks’ excess reserves from 1990 to 2010. It proved that an increase in the level of demand deposits increases the level of excess reserves. While the measurement of opportunity cost, which is the 91-day treasury bills rate, is found to be inconsistent with the findings of the current literature. However, it is to be highlighted that the two crises encountered by the Philippines gave a contradicting impact on the behavior of the thrift banks’ level of excess reserves. In the Asian Financial Crisis, thrift banks did not hoard excess reserves. On the contrary, the Global Financial Crisis pressured the financial systems which made the thrift banks to hoard excess reserves. Demand DepositSince this study found a significant relationship on how demand deposits affects excess reserves. Monetary policy makers can use this information to optimally management the money supply. Furthermore, since demand deposits are part of the narrow money or M1, which is the basic money supply aside from OMO, the BSP can also regulate contractionary money supply through accumulation of excess reserves. Since the literature suggests that uncertainty can result to bank run, maintaining an optimal level of excess reserves can serve as cushion to sudden shocks to demand deposits or self-fulfilling prophecy bank run of depositors. For this reason, banks’ liquidity position must be monitored.Since an increase in the level of demand deposit would also increase the level of excess reserves, the study therefore suggested that whenever there is a crisis, the BSP should induce willingness to deposit among the depositors to help banks maintain their liquidity and regulate properly their level of excess reserves. Panic among banks as well as to depositors should be minimized to avoid bank runs that lead to sudden bankruptcy of banks.91-Day Treasury Bills RateSubsequently, findings on how 91-day treasury bills rate affect excess reserves can be used on handling uncertainty, improvement of banks’ investment portfolio and assessing the opportunity cost of holding excess reserves. Since literature supplements that there is a problem between asset maturity and time preferences of depositors that financial institutions must face, there is a need for banks to optimize their investment portfolio. Further, through the established opportunity cost and benefits from holding excess reserves it can be used in weighing options and monitor banks’ liquidity.In addition, since 91-day treasury bills rate only affect the excess reserve on the month after its official release, BSP should find a way in making incentive for banks to put their funds in government securities instead of hoarding it as an excess reserves. Incentives could be by giving a higher interest-yielding treasury bills or a more access to loans if they have efficient government securities. By doing this suggested policy, the 91-day treasury bills rate would be more attractive for thrift banks thus, leading them to decrease their level of excess reserves.CrisesThe difference in the effect of the two crises to excess reserves can be explained perhaps, through the nature of the crisis itself. In the Asian Financial Crisis, the main cause of its occurrence was the moral hazard problem. Take note that the level of excess reserves went down during those times. It can be concluded that due to this moral hazard problem or state of being complacent of the banks, banks had invested their funds in the global economy even though there were lots of risks or losses that can be accumulated from these investments. Thus, instead of putting their excess funds in reserves, they would rather invest it in the market even if it is risky since the government gave them full support and bail them out if ever they have failed.While in the Global Financial Crisis, one of the main causes of its occurrence was the sub-prime crisis or the “housing bubble”. Take note again that the level of excess reserves went high during this crisis. Perhaps, it could be explained that the banks were more afraid to lend out or invest their money by this time because of so much uncertainties and risks in the global economy. Also, since this was a global phenomenon, banks were afraid of the so-called “bank runs”, the state wherein the people would want to withdraw their money out from the banks. Thus, they would rather keep their funds in reserves, a much safer place, to avoid these uncertainties, risks and banks runs.This ironic result had given this study a much extensive view between the relationship of crisis and excess reserves. A presence of crisis would not necessarily mean that banks would increase their level of excess reserves. It is still depended on the nature of crisis per se. A much effort on the part of the Bangko Sentral ng Pilipinas should be taken into importance. If the nature of crisis would be the same as to the Asian Financial Crisis, BSP should be more aggressive in the investment portfolios of each bank. This could be possible through policies that would require banks to be more transparent when it comes to their investments. Aggressiveness does not mean that the BSP should always intervene to every decision of banks but rather it is more on the monitoring of the BSP to ensure the financial health and stability of the country.However, if the nature of the crisis would be the same as to the Global Financial Crisis, BSP should focus in setting the most-optimal level of interest rates or reserve requirement ratios because these are significant to maintain the correct level of money in the economy. Take note also that the crisis happened due to unpredicted financial condition which was the sub-prime crisis or the housing bubble. The study therefore suggests that extensive research should be done to assess the current global economy. This would help ensure the domestic financial stability of the country and the BSP could make precautionary measures if ever there would be a future threat in the global economy.Other InstrumentsThe central bank uses various instruments to attain the inflation target set by the National Government. The main instrument used is the regulation in the BSP’s key policy interest rates. The central bank also employs measures to expand or contract liquidity in the financial system through open market operations (OMO), special deposit accounts (SDA), rediscounting rates and reserve requirement. Further, the identification of the significant effects of the endogenous variables in the model is crucial to steering the levels of reserves to supply through OMO. According to Goodfriend, “interest on reserves can and should be employed as a policy instrument equal in importance with open market operations. In effect, this paper resolves the historical dispute over bank reserves and interest rate operating procedures by pointing out how a central bank can target both independently. Thus, a central bank without the authority to pay and vary interest on reserves at a market rate is at a considerable disadvantage in the implementation of monetary policy. Paying interest on reserves would seem to be expensive from the Treasury’s point of view. Interest earnings ordinarily transferred by a central bank as tax revenue to the Treasury would be diverted to pay interest on reserves.” In the Philippine setting, it is to be noted that reserves have different interest rates depending on what category it is placed. This study also suggests that since the BSP always forecast the daily level of excess reserve to be used as basis for OMO, it would be a less burden for BSP if the individual banks will regularly provide their needed level of excess reserves to optimize the procedure in determining the OMO. Further, if this information provided by banks can be used as a basis for other there is available information and that can be used instead of forecasting. Since excess reserves are the funds BSP use for inter-bank borrowing, it would be optimal if there will be a regulation like ceiling or floor to optimize the placing of banks in their excess reserves and to determine the optimal level of excess reserves needed by those that will be in default or have deficient reserves.REFERENCESAgénor, P.-R., & Aynaoui, K. E. (2010). Excess liquidity, bank pricing rules, and monetary policy. Journal of Banking & Finance. Agénor, P.-R., Aizenman, J., & Hoffmaister, A. W. (2004). 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Global Financial Crisis In the Asian Context. Quenzon City: Ateneo Center for Asian Studies.Whitesell, W. (2006). Interest rate corridors and reserves. Journal of Monetary Economics.APPENDICESScatterplot:0-547600Figure 2The scatterplot graph between the dependent and explanatory variables is essential in determining the proper functional form used in the econometric model. The relationship of excess reserves to demand deposit, based on the scatterplot, it requires the demand deposit to be in the log form. The same applies to interest rates which takes the form of log. The Asian and Global crises were seen to be in the linear form only. Ramsey RESET Test:Ramsey RESET TestEquation: UNTITLEDSpecification: DEXRES C LOG(DDEMDEP) DLOG(DTBILLS) ASIAN????????GLOBAL DLOG(DTBILLS(-1))Omitted Variables: Powers of fitted values from 2 to 3ValuedfProbabilityF-statistic?0.125321(2, 242)?0.8823Likelihood ratio?0.258793?2?0.8786Table 2The results showed that with a specification of 2 number of fitted terms, the model passed and found to be significant at 0.1 level of significance. This verifies that the model has no misspecified variables and that the model adapts the correct functional form.?NominalDeflatorReal/DeflatedDummyOBSExResDemDepTbillsCPI 2000decimalDexresDdemdepDtbillsGlobalAsian90:Jan83.2594.119.6842.80.309920348268.45611916.94463.500186920090:Feb38562020.31430.3113685731236.4771991.20965.228162790090:Mar-570.8568.422.9343.20.312816799-1824.711817.03873.301689810090:Apr-399.249725.2543.60.315713251-1264.441574.21379.977637610090:May305.1649.722.6743.90.31788559959.77932043.81771.314965830090:Jun-170.1650.723.0844.30.320782042-530.2672028.4871.949164790090:Jul-467020.9344.90.32512672-12.30292060.73564.374899780090:Aug-49.4447.721.45450.325850833-151.6031373.94265.827666670090:Sep18.1484.827.945.50.32947139854.936481471.44884.68109890090:Oct416.1492.827.3846.40.3359884141238.4361466.71781.490905170090:Nov157.6496.225.9847.20.341781318461.11361451.80676.013516950090:Dec-643.2659.126.5249.10.355539464-1809.081853.80374.590875760091:Jan96.4481.528.5750.70.367125272262.58071311.54177.820848130091:Feb89.2488.223.9651.70.374366401238.26921304.0764.001470020091:Mar-278.5501.523.1652.20.377986966-736.7981326.76561.271954020091:Apr-96.9511.921.9452.50.380159305-254.8931346.54157.712647620091:May-130.8520.218.8552.90.383055757-341.4651358.02749.209546310091:Jun-56.1536.317.5753.30.385952209-145.3551389.5545.523771110091:Jul103.1619.617.2653.90.390296886264.15791587.50944.222745830091:Aug-26.1620.720.3254.50.394641564-66.1361572.8251.489761470091:Sep113.8636.521.96550.398262129285.74151598.19455.139563640091:Oct17.5625.521.5655.10.39898624243.861161567.72354.0369510091:Nov-16.2638.321.4855.30.400434468-40.45611594.01953.641735990091:Dec-150.1777.421.155.60.402606807-372.821930.91652.408453240092:Jan-29645.620.1956.20.406951484-71.26161586.4349.612793590092:Feb-129.6668.818.7456.40.40839971-317.3361637.61145.886418440092:Mar-303.6706.316.9556.80.411296162-738.1541717.25441.211179580092:Apr-10.7708.615.39570.412744388-25.9241716.80137.2870092:May60.4727.515.3857.60.417089066144.81321744.23236.874618060092:Jun-204.9784.214.4358.10.420709631-487.0341863.99334.299191050092:Jul-275.8746.215.4958.70.425054308-648.8581755.5436.442402040092:Aug15.5815.715.21590.42722664736.280511909.29135.601711860092:Sep-16774.116.1459.50.430847212-37.13611796.69337.461075630092:Oct55675.915.2359.60.431571325127.44131566.13735.289647650092:Nov52.5656.214.5859.70.432295438121.44471517.94333.726934670092:Dec24.11107.614.4859.70.43229543855.748912562.13733.495611390093:Jan60.3710.91460.40.437364229137.87141625.41932.009933770093:Feb247.9690.813.3260.50.438088342565.86761576.85130.404826450093:Mar193.6987.812.6760.70.439536568440.46392247.36728.825815490093:Apr49.774811.660.80.440260681112.88771698.99326.348026320093:May342.4783.310.7661.10.44243302773.90251770.43724.320065470093:Jun355.7822.110.2361.60.446053584797.43781843.05222.934464290093:Jul130.2844.910.0662.30.451122375288.61351872.88422.299935790093:Aug178.8852.311.1962.70.454018827393.81631877.23524.646555020093:Sep-1271.31128.911.4563.40.459087618-2769.192459.00824.940772870093:Oct372.51242.412.6563.70.461259957807.57062693.49227.424882260093:Nov-408.21258.215.5163.90.462708182-882.1972719.20833.520046950093:Dec310134415.9464.10.464156408667.87832895.57634.341872070094:Jan-159.9894.615.28670.485155684-329.5851843.94431.495044780094:Feb-89.3980.915.0767.80.490948588-181.8931997.96930.695678470094:Mar837.5971.414.967.70.4902244751708.4011981.54130.394239290094:Apr737.994514.7767.90.4916727011500.7951922.0130.040309280094:May725.8918.114.868.10.4931209271471.851861.81530.012922170094:Jun-1231953.314.7168.40.495293266-2485.41924.71829.699576020094:Jul701.5945.413.9268.80.4981897181408.0981897.67127.941162790094:Aug-141.3964.910.8869.40.502534395-281.1751920.06821.650259370094:Sep185.21010.38.9569.30.501810282369.06382013.31117.835425690094:Oct198.61094.48.7769.40.502534395395.19682177.76117.451541790094:Nov107.311609.8369.30.501810282213.82582311.63119.589076480094:Dec501.71119.210.6769.50.503258508996.90322223.90721.201827340095:Jan254.71130.110.1870.90.51339609496.10822201.22419.828744710095:Feb575.21232.411.1171.20.5155684291115.6622390.37121.54903090095:Mar-836.81183.313.871.50.517740768-1616.252285.50726.654265730095:Apr128.11237.314.8671.70.519188993246.7312383.1428.621562060095:May-132.31282.514.2472.40.524257784-252.3572446.31627.162209940095:Jun79.31307.313.6172.90.527878349150.2242476.51825.782455420095:Jul108.51387.811.473.20.530050688204.69742618.2421.507377050095:Aug287.31933.89.2874.10.536567705535.44043604.01917.295114710095:Sep2921880.59.6275.40.545981173534.8173444.25817.619655170095:Oct523.61759.29.9875.50.546705286957.73723217.82118.254807950095:Nov377.21878.911.0274.90.542360608695.47823464.320.318584780095:Dec6642323.112.0375.10.5438088341221.0174271.90622.121744340096:Jan-122.52609.412.5276.90.556842867-219.994686.06222.483901170096:Feb707.22683.712.7977.40.5604634321261.8134788.35922.820400520096:Mar7292618.112.9577.70.5626357711295.6874653.27723.016666670096:Apr47.42711.212.9278.10.56553222383.814854794.06822.845736240096:May307.83099.412.9578.20.566256336543.57015473.49322.869501280096:Jun-19.33172.712.8478.70.569876901-33.8675567.34322.53118170096:Jul-208.73001.112.6578.90.571325127-365.2915252.87622.141508240096:Aug357.7311012.1679.50.575669804621.36315402.40321.123220130096:Sep-210.8346411.4879.40.574945692-366.6436024.91719.967103270096:Oct296.33684.411.5679.60.576393917514.05826392.15620.055728640096:Nov229.43613.211.6879.80.577842143396.99426252.91920.213132830096:Dec1031.63843.911.5580.30.5814627081774.1466610.74219.863698630097:Jan415.33656.210.8381.20.587979725706.31696218.24218.419002460097:Feb666.64231.410.6681.50.5901520641129.5397170.01618.06314110097:Mar300.34018.610.0681.90.593048516506.36676776.17416.963199020097:Apr-16204563.19.9982.10.594496741-2724.997675.56816.804129110097:May-31.45136.110.8782.10.594496741-52.81788639.40818.284372720097:Jun65.75170.610.4983.10.601737871109.18388592.77817.432839950097:Jul-1791.84512.512.1883.20.602461984-2974.137490.09920.217043270197:Aug2220.24676.514.1683.70.6060825493663.1977715.94623.363154120197:Sep-1158.34431.215.35840.608254888-1904.37285.10425.236130950197:Oct693.94125.616.5284.30.6104272271136.7456758.54527.063013050197:Nov231.9425015.8984.90.614771904377.21316913.13325.846984690197:Dec477.1485617.785.30.617668356772.4217861.82428.656154750198:Jan568.84468.219.186.50.626357712908.10737133.62330.493757230198:Feb-758.84286.617.7987.70.635047067-1194.876750.05128.013671610198:Mar-1295.54262.316.688.50.640839971-2021.576651.11425.903502820198:Apr-260.14346.715.288.90.643736423-404.0476752.29823.612148480198:May107.74285.114.3890.10.652425778165.07626567.9522.040821310198:Jun446.84368.81491.40.661839247675.08846600.99921.153172870198:Jul-343.64195.714.6791.60.663287473-518.0266325.61322.117106990198:Aug-1848.14195.614.08920.666183925-2774.166297.9621.135304350198:Sep-776.34109.613.8292.30.668356264-1161.516148.81620.67759480198:Oct-399.84040.413.5392.60.670528602-596.2466025.69420.178110150198:Nov-320.34168.213.45940.680666184-470.5686123.70719.760053190198:Dec-132.84852.513.4393.80.679217958-195.5197144.24619.772739870199:Jan-571.74358.113.2495.60.692251991-825.8556295.5419.125983260099:Feb-379.14515.712.7395.60.692251991-547.6336523.20318.389257320099:Mar-395.94550.812.1495.30.690079652-573.7026594.60117.592172090099:Apr-1215259.310.8595.20.689355539-175.5267629.315.739338240099:May309.15656.49.9695.30.690079652447.91938196.73514.433116470099:Jun-13095981.39.2695.90.69442433-1885.018613.32113.334786240099:Jul27.26072.68.43960.69514844339.128338735.68812.126906250099:Aug-1438.86224.68.4596.30.697320782-2063.338926.45112.117808930099:Sep716.86253.28.5796.80.7009413471022.6258921.14612.226415290099:Oct2766195.98.5897.20.703837799392.13588803.02312.190308640099:Nov364.76688.88.8697.40.705286025517.09529483.81212.562279260099:Dec1431.87239.18.997.50.7060101382028.01610253.5412.606051280020:Jan681.97012.88.9197.70.707458364963.8739912.66812.594380760020:Feb-278.57298.28.85980.709630702-392.45810284.512.471275510020:Mar517.17407.78.94980.709630702728.688910438.8112.598102040020:Apr59.577688.7698.30.71180304183.5905410913.1312.306775180020:May-655.78249.68.898.50.713251267-919.31111566.1912.337868020020:Jun237.98197.58.9199.50.720492397330.190911377.6412.366542710020:Jul833.78423.88.91000.7241129621151.3411633.2712.29090020:Aug511.68286.88.93100.50.727733526703.004611387.1412.270975120020:Sep648.58385.99.14100.90.730629978887.590211477.6312.509752230020:Oct801.98364.29.41101.70.7364228821088.91211357.8812.777984270020:Nov285.88679.415.81030.74583635383.19411637.1421.184271840020:Dec990.68768.913.61103.80.7516292541317.93711666.5218.107331410021:Jan-76.99070.712.231050.76031861-101.14211930.1316.08536190021:Feb8468598.310.61105.30.7624909491109.52111276.5913.914919280021:Mar515.48683.99.73105.40.763215062675.301111378.0512.748700190021:Apr899.79072.99.9105.60.7646632871176.59611865.2212.9468750021:May1584.790289.49105.80.7661115132068.49811784.1912.387230620021:Jun967.49100.68.76106.70.772628531252.08911778.7511.33791940021:Jul1481.689998.88107.40.7776973211905.11111571.3411.418324020021:Aug47.38772.79.51107.50.77842143460.76411269.8612.217032560021:Sep-112.68594.79.51107.80.780593773-144.24911010.4612.18303340021:Oct612.287589.77107.90.781317886783.547911209.2712.504513440021:Nov455.388529.54108.20.783490224581.117711298.1612.176284660021:Dec-940.99071.88.88108.50.785662563-1197.5911546.6911.302562210022:Jan-89599.17.88108.90.788559015-10.145112172.969.9929109270022:Feb-919.710398.17.18108.70.787110789-1168.4513210.479.1219687210022:Mar504.3105326.37109.10.790007241638.348613331.528.0632172320022:Apr-719.712157.74.69109.30.791455467-909.33715361.195.92579140022:May-955.312564.74.41109.50.792903693-1204.8115846.445.5618356160022:Jun-238.213126.34.78109.80.795076032-299.59416509.496.0120036430022:Jul-620.1129444.77110.20.797972484-777.09416221.115.9776497280022:Aug-96311480.34.93110.70.801593049-1201.3614321.866.1502529360022:Sep20.311538.75.21110.70.80159304925.3245714394.716.4995573620022:Oct904.411136.35.28110.70.8015930491128.25313892.716.5868834690022:Nov433.911388.35.26110.80.802317161540.808614194.266.556010830022:Dec172.411281.85.16111.20.805213613214.104714010.946.408237410023:Jan695112775.18111.90.810282404857.725613917.376.3928328870023:Feb629112935.67112.20.812454743774.19713899.856.9788502670023:Mar556114266.17112.40.813902969683.128114038.537.5807562280023:Apr1589111717.35112.90.8175235341943.67513664.448.9905668730023:May598114216.57113.20.819695873729.538913933.228.0151678450023:Jun722118415.58114.10.826212889873.866814331.666.7537072740023:Jul618117125.24114.30.827661115746.682414150.726.3310936130023:Aug759117695.22114.50.829109341915.440214194.756.2959126640023:Sep677119905.32114.70.830557567815.115114436.096.4053356580023:Oct-156122095.66114.70.830557567-187.82614699.766.8146992150023:Nov646124986.44115.10.833454019775.087714995.437.7268809730023:Dec987127586.44115.50.8363504711180.12715254.377.7001212120024:Jan684128276.2116.50.8435916810.818915205.227.3495278970024:Feb707128326.33116.70.845039826836.64715185.087.4907712080024:Mar676130017.62117.10.847936278797.229715332.528.9865243380024:Apr663130927.41117.70.852280956777.912515361.138.6943160580024:May613133937.08118.30.856625634715.598515634.68.264987320024:Jun669137477.39120.30.871107893767.987515781.058.4834497090024:Jul687138187.56121.80.881969587778.938415667.218.5717241380024:Aug772141217.15122.30.885590152871.735115945.38.0737121830024:Sep681141427.611230.890658943764.602415878.138.5442357720024:Oct656142647.83123.50.894279508733.551415950.278.7556518220024:Nov666144227.87124.50.901520637738.751815997.428.7296947790024:Dec891148077.79125.40.908037654981.236816306.598.5789393940025:Jan1079153597.66126.30.9145546711179.80916793.978.3756611240025:Feb1188157946.78126.60.9167270091295.91517228.687.3958767770025:Mar1377158076.621270.9196234611497.35217188.567.1985984250025:Apr1427157846.63127.70.9246922521543.21617069.467.1699530150025:May1109161316.1128.30.929036931193.70917363.146.5659392050025:Jun995164735.8129.40.9370021721061.89717580.546.1899536320025:Jul1098169395.72130.50.9449674151161.94517925.496.0531187740025:Aug1173166415.62131.10.9493120931235.63217529.545.9200762780025:Sep1209169895.8131.60.9529326571268.71517828.126.0864741640025:Oct1113167345.86132.20.9572773351162.67217480.836.1215279880025:Nov1056174035.39133.40.9659666911093.20518016.155.5799025490025:Dec1105173325.39133.80.9688631431140.51217889.015.5632212260026:Jan2213174274.91134.80.9761042722267.17617853.635.0302002970026:Feb483177135.16136.20.986241854489.737917960.15.2319823790026:Mar1909179495136.70.9898624191928.55118132.825.0512070230026:Apr1731174664.74136.80.9905865311747.4517631.984.785043860026:May171181854.84137.10.99275887172.247318317.644.8753026990026:Jun1712189036.5138.111712189036.50026:Jul2413196456.08138.81.0050687912400.83119545.936.0493371760026:Aug1729199455.4139.31.0086893561714.10619773.185.3534816940026:Sep-994203955.44139.11.00724113-986.85420248.385.4008914450026:Oct1217203575.47139.31.0086893561206.51620181.635.4228786790026:Nov2701213724.84139.51.0101375812673.89321157.514.7914265230026:Dec2836221704.84139.61.0108616942805.52721931.784.7879942690027:Jan1736232613.481401.0137581461712.4422945.323.4327714290027:Feb2530236502.94139.81.012309922499.23523362.412.9042489270027:Mar2952243522.97139.71.0115858072918.1924073.092.9359842520027:Apr2095243242.921401.0137581462066.56823993.892.8803714290027:May-1139237083.03140.41.016654598-1120.3423319.622.9803632480027:Jun3290240023.03141.31.0231716153215.49223458.432.9613800420027:Jul1135241363.55142.41.0311368571100.72723407.173.4428019660027:Aug4703234093.72142.61.0325850834554.58822670.293.6026086961027:Sep3707230423.76142.81.0340333093584.99122283.613.6362464991027:Oct1484229053.76143.11.0362056481432.14822104.693.628623341027:Nov3402243303.691441.0427226653262.61323333.153.53881251027:Dec1859249073.69145.11.0506879071769.31723705.423.5119848381028:Jan2504243973.67146.81.0629978282355.60222951.133.45251028:Feb2305242233.67147.31.0666183922161.03522710.093.440780721028:Mar306346393.67148.61.076031861284.378232191.433.4106796771028:Apr217371763.67151.61.09775525197.676133865.473.3431860161028:May548363883.67153.81.113685735492.059832673.493.2953641091028:Jun644371553.67157.41.139753802565.034332599.153.2199936471028:Jul438361525.7159.91.157856626378.285231223.214.9228893060028:Aug689361005.7160.31.160753077593.580231100.54.9106051150028:Sep410371765.7159.71.1564084354.54632147.814.9290544770028:Oct111345505.7159.11.15206372296.3488429989.664.9476429920028:Nov731352805.7158.21.145546705638.123330797.524.9757901390028:Dec1477425976.12156.71.1346850111301.68337540.815.3935673260029:Jan598351824.65157.21.138305576525.342230907.344.0850190840029:Feb479362254.651581.144098479418.670331662.484.0643354430029:Mar141394134.41158.11.144822592123.163234427.173.8521252370029:Apr768378094.32158.91.150615496667.468832859.83.7545122720029:May672453564.29158.81.149891383584.40339443.733.7307871540029:Jun991402304.44159.71.1564084856.963734788.753.8394740140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THE AUTHORS2540010985500Felipe T. Polintan Jr. (polintan_felipejr@) is currently a fourth year Business Economics student in the College of Commerce and Business Administration in the University of Santo Tomas. He is a scholar of Nestlé since 2006. Moreover, he is also active in extra-curricular activities. He is the Vice President for External Affairs of UST Economics Society (UST EcoSoc), a duly recognized college-based organization of business economics department. He is also an active member of Gleeconomics, the official chorale of UST EcoSoc and UST EcoSoc Debate Team. He competed in various debate competitions such as inter-organizational, intercollegiate and even in nationwide debate competitions i.e. annual debate competition of JPES. He also went under the internship program of the Department of Trade and Industry – Center for Industrial Competitiveness where he learned various ways on how to make the country competitive. Lastly, he is a Christian because he allows God to conquer his life and in all things that he does, he lifts it all up to Him.-260355778500Jasmin S. Poquiz (jasmin_poquiz@) is currently a fourth year Business Economics student in the College of Commerce Business Administration in the University of Santo Tomas. She finished her secondary education in the Polytechnic University of the Philippines –Laboratory High School. She is a member of Ecocyphers –official dance troupe of Economics Society (Ecosoc), Red Cross Youth Council and the Lakas Diwa CBA Unit. Last year, she competed in Ecosoc’s annual quiz bee entitled, EcoKNOWmics: Clash of the Wits and just recently, in the Mr. and Ms. Ideal Thomasian Economist where she placed third runner-up. Moreover, she was part of the dean’s list in the A.Y. 2010 – 2011. Last April, she passed the civil service eligibility examination for professional level. Furthermore, she spent her summer internship in the Bangko Sentral ng Pilipinas under the Department of Research, Real and External Sector Research Group. 03683000Justin G. Simon (justingsimon@) is currently a fourth year Business Economics student in the University of Santo Tomas College of Commerce and Business Administration. He is the Vice President for Finance of the Junior Philippine Economics Society, the junior arm of Philippine Economics Society and a duly recognized national society for all economics students of the Philippines. Moreover, he is also the vice-captain of the UST Economics Society Debate Team and an active member of the Commerce Pautakan Team, the official team of the college for the annual intercollegiate quiz bee, and the Commerce Social Science Team, another official team of the college for the an annual intercollegiate quiz bee. He competed in various debate competitions such as inter-organizational, intercollegiate and nationwide debate competitions, such as the annual debate competition of JPES. He also went under the internship program of the Bureau of Customs where he worked under the Planning and Policy Research Division and International Affairs and learned how the country would benefit domestically and internationally from effective customs policies. ................
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