Chapter

V The Chilean Banking System: Recent Developments

Author(s):
Eliot Kalter, Steven Phillips, Manmohan Singh, Mauricio Villafuerte, Rodolfo Luzio, and Marco Espinosa-Vega
Published Date:
June 2004
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Author(s)
Marco A. Espinosa-Vega

This section provides a brief update of the Chilean banking system by reporting recent developments and regulatory changes, standard prudential indicators, and the view of rating agencies. It also discusses the recent Inverlink affair, focusing on the preemptive liquidity measures taken by the authorities after this incident of fraud came to light.

Structure and Activities of the Banking System

As of December 2002, the Chilean banking system held about US$63.2 billion in assets or about 100 percent of GDP—including about US$44.5 billion in loans and US$ 12.3 billion in negotiable financial instruments.

The structure of the banking system continues to evolve. Currently the system consists of 26 banks, including 7 branches of foreign banks and the government-owned bank (Banco Estado). During 2002, two new banks (Banco Ripley and Banco HNS) entered the system. Early in 2003, the only remaining finance company or consumer credit agency (Financiera Conosur, with 53 branches throughout the country) became a full-fledged commercial bank (Banco Conosur).

During 2002, the total bank loan portfolio continued to grow in tandem with economic activity. Consumer loans1 have shown the strongest performance with a 12 percent (year-on-year) growth rate in real terms. Mortgage lending grew at 6 percent (year-on-year) in real terms while commercial lending stayed flat—due in part to alternative financing sources available to large firms.

There has been a shift in the composition of banks’ assets, as well as in their deposits and loans. Since the announcement in 2001 of the central bank’s “nominalization” of its monetary policy operations there has been a shift in the composition of banks’ assets (Figure 5.1), deposits, and loans from inflation-indexed (denominated in Unidad de Fomento (UF))2 to nonindexed instruments.

Figure 5.1.Nominal Versus Inflation-Indexed Loans and Deposits

(In percent of total)

Source: Central Bank of Chile.

Banks have not been heavily involved in under-writing and securitization, even though the 1997 amendment to the 1986 banking law permits such activities. Banks’ involvement in the derivatives market is dominated by currency hedging. Banks participate actively in foreign exchange forwards and swaps.

A long-standing characteristic of the Chilean banking system, its relatively low levels of dollarization, continues to hold (Figure 5.2). Since early 2002, dollarization ratios have been essentially flat (for deposits) or have tended to decline slightly (for loans).3

Figure 5.2.Dollarization of the Banking System

(In percent of total)

Source: Central Bank of Chile.

The banking system appears fairly concentrated. The 10 largest banks account for some 85 percent of deposits and loans, and the 2 largest banks represent almost half of the system’s deposits. Such concentration might raise concerns of possible anticompetitive practices and increased systemic risk. However, recent studies find that Chile does not stand out as having a particularly concentrated banking system, that this concentration so far has not adversely affected the degree of competition, and that larger banks are not associated with riskier practices in Chile.4

The system also continues to have significant foreign participation. Foreign-owned or controlled banks’ assets account for 44 percent of banking system’s assets. Recent cross-country research associates the presence of foreign banks with the import of sound risk management systems developed by head offices with advanced financial and banking markets, and with increased efficiency of domestic banks.5 In some countries, there has been concern that entry of foreign banks could eliminate the small local banks that normally cater to low-income consumers; however, there is no empirical evidence to support this claim.6 In addition, in Chile, the Banco Estado ensures the provision of banking services to all regions of the country through its widespread branch network, maintains a large volume of pass-book savings accounts, and makes a substantial amount of consumer and mortgage loans including to low-income households.7

Recent Changes in Banking Regulation and Supervision

Mortgage refinancing activity has been spurred by the November 2002 approval by congress of the elimination of the “stamp” tax paid on refinancing of home mortgages and by low interest rates.

The central bank is engaged in modernizing the country’s payments system. Open market operations already are conducted electronically. By 2004, the central bank will require the electronic custody and trading of all large-denomination assets. Also in 2004, all large-denomination asset transactions will be settled on a real-time gross settlement (RTGS) basis.

In Chile, the central bank and the Superintendency of Banks and Financial Institutions (SBIF) have regulatory powers over the banking system. Since the 2002 Article IV consultation with the IMF, they have taken the following regulatory measures:

  • The central bank authorized banks to issue interest-bearing deposit accounts. However, the move has not induced a large switch from noninterest-bearing to interest-bearing accounts—in part due to the low opportunity cost that a low inflationary environment represents for depositors.8

  • The SBIF issued a new regulation requiring banks to include all loan charges in a single interest rate figure, and to publish interest rates charged on consumer loans periodically. The goal of this increase in transparency was to promote more competition among banks, in particular to induce a higher degree of interest rate pass-through to consumer lending rates.

  • The SBIF introduced regulations that would require banks to (1) restrict how much of the net worth of their affiliates could be included in the consolidated balance sheets; (2) obtain previous authorization of the SBIF before selling or charging-off reposed assets; (3) apply their own portfolio risk models for loan provisioning; and (4) meet guidelines for internal auditing committees to bring them up to international best practices by 2004.

Perhaps the most significant of these regulatory changes has been allowing banks to design their own portfolio risk models. The regulation anticipates the new direction of the Basel II Committee’s recommendations of moving to greater reliance on banks’ internal risk management systems. The SBIF reports that it is training its staff to better understand and evaluate the banks’ internal risk models. The SBIF also reports that its risk unit has met with all the risk departments of the different banks to look into the assumptions of the banks’ risk models and to ensure consistency between the asset classification and their provisioning.

Risk Management Policies, Prudential Indicators, and Stress Tests

The Chilean banking system continues to enjoy a reputation for soundness, for weathering regional storms, and for an effective provision of credit to the private sector (Box 5.1). The recent collapse of the Argentine banking system and political uncertainties in Brazil had a limited impact on the Chilean banking system.

Overall prudential indicators continue to point to a healthy banking system (Table 5.1). The system continued to be well capitalized during 2002, but there was a slight deterioration in the quality of the banking system’s portfolio, and a small decline in the banking system’s profits. As shown in Table 5.1, during 2002 the banking system as a whole

Table 5.1.Financial System Indicators(In percent)
DecemberApril 2003
1996199719981999200020012002
Solvency
Effective capital/risk-weighted assets112.4813.5313.3412.7314.0114.40
Basic capital/total assets27.497.757.517.247.207.38
Credit risks
Loan loss provisions/total loans1.341.421.912.552.522.372.362.30
Overdue loans/total loans0.950.961.451.671.731.621.821.94
Loan loss provisions/overdue loans141.1147.9131.7152.7145.7146.3129.5118.9
Results
After income/adjusted assets (ROA)31.141.010.900.731.001.281.041.10
After tax income/capital and reserves (ROE)15.5013.6711.549.3612.7017.7014.3914.90
Efficiency
Operating costs/gross operational margin66.5066.4561.4460.1960.7656.1555.2153.92
Operating costs/adjusted assets3.333.193.132.942.842.782.552.58
Foreign exchange risk
Net open foreign exchange position (percent of capital)3 (sum of on- and off-balance-sheet exposure)11.674.333.584.274.30
Source: Superintendency of Banks and Financial Institutions.

Effective capital corresponds to basic capital less equity plus the sum of voluntary provisions and subordinated bonds.

Basic capital is equivalent to capital and reserves.

Figure for 2003 is through March.

Source: Superintendency of Banks and Financial Institutions.

Effective capital corresponds to basic capital less equity plus the sum of voluntary provisions and subordinated bonds.

Basic capital is equivalent to capital and reserves.

Figure for 2003 is through March.

  • Registered a slight increase in overdue loans;9

  • Showed a slight decrease in loan loss reserve coverage;

  • Maintained a healthy coverage ratio of 129.5 percent as of December 2002;

  • Continues to be well capitalized, displaying a small increase in its capital adequacy ratio to 14.01 percent in December 2002; and

  • Experienced a small decline over the year in net income after taxes, both as a rate of return on assets and as a rate of return on equity. The most significant factor in this was the higher costs associated with the mergers of several banks (greater administrative costs and increases in loan loss provision reserves).10 Nevertheless, the overall profitability of the banking system remains strong and stable.

Even with the favorable prudential indicators just listed, the Chilean banking system could still be exposed to a number of potential shocks. In order to assess the vulnerability of the banking system to some of these shocks, in late 2001 IMF staff conducted a series of stress tests.11 The tests consisted of applying (1) a hypothetical 25 percent depreciation of the peso to the net foreign exchange rate exposure of each bank; (2) a shock to the central bank bonds yield curve and using a repricing gap model of interest rate risk to analyze the sensitivity to interest rate shocks of the difference between the flow of interest earned by each bank’s assets and flow of interest paid on its liabilities; and (3) a credit risk shock by assuming that the share of overdue loans as a percentage of total loans doubled with 100 percent provisioning of the simulated increase. Most banks would have been able to comfortably meet the minimum risk-based capital adequacy requirements after each shock.

The SBIF is considering making this kind of stress analysis part of its routine vulnerability assessment. It is currently engaged in an updated, similar stress-testing exercise, and expects to release its findings.

Preemptive Liquidity Measures: The Aftermath of the Inverlink Affair

A case of fraud of some significance, involving a financial holding company, emerged in March 2003. Although this case originated outside the banking system, its repercussions soon extended to the banking system.

In early March, a bribed official at CORFO (a second-tier development bank, under the supervision of the Ministry of Economy) was discovered to have handed over more than US$ 100 million in government-owned securities to Inverlink, a private financial holding company, which had then recently sold them in the secondary market. Only a few weeks earlier, Inverlink—whose interests included a mutual fund, an insurance company, and a pension fund—had been caught bribing a central bank employee to deliver confidential information.

Box 5.1.The Credit Allocation Role of Banks in Chile

Since the 1970s Chilean banks have played a key role in the allocation of credit to the private sector. These banks have been the most dynamic in terms of credit allocation in Latin America. For example, at end-2002, bank lending portfolio accounted for 70 percent of GDP compared with less than 30 percent for Brazil. The banking sector has held on to its financial liberalization efforts and has carried out some financial innovations. Factors that have contributed to the prominent role of banks in the allocation of credit include financial liberalization, fiscal discipline, a limited-participation state-owned bank, availability of an inflation-indexed unit of account, a strong technology to evaluate consumers’ creditworthiness, privatization of the pension system, and the banking regulatory regime and safety net.

As reported in, for example, Caballero (2001), equity markets saw a rapid expansion in the early 1990s. Also, as reported in Section III, in just the last few years, there has also been a resurgence of domestic bond financing and a retreat from equity markets. However, the importance of bank credit continues to grow (see table).

Relative Importance of Bank Loans
Stock as Percent of Total
Source of Financing199519992003
Loans324144
Equity665749
Bonds227
Sources: Superintendency of Banks and Financial Institutions; and Superintendency of Securities and Insurance.
Sources: Superintendency of Banks and Financial Institutions; and Superintendency of Securities and Insurance.

The market for consumer loans and mortgage loans has recently experienced rapid growth. Nevertheless, credit to firms continues to be the largest component of bank credit (Figure A).

A. Composition of Bank Credit by Destination

Source: Superintendency of Banks and Financial Institutions,

Financial liberalization is credited1 with the takeoff of credit to the private sector observed after the mid-1970s. After years of financial repression, there was a move to drastically reduce reserve requirements, relax deposit and loan interest rate caps, reduce entry barriers, and privatize the banking system. These measures are summarized by Morley and others (1999) in the financial liberalization index presented in Figure B. It is important to mention, however, that as reported in Section II, the liberalization of the 1970s left some underlying vulnerabilities unaddressed.

B. Bank Credit and Financial Liberalization

Sources: Morley and others (1999); and Central Bank of Chile.

Fiscal discipline has meant that commercial banks have not ended up absorbing massive amounts of public debt. The private sector is the main recipient of bank funds. The consolidated government debt represents only 13 percent of the banking system’s total assets (Figure C). From a Latin American perspective, Chile is a clear outlier in this regard.

C. Composition of Financial Investments of the Banking System, December 2002

Source: Superintendency of Banks and Financial Institutions.

Government participation in the banking system is limited. There is only one state-owned bank, the Banco Estado. Its assets now represent 14 percent of total bank assets (Figure D). The Banco Estado ensures the provision of banking services to all regions of the country through its branch network. It maintains a large volume of passbook savings accounts and makes a substantial amount of low income housing loans. Quasi-fiscal activity seems to be limited, however, judging by Banco Estado’s record of profitability.

D. Composition of Bank Ownership, June 2003

Source: Superintendency of Banks and Financial Institutions.

The creation of the UF may help explain two long-standing characteristics of Chilean banking: the extensive use of inflation-indexed assets and liabilities, and a relatively low level of dollarization. (Since 2001, the use of UF denomination has declined somewhat, prompted by a change in central bank policy known as nominalization (Figure E).)

Privatization of the pension system created an institutional investor base able to absorb public debt and also to fund banks. Private pension funds, which are major collectors of savings, now hold assets in excess of 50 percent of GDP.

E. Financial System Credit by Currency

(In percent of total)

Source: Central Bank of Chile.

Banking regulation and market discipline seem appropriately balanced. As discussed in Section II, the banking law of 1986 provided the supervisory agency (the SBIF) with new tools to limit risk taking by banks: restriction of business with related parties; rating the quality of banking investments; and in 1997 requiring compliance with Basel capital requirements. (The direction of criticism of Chilean regulation has normally been that it has been too risk-averse.) Private monitoring seems to complement official supervision adequately. Chile has enjoyed a fairly strong technology to evaluate consumers’ creditworthiness DICOM, the local credit bureau, has operated in the country since 1979. In addition, Chile has a system of explicit deposit insurance that according to Budnevich and Franken (2003) and Martinez and Schmukler (2001) is not so generous as to prevent market discipline by depositors.

The credit allocation role of banks in Chile is not yet fully developed. Levine and Carkovic (2002) make the case that the Chilean financial system is not all that it could be, and in fact is less developed than in some other countries with strong growth records. Large corporations are the main beneficiaries of bank credit. Small and medium-sized enterprises still enjoy a relatively minor share of bank credit and are the first to face the brunt of credit crunches and economic downturns. Short-term lending comprises a large percentage of the banks’ credit portfolio. An important factor in this is prudential regulation limiting banks’ maturity mismatch.

The banks’ credit portfolio is dominated by large loans, but the composition has only recently been shifting to smaller loans (Figure F).

F. Composition of Bank Loans by Amount

(In Unidades de Fomento)1

Source: Superintendency of Banks and Financial Institutions.

1 In August 1999, 500 UF were worth about US$ 14,400; in June 2002, 500 UF were worth about US$ 11,900.

1 See, for example, Gallego and Loayza (2000).

When the theft and subsequent sale of CORFO’s financial instruments was discovered on March 7, the Treasury asked the courts to declare an embargo on the payment of the stolen instruments. After finding enough merit on the request, the courts complied and declared an embargo. Trading in all time deposits soon stopped as the market worked to sort out the holders of the stolen instruments. The holdup on trading of time deposits generated some market uncertainty. A number of mutual funds (most of them bank affiliates) also experienced very significant withdrawals.12 As a consequence, the liquidity needs of the banking system increased markedly. In response, during March 10–14, 2003:

  • The central bank provided liquidity through its overnight repo window, and swap operations in U.S. dollars with resale agreements. The liquidity provided by the central bank between March 10 and March 14 represented an abrupt increase of about 50 percent in the level of liquidity in the system that, judging by the lack of gap between interbank market interest rates and the bank’s unchanged monetary policy rate, appeared adequate;

  • Regulators put some Inverlink companies under government administration and their assets in trust;

  • The central bank relaxed its redeeming of maturing regulations on deposits in order to provide additional liquidity to the market;

  • The SBIF made a public statement about the health of the banking system; and

  • The government struck an agreement with the banking community and reversed the stop payment order on the stolen securities pending a decision by the courts on their lawful ownership.

The central bank allowed the liquidity to remain in the system until March 24. In hindsight, the extended liquidity period was more than adequate, judging by the fact that, on average, for this period the interbank rate was 20 basis points below the monetary policy rate. The authorities indicated that the reason for this liquidity excess was to signal the central bank’s intent to meet any liquidity needs during the exceptional circumstances. The liquidity excess was gradually removed until its total recall on April 8, 2003.

Looking back, Chile avoided major systemic effects because the banking system as a whole is on a sound footing, because it is vastly larger than the amount of stolen securities (0.15 percent of GDP),13 and because the central bank and the SBIF intervened swiftly. In the end, the episode did not induce rating agencies to change any of their bank ratings.14

Although the CORFO-Inverlink affair has not had a lasting negative effect on the banking system, it did bring to light a number of current and potential problems with the financial system and its supervision:

  • The need to institute better public sector financial controls. A recent congressional investigative commission concluded that CORFO lacked basic financial controls, and its financial desk was not implementing existing procedures. The commission also noted that the Controller General had identified problems relevant to the case as far back as 1998, but that these had not been addressed. (It can be noted also that the securities thefts had gone on for some time, yet had gone undetected by several government review procedures; CORFO became aware of the problem only after a private bank suspected irregularities and notified it.)

  • The desirability of having electronic custody and trading of assets. The theft of assets from CORFO was facilitated by their being in physical (paper) form. Subsequently, the difficulty of sorting out who was currently holding the paper assets created unnecessary havoc.

  • The need to establish better mechanisms for the three supervisory agencies15 to share information. The SVS oversees all mutual funds but did not have to share information with the SBIF regarding the activities of Inverlink’s mutual fund because it did not have a banking interest directly associated with it.

In response, the authorities appended a number of proposals to the capital market reform package that had already been in preparation. Capital Market Reform II is an ambitious set of 60 proposals, recently sent to congress, to either modify old or create new laws. The proposals include

  • Regulation, coordination, and modernization changes in the financial system by, for example, allowing the SBIF more discretion in denying bank licenses;

  • Allowing more SBIF control over banks’ subsidiaries;

  • Establishing mechanisms to share information among the three supervisory agencies; and

  • Immaterialization and electronic trading of assets.

These measures should help resolve some of the current and potential infrastructure problems in the banking system and its supervision identified above. However, a comprehensive assessment of the remaining and potential problems and their solution would be better addressed in the upcoming Financial Sector Assessment Program.

Grading by Rating Agencies

Ratings agencies continue to see the Chilean banking system as one of the strongest and best regulated in Latin America. For example, in a February 2003 report, Fitch observed that in a second year of regional volatility, Chile continued to differentiate itself from the rest of Latin America. Moody’s June 2003 report on the Chilean banking system also provides a positive outlook. This report sees the Chilean banking system as one with sound financial fundamentals.16 Nevertheless, both reports stress the need for close monitoring in the face of regional and global uncertainties and a slower economy.

Table 5.2 reports the long-term foreign and local currency classifications of individual banks, as of July 2003. This table presents a picture of a stable banking system with the four largest banks displaying some of the best ratings and with most banks assigned a positive outlook.

Table 5.2.Long-Term Credit Ratings, as of June 2003
Foreign Currency1Local Currency
FitchMoody'sStandard & Poor'sFellerFitch-Chile
ABNAMRO Bank (Chile)AA+AA
Banco BICEBaa 1 6/3/2003AAAA
Banco ConosurBBB+BBB+
Banco de ChileA- 10/18/2002Baa 1 6/9/2003A- 11/20/2002AA+AA+
Banco de Crédito e InversionesBaa 1 6/3/2003AAAA
Banco de la Nación ArgentinaBBBB+
Banco del DesarrolloA-A
Banco EstadoBaa 1 6/3/2003A-9/II/20022AA+AA+
Banco do Brasil S ABBBBBB
Banco FalabellaA+A+
Banco InternacionalBBB+A-
Banco RipleyA-A-
Banco Santander—SantiagoA- 12/2/2002Baa 1 6/3/2003A- I2/I3/20022AA+AA+
Banco SecurityAA-AA-
Banco SudamerisA+AA-
Bank Boston N.A.AAAA-
BBVABaa 1 6/3/2003AA-AA
Citibank N.A.AA+AA+
CorpbancaBBB 12/12/20022Baa 3 6/3/2003AA-AA-
Deutsche Bank ChileAA+AA+
Dresdner Bank LateinamerikaAAAA
HNS BancoA-A-
HSBC Bank ChileAA+AA-
JP Morgan Chase BankAA+AA+
Scotiabank Sud AmericanoBaa 1 6/3/2003BBB+3/19/2003A+AA-
The Bank of Tokyo-MitsubishiAA-AA-
Sources: Fitch; Moody's; Standard & Poor's; Feller Rate; and Fitch-Chile.

Including date of most recent rating change or affirmation.

Positive rating outlook.

Sources: Fitch; Moody's; Standard & Poor's; Feller Rate; and Fitch-Chile.

Including date of most recent rating change or affirmation.

Positive rating outlook.

Concluding Remarks

The Chilean banking system continues to command a reputation for stability and strength. The system has been tested in the last two years by regional uncertainties, slow recovery, and more recently, by a homegrown shock, in the form of the Inverlink case. The system has weathered these shocks well. However, the first type of shocks highlights the importance, as suggested in the Moody’s and Fitch reports, for close monitoring. The adoption and improvements of vulnerability assessment techniques of the type discussed above are likely to help analysts in their endeavor.

The shock originating from the Inverlink case highlighted the need for modernization of certain practices and regulations involving transactions and custody of securities in secondary markets. The authorities took swift action and seized the opportunity to add proposals for some of these needed changes to the Capital Markets Reform II program that had been under preparation and is now in congress. Furthermore, the SBIF has started to anticipate the new winds of the Basel II Accord. However, as the globalization process continues, as new financial products become part of the banking landscape, and as the line between banking and other financial sectors continues to blur, regulation and safety net designs will have to adapt flexibly and expeditiously in Chile as elsewhere.

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The system’s technology to evaluate consumers’ creditworthiness is fairly strong. The local credit bureau (DICOM) is owned by Equifax.

The UF is a unit of account that indexes the principal of financial contracts and transactions to the previous month’s inflation rate.

Earlier, the 4- to 5-point rise in dollarization ratios seen from January to October of 2001 was associated partly with a 23 percent depreciation of the Chilean peso against the U.S. dollar, rather than a significant flow increase.

See, for instance, Clarke and others (2001).

Some of this activity reflects savings deposits and the servicing of subsidized mortgages provided in conjunction with the government’s low-income housing programs.

This situation is likely to change when the central bank switches to a tighter mode. Significant increases in sight deposit accounts would represent a larger potential deposit insurance liability for the central bank. In light of this possibility, it might be a good idea to revisit the question of how generous deposit insurance might be.

Chile differs from Generally Accepted Accounting Procedures (GAAP) accounting practices regarding overdue loans. Only the portion of loan overdue for more than 90 days is classified as overdue, unless legal proceedings are initiated for recovery.

Banco de Chile and Banco Edwards merged in January, and the Santander and Santiago banks merged in August.

For details, see IMF (2002).

A reported US$800 million was withdrawn from the mutual funds, out of a total of US$6.2 billion after the scandal broke.

Total assets of the banking system are close to 100 percent of GDP.

The SBIF, the Superintendency of Securities and Insurance (SVS), and the Superintendency of Pension Fund Administrators (SAFP).

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