This Selected Issues paper examines a number of potential factors that may have influenced the short-term behavior of the exchange rate between the Chilean peso and the U.S. dollar during the period of floating exchange rate, including the possible impact of developments in Argentina during 2001. The paper investigates whether copper prices can be successfully forecasted over medium-term horizons, emphasizing the properties of copper prices most relevant in the Chilean context, including for fiscal policymaking. The paper also provides a snapshot of the Chilean banking and corporate sectors.

Abstract

This Selected Issues paper examines a number of potential factors that may have influenced the short-term behavior of the exchange rate between the Chilean peso and the U.S. dollar during the period of floating exchange rate, including the possible impact of developments in Argentina during 2001. The paper investigates whether copper prices can be successfully forecasted over medium-term horizons, emphasizing the properties of copper prices most relevant in the Chilean context, including for fiscal policymaking. The paper also provides a snapshot of the Chilean banking and corporate sectors.

IV. Chile’s Banking System Soundness 62

A. Introduction

135. This chapter provides a brief description of the Chilean banking system and reports standard measures of its financial health. In particular, the chapter highlights standard prudential indicators, the results of stress tests conducted by staff, and recent rating agencies’ evaluation of the banking system.

B. Structure and Activities of the Banking System

136. The Chilean banking system is relatively large for the size of the economy and has substantial foreign participation. As of December 2001, the banking system held about US$61 billion in assets or about 95 percent of GDP—including about US$46.3 billion in loans and US$12.3 billion in negotiable financial instruments. At present, the Chilean banking system consists of a government-owned bank (Banco del Estado), fifteen private banks, and nine branches of foreign banks. In addition, Chile has one finance company (or consumer credit agency) which conducts many operations similar to banks but is not allowed to offer checking accounts or engage in international business. Seven of the system’s banks (ABN Amro, BBVA Banco Bhif, Deutsche Bank, Dresdner BNP, Santander, Santiago, and Scotiabank SudAmericano) are either majority owned (directly or indirectly) or controlled by foreign bank interests. As shown in Table 1, foreign-owned or controlled banks and branches account for about 45 percent of total deposits and loans.

Table 1

Structure of the Banking System 1/

(December 2001)

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Source: Banking Superintendency (SBIF)

In percent of total. Totals may not add to 100 Percent due to rounding.

137. Most foreign banks have tended to concentrate on earning fees from syndicated loans to Chilean firms and in generating income from trading securities. However, Santander and BBVA have a full fledged banking presence, albeit, with significant exposure to Chilean corporations acquired with Spanish capital. Citibank and BankBoston also have significant exposures to Chilean corporations and multinational firms with Chilean operations.

138. Banco del Estado (BE) ensures the provision of banking services to all regions of the country through its widespread branch network. Reflecting its mission, BE maintains a large volume of passbook savings accounts and makes a substantial amount of low income housing loans.

139. The banking system continues to evolve. While five new banks (Deutsche Bank, Monex, Safra, Ripley, and HNS) were recently licensed, two existing foreign banks—American Express and Bank of America—were in the process of downgrading their banking operations to representative offices.

140. There is a substantial degree of price indexation in banks’ assets and liabilities (although this has been declining recently), but dollarization is low. In August 2001, the Central Bank of Chile (BCCh) announced a major change in the design of its monetary policy operations. Specifically, the BCCh announced that it was changing its daily operating target from a “real” rate of interest (measured in terms of UFs, an inflation-adjusted unit ofaccount) in the overnight interbank market to a nominal interest rate (denominated in pesos) in this market.63 This change in policy has induced a shift in the composition of bank deposits and loans from UF-denominated to non-index instruments. For example, as of April 2002, 36 percent of bank deposits were inflation indexed compared to 61 percent in July 2001. Dollarization of the banking system continues to be low, although it has been growing gradually over the last few years. By the end of 2001, 14 percent of bank deposits were dollar indexed compared with 12 percent a year earlier.

C. Concentration in the Banking System

141. The system is fairly concentrated, with the largest ten banks accounting for some 85 percent of deposits and loans. Furthermore, a significant increase in concentration of banking activity will result from two recently approved mergers. The shareholders of Banco de Chile (the second largest in the system) and Banco Edwards voted to approve the merger of their respective institutions, which was approved in December by the Banking Superintendency (SBIF). The newly merged institution will account for about 20 percent of the total banking system. A merger between Banco de Santiago and Banco Santander, Chile (the largest and the fourth largest, respectively) was also approved recently. When completed, this merger would account for at least 25 percent of total deposits of the banking system.64 Thus, the two largest banks would represent almost half of the system’s deposits.

142. Concentration in the banking system normally could raise two types of concerns: the possibility of anti-competitive practices, and the possibility of increased systemic risk. To increase competition in the financial system and thus help diminish the likelihood of monopolistic practices, the authorities have recently reduced the minimum capital requirements to open a bank. Entry in the banking industry, and thus competition, has also been facilitated by a reform introduced to the banking law in 1997; this reform stipulates that applications for bank licenses can only be denied if the applicant fails to comply with a list of clearly specified requirements (including, inter alia, proof of solvency and integrity of the founding shareholders), thereby reducing official discretion over licensing decisions. To address concerns about systemic risk arising from banks that may be “too big to fail,” the authorities have recently introduced regulations that grants the SBIF authority to establish certain conditions for the approval of bank mergers or acquisitions (or the taking control of two or more banks by the same person or controlling group), when these operations result in a bank (or group of banks controlled by the same person or group) that accounts for a significant market share (defined as above 15 percent of the banking system’s loans); these conditions include, inter alia, minimum capital requirement of up to 14 percent of risk-adjusted assets, above the customary 8 percent. Systemic risk concerns may also be eased, if as expected, the newly merged banks have an advantage in diversifying their portfolio over its parts, banks continue to upgrade their risk management practices and bank regulations and its monitoring continue to change to take into account newly evolving risks. The authorities are also studying the structure of the safety net in conjunction with planned reforms of the payment system, expected to be completed toward the end of 2002 or early 2003.65 Refinements in the safety net should help ease systemic risk concerns from the liability side of the banking system.

D. Risk Management Policies and Prudential Indicators

143. The SBIF and the central bank have a number of regulations aimed at limiting banks’ credit risk, connected lending, and foreign exchange exposure. Also, regardless of national origin of the bank’s ownership, all banks have internal risk management policies that complement official regulations regarding liquidity, interest rate, and exchange rate risk. In house risk management policies are based on a variety of methodologies. For the banking book, limits may be established based on earnings at risk and the sensitivity of the economic value of the institution’s capital to specific risks. For the trading book, banks employ position limits, duration limits, sensitivity limits, value-at-risk limits, and stop-loss or call-loss limits. Foreign-owned banks and branches are considered to be more advanced than smaller domestic banks in their overall capacity for risk management. The advantage reflects the reliance on risk management systems developed by head offices mainly located in countries with advanced financial and banking markets.

144. Notwithstanding the slowdown in economic growth and the negative shocks faced by Chile in 2001, overall prudential indicators continue to point to a healthy banking system. The quality of their loan portfolio remained stable, the system continued to exhibit healthy profits and to be well capitalized.

145. A set of prudential and earning indicators is presented in Table 2. The table shows that the system remained well capitalized as of December 2001, in spite of a small decline in the Basel risk rated capital adequacy during the year (the simple capital to asset ratio increased somewhat). The capital adequacy ratio for the system as a whole was 12.7 percent, with the lowest ratio for an individual bank at 10.3 percent. Net income after taxes improved during the year, both as a rate of return on assets and as a rate of return on equity, reflecting continued increases in efficiency, gains in net interest inflows, a boost in capital gains on the banks’ holdings of securities and a reduction in the need to make loan loss provisions. The level of provisions for all banks exceeded the outstanding amount of overdue loans as of December 2001, reflecting the tapering off of the rise in the ratio of overdue to total loans that emerged in 1998.66 At the same time, liquidity risk indicators used by the SBIF have remained stable.

Table 2

Financial System Indicators

(In percent)

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Source: Banking Superintendency (SBIF)

Prior to the Banking Law of 1997, banks were instead subject to a prudential ratio of capital to debt.

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

E. Stress Tests

146. Notwithstanding the favorable prudential indicators listed in Table 2, the Chilean banking system could still be exposed to a number of potential shocks. Last year, Chile’s exchange rate experienced a significant depreciation suggesting that exchange rate volatility could be a potential problem. Also, while worldwide interest rates came down significantly throughout 2001, an unexpected sharp rebound could have a significant impact on the balance sheet of the banking system. At the same time, Chile’s slow expansion could lead banks to face a higher rate of defaults on loans.

147. In order to assess the future vulnerability of the banking system to these types of shocks, in late 2001, staff conducted stress tests using the August 2001 bank balance sheets as a base. Drawing from historical events, the tests calculated (for each bank) the losses (or profits) resulting from a 25 percent depreciation of the peso with respect to the U.S. dollar, a sharp increase in interest rates, and a 90 percent increase in nonperforming loans (which was assumed to be fully provisioned).

148. In order to test the banking system’s resilience to a foreign exchange depreciation, a hypothetical 25 percent depreciation of the peso (similar to the actual depreciation experienced in the first 10 months of 2001) was applied to the net foreign exchange rate exposure of each bank (defined as the difference between the assets and liabilities denominated or indexed to dollars and the net forward position in foreign exchange). The stress test suggests that the banking system’s current capacity to withstand foreign exchange rate changes is fairly robust. After the valuation effects of this shock were accounted for, about half of the banks would have benefited from the depreciation and the Basel ratio for all banks would still have continued to meet the minimum regulatory requirements.67

149. Next, a sharp increase in the interest yield curve that simulated a shock of the magnitude experienced during the Russian crisis of June-September 1998 was considered. Because changes in interest rates affect both a bank’s income flows and a bank’s net worth, both types of effects were evaluated. A repricing gap model of interest rate risk was used to analyze the potential impact on net income over a period of up to twelve months. First, all assets and liabilities were sorted in a few time categories, according to their interest rate sensitivities (remaining time to repricing for floating rate instruments, remaining time maturity for fixed rate instruments). Based on this information, a repricing gap model of interest rate risk was used to analyse the sensitivity to interest rate shocks of the difference between the flow of interest earned by a financial institution on its assets and the flow of interest paid on its liabilities. The repricing gap model was used to calculate the change in net interest income in each time category and for the total portfolio on a bank-by-bank basis following a potential shock. This information was used to analyze the impact on annual net interest earnings in UFs, pesos, and dollars (assuming no variations in the exchange rate), respectively. The potential effects of this test on the Basel capital requirements were analyzed. The exercise found that all banks would have continue to meet the regulatory requirement. Also, a duration gap model for the sum of the trading and banking book was used to estimate the potential changes in net present value of each bank and therefore the potential effect on the Basel capital requirements. The exercise found that the Basel ratio for two banks would have fallen slightly below the 8 percent regulatory requirement

150. The third shock considered was an increase in credit risk. Other things equal, it was assumed that overdue loans increased to close to 3.5 percent of total loans from the 1.8 percent prevailing in August 2001, similar to the rise that occurred several years ago in the wake of the Asian crisis. The test also assumed 100 percent provisioning of the simulated increase in overdue loans. In this credit stress test, the Basel ratio would have been about 4 percent for one bank, while for a second bank this ratio would have fallen slightly below 7 percent below the regulatory capital adequacy ratio. The capacity of current earnings to absorb losses was not taken into account for any of the stress tests. Since all Chilean banks were reporting positive after-tax earnings in 2001, these results are therefore conservative.

F. Grading by Rating Agencies

151. Ratings agencies share the opinion that the Chilean banking system is among the strongest in Latin America, and that is well regulated. For example, in a report dated December 2001, S&P stated that some banks’ ratings had been upgraded, that the system’s asset quality was stable and that the Chilean banking system was one of the best supervised among all emerging markets. Also, a May 2002 Country report by Fitch Ratings explains that Chile had endured the emerging market crises of the 1990s with minimal side effects thanks to the successful de-coupling from the rest of Latin America. The report also credits the General Banking Act of 1997 with providing the foundations for Chile’s current strong regulatory framework.68 Finally, Table 3 and 4 present the long-term foreign and local currency classifications by international and local rating agencies available as of June 2002. These tables present a picture of a stable banking system with the four largest banks displaying some of the highest ratings and with most of them featuring a positive outlook.

Table 3

Long-term Foreign Currency Credit Ratings and Most Recent Ratings Change or Affirmation

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Sources: Fitch, Moody, and S & P.
Table 4

Long-term, Local Currency Credit Ratings

(As of May 2002)

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Sources: Feller and fitch.
62

Prepared by John Leimone (MAE) with input from Marco Espinosa (WHD).

63

Interest on other BCCh instruments, namely, credit facilities and the overnight deposit facility, are also set in nominal terms.

64

Some experts suggest that once the merger is finalized, it is very likely that the merged bank will sell about 5 percent of its loan portfolio.

65

The reforms are being studied by the BCCh, the SBIF, the Ministry of Finance, and the Chilean Banking Association.

66

Chile differs from GAAP accounting practices regarding overdue loans. In particular, only the portion of a loan overdue for more than 90 days is classified as overdue, unless legal proceedings are initiated for recovery. Based on SBIF adjustments, estimated overdue loans using U.S. GAAP methodology would result in a figure of less than 3.9 percent of the total loan portfolio.

67

Under central bank regulatory requirements, no domestic bank can have a positive or negative foreign exchange rate position of more than 20 percent relative to their capital. Specifically, twenty one banks (fourteen) of the banks in the study had a foreign exchange exposure, in absolute terms, lower than 20 percent (10 percent) relative to their capital.

68

See “Latin American Roundup: Argentina and the Region,” by C. Krossler, S &P, December 2001 and “The Chilean Banking System” by G. Lopez-Cortes, FitchRatings, May 2002.