"From Weakness to Strength: The Journey of the Chilean Financial System and its Next Steps"
ChileDay - September 10 and 11th, 2019 - London, England
Mario Marcel
Governor of the Central Bank of Chile
The Chilean financial system has changed notably in the past four decades. While in the early 1980s it was at
the center of one of the worse economic and social crises in history, now it is a major source of strength,
providing resilience to the economy in the face of external shocks. So, how did this happen? What is the
source of such resilience? What new challenges lie ahead? That is the purpose of this presentation.
In a nutshell, we can argue that the regulatory changes that followed the crisis set a new framework that, far
from preventing financial development facilitated it in a way consistent with economic development. Some
key reforms -most notably pension reform-facilitated the emergence of new actors, making the financial
sector more diverse, deep and forward-looking.
Many pieces of evidence and tests in our semi-annual Financial Stability Report, have demonstrated over
recent years that the Chilean financial sector is currently well equipped to face external shocks, providing
key support to the flexible exchange rate regime by reducing the exposure of the business and financial
sector to FX fluctuations. Similarly, the development of long-term capital markets secure local currency
financing to investment projects and to the government itself.
The relationship between the financial sector and FX markets will indeed be an important part of this
presentation as a connection between financial and macro stability. This is an important pillar for a small
open economy like Chile, where the capital account was opened almost 20 years ago. This is, at the same
time, an area where we can make additional progress, and I will share with you some of our immediate
plans that combine well with the agenda that Minister Larrain has just presented.
Some 50 years ago, banks where almost the only source of financing for firms and households. The Chilean
economy was closed to international trade and capital flows, interest rates were regulated, credit was
restricted, and banking activity was largely controlled by the State.
In the second half of the 1970s, the banking sector was privatized and liberalized. However, this was not
accompanied with adequate regulation and supervision; and a relatively small financial system built major
vulnerabilities. When macro policy missteps and external shocks hit in 1982, the banking sector was not just
a weak link: it amplified these shocks leading the country into the deepest economic and financial crisis in a
generation.
Financial crises are abrupt, costly and protracted affairs, and the Chilean financial crisis of the early eighties
was no exception. This crisis is often placed among the top 25 most severe financial crises in modern history.
In 1981, annual output growth went from positive 9% in the first quarter, to 0% in the fourth quarter, and to
minus 14% in 1982. That same year, unemployment reached a record of 25%, and businesses all over the
country were seriously hampered, ultimately affecting their solvency. Banking profitability went quickly to
negative territory and the delinquency rate quadrupled to 15% of the total portfolio, putting several banks
at risk.
Several factors contributed to the deterioration of the macroeconomic environment in 1982. External
interest rates rose, the availability of external credit decreased, and terms of trade worsened in the wake of
the escalation of oil prices. This put enormous pressure on the Chilean peso-which had been under a fixed
exchange rate scheme since 1979. This regime broke down dramatically and spread to almost all business
sectors, given large FX exposures, and heavily leveraged financial conglomerates.
All these factors interacted with one another to become an outright banking crisis. Nevertheless, whatever
the causes of the crisis, unsustainable debt was mostly explained by internal vulnerabilities: inappropriate
regulation, weak supervision, and lack of attention to excessive credit growth, leveraged on a fixed exchange
rate scheme.
The lessons learned from this crisis highlighted the fact that banking regulation and supervision needed to
be substantially upgraded. In 1986, the General Banking Law introduced limitations on currency mismatch,
constraints on related party lending, and restrictions for banks to be paid in kind instead of liquid resources.
All of these elements were common practice before the 1982 crisis.
Paradoxically, what could be considered harsher regulation did not hamper financial deepening. Instead, it
fostered a systematic buildup of solvency and credibility of the banking system and allowed its healthy
development in the ensuing decades. Yet the 1986 Banking Law was hardly the only piece of the financial
architecture that changed significantly. Notably, the creation of a funded pension system, and subsequent
capital market reforms, together with capital market openness, dramatically changed the size, composition,
depth, and strength of the financial sector in Chile.
By funneling household savings into capital markets, Pension Funds were especially important in the early
development of a deep debt market; and their contribution to market-making benefited from a stable
macroeconomic environment with controlled inflation, extensive use of the UF (a currency unit indexed to
inflation), and the restructuring of Central Bank's debt into longer maturities. A deeper and more liquid debt
market also facilitated the pricing of debt issued by private companies in local markets.
Over time, pension funds were allowed to invest abroad. This fostered profitability and diversification of
pension funds, prevented distorting prices in the domestic financial sector, and created a two-way street for
capital flows managed by domestic agents. As foreign assets of pension funds needed to be protected from
FX risk, a hedging market also developed. This fit well with changes on the macroeconomic side. In the late
1990s Chile adopted a flexible exchange rate regime and liberalized capital flows.
All of these reforms led to developing the Chilean financial system in a sound way. Currently placing Chile
near the median of a group of countries in terms of private indebtedness.
How does the Chilean financial market currently combine with the exchange rate regime? Under the flexible
exchange regime adopted in 1999 and taking into account all the reforms mentioned above, it is not
surprising that Chile has a relatively volatile currency. However, in terms of GDP growth we appear more
stable than our peers.
This is due, in part, to the fact that households, the government and small businesses are not exposed to
exchange rate risk, either because they do not borrow in foreign currency or because they hold a natural
hedge. Paradoxically, given the openness of the capital account and free exchange rate, Chile is not a
dollarized country at all. Banks and regulators, on the other hand learned well the lessons of the 1980s
crises and FX exposure is central to risk assessment and prevention.
Larger companies, on the other hand, can draw on the openness of the economy and the prestige of local
regulations to take advantage of the overseas bond market while avoiding undertaking FX risk. Corporations
have learned to operate in a flexible FX environment by using both, natural and market-based FX risk
hedging instruments. This, in turn, has also been supported by the development of the derivatives market,
in which Pension Funds have been key counterparts as well.
Total external debt in dollars has been stable over the last few years, at around US$120 billion. A substantial
part of this reflects the growing internationalization of the Chilean corporate sector. A large share of that
total is associated with foreign direct investment (FDI) on local subsidiaries of multinational corporations. To
the extent that FDI represents a commitment between related companies, the enforceability of debt
repayment and the associated financial conditions respond to different factors than in the case of debt with
other institutions, which mitigates risk in the event of an increase in financing costs. Among firms that report
to the FMC, two-thirds of external debt is concentrated among companies that use the U.S. dollar as their
accounting currency, this share has been stable over the last decade.
Learning from previous episodes, the risks associated with external debt remain low, given the
characteristics of the debt and an appropriate use of hedging by the firms. Among firms that report in pesos,
the debt is mostly concentrated in those with a limited individual currency mismatch: firms with a mismatch
of over 10% of their assets hold just 3% of external debt, and represent about 10% of the total number of
companies that use the Chilean peso as accounting currency.
Local institutional investors' participation in the local sovereign debt market, especially in the longer
segments of the yield curve, is much higher in Chile than in most emerging economies, at 80 to 90%. Thus,
the buy-and-hold strategy of these investors reduces the volatility of both local sovereign rates and
domestic funding costs.
By now, the Chilean financial sector is one of the most developed in the emerging world. It has transited
from being largely dominated by traditional banking to being composed by several other market
participants, including Pension Funds, General Fund Administrators and Insurance Companies; among
others. Assets under management of these non-bank investors went from less than 1% of GDP in 1984, to
65% in 2000, and to almost 100% of GDP in 2018. This development has translated into improved access to
alternative sources of funding by Chilean firms. Currently, around 85% of total corporate bonds are held by
institutional investors, thus reliance on banking credit of these corporations has gone from 91% of financial
debt in 1986 to around 25% in recent years.
Financial development has been important not only for firms but also for the country as a whole. A deeper
and far-reaching financial system contributes to building financial and economic inclusion, and financial
stability against external shocks. In this respect, the Chilean financial system shows better performance than
other Latin American and Emerging economies, in dimensions like market capitalization, number of
branches per inhabitant, use of derivatives, and participation in domestic credit to the private sector, to
name a few.
Nonetheless, increased development and complexity of financial markets also means that risks may be
higher, and that a stronger and more sophisticated regulatory framework is required.
The Chilean financial crisis of the early eighties led not only to a radical bank regulation revision, but also to
learning valuable lessons for the future. A deeper and properly regulated financial system contributes to
financial stability, inclusion and increased welfare. Even though significant progress has been made in this
regard, there are still challenges ahead that must be faced to further strengthen our financial system.
Let me now address some of these regulatory challenges the CBC has been working on.
In order to have a deeper FX market and enhance resilience of the financial sector a number of measures
are being taken by the Central Bank of Chile (CBC). The internationalization of the Chilean peso can enhance
financial stability, by alleviating liquidity concerns during stress episodes and reducing counterparty risks,
among other effects. All of these changes must be accompanied with more robust and developed financial
infrastructures. Also, the wider cross-border usage of the Chilean peso improves our position as a financial
center.
Regarding concrete measures towards accomplishing these goals, the CBC is reviewing its FX regulation, in
order to modernize and simplify it. In addition, a larger and more developed FX market should benefit from
having access to more robust financial market infrastructures.
In order to do so, the CBC issued regulation and is implementing a Trade Repository for OTC derivatives,
relying on its current faculties and in coordination with the Financial Market Commission.
Additionally, the CBC is working on an initiative that will allow its Real Time Gross Settlement (RTGS)
payment system to settle US dollars large-value interbank transactions. These measures add to the future
inclusion of the Chilean Peso as the first CLS-eligible currency in South America. This is a priority for the CBC,
therefore we are working closely with the CLS Bank to materialize this in the next three years.
We believe these policy actions, as well as those announced by the Minister of Finance in order to promote
Chile as a Regional Financial Center, should greatly contribute to a more resilient financial sector, wider
cross-border use of the Chilean Peso and a greater participation of non-residents in our FX market.
 The Strategic Planning 2018-2022 of the CBC includes a thorough review of its FX regulation.
Current FX regulations require most FX transactions to be executed through the "Formal Exchange
Market" -which is comprised by banks and some stockbrokers- and to be reported to the CBC. These
two elements have remained largely unchanged since the capital account was opened 20 years ago.
Back then, re-imposing capital controls could not be ruled out, and that rationale underlies the
somewhat cumbersome structure of the FX regulation. Currently, while capital controls are still part of
the regulatory toolbox, re-imposing them could only be considered during an exceptional situation.
Therefore, the CBC has decided to streamline its FX regulations and reduce the burden of compliance to
the private sector, whenever possible, without affecting the quality of the statistical information or the
capacity to act in an extreme scenario.
The first part of this process, eliminating some of the existing reporting requirements, is about to be put
out for public consultation.
 Modernizing FX transactions goes beyond a review of existing reporting requirements and the structure
of the regulation. It also considers the review of long-standing policy definitions. One of those
definitions is the restrictive regulation in terms of the currency denomination of FX transactions.
The Central Bank's Law establishes that FX transactions cannot be denominated in CLP unless authorized
by the Central Bank. This faculty has been used only exceptionally, as it was seen as a tool to prevent the
circumvention of capital controls.
Consequently, for instance, residents cannot grant CLP denominated credits to non-residents (but they
can do so in foreign currency). While this provision does not prevent transactions to occur, it adds
transaction costs that may be preventing a wider cross-border use of the Chilean Peso.
The CBC has implemented a free-floating exchange rate regime, in which the possibility of capital
controls is extremely exceptional and even if applied this measure might not be effective to prevent
circumvention. Therefore the CBC is considering the extension of present transactions that are
authorized to be denominated in Chilean Pesos (bonds issued in Chile by non-residents, and transaction
of foreign securities), as well as the related conditions to that authorization. Such as providing
information to the CBC.
This change of policy will be put out for public consultation by the end of this year.
The Central Bank is developing a new regulatory framework that will allow the real time gross settlement
(RTGS) of interbank payments in U.S. dollars, through the incorporation of this currency in the RTGS system
managed and operated by the CBC.
The financial system's large-value payments in national currency are currently settled in the RTGS system,
where payments are final and irrevocable in accordance with international practices. In contrast, foreign
currency payments are settled through correspondent banks, a process that is not exempt from credit,
operational, and liquidity risk. The requirements of the new regulatory framework were defined taking into
account international experience and risk considerations, after which the draft regulations will be published
for public consultation within the next weeks.
Dollar settlement at the CBC will improve the competitiveness of local infrastructures and promote the
development of the financial market. Moreover, the implementation of this initiative will align local FMIs
with international standards, which recommend settlement in RTGS systems due to their contribution to the
risk management of participants, the functioning of the economy, and the preservation of financial stability.
Another initiative that it is currently under development is the incorporation of the Chilean Peso to the
Continuous Linked Settlement System (CLS). This financial market infrastructure is currently the international
standard for the settlement of cross-currency payments because reduces the risk of settlement, also known
as Hersttat Risk, to barely zero. Currently, 18 currencies are allowed to settle through CLS. The CBC along
with CLS and the banking sector are working to make the CLP the 19th currency of this system.
In addition to acting in accordance with its financial stability mandate and contributing to the development
of the Chilean financial sector, the promotion of this initiative further support the internationalization of the
CLP.
The reduction of settlement risk of the FX transactions through a PvP settlement in CLS is just one of the
benefits of the system. Moreover, CLS reduce the liquidity needs of its participants through the use of
multilateral netting, and enhance confidence, particularly in times of financial stress.
From a more general perspective, a satisfactory CLS due diligence process along with a broad international
participation trading in the CLP, will be a strong signal of the development and competitiveness of the
Chilean financial markets.
The process for the Chilean peso to become the first South American currency on CLS has started. Last July,
we received the visit of CLS executives who had conversations with market participants and fruitful
discussions at the CBC. After that visit, CLS and the CBC started the due diligence process. During this phase,
the actions from the public and private sectors are essential.
Nevertheless, a successful process should not be over before the end of 2021.
The CBC is willing to take all the necessary measures to include the CLP into CLS, such as extending the
opening hours of its RTGS system.
Related to Financial Markets Infrastructures, I would like to mention that last June the CBC issued a new
regulation framework which will implement the first Trade Repository (TR) of the country. This TR, called
Integrated System of Derivatives Information (SIID, in Spanish), will be owned and operated by the central and,
after a transition process, will be in full operation by 2021.
The SIID will collect, store and disseminate information of OTC derivatives trades, following the Principles for
Financial Market Infrastructures (PFMIs) and international standards for reporting.
This infrastructure should promote transparency and market conduct, improve decision-making of market
participants, and contribute to the supervision processes of the Financial Market Commission.
It is important to note that the Minister of Finance has just announced that a bill to regulate Trade Repositories
will be sent to Congress. The SIID is perfectly compatible with the existence of private-owned trade repositories.
According to the latest BIS Triennial Review of foreign exchange and OTC derivatives, the Chilean Peso
represents 0.2% of the global FX turnover. We strongly believe that this share should increase in the future.
The different developments that are underway should contribute to financial stability and increase the
crossborder use of the CLP, as well as the participation of non-residents in the domestic market. Therefore,
authorities and market participants should be prepared to be part of a bigger and more internationally
integrated FX market.
Let me conclude by remarking that this journey for the Chilean financial system, through a deep financial crisis,
has led to just new bank regulation but also to valuable lessons learnt for the future. A deeper and properly
regulated financial system contributes to financial stability, inclusion and increased welfare.
Preventing stress episodes is a task that requires constant monitoring and early detection of potential sources of
vulnerabilities and risk.
The enactment of a new Banking General Act and internationalization of the Chilean peso, among other
measures, open up a new phase for modern regulation. Even though significant progress has been made in this
regard, there are still challenges ahead that must be faced to further strengthen our financial system.
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