August 2004

SecM2004-0404

Chile
FSA Financial Sector Assessment

This volume is a product of the staff of the International Bank for Reconstruction and Development /
The World Bank. The World Bank does not guarantee the accuracy of the data included in this work.
The findings, interpretations, and conclusions expressed in this paper do not necessarily reflect the
views of the Executive Directors of The World Bank or the governments they represent.

The material in this publication is copyrighted.

 -1-

1. This Financial Sector Assessment (FSA) summarizes the FSAP report for Chile,
with emphasis on structural and developmental issues. The FSAP included two visits to
Santiago, Chile, in December 2003 and March 2004. 1 Its findings and recommendations
were thoroughly discussed with the authorities in a wrap-up session at the end of the second
mission and also during the IMF Article IV mission in May 2004. The diagnosis and
assessment of the FSAP, and hence of this FSA, are based on information as of end-March
2004. Following the FSAP, the Chilean authorities requested Technical Assistance from the
World Bank, which is expected to be funded in large part with resources from the FIRST
Initiative. A list of the acronyms used throughout this FSA is provided in Appendix I.

I. OVERALL ASSESSMENT

2. Chile’s financial system is large and well diversified. Following the reform of the
pension system in the early 1980s, mandatory pension funds (AFPs) have grown at a
particularly remarkable rate, pulling in their wake most of the financial system, including
banks (that have benefited from large deposits by AFPs), the life insurance sector (mainly
through annuities), the mortgage industry, and, more recently, commercial paper and
corporate bond s. Together, AFPs and insurance companies hold a substantial fraction of
total bank deposits, public securities, corporate and mortgage bonds, and, more recently,
Chile’s external assets. Other remarkable features include low dollarization, relatively lo ng
bond maturities, large corporate external liabilities, and large private assets abroad. The
equity market is also large by Latin American standards, yet illiquid, perhaps reflecting (at
least in part) a concentrated distribution of wealth and income.

3. The financial system was found to be sound, overall, and resilient to shocks. The
banking system weathered well the economic downturn that followed the external shocks of
the late 1990s. Notwithstanding a moderate increase in delinquent loans and a substantial
contraction of credit, particularly to the smaller enterprises, the system remained profitable
and well capitalized. Its exposure to macroeconomic shocks, within a range consistent with
recently observed volatilities, was found to be moderate. The main note of caution concerns
the insurance sector, which, due to heightened competition, some under-provisioning of
risks, and some weaknesses in the resolution framework, could face difficulties ahead, with
possibly adverse fiscal implications.

4. Chile’s exposure to sudden stops in capital flows is diminished under the current
policy environment and rising international financial integration. Notwithstanding a
substantial diversification during the last decade, export concentration remains high and
fluctua tions in copper prices may continue to have a significant impact on economic activity.
At the same time, despite Chile’s low and fairly stable sovereign spread, a repeat of the late

1
The Chile FSAP team gratefully acknowledges the excellent hospitality, cooperation, and openness of the
Chilean authorities and technical counterparts. The FSAP missions were co-led by Alain Ize (IMF) and
Augusto de la Torre (World Bank) and included Marie-Thérèse Camilleri, Eva Gutierrez, and Meral Karasulu
(all IMF); Ernesto Aguirre, Thomas Glaessner, Roberto Rocha, Sophie Sirtaine, Constantinos Stephanou, and
Craig Thorburn (all World Bank); Juan Ortiz (Bank of Spain), Brian Quinn (formerly Bank of England),
Irit Mendelson (Bank of Israel), Marc Bayle (European Central Bank), and Jonathan Katz (U.S. SEC).
 -2-

1990s capital account shocks cannot be ruled out in view of Chile’s likely continued
dependence on foreign savings. Yet, the likelihood of a repeat of those events is much lower
in the current policy environment of full fledged inflation targeting. Chile’s exposure to
currency attacks is also likely to decline as it becomes better hedged and financially more
integrated with the rest of the world. However, to ensure the BCCh’s capacity to manage an
effective monetary policy under a broad range of macroeconomic conditions, its financial
accounts need strengthening.

5. The challenges faced by the financial system are mainly developmental. To help
generate the productivity growth needed to support a new phase of rapid output growth, the
financial system will need to further improve its efficiency in the sound allocation of
resources. This will require that: (i) distribution channels for the funding now concentrated
in AFPs be broadened and diversified; (ii) gaps in securities market infrastructure, that limit
market liquidity and development, be filled; and (iii) the oversight framework be adapted to
meet the needs of an increasingly integrated and complex financial system. These areas of
concern interact and reinforce each other. Illiquid and, in some cases, insufficiently
transparent markets hinder the efficient dispersion of funds while the excessive concentration
of funds in AFPs, combined with strict investment restrictions, exacerbates the lack of
market liquidity. The reform agenda should therefore address all three areas simultaneously.

6. Greater competition in financial services will be key in facilitating a broader

allocation of investable funds. The concentration of funding in six AFPs, coupled with a
still insufficient range of financing vehicles and products, including interest rate derivatives,
tends to segment access to the capital market. By on- lending AFP funds, banks are helping
bridge the gaps between AFPs and smaller firms but they do so at relatively high interest
margins. Mutual funds and factoring and leasing companies are also helping bridge these
gaps and their role is growing but remains marginal. Reforms in the pensions sector can help
in this regard. There is room for a judicious relaxation of the overly complex and rigid
investment regime without undermining AFPs’ fiduciary function. The authorities should
intensify the current efforts at gradually enhancing competition in the pension fund industry.
They should also prepare a contingent, more radical reform strategy geared at unbundling
services subject to economies of scale from services where price competition can thrive.

7. The modernization of securities markets infrastructure is necessary to enhance

liquidity. Secondary market liquidity lags that in comparable countries, particularly in
equity and corporate debt markets. Liquidity is limited by structural factors (including high
concentration of ownership and the relatively small size of the economy) and shortfalls in
market infrastructure. In particular, concepts that are central to securities clearance and
settlement (finality, novation, netting) must be embedded more firmly in the law, a market
for securities lending and borrowing organized, conditions for the eventual introduction of
multilateral netting arrangements established, OTC price reporting and disclosure enhanced,
valuation methods improved, contracts and instruments standardized, and the system of
market makers suitably formalized. A review of financial sector taxation is also needed, as
well as a program to adopt international financial reporting standards for listed corporations
after a well-designed transition period.
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8. Reforms to the silo-based financial system oversight are required to enhance

efficiency and risk management. The segregation of supervisory responsibility by type of
entity among three agencies has functioned well so far. Problems that could have arisen from
the co-existence of institution-oriented supervision and the dominance of financial
conglomerates have been kept at bay by regulatory limits and firewalls, high profitability,
and the strong presence of foreign banks supervised by their home-country regulators.
However, as competition intensifies and boundaries between financial sectors blur, the
pitfalls of this approach are surfacing. The pitfalls include gaps in market transparency and
surveillance (particularly in the thriving yet opaque OTC market), shortcomings in cross-
sectoral and systemic analysis coupled with weaknesses in information systems, undue scope
for regulatory arbitrage, and statutory obstacles to fully consolidated supervision of financial
conglomerates. Reforms should focus, in the short-term, on enhancing cooperation among
regulators and filling the gaps in information, analysis, and market surveillance. Existing
coordinating bodies can be strengthened and supported by a permanent technical secretariat.
For the medium-term, legal changes will be needed to support consolidated supervision.
This should be accompanied by further progress from rule-based to risk-based supervision
and a strengthening of the financial and legal autonomy of the supervisory agencies.

9. The main FSAP recommendations are summarized in Appendix II. Some of the
recommendations are addressed, totally or partially, in the proposed Capital Markets Reform
II Law (CMII), under Congressional discussion at the time of this writing. Some reforms can
proceed in parallel, within a plan that sets out priorities, identifies complementarities,
allocates institutional responsibilities, provides for coordination mechanisms, and establishes
suitable timetables. The classification of a recommendation as “medium term” is often
because it would require legal changes. It does not necessarily imply less urgency.

II. FINANCIAL STRUCTURE AND M ACROECONOMIC ENVIRONMENT

A. Overview of the Financial System

10. The Chilean financial sector is large, we ll diversified, and increasingly integrated
with the rest of the world. It showed remarkable growth throughout the last two decades
and is now the largest (in assets to GDP) and among the deepest in the region. (Figure 1 and
Tables 1 and 2). The core of the system are the banking sector and the mandatory, privately-
administered, pension system. The latter is one of the largest in the world (only 8 OECD
countries have comparable pension assets). The markets for insurance products (mainly
annuities), equity securities, corporate bonds, and mortgage-related instruments are also large
by regional standards. The corporate bond and mortgage markets have grown rapidly during
recent years and so have the markets for commercial paper, albeit from a lower base. The
mutual fund industry and the nonbank finance sector, while also growing rapidly, remain
relatively small. The domestic public debt market is moderate in size and mostly
concentrated in instruments issued by the BCCh. Other remarkable features of Chile’s
financial system include relatively long (and lengthening) bond and mortgage maturities
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(mostly a result of the widespread use of instruments denominated in UFs), very large
external liabilities (mostly of the corporate sector, in the form of both foreign direct
investment and external loans and bonds), and large external assets. The latter grew rapidly
in recent years as AFPs were allowed to invest abroad a rising share of their portfolio.

11. The development of the financial system has been closely linked to the growth of
private pension funds. At end-2003, pension fund assets reached 60 percent of GDP, or
roughly one third of total assets of domestic financial institutions, and are projected to
increase to 80 percent of GDP in the next decade before tapering off as the system matures.
The large size of Chile’s pension sector is the result of an innovative reform initiated in 1981,
that involved the switch from a public pay-as-you-go system of predefined benefits to a
defined-contribution system of fully- funded individual accounts managed by the private
sector. The new system created a significant demand for investment assets and helped
develop capital markets. Together with the life insurance companies, whose growth is
mainly derived from that of the pension funds, AFPs hold a substantial fraction of total bank
deposits, public sector debt securities, corporate and mortgage bonds, and, more recently,
Chile’s external assets (Table 3). Projections suggest that institutional investors will become
larger than the banking sector in the next two decades, further increasing their systemic
importance. This increasing dominance partly reflects the fact that the bulk of household
savings is channeled into the compulsory (Pillar II) component of the pension system.
Household savings excluding mandatory pension contributions are small and corporate
savings account for a large part of private savings, which helps explain the very limited retail
investors base (Figure 2).

12. The financial (and real) sectors are characterized by high concentration and
conglomeration. With the exception of insurance, a small number of institutions dominate
the financial sector. The three largest banks account for 55 percent of bank assets, while the
three largest AFPs manage 70 percent of pension fund assets. Moreover, a majority of
financial institutions is controlled by a handful of financial conglomerates with significant
linkages between the banking, securities, mutual and pension fund management, and
insurance businesses (Table 4). The high concentration in the financial sector echoes an
equally high concentration of ownership in the real sector, where the large nonfinancial
conglomerates account for a disproportionately large fraction of economic activity and
absorb most of the available financing. 2 In turn, this high concentration, which has adverse
implications for liquidity in securities markets, in part reflects a high concentration of income
and wealth (Figure 3).

B. Macroeconomic Environment

13. Chile’s strong macroeconomic performance and financial development were

supported by sound macroeconomic management and an impressive agenda of reforms.
Boosted by strong productivity gains, average annual real GDP growth rates exceeded
5 percent during 1990-2003, resulting in a doubling of per capita income. Chile’s growth

2
One percent of firms account for 78 percent of sales by enterprises and absorb 79 percent of domestic bank
financing and virtually all financing through the capital market (Table 5).
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rate was twice that of the large Latin American economies, and compared favorably, at least
until 1998, to that of the strongest Asian performers (Figure 4). This strong performance was
supported by a steady monetary stabilization to low single digit inflation rates, a long record
of prudent fiscal management (consolidated into a structural fiscal balance target rule in
2000), and a comprehensive and far reaching program of structural reforms. In the financial
area, in addition to the already cited pension reform, other initiatives included: (i) the
consistent promotion of price- indexed financial instruments (which, together with the build
up of monetary policy credibility, resulted in a low level of dollarization3 ); (ii) the
introduction of comprehensive capital market reforms (the 2001 Capital Markets I law,
followed by the draft CMII law); and (iii) recent reforms to monetary and public debt
management practices. Chile’s economic performance and financial development was
supported by well- functioning institutions, including in the legal and political realms, placing
Chile well above the regional average in terms of reliability and security in the rule of law
and property rights. 4

14. Despite its sound macroeconomic frame work, Chile was not immune to the
regional financial turmoil during the late 1990s. Chile’s rapid output growth of the 1990s
was accompanied by substantial current account deficits, as domestic saving rates remained
moderate (Figure 5). The dependence on foreign savings increased Chile’s vulnerability to
the international and regional turbulences of the late 1990s. While Chile weathered the storm
much better than most of the neighboring countries, output and credit growth decelerated
sharply as the current account deficit swung from a large deficit into a small surplus (Figure
6 and Table 1). The contraction of credit was particularly strong for the smaller enterprises
(Figure 7). Output growth has started to recover only recently, stimulated by a favorable
external environment, a notable strengthening of copper prices, and a supportive monetary
policy (growth is expected to reach around 5 percent in 2004). The recovery in confidence
has led to a strong recovery of private consumption and buoyant growth of credit to
households while corporate borrowing and gross capital formation remain weak.

III. M ACRO-FINANCIAL STABILITY ANALYSIS

15. Chile remains somewhat vulnerable to real external shocks. Notwithstanding a

substantial diversification during the last decade, export concentration remains high, with
copper accounting for 36 percent of total exports in the last four years (Figure 8). While the
Copper Stabilization Fund (CSF) 5 and the recently introduced structural fiscal balance rule
should help mitigate the fiscal impact of terms of trade shocks, the correlation between
copper prices and the business cycle has been strong historically and could continue to be
significant in the foreseeable future. In particular, investment, the exchange rate, and capital
inflows could remain sensitive to changes in copper prices, contributing to macroeconomic

3
At end-2003 foreign currency deposits and loans accounted for 10 and 14 percent of total banking sector
assets, respectively.
4
Chile was ranked in the 9th decile, together with Hong Kong and the U.S., in the 2000/2001 index of the “rule
of law” (Kaufmann et al., 2002).
5
The CSF (established in 1985) receives transfers from the state-owned copper company (CODELCO) when
copper prices are high. Funds can be withdrawn by the government when prices decline.
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volatility and potential banking system vulnerabilities. Stress tests conducted by the FSAP
team indicate that while a 10 percent adverse terms of trade shock would have only a
marginal impact on banks’ solvency, it could nonetheless result in some liquidity tensions if
it leads AFPs to abruptly reallocate their deposits across banks.

16. Chile’s exposure to sudden stops in capital flows cannot be totally dismissed but
it is much diminished in the current monetary policy environment. Notwithstanding its
record of low and fairly stable sovereign spread (Figure 9), a repeat of the late 1990s sudden
stop in capital flows cannot be totally ruled out because Chile is likely to continue depending
on foreign savings. The severity of the 1998-1999 sudden stop and associated economic
deceleration mainly reflected a domestic portfolio reshuffling (away from dollar liabilities
and towards dollar assets) resulting from the liberalization of the capital account and the
elimination of the foreign exchange band, rather than a loss of access to international capital
markets (Figure 10). 6 The new policy environment of full- fledged inflation targeting,
together with the strong fiscal rule, is more resilient to that type of shocks. It should limit the
risk of sharp policy discontinuities while enhancing the scope for countercyclical policies. 7

17. The high and increasing financial integration with the rest of the world should
further increase the resilience of the system to sudden stops. Chile’s financial integration
with the rest of the world is high compared to most emerging economies (Figure 13). It
expanded rapidly in recent years, reflecting in part the strong increase in AFPs’ foreign
assets. The 1998 liberalization of the capital account has also promoted financial integration,
illustrated by the recent increase in the comovements of returns between the local and
international equity markets (Figure 14). The rapid expansion of the market for foreign
exchange rate hedges (see below), facilitated by the expanding supply of hedges by AFPs,
should also contribute to the overall stability and resilience of the currency market.

18. Notwithstanding the high foreign corporate debt, the exposure of corporations
and banks to currency risk was found to be moderate. Banks’ direct exposure to currency
risk—and more generally to market risk—was found to be insignificant. Their indirect
exposure to currency risk (i.e., through credit risk) was found to be moderate. 8 The increased
hedging of large corporates against currency risk (it is estimated that over 40 percent of the
corporate dollar debt currently hedged) has contributed to limit their exposure. More

6
There was a shift in relative costs in favor of the peso, following the liberalization of the capital account that
removed the interest rate wedge associated with reserve requirements (Figure 11). This was compounded by
shifts in uncertainty as investors, concerned about the sustainability of the exchange rate band and, later, by its
elimination, flew to dollar assets and debtors moved away from dollar obligations due to the increased volatility
of dollar rates (the variance of the exchange rate increased three-fold after it was allowed to float freely). The
increase in exchange rate uncertainty during 1997-1999 is apparent in the increased bid-ask spreads and the
surge in demand for currency hedges by dollar-indebted bank customers (Figure 12).
7
The assessment of the Code of Good Practices of Transparency in Monetary Policy conducted under the
FSAP revealed a very high degree of observance.
8
Nearly 60 percent of corporate debt is denominated in US dollars. Out of the 50 firms (accounting for
90 percent of total US dollar debt and 64 percent of corporate debt to domestic banks), 7 would incur debt
servicing difficulties under a one-year real exchange rate depreciation of 25 percent (Figure 16). As a result,
one bank (with less than 1 percent of banking assets) would experience a decline in its CAR below 8 percent.
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generally, the floating exchange rate has encouraged better risk management and led to a
pronounced increase in foreign exchange forwards (Figure 15).

19. The BCCh’s financial accounts need strengthening. With the current low inflation
target, the inflation tax on the money base does not cover the BCCh’s moderate operating
expenditures and carrying cost of its debt- funded foreign and domestic assets (Tables 6a and
6b). The BCCh’s weak financial accounts could constrain its policies (e.g., increasing
international reserves, and reducing or remunerating required bank reserves). While the
BCCh’s profitability could be improved by downsizing its balance sheet (in particular, the
carrying cost of claims on the government will disappear once this debt is repaid), the scope
for doing so is limited in view of the need to maintain minimum levels of international
reserves and domestic public debt. 9 Addressing this issue will require recapitalizing the
BCCh and preferably transferring at least some of its debt to the government.

IV. BANKING

20. The banking sector has incurred a rapid pace of consolidation. The relatively
small number of banks (26 at end 2003, down from 40 in 1992) reflects the 1982-83 banking
crisis and a wave of recent mergers. However, following a lowering of minimum capital
requirements in 2001, there was a number of niche entrants. Nineteen banks are privately
held and one (the third largest) is state-owned. Six banks (40 percent of system assets) are
majority owned or controlled by foreign banks. Banking concentration, as measured by the
market share of the three or five largest banks, is somewhat high by international comparison
(Figure 17).

21. Chilean banks are sound, profitable, and their efficiency has been improving.
Chilean banks have historically enjoyed high profitability, driven mainly by comfortable
interest margins (Table 7). They maintained NPL ratios in the 1–2 percent range throughout
the 1990s. 10 While asset quality deteriorated modestly as a consequence of the 1998-2001
economic slowdown, profitability and capital remained high. Stress tests indicate that the
banking system would only be moderately affected by further shocks affecting market risk or
credit risk. The operating efficiency of Chilean banks is good by regional standards. 11
Banks’ fee income appears low (albeit rising) as a ratio to net interest income when Chile is
compared with other countries (Figure 18). 12

22. Competition in the banking industry, while increasing, is still limited.

Competition and innovation have increased in the last few years as a result of new entrants,
rising participation of foreign banks, and the development of the local capital market.

9
A deep and liquid market for domestic public debt is needed to sustain a reliable yield curve (required to
adequately price private sector debt) and provide collateral for the payments system.
10
However, Chilean accounting of past-due loans is less stringent than international standards. If measured
under U.S. GAAP, the ratio would double.
11
The ratio of operating costs to total assets in the Chilean banking system was 2.8 percent in 2003 (SBIF data),
compared to ratios of over 6 percent in Mexico and Brazil (Bankscope data).
12
Then authorization in 2002 to pay interest on sight deposits is inducing banks to increase fee income.
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Competition is intense at the higher end where the very large corporations generally have
access to foreign credit and the local capital markets. It has also become quite intense in
consumer credit, partly reflecting the competition from department stores (recently
intensified through their direct entry into the banking business). Yet, competition remains
more limited in the middle segment where the smaller enterprises ha ve difficulties in
accessing alternative funding sources and benefiting from direct funding by institutional
investors (see below). The dominating presence in the wholesale deposit market of large,
risk averse, institutional investors may impress a somewhat conservative bias on banks and
stifle competition from non-bank intermediaries, as only the reputable and well rated
intermediaries (mainly the banking groups) can benefit from AFP funding. Banks face
almost no competition in the credit markets from no n-deposit taking finance institutions and,
at least until recently, very limited competition from mutual funds. 13 The scope for
competition is limited in some other areas, notably retail payment, partly reflecting the need
(driven by scale economies) for large minimum volumes needed to compete.

23. Strong financial oversight underpins a robust banking system. Bank regulation is
shared between the BCCh and the SBIF, but supervision is entrusted solely to the latter. The
supervisory regime is robust and well established. It enjoys a well deserved reputation for
good technical skills and integrity. Efforts are under way to move away from a strict
compliance-driven supervisory style towards one which allows banks more room to manage
their risks, while placing increasing responsibility on bank directors and management.

24. However, bank oversight needs further strengthening in some areas. The
transition to risk-based supervision increases the need to fortify the supervisory approach
with strong analytical and informa tion processing capabilities. Provided it is matched with
adequate accountability, this calls for strengthening and clarifying the independence of the
SBIF (see below). It also requires adapting the regulatory framework to address some
weaknesses identified in the BCP assessment. In particular, risk-specific regulations need to
be replaced by a broader capital charge for market risk and consolidated supervision
expanded beyond the bank and its subsidiaries. The scope of fit and proper tests should be
extended to banks’ directors and senior management. There is also room to further
strengthen banks’ credit risk management practices and disclosure of risk exposures
(Appendix III).

25. While the Chilean safety net and bank resolution scheme is original and
attractive, it is untested and has some limitations. The scheme, which is based on a
“narrow banking” concept (Appendix IV), remains untested, partly reflecting good
supervision supported by an effective system of early warning and prompt remedial action.
Should the need to activate the system arise, the dominance of large institutional depositors
should help expedite the resolution process with only limited losses for involved parties.
However, obtaining agreement from a majority of non-sight creditors (sight deposits are fully
guaranteed by the BCCh) could be difficult if the largest creditors have already left the bank
in anticipation of difficulties. When the bank is too big to fail or the system is perceived to

13
The fastest growing segments of the nonbank credit sector (leasing and factoring) are owned by (and
increasingly integrated into) banking groups. Similarly, the largest mutual funds are owned by banking groups.
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be vulnerable to contagion, this could ha ve adverse systemic implications. Under the current
regime, a rapid transfer of assets and non-sight liabilities of the distressed bank to a sound
financial institution is not permitted since it would entail a de facto differential treatment of
creditors. Nor is it possible for the State to transitorily assume the bank’s ownership or for
the SBIF to grant a temporary license to a bridge bank. Such options and tools could be
usefully integrated to the legal framework.

V. CORPORATE S ECTOR

26. Chilean firms are conservatively managed but currently have low profitability.
The average leverage ratio at end-2003 was low and the debt servicing capacity high
(Figure 19 and Table 8). 14 However, ROE was significantly below the estimated cost of
capital, reflecting incomp lete cost restructuring in the face of the post-1998 decline in sales.
Firms’ depressed profitability has discouraged them from issuing equity in recent years.

27. Only the largest (“mega”) firms have access to international capital markets and
to the whole range of financing instruments available in the domestic financial market.
Smaller firms do not have access to finance in international markets and face some form of
financing constraint at home. 15 Even large firms have virtually no access to the local bond
market, in part because of the relatively large minimum bond issue size (US$45 million)
required to attract AFP investment and cover the large issue fees (Table 9 and Figure 21).
Bond issue fees are large mainly because of the stamp tax, which accounts for 50 percent of
the fees (Figure 20). 16 In contrast, some SMEs managed to issue equity in the mid-1980s and
early-1990s, reflecting relatively low access costs. Only a minor fraction of SMEs have
access to private equity in the OTC market (as opposed to public offerings in the stock
exchange)—an industry that is noticeably under-developed in Chile. To be sure, in the most
recent period, banks rapidly expanded their lending to SMEs as well as their leasing and
factoring lines—although the latter are still small. Micro firms have access to loans from
dedicated institutions, which often take the form of consumer loans. While better off than in
most countries in the region, SMEs in Chile still have significantly less access (in quantity
and diversity) to financial services than do similar firms in developed countries.

28. There is room to further improve SME’s access to finance. Although Chile’s
lending environment is already relatively strong, 17 SME’s access to bank finance cold be

14
Much of the corporate sector analysis was based on the so-called FECUs data, which contains summary
financial statements for around 500 formal firms. The data is tilted towards larger firms, although it also
includes SMEs and a few micro firms.
15
Mega firms are defined as those with annual sales (net of value-added tax) above UF600,000
(US$17,172,000); large firms have sales between UF100,000 (US$2,862,000) and UF600,000; medium firms
have sales between UF25,000 (US$715,500) and UF100,000; small firms have sales between UF2,400
(US$68,688) and UF25,000; and micro firms have sales below UF2,400.
16
As the stamp tax also applies to domestic bank loans, it does not raise the cost of bond issues relative to bank
borrowing. However, it raises the cost of domestic bond issues relative to external bond issues, favoring the
largest firms that have access to external borrowing over the smaller firms that must borrow domestically.
17
Chile ranks high (72th percentile) on “effective creditor rights,” close to Sweden (75th percentile) and far
above Brazil (25th percentile) according to Chong, Galindo, and Micco (IDB, 2004).
 - 10 -

aided by unifying the legislation on movable collateral and creating a single registry for
pledges. While credit bureaus work well in Chile, the quality of SME financial statements
needs to be improved. The ceiling on lending rates (tasa máxima convencional) should be
made more flexible or eliminated. 18 A revenue neutral tax reform that eliminates the stamp
tax (or exonerates smaller customers) should also be considered, as this tax penalizes all
forms of borrowing, especially by the smaller firms. Firms' access to equity will also be
enhanced through the vigorous implementation of recent improvements in the framework for
corporate governance. 19 Further steps include upgrading the accounting and auditing system
(see below), clarifying definitions and improving corporate disclosure of related party
transactions, establishing clearer standards for appointing directors. Training of independent
directors and the judiciary should be considered to ensure consistent application and
enforcement of the corporate governance framework.

VI. INSURANCE S ECTOR

29. The insurance sector is large, reflecting its important role in providing annuities.
It comprises 57 companies (domestic and international) and has grown steadily over the last
decade (total assets reached 19 percent of GDP in 2002, up from 7.5 percent in 1992). The
industry is dominated by life insurance, which grew in connection with the pension system (it
accounts for 62 percent of total premiums, compared to a regional average of 38 percent).
Annuities are the dominant choice of retirees due to high money worth ratios of annuity
products, which in turn is partly attributable to the availability of inflation- indexed bonds. 20

30. Heightened competition, some under-provisioning of risks, and weaknesses in

the resolution framework, point to potential difficulties ahead. Competition among
insurance companies should increase due to recent changes in the legal framework for
annuities that will stimulate price competition, allow banks to distribute insurance products,
and tighten conditions for early retirement (thereby creating a temporary dip in annuity
sales). At the same time, provisions will need to be increased to reflect updated mortality
tables, 21 make allowance for future improvements in life expectancy, and fully incorporate
credit and prepayment risks. 22 A further complication is that, as illustrated by the recent
failure of the Inverlink group (Appendix V), key tools to facilitate an orderly transfer of

18
Although relatively high, the ceiling is becoming binding as credit institutions move down market towards
riskier borrowers. A bill that makes the ceiling more product-specific has recently been submitted to Congress.
To protect small customers from potentially abusive practices the authorities should consider consumer
protection arrangements rather than usury laws. The U.S. experience with provisions to prevent “predatory
lending” can serve as a point of reference in this regard.
19
A 2003 assessment by the World Bank found Chile to score well on the OECD Principles for Corporate
Governance. The CMII reform is expected to further strengthen corporate governance.
20
The money worth ratio is the present value of the stream of annuity payments divided by the purchase price
of the annuity. Such ratio in Chile hovers around 100 percent, compared to around 90 percent in the U.K.
21
A major part of the insurance sector could fall below the minimum capital requirement once the necessary
provisioning is made, even if allowance is made for an increase in the discount rate (Figure 22).
22
The current rule -based style of supervision has led insurance companies to devote considerable energy to
“managing rules,” rather than “managing risks.” Exposure to prepayment and credit risks might have been
more limited in a risk-focused environment.
 - 11 -

obligations and dealing with asset deficiencies are missing. Reforms are also needed to
mitigate incentives in the current framework for companies to raid available funds ahead of
the intervention and, once in the intervention phase, for the administrator acting in the
interests of claimants to maximize the resolution cost to the government. In view of low
average ROE (partly resulting from aggressive pricing), the large number of players (that will
require consolidation), and lack of key resolution tools, the road ahead could be difficult.

31. The road map requires a well-designed transition, focused on risk-based

management and supervision. Concerns about the solvency of insurance companies that
belong to financial conglomerates could spill over to other members of the group,
particularly banks and mutual funds. More importantly, the government’s exposure on its
annuity performance guarantee could be large (about 1 percent of GDP on account of the
under-provisioning effect alone). Given the magnitude of needed changes to the regulatory
requirements, they will need to be introduced with a trans ition period and under close
supervision. Both off site analysis (including a monitoring of market values and pricing, the
development of early warning systems, and risk focused capital assessments) and on-site
reviews (to gain a better understanding of companies’ management and strategies looking
ahead) will need strengthening. A two-tiered regulatory regime emphasizing a full fledged
asset- liability management approach could be introduced in the longer term for the larger and
more sophisticated companies in lieu of a more standard approach.

VII. PENSION FUNDS

32. AFPs are by far the dominant institutional investors in the country. They hold
40 percent of government bonds, 50 percent of mortgage bonds, 38 percent of corporate
bonds, and 35 percent of time deposits. 23 Their number dropped to 6 at end-2003 (from 21 in
1994) following a marketing war in the 1990s. AFPs have enjoyed persistently high profits
(annual ROEs averaged 30 percent in recent years, twice that of banks), despite low levels of
risk. While costs have declined and are becoming more comparable to those in OECD
pension funds, there is scope for further reductions. A voluntary pension system (opened to
all financial institutions) was introduced in 2002, but it is still small.

33. Pension funds’ port folio composition partly reflects an overly complex and
restrictive investment regime. Despite the significant increase in their share of foreign
assets (to almost 30 percent) and the introduction of multiple funds among which workers
can choose (to increase risk diversification), pension funds continue to have a relatively high
level of low- yield, short-term assets, mainly bank certificates of deposits (Table 10). The
share of domestic equity is small, the range of equity holdings is narrow (90 corporations, out
of more than 200 listed companies), and corporate bond holdings are heavily concentrated in
companies rated A and above (Figure 23). This is mainly the result of the fast growth of
pension funds outstripping the availability of investable assets in a relatively small economy,
and more recently the fall in investment following the 1998 economic slowdown.

23
The fast asset growth in pension funds has reflected the mandatory nature of the system and reinvestment of
high historical rates of return (7 percent per annum since 1981).
 - 12 -

34. The scope for liberalizing AFP regulations is constrained by their inherent
fiduciary role. Policies may be considered to enhance AFPs’ impact on financial
development only to the extent that their primordial fiduciary responsibility is safeguarded.
A conservative portfolio allocation is particularly justified in Chile given that the second
(mandatory, privately-administered, fully- funded) pillar of the system constitutes the core of
the national social security scheme. As a result, workers are more exposed to market risk
than if the second pillar was a complement to a core pay-as-you- go system. A major
liberalization of the investment regime would therefore not be advisable. 24

35. Nonetheless, a judicious relaxation of the investment regime is recommended.

There is ample room for simplifying and relaxing investment regulations and improving the
welfare of retirees through higher returns, without necessarily increasing risks. A prudent
liberalization of the investment regime would require legal reform (much of the detail of
investment restrictions is embedded in the law) and should be accompanied by measures to
modernize securities markets infrastructure and enhance liquidity and price integrity (see
below), as well as by a shift from compliance-based to risk-based supervision. 25 A prudent
liberalization program would maintain the main ceilings on investment in major instruments
(to ensure overall safety) and the basic limits by issuer (to avoid excessive concentration and
minimize connected lending). It would, however, remove most sub- limits on instruments, all
sub- limits on combinations of fixed-income and variable-income instruments, and all the
“specific reducing factors” on issuers (linked to concentration, diversification, liquidity, and
other factors) could be removed. It would also streamline the approval process for eligible
investments, permitting investment in all listed equities except for a reasonable negative list
and allowing marginal holdings of below-grade corporate bonds.

36. Regulatory improvements are also recommended regarding foreign investments.

The recent increase of the ceiling on investments abroad should provide long-term risk
diversification benefits considering the small size and openness of the Chilean economy.
While further increases in the ceiling may be advisable in the future, the stock of foreign
assets is already large and needs to be better managed. This requires, inter alia, allowing the
use of more instruments to hedge risk (such as currency swaps), correcting definitional and
misclassification problems in mutual fund investments, increasing the ceilings on individual
foreign shares and mutual funds, and permitting that fees on foreign mutual funds be netted
from the gross returns (to level the playing field with investments in mutual funds at home).

37. The authorities should also deepen their efforts to gradually enhance
competition in the pension sector. Greater competition in asset management should not
only contribute to a further lowering of fees but also to a broader diversification of investable
funds. The recent creation of the voluntary pension system should enhance competition, but

24
Also, a move towards a “prudent man” rule is not recommended at this stage because, among other reasons,
courts may not be legally and technically equipped to enforce jurisprudence of prudent man behavior, the
regulatory framework is not suited to ensure effective risk management (while risk management capacities seem
very uneven across AFPs), and the SAFP is not sufficiently trained to perform risk-based supervision.
25
This includes training of staff on risk management techniques and the introduction of a compliance officer
inside each AFP reporting directly to the AFP Board.
 - 13 -

further outsourcing of administrative services could be encouraged and the SAFP should be
given authority to regulate service providers directly. The authorities are also encouraged to
implement their plans for “decompressing” the mandatory pension system (members that
achieve a threshold balance in their mandatory pension can be diverted to the voluntary
pension system) and enhancing the attractiveness of the voluntary system (including by
allowing the formation of employer-based groups and introducing a different tax treatment
for low-income workers). Allocating undecided new entrants to the lowest-cost AFP could
also promote healthy, fee-based competition, rather than expensive marketing practices.

38. Should this gradual approach fall short of expectations, a more radical reform
could be introduced at a later stage. This would unbundle pension-related services that are
subject to economies of scale (contributions collection, accounts management, payouts to
retirees, etc.) from those services where price competition can thrive (asset management).
This could be achieved by centralizing the provision of basic services (contributions
collection, accounts management, payouts to retirees, etc.) within a regulated provider while
allowing open competition among asset managers. The danger of a marketing war could be
dispelled by simultaneously considering, among other alternatives, the introduction of a blind
quotation system (workers know which asset manager they choose but asset managers do not
know the identity of the workers whose pens ion assets they manage). The excessive number
of entries could be avoided through proper licensing criteria, including fit and proper tests. 26

39. Policies should also be considered to reduce the market risks faced by workers at
the moment of retirement. The current system, which separates the administration of the
retirement savings between AFPs (pension fund administration) and life insurance companies
(provision of annuities), each operating under different market incentives, is not necessarily
consistent with smoothing and maximizing lifetime consumption for a given level of risk. In
particular, with AFPs focused mainly on maximizing short-term return, the system does not
adequately protect retiring workers from interest rate and other market risks when switching
from the pension fund to annuities. To address this problem, a long-duration fund for
workers approaching retirement could be introduced and workers could be allowed to
purchase fixed annuities gradually in the years before retirement. Complementary, more
adequate information on replacement ratios (the ratio of retirement pension to pre-retirement
income) needs to be provided. 27

VIII. M UTUAL FUNDS

40. Mutual funds need to be closely monitored to ensure fair competition and limit
systemic risk. The industry was affected by the Inverlink scandal (Appendix V) and the
resulting run-off on money market funds, particularly on those not affiliated with banks. In
the case of the longer duration funds, “exit load fees” (commissions that decline over time),

26
The authorities may wish to consider the experience of Sweden and its recent adaptation to Latvia.
27
This is all the more important considering the downward pressure on replacement ratios stemming from the
declining trend in net pension fund returns (relative to real wage growth), which also raises the relevance of
further reducing fees through competition in the pension industry. In effect, a decrease in fees by 30-40 basis
points of assets accumulated over long periods would lead to a 7-9 percent increase in replacement ratios.
 - 14 -

and the upper regulatory limit on asset duration have so far limited interest rate and liquidity
risks. However, as regulations on duration are relaxed and competitive pressures increase,
some funds, particularly the ones affiliated with banking groups (that benefit from potential
liquidity backing), may attract customers by combining higher yield-higher duration assets
with higher liquidity. This could put the independent mutual funds at a disadvantage and
induce them to take excessive risk, or else further promote concentration. The authorities
will thus need to remain vigilant and ensure, via regulation if needed, that risks are well
managed and disclosed and not passed on to banks.

IX. OTHER INSTITUTIONAL INVESTORS AND FINANCING VEHICLES

41. A sustainable diversification of vehicles to mobilize and allocate investable funds

is key to broadening the access to finance for efficient newcomers. Greater competition
in the asset management industry and the development of “bridging” vehicles is key to level
the opportunity playing field and more broadly finance economic activity. At present, the
concentration of investable funds in AFPs, coupled with a still insufficient range of financing
vehicles and products, including derivatives, tends to segment and tilt the demand fo r
securities. Pension funds are so large relative to the size and liquidity of domestic securities
markets that AFPs face increasing difficulties in selecting assets in which to invest without
creating price bubbles or becoming locked in their investments. They thus “pick” a few,
liquid securities issued by the most reputable issuers, fully use their allowance to invest
abroad, and invest their residual funds in bank CDs. The segmentation in access to finance
via the securities market is exacerbated by the excessively complex and over-determined
investment regime, as noted above. This segmentation is illustrated by the sharp
discontinuities in bond ratings and the near complete absence of bond issues below the AFP
investment grade threshold (Figure 23). As noted, banks are playing an increasing role in
channeling AFP investable funds down market, but they do so at somewhat high interest
margins. Thus, the risk-adjusted cost of access to finance is substantially higher for firms
that do not obtain direct access to AFP funds. Mutual funds and factoring and leasing
companies have been growing fast, as already noted, and are helping bridge the access gaps
but their role is still miniscule and their funding of firms limited. 28

42. The authorities should continue with their efforts at identifying and removing
obstacles to healthy competition and diversification in the financial services industry.
Mutual and investment funds can help channel funds to smaller firms to the extent that they
can credibly reduce the risk of investing in smaller firms though monitoring and
diversification (pooling, mixed funds) at reasonable cost. In this connection, actual cost and
fees deserve analysis. For instance, the fact that pension fund investments in mutual funds
are minuscule reflects in part the high fees (about 200 basis points) charged by the medium-
term mutual funds. In the area of venture capital, the reforms proposed in CMII should help

28
Mutual funds in Chile are open-ended. Money market funds (whose assets must have an average duration of
less than 90 days) and medium-term mutual funds (with durations of no more than 2 years) dominate the mutual
fund sector. The so-called investment funds are close-ended and their asset holdings are significantly smaller
that those of mutual funds. Compared to mutual funds, investment funds invest more in equity and, at the
margin, invest in riskier companies than pension funds do.
 - 15 -

develop the industry. The evolution of securitization and of the market for corporate control
(e.g., via the development of investment banking services, venture capital funds, vulture
funds, etc.) should further help bridge the access gaps.

X. SECURITIES M ARKETS LIQUIDITY, INFRASTRUCTURE, AND OVERSIGHT

43. The Chilean securities markets are large, as noted above, but their liquidity
remains limited and needs to be enhanced. Secondary market liquidity lags that in
comparable emerging market countries, particularly in corporate paper, mortgages, and
equity markets. The illiquidity of the equity market reflects both concentration of supply (the
concentrated firm ownership results in very low “float ratios,” as shown in Figure 24) and
concentration of demand at six AFPs which mostly “buy and hold.” The significant
migration of securities issues and trading abroad has also reduced liquidity in the domestic
capital market. 29 Enhancing liquidity, which is essential to securities markets development,
should therefore be a key focus of policy. 30 To be sure, the scope for enhancing liquidity is
fundament ally limited by the mentioned concentration factors and the relatively small size of
the Chilean economy, as liquidity is strongly dependent of economies of scale and
agglomeration. Nonetheless, there is room to improve liquidity by removing impediments
that currently exist in various dimensions of market infrastructure, including legal aspects,
clearance and settlement systems, valuation, contract standardization, market making
arrangements, taxation, and financial reporting, as discussed below. Due to incentive
problems among the various capital market participants to act collectively, this will require
strong leadership and a major coordination effort.

44. Legal voids that affect the clearing and settlement of securities need to be filled. 31
The legal foundations for securities clearing and settlement need to be strengthened by
embedding more clearly in the law the concepts of finality (irrevocable and unconditional
completion of transactions), netting (offsetting of credits and debits between parties to a
series of transactions involving the same security), and novation (the substitution of an old
obligation or obligor with a new obligation or obligor). Further clarifying the concept of
finality in payments would also provide a more solid anchor for the forthcoming introduction
by the BCCh of a real-time gross-settlement payments system and the nearly complete move
towards dematerialization of securities. Clarifications to the concept of netting (further to
those envisioned under CMII) should be introduced as part of a broader reform of the
bankruptcy code. Firmly embedding novation and netting in the law would facilitate the

29
Econometric evidence on this effect is presented in a recent World Bank study on “Whither Capital Markets
in Latin America?”, which can be found at:
http://wbln1018.worldbank.org/LAC/LAC.nsf/ECADocbyUnid/01A51A58B764B8D585256EA9005BFE00?O
pendocument
30
Illiquidity hampers price revelation—the most distinctive function of securities markets vis -à-vis, say,
banking markets. It weakens the reliability of marking to market and fair value accounting and limits the
development of derivatives markets. Moreover, it magnifies the effects of shocks on asset price fluctuations.
31
Informal assessments of observance of the CPSS Core Principles for Systemically Important Payment
Systems and the CPSS-IOSCO Recommendations for Securities Clearance and Settlement were conducted as
part of the FSAP.
 - 16 -

introduction at a later stage of multilateral netting arrangements and a central clearing

counter-party.

45. Reforms are needed to modernize securities clearance and settlement, improve
securities valuation, enhance standardization, and suitably formalize a market making
system. Such efforts should affect securities traded in both the exchange and over the
counter (OTC). 32 In particular, securities valuation, already undermined by secondary market
illiquidity, is further hampered by inadequate price information on OTC trades and lack of
uniformity in valuation methodologies. The authorities should consider introducing a
standard contract for repos (and, possibly, an omnibus master agreement for both repo and
derivatives contracts). More generally, a comprehensive review of shortfalls in contract
standardization, including in the highly fragmented mortgage market, would be desirable. At
the same time, a market for securities lending and borrowing needs to be promoted and a
suitable formalization of a market making system considered. 33

46. There is also a need for a thorough review of financial sector taxation. As noted,
important distortions arise from the stamp tax, which raises the cost of bond issuance and,
according to anecdotal evidence, promotes ever-greening in bank lending. There is also
excessive complexity in the design and application of capital gains tax and its exemptions,
making it difficult to assess its incentive effects. Moreover, the competitive disadvantages
created by the uneven application of the value-added tax (e.g., transactions by AFPs are
exempt but transactions by insurance companies, mutual fund administrators, and banks are
not) are likely to intensify as different financial entities are allowed to provide the same
financial service (e.g., the administration of voluntary pension funds). 34

47. The financial reporting regime for companies listed on the stock exchange
should be strengthened. 35 Chilean accounting principles differ significantly from
International Financial Reporting Standards (IFRS). They fail to require disclosure on
certain critical areas. For instance, companies do not have to provide summary informatio n
on their financial position and performance by business segments or geographical areas.
Furthermore, Chilean GAAP are not as rigorous as international standards with respect to
disclosure of the fair value of financial instruments, especially derivatives. Chile should
adopt IFRS but only after a period of transition that would allow companies to adequately
prepare to meet the new requirements and users to properly assess the implications. As
regards external auditing, the current lack of licensing and quality control mechanisms in the
audit profession weakens its role, potentially compromising the overall strength of the

32
OTC trading dwarfs the exchange-based trading (Figure 25).
33
Granting exclusivity for participation in primary auctions to primary dealers is not recommended, partly
because of the already high concentration in the Chilean system. Instead, primary auctions would be open to all
participants while market makers can be given the right of first refusal to an allocation of securities in an
oversubscribed auction, at an appropriate price. In turn, they would have measurable obligations, especially
with respect to continuously quoting bid-ask spreads for minimum transaction sizes and distributing securities.
34
CMII, if enacted, should resolve this issue by subjecting all voluntary pension funds to the VAT,
independently of which institution administers them.
35
A Review of Accounting and Auditing Practices was conducted by the World Bank in parallel to the FSAP.
 - 17 -

reporting system. The current efforts of the audit profession toward creating a licensing
system are welcome. Additionally, Chile should establish independent oversight
mechanisms to ensure the proper functioning of these systems and give the SVS greater
authority to play a more proactive role in monitoring and enforcing compliance.

48. While securities market regulation is basically sound, important weaknesses

need to be addressed.36 The SVS would benefit from a significant increase in budgetary
and staff resources, which should focus on boosting the recently created enforcement unit,
enhancing IT support for data collection and market surveillance, and strengthening on-site
inspections of brokerage firms, mutual funds, and self-regulatory organizations (SROs).
There is also a need to: (i) introduce minimum professional standards for brokers, investment
advisors, asset managers, etc.; (ii) submit brokerage firms to internal compliance programs
and ensure their fiduciary duty rule; and (iii) grant the SVS powers to suspend individuals for
misconduct; finalize disciplinary action via negotiated settlement (rather than court
litigation); and intervene (or appoint a conservator or liquidator for) a failing brokerage
firm. 37 The intervention power should be coupled with the creation of an industry-wide
guarantee fund to facilitate an orderly settlement of open transactions, thereby limiting the
ripple effects of a failure of a broker or mutual fund.

XI. H EDGES

49. Notwithstanding ample hedging needs, the use of derivatives remains so far
limited. Following the removal of the exchange rate band, the domestic market for
nondeliverable foreign-exchange forwards (NDFs) expanded rapidly and has now become
quite deep and liquid (Figures 25, 26, and 27). However, the use of other derivatives remains
extremely limited or nonexistent. In particular, there is no active market for interest rate
derivatives. Yet, some sectors, particularly life insurance, are significantly exposed to
interest rate risk, reflecting a substantial duration gap and a growing exposure to repayment
risk. The absence of equity derivatives and options of any kind also hinders the capacity of
financial intermediaries and corporates to manage and allocate risk effectively. Such gaps
will become increasingly binding as the financial system evolves from “managing rules” to
“managing risks.” Moreover, new derivatives would help increase trading in assets that are
now locked- in in institutional investors’ portfolios, thereby contributing to market liquidity.

50. The development of new derivatives products should be fostered by a cautious

relaxation of current restrictions coupled with enhancements to market infrastructure.
The limited development of derivative products in part reflects regulatory barriers on trading
that affect banks, pension funds and insurance companies. However, caution is advisable
given the limited liquidity of underlying markets (particularly equity), which hinders the use
of derivatives and increases their potential risks. The restriction on banks to write options
could be removed but only after a capital charge for market risk has been introduced and

36
A formal assessment of observance of the IOSCO Objectives and Principles of Securities Regulation was
conducted under the FSAP.
37
The SVS has power to intervene and liquidate a mutual fund and to suspend the operations and cancel the
license of a brokerage firm, but not to intervene and liquidate the latter.
 - 18 -

supervisors are satisfied that banks have adequate capacity to manage the associated risks
(this may also require capacity building at the SBIF). The removal of restrictions on
derivatives trading for pension funds and insurance companies would be a logical second
step, based on similar requirements. The limited development of derivatives also reflects
already noted deficiencies in information and market infrastructure. There is a particular
need to: (i) follow intraday market indicators to measure liquidity and ascertain disorderly
market conditions; (ii) increase the data available to the public to promote competition and
avoid manipulation; (iii) enable netting and securities lending; v) define a proper tax,
accounting, and valuation treatment of derivatives; and (vi) promote knowledge building,
standardization of contracts, and an industry code of conduct.

XII. CROSS-SECTORAL ISSUES IN FINANCIAL OVERSIGHT

51. Supervisory oversight is currently based on a silo approach, strong regulatory

firewalls, and mostly informal coordination arrangements. Supervisory responsibility is
segregated by type of financial entity and distributed among three superindendencies (banks,
securities and insurance, and pensions). The BCCh retains significant regulatory powers and
pre-eminence in systemic stability matters while the MoF provides leadership in financial
sector development policy. This silo approach is supported by strong regulatory firewalls
that include limits on permissible activities, cross-ownership, and connected lending and
investments, as well as prohibitions on sharing infrastructures and customer bases. While
inter-agency coordination has been strengthened in recent years, the two main coordinating
bodies, the Superintendents Committee and the Capital Markets Committee, have no legal
basis and there is no comprehensive framework that describes the roles and responsibilities
of each participant. 38

52. The silo approach will become increasingly limiting as financial services become
more integrated and complex. The problems that could have arisen from the co-existence
of institution-oriented supervision and the dominance of financial conglomerates have
hitherto been kept at bay by the regulatory firewalls, comfortable profitability, and strong
presence of foreign banks supervised by their home-country regulators. However, rapid
changes in financial services are increasingly exposing the limitations of this approach. As
evidenced by the thriving yet opaque OTC market, there are gaps in market transparency and
surveillance in markets that involve different types of financial entities that are subject to
different regulations. These markets, as a result, fall outside the purview of any of the
individual regulatory agencies. In addition, the uneven regulatory treatment of similar
products promotes regulatory arbitrage. 39 Moreover, statutory obstacles to the full
consolidated supervision of financial conglomerates 40 could impede early recognition of
38
While CMII would give stronger legal grounding to information sharing, cooperation would remain rather
informal and limited in scope.
39
For example, insurance companies can originate consumer loans and mo rtgages and launch mutual fund and
credit card subsidiaries, but are subject to different regulations than banks. Voluntary pension funds will be
subject to the same (SAFP) regulations as mandatory pension funds when administered by AFPs but by
different (SVS) regulations when administered by other financial entities.
40
At present, the SBIF is empowered to supervise on a consolidated basis a subset of a financial conglomerate,
namely, the bank and its subsidiaries and affiliates (where the bank has an ownership interest).
 - 19 -

group-wide risks, especially in cases where the conglomerate includes nonfinancial firms.
The importance of these linkages will rise as financial groups are increasingly driven by
competition to exploit synergies and scale economies (Figure 28).

53. Improved inter-agency coordination and enhanced analytical and informational

capacity will be needed. While cooperation between regulators has improved, it remains
limited in view of the range of issues that require coordination (Table 11). As the Inverlink
case shows (Appendix V), the result can be a reduced ability to detect emerging problems, as
well as increased potential for arbitrage and inefficiencies. Despite important inroads by the
BCCh in financial system stability analysis, issues at the interface between the different
components of the financial system and between macro- financial developments and micro-
market underpinnings will require more attention. This problem is often exacerbated by
shortcomings in the overall analytical capacity of the supervisory agencies and weaknesses in
data collection and information systems. 41

54. Reforms should focus, in the short-term, on enhancing cooperation among

regulators and filling the gaps in information, analysis, and market surveillance. Much
can be achieved in the short-term, without legal reform, within the current organizational
arrangements. The functions of the two coordinating bodies can be suitably redefined, and
their operating principles and protocols formalized via a well- designed MOU (Table 12).
Consideration should be given to the creation of a small but competent permanent technical
secretariat focusing on the analysis of cross-cutting issues and the coordination of efforts to
rationalize (and facilitate access to) information. Efforts should also be made to boost the
overall analytical capacity of the agencies and broaden the scope of analysis, for example
through a program of regular staff exchanges.

55. For the medium-term, legal reforms will be needed to support fully consolidated
supervision. The authorities should consider legislative reform to define and embed the
concepts of financial conglomerate, financial holding company, and lead regulator in the law
and, hence, appropriately underpin the full application of consolidated supervision. This
should be established simultaneously with some relaxation of existing regulatory firewalls,
while promoting further enhancements in financial conglomerates’ corporate governance
(which should result in appropriate Chinese walls) and ring fencing the financial
conglomerate from the rest of the group. In addition, the authorities are encouraged to
improve coordination protocols to deal with the possible failure of a complex financial
conglomerate.

56. The shift from “managing rules” to “managing risks” puts a premium on
further enhancing the autonomy and legal protection of supervisors. The authorities
should consider reforms to enshrine in the law the political and budgetary autonomy of the
regulatory agencies, and enhance the legal protection of supervisors. To minimize the scope
for abuses of power and inefficiencies, increased autonomy must be matched with increased
transparency and accountability.

41
While information systems are often adequate in meeting the needs of silo-based supervision, they generally
fall short in supporting more analytic, broader, cross-sectoral, systemic analysis.
 - 20 -

XIII. ANTI-M ONEY LAUNDERING

57. Further to the 2003 GAFISUD assessment, there remains scope for tightening
the AML/CFT framework. The recent passage of a law endorsing the authority of a
Financial Intelligence Unit (FIU) and extending the definition of offences and the institutions
subject to reporting constituted an essential first step towards compliance with AML/CFT
standards. However, subsequent rulings of the Constitutional Court eliminated the FIU’s
sanctioning powers, limited its discretion in requesting data on suspicious transaction
records, and denied its access to information protected by bank secrecy or on other public
databases. This undermines investigations on (and the disclosure of) potential offences,
precluding effective international cooperation through the FIU, including in freezing assets
The monitoring of compliance by securities firms, insurance companies, and foreign
exchange retail operators also needs improvement.
 - 21 -

TABLES AND FIGURES

 Table 1. Chile: Selected Macroeconomic Indicators, 1997-2003
1997 1998 1999 2000 2001 2002 2003

Real Sector
GDP (real change) 1/ 6.6 3.2 -0.8 4.2 3.1 2.2 3.2
Consumer price index (e.o.p.) 95.5 100.0 102.3 106.9 109.8 112.9 114.07
Consumer price index (e.o.p.) change 4.7 2.3 4.5 2.6 2.8 3.3.
Private savings ratio (in percent) 2/ 23.1 21.8 21.0 20.6 20.0 21.0 n.a.

Monetary and credit data (change in annual averages)

Monetary base 15.8 13.2 4.4 6.1 7.2 7.9 5.53
Money (M1) 3/ 17.0 3.3 5.1 7.8 14.4 14.2 18.33
Broad money (M3) 4/ 20.8 13.3 9.2 8.8 9.0 4.3 3.57
Domestic credit 11.3 -8.1 13.4 23.6 -3.6 -11.4 8.2
Yield on government bills 5/ 13.4 16.4 10.6 10.7 6.9 3.8 2.77
Yield on government bonds 5/ 6.5 7.4 6.5 6.3 5.0 3.7 2.87
Reference bank lending rate 6/ 20.2 27.4 17.6 18.7 16.7 14.4 12.96
Spread of benchmark bonds (basis points, end of period)
Stock market index (percent change, end of period)
IPSA 12.9 -22.6 43.1 -3.6 9.1 -15.5 48.48
IGPA -2.2 -25.0 43.8 -5.8 10.9 -7.0 46.16

Public finances (in percent of GDP)

Central government financial balance 1.8 0.4 -1.4 0.1 -0.3 -0.8 n.a.

- 22 -
General government financial balance 1.8 0.4 -1.4 0.1 -0.3 -0.8 n.a.

External sector (levels, unless otherwise indicated)

Billions of USD (end of period)
Trade balance -1.4 -2.0 2.4 2.1 2.1 2.5 2.9
Current account -3.7 -3.9 0.1 -0.8 -1.2 -0.6 -0.3
Foreign direct investment (net) 3.8 3.1 6.2 -0.3 3.0 1.1 n.a.
Portfolio investment (net) 1.6 -2.5 -3.2 0.6 0.0 -1.9 n.a.
Gross official reserves (billions of US$, end period) 18.3 16.3 14.9 15.1 14.4 15.4 n.a.
Reserve cover (months of imports) 7/ 9.4 8.6 9.3 8.3 8.1 8.9 n.a.
Reserve cover (short-term external debt) 8/ 2.3 2.1 2.1 1.5 1.4 1.3 1.2
Total external debt 29.0 32.6 34.8 37.2 38.5 41.0 43.3
of which: Public sector debt 5.5 5.8 6.0 6.0 6.1 7.5 9.3
of which: Banking sector debt 2.1 2.5 1.7 1.5 2.5 3.7 5.1
External interest payments to exports (in percent) 9/ 6.2 7.1 7.7 8.3 7.9 6.6 4.9

Sources: BCCh and National Statistics Institute (INE).

1/ GDP real change in percentage based on 1996 millions of USD.

2/ Gross domestic savings over GDP.
3/ According to definition of M1A.
4/ According to definition of M7.
5/ PDBC 90 days rate for bills, PRC-8 and BCU for bonds since September 2002. Central Bank bills and inflation indexed bonds are used since
the Government started to issue bonds in October 2003.
6/ Nominal TIP (average interest rate charged by commercial banks) 90-365 days rate.
7/ Imports of goods and services, excluding factor income.
8/ Exports of goods and services excluding factor income.
 Table 2. Chile: Financial System Structure, 1997-2003
Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Dec-03
Number Percent of Percent of Number Percent of Number Percent of Number Percent of Number Percent of Percent of Number Percent of Number Percent of
total assets GDP GDP GDP GDP total assets GDP GDP GDP

Banking System 32 54.9 86.1 32 89.4 30 96.7 29 97.7 28 51.8 99.6 26 98.4 26 95.6
Banks 29 53.4 83.7 29 87.0 29 95.6 28 96.8 27 51.5 99.0 25 98.0 26 95.6
Private 28 45.4 71.1 28 74.3 28 81.9 27 83.7 26 44.7 85.9 24 83.5 25 80.8
Domestic 11 33.9 53.1 11 50.6 9 36.9 9 38.5 9 20.6 39.5 10 39.6 12 41.8
Foreign 17 11.5 18.0 17 23.7 19 45.0 18 45.1 17 24.1 46.4 14 43.9 13 39.0
State-owned 1 8.1 12.6 1 12.8 1 13.7 1 13.2 1 6.8 13.2 1 14.4 1 14.8
Finance Companies 3 1.5 2.3 3 2.4 1 1.1 1 0.9 1 0.3 0.6 1 0.4 0 0.0

Institutional investors 212 38.1 59.7 218 59.2 227 72.6 261 76.6 281 42.5 81.7 303 87.4 312 93.1
Insurance companies 59 7.4 11.6 58 12.6 55 14.8 56 16.5 54 9.3 17.9 55 19.1 55 20.2
Life and Retirement 34 7.1 11.1 33 12.2 32 14.4 33 16.0 32 9.1 17.5 32 18.7 32 19.8
Nonlife 25 0.3 0.5 25 0.5 23 0.5 23 0.4 22 0.2 0.4 23 0.5 23 0.5
Pension funds 13 24.9 39.0 9 40.3 8 49.2 8 51.0 7 27.9 53.6 7 55.8 7 59.7
Foreign-owned 4 9.3 14.6 4 22.8 3 27.6 3 28.4 3 15.6 29.9 3 30.8 4 34.8
Domestically owned 9 15.6 24.5 5 17.5 5 21.6 5 22.6 4 12.3 23.7 4 24.9 3 24.9
Mutual funds 92 3.6 5.7 102 3.5 115 5.2 150 6.4 177 3.8 7.3 199 9.9 206 10.1
Money market 39 2.6 4.0 41 2.6 42 3.5 45 3.9 50 2.0 3.9 60 5.7 58 5.4

- 23 -
Others 53 1.0 1.6 61 0.9 73 1.7 105 2.4 127 1.8 3.4 139 4.3 149 4.8
Investment funds 25 1.0 1.6 27 1.6 28 1.9 29 1.9 30 1.0 2.0 31 2.0 35 2.2
Foreign capital investment funds 23 1.1 1.8 22 1.1 21 1.4 18 0.9 13 0.5 0.9 11 0.7 9 0.9

Other nonbank 166 7.0 11.0 160 9.4 160 11.7 157 14.6 158 5.7 11.0 154 11.2 79 12.6
Securities firms 9 1.5 2.3 10 1.7 8 3.0 8 1.6 8 0.7 1.4 7 1.6 7 2.1
Brokers 53 2.4 3.8 51 2.9 47 2.8 44 7.2 45 2.0 3.9 43 4.2 42 4.8
Mortgage funds 7 0.0 0.0 7 0.0 8 0.1 8 0.1 8 0.1 0.2 8 0.3 8 0.4
Mortgage securities administrators 18 0.2 0.3 10 0.3 17 0.3 14 0.2 15 0.2 0.3 15 0.4 17 0.5
Credit unions and cooperatives 1/ 78 0.2 0.3 81 0.3 79 0.4 78 0.5 77 0.3 0.5 76 0.6 79/34 0.7
CORFO 1 4.3 1 4.2 1 5.3 1 4.8 1 2.3 4.4 1 4.0 1 3.9
Factoring companies n.a. n.a. n.a. n.a. n.a. n.a. n.a. 3 0.1 3 0.1 0.1 3 0.2 3 0.2
Auto Finance Companies n.a. n.a. n.a. n.a. n.a. n.a. n.a. 1 0.1 1 0.1 0.1 1 0.1 1 0.2

Total Financial System 410 100.0 156.7 410 158.0 417 181.0 447 188.9 467 100.0 192.3 483 197.0 417 201.4

Sources:
1/ Data corresponds to financial cooperatives. Number "xx/yy": xx corresponds to active cooperatives; yy corresponds to cooperatives included in assests data.
 Table 3. Chile: National Balance Sheet 1/
Financial Assets/Liabilities by Sector as a % of GDP, Dec-2003 ( unless otherwise specified)

Households Firms Public External Banks AFPs Insurance Total

Sector Sector 3 Companies
Liabilities of ? Mutual Funds
Assets of ?

2
Households 0.0 0.0 0.0 6.9 19.2 67.8 1.1 0.0 94.9
4 2
Firms 0.0 0.0 0.0 39.8 18.5 0.0 0.4 0.0 58.7
Public sector 0 1.9 0.0 22.2 3.8 0.0 0.0 0.0 27.9
5
External Sector 3 0.0 107.7 10.5 0.0 6.6 0.0 0.0 0.0 124.8
2 2
Banks 19.6 40.1 11.5 2.7 0.0 0.1 0.1 0.1 74.2

- 24 -
AFPs 0.0 12.7 14.7 14.2 16.3 0.0 0.4 1.6 60.0
6 7
Insurance Companies 0.1 5.1 3.7 0.5 6.0 0.0 0.0 0.3 15.8
Mutual Funds 0.0 2.5 4.1 0.6 1.5 0.0 0.0 0.0 8.7

Total 19.7 170.0 44.6 86.9 71.8 67.8 2.1 2.0 465.0

Source: BCCh, SBIF, SAFP, SVS, IFS and staff calculations

1/
The totals do not necessarily correspond to total asset/liabilities of each sector, as some types of assets(eg. fixed assets)and capital are not included.
2/
as of end-Sept. 2003
3/
end-2002
4/
Assumes that all direct and portfolio investment is done by firms
5/
includes FDI, which accounts for 66 % of GDP
6/
Includes investments in AFP and insurance companies' equities as well. Separation is not possible.
7/
Includes both government and central bank securities; but majority of investments are in BCCh securities
 - 25 -

Table 4. Chile: Presence of Financial Conglomerates in Chilean Financial System (2003)

Insurance
As proportion (%) of each sector1/ Banking Securities Pensions 2/
(life and nonlife)
Belonging to a financial
98% 91% 40% 97%
conglomerate3/
Belonging to foreign financial
41% 47% 13% 80%
conglomerate
Belonging to domestic ‘pure’
34% 23% 9% 2%
financial conglomerate
Belonging to domestic conglomerate
23% 21% 18% 16%
with mixed activities 4/
Sources: SBIF, SVS, SAFP, and staff calculations.

1/ Percentages are based on bank assets (banking), securities turnover by stock brokerage companies/corredores
de bolsa (securities), direct premiums (insurance) and AFP assets under management (pensions) for 2003.
2/ AFP Habitat is assumed to be controlled by Citibank even though it is jointly owned with the Chilean
Chamber of Construction.
3/ Domestic and foreign groups that are only active in one Chilean financial sector are not considered financial
conglomerates.
4/ Only conglomerates with nonnegligible mixed activities are included.

Table 5. Chile: Firms’ Breakdown by Size, Sales, Exports, and Employment

Firms Companies Sales Export Employment

Number % US$ million % US$ million % ‘000 of people %
Micro 535,537 82 7,041 3 14 0 2,124 50
Small 96,842 15 19,920 9 176 1 845 20
Medium 13,597 2 18,632 9 527 3 539 13
Large & megas 6,469 1 164,393 78 17,477 96 713 17
Total 652,445 100% 209,985 100% 18,194 100% 4,221 100%
Source: Government of Chile.
Note: Data are for 2001, except exports (2000)
Definition:Mega firms are defined as those with annual sales net of VAT above UF600,000 (US$17.2 million);
large firms have sales between UF100,000 (US$2.8 million) and UF600,000; medium firms have
sales between UF25,000 (US$0.7 million) and UF100,000; small firms have sales between UF2,400
(US$68,688) and UF25,000 and micro firms have sales below UF2,400.
 - 26 -

Table 6a. Chile: BCCh Summary Balance Sheet, End 2003

(In billions of US dollars)

Liabilities Assets
Monetary base 3.0 International Reserves 18.0
Currency (2.0)
Bank Reserves (1.0)
BCCh debt 23.0 BCCh claims on government 5.0
Capital -3.0
Total 23.0 Total 23.0
Source: BCCh and staff calculations.

Table 6b. Chile: BCCh Structural Income Statement

(In millions of US dollars)

Revenues 90
Inflation tax on monetary base (3% inflation) 3 x 0.03 90
Expenditures 364
Carrying cost of NIR (140 basis points) 1/ 16 x 0.0014 224
Carrying cost of claims on government (190 basis points) 2/ 5 x 0.0019 95
Operating expenditures 50
Changes in real net worth: -274
Memorandum Item
Net losses as a fraction of GDP -274/73,000 -0.37
Source: BCCh and staff calculations.

1/
Calculated as Chile’s country risk (90 basis points as of Chile EMBIG’s spread of March 4, 2004)
plus a premium for currency risk and the duration mismatch between debt and international reserves
(50 basis points).
2/
Calculated as the country risk plus the excess average yield of international reserves during 2003
over the yield of BCCh’s claims on government during the same period (Libor plus 50 basis points).
 - 27 -

Table 7. Chile: Financial Soundness Indicators , 1997-2003

(In percent, unless otherwise indicated)
Dec-97 Dec-98 Dec-99 Dec-00 Dec-01 Dec-02 Sep-03
Banking Sector Indicators
Capital Adequacy 1/
Regulatory capital to risk-weighted assets2/ n.d. 12.5 13.5 13.3 12.7 14.0 14.5
Regulatory Tier I capital to risk-weighted assets3/ n.d. 11.0 10.6 10.5 9.9 11.1 11.5
Capital (net worth) to assets 7.38 7.5 7.8 7.5 7.2 7.2 7.5
Asset composition and quality
Consumer loans 10.40 9.19 8.44 7.94 7.69 8.47 9.14
Mortgage loans 14.20 15.16 16.58 16.69 16.59 17.32 18.26
Commercial loans 57.02 57.41 55.79 55.19 56.57 54.24 52.81
FX liabilities to total liabilities 9.5 10.6 10.9 10.4 12.2 15.5 16.6
Net open positions in FX to capital n.d. n.d. 11.7 4.3 3.6 4.3 0.5
NPLs to gross loans 4/ 1.2 1.6 1.8 1.9 1.8 2.0 2.0
Consumer 0.8 1.2 0.9 0.9 0.9 0.8 0.8
Mortgage 0.4 0.5 0.6 0.8 0.9 1.1 1.2
Commercial 1.6 1.9 2.2 2.4 2.1 2.4 2.4
NPLs net of provisions to capital 5.2 8.7 9.2 10.1 10.1 10.5 10.2
Large exposures to capital 5/ n.d. n.d. n.d. 1.8 1.8 1.3 1.3
Spread between highest and lowest interbank rates 6/ 4.8 4.5 2.1 2.4 0.5 0.1 0.0
Earnings and Profitability
ROA 7/ 1.0 0.9 0.7 1.0 1.3 1.1 1.3
ROE 7/ 13.7 11.5 9.4 12.7 17.7 14.4 16.4
Interest margin to gross income 80.7 75.4 75.0 75.4 75.8 80.1 61.4
Noninterest expenses to gross income 63.5 59.3 57.7 57.0 56.2 55.2 53.7
Personnel expenses to noninterest expenses 56.2 55.3 55.7 55.7 56.0 53.9 54.3
Trading and fee income to total income 6.6 6.7 6.4 5.0 4.4 5.5 6.0
Spread between reference loan and deposit rates 8/ 3.3 4.5 3.7 5.1 5.3 3.8 3.3

Dollarization
FX loans to total loans 14.2 13.5 13.9 13.7 15.8 14.8 13.7
FX deposits to total deposits 3.5 5.6 8.7 9.5 11.3 11.1 11.6

Liquidity
Liquid assets to total assets 16.6 15.2 17.7 16.9 17.2 18.7 16.9
Liquid assets to total short-term liabilities 18.3 17.8 20.5 20.0 20.6 22.0 20.2
Customer deposits to total (non-interbank) loans 72.7 75.2 81.3 80.6 78.9 80.8 77.6
Average bid-ask spread in the securities market 9/ 10.0 8.0 6.0 5.0

Household Sector Indicators

Rate of growth of financial assets n.a. n.a. 11.5 9.9 4.9 4.4 n.a.
Rate of growth of liabilities 10/ 30.7 19.5 7.6 4.1 7.5 3.4 10.5
Rate of growth of housing value 11/ 12/
Net financial assets to disposable income n.a. 82.8 96.2 101.6 104.1 102.9 n.a.
Debt servicing cost to disposable income 12/ 11.7 12.6 12.3 12.6 12.0 12.6 n.a.

Corporate sector indicators

Corporate debt to equity ratio 10/ 55.9 61.1 77.8 70.0 75.3 79.5 81.3
Growth rate of company liquidations -8.2 86.6 12.8 7.8 17.1 2.8 n.a.
EBITDA to interest expenses 2.4 1.7 1.1 1.1 1.3 1.5 n.a.
ROA 9.8 7.3 4.1 5.8 6.1 4.4 n.a.
ROE 6.3 4.6 2.3 3.4 3.5 2.4 n.a.
Insurance sector indicators -Life Insurance
Growth rate of gross premiums written (% change from last Yr) 11.3 -2.1 17.8 15.6 9.3 -8.2 n.a.
Life Surplus to Total Assets -0.54 -1.5 1.7 -0.6 0.5 0.2 n.a.
Investment income / Investment assets 96.16 96.7 96.8 96.6 95.6 96.5 n.a.

Insurance sector indicators - Non Life Insurance

Growth rate of gross premiums written (% change from last Yr) -3.76 -3.2 -3.5 6.8 21.8 24.8 n.a.
Combined ratio 99.78 98.1 101.0 105.9 97.9 90.4 n.a.
Investment income to investment assets 47.08 48.8 47.1 41.7 37.1 36.6 n.a.
Underwriting profit to net investment income 5.5 6.4 7.8 5.1 5.9 4.3 n.a.

Source:
1/ The indicators are calculated in consolidated terms for branches and subsidiaries abroad starting on June 2002.
1/ Or in other markets that are most relevant to bank liquidity, such as domestic foreign exchange markets.
2/ Regulatory capital is equivalent to equity.
3/ Tier 1 regulatory capital is the basic capital.
4/ Overdue loans are unpaid loans with more than 90 days since the due date. In the case of credit in quotas, the general rule is
to account for the quota only. The only exception is when the loan has an accelaration clause in the agreement. As of Oct.'03.
5/ Correspond to a commercial portfolio greater than 20,000 UF and 2% of the equity of the financial institution.
6/ One day non readjustable interbank rate.
7/ ROA and ROE are calculated using annualized terms of final utility. To annualize, they are divided by the numbers of months
and multiplied by twelve. The denominator of both corresponds to the oustanding balance of the month in question.
8/ Nomi9al 30-89 day rate.
9/ Corresponds to PRC-8, data for October 2003.
10/ As of June 2003 data.
11/ For Santiago only and according to the Cámara Chilena de la construcción. It corresponds to the annual growth of average
price (per square meter) at which new properties are offered (not the final price of the transaction).
12/ For January-September.
 - 28 -

Table 8. Chile: Corporate Sector Indicators

(end-2003)

Leverage Ratio 1.3

ICR (%) 145
ROE 6
Cost of Capital 10
Source: Fecus.

Table 9. Bond Issuance Fees

(end-2003)

US$ 100 mn Issue

Chile 3.2
Mexico 1.2
Brazil 2.3

Source: World Bank.

Table 10. Portfolio Composition of Pension Funds (%): Chile and Selected Countries

Cash and Bills and Assets/

Country Deposits Bonds Loans Shares Other Total Foreign GDP
Chile (2003) 15.0 45.6 0.0 37.8 1.6 100.0 23.8 59.9
Australia (2002) 7.7 19.8 3.9 59.8 8.9 100.0 19.1 67.4
Canada (2001) 0.4 40.7 2.9 49.6 6.4 100.0 21.4 48.2
Denmark (2001) 1.3 49.2 1.6 45.6 2.3 100.0 25.0 23.8
Ireland (2001) 2.8 21.4 0.0 65.6 10.2 100.0 67.8 44.7
Netherlands (2001) 1.5 34.7 8.8 49.5 5.4 100.0 65.0 105.1
Spain (2001) 16.0 50.9 0.6 21.0 11.5 100.0 34.3 6.8
Switzerland (2000) 7.3 31.2 12.0 33.9 15.6 100.0 25.0 121.1
United Kingdom (2001) 3.2 13.9 0.0 60.9 22.1 100.0 22.9 69.2
United States (1998) 3.6 20.9 1.6 61.6 12.2 100.0 11.0 72.0
Sources: SAFP, OECD, APRA, Irish Pension Fund Association, Danish Supervisor, Davis (1995 and 2001).
 - 29 -

Table 11. Chile: Issues Requiring Cross-Sector Supervisory Cooperation

ISSUE EXAMPLE(S)
Surveillance of macro- ‘Wiring’ of system (inter-sector linkages via common
financial issues instruments and markets)
‘Fire drill’ (contingency planning)
Crisis management
Resolution of conflicts of competence in event of failure of a
arrangements
More Systemic

Avoiding supervisory gaps
and overlaps
financial conglomerate
Responsibility for monitoring and disclosing activities in
securities and derivatives markets
‘Hybrid’ products

Monitoring of FCs Analysis of risk profile of FC

Competition within and Stimulating competition in AFP sector by (potentially) opening

across financial sectors it to other sectors
Consistency and integrity of valuation in different entities for
same financial instruments
Level playing field
Consistency of capital adequacy treatment for same instrument
in different sector entities

Table 12. Chile: Re-defining the Roles of Coordinating Bodies

Capital Markets Committee Committee of Superintendents

Financial policy (legislative changes) Policy implementation and regulation

Issues pertaining to better exercise of supervisory functions
Surveillance of macro-financial issues Definition and monitoring of risk profiles and activities of FCs
Monitoring connections across financial system / market developments
Systemic crisis management policy Modus operandi for crisis management and joint problems
 Figure 1. Financial Sector Size Across Countries Figure 2. Chile: Composition of Private Savings
25
160 Private Sector Savings (% of GDP)
End-2002, as % of GDP
140 20

120
15
100

80
10
60

40 5

20
0
0 1960 1963 1966 1969 1972 1975 1978 1981 1984 1987 1990 1993 1996 1999

United Kingdom
Brazil

Chile

Malaysia
Argentina

Hong Kong

Thailand

United States
Japan
Peru
Mexico

-5

-10
Bank credit to private sector Corporate sector savings Total household savings
Stock market capitalization Voluntary household savings Mandatory household savings
Amount outstanding of private sector domestic bonds -15
Sources: International Financial Statistics (IFS), IFC's Emerging Markets Data Base, World
Federation of Exchanges (FIBV), Bank of International Settlements (BIS), and The World Bank Sources: BCCh and staff estimates.

- 30 -
Figure 3. Gini Index, various countries Figure 4. GDP per capita, various countries
Gini Index
(Latest year available) 28000
US$, PPP basis
Brazil
23000

Chile
18000
Mexico

Thailand 13000

New Zealand
8000

Australia

3000
Korea
1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003

Brazil Australia Chile Korea Thailand Mexico New Zealand

0 10 20 30 40 50 60 70

Source: World Development Indicators.

Source: IFS.
 Figure 5. Savings and Investments, various countries Figure 6. Chile: Current Account Deficit
35 Current account deficit
Korea (percent of GDP) [Source: WEO]
33 Savings and Investment Korea 1

(Percent of GDP; Average 1990-2003)

Gross fixed capital formation

31 [Source: WEO] Thailand 0

29
-1
27

25 Chile -2

23
Australia -3
21
New Zealand Brazil
19 -4

Mexico
17
-5

15 Brazil Chile Mexico

10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 -6
1995 1996 1997 1998 1999 2000 2001 2002 2003
Source: WEO Gross domestic private savings
Source: IFS.

Figure 7. Chile: Corporate Lending by Banks Figure 8. Export Concentration Index, various countries

- 31 -
Corporate Lending by Banks
(average annual growth rate, 2001-03) Export concentration index
6.0
5.2 Brazil 1990 2001
5.0

4.0 Korea

3.0
Thailand
2.0
2001
Chile
1.0 0.6 1990

0.0 Mexico
Mega Large Medium Small Micro
-1.0
New Zealand
-1.3
-2.0 -1.7
-3.0 Australia
-2.9
-4.0 0 0.05 0.1 0.15 0.2 0.25 0.3 0.35 0.4 0.45
Source: SBIF.
Source: UNCTAD.
 Figure 9. EMBI Global Sovereign Spreads, various countries Figure 10. Chile: Local and International Corporate Bond Issues
EMBI GLOBAL SOVEREIGN SPREADS (Equivalent in Million US$)
Souce: Morgan Markets.

BRAZIL CHILE 3,000

MEXICO SOUTH KOREA
2,000 THAILAND COMPOSITE 2,750
2,500
2,250
1,500 2,000
1,750
1,500
1,000
1,250
1,000
750
500
500
250
0
1995 1996 1997 1998 1999 2000 2001 2002 2003
0
Dec-97 Jun-98 Dec-98 Jun-99 Dec-99 Jun-00 Dec-00 Jun-01 Dec-01 Jun-02 Dec-02 Jun-03 Dec-03
Source: World Bank. Local Int'l
Source: J.P. Morgan.

- 32 -
Figure 11. Chile: Differential between Domestic Lending Rates Figure 12. Chile: Indicators of Uncertainty
and US Prime Rate Forward bid-offer spreads (%) Net Forward Position of Banks
25
Differential between domestic lending rates and US prime rate (mn. CH$)
20 40,000
0.7
15 30,000 1998 1999

0.6 2001
10
20,000 1997

5
0.5 10,000
2000
0 2002
-
0.4
-5
-10,000
-10 0.3
-20,000
-15
Differential between domestic lending rate and US prime loan 0.2
rate (adj. for exchange rate) -30,000
-20
Average (pre- and post- Sept 98)
0.1
-25 -40,000
Nov-94

Apr-95

Nov-99

Apr-00
Jan-94

Sep-95

Oct-97

Jan-99

Sep-00

Oct-02
May-97

May-02
Aug-98

Aug-03
Jun-94

Feb-96

Dec-96

Mar-98

Jun-99

Feb-01

Dec-01

Mar-03
Jul-96

Jul-01

0.0 -50,000
1998 1999 2000 2001 2002

Sources: BCCh and staff estimates. Source: BCCh.

 Figure 13. Chile: Financial Integration Figure 14. Chile: Correlation of Stock Market Indices
12000 1800
(Assets and Liabilities/GDP) Stock market indices
[Corr. coeff. pre/post Sept98: 0.36/0.58] 1600
10000
1400

8000 1200

1000
6000
800

4000 600

400
2000
DowJones Ind. Ave. (INDU) Index - left axis 200
Chile IPSA Index (right axis)
Source: International Investment Position, IMF.
0 0
J a n - 0 0 Apr-91 Jul-92 O c t - 9 3 J a n - 9 5 Apr-96 Jul-97 O c t - 9 8 Jan-00 Apr-01 Jul-02 O c t - 0 3
Source: Datastream.

Figure 15. Chile: Volumes Traded in the Spot and NDF Markets Figure 16. Chile: Stress Test on Currency Risk in Corporates
(1996-2003, in US$ Millions)

- 33 -
450,000
Number of firms for which the interest coverage would fall below 1 in case of
400,000
an exchange rate movement
(out of 50 firms with the largest FX gap)
350,000

18 17
Volume (notional) US$ millions

300,000
16
250,000 14 13
Spot volumes
Derivatives 12
200,000
10
8
150,000 8
6 5
100,000
4 3
4
50,000 2
0
0
1996 1997 1998 1999 2000 2001 2002 2003
below -25% -10 to -25% -5 to -15% 0 to -5% 0 to 5% 5 to 15% 10 to 25% above 25%
Years

Source: BCCh. Note: Data at end-2003 covering the 50 firms with the largest FX gap. The X axis
displays the % depreciation; the Y axis shows the # of firms with ICR below 1 after
the exchange rate shock.

Sources: FECUs and staff estimates.

 Figure 17. Chile: Banking Sector Concentration Ratios Figure 18. Net Interest Revenue/Other Operating Income
(Commercial Banks, 2002) (various countries)
120 4.0
Net Interest Revenue/ Other Operating Income
3-firm ratio 3.5 (Commercial Banks, 2002)
100 5-firm ratio
3.0

80
2.5

2.0
60

1.5
40
1.0

20 0.5

0.0
0 Australia Thailand Korea New Zealand Mexico Brazil Chile
ile
ru
d

da

rea

zil
re

co

a
lia

tina
an

Pe

tes
Ch

ysi
ng

Bra
po

na

Ko
nd
exi

m
stra
ail

Ko

ala

Sta
gen
Ca
ala
ga

do
M

Au
Th

M
Ze
Sin

ng
ng

Ar

ited
Ho

Ki
w

Un
Ne

ited
Un
Source: Bankscope
Source: Bankscope

- 34 -
Figure 19. Chile: Main Characteristics of the Sample of Firms (2003) Figure: 20. Chile: Issuance Costs of Selected Instruments
Sample breakdown by size of cies Sample breakdown by sector Agriculture
57 22 23 7 Mining
Mega 32 Manufacturing
66 I s s u a n cIssuance
e c o s t bCost
r e a Breakdown
k d o w n i n in
C hChile
ile
51 Large Industry ( i s s u e (End
of US $ 1 0Issue
0 m i loflio n) Other
206 50
2002, US$100 million)
Utilities Stamp tax
Medium 19 3.5%
Construction Regulatory
65 Small 4 Commerce
3.0% Legal costs
Micro Real estate
Investment Banking
Social serv.
97 177 2.5%

Sample breakdown by Sample breakdown by 2.0%

access to listed equity access to capital markets Firms without
capital market
26 issues 1.5%
Non listed firms Firms with local
182 issues (bonds or 1.0%
Listed firms equity)
196 254
294 Firms with issues 0.5%
abroad (bonds or
equity)
0.0%
Domestic debt Domestic equity International debt

Source: FECUS and Staff Estimates.

Source: SVS and staff estimates.
Figure 21. Issuance Costs by Instruments, various countries Figure 22. Chile: Capacity to Absorb Provisioning Increases in Ins. Sector

Annuity provisions as a proportion of total insurance

Issuance costs by instruments, 120%
Equity over reported annuity provisions (in %)
Domestic debt
a regional comparison Domestic equity Current Capital
(US$ 100 million issue) Requirement
International debt 100%
through 'gearing
4.5% rule'
4.0% 80%

provisions
3.5%
60% With a 13% increase, only
3.0%
companies to the right of this
2.5% line would have positive capital
40%
2.0% unless they could realise Market
Value / Book Value hidden
1.5% 20% margins to move their position to
1.0% the right.
International debt
0.5% 0%
Domestic equity
0.0% 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 2 5
Domestic debt % % % % % % % % % % % % % % % % % % % % % % % % % %
Chile
Brazil
Mexico
Sources: SVS and staff estimates.
Sources: World Bank and staff estimates.

- 35 -
Figure 23. Chile: Corporate Debt Outstanding by Credit Rating Figure 24. Average Free Float Ratios for Emerging Equity Markets

Debt Outstanding by2003

Credit Rating (9/2003) 80
1600 100 70
1400 90 60
1200
80 50
70 40
1000 60
30
800 50
40 20
600
30 10
400
20 0

Colombia
200

Chile
India
China

Philippines
Poland

Thailand

Pakistan
Indonesia

Czech Republic
Peru

Malaysia

Egypt
Hungary

Venezuela

Morocco
Israel
Mexico

Turkey

Jordan
Russia
Korea

Brazil

Argentina
South Africa

10

Taiwan
0 0
C
A

B
A-
AAA

A+
AA

BB
AA-
AA+

BB+
BBB
BBB+

Debt Outstanding (bln pesos) Number of issues

Source: SVS. Source: World Bank.

 Figure 25. Chile: Daily Trading Volume Figure 26. Foreign Exchange Derivatives
Daily Trading Volume (various countries)
900
25.00
2001 1998 FOREIGN EXCHANGE DERIVATIVES
800
Various countries
700
Forward, Swap, Options - Volume/GDP
20.00

600
Millions of USD

500 15.00

400

2001
300 10.00

200 1998

100 5.00

0
Public Stocks Corporate Money market Mortgage Forex Repurchase
0.00
securities 1/ Bonds instruments 2/ bonds derivatives 3/ agreements
1/ includes central bank and treasury paper (99.9% CB paper) (gross) 4/

ile

a
ea

ru
ry

il
l
nd

a
ico

ae

di

as

bi
Ch

Pe
or

ga

Isr

In
la

ex
2/ commercial paper, fixed term deposits etc.

Br

lom
K

un
ai

M
On-Exchange OTC

Th
3/ non-deliverable forwards (NDFs)

Co
H
4/ includes only repos between banks and the Central Bank

Source: World Bank. Source: World Bank.

- 36 -
Figure 27. One Month Forward Bid-offer Spread
(March 2004, %)
Various countries
1 Month Forward bid-offer spread (%)
0.25

0.2

0.15

0.1

0.05

0
Thailand Brasil Korea Chile Mexico New Australia
Zealand

Source: World Bank.

 - 37 -

Figure 28. Chile: Stylized Structure of Domestic Mixed-Activity Conglomerate

Ultimate Owner

Direction of equity investment

Responsibility for regulatory oversight Investment Vehicle

(can be one or several)
XYZ

SVS (only if
registered with it) Various non-financial
All companies below sector companies
can come under the bank Holding Company (directly or via
or directly under the (can be one or several) intermediate
holding company; investment vehicles)
leasing and factoring
operations can also
be part of the bank SBIF SAFP
itself (no subsidiaries Life Insurance P&C Insurance
needed); most companies Bank (BHC) AFP
Company Company
(e.g. mutual funds, brokerage)
can also be owned by an
insurance company

Leasing Factoring Securitization Insurance Securities Mutual Funds

Company Company Company Brokerage Brokerage Management

SBIF (only if part of BHC) SVS

 - 38 -

APPENDICES
 - 39 -

APPENDIX I

List of Acronyms

AFPs Administrators of Mandatory Pension Funds

(Administradoras de Fondos de Pensiones)
AML/CFT Anti-Money Laundering / Combating the Financing of
Terrorism
BCCh Central Bank of Chile (Banco Central de Chile)
BCP Basel Core Principles of Effective Banking Supervision
Bolsa de Comercio de Santiago Santiago Stock Exchange
CAR Capital Adequacy Ratio (Regulatory Capital to Risk-
Weighted Assets)
CMII Draft Capital Markets II Reform Law
CP Core Principle
DCV Centralized Securities Depository(Depósito Central de
Valores)
FCs Financial conglomerates
FECUs Uniformly Codified Statistical Form
FIRST Initiative Financial Sector Reform and Strengthening Initiative
FIU Financial Intelligence Unit
IAS International Accounting Standards
IFRS International Financial Reporting Standards
IT Information technology
MoF Ministry of Finance
NBFIs Nonbank financial institutions
NDFs Nondeliverable forwards
NPLs Nonperforming loans
ROE Return on equity
SAFP Superintendency of Pension Fund Administrators
(Superintendencia de Administradoras de Fondos de
Pensiones
SBIF Superintendence of Banks and Financial Institutions
Insurance (Superintendencia de Bancos e Instituciones
Financieras)
SMEs Small and medium enterprises
SROs Self-regulatory organizations
SVS Superintendency of Securities and Insurance
(Superintendencia de Valores y Seguros)
UF Unidad de Fomento, a unit of account linked to the CPI.
 - 40 -

APPENDIX II

Summary of FSAP Recommendations

Short- Medium-
In CMII
Term Term
A. Central Bank
Strengthen BCCh’s financial accounts. X
B. Commercial Banks
Further develop risk-based supervisory approach. X X
Clarify SBIF’s powers as regards licenses and expand ‘fit and proper’
X
tests.
Impose capital requirements for market risk. X X
Improve disclosure of risk exposure & management practices by banks. X
Strengthen bank resolution regime. X
C. Corporate Sector
Reform legislation for movable collateral. X Yes
Create national register of pledges. X Yes
Improve quality of SME financial statements. X
Eliminate ‘tasa máxima convencional’or introduce more flexibility. X
D. Insurance
Upgrade provisioning requirements and strengthen supervision. X
Strengthen insurance company failure resolution framework. X Partially
Shift emphasis from rules management to risk management. X X
E. AFPs
Judiciously relax investment regime. X
Move from compliance-based to risk-based supervision. X X
Encourage outsourcing and regulate service providers. X
Enhance attractiveness of voluntary system. X Partially
Develop contingent strategy to enhance competition. X
Reduce risks faced by workers at retirement. X
F. Securities Markets
Embed concepts of finality, netting, and novation in the law. X Partially
Promote industry-financed fund for multilateral netting. X X
Organize securities lending and borrowing. X
Establish price reporting for OTC trades and harmonize securities
X
valuation.
Introduce international standard contract for repos and derivatives. X
Enhance standardization of financial instruments. X
Suitably formalize market-makers for public debt. X
Increase SVS’s budgetary and staff resources. X
Introduce minimum standards for securities industry. X
 - 41 -

Require internal compliance programs by brokerage firms. X

Widen SVS enforcement powers. X Partially
Give SVS power to appoint a conservator or liquidator for brokerage
X
firms.
Implement risk based supervision. X X
G. Taxation, Financial Reporting Standards, Corporate Governance
Review financial sector taxation. X X Partially
Strengthen financial reporting regime for listed companies. X
Enhance corporate governance, including training of directors and judges. X
H. Hedges
Correct deficiencies in information and market infrastructure. X X
Relax restrictions on short selling, writing and trading. X
I. Other Financing Vehicles
Support development of “bridging” vehicles. X Partially
J. Cross-Sectoral Financial Oversight
Embed Committee of Superintendents in the law. X Yes
Establish MOUs and technical secretariat for coordinating committees. X
Introduce regular staff exchanges. X
Introduce fully consolidated supervision and relax firewalls. X
Resolve conflicts of competence and draw contingency plans for failure of
X X
financial conglomerates.
Strengthen the information system. X
Clarify and strengthen legal protection of supervisors. X
Allow supervisors control over budget with appropriate accountability. X
Disconnect timing of Superintendents’ appointments from political cycle. X
K. Anti-Money Laundering
Strengthen capacity to monitor compliance. X
Enhance monitoring of securities, insurance, and FX operators. X
Improve mutual assistance and international cooperation in freezing assets. X
 - 42 -

APPENDIX III

Chilean Banks’ Risk Management and Disclosure Practices

The assessment of banks’ risk management practices is based on a survey prepared by the
FSAP mission (twenty out of the twenty six authorized banks responded). As regards credit
risk management, Chilean banks are still mostly on the learning curve. Only foreign
subsidiaries and branches use models to classify corporate loans, less than a third of the
banks stress test their corporate loan portfolio, and only a third estimate unexpected losses.
Most banks classify consumer loans as category A (the highest credit ranking) at inception
and few banks use credit scoring models and control for negative information on the client.

As regards market risk management, there are considerable differences across banks. While
almost all large banks (as well as the subsidiaries and branches of foreign banks) use VAR
models, only 40 percent of the small and medium domestic banks do; among those that do,
only half consider risk correlations. The average time length of the historical data used by
small domestic banks is only half a year, and back testing is rare. Given the relatively
simplicity of the products offered and held by Chilean banks, Monte Carlo simulations are
the exception. However, more sophisticated modeling will be needed if the use of structured
products and options intensifies.

The SBIF’s disclosure requirements regarding banks’ capital structure and adequacy, as well
as accounting policies and geographical portfolio diversification, compare favorably with
best international practice, as reported by the BIS. However, differences in definitions hinder
international comparisons of asset quality (NPLs and provisions) as Chilean norms require
that only the past-due portion of a delinquent loan (rather than the entire balance and accrued
interest) be classified as past-due. While the SBIF also discloses a bank risk index, the latter
does not fully reflect credit exposure since information on collateral and loan guarantees is
not included.

Mandatory disclosure of risks exposures and risk management techniques is not required, and
disclosure is uneven, particularly as regards derivatives and securitization. Among the largest
five banks, the three that are listed in the NYSE disclose all the necessary information on risk
exposure in the US, but only two of them do it in Chile. Information on income by business
line is generally lacking. Only one of the large banks discusses its risk management practices
in Chile (two more do it in the US).
 - 43 -

APPENDIX IV

The Chilean “Narrow Bank” Safety Net

Sight deposits (and term deposits of less than 30 days or whose term to maturity is less than
10 days) are fully guaranteed by the BCCh which protects itself from potential losses by
requiring that banks hold liquid assets (in the form of central bank debt) against sight
deposits in excess of 2.5 times their capital. In addition, if the guarantee were triggered, the
BCCh would become the most senior claimant on the bank’s assets.

When a bank is unable to meet its commitments (including as regards its liquid asset
requirement) or severe solvency or managerial shortfalls emerge (as defined in the banking
law), the bank’s non-sight liabilities are frozen while sight deposits remain fully accessible;
they are “decoup led” from the rest of the bank together with the corresponding liquid assets
plus the BCCh guarantee. This protects the payments system, mitigates the contagion risk of
a bank closure, and provides breathing room for an efficient resolution of the non-narrow
part of the bank.

The risk of an unwarranted last minute expansion of the guarantee is limited by a five-day
advance notice required by banks for transferring term deposits into sight deposits. The bank
resolution system is conditioned to (and shaped by) a creditor agreement ratified by the
majority (in terms of claims) of the bank’s non-sight creditors (and the SBIF). When an
agreement cannot be reached, outright liquidation on the entire non-narrow bank is the only
possible outcome.
 - 44 -

APPENDIX V

The Inverlink Episode

Founded in the early 1990’s, Inverlink grew rapidly from a stock brokerage firm into a full-
fledged conglomerate with pension fund, life insurance, and nonfinancial concerns. After
being accused of share price manipulation in 2001, the group was encouraged by the SBIF to
retract its banking license application, while the Central Bank refused it authorization to deal
on the foreign exchange market.

At the beginning of February 2003, Inverlink’s brokerage arm was revealed to have been
buying market-sensitive information from the personal secretary of the Central Bank
president. Faced with a run on its mutual funds caused by these accusations, the group
resorted to selling paper-based CDs from CORFO that it illegally held and had been using as
collateral for short-term trading for years. It also borrowed substantially from its insurance
subsidiary, resulting in the latter’s subsequent insolvency and collapse.

CORFO’s reporting of the theft in March (by that time, the CDs had changed hands and were
held mostly by local mutual funds) triggered a dispute as to their ownership (the holders
maintained they had acquired the CDs in good faith). Over the next three days, the mutual
fund industry lost over US$1.5 billion (around 27 percent of its assets) as nervous investors
unloaded positions; this led to knock-on effects on the prices of other secondary market
securities.

Faced with a paralyzed market and mounting fears of a broader liquidity run, the government
lifted the stop payment on the CDs until the courts determined their legal ownership, a
process that is still on-going. In addition, it reached an agreement with SVS and the banks
(owners of most mutual funds) so that the latter would guarantee the immediate repayment of
the stolen instruments and would take any court- mandated loss. This stabilized the financial
markets.

The scandal led to the resignation of the CORFO Executive Vice President, Central Bank
President, and SVS Superintendent, as well as to the arrest and trial of Inverlink senior
management. It was Chile’s first (albeit limited) market confidence crisis since the early
1980’s, raising serious questions about cross-sector contagion, inadequacies in market
infrastructure, insufficient internal controls, and ineffective surveillance.