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Chile survived the global financial crisis better than many countries with no major banking failures and a swift recovery in markets. It helped that Chile had no mortgage-backed securities or subprime mortgages, which were the downfall of the US financial markets, but the main reason for the escape was the solid management by the authorities during the crisis combined with a well-capitalized banking system.

The stability of Chile’s banking sector is thanks, in large part, to the privatization of the country’s pension system 30 years ago - pension fund managers, or AFPs, today manage around US$157 billion in assets, or almost 70 percent of Chile’s GDP – as well as a solid regulatory model developed after a banking crisis in the early 1980s.

But as governments around the world including in the United States and Britain look to improve financial oversight and safeguard their economies against future banking meltdowns, Chile has also taken the opportunity to strengthen the supervision of its financial system.

In August 2010, Finance Minister Felipe Larraín created a commission headed by Jorge Desormeaux, a banking industry consultant and former vice-president of the Central Bank, to evaluate the country’s financial supervision and regulatory framework.

The commission’s report, submitted to the Finance Ministry in March, recommends a series of reforms. “The truth is that if we don’t upgrade our financial regulations, the next financial crisis will find us unprepared,” Desormeaux told bUSiness CHILE.

The report states that Chile’s regulators are unable to effectively supervise the operations of conglomerates, which makes the financial system vulnerable to future crises or shocks, such as a sudden drop in the copper price.

Even before the crisis, in 2004, the IMF’s Financial Services Assessment Program (FSAP) recommended consolidating oversight of Chile’s financial system to better adapt to “meet the needs of an increasingly integrated and complex financial system.”

Financial services in Chile are currently regulated by different institutions according to the type of service. The Superintendencia de Bancos e Instituciones Financieras (SBIF) and the Central Bank are in charge of banking, the Superintendencia de Valores y Seguros (SV) is in charge of securities and insurance, and the Superintendencia de Pensiones (SP) supervises the pension system and unemployment insurance.

This means conglomerates including banks, insurance firms and pension fund administrators could, in theory, develop high risk activities in areas where regulations are weakest. This situation also contributed to the collapse of the US banking system, as risky derivatives trading was concentrated in the insurance industry.

The danger was noted by the Organisation for Economic Co-operation and Development (OECD) in its 2011 Chile report Maintaining Momentum: “The undetected build-up of risks in parts of a group can reach levels at which the stability of important financial institutions may be endangered.”

Financial oversight

The commission’s proposal to strengthen financial supervision is based on a Twin Peaks model that divides regulatory functions between one regulator, focused on market conduct and consumer protection, and another focused on the solvency and risk-management practices of financial institutions.

Desormeaux insists that this model, which has been adopted by Australia and the Netherlands, is the best way to regulate conglomerates in Chile.

“The crisis showed that it’s not good enough to keep an eye on the individual trees, you have to see the forest as a whole,” he said.

The new market conduct regulator would also provide better protection for consumers, which is important given that the credit practices of some institutions and non-bank credit card issuers have recently called consumer protection standards into doubt, said Desormeaux.

This regulator would also have more independence than the government’s proposed consumer financial watchdog, known as the Sernac Financiero, which would have a president appointed by the Finance Minister, he added.

The twin regulators, and a third entity in charge of pensions, would be overseen by a Financial Stability Council (CEF by its Spanish initials) designed to spot potential problems in the system, mitigate risks and recommend policies that contribute to macroeconomic stability.

The Council will serve a similar role to the US Financial Stability Oversight Council created by the Dodd–Frank Act in 2010, which is designed to coordinate between regulators and ensure the overall stability of the financial system.

Headed by the Finance Minister, the Council will include the president of the Central Bank and the heads of the three new regulators. One difference with the Oversight Council is that it will have five members as opposed to ten, which Desormeaux said will allow it to respond more quickly to future crises in coordination with the Central Bank.

Minister Larraín announced in April that this Council will be created as the first stage of the reform: “The functions of this type of council are, in part, to prevent crises by flashing warning lights that allow actions to be taken before a crisis occurs, and if one does occur, which we can’t prevent, to try to mitigate its impact on the economy,” he said in a press conference.

The second stage of the reform will be to strengthen Chile’s existing regulators by adopting the commission’s proposals regarding corporate governance.

Corporate governance

Another potential weakness of Chile’s financial system is that the regulators are all led by individuals appointed by the President who, crucially, may also remove them at any time without giving a reason.

In reality, this does not happen often. The current heads of the SVS, SBIF, and SP have all remained in their jobs since being appointed in March 2010.

“The data from the last 30 years shows that the Superintendencias have been led by highly qualified professionals who, on average, have remained in their position for a long period of time,” said Jorge Awad, the new president of Chile’s banking association, ABIF.

But the system is still vulnerable. “It doesn’t offer guarantees of objectivity to those entities subject to regulations and penalties,” said Desormeaux.

Another negative consequence of the regulators’ perceived lack of independence is that they have not been given the power to reform market regulations. Instead, they must wait for Congress to approve new laws, which means they are slow to react to new developments in capital markets.

Given the speed of change in the financial system, this could be lethal, said Desormeaux. “But no one will give lawmaking powers to regulators that are not independent.”

To solve this problem the new regulators would each be led by a board of five directors nominated by the President and approved by a Senate majority. In addition, they could only be removed by unanimous decision of the other directors or by a Supreme Court ruling.

The government plans to submit a bill to Congress in the next few months that will include changes to the corporate governance of Chile’s financial regulators.

Mario Farren, head of corporate and investment banking at Banco de Chile, welcomes the commission’s proposal to make regulators more independent.

A new regulator in charge of supervising credit-issuing entities, including retail stores, would also help the authorities to act more swiftly if problems arise, said Farren.

The recent announcement by Chilean department store chain La Polar of increased loss provisions due to dodgy lending practices is an example of the problems that can occur when retail companies use different credit criteria than the banking sector, he noted.

But, despite the commission’s good intentions, Farren argued that the reforms do not address the underlying need for a modernization of Chile’s capital markets regulation.

Modernizing capital markets

Efforts by successive governments have made Chile more integrated with global capital markets, but local banks still face barriers to raising capital abroad.

The stamp and withholding taxes on offshore bond issues, for example, increases costs for Chilean banks by 30 to 50 basis points, said Farren.

“It’s not cost efficient, but if the playing field was level and banks could fund themselves abroad, it would make the market more competitive,” he said.

And it’s not just about reducing taxes. “Netting” – whereby banks and financial institutions that loan to each other only pay their net debt – is common practice in developed countries but does not occur in Chile.

“As a result, when a foreign bank deals with a Chilean bank they use a much bigger credit line,” said Farren.

Stricter regulations increase fixed costs for banks, which hurts entrepreneurs and investors while also making it harder for small institutions to compete, but the authorities have resisted deregulating capital markets due to concerns about tax evasion and further appreciation of the peso, said Farren.

The Bicentennial Capital Markets Reform Agenda (MKB) aims to improve access to credit for individuals and businesses, but it also includes a proposal to regulate derivatives and the adoption of best practices on competition, supervision and transparency.

But closer supervision does not have to be an impediment to economic growth and consolidating financial oversight should make Chile better prepared for future crises. When it comes to fixing what ails the financial system, an ounce of prevention is better than a pound of cure.

Julian Dowling is editor of bUSiness CHILE