FOR OFFICIAL USE ONLY

FINANCIAL SECTOR ASSESSMENT CHILE AUGUST 2004

THE WORLD BANK LATIN AMERICA & THE CARIBBEAN REGION VICE PRESIDENCY FINANCIAL SECTOR VICE PRESIDENCY

BASED ON THE JOINT IMF-WORLD BANK FSAP REPORT

1. This Financial Sector Assessment (FSA) summarizes the F S A P report for Chile, with emphasis on structural and developmental issues. The FSAP included two visits to Santiago, Chile, in December 2003 and March 2004.' I t s findings and recommendations were thoroughly discussed with the authorities in a wrap-up session at the end o f the second mission and also during the IMF Article N mission in May 2004. The diagnosis and assessment of the FSAP, and hence of this FSA, are based on information as o f end-March 2004. Following lhe FSAP, the Chilean authorities requested Technical Assistance from the Wor ld Bank, which i s expected to be funded in large part with resources from the FIRST Initiative. A l i s t o f the acronyms used throughout this FSA i s provided in Appendix I.

I. OVERALL ASSESSMENT

2. pension system in the early 198Os, mandatory pension funds (AFPs) have grown at a particularly remarkable rate, pulling in their wake most o f the financial system, including banks (that have benefited f rom large deposits by AFPs), the l i f e insurance sector (mainly through annuities), the mortgage industry, and, more recently, commercial paper and corporate bonds. Together, AFF's 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 long bond maturities, large corporate external liabilities, and large private assets abroad. The equity market i s also large by Lat in American standards, yet illiquid, perhaps reflecting (at least in part) a concentrated distribution of wealth and income.

Chile's financial system i s large and well diversified. Following the reform o f the

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 M a i n Ize (IMF) and August0 de la Torre (World Bank) and included Marie-Thtrtse Camilleri, Eva Gutierrez, and Meral Karasulu (all IMF); Ernest0 Aguirre, Thomas Glaessner, Roberto Rocha, Sophie Sirtaine, Constantinos Stephanou, and Craig Thorburn (all World Bank); Juan Ort iz (Bank o f Spain), Brian Quinn (formerly Bank o f England), hit Mendelson (Bank of Israel), Marc Bayle (European Central Bank), and Jonathan Katz (US. SEC).

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

The financial system was found to be sound, overall, and resilient to shocks. The

4. policy environment and rising international financial integration. Notwithstanding a substantial diversification during the last decade, export concentration remains high and fluctuations in copper prices may continue to have a significant impact on economic activity. At the same time, despite Chile’s l ow and fairly stable sovereign spread, a repeat o f the late 1990s capital account shocks cannot be ruled out in view o f Chile’s l ikely continued dependence on foreign savings. Yet, the likelihood of a repeat o f those events i s much lower in the current policy environment o f full fledged inflation targeting. Chile’s exposure to currency attacks i s also l ikely to decline as i t becomes better hedged and financially more integrated with the rest o f the world. However, to ensure the BCCh’s capacity to manage an effective monetary policy under a broad range of macroeconomic conditions, i t s financial accounts need strengthening.

5. generate the productivity growth needed to support a new phase o f rapid output growth, the financial system w i l l need to further improve i t s efficiency in the sound allocation of resources. This wil l 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 o f an increasingly integrated and complex financial system. These areas o f 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 A F P s , combined with strict investment restrictions, exacerbates the lack of market liquidity. The reform agenda should therefore address all three areas simultaneously.

Chile’s exposure to sudden stops in capital flows i s diminished under the current

The challenges faced by the financial system are mainly developmental. To help

6. allocation of investable funds. The concentration of funding in six AFPs, coupled with a s t i l l insufficient range o f 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 A F p s and smaller f i r m s 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 i s growing but remains marginal. Reforms in the pensions sector can help in this regard. There i s room for a judicious relaxation o f the overly complex and rigid investment regime without undermining A F P s ’ fiduciary function. The authorities should intensify the current efforts at gradually enhancing competition in the pension fund industry.

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

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They should also prepare a contingent, more radical reform strategy geared at unbundling services subject to economies o f scale from services where price competition can thrive.

7. The modernization of securities markets infrastructure i s necessary to enhance liquidity. Secondary market liquidity lags that in comparable countries, particularly in equity and corporate debt markets. Liquidity i s limited by structural factors (including high concentration o f ownership and the relatively small size o f 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 o f multilateral netting arrangements established, OTC price reporting and disclosure enhanced, valuation methods improved, contracts and instruments standardized, and the system o f market makers suitably formalized. A review o f financial sector taxation i s also needed, as well as a program to adopt international financial reporting standards for listed corporations after a well-designed transition period.

8. efficiency and risk management. The segregation o f supervisory responsibility by type o f entity among three agencies has functioned well so far. Problems that could have arisen from the co-existence o f institution-oriented supervision and the dominance o f financial conglomerates have been kept at bay by regulatory limits and firewalls, high profitability, and the strong presence o f foreign banks supervised by their home-country regulators. However, as competition intensifies and boundaries between financial sectors blur, the pitfalls o f 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 h l l y consolidated supervision o f 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 b y 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 o f the financial and legal autonomy o f the supervisory agencies.

Reforms to the silo-based financial system oversight are required to enhance

9. The main FSAP recommendations are summarized in Appendix 11. Some o f the recommendations are addressed, totally or partially, in the proposed Capital Markets Reform I1 Law (CMII), under Congressional discussion at the time o f 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 o f a recommendation as “medium term” i s often because it would require legal changes. I t does not necessarily imply less urgency.

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11. FINANCIAL STRUCTURE AND MACROECONOMIC ENVIRONMENT

A. Overview of the Financial System

10. with the rest of the world. I t showed remarkable growth throughout the last two decades and i s now the largest (in assets to GDP) and among the deepest in the region. (Figure 1 and Tables 1 and 2). The core o f the system are the banking sector and the mandatory, privately- administered, pension system. The latter i s one o f 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 i s moderate in size and mostly concentrated in instruments issued by the BCCh. Other remarkable features o f Chile’s financial system include relatively long (and lengthening) bond and mortgage maturities (mostly a result o f the widespread use o f instruments denominated in UFs), very large external liabilities (mostly o f the corporate sector, in the form o f 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 o f their portfolio.

The Chilean financial sector i s large, well diversified, and increasingly integrated

11. private pension funds. At end-2003, pension fbnd assets reached 60 percent o f GDP, or roughly one third o f total assets o f domestic financial institutions, and are projected to increase to 80 percent o f GDP in the next decade before tapering o f f as the system matures. The large size o f Chile’s pension sector i s the result o f an innovative reform initiated in 198 1, that involved the switch from a public pay-as-you-go system o f predefined benefits to a defined-contribution system o f 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 l ife insurance companies, whose growth i s mainly derived from that o f the pension funds, AFPs hold a substantial fraction o f 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 o f household savings i s channeled into the compulsory (Pillar 11) component o f the pension system. Household savings excluding mandatory pension contributions are small and corporate savings account for a large part o f private savings, which helps explain the very limited retail investors base (Figure 2).

The development of the financial system has been closely linked to the growth of

12. conglomeration. With the exception o f insurance, a small number o f institutions dominate the financial sector. The three largest banks account for 55 percent o f bank assets, while the three largest AFPs manage 70 percent o f pension hnd assets. Moreover, a majority o f financial institutions i s controlled by a handful o f financial conglomerates with significant

The financial (and real) sectors are characterized by high concentration and

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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 o f ownership in the real sector, where the large nonfinancial conglomerates account for a disproportionately large fraction o f economic activity and absorb most o f the available financing.2 In turn, this high concentration, which has adverse implications for liquidity in securities markets, in part reflects a high concentration o f income and wealth (Figure 3).

B. Macroeconomic Environment

13. 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 o f per capita income. Chile’s growth rate was twice that o f the large Latin American economies, and compared favorably, at least until 1998, to that o f 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 o f prudent fiscal management (consolidated into a structural fiscal balance target rule in 2000), and a comprehensive and far reaching program o f structural reforms. In the financial area, in addition to the already cited pension reform, other initiatives included: (i) the consistent promotion o f price-indexed financial instruments (which, together with the build up o f monetary policy credibility, resulted in a low level o f dol lar i~at ion~); (ii) the introduction o f comprehensive capital market reforms (the 2001 Capital Markets I law, followed by the draft C M I I 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 o f reliability and security in the rule o f law and property right^.^

Chile’s strong macroeconomic performance and financial development were

14. regional financial turmoil during the late 1990s. Chile’s rapid output growth o f 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 o f the late 1990s. While Chile weathered the storm much better than most o f 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 o f 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 o f copper prices, and a supportive monetary

Despite i t s sound macroeconomic framework, Chile was not immune to the

One percent o f f i rms account for 78 percent o f sales by enterprises and absorb 79 percent o f domestic bank

At end-2003 foreign currency deposits and loans accounted for 10 and 14 percent o f total banking sector

Chile was ranked in the gth decile, together with Hong Kong and the U.S., in the 2000/2001 index o f the “rule

financing and virtually all financing through the capital market (Table 5).

assets, respectively.

o f law” (Kaufinann et al., 2002).

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policy (growth i s expected to reach around 5 percent in 2004). The recovery in confidence has led to a strong recovery o f private consumption and buoyant growth o f credit to households while corporate borrowing and gross capital formation remain weak.

111. MACRO-FINANCIAL STABILITY ANALYSIS

15. substantial diversification during the last decade, export concentration remains high, with copper accounting for 36 percent o f total exports in the last four years (Figure 8). While the Copper Stabilization Fund (CSF)’ and the recently introduced structural fiscal balance rule should help mitigate the fiscal impact o f terms o f 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 volatility and potential banking system vulnerabilities. Stress tests conducted by the FSAP team indicate that while a 10 percent adverse terms o f trade shock would have only a marginal impact on banks’ solvency, i t could nonetheless result in some liquidity tensions if it leads AFPs to abruptly reallocate their deposits across banks.

Chile remains somewhat vulnerable to real external shocks. Notwithstanding a

16. Chile’s exposure to sudden stops in capital flows cannot be totally dismissed but it i s much diminished in the current monetary policy environment. Notwithstanding i t s record o f low and fairly stable sovereign spread (Figure 9), a repeat o f the late 1990s sudden stop in capital flows cannot be totally ruled out because Chile is l ikely to continue depending on foreign savings. The severity o f 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 o f the capital account and the elimination o f the foreign exchange band, rather than a loss o f access to international capital markets (Figure 1 O).6 The new policy environment o f full-fledged inflation targeting, together with the strong fiscal rule, i s more resilient to that type o f shocks. It should limit the risk o f sharp policy discontinuities while enhancing the scope for countercyclical p ~ l i c i e s . ~

17. further increase the resilience of the system to sudden stops. Chile’s financial integration with the rest o f the world i s high compared to most emerging economies (Figure 13). It expanded rapidly in recent years, reflecting in part the strong increase in AFPs’ foreign

The high and increasing financial integration with the rest o f the world should

The CSF (established in 1985) receives transfers fiom the state-owned copper company (CODELCO) when copper prices are high. Funds can be withdrawn by the government when prices decline.

There was a shift in relative costs in favor o f the peso, fol lowing the liberalization o f 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 o f 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 o f dollar rates (the variance o f the exchange rate increased three-fold after it was allowed to float freely). The increase in exchange rate uncertainty during 1997-1999 i s apparent in the increased bid-ask spreads and the surge in demand for currency hedges by dollar-indebted bank customers (Figure 12).

The assessment o f the Code of Good Practices of Transparency in Monetary Policy conducted under the FSAP revealed a very high degree o f observance.

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assets. The 1998 liberalization o f the capital account has also promoted financial integration, illustrated by the recent increase in the comovements o f returns between the local and international equity markets (Figure 14). The rapid expansion o f the market for foreign exchange rate hedges (see below), facilitated by the expanding supply o f hedges b y AFPs, should also contribute to the overall stability and resilience o f the currency market.

18. 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 (ie., through credit risk) was found to be moderate.8 The increased hedging o f large corporates against currency risk (it i s estimated that over 40 percent of the corporate dollar debt currently hedged) has contributed to limit their exposure. More generally, the floating exchange rate has encouraged better risk management and led to a pronounced increase in foreign exchange forwards (Figure 15).

Notwithstanding the high foreign corporate debt, the exposure of corporations

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 o f i t s debt-funded foreign and domestic assets (Tables 6a and 6b). The BCCh’s weak financial accounts could constrain i t s policies (e.g., increasing international reserves, and reducing or remunerating required bank reserves). While the BCCh’s profitability could be improved by downsizing i ts balance sheet (in particular, the carrying cost o f claims on the government will disappear once this debt i s repaid), the scope for doing so i s limited in view o f the need to maintain minimum levels o f international reserves and domestic public debt.’ Addressing this issue will require recapitalizing the BCCh and preferably transferring at least some o f i t s debt to the government.

rv. BANKING

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

2 1. 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

Chilean banks are sound, profitable, and their efficiency has been improving.

* Nearly 60 percent o f corporate debt i s denominated in US dollars. Out o f the 50 f i rms (accounting for 90 percent o f total US dollar debt and 64 percent o f corporate debt to domestic banks), 7 would incur debt servicing difficulties under a one-year real exchange rate depreciation o f 25 percent (Figure 16). As a result, one bank (with less than 1 percent o f banking assets) would experience a decline in its CAR below 8 percent. ’ A deep and liquid market for domestic public debt i s needed to sustain a reliable yield curve (required to adequately price private sector debt) and provide collateral for the payments system.

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the 199Os.l0 While asset quality deteriorated modestly as a consequence o f the 1998-2001 economic slowdown, profitability and capital remained high. Stress tests indicate that the banking system would only be moderately affected by fbrther shocks affecting market risk or credit risk. The operating efficiency o f Chilean banks i s good by regional standards." Banks' fee income appears low (albeit rising) as a ratio to net interest income when Chile i s compared with other countries (Figure 1 8).12

22. Competition and innovation have increased in the last few years as a result o f new entrants, rising participation o f foreign banks, and the development o f the local capital market. Competition i s intense at the higher end where the very large corporations generally have access to foreign credit and the local capital markets. I t 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 have difficulties in accessing alternative funding sources and benefiting from direct funding by institutional investors (see below). The dominating presence in the wholesale deposit market o f 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 wel l rated intermediaries (mainly the banking groups) can benefit from AFP funding. Banks face almost no competition in the credit markets from non-deposit taking finance institutions and, at least until recently, very limited competition from mutual fbnds.13 The scope for competition i s limited in some other areas, notably retail payment, partly reflecting the need (driven by scale economies) for large minimum volumes needed to compete.

Competition in the banking industry, while increasing, i s still limited.

23. Strong financial oversight underpins a robust banking system. Bank regulation i s shared between the BCCh and the SBIF, but supervision i s entrusted solely to the latter. The supervisory regime i s robust and we11 established. I t enjoys a wel l deserved reputation for good technical ski l ls 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. transition to risk-based supervision increases the need to fortify the supervisory approach with strong analytical and information processing capabilities. Provided it i s matched with adequate accountability, this calls for strengthening and clarifying the independence o f the SBIF (see below). I t also requires adapting the regulatory framework to address some weaknesses identified in the BCP assessment. In particular, risk-specific regulations need to

However, bank oversight needs further strengthening in some areas. The

lo However, Chilean accounting o f past-due loans i s less stringent than international standards. If measured under US. G A M , the ratio would double.

compared to ratios o f over 6 percent in Mexico and Brazil (Bankscope data). l2 Then authorization in 2002 to pay interest on sight deposits i s inducing banks to increase fee income. l3 The fastest growing segments o f 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.

The ratio o f operating costs to total assets in the Chilean banking system was 2.8 percent in 2003 (SBIF data), 11

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be replaced by a broader capital charge for market risk and consolidated supervision expanded beyond the bank and i ts subsidiaries. The scope o f fit and proper tests should be extended to banks’ directors and senior management. There i s also room to further strengthen banks’ credit risk management practices and disclosure o f risk exposures (Appendix 111).

25. attractive, i t i s untested and has some limitations. The scheme, which i s based on a “narrow banking” concept (Appendix IV), remains untested, partly reflecting good supervision supported by an effective system o f early warning and prompt remedial action. Should the need to activate the system arise, the dominance o f large institutional depositors should help expedite the resolution process with only limited losses for involved parties. However, obtaining agreement from a majority o f non-sight creditors (sight deposits are fully guaranteed by the BCCh) could be difficult if the largest creditors have already le f t the bank in anticipation o f difficulties. When the bank i s too big to fail or the system i s perceived to be vulnerable to contagion, this could have adverse systemic implications. Under the current regime, a rapid transfer o f assets and non-sight liabilities o f the distressed bank to a sound financial institution i s not permitted since i t would entail a de facto differential treatment o f creditors. Nor i s 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.

While the Chilean safety net and bank resolution scheme i s original and

V. CORPORATE SECTOR

26. 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 o f capital, reflecting incomplete cost restructuring in the face of the post-1998 decline in sales. Firms’ depressed profitability has discouraged them from issuing equity in recent years.

Chilean firms are conservatively managed but currently have low profitability.

27. to the whole range of financing instruments available in the domestic financial market. Smaller f i r m s do not have access to finance in international markets and face some form of financing constraint at home.” Even large f i r m s have virtually no access to the local bond market, in part because o f the relatively large minimum bond issue size (US45 million) required to attract AFP investment and cover the large issue fees (Table 9 and Figure 21). Bond issue fees are large mainly because o f the stamp tax, which accounts for 50 percent o f

Only the largest (“mega”) firms have access to international capital markets and

l4 Much o f the corporate sector analysis was based on the so-called FECUs data, which contains summary financial statements for around 500 formal f i rms. The data is tilted towards larger firms, although i t also includes SMEs and a few micro f i rms.

(US$ I7,172,000); large f i rms have sales between UF100,OOO (US$2,862,000) and UF600,OOO; medium firms have sales between UF25,000 (US$715,500) and UF100,OOO; small firms have sales between UF2,400 (US$68,688) and UF25,OOO; and micro f i rms have sales below UF2,400.

Mega firms are defined as those with annual sales (net o f value-added tax) above UF600,OOO 15

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the fees (Figure 20).16 In contrast, some SMEs managed to issue equity in the mid-1980s and early-l990s, reflecting relatively low access costs. Only a minor fraction o f SMEs have access to private equity in the OTC market (as opposed to public offerings in the stock exchange)-an industry that i s 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 s t i l l small. Micro f i r m s have access to loans from dedicated institutions, which often take the form o f consumer loans. While better o f f than in most countries in the region, SMEs in Chile s t i l l have significantly less access (in quantity and diversity) to financial services than do similar f i r m s in developed countries.

28. There is room to further improve SME’s access to finance. Although Chile’s lending environment i s already relatively strong,17 SME’s access to bank finance cold be aided by unifying the legislation on movable collateral and creating a single registry for pledges. While credit bureaus work well in Chile, the quality o f SME financial statements needs to be improved. The ceiling on lending rates (tusa maxima 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 o f borrowing, especially by the smaller f i rms. Firms’ access to equity will also be enhanced through the vigorous implementation o f recent improvements in the framework for corporate governance. l 9 Further steps include upgrading the accounting and auditing system (see below), clarifying definitions and improving corporate disclosure o f related party transactions, establishing clearer standards for appointing directors. Training o f independent directors and the judiciary should be considered to ensure consistent application and enforcement o f the corporate governance framework.

VI. INSURANCE SECTOR

29. I t comprises 57 companies (domestic and international) and has grown steadily over the last decade (total assets reached 19 percent o f GDP in 2002, up from 7.5 percent in 1992). The industry i s dominated by l i f e insurance, which grew in connection with the pension system (it accounts for 62 percent o f total premiums, compared to a regional average o f 38 percent).

The insurance sector i s large, reflecting i ts important role in providing annuities.

As the stamp tax also applies to domestic bank loans, i t does not raise the cost o f bond issues relative to bank borrowing. However, i t raises the cost of domestic bond issues relative to external bond issues, favoring the largest f i rms that have access to external borrowing over the smaller f i rms that must borrow domestically. l7 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). l8 Although relatively high, the ceiling i s becoming binding as credit institutions move down market towards riskier borrowers. A bil l 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 o f reference in this regard. l 9 A 2003 assessment by the World Bank found Chile to score well on the OECD Principles for Corporate Governance. The CMII reform i s expected to hrther strengthen corporate governance.

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Annuities are the dominant choice o f retirees due to high money worth ratios o f annuity products, which in turn i s partly attributable to the availability o f inflation-indexed bonds2’

30. 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 wil l 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 wil l 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 i s that, as illustrated by the recent failure o f the Inverlink group (Appendix V), key tools to facilitate an orderly transfer o f 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 o f the intervention and, once in the intervention phase, for the administrator acting in the interests o f claimants to maximize the resolution cost to the government. In view o f low average ROE (partly resulting from aggressive pricing), the large number o f players (that will require consolidation), and lack o f key resolution tools, the road ahead could be difficult.

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

3 1. The road map requires a well-designed transition, focused on risk-based management and supervision. Concerns about the solvency o f insurance companies that belong to financial conglomerates could spill over to other members o f the group, particularly banks and mutual funds. More importantly, the government’s exposure on i ts annuity performance guarantee could be large (about 1 percent of GDP on account o f the under-provisioning effect alone). Given the magnitude o f needed changes to the regulatory requirements, they will need to be introduced with a transition period and under close supervision. Both o f f site analysis (including a monitoring o f market values and pricing, the development o f early warning systems, and risk focused capital assessments) and on-site reviews (to gain a better understanding o f companies’ management and strategies looking ahead) wil l 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 o f a more standard approach.

VII. PENSION FUNDS

32. 40 percent o f government bonds, 50 percent o f mortgage bonds, 38 percent o f corporate

AFPs are by far the dominant institutional investors in the country. They hold

2o The money worth ratio i s the present value o f the stream o f 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 o f the insurance sector could fall below the minimum capital requirement once the necessary provisioning i s made, even i f allowance i s made for an increase in the discount rate (Figure 22). 22 The current rule-based style o f 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 l imited in a risk-focused environment.

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bonds, and 35 percent o f time deposit~.’~ Their number dropped to 6 at end-2003 (from 21 in 1994) following a marketing war in the 1 990s. AFPs have enjoyed persistently high profits (annual ROES averaged 30 percent in recent pears, twice that o f banks), despite low levels o f risk. While costs have declined and are becoming more comparable to those in OECD pension funds, there i s scope for further reductions. A voluntary pension system (opened to all financial institutions) was introduced in 2002, but it i s s t i l l small.

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

34. fiduciary role. Policies may be considered to enhance AFPs’ impact on financial development only to the extent that their primordial fiduciary responsibility i s safeguarded. A conservative portfolio allocation i s particularly justified in Chile given that the second (mandatory, privately-administered, fully-funded) pillar o f the system constitutes the core o f 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 o f the investment regime would therefore not be advisable.24

The scope for liberalizing AFP regulations i s constrained by their inherent

35. Nonetheless, a judicious relaxation of the investment regime i s recommended. There i s ample room for simplifying and relaxing investment regulations and improving the welfare o f retirees through higher returns, without necessarily increasing risks. A prudent liberalization o f the investment regime would require legal reform (much o f the detail o f investment restrictions i s 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 ~ u p e r v i s i o n . ~ ~ 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). I t would, however, remove most sub-limits on instruments, al l

23 The fast asset growth in pension h n d s has reflected the mandatory nature o f the system and reinvestment o f high historical rates o f return (7 percent per annum since 1981). 24 Also, a move towards a “prudent man” rule i s not recommended at this stage because, among other reasons, courts may not be legally and technically equipped to enforce jurisprudence o f prudent man behavior, the regulatory framework i s not suited to ensure effective risk management (while r isk management capacities seem very uneven across AFPs), and the SAFP is no t sufficiently trained to perform risk-based supervision. 25 This includes training o f staff o n r isk management techniques and the introduction o f a compliance officer inside each AFP reporting directly to the AFP Board.

13

sub-limits on combinations o f 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. I t would also streamline the approval process for eligible investments, permitting investment in all listed equities except for a reasonable negative l i s t and allowing marginal holdings o f below-grade corporate bonds.

36. The recent increase o f the ceiling on investments abroad should provide long-term risk diversification benefits considering the small size and openness o f the Chilean economy. While further increases in the ceiling may be advisable in the future, the stock o f foreign assets i s already large and needs to be better managed. This requires, inter alia, allowing the use o f 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).

Regulatory improvements are also recommended regarding foreign investments.

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 o f fees but also to a broader diversification o f investable funds. The recent creation o f the voluntary pension system should enhance competition, but further outsourcing o f 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 o f the voluntary system (including by allowing the formation o f 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. could be introduced at a later stage. This would unbundle pension-related services that are subject to economies o f 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 o f basic services (contributions collection, accounts management, payouts to retirees, etc.) within a regulated provider while allowing open competition among asset managers. The danger o f a marketing war could be dispelled by simultaneously considering, among other alternatives, the introduction o f a blind quotation system (workers know which asset manager they choose but asset managers do not know the identity o f the workers whose pension assets they manage). The excessive number o f entries could be avoided through proper licensing criteria, including fit and proper tests.26

Should this gradual approach fall short of expectations, a more radical reform

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 o f the retirement savings between AFPs (pension fund administration) and life insurance companies

The authorities may wish to consider the experience o f Sweden and i ts recent adaptation to Latvia. 26

14

(provision o f annuities), each operating under different market incentives, i s not necessarily consistent with smoothing and maximizing lifetime consumption for a given level o f 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 r isks 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 o f retirement pension to pre-retirement income) needs to be provided.27

VIII. MUTUAL FUNDS

40. M u t u a l 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 o f the longer duration funds, “exit load fees” (commissions that decline over time), 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 r isks are well managed and disclosed and not passed on to banks.

Ix. OTHER INSTITUTIONAL INVESTORS AND FINANCING VEHICLES

41. i s key to broadening the access to finance for efficient newcomers. Greater competition in the asset management industry and the development o f “bridging” vehicles i s key to level the opportunity playing field and more broadly finance economic activity. At present, the concentration o f investable funds in AFPs, coupled with a s t i l l insufficient range o f financing vehicles and products, including derivatives, tends to segment and tilt the demand for securities. Pension funds are so large relative to the size and liquidity o f 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 i s exacerbated by the excessively complex and over-determined investment regime, as noted above. This segmentation i s illustrated by the sharp discontinuities in bond ratings and the near complete absence o f bond issues below the AFP

A sustainable diversification o f vehicles to mobilize and allocate investable funds

27 This i s al l the more important considering the downward pressure on replacement ratios stemming from the declining trend in net pension hnd retums (relative to real wage growth), which also raises the relevance o f further reducing fees through competition in the pension industry. In effect, a decrease in fees by 30-40 basis points o f assets accumulated over long periods would lead to a 7-9 percent increase in replacement ratios.

15

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 o f access to finance i s substantially higher for f i r m s 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 i s s t i l l miniscule and their funding o f firms limited.**

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 f i r m s to the extent that they can credibly reduce the risk o f investing in smaller f i r m s 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 o f venture capital, the reforms proposed in C M I I should help develop the industry. The evolution o f securitization and o f the market for corporate control (e.g., via the development o f investment banking services, venture capital funds, vul lure funds, etc.) should further help bridge the access gaps.

x. SECURITIES MARKETS 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 o f the equity market reflects both concentration o f supply (the concentrated firm ownership results in very low “float ratios,’’ as shown in Figure 24) and concentration o f demand at six AFPs which mostly “buy and hold.” The significant migration o f securities issues and trading abroad has also reduced liquidity in the domestic capital market.” Enhancing liquidity, which i s essential to securities markets development, should therefore be a key focus o f policy.3o To be sure, the scope for enhancing liquidity i s fundamentally limited by the mentioned concentration factors and the relatively small size o f the Chilean economy, as liquidity i s strongly dependent o f economies o f scale and agglomeration. Nonetheless, there i s room to improve liquidity by removing impediments that currently exist in various dimensions o f market infrastructure, including legal aspects,

28 Mutual funds in Chile are open-ended. Money market funds (whose assets must have an average duration o f less than 90 days) and medium-term mutual funds (with durations o f no more than 2 years) dominate the mutual hnd sector. The so-called investment funds are close-ended and their asset holdings are significantly smaller that those o f mutual funds. Compared to mutual funds, investment funds invest more in equity and, at the margin, invest in riskier companies than pension funds do. 29 Econometric evidence on this effect i s presented in a recent Wor ld Bank study o n “Whither Capital Markets in Lat in America?’, which can be found at: http://wblnl 0 1 8.worldbank.org/LAC/LAC .nsflECADocbyUnid/O 1 A5 1 A5 8B 764B8D5 85256EA9005BFE00?0 pendocument 3o I l l iquidity hampers price revelation-the most distinctive hnc t i on o f securities markets vis-a-vis, say, banking markets. I t weakens the reliability o f marking to market and fair value accounting and l imi ts the development o f derivatives markets. Moreover, i t magnifies the effects o f shocks on asset price fluctuations.

16

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

Legal voids that affect the clearing and settlement of securities need to be filled.31

45. 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, i s further hampered by inadequate price information on OTC trades and lack o f uniformity in valuation methodologies. The authorities should consider introducing a standard contract for repos (and, possibly, an omnibus master agreement for both rep0 and derivatives contracts). More generally, a comprehensive review o f 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 o f a market making system con~ idered.~~

Reforms are needed to modernize securities clearance and settlement, improve

46. important distortions arise from the stamp tax, which raises the cost o f bond issuance and, according to anecdotal evidence, promotes ever-greening in bank lending. There i s also excessive complexity in the design and application o f capital gains tax and i t s exemptions, making it difficult to assess i t s incentive effects. Moreover, the competitive disadvantages created by the uneven application o f the value-added tax (e.g., transactions by AFPs are

" Informal assessments o f observance o f the CPSS Core Principles for Systemically Important Payment Systems and the CPSS-IOSCO Recommendutions,for Securities Clearance and Settlement were conducted as part o f the FSAP. 32 OTC trading dwarfs the exchange-based trading (Figure 25).

because o f the already high concentration in the Chilean system. Instead, primary auctions would be open to a l l participants while market makers can be given the right o f first r e k s a l to an allocation o f securities in an oversubscribed auction, at an appropriate price. In tum, they would have measurable obligations, especially with respect to continuously quoting bid-ask spreads for minimum transaction sizes and distributing securities.

There i s also a need for a thorough review of financial sector taxation. As noted,

.

Granting exclusivity for participation in primary auctions to primary dealers i s not recommended, partly 33

17

exempt but transactions b y 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 o f voluntary pension f i~nds).~~

47. The financial reporting regime for companies listed on the stock exchange should be ~trengthened.~’ 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 information 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 o f the fair value o f financial instruments, especially derivatives. Chile should adopt IFRS but only after a period o f 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 o f licensing and quality control mechanisms in the audit profession weakens i ts role, potentially compromising the overall strength o f the reporting system. The current efforts o f the audit profession toward creating a licensing system are welcome. Additionally, Chile should establish independent oversight mechanisms to ensure the proper functioning o f these systems and give the SVS greater authority to play a more proactive role in monitoring and enforcing compliance.

48. need to be addressed.j6 The SVS would benefit from a significant increase in budgetary and staff resources, which should focus on boosting the recently created enforcement unit, enhancing I T support for data collection and market surveillance, and strengthening on-site inspections o f brokerage firms, mutual funds, and self-regulatory organizations (SROs). There i s also a need to: (i) introduce minimum professional standards for brokers, investment advisors, asset managers, etc. ; (ii) submit brokerage f i r m s 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.j7 The intervention power should be coupled with the creation o f an industry-wide guarantee fund to facilitate an orderly settlement o f open transactions, thereby limiting the ripple effects o f a failure o f a broker or mutual fund.

While securities market regulation i s basically sound, important weaknesses

XI. HEDGES

49. limited. Following the removal o f the exchange rate band, the domestic market for

Notwithstanding ample hedging needs, the use o f derivatives remains so far

j4 CMII, i f enacted, should resolve this issue by subjecting al l voluntary pension f h d s to the VAT, independently o f which institution administers them. 35 A Review of Accounting and Auditing Practices was conducted by the World Bank in parallel to the FSAP. 36 A formal assessment o f observance o f the IOSCO Objectives and Principles of Securities Regulation was conducted under the FSAP. 37 The SVS has power to intervene and liquidate a mutual fimd and to suspend the operations and cancel the license o f a brokerage firm, but not to intervene and liquidate the latter.

18

nondeliverable foreign-exchange forwards (NDFs) expanded rapidly and has now become quite deep and liquid (Figures 25,26, and 27). However, the use o f other derivatives remains extremely limited or nonexistent. In particular, there i s no active market for interest rate derivatives, Yet, some sectors, particularly l i fe insurance, are significantly exposed to interest rate risk, reflecting a substantial duration gap and a growing exposure to repayment risk. The absence o f equity derivatives and options o f any kind also hinders the capacity o f 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. relaxation of current restrictions coupled with enhancements to market infrastructure. The limited development o f derivative products in part reflects regulatory barriers on trading that affect banks, pension hnds and insurance companies. However, caution i s advisable given the limited liquidity o f underlying markets (particularly equity), which hinders the use o f 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 supervisors are satisfied that banks have adequate capacity to manage the associated r isks (this may also require capacity building at the SBIF). The removal o f restrictions on derivatives trading for pension funds and insurance companies would be a logical second step, based on similar requirements. The limited development o f derivatives also reflects already noted deficiencies in information and market infrastructure. There i s 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 o f derivatives; and (vi) promote knowledge building, standardization o f contracts, and an industry code o f conduct.

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

XII. CROSS-SECTORAL ISSUES IN FINANCIAL OVERSIGHT

5 1. firewalls, and mostly informal coordination arrangements. Supervisory responsibility i s segregated by type o f 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 i s 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

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

19

basis and there i s no comprehensive framework that describes the roles and responsibilities o f each p a r t i ~ i p a n t . ~ ~

52. more integrated and complex. The problems that could have arisen from the co-existence o f institution-oriented supervision and the dominance o f financial conglomerates have hitherto been kept at bay by the regulatory firewalls, comfortable profitability, and strong presence o f foreign banks supervised by their home-country regulators. However, rapid changes in financial services are increasingly exposing the limitations o f 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 o f financial entities that are subject to different regulations. These markets, as a result, fall outside the purview o f any o f the individual regulatory agencies. In addition, the uneven regulatory treatment o f similar products promotes regulatory arbitrage.39 Moreover, statutory obstacles to the full consolidated supervision o f financial cong lomera te~~~ could impede early recognition o f group-wide risks, especially in cases where the conglomerate includes nonfinancial f i rms . The importance o f these linkages will rise as financial groups are increasingly driven by competition to exploit synergies and scale economies (Figure 28).

The silo approach will become increasingly limiting as financial services become

53. capacity will be needed. While cooperation between regulators has improved, it remains limited in view o f the range o f 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 o f the financial system and between macro-financial developments and micro- market underpinnings wil l require more attention. This problem i s often exacerbated by shortcomings in the overall analytical capacity o f the supervisory agencies and weaknesses in data collection and information

Improved inter-agency coordination and enhanced analytical and informational

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 hnctions o f 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 o f a small but competent permanent technical

3* W h i l e CMII would give stronger legal grounding to information sharing, cooperation would remain rather informal and limited in scope. 39 For exampIe, insurance companies can originate consumer loans and mortgages and launch mutual fund and credit card subsidiaries, but are subject to different regulations than banks. Voluntary pension hnds wil l 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 i s empowered to supervise on a consolidated basis a subset o f a financial conglomerate, namely, the bank and i t s subsidiaries and affiliates (where the bank has an ownership interest). 41 W h i l e information systems are often adequate in meeting the needs o f silo-based supervision, they generally fall short in supporting more analytic, broader, cross-sectoral, systemic analysis.

20

secretariat focusing on the analysis o f cross-cutting issues and the coordination o f efforts to rationalize (and facilitate access to) information. Efforts should also be made to boost the overall analytical capacity o f the agencies and broaden the scope o f analysis, for example through a program o f 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 o f financial conglomerate, financial holding company, and lead regulator in the law and, hence, appropriately underpin the full application o f consolidated supervision. This should be established simultaneously with some relaxation o f 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 o f the group. In addition, the authorities are encouraged to improve coordination protocols to deal with the possible failure o f a complex financial conglomerate.

56. further enhancing the autonomy and legal protection of supervisors. The authorities should consider reforms to enshrine in the law the political and budgetary autonomy o f the regulatory agencies, and enhance the legal protection o f supervisors. To minimize the scope for abuses o f power and inefficiencies, increased autonomy must be matched with increased transparency and accountability.

The shift from “managing rules” to “managing risks” puts a premium on

XIII. ANTI-MONEY LAUNDERMG

57. the AML/CFT framework. The recent passage o f a law endorsing the authority o f a Financial Intelligence Unit (FIU) and extending the definition o f offences and the institutions subject to reporting constituted an essential f i rst step towards compliance with A M L K F T standards. However, subsequent rulings o f the Constitutional Court eliminated the FIU’s sanctioning powers, limited i ts discretion in requesting data on suspicious transaction records, and denied i t s 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 o f compliance by securities f i rms, insurance companies, and foreign exchange retail operators also needs improvement.

Further to the 2003 GAFISUD assessment, there remains scope for tightening

21

TABLES AND FIGURES

22

(" 0 N

N 0

i 3 -4

3 3

> 5

C

2

A 2

m 9

B m 7 d 0 0

24

25

As proportion (%) o f each sector’’

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

Banking

conglomerate-” Belonging to foreign financial

conglomerate Belonging to domestic ‘pure’

financial conglomerate Belonging to domestic conglomerate

w i th mixed activities4’

98%

41%

34%

23%

Sources: SBIF, SVS, SAFP, and staff calculations.

~~

Securities

91%

47%

23%

21%

Insurance ( l i fe and nonlife)

40%

13%

9 Yo

18%

Pensions2’

97%

80%

2%

16%

1 1 Percentages are based on bank assets (banking), securities tumover by stock brokerage companies/corredores de bolsa (securities), direct premiums (insurance) and AFP assets under management (pensions) for 2003. 2/ AFP Habitat i s assumed to be controlled by Citibank even though i t i s jo int ly owned w i th the Chilean Chamber o f Construction. 31 Domestic and foreign groups that are only active in one Chilean financial sector are not considered financial conglomerates. 41 Only conglomerates wi th nonnegligible mixed activities are included.

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

Source: Government of Chile.

Note: Data are for 2001, except exports (2000) Definition:Mega firms are defined as those with annual sales net o f VAT above UF600.000 (USS17.2 million);

large firms have sales between UF100,OOO (US$2.8 mil l ion) and UF600,OOO; medium f imis have sales between UF25,000 (US$0.7 million) and UF100,OOO; small firms have sales between UF2,400 (US$68,688) and UF25,000 and micro firms have sales below UF2,400.

26

Liabilities Monetary base 3.0

Currency (2.0) Bank Reserves (1 .o>

BCCh debt 23.0

Total 23.0 Capital -3 .O

Table 6a. Chile: BCCh Summary Balance Sheet, End 2003 (In billions o f U S dollars)

Assets International Reserves 18.0

BCCh claims on govemment 5.0

Total 23.0

Source: BCCh and staff calculations.

Table 6b. Chile: BCCh Structural Income Statement (In mil l ions o f U S dollars)

Revenues - 90 Inflation tax on monetary base (3% inflation) 3 x 0.03 90 Expenditures - 364 Carrying cost o f N IR (140 basis points) ” 16 x 0.0014 224

5 x 0.0019 95 Operating expenditures 50

-274 Memorandum Item

Net losses as a fraction o f GDP -274173,000 -0.37

Carrying cost o f claims on govemment (1 90 basis points) 2’

Changes in real net worth:

Source: BCCh and staff calculations.

l i qalculated as Chile’s country risk (90 basis points as o f Chile EMBTG’s spread o f March 4,2004) plus a premium for currency r isk and the duration mismatch between debt and international reserves (50 basis points). ” Calculated as the country risk plus the excess average yield o f intemational reserves during 2003 over the yield o f BCCh’s claims on govemment during the same period (Libor plus 50 basis points).

27

Table 7. Chile: Financial Soundness Indicators , 1997-2003 (In percent, unless o the rwsc mdicated)

Dee-97 Dec-98 Dec-99 D e 0 0 13ec-01 Dec-02 s'ep-03 Bankmg Sector Indicarors

n d 12 5 13 5 13 3 12 7 14 0 14 5 n d 11 0 10 6 10 5 9 9 11 1 11 5 7 38 7 5 7 7 5

10 4.0 9 19 8 4 4 7 94 1420 1516 16.58 1669 5702 5 7 4 1 55.79 55 19

o to ta l habllrties 9 5 10 6 10 9 10 4 n 11 7

1 1 8 conbumer 0 8 1 2 0 9 0 9 0 9 0 8 0 8

0 4 0 5 0 6 o s 0 9 1 1 1 2 commerclal 1 6 1 9 2 2 2 4 2 1 2 4 2 4 M o w a s

NPLs net ofprovls ions t o capital 8 7 9 2 10 1 10 1 10 5 10 2 n d n.d 1 8 1 8 1 3 1 3

t slid lowest mterbank rat 4 5 2 1 2 4 0 5 0 0

1 0 0 9 0 7 1 0 1 3 1 1 1 3 13 7 11 5 9 4 12 7 17 7 14 4 16 4 80 7 75 4 75 0 75 4 75.8 80 1 61 4

N o n m r a e s t expenses. t o g o s s mcome 63 5 59 3 57 7 57 0 56.2 55 2 53 7 Peironnel eqenses t o nomnterest expenses 56 2 s5 3 55 7 55 7 56 0 53 9 54 3

55 9 61 1 77 8 70 0 75 3 79.5 81 3

ROA ROE

G r o w t h l a te o w r i t t e n W change f i o m k 11 3 -2 1 17 8 15 6 9.3 -8 2 n a Llfe surp l U S t 0 -0 54 -1.5 1.7 -0 6 0 5 0 2 n a Investment m c 96 16 96 7 96 8 96 6 95 6 96 5 n a

Insurance seefor mdzcutor2 - Non Lfe Insurunce G r o w t h rate o f g o o s preni iums w r i t t e n (% change f i o m 1.. -3 76 -3 2 -2 5 6 8 21 8 24 n

Investment income to m v s t m m t assets 47 08 48 8 47 1 41 7 3 7 1 36 n Combmed rat io 99 78 98 1 101 0 105 9 97 9 90 n

Underwrnmgprofit t o net m v s t m m t mconie 5 5 6 4 7 8 5 1 5 9 4 n

Source for branches and subs idmes abroad start lng o n June 2002 liquidity, such a s domestic foreign e x c h a n s markets

d a y f smce the due date In the case o f credit m quotas, t he general ru le IS

t o account for t he quota on ly T exception IS when the loan has an accelaration clause m the ageenlent AF o f Oci *03 S / Correspond t o a c o m m e r c d port fo l io meate, than 20,000 Z I F and 2% o f t h e equi ty o f t h e fmanclal u ist i tut ion 6/ O n e day n o n readjustable mrerbank rate 7 / ROA and ROE are calculated usmg annualued t e r n s of final u t i h t y T o and multiphed by iwe lve T h e denommaror o f b o t h corresponds t o the ou

of months

to PRC-8, data fo r October 2003

accoidmg t o the C h a Chllenr de la construc 6 n I t corresponds t o the annual g o w t h of a v e r a s e (per square meter) at w h i c h n e w p r o p e r t i e are of faed (not t he fmal p n c e o f t he tiansaclion)

12/ F o r January-September

28

Country Chile (2003) Australia (2002) Canada (2001) Denmark (2001) Ireland (2001) Netherlands (2001) Spain (2001) Switzerland (2000) United Kingdom (2001) United States (1998)

Table 8. Chile: Corporate Sector Indicators (end-2003)

Cash and Bills and Deposits Bonds Loans Shares Other

15.0 45.6 0.0 37.8 1.6 7.7 19.8 3.9 59.8 8.9 0.4 40.7 2.9 49.6 6.4 1.3 49.2 1.6 45.6 2.3 2.8 21.4 0.0 65.6 10.2 1.5 34.7 8.8 49.5 5.4

16.0 50.9 0.6 21.0 11.5 7.3 31.2 12.0 33.9 15.6 3.2 13.9 0.0 60.9 22.1 3.6 20.9 1.6 61.6 12.2

Leverage Ratio 1.3 ICR (%) 145 ROE 6 Cost o f 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 o f Pension Funds (%): Chile and Selected Countries

Total 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0 100.0

Assets/ Foreign GDP

23.8 59.9 19.1 67.4 21.4 48.2 25.0 23.8 67.8 44.7 65.0 105.1 34.3 6.8 25.0 121.1 22.9 69.2 11.0 72 .O

Sources: SAFP, OECD, APRA, Irish Pension Fund Association, Danish Supervisor, Davis (1995 and 2001).

29

~- ~

Capital Markets Committee

Financial pol icy (legislative changes)

Surveillance o f macro-financial issues

Systemic crisis management pol icy

Table 1 1. Chile: Issues Requiring Cross-Sector Supervisory Cooperation

Committee of Superintendents

Policy implementation and regulation Issues pertaining to better exercise o f supervisory functions Definit ion and monitoring o f risk profiles and activities o f FCs Monitoring connections across financial system / market developments Modus operandi for crisis management and jo in t problems

ofsystcm (inter-sector linkages \ i a comnwn financial issues Lnstrunicnts and markets)

i 'Firc drill' (contingency planning) i Rcsolution of conflicts ofcompctencc in cvcnt offailurc ofa finaiicial congiomcrate

Crisis management arrangements

4 Responsibility for inonitormg and disclosing acti \ i t ics in mx.mtics and dcrivatibcs markcts 4 'Hybrid' products

Avoidi'lg supervisory gaps and overlaps

~

Monitoring of FCs

Competition within and across financial sectors

i Analysis ofrisk profilc ofFC

4 Stimulating coiiipctition in AFP sector by (potentially) opening It to other sectors

7 - 1 +Consistency and intcgity of valuation m diflcrcnt entities for same financial instrumcnts I 'laying I 4 Cnnsistcncy of capital adequacy treatment for same instrument

I I in diffcrent scctor entities

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

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37

I I . . I 8

Figure 28. Chile: Stylized Structure o f Domestic Mixed-Act iv i ty Conglomerate

- .. . . . . AFP . . .. .. . Li fe Insurance P&C Insurance :: .

Company :: .. Bank (BHC) : : Company . . .

Direction o f equity investment - Ultimate Owner 52 Investment Vehicle

(can be one or several) Responsibility for regulatory oversight

. . m i m m m . m i m m m i i m : XYZ i \ m m m .. m 8

All companies below can come under the bank

or directly under the holding company;

leasing and factoring operations can also be part o f the bank

itself (no subsidiaries needed); most companies

r I I I I I I I I I I

(e.g. mutual funds, brokerage) can also be owned by an I

insurance company + m . m * . 8 . . I . . I

. . . . t iza tm Insurance Securities Mutual Funds 2 . Company Brokerage Brokerage Managenlent I : . SBIF (only ifpart of BHC) : svs:

~.I.........................~......................m.....m...................~...=

38

APPENDICES

39

APPENDIX I

AFPs

AML/CFT

List of Acronyms

Administrators o f Mandatory Pension Funds (Administradorus de Fondos de Pensiones) Anti-Money Laundering / Combating the Financing o f

BCCh BCP Bolsa de Comercio de Santiago CAR

Terrorism Central Bank o f Chile (Banco Central de Chile) Base1 Core Principles o f Effective Banking Supervision Santiago Stock Exchange Capital Adequacy Ratio (Regulatory Capital to Risk-

C M I I CP D C V

FCs Financial conglomerates FECUs Uniformly Codified Statistical Form FIRST Initiative FIU Financial Intelligence Unit IAS International Accounting Standards IFRS International Financial Reporting Standards I T Information technology M o F Ministry o f Finance

Financial Sector Reform and Strengthening Initiative

Weighted Assets) Draft Capital Markets I1 Reform L a w Core Principle Centralized Securities Depository(Dep6sito Central de

I NBFIs I Nonbank financial institutions

SBIF

NDFs Nondeliverable forwards NPLs Nonperforming loans ROE Return on equity SAFP Superintendency o f Pension Fund Administrators

(Superintendencia de Administrudoras de Fondos de Pens iones Superintendence o f Banks and Financial Institutions Insurance (Superintendencia de Buncos e Instituciones

SMEs SROs svs

Financieras) Small and medium enterprises Self-regulatory organizations Superintendency o f Securities and Insurance

UF (Superintendencia de Vulores y Seguros) Unidad de Fomento, a unit o f account linked to the CPI.

40

Further develop risk-based supervisory approach. Clari fy SBIF’s powers as regards licenses and expand ‘fit and proper’ tests. Impose capital requirements for market risk.

APPENDIX I1

X X

X

X X

I Summary of FSAP Recommendations

Strengthen bank resolution regime. C. Corporate Sector Reform legislation for movable collateral.

I I I

A. Central Bank

X

X Yes

~~~ I Strengthen BCCh’s financial accounts.

Improve quality o f SME financial statements. Eliminate ‘tasa maxima convencional’or introduce more flexibility. D. Insurance

I T I

X X

I B. Commercial Banks I I I

Strengthen insurance company failure resolution framework.

E. AFPs Shift emphasis from rules management to risk management.

X Partially X X

I Improve disclosure o f r isk exposure & management practices by banks. I 1 x 1

Encourage outsourcing and regulate service providers. Enhance attractiveness o f voluntary system.

X X Partially

I Create national register o f pledges. 1 x 1 I Yes

~

Develop contingent strategy to enhance competition. Reduce risks faced by workers at retirement.

X X

[-Upgrade provisioning requirements and strengthen supervision. 1 x 1 I

F. Securities Markets Embed concepts o f finality, netting, and novation in the law. Promote industry-financed fund for multilateral netting.

X Partially X X

IJudiciously relax investment regime.

Organize securities lending and borrowing. Establish price reporting for OTC trades and harmonize securities valuation . Introduce international standard contract for repos and derivatives. Enhance standardization o f financial instruments.

1 x 1

X

X

X

X

I Move fi-om compliance-based to risk-based supervision. l x l x l

Increase SVS’s budgetary and staff resources. Introduce minimum standards for securities industrv.

X X

I Suitably formalize market-makers for publ ic debt. 1 x 1 I

41

Require internal compliance programs bv brokerage f i rms. X Widen SVS enforcement powers. I 1 x I Partially

Implement risk based supervision. G. Taxation. Financial ReDorting. Standards. CorDorate Governance

Give SVS power to appoint a conservator or liquidator for brokerage f i l T l S .

X X

Enhance corporate governance, including training o f directors and judges. H. Hedges Correct deficiencies in information and market infrastructure.

Review financial sector taxation.

X

X X

Strengthen financial reporting regime for l isted companies. I

I. Other Financing Vehicles Support development of “bridging” vehicles. J. Cross-Sectoral Financial Oversieht

X Partially

Relax restrictions on short selling, writing and trading. I 1 x 1

Establish MOUs and technical secretariat for coordinating committees. Introduce regular staff exchanges. Introduce hI lv consolidated supervision and relax firewalls.

X X

X

Embed Committee o f Superintendents in the law. 1 x 1 I Yes

ClarifL and strengthen legal protection o f supervisors. Allow supervisors control over budget with appropriate accountability. Disconnect timing o f Superintendents’ appointments from political cycle. K. Anti-Money Laundering Strengthen capacity to monitor compliance, Enhance monitoring o f securities. insurance. and FX oDerators.

X X X

X X

I x I x / Resolve conflicts o f competence and draw contingency plans for failure o f financial conglomerates. Strengthen the information svstem. 1 x 1 I

Improve mutual assistance and international cooperation in freezing assets. 1 X 1 I

42

APPENDIX I11

Chilean Banks’ Risk Management and Disclosure Practices

The assessment o f banks’ risk management practices i s based on a survey prepared by the FSAP mission (twenty out o f the twenty six authorized banks responded). As regards credit risk management, Chilean banks are s t i l l mostly on the learning curve. Only foreign subsidiaries and branches use models to classify corporate loans, less than a third o f 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 o f foreign banks) use VAR models, only 40 percent o f the small and medium domestic banks do; among those that do, only ha l f consider risk correlations. The average time length o f the historical data used by small domestic banks i s only ha l f a year, and back testing i s rare. Given the relatively simplicity o f the products offered and held by Chilean banks, Monte Carlo simulations are the exception. However, more sophisticated modeling will be needed if the use o f 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 o f asset quality (NPLs and provisions) as Chilean norms require that only the past-due portion o f 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 i s not included.

Mandatory disclosure o f r isks exposures and risk management techniques i s not required, and disclosure i s 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 o f them do it in Chile. Information on income by business l ine i s generally lacking. Only one o f 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 o f less than 30 days or whose term to maturity i s 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 o f central bank debt) against sight deposits in excess o f 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 i s unable to meet i t s 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 fblly accessible; they are “decoupled” from the rest o f the bank together with the corresponding liquid assets plus the BCCh guarantee. This protects the payments system, mitigates the contagion risk o f a bank closure, and provides breathing room for an efficient resolution o f the non-narrow part o f the bank.

The risk o f an unwarranted last minute expansion o f the guarantee i s limited by a five-day advance notice required by banks for transferring term deposits into sight deposits. The bank resolution system i s conditioned to (and shaped by) a creditor agreement ratified by the majority (in terms o f claims) o f the bank’s non-sight creditors (and the SBIF). When an agreement cannot be reached, outright liquidation on the entire non-narrow bank i s 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, l i fe insurance, and nonfinancial concerns. After being accused o f share price manipulation in 2001, the group was encouraged by the SBIF to retract i t s banking license application, while the Central Bank refused it authorization to deal on the foreign exchange market.

At the beginning o f February 2003, Inverlink’s brokerage arm was revealed to have been buying market-sensitive information from the personal secretary o f the Central Bank president. Faced with a run on i t s 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. I t also borrowed substantially f rom i ts insurance subsidiary, resulting in the latter’s subsequent insolvency and collapse.

CORFO’s reporting o f 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$l .5 bil l ion (around 27 percent o f i t s assets) as nervous investors unloaded positions; this led to knock-on effects on the prices o f other secondary market securities.

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

The scandal led to the resignation o f the CORFO Executive Vice President, Central Bank President, and SVS Superintendent, as well as to the arrest and trial o f Inverlink senior management. I t was Chile’s f i r s t (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.