## EXECUTIVE SUMMARY ## Source details **Canonical URL:** [EXECUTIVE SUMMARY](https://www.imf.org/-/media/files/publications/cr/2021/english/1chlea2021006.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2021/english/1chlea2021006.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2021/english/1chlea2021006.pdf.json) --- ### Macro-Financial Context - Chile experienced twin shocks: social unrest in 2019Q4 and the 2020 COVID-19 crisis; authorities responded with coordinated monetary, fiscal, and supervisory policies. - Central government gross debt is 32 percent of GDP (up from 11 percent in 2011). Credit ratings by S&P, Moody’s, and Fitch are A, A1, and A-, respectively. - Growth projections and uncertainty: - Growth is projected at 11 percent for 2021. - Medium-term growth forecast is 2.5 percent in 2022. - Key crisis-response measures and effects: - MoF expanded government guarantee programs for commercial bank loans (FOGAPE-COVID) and SME loans (FOGAPE-REACTIVA), offsetting a dramatic decline in market loan demand. - CMF established special provisioning rules facilitating banks' rescheduling (limited 3–6-month payment deferrals); by end-October 2020, rescheduled loans represented 38 percent of bank mortgage and commercial lending combined. Additional guaranteed six-month mortgage payment delays were introduced in January 2021. - BCCh established the Financing Facility Conditional on Increased Lending (FCIC) and a bank bond purchasing program to offset wholesale funding dislocations; as of October 2021 about US$35.7 billion of the FCIC has been employed. - BCCh cut the policy rate by 125 bps to its historical low of 0.5 percent and began a special asset purchase program in June 2020. Since July 2021, BCCh increased its policy rate three consecutive times to 2.75 percent. - Pension and annuity disruptions: - Congress approved three extraordinary pension fund withdrawals totaling about 19 percent of GDP. - In May 2021, retirees and others were allowed to liquidate up to 10 percent of their life annuities; legality was challenged by insurers in Chilean courts and international arbitration. - Financial system structure and size: - Financial assets comprised 300 percent of GDP at end-2020. - Pension funds (PFs) held assets equal to 74 percent of GDP at end-December 2020. - Mutual funds (MFs) grew from 17 to 26 percent of GDP from 2010 to 2020. - Banks dominate credit provision; the top four (six) banks hold 66 (89) percent of assets. - Over the last decade wholesale funding through bond issuance grew; smaller banks have up to 40 percent of liabilities in bonds while the biggest banks have a large sight deposit base. - Pre-crisis return on assets (ROA) was below 0.5 percent. ### Policy Advice and Financial Stability Findings - Banking solvency and capital: - Solvency stress tests show the banking sector is sufficiently capitalized overall, but pockets of weakness need addressing. - Recommendation: Ensure banks transition to Basel III-compliant capital structures and complete announced plans for capital raises in a timely manner. - Improving timely collateral valuation and reporting would lower downside risks. - Climate stress tests do not show current vulnerabilities but suggest transition risks merit further monitoring. - Banking liquidity: - Bank liquidity appears ample but has been boosted by policy measures (high deposits, BCCh funding, pension withdrawals). - Liquidity stress tests show limited risks under current conditions; a reversal of these conditions will require clear official communication and careful liquidity management by banks. - Recommendation: Define and communicate clear criteria regarding conditions for the future unwinding of extraordinary liquidity support measures (FCIC and LCL). - Recommendation: Introduce liquidity stress tests for prudential and stability monitoring. - Supervision and regulation: - The Basel Core Principles (BCP) assessment found the CMF capably staffed with expertise in monitoring individual risks, but reforms are needed in several areas, including credit risk, asset classification, risk management, corporate governance, licensing, and corrective actions. - Deferred Basel III implementation to December 2021 should largely address capital framework shortcomings. - Recommendation: Ensure sufficient budget resources to attract and retain specialized talent. - Recommendation: Strengthen credit risk management and asset classification, including provisioning and treatment of restructured loans. - Recommendation: Establish an integrated risk management framework and enhance corporate governance standards and supervision. - Recommendation: Strengthen the legal framework for licensing to ensure banks’ shareholders are fit, proper and financially strong. - Recommendation: Improve the corrective actions framework. - Recommendation: Improve consolidated supervision by enhancing the legal framework, supervision practices and organizational arrangements. - Pension system and market functioning: - Excessive pension fund switching was driven by a social media-based financial advisor; this lowered returns and increased market volatility. - Additional extraordinary pension withdrawals would further weaken domestic capital markets and should be avoided. - Recommendation: Improve pension fund regulation and investment options to promote long-term investment and minimize excessive switching. - Recommendation: Avoid further pension withdrawals and ensure that the pension system continues to support deep and liquid long-term capital markets. - Insurance and annuities: - Further life annuity liquidations carry severe liquidity risks and broader implications for macroeconomic stability. - While insurers managed previous withdrawals, they could face forced fire sales under future unwinds, threatening solvency and causing spillovers. - Recommendation: Halt any further liquidations of life annuities. - Recommendation: Implement a modern risk-based capital framework in insurance with due regard to the impact of introducing IFRS 17 and IFRS 9. - Mutual funds and nonbank institutions: - Mutual funds need a stronger liquidity management framework; current regulations provide only limited ability for supervisors to ensure sufficient liquidity to meet redemptions in stress scenarios. - Recommendation: Strengthen the mutual fund liquidity management framework. - Systemic liquidity framework and market infrastructure: - The absence of a secured money market may overburden the central bank’s liquidity-providing operations. - Stronger risk management practices are needed regarding collateral requirements and acceptance of bank bonds. - The Emergency Liquidity Assistance (ELA) framework needs operationalizing. - Recommendation: Facilitate the development of the interbank repo market. - Recommendation: Enhance the risk management function of the BCCh through higher haircuts and a stricter approach to unsecured bank bonds. - Recommendation: Finalize the Emergency Liquidity Assistance (ELA) framework. - Crisis preparedness and resolution: - A statutory bank resolution authority is needed to conduct resolution planning and manage bank failures. - Chile is well positioned to introduce loss-absorbing capacity (LAC) requirements for systemic banks. - To minimize moral hazard and central bank balance sheet risks associated with current deposit guarantee arrangements, an industry-funded deposit protection scheme should be established to replace MoF and BCCh’s deposit guarantee arrangements. - Recommendation: Establish a statutory bank resolution authority with a comprehensive range of crisis management and resolution tools. - Recommendation: Establish and implement recovery and resolution planning and set a loss-absorbing capacity requirement for systemically important banks. - Recommendation: Establish a new industry funded deposit protection scheme. - Macroprudential coordination: - The Financial Stability Council (CEF) should play a greater role to enhance macroprudential cooperation and coordination. - Recommendation: Increase CEF secretariat resources and consider an annual publication of official CEF views on macroprudential risks. - Recommendation: Enhance interagency coordination on the use of the macroprudential toolkit. - Recommendation: Establish a consolidated and comprehensive public credit registry. - AML/CFT: - A regional peer assessment of the AML/CFT framework against the Financial Action Task Force standard was adopted in July 2021. The MER found strengths but identified gaps on the legal and effectiveness fronts. - Recommendation: Ensure a swift implementation of the 2021 AML/CFT MER recommendations. ### FSAP Key Recommendations (selected items with timing) - Ensure banks transition to Basel III-compliant capital structures and complete announced plans for capital raises in a timely manner. (NT) - Improve the collateral valuation and reporting framework. (NT) - Define and communicate clear criteria regarding conditions for the future unwinding of extraordinary liquidity support measures (FCIC and LCL). (I) - Introduce liquidity stress tests for prudential and stability monitoring. (NT) - Ensure sufficient budget resources to attract and retain specialized talent. (I) - Strengthen credit risk management and asset classification, including provisioning and treatment of restructured loans. (I, NT) - Improve the corrective actions framework. (NT) - Avoid further pension withdrawals and ensure that the pension system continues to support deep and liquid long-term capital markets. (I) - Improve pension fund regulation and investment options to promote long-term investment and minimize excessive switching. (NT) - Halt any further liquidations of life annuities. (I) - Strengthen the mutual fund liquidity management framework. (NT) - Establish a statutory bank resolution authority with a comprehensive range of crisis management and resolution tools. (I) - Establish and implement recovery and resolution planning and set a loss-absorbing capacity requirement for systemically important banks. (I) - Establish a new industry funded deposit protection scheme. (NT) - Facilitate the development of the interbank repo market. (NT) - Enhance the risk management function of the BCCh through higher haircuts and a stricter approach to unsecured bank bonds. (I) - Finalize the Emergency Liquidity Assistance (ELA) framework. (NT) - Increase CEF secretariat resources and consider an annual publication of official CEF views on macroprudential risks. (NT) - Ensure a swift implementation of the 2021 AML/CFT MER recommendations. (NT) ### Non-performing loans (NPLs), past-due loans, and recent support measures - NPL (over 90 days past due) ratio is below 2 percent. - The past-due loan ratio is about 5 percent at end-2020. - Recent support that helped keep NPLs low: - Mortgages, personal and commercial loan repayment deferrals. - Voluntary rescheduling. - Pension withdrawals. ### Non-bank sector, mutuals, pensions, and shadow banking - Mutual and pension funds allocate 64 percent of their long-term credit portfolio to bank bonds. - Life insurance companies allocate 72 percent of their similar portfolio to corporates. - Mutual funds buying bank debt have driven growth in non-bank financial intermediation. - Riskier non-bank lending dependent on short-term funding has remained relatively constant. - Chile has the largest dependency of bank funding on nonbank financial institutions (NBFIs) amongst the 29 FSB-monitored countries, but average bank exposure to NBFIs is small. - Nonbank consumer lenders (NBL) are small but growing: - Bank exposure to consumer loans through NBLs represents only about 2 percent of bank assets. - Lack of a consolidated credit registry complicates assessment of borrowers’ total debts. ### Wholesale funding, pension funds, and central bank backstops - Mutual and pension funds (retail investor bases) are prone to redemption and reallocation shocks; pension fund reallocation increased dramatically since 2011. - Pension fund switching is virtually unrestricted, increasing the risk of dislocations in bank and corporate bond funding. - Q3 2019 reallocations/redemptions put significant pressure on bank and corporate bonds and the CLP; BCCh interventions quelled market volatility. - BCCh expanded collateral framework for liquidity operations to include unsecured bank bonds, increasing correlation risk and BCCh exposure to the banking sector. - BCCh interventions also included FX spot market operations and FX swaps to attenuate banks’ US dollar funding stress. - Funding risks are heightened by the lack of a functioning secured inter-bank lending market. ### Central bank balance sheet and potential losses - BCCh currently has a negative equity position of 0.9 percent of GDP, stemming from the 1980’s banking crisis when BCCh bought bank assets and provided lender of last resort funding. - BCCh guarantees banks’ sight deposits in the absence of a deposit protection scheme, raising potential for significant BCCh losses following a bank failure. ### Liquidity risks from further withdrawals and annuity liquidations - Further pension fund withdrawals or annuity liquidations would pose a systemic liquidity risk. - Previous withdrawals were well managed by the authorities. - BCCh established a USD$10 billion spot purchase with term sale facility (CC-VP) to soften the market impact of pension liquidations. - Further withdrawals risk market disruptions, especially given uncertain environment and lack of an obvious buyer base for long-term assets. - Particular risk to life annuities: insurance company liquidity buffers could be severely tested, potentially leading to asset fire-sales and capital shortfalls. ### Solvency and provisioning (exact figures) - Banking system is sufficiently capitalized overall but has pockets of weakness. - Provision coverage noted: - Non-performing mortgages provisioning: 8.8 percent. - Consumer loans provisioning: 48.3 percent. - International comparators (EBA 2020 EU-wide transparency exercise) provision rates: 26.4 percent for mortgages and 61.9 percent for consumer loans across EU27/EEA exposure countries. - Ratio of specific provisions to all past due loans is 29.7 percent as of end 2020. - Risks are heightened due to a large share of loans currently covered by COVID-related special provisioning rules and potential stale collateral valuations. - Example from stress testing: loss-given-default (LGD) for mortgages under the adverse scenario jumps to 22 percent for year 3 versus a current 8.9 percent prudential provision rate. ### Emerging vulnerabilities - Household and corporate leverage increased with easy financial conditions and financial deepening; pockets of vulnerability among low-income households where consumer loans had increased until the pandemic. - Housing market appears stable; rising housing prices drove increases in mortgage debt. - Increasing vacancy rates in commercial real estate could lead to medium-term risks. - Corporate leverage risks appear limited: financial debt to equity is relatively low; a large share of corporate FX debt is hedged and related to FDI/obligations to parent companies. - Banks’ sovereign debt holdings rose from 3.5 percent of total assets in 2019Q2 to 6.7 percent in 2021Q2, raising the potential for an intensified sovereign-bank nexus if trends continue. - Gradual expansion of fintech requires balanced innovation and regulation; a new fintech bill intends to establish a legal framework for fintech companies and a regulatory framework for open banking. ### Stress testing, scenarios, and key quantitative results - Quantitative approaches in FSAP included: - (i) bank solvency tests to assess resilience to credit, interest rate, and market risks; - (ii) bank liquidity stress tests; - (iii) exploratory analysis on climate transition and physical risks; - (iv) mutual and pension funds liquidity stress tests; - (v) interconnectedness and contagion risk analysis. - Solvency stress test scenarios: - Baseline follows April 2021 WEO forecast. - Adverse scenario implies a negative GDP shock close to 3 standard-deviations of the real GDP growth rate relative to the next two-year baseline (14 percent cumulative in level terms). - Under the baseline scenario: - Aggregate common equity Tier-1 (CET1) capital ratio rises. - System aggregate capital ratio (CAR) would increase by 0.8 percentage points to 15 percent by 2023. - Under the adverse scenario: - Pockets of weaknesses in individual banks: several banks use CCB buffers; two fall below CET1/T1 hurdle rates; a third falls below the T1 threshold. - Planned capital raises not considered in exercise; some shortfalls partly attributable to low starting capital or phased derecognition of capital instruments during Basel III implementation. - Sensitivity analysis on unwinding BCCh liquidity support and credit lines: three-year cumulative effect on capital ratio would be in the 0.3–1.3 percentage point range. - Bank liquidity stress tests: system appears resilient to sizeable funding withdrawals though results vary across banks and extraordinary liquidity support measures materially affect outcomes. - Climate risk stress tests: - Physical risks (floods and droughts) suggest relatively small impact on banking system capitalization, with caveats on data limitations and non-linear effects. - Transition risks (carbon pricing shock) increase segment exposure-weighted corporate portfolio PDs by 0.3 to 0.5 percent under a 3-year scenario, with transportation, electricity and gas, forestry and mining as largest contributors. - If transition risk were taken into account under the adverse scenario, it would have resulted in an additional depletion of capital ranging between 26 and 53 bps. - Mutual and pension fund liquidity stress tests: - Most fixed income mutual funds hold liquidity buffers larger than 15 percent of AUM, but a significant share hold less; 15 percent corresponds to the first percentile (severe stress) of typical weekly redemptions. - Type “E” pension funds: liquidity buffers are larger than 30 percent for all AFPs. - Recommendation: consider a more robust liquidity management framework for mutual funds; more restrictive switching rules and/or appropriate market mechanisms for pension funds to reduce excessive switching. ### Interconnectedness and contagion - Network analysis indicates contained domestic contagion risks; cross-border exposures are significant for transmission of credit shocks. - Banks’ total capital is six times larger than aggregate interbank exposures, limiting cascading failure risk from domestic contagion. - Highly interconnected network between conglomerates and banks suggests vulnerabilities to contagion effects. - Inward spillover: U.S. has the largest impact on Chilean banks in inward spillover analysis. ### Supervisory structure, BCP assessment, and reform priorities - BCP assessment highlights strengths and areas for improvement: - Strength: CMF capably staffed with expertise in monitoring individual risks. - Needed improvements: integrated risk management framework; corporate governance standards and supervision; legal framework for licensing; corrective actions; consolidated supervision; collateral valuation and provisioning guidance; stronger AML/CFT legal and effectiveness measures. - Transition to Basel III: - Implementation of Basel III starting from December 2021 will largely address shortcomings of the capital framework. - Pillar 2 capital requirements were introduced in the regulatory framework in September 2020 but are not fully in force. - Key supervisory reform actions recommended: - Establish integrated risk management frameworks in CMF and banks. - Strengthen corporate governance standards, including fit and proper criteria and collective suitability of boards. - Strengthen legal framework for licensing and ensure shareholders can provide additional financial support. - Expand corrective actions toolkit to enable earlier and broader supervisory interventions. - Improve consolidated supervision by enhancing legal framework and organizational arrangements, and establishing a unit for comprehensive financial analysis of conglomerates. - Strengthen collateral valuation practices and provisioning requirements; update collateral valuations regularly. - Enhance CMF resourcing and capacity to attract specialized talent (cyber risk, IT, data science). ### Mutual funds, pension funds, and retirement system findings and recommendations - Mutual funds: - Liquidity regulation constrained: general prohibition on more than 50 percent of a MF portfolio being in “illiquid assets” is insufficient for systemic liquidity management. - Type 3 fixed income mutual funds: about 40 percent of Type 3 Fund AUM are held by funds with buffers below the 15 percent level; stress tests show vulnerability to tail redemptions. - Recommendation: implement a mutual fund liquidity management framework (LMF) with risk-based approach, stress-testing, and consider standard liquidity management tools (redemption fees, gating, redemption in kind). - Pension funds: - Multifondos approach contributed to excessive switching, amplified by social media advisors. - Type E pension funds: liquidity buffers are larger than 30 percent for all AFPs (except one AFP noted in tests); coordinated switching remains a systemic concern. - Recommendation: consider replacing multifondos with target-date default funds; more restrictive switching rules and/or market mechanisms (fees) recommended. - Extraordinary withdrawals reduced AUM by at least 25 percent (over US$50 billion) and left over 3 million of the 11 million individual accounts empty. - Recommendation: avoid additional pension fund withdrawals; increase contributions (of at least the recently proposed 6 percent) to raise replacement rates. ### Insurance, annuities, and accounting standards - Life annuity liquidations pose severe liquidity and solvency risks to insurers; authorities should halt further liquidations. - Recommendation: implement a modern risk-based capital (RBC) framework in insurance that complements IFRS 17 and IFRS 9 adoption. - IFRS adoption status: - CMF has adopted IFRS since 2009. - IFRS 9 is not adopted; financial sector follows CMF-prescribed provisioning requirements for accounting and prudential purposes. ### Crisis preparedness, resolution, and deposit protection - Chile lacks a statutory resolution regime; liquidation remains the only statutory process for insolvent firms. - Recommendation: establish a statutory bank resolution authority with a comprehensive range of resolution tools and structural separation from prudential supervision. - Recommendation: implement recovery and resolution planning and set loss-absorbing capacity (LAC) requirements for systemic banks. - Deposit protection: - Current arrangements: BCCh guarantees sight deposits and MoF guarantees time deposits of natural persons up to about US$8,000; guarantees cover all banks with no direct levy cost. - Recommendation: establish an industry-funded prefunded deposit protection scheme to limit moral hazard and central bank balance sheet risks. ### Systemic liquidity, central bank risk management, and market infrastructure - Lack of an institutional repo market: despite deep capital markets, an institutional secured money market does not exist; banks prefer unsecured exchanges and the central bank serves as backstop. - BCCh risk management concerns: - Use of unsecured bank bonds as collateral with minimal haircuts increased correlation risk and BCCh exposure to banks. - Recommendation: strengthen issuer limits, implement a more prudent haircut schedule, exclude unsecured bank bonds from collateral framework except in crisis times, and reinforce risk management perspective in policy proposals. - Emergency Liquidity Assistance (ELA) framework: - Operationalization requires a specific ELA Regulation, procedures, a master agreement, and an MoU between BCCh and CMF. - ELA should be reserved for solvent banks facing temporary liquidity issues and be accompanied by government guarantees when provided to banks with uncertain solvency or under resolution. ### Key exact economic and financial indicators (selected figures) - Output Real GDP (annual % change): 2019 = 1.0, 2020 = -5.8, 2021 = 11.0, 2022 = 2.5 - Unemployment rate (annual average): 2019 = 7.2, 2020 = 10.8, 2021 = 9.1, 2022 = 7.4 - Inflation (End of period, %): 2019 = 3.0, 2020 = 2.9, 2021 = 5.5, 2022 = 3.4 - Central Government Gross Debt (percent of NGDP): 2019 = 28.2, 2020 = 32.5, 2021 = 34.4, 2022 = 37.3 - Gross international reserves (USD billions): 2019 = 40.7, 2020 = 39.2, 2021 = 51.2, 2022 = 51.2 - Nominal GDP (USD billions): 2019 = 279, 2020 = 253, 2021 = 331, 2022 = 353 - Financial system: Total assets (USD billions) = 455.5, Percent of GDP = 299.9 (Table 3, 2020) - Banks (2020): Number = 18, Assets (USD billions) = 454.3, Percent of GDP = 161.2 - Pension fund administrators (2020): Number = 7, Assets (USD billions) = 209.5, Percent of GDP = 74.3 - Mutual funds (2020): Number = 197, Assets (USD billions) = 72.2, Percent of GDP = 25.6 - Financial Soundness Indicators (selected exact items, Table 4): - Regulatory Capital to Risk-Weighted Assets: 2020 = 14.7; 2021 Q1 = 14.8 - Regulatory Tier 1 Capital to Risk-Weighted Assets: 2020 = 10.7; 2021 Q1 = 10.8 - NPLs to Gross Loans: 2020 = 1.6; 2021 Q1 = 1.5 - Return on Assets: 2020 = 0.5; 2021 Q1 = 1.5 - Liquid Assets to Total Assets: 2020 = 22.2; 2021 Q1 = 21.1 - FX Loans to Total Loans: 2020 = 16.1; 2021 Q1 = 15.9 - Total assets (In billions of Chilean pesos): 2020 = 323,127; 2021 Q1 = 313,784 - Percent of GDP (Total assets): 2020 = 161.3; 2021 Q1 = 152.6 ### FSAP Risk Assessment Matrix (selected risks and impacts) - Global resurgence of the COVID-19 pandemic (Overall Level of Concern: Medium) - Expected impact: Lower export revenue, financial outflows, higher debt service burdens, exchange rate mismatches, transmission via conglomerates, credit losses on mortgages. - De-anchoring of inflation expectations in the U.S., rising core yields and risk premia (Overall Level of Concern: Medium) - Expected impact: Large interest rate increase, corrections to stretched asset valuations, losses from higher debt service, mutual fund losses from maturity mismatches, severe real estate price correction. - Widespread social discontent and political instability (Overall Level of Concern: Medium) - Expected impact: Income shocks to less affluent borrowers, sharp market reactions, credit losses in leveraged NBLs, higher mortgage delinquency. ### Authorities’ views and responses - Authorities are largely supportive of FSAP recommendations and consider the Chilean financial system resilient and regulators well-coordinated in crisis response. - Authorities emphasized concerns about further pension withdrawals and life annuity liquidations undermining financial markets and creating liquidity risks. - Authorities noted that incorporation of announced capital raising plans and Basel III secondary regulation would materially affect stress test outcomes and reduce identified capital shortfalls. - Authorities agreed on the need for improved collateral valuation frameworks and liquidity stress testing, noting that unwinding of extraordinary liquidity support will be state-dependent. *Source: EXECUTIVE SUMMARY and selected chapters, Chile Financial Sector Assessment Program (FSAP), 1chlea2021006.* ### EXECUTIVE SUMMARY ___________________________________________________________________________ 7 ### EXECUTIVE SUMMARY ### Macro-Financial Context - Chile experienced twin shocks: social unrest in 2019Q4 and the 2020 COVID-19 crisis; authorities responded with coordinated monetary, fiscal, and supervisory policies. - Central government gross debt is 32 percent of GDP (up from 11 percent in 2011). Credit ratings by S&P, Moody’s, and Fitch are A, A1, and A-, respectively. - Growth projections and uncertainty: - Growth is projected at 11 percent for 2021. - Medium-term growth forecast is 2.5 percent in 2022. - Key crisis-response measures and effects: - MoF expanded government guarantee programs for commercial bank loans (FOGAPE-COVID) and SME loans (FOGAPE-REACTIVA), offsetting a dramatic decline in market loan demand. - CMF established special provisioning rules facilitating banks' rescheduling (limited 3–6-month payment deferrals); by end-October 2020, rescheduled loans represented 38 percent of bank mortgage and commercial lending combined. Additional guaranteed six-month mortgage payment delays were introduced in January 2021. - BCCh established the Financing Facility Conditional on Increased Lending (FCIC) and a bank bond purchasing program to offset wholesale funding dislocations; as of October 2021 about US$35.7 billion of the FCIC has been employed. - BCCh cut the policy rate by 125 bps to its historical low of 0.5 percent and began a special asset purchase program in June 2020. Since July 2021, BCCh increased its policy rate three consecutive times to 2.75 percent. - Pension and annuity disruptions: - Congress approved three extraordinary pension fund withdrawals totaling about 19 percent of GDP. - In May 2021, retirees and others were allowed to liquidate up to 10 percent of their life annuities; legality was challenged by insurers in Chilean courts and international arbitration. - Financial system structure and size: - Financial assets comprised 300 percent of GDP at end-2020. - Pension funds (PFs) held assets equal to 74 percent of GDP at end-December 2020. - Mutual funds (MFs) grew from 17 to 26 percent of GDP from 2010 to 2020. - Banks dominate credit provision; the top four (six) banks hold 66 (89) percent of assets. - Over the last decade wholesale funding through bond issuance grew; smaller banks have up to 40 percent of liabilities in bonds while the biggest banks have a large sight deposit base. - Pre-crisis return on assets (ROA) was below 0.5 percent. ### Policy Advice and Financial Stability Findings - Banking solvency and capital: - Solvency stress tests show the banking sector is sufficiently capitalized overall, but pockets of weakness need addressing. - Recommendation: Ensure banks transition to Basel III-compliant capital structures and complete announced plans for capital raises in a timely manner. - Improving timely collateral valuation and reporting would lower downside risks. - Climate stress tests do not show current vulnerabilities but suggest transition risks merit further monitoring. - Banking liquidity: - Bank liquidity appears ample but has been boosted by policy measures (high deposits, BCCh funding, pension withdrawals). - Liquidity stress tests show limited risks under current conditions; a reversal of these conditions will require clear official communication and careful liquidity management by banks. - Recommendation: Define and communicate clear criteria regarding conditions for the future unwinding of extraordinary liquidity support measures (FCIC and LCL). - Recommendation: Introduce liquidity stress tests for prudential and stability monitoring. - Supervision and regulation: - The Basel Core Principles (BCP) assessment found the CMF capably staffed with expertise in monitoring individual risks, but reforms are needed in several areas, including credit risk, asset classification, risk management, corporate governance, licensing, and corrective actions. - Deferred Basel III implementation to December 2021 should largely address capital framework shortcomings. - Recommendation: Ensure sufficient budget resources to attract and retain specialized talent. - Recommendation: Strengthen credit risk management and asset classification, including provisioning and treatment of restructured loans. - Recommendation: Establish an integrated risk management framework and enhance corporate governance standards and supervision. - Recommendation: Strengthen the legal framework for licensing to ensure banks’ shareholders are fit, proper and financially strong. - Recommendation: Improve the corrective actions framework. - Recommendation: Improve consolidated supervision by enhancing the legal framework, supervision practices and organizational arrangements. - Pension system and market functioning: - Excessive pension fund switching was driven by a social media-based financial advisor; this lowered returns and increased market volatility. - Additional extraordinary pension withdrawals would further weaken domestic capital markets and should be avoided. - Recommendation: Improve pension fund regulation and investment options to promote long-term investment and minimize excessive switching. - Recommendation: Avoid further pension withdrawals and ensure that the pension system continues to support deep and liquid long-term capital markets. - Insurance and annuities: - Further life annuity liquidations carry severe liquidity risks and broader implications for macroeconomic stability. - While insurers managed previous withdrawals, they could face forced fire sales under future unwinds, threatening solvency and causing spillovers. - Recommendation: Halt any further liquidations of life annuities. - Recommendation: Implement a modern risk-based capital framework in insurance with due regard to the impact of introducing IFRS 17 and IFRS 9. - Mutual funds and nonbank institutions: - Mutual funds need a stronger liquidity management framework; current regulations provide only limited ability for supervisors to ensure sufficient liquidity to meet redemptions in stress scenarios. - Recommendation: Strengthen the mutual fund liquidity management framework. - Systemic liquidity framework and market infrastructure: - The absence of a secured money market may overburden the central bank’s liquidity-providing operations. - Stronger risk management practices are needed regarding collateral requirements and acceptance of bank bonds. - The Emergency Liquidity Assistance (ELA) framework needs operationalizing. - Recommendation: Facilitate the development of the interbank repo market. - Recommendation: Enhance the risk management function of the BCCh through higher haircuts and a stricter approach to unsecured bank bonds. - Recommendation: Finalize the Emergency Liquidity Assistance (ELA) framework. - Crisis preparedness and resolution: - A statutory bank resolution authority is needed to conduct resolution planning and manage bank failures. - Chile is well positioned to introduce loss-absorbing capacity (LAC) requirements for systemic banks. - To minimize moral hazard and central bank balance sheet risks associated with current deposit guarantee arrangements, an industry-funded deposit protection scheme should be established to replace MoF and BCCh’s deposit guarantee arrangements. - Recommendation: Establish a statutory bank resolution authority with a comprehensive range of crisis management and resolution tools. - Recommendation: Establish and implement recovery and resolution planning and set a loss-absorbing capacity requirement for systemically important banks. - Recommendation: Establish a new industry funded deposit protection scheme. - Macroprudential coordination: - The Financial Stability Council (CEF) should play a greater role to enhance macroprudential cooperation and coordination. - Recommendation: Increase CEF secretariat resources and consider an annual publication of official CEF views on macroprudential risks. - Recommendation: Enhance interagency coordination on the use of the macroprudential toolkit. - Recommendation: Establish a consolidated and comprehensive public credit registry. - AML/CFT: - A regional peer assessment of the AML/CFT framework against the Financial Action Task Force standard was adopted in July 2021. The MER found strengths but identified gaps on the legal and effectiveness fronts. - Recommendation: Ensure a swift implementation of the 2021 AML/CFT MER recommendations. ### FSAP Key Recommendations (selected items with timing) - Ensure banks transition to Basel III-compliant capital structures and complete announced plans for capital raises in a timely manner. (NT) - Improve the collateral valuation and reporting framework. (NT) - Define and communicate clear criteria regarding conditions for the future unwinding of extraordinary liquidity support measures (FCIC and LCL). (I) - Introduce liquidity stress tests for prudential and stability monitoring. (NT) - Ensure sufficient budget resources to attract and retain specialized talent. (I) - Strengthen credit risk management and asset classification, including provisioning and treatment of restructured loans. (I, NT) - Improve the corrective actions framework. (NT) - Avoid further pension withdrawals and ensure that the pension system continues to support deep and liquid long-term capital markets. (I) - Improve pension fund regulation and investment options to promote long-term investment and minimize excessive switching. (NT) - Halt any further liquidations of life annuities. (I) - Strengthen the mutual fund liquidity management framework. (NT) - Establish a statutory bank resolution authority with a comprehensive range of crisis management and resolution tools. (I) - Establish and implement recovery and resolution planning and set a loss-absorbing capacity requirement for systemically important banks. (I) - Establish a new industry funded deposit protection scheme. (NT) - Facilitate the development of the interbank repo market. (NT) - Enhance the risk management function of the BCCh through higher haircuts and a stricter approach to unsecured bank bonds. (I) - Finalize the Emergency Liquidity Assistance (ELA) framework. (NT) - Increase CEF secretariat resources and consider an annual publication of official CEF views on macroprudential risks. (NT) - Ensure a swift implementation of the 2021 AML/CFT MER recommendations. (NT) *Source: EXECUTIVE SUMMARY, Chile Financial Sector Assessment Program (FSAP).* ### 8. Non-performing loans (NPLs) are low versus peers (text chart). Recently this has been ### 8. Non-performing loans (NPLs) are low versus peers (text chart) ### NPLs, past-due loans, and recent support measures - NPL (over 90 days past due) ratio is below 2 percent. - The past-due loan ratio is about 5 percent at end-2020. - Recent support that helped keep NPLs low: - Mortgages, personal and commercial loan repayment deferrals. - Voluntary rescheduling. - Pension withdrawals. ### Non-bank sector, mutuals, pensions, and shadow banking - Mutual and pension funds allocate 64 percent of their long-term credit portfolio to bank bonds. - Life insurance companies allocate 72 percent of their similar portfolio to corporates. - Mutual funds buying bank debt have driven growth in non-bank financial intermediation. - Riskier non-bank lending dependent on short-term funding has remained relatively constant. - Chile has the largest dependency of bank funding on nonbank financial institutions (NBFIs) amongst the 29 FSB-monitored countries, but average bank exposure to NBFIs is small. - Nonbank consumer lenders (NBL) are small but growing: - Bank exposure to consumer loans through NBLs represents only about 2 percent of bank assets. - Lack of a consolidated credit registry complicates assessment of borrowers’ total debts. ### Wholesale funding, pension funds, and central bank backstops - Mutual and pension funds (retail investor bases) are prone to redemption and reallocation shocks; pension fund reallocation increased dramatically since 2011. - Pension fund switching is virtually unrestricted, increasing the risk of dislocations in bank and corporate bond funding. - Q3 2019 reallocations/redemptions put significant pressure on bank and corporate bonds and the CLP; BCCh interventions quelled market volatility. - BCCh expanded collateral framework for liquidity operations to include unsecured bank bonds, increasing correlation risk and BCCh exposure to the banking sector. - BCCh interventions also included FX spot market operations and FX swaps to attenuate banks’ US dollar funding stress. - Funding risks are heightened by the lack of a functioning secured inter-bank lending market. ### Central bank balance sheet and potential losses - BCCh currently has a negative equity position of 0.9 percent of GDP, stemming from the 1980’s banking crisis when BCCh bought bank assets and provided lender of last resort funding. - BCCh guarantees banks’ sight deposits in the absence of a deposit protection scheme, raising potential for significant BCCh losses following a bank failure. ### Liquidity risks from further withdrawals and annuity liquidations - Further pension fund withdrawals or annuity liquidations would pose a systemic liquidity risk. - Previous withdrawals were well managed by the authorities. - BCCh established a USD$10 billion spot purchase with term sale facility (CC-VP) to soften the market impact of pension liquidations. - Further withdrawals risk market disruptions, especially given uncertain environment and lack of an obvious buyer base for long-term assets. - Particular risk to life annuities: insurance company liquidity buffers could be severely tested, potentially leading to asset fire-sales and capital shortfalls. ### Solvency and provisioning - Banking system is sufficiently capitalized overall but has pockets of weakness. - Provision coverage noted: - Non-performing mortgages provisioning: 8.8 percent. - Consumer loans provisioning: 48.3 percent. - International comparators (EBA 2020 EU-wide transparency exercise) provision rates: 26.4 percent for mortgages and 61.9 percent for consumer loans across EU27/EEA exposure countries. - Ratio of specific provisions to all past due loans is 29.7 percent as of end 2020. - Risks are heightened due to a large share of loans currently covered by COVID-related special provisioning rules and potential stale collateral valuations. - Example from stress testing: loss-given-default (LGD) for mortgages under the adverse scenario jumps to 22 percent for year 3 versus a current 8.9 percent prudential provision rate. ### Emerging vulnerabilities - Household and corporate leverage increased with easy financial conditions and financial deepening; pockets of vulnerability among low-income households where consumer loans had increased until the pandemic. - Housing market appears stable; rising housing prices drove increases in mortgage debt. - Increasing vacancy rates in commercial real estate could lead to medium-term risks. - Corporate leverage risks appear limited: financial debt to equity is relatively low; a large share of corporate FX debt is hedged and related to FDI/obligations to parent companies. - Banks’ sovereign debt holdings rose from 3.5 percent of total assets in 2019Q2 to 6.7 percent in 2021Q2, raising the potential for an intensified sovereign-bank nexus if trends continue. - Gradual expansion of fintech requires balanced innovation and regulation; a new fintech bill intends to establish a legal framework for fintech companies and a regulatory framework for open banking. ### Stress testing, scenarios, and key quantitative results - Quantitative approaches in FSAP included: - (i) bank solvency tests to assess resilience to credit, interest rate, and market risks; - (ii) bank liquidity stress tests; - (iii) exploratory analysis on climate transition and physical risks; - (iv) mutual and pension funds liquidity stress tests; - (v) interconnectedness and contagion risk analysis. - Solvency stress test scenarios: - Baseline follows April 2021 WEO forecast. - Adverse scenario implies a negative GDP shock close to 3 standard-deviations of the real GDP growth rate relative to the next two-year baseline (14 percent cumulative in level terms). - Under the baseline scenario: - Aggregate common equity Tier-1 (CET1) capital ratio rises. - System aggregate capital ratio (CAR) would increase by 0.8 percentage points to 15 percent by 2023. - Under the adverse scenario: - Pockets of weaknesses in individual banks: several banks use CCB buffers; two fall below CET1/T1 hurdle rates; a third falls below the T1 threshold. - Planned capital raises not considered in exercise; some shortfalls partly attributable to low starting capital or phased derecognition of capital instruments during Basel III implementation. - Sensitivity analysis on unwinding BCCh liquidity support and credit lines: three-year cumulative effect on capital ratio would be in the 0.3–1.3 percentage point range. - Bank liquidity stress tests: system appears resilient to sizeable funding withdrawals though results vary across banks and extraordinary liquidity support measures materially affect outcomes. - Climate risk stress tests: - Physical risks (floods and droughts) suggest relatively small impact on banking system capitalization, with caveats on data limitations and non-linear effects. - Transition risks (carbon pricing shock) increase segment exposure-weighted corporate portfolio PDs by 0.3 to 0.5 percent under a 3-year scenario, with transportation, electricity and gas, forestry and mining as largest contributors. - If transition risk were taken into account under the adverse scenario, it would have resulted in an additional depletion of capital ranging between 26 and 53 bps. - Mutual and pension fund liquidity stress tests: - Most fixed income mutual funds hold liquidity buffers larger than 15 percent of AUM, but a significant share hold less; 15 percent corresponds to the first percentile (severe stress) of typical weekly redemptions. - Type “E” pension funds: liquidity buffers are larger than 30 percent for all AFPs. - Recommendation: consider a more robust liquidity management framework for mutual funds; more restrictive switching rules and/or appropriate market mechanisms for pension funds to reduce excessive switching. ### Interconnectedness and contagion - Network analysis indicates contained domestic contagion risks; cross-border exposures are significant for transmission of credit shocks. - Banks’ total capital is six times larger than aggregate interbank exposures, limiting cascading failure risk from domestic contagion. - Highly interconnected network between conglomerates and banks suggests vulnerabilities to contagion effects. - Inward spillover: U.S. has the largest impact on Chilean banks in inward spillover analysis. ### Policy implications and recommendations (implicit in analysis) - Enhance monitoring of funding and liquidity risks as extraordinary liquidity support measures are unwound. - Ensure realistic capital planning by banks given potential phase-out of support measures and capital instrument derecognition. - Strengthen liquidity management frameworks for mutual funds; consider measures to limit systemic risks from low liquidity buffers. - Consider more restrictive pension fund switching rules and/or market mechanisms to reduce excessive switching and associated market disruption risks. - Develop a consolidated credit registry to improve assessment of borrower indebtedness. - Balance fintech innovation with regulatory safeguards, including frameworks for open banking. - Maintain vigilance on sovereign-bank linkages given rising bank holdings of sovereign debt. *Source: IMF staff and Chile FSAP material in the supplied content unit.* ### 35. The Basel Core Principles (BCP) assessment found CMF to be capably staffed with ### The Basel Core Principles (BCP) assessment found CMF to be capably staffed with ### Staffing, mandate, and resources - BCP assessment found CMF to be capably staffed with expertise in monitoring of individual risks, although further improvements are required. - CMF’s legal mandate is broad and does not prioritize prudential supervision relative to its other mandates; it encompasses market conduct, market development, and financial stability, which could result in potential conflicts with prudential supervision. - Budget constraints might hinder the effectiveness of supervisory processes in the future. CMF’s budget depends on MoF approval. Sufficient funding is essential to allow CMF to attract and retain staff in highly specialized fields. ### Reforms to supervisory structure and legal framework - In 2018, the authorities revised the banking law and overhauled the financial supervisory structure to improve supervision through better coordination on financial markets and supervision of the regulatory perimeter and conglomerates. - The FSAP conducted a full BCP assessment of banking supervision, the first under 2012 BCP standards. ### Capital framework and Basel implementation - Implementation of Basel III starting from December 2021 will largely address shortcomings of the capital framework. - The Basel I framework is not compatible with the size and complexity of the banking industry. For now, capital is required for credit risk only. - Pillar 2 capital requirements were introduced in the regulatory framework in September 2020 but are not fully in force. ### Key reform areas (enumerated) - Establishing an integrated risk management framework to help CMF and banks have a holistic view on banks’ risk management capabilities. - Strengthening of corporate governance standards and supervision, including in respect to aspects of governing banks’ board members and senior management (fit and proper criteria, collective suitability of the board). - Strengthening the legal framework for licensing, including granting powers to ensure banks’ shareholders and senior management are fit and proper and that shareholders have capacity to provide additional financial support. - Increasing the scope of the corrective actions framework: - Current triggers rely mostly on breaches of regulatory requirements or materialized indications of deterioration, which could affect supervisory effectiveness. - The corrective action toolkit should be enhanced, including by imposing more stringent prudential limits and requirements, restricting payments to shareholders, and facilitating takeovers/mergers with healthier institutions. - Strengthening consolidated supervision: - Improvements in the legal framework, establishment of a unit for comprehensive financial analysis and monitoring of financial conglomerates (2011 FSAP recommendation), and establishment of lead examiners and ratings for conglomerates would all be beneficial. - Improving credit risk management and asset classification: - Current regulatory guidance on the definition, identification, and treatment of loans subject to restructuring/refinancing is insufficient. - Restructured loans can be quickly reclassified up to performing, creating a risk that banks delay the recognition of inevitable credit losses through aggressive restructurings. - CMF is aware of this risk and is closely monitoring rescheduling activity. - Strengthening collateral valuation and provisioning requirements: - Regulations lack explicit supervision guidelines on collateral revaluation to help adequately provision for problem exposures, including estimation of foreclosure and liquidation costs. - Collateral valuations should be updated on a regular basis. - There is recognition by the authorities that bank consumer loans are under-provisioned, which should be addressed with the adoption of CMF’s standardized provisioning methodology. ### Mutual Fund supervision and liquidity - Liquidity regulation is constrained by the current legal framework: regulators are limited to a general prohibition on more than 50 percent of a MF portfolio being in “illiquid assets”. - Given large fixed-income (type 3) mutual funds with assets (bank and corporate bonds) whose liquidity can deteriorate rapidly under stress, a more sophisticated approach is recommended. - Fixed income market volatility and ensuing supervisory actions during Q4 2019 support the need for greater attention to this area. - A MF liquidity management framework (LMF) is needed to reduce systemic risks: - The LMF should utilize a risk-based regulatory approach and conduct periodic stress-testing. - While applicable to all MFs, it should be customized according to fund assets and redemption rules. - Standard liquidity management tools (LMTs) that allow fixed income fund managers to respond to stress events should also be considered, including redemption fees, gating, and redemption in kind. - Additional regulations limit leverage, prohibit certain investment types, and enforce portfolio concentration limits. ### Pension fund regulation and supervision - Supervisory measures are needed to reduce switching and improve participant outcomes. - The multifondos approach was best-in-class twenty years ago but is now outdated and has helped enable recent switching behavior by providing extreme options (Funds A and E). - Implementing target-date default funds, which in other markets have achieved a higher resistance to excess switching even during periods of higher market stress, could help facilitate this. - The risk-based supervision (RBS) model of the pension supervisor should be enhanced: - Overall, SP has provided robust oversight of the pension system. - Though the move to a risk-based supervision approach has successfully begun, burdensome compliance-based oversight needs streamlining (in parallel with improvements to the investment regime) to allow SP to focus on the riskiest entities and activities. ### Insurance sector supervision - More work is needed to strengthen the regulatory framework for RBS of insurance companies; some aspects require approval of changes in the broader legal framework. - Authorities should implement a modern risk-based capital (RBC) framework to replace the current leverage limit and simple minimum solvency requirement: - The RBC requirement should include capital requirements based on market and credit risks rather than current legal restrictions on asset allocation. - A RBC requirement will complement the economic basis of valuation enabled by IFRS 17 and IFRS 9 and encourage better risk management, in particular better matching of assets and liabilities. ### Macroprudential policy and coordination - Macroprudential policy coordination is run through the Financial Stability Council (Consejo de Estabilidad Financiera, CEF), which lacks hard powers. - Created through legislation in 2011, CEF is chaired by the Finance Minister and includes the CMF president, the Pension Superintendent, and the BCCh Governor as a permanent invitee and advisor. - Despite multiplicity of mandates and lack of hard powers, CEF has historically performed well in facilitating macroprudential coordination and crisis response. - Formal “opinion” mechanisms are embedded in legislation that foster coordination between BCCh and CMF. - BCCh’s financial stability report (FSR) plays a central role in macroprudential risk analysis: - The FSR is one of the highest quality financial stability reports in Latin America and has facilitated the identification and containment of financial stability risks in Chile. - While CMF and other CEF members are given some input into the FSR, they lack a public venue for communication of their own views on financial stability. - The counter-cyclical capital buffer (CCyB) is currently being introduced: - Given complementarities between the CCyB (under BCCh’s primary jurisdiction) and the rest of the macroprudential toolkit (largely controlled by the CMF), regulators should further strengthen coordination. - Careful thought should be given to the desired neutral rate of the CCyB, which should balance regulatory flexibility against potential capitalization needs. - The Chilean authorities are well equipped for the use of broader macroprudential measures and have a large number of tools, although few new measures have been implemented recently. - Recommendations for the CEF to take a more active role: - Expanding the capacity of the CEF secretariat. - Conducting annual reviews of systemic risks in a dedicated CEF meeting. - Publishing CEF member views on financial stability risks and regulatory responses. ### AML/CFT framework - Chile has taken important steps to strengthen its AML/CFT regime in line with international standards. - The July 2021 MER notes that Chile has made significant effort in identification and assessment of money laundering and terrorism financing risks through its 2017 National Risk Assessment and other sectoral studies. - Strong AML/CFT policies and strategies are in place, with a high level of implementation of priorities identified in its 2018–2020 Action Plan. - Efforts should continue to enhance effectiveness: - MER notes remaining gaps in the legal framework and effectiveness that require attention. - Authorities should ensure the application of effective, proportionate, and dissuasive sanctions for AML/CFT breaches to the preventive measures. - They should also strengthen the implementation of the preventive framework regime and AML/CFT risk-based supervision. - On entity transparency, significant improvements are needed to ensure timely availability of beneficial ownership information. ### Crisis preparedness, bank resolution, and deposit protection - Progress has been made in crisis management since the 2011 FSAP, but significant gaps remain. - Banking regulations were revised to increase supervisory powers and expand the crisis management toolkit. - CMF’s prudential toolkit to manage banks at risk of failure lacks an ex-ante recovery planning requirement for banks. - Main recommendations: - Establishing a statutory bank resolution authority with a comprehensive range of resolution tools, clearly setting failing banks apart from the general insolvency framework; ensure structural separation and operational independence between resolution and prudential supervision functions. - Enhancing cross-authority crisis coordination, including finalizing and publishing the crisis management MoU between MoF, CMF, and BCCh. - Establishing and implementing resolution planning for all banks in scope; for systemic banks this should include setting a loss-absorbing capacity (LAC) requirement. - Chilean Systemic banks are well-positioned to comply with LAC requirements given their issuance of wholesale debt securities, which could be adjusted to meet LAC eligibility requirements when refinanced. - Establishing an industry funded deposit protection scheme (DPS) to replace existing MoF and BCCh deposit guarantee arrangements: - A prefunded DPS would limit moral hazard and central bank balance sheet risks associated with the unlimited guarantee of sight deposits by the BCCh and term deposits of natural persons by the MoF. - The DPS should be implemented alongside a new resolution regime, have the ability to ensure a rapid pay out of covered depositors under liquidation, and be able to contribute to the costs of resolution. ### Systemic liquidity and central bank risk management - The absence of a secured money market may overburden BCCh’s liquidity-providing operations: - Despite well-developed capital markets, an institutional repo market does not exist in Chile, as banks prefer exchanging liquidity on an unsecured basis, with the central bank serving as backstop. - Setting appropriate risk/reward and regulatory incentives to develop this market should be a policy priority. - BCCh needs to implement stronger risk management practices, particularly regarding collateral requirements: - BCCh took significant risks in its crisis response, particularly with the use of bank bonds as collateral with minimal haircuts, exposing the BCCh to correlation risk. - Authorities should: (i) strengthen risk control measures through issuer limits and a more prudent haircut schedule, based on the risk equivalence principle; (ii) exclude unsecured bank bonds from the collateral framework except in crisis times; and (iii) reinforce the risk management perspective in policy proposals. - Operationalization of the Emergency Liquidity Assistance (ELA) framework will require close cooperation between the central bank and the banking supervisor: - ELA should be reserved, as last resort, to solvent banks facing temporary liquidity issues, and should be accompanied by a government guarantee when liquidity support is provided to a bank with uncertain solvency or under resolution. - While the BCCh Act provides an appropriate legal basis for an effective ELA framework, the legal architecture should be completed by a specific ELA Regulation, procedures for the central bank and the banking supervisor, a master agreement, and an MoU between the BCCh and the CMF. ### Authorities’ views - The Chilean authorities have been highly supportive of the FSAP mission and are largely in agreement with its key recommendations, which they believe would foster a more comprehensive reform agenda, particularly in crisis management, pension and mutual fund regulation, and insurance and banking supervision. - Authorities believe their strong response to the events of 2019 and 2020 and continuing financial stability have demonstrated both the resilience of the Chilean financial system and the ability of regulators to deal with shocks in a well-coordinated fashion. - Looking forward, authorities are most concerned with potential risks posed by further legislation allowing extraordinary withdrawals from the pension system and/or anticipated liquidation of life annuities, which could undermine these sectors and domestic financial markets more broadly, and potentially create liquidity risks. ### Financial stability analysis and oversight - Authorities assess the banking sector as sound with adequate capital and liquidity levels, and risks being recognized in a timely manner. - Authorities saw merit in the FSAP team’s bank stress testing approach and the alternative views it delivered compared to their own frameworks: - For the solvency analysis, authorities expressed concerns with the severity of the adverse scenario and the reliance on satellite model estimations based on historical default rates, which no longer reflect the recent credit quality improvement of several market segments. - Authorities emphasized that if announced capital raising plans had been incorporated into these scenarios, capital shortfalls identified by the FSAP exercise are materially eliminated. - They also noted that regulators had already issued all secondary regulation towards Basel III and that the banks with the largest gaps were already taking steps. - Authorities agree with the need to introduce a more updated collateral valuation framework and to fully integrate liquidity stress testing. - They emphasized that the conditions for the unwinding of extraordinary liquidity support measures will be largely state-dependent, and that banks know the expiration date and should be already preparing for their termination. - Authorities welcomed the work on climate, especially the analytical work conducted with BCCh staff on modelling transition risks, which could become a key component of their future stress testing exercises. - Financial System Oversight: Authorities noted that the BCP assessment was conducted when the CMF is still in the process of integration and the impact of the pandemic is continuing. CMF officials ensured excellent cooperation with the team in this challenging period. *IMF FSAP chapter content.* ### 65. CMF generally agrees with the BCP assessment and assigned grades but has some ### CMF generally agrees with the BCP assessment and assigned grades but has some ### Authorities’ agreements and disagreements with FSAP findings - CMF generally agrees with the BCP assessment and assigned grades but does not fully agree with: - the assessment that supervisors are constrained by an incomplete legal framework for licensing; - that the corrective actions framework needs to be strengthened; - aspects of the asset classification and provisioning framework. CMF acknowledges some gaps compared to international standards but believes that the overall framework is sound. - Authorities agreed with recommendations for strengthening of pension, insurance, and mutual fund supervision. - Authorities agreed on the need for a more robust liquidity management framework for mutual funds, while emphasizing that mutual funds withstood the redemptions experienced in 2019 without incidents and that regulation must trade-off liquidity concerns with the development of local debt markets. - Authorities agreed with the FSAP recommendations on macroprudential framework and tools. - Noted BCCh has a long-standing role in financial stability, including publishing the FSR since 2004. - Financial stability mandate is shared with CMF; institutional macroprudential coordination among agencies has been very effective. - Authorities agree on enhancing systemic risk monitoring by strengthening the CEF. ### Crisis preparedness and financial safety nets - Authorities largely agreed with recommendations regarding bank resolution and crisis management, while noting: - challenges of establishing a new resolution authority; - they did not fully agree that crisis coordination arrangements are triggered too late. - On deposit insurance, authorities emphasized balancing the substantial costs with the potential benefits of transitioning away from the current guarantees of sight and time deposits. - Authorities agreed with recommendations on systemic liquidity, emphasizing the need for flexibility regarding the provision of ELA. ### Financial system trends and shocks (selected findings from figures) - Financial system growth and funding: - The financial system "has grown steadily" and, before the 2019 and 2020 shocks, banks relied increasingly on market funding. - As credit collapsed during the pandemic, government guaranteed loans "took up the slack." - Interest rates dropped across the economy; investment in mutual funds has grown steadily. - Banking indicators: - Capital adequacy increased recently as risk-weighted assets declined due to state guarantees, capital increased, and loans contracted. - Bank profitability declined with higher provisions. - Non-performing loans have remained low, but provisions have not kept pace with all past due loans. - Nonbank financial institutions and shadow banking: - Chile NBFIs are large, driven by Pension/Mutual Funds. - True shadow banking is not large and is dominated by fixed income mutual funds (EF1). - Fixed income funds have grown steadily; other shadow banking activities have stayed constant or declined. - Lending dependent on short-term funding (EF2) remains large, particularly in non-bank consumer lending. ### Bank funding dynamics and stress tests (selected findings) - Bank funding dynamics: - Bond spreads, exchange rate movements, and BCCh interventions (including FX swap, repos, FX spot/NDF) are notable for 2019 interventions. - Bank stress test scenarios and results: - Large dispersion among bank results with two falling below regulatory minimum, mainly due to low starting points and Basel III phase-in impact. - In the baseline, solid internal capital generation capacity driven by elevated net interest income partially offsets transitory capital reductions attributed to Basel III. - In the adverse scenario, losses eat into banks’ capital buffers; in some cases ratios fall below the regulatory minimum. - Credit losses and lower net interest income drive negative results in Year 3 of the adverse scenario. - Effects of stressed interest and non-interest income and significant credit impairments are only partially offset by lower effective taxes and restrictions on dividend payouts. - Net income after taxes would only start recovering under Year 3 of the adverse scenario due to a favorable interest rate environment and contained credit impairments. - Sensitivity analysis: - The 3-year cumulative impact of unwinding FCIC and LCL measures might reach 150 bps; banks should anchor capital planning on the unwinding timeline. - In the adverse scenario, the impact of partially unwinding the effect of 2020 policy support measures could exceed 60 bps in terms of capital ratios. ### Liquidity stress testing and mutual funds - Liquidity stress testing: - Impact of extraordinary liquidity support measures and pension fund withdrawals on LCRs has been "spectacular"; the transitory effect of measures should not be ignored. - Weak U.S dollar LCR outlook warrants attention to avoid amplifying systemic liquidity stress. - ASF component of NSFR was affected by stable funding injections; potential cliff-effects as policies phase out and the requirement becomes binding. - Some small liquidity shortfalls under the 3-month cash-flow analysis stress; large funding profile dispersion requires regular monitoring via liquidity stress testing. - Mutual funds: - Type 3 mutual funds saw unprecedented redemptions during social unrest and, to a lesser extent, at the onset of the COVID-19 crisis. - Stress-testing of type 3 mutual funds shows that liquidity buffers may be less than desirable. - Social unrest and COVID-19 generated a flight-to-quality: type 3 MFs suffered redemptions while MMFs saw inflows. - Corporate bonds gained share from Treasuries and bank bonds because corporate bonds were not eligible for collateral for BCCh. - Pension funds: - Type E pension funds saw significant pressures during social unrest and resorted to using Treasuries while increasing Bank CDs. - Pressures were more contained at the onset of COVID-19 but similar compositional shifts occurred. - Pension fund switching has an increasing trend; default funds B, C and D are not heavily affected, but funds A and E have been severely affected with switching negatively correlated between the extreme portfolios. - Stress-testing of type E pension funds confirms AFPs have ample liquidity buffers. - Type A PFs saw large inflows during social unrest and at the onset of COVID-19; type E funds saw large swings tilted to outflows. ### Key economic and financial indicators (selected exact figures from Table 2, Table 3, Table 4) - Table 2: Selected Economic Indicators (annual percentage change, unless otherwise specified) - Output Real GDP: 2019 = 1.0, 2020 = -5.8, 2021 = 11.0, 2022 = 2.5 - Total domestic demand: 2019 = 0.9, 2020 = -9.3, 2021 = 20.2, 2022 = 1.9 - Consumption: 2019 = 0.9, 2020 = -6.9, 2021 = 16.8, 2022 = 3.7 - Investment 2/: 2019 = 1.0, 2020 = -17.8, 2021 = 34.1, 2022 = -4.6 - Unemployment rate (annual average): 2019 = 7.2, 2020 = 10.8, 2021 = 9.1, 2022 = 7.4 - Inflation (End of period, %): 2019 = 3.0, 2020 = 2.9, 2021 = 5.5, 2022 = 3.4 - Central government fiscal balance (in percent of NGDP): 2019 = -2.9, 2020 = -7.3, 2021 = -8.1, 2022 = -1.8 - Central Government Gross Debt: 2019 = 28.2, 2020 = 32.5, 2021 = 34.4, 2022 = 37.3 - Central Government Net Debt: 2019 = 8.0, 2020 = 13.4, 2021 = 19.8, 2022 = 20.7 - Gross international reserves (in billions of U.S. dollars): 2019 = 40.7, 2020 = 39.2, 2021 = 51.2, 2022 = 51.2 - Gross external debt (% of GDP): 2019 = 66.1, 2020 = 77.7, 2021 = 70.6, 2022 = 68.9 - Nominal GDP (in billions of USD): 2019 = 279, 2020 = 253, 2021 = 331, 2022 = 353 - Table 3: Structure of the Financial System, 2020 - Banks: Number = 18, Assets (USD billions) = 454.3, Percent of total assets = 53.7, Percent of GDP = 161.2 - Domestic: Number = 8, Assets = 192.5, Percent of total assets = 22.8, Percent of GDP = 68.3 - Foreign: Number = 9, Assets = 187.1, Percent of total assets = 22.1, Percent of GDP = 66.4 - Insurance Companies: Number = 69, Assets = 76.7, Percent of total assets = 9.1, Percent of GDP = 27.2 - Pension fund administrators: Number = 7, Assets = 209.5, Percent of total assets = 24.8, Percent of GDP = 74.3 - Mutual funds: Number = 197, Assets = 72.2, Percent of total assets = 8.5, Percent of GDP = 25.6 - Total financial system: Number = 1628, Assets = 455.5, Percent of total assets = 100.0, Percent of GDP = 299.9 - Memo: GDP (USD bn) = 282 - Table 4: Financial Soundness Indicators (selected exact items) - Total assets (In billions of Chilean pesos): 2014 = 180,846; 2015 = 203,609; 2016 = 211,687; 2017 = 220,365; 2018 = 246,266; 2019 = 290,500; 2020 = 323,127; 2021 Q1 = 313,784 - Percent of GDP (Total assets): 2014 = 121.7; 2015 = 127.6; 2016 = 124.9; 2017 = 122.7; 2018 = 129.1; 2019 = 147.9; 2020 = 161.3; 2021 Q1 = 152.6 - Regulatory Capital to Risk-Weighted Assets: 2014 = 13.4; 2015 = 12.6; 2016 = 13.8; 2017 = 13.8; 2018 = 13.3; 2019 = 12.8; 2020 = 14.7; 2021 Q1 = 14.8 - Regulatory Tier 1 Capital to Risk-Weighted Assets: 2014 = 10.0; 2015 = 9.4; 2016 = 10.9; 2017 = 11.0; 2018 = 10.7; 2019 = 10.3; 2020 = 10.7; 2021 Q1 = 10.8 - NPLs to Gross Loans: 2014 = 2.1; 2015 = 1.9; 2016 = 1.8; 2017 = 1.9; 2018 = 1.9; 2019 = 2.1; 2020 = 1.6; 2021 Q1 = 1.5 - Return on Assets: 2014 = 1.5; 2015 = 1.3; 2016 = 1.2; 2017 = 1.3; 2018 = 1.3; 2019 = 1.2; 2020 = 0.5; 2021 Q1 = 1.5 - Liquid Assets to Total Assets: 2014 = 13.6; 2015 = 13.8; 2016 = 14.7; 2017 = 15.3; 2018 = 14.2; 2019 = 15.3; 2020 = 22.2; 2021 Q1 = 21.1 - FX Loans to Total Loans: 2014 = 18.4; 2015 = 20.0; 2016 = 18.2; 2017 = 16.6; 2018 = 18.4; 2019 = 18.9; 2020 = 16.1; 2021 Q1 = 15.9 ### FSAP Risk Assessment Matrix (selected risks and impacts) - Global resurgence of the COVID-19 pandemic - Overall Level of Concern: Medium - Relative Likelihood: (staff’s subjective assessment; see RAM note) - Expected Impact if Materialized: - Lower export revenue leading to lower growth, consumption, and investment. - Financial outflows from emerging markets. - Losses due to higher debt service to income ratio for leveraged corporations and households, including on banks’ residential mortgage portfolios. - Losses due to exchange rate mismatches following large exchange rate adjustment. - Transmission between affiliated institutions via the conglomerate structure. - De-anchoring of inflation expectations in the U.S., rising core yields and risk premia - Overall Level of Concern: Medium - Expected Impact if Materialized: - Large interest rate increase in response to higher risk premia and capital outflows. - Disruptive corrections to stretched asset valuations. - Losses due to higher debt service and refinancing cost. - Losses due to interest rate mismatches following a large interest rate increase. - Losses in mutual funds due to maturity mismatches that translate into difficulties for banks to roll over market funding as corporate issuances are impaired. - Severe price correction in the real estate market. - Widespread social discontent and political instability - Overall Level of Concern: Medium - Expected Impact if Materialized: - Shock affects income of less affluent borrowers via higher unemployment, affecting consumption. - Sharp negative market reaction to social or political events. - Credit losses in leveraged NBLs exposed to less affluent borrowers, which could transmit to affiliated banks via the conglomerate structure. - Lower capacity to repay mortgages for less affluent borrowers, leading to an increase in delinquency. - Increase in risk premia. *Source: https://www.imf.org/-/media/files/publications/cr/2021/english/1chlea2021006.pdf* ### Appendix I. Banking Sector Stress Testing Matrix ### Appendix I. Banking Sector Stress Testing Matrix ### Banking Sector: Solvency Risk — Institutional Perimeter and Data - Institutions included: The six largest banks in Chile at the highest level of consolidation - Market share: For the six banks within scope, approximately 88 percent of banking sector assets - Data Source and Baseline Date: - CMF regulatory returns and supervisory data - Historical data on bank parameters based on BCCh and CMF statistical data warehouse - Balance sheet and financial statement data available in the public domain - Moody’s Analytics: CreditEdge data on corporate default probabilities - Data as of December 2020 (cut-off). End-2019 data were also be used for comparisons and sensitivity analysis purposes - Scope of financial consolidation: group-wide at the global level ### Banking Sector: Solvency Risk — Channels of Risk Propagation and Methodology - Methodology: - Balance sheet approach - Projections of key balance sheet, income statement and capital account items - Static balance sheet assumption - Credit risk, market risk, net interest income and non-interest income projections for two scenarios: baseline and macro adverse - Granular projections of credit risk parameters including exposures at default (EADs), probabilities of default (PDs), losses given default (LGDs) for each asset class - Four loan segments: large corporates (monitored individually), smaller commercial loans, mortgages and consumer credit; segmentation based on prudential rules and data availability - PD PiT satellites based on historical PD series for system and individual banks; LGD PiTs produced by applying scenario shocks to collateral of each exposure and aggregating - Net interest income projected based on sensitivity to macrofinancial conditions for reference rates and effective spread margins; liability reference and margin rate shocks linked to macro scenario and repricing profiles used to approximate pass-through rates - Market risk: impact on P&L and OCI due to FVTPL and FVOCI positions; impact on mutual fund, equity and FX exposures measured - Net fee and commission income stressed using historical volatility and conservative haircuts reflecting scenario narrative - Operational expenses over total assets kept at the same level as in 2020 - Risk weighted assets adjusted to reflect changes in credit quality - Satellite models for macro-financial linkages: - PD PiT models for each segment based on country aggregate historical PD time series and scenario translation of bank-specific starting points in the distance to default space; Bayesian Model Averaging (BMA) techniques used to control for model uncertainty - Panel PD-PiT econometric estimation models on bank-specific historical PD PiT time series using BMA - Moody’s EDF data series used to produce econometric satellites for corporate/commercial segments - Loan level simulation used to estimate macro scenario impacts on aggregate portfolio LGDs - Cross-sector country proxies used where direct calibration not feasible - Stress test horizon: Three years (2021 Q1 – 2023 Q4) ### Banking Sector: Solvency Risk — Tail Shocks, Scenarios and Sensitivities - Scenario analysis: - Two macrofinancial and financial scenarios: baseline and macro adverse - Scenarios specify key macrofinancial variables for Chile and global variables (e.g., copper, oil and other commodity prices) - Baseline scenario based on April 2021 World Economic Outlook (WEO) projections - Macro adverse scenario calibrated using the Global Macrofinancial Model (GFM); assumes materialization of systemic risks highlighted in the RAM - Adverse scenario narrative includes: prolonged real and financial stress post-COVID-19, suppressed mobility and contact-intensive sector demand, reduced income and confidence, tightening financial conditions for vulnerable corporates, reassessment of asset valuations triggering risk-off and asset corrections - Domestic layer: prolonged election uncertainty introduces additional confidence shock, downward pressure on domestic demand, subdued consumption and investment, sharp correction in real estate and equity prices absorbed largely by banks, curtailing profitability and tightening interbank market - External channel: stifled global commodity demand leads to markdown of copper price partially offset by depreciation of Chilean peso; monetary policy assumed accommodative and short-term interest rates assumed to remain at current levels for entire scenario horizon - Adverse scenario severity (verbatim): - deviation of Chile real GDP from its baseline of 7.6 percent by 2021, with a 2.9 Standard Deviation move in two-year cumulative real GDP growth rate, 1 6.8 percent increase in unemployment rate from its baseline and a 27 percent peak-to-trough decline in real estate prices - Sensitivity analysis: - Focus on impact of policy support measures during 2020 and their gradual unwinding - COVID-19 related measures explored: - Loan deferrals, grace periods or any other type of voluntarily or regulatory forbearance - State guarantees for the provision of new credit (FOGAPE credits) - Liquidity support measures and their impact in the provision of new credit - Pension-fund account withdrawals and their impact on delinquencies during the pandemic - Assessment of pass-through constraints for high net interest margin geographies to assess profitability resiliency - Comparison of IRRBB approaches: earnings-based (effective NII) by FSAP team vs economic value (EV) approach of CMF and BCCh - Comparison of market risk approaches: FV duration revaluation by FSAP team vs cash flow revaluation of CMF and BCCh frameworks ### Banking Sector: Solvency Risk — Risks, Behavioral Assumptions and Reporting - Risks/factors assessed: - Credit risk: all on-balance/off-balance sheet exposures at amortized cost by regulatory exposure sector and geography; different paths by sector/geography - Starting point of credit parameters used to project scenario dependent forward paths; 2020 starting points adjusted for policy measures where applicable - Market risk: valuation effects of FVTPL and FVOCI positions and net open financial positions (equities, funds and inflation-linked instruments); scenario-based interest rate curves and additional shocks (corporate spread rate shock, bank issued bonds spread shock) - Net interest income: projected effective interest rates by asset/liability class; time to repricing approach based on fixed/variable break-down and point in time repricing ladder - Non-interest income: shocks simulated to capture market-sensitive components - Projected RWA densities capture deterioration of credit quality and partial/full unwinding of policy support measures - Behavioral adjustments (assumptions): - Static balance sheet: exposures remain constant, not evolving with scenario credit growth - For NII, maturing assets/liabilities replaced by instruments of same type and maturity but at current rates - No recognized interest on non-performing exposures - If banks’ capital falls below regulatory requirements, no prompt corrective action assumed - Banks are assumed to pay 27 percent of their profits as tax and dividend payout ratio assumed to be the maximum of 40 percent or the payout ratio of the cut-off year - Reporting format for results: - System-wide evolution of CET1 and capital ratios - Distribution of banks’ capital positions - Contribution to key drivers to system-wide net income and capital position, including differences between baseline and adverse scenarios - Share of institutions with capital below the hurdle rates ### Banking Sector: Solvency Risk — Regulatory and Calibration Standards - Calibration of risk parameters: - Current regulation under Basel I rules; transition to Basel III planned for gradual implementation in Q4 2021 - FSAP stress test produced results based on a fully loaded Basel III framework under assumption that system transitions to Basel III on Dec 31st, 2021; a phase-in capital calculation also attempted - FSAP team used CMF’s internal projections/estimates on eligible capital, RWA densities and levels for credit, market and operational risk, minimum capital requirements and capital buffer phase-in plan - Accounting provisions set by CMF regulations (IFRS 9 not yet implemented; CMF sets accounting loan loss provisioning); stress test followed CMF definitions of PDs and LGDs where applicable - All credit exposure portfolios under the standardized approach (STA); working assumption remained post-transition to Basel III (all portfolios remain under STA) - RWA densities assumed constant or following path defined by extraordinary policy support measures phase-out; changes driven by credit quality deterioration or policy support unwinding - PiT PDs and LGDs estimated for each asset class - Regulatory/accounting and market-based standards: - Baseline hurdle rates include regulatory minimum and any applicable capital buffers - Adverse scenario: regulatory minimum assumed to be the hurdle rate - Hurdle rates based on common equity tier-1 and total capital ratios --- ### Banking Sector: Liquidity Risk — Institutional Perimeter and Data - Institutions included: The six largest banks in Chile at the highest level of consolidation - Market share: For the six largest banks, approximately 88 percent of banking sector assets - Data and baseline date: - C46 and C47 CMF regulatory returns monitoring the Liquidity Coverage Ratio and the Net Stable Funding Ratio and additional monitoring returns capturing liquidity contractual maturity ladder - Scope of financial consolidation: group-wide at the highest level ### Banking Sector: Liquidity Risk — Channels, Methodology and Horizons - Methodology: - Three types of tests: LCR test, cash-flow analysis and NSFR test - LCR test aligned with CMF (and Basel compliant) monitoring tool; features total consolidated liquidity and liquidity in significant currencies (mainly U.S. dollar or euro) - Scenarios for LCR outflows and HQLA haircuts used to produce stressed LCR ratios by currency and consolidated level - Cash-flow analysis assesses net cash balance accounting for available unencumbered assets, contractual cash inflows/outflows and behavioral flows - Scenarios explore funding run-off rates, liquid assets haircuts and inflow/outflow assumptions for different stress durations - Cash-flow analysis may consider second-round effects: margin calls, central bank liquidity provision, additional asset haircuts due to fire sales, additional repo haircuts, wholesale funding market freezes - NSFR stress estimates projected ratios under prolonged stress where stable funding cannot be rolled over - Asset haircuts in cash-flow analysis reflect: (i) shocks to interest rates and asset prices captured by macro scenarios; and (ii) additional haircuts required by counterparties to accept assets as collateral - LCR test horizon: 30 days - Cash-flow analysis horizon: normally 3 months; sensitivity may extend up to 1 year ### Banking Sector: Liquidity Risk — Risks, Behavioral Assumptions - Risks: - Funding liquidity risk reflected in funding run-off rates and asset roll-over rates (cash inflows related to non-renewal of maturing assets) - Market liquidity risk reflected in asset haircuts influenced by market movements, potential fire sales and collateral supply - Behavioral adjustments: - Liquidity from central bank emergency lending assistance (ELA) is not considered - Inflows from maturing loans are ignored in cash-flow analysis to capture systemic liquidity stress vs bank-idiosyncratic - Cash-flow analysis may include behavioral assumptions about counterparties’ willingness to transact based on banks’ solvency/liquidity conditions ### Banking Sector: Liquidity Risk — Tail Shocks, Scenarios and Calibration - Scenario analysis: - LCR test: 12 scenarios as combination of (i) three liquid asset shock scenarios (regulatory, mild and severe) and (ii) four liability outflow scenarios (regulatory, retail outflows, higher wholesale outflows, combined retail and wholesale outflows) - Cash-flow analysis: series of scenarios from mild to severely adverse liquidity conditions; considers both funding and market liquidity risks - NSFR analysis: single stress scenario featuring inability to roll-over longer term (stable) funding positions for a period of a year (exploratory) - Calibration of risk parameters: - LCR tests based on regulatory and stress parameters - Cash-flow analysis may incorporate second-round effects - Stress funding run-off rates, asset roll-over rates, and asset haircuts calibrated using empirical evidence and international experiences - Regulatory/accounting and market-based standards: - LCR per Basel III; hurdle at 100 percent - Net cash balance for cash-flow analysis: to pass, a non-negative net cash balance required - NSFR per Basel III; (targeted) hurdle at 100 percent ### Banking Sector: Liquidity Risk — Reporting and Sensitivity - Reporting format for results: - Changes in system-wide liquidity position, including drivers for cash outflows, inflows and counterbalancing capacity - Distribution of banks’ liquidity positions - Number of institutions with LCR/NSFR below 100 percent and/or negative net cash balance - Amount of liquidity shortfalls, including by currencies - Sensitivity analysis: - Analysis covers policy support measures and identifies how such measures impacted regulatory liquidity metrics - Also assesses how gradual unwinding of measures will affect banks’ liquidity positions - Infrastructure: - IMF staff developed infrastructure using C46 and C47 CMF returns as data repository; Matlab and Excel based ### Climate Change: Physical Risk — Institutional Perimeter and Data - Institutions included: The six largest banks in Chile at the highest level of consolidation - Data and baseline date: - Source: Supervisory data - Data as of December 2020 (cut-off) ### Climate Change: Physical Risk — Channels, Methodology and Scenario Design - Methodology: - Tail shock physical-risk event assumed: extreme hydrometeorological events - In absence of Chile-specific catastrophe risk model, event-linked damage shock assumption based on historical data analysis (provided by the WB FSAP team) - Adverse physical risk scenario (damage estimate) used as shock layer to physical capital stock within the GFM model - Simple OLS on Cobb Douglas production function used to obtain elasticity between GDP and capital stock to derive output growth impact shock (TFP and labor assumed constant) - Underlying DSGE model (GFM) used to calibrate a full macroeconomic scenario - Positive investment shocks imposed in years 3,4 and 5 to allow accumulation of capital stock and full recovery to baseline value ### Climate Change: Physical Risk — Risks, Buffers and Projections - Risks: - Credit channel risks assumed (revised PD paths); all other channels assumed unaffected - Scenario dependent capital projections produced based on revised PD paths for physical risk shock - Buffers: - Banks’ own capital *Source: Appendix I. Banking Sector Stress Testing Matrix — 1chlea2021006 (data and text as provided).* ### 5. Reporting ### 5. Reporting ### Climate Change: Transition Risk — Format for Results and Institutional Perimeter - Output presentation: - System-wide capital path projection under the physical risk scenario. - Comparison with the central baseline scenario. - Bank-level capital shortfalls. - Institutions included: - The six largest banks in Chile at the highest level of consolidation. - Data and baseline date: - Sectoral exposure breakdown: Source: Supervisory data. - Firm-specific emissions: publicly available dataset of the Ministry of Environment of Chile and BCCh calculations. - Firm balance sheets: Capital IQ and BCCh data post pre-processing. - Firm-specific historical default rates: Moody’s firm-level EDFs. ### Climate Change: Transition Risk — Channels of Risk Propagation and Methodology - Pricing shock: - An (arbitrarily set) carbon tax per metric tonne is assumed to be the pricing shock (a value of 100 USD per mt is used in the sample FSAP implementation). - Stepwise methodology: - Step 1 (Bridge equation): establish relationship between firm-specific default rates and three firm level balance sheet indicators (ICR, current ratio and leverage ratio called vulnerability indicators). Model averaging technique with sign constraint to perform a fixed effects panel regression on historical firm level default rates. - Firm sample restricted to listed companies with available historical default rate estimates. - Step 2: Carbon tax scenario applied to firms’ balance sheet according to firm level carbon emissions. Multi-year projections for balance sheet and profit components (forward-looking ICR, current ratios and leverage ratios) estimated using accounting identity. Constant economic conditions, no shifts in business models, energy usage or technological advancement are assumed. - Sample augmented to listed or non-listed companies for which balance-sheet information is available. - Step 3: Elasticities from Step 1 used to infer stressed default rates (using forward looking metrics from Step 2) for the augmented sample of firms. - Step 4: Weighted sectoral aggregates (pre- and post-stress) produced by aggregating firm level default rates and using total outstanding debt as weights. - Step 5: Bank level sectoral corporate exposure breakdown used to produce delta PDs using the pre- and post-stress default rates from Step 4. - Step 6 (optional): Stressed delta PDs (reflecting transition risk) can be optionally fed to the standard solvency ST machinery to produce capital projections. - Horizon: - One to five years: multi-year projection of balance sheet dynamics and vulnerability indicators under a carbon pricing shock assumption. - Tail shocks and sensitivity: - Scenario analysis based on an assumed level of carbon pricing shock (a 100 USD price shock per metric tonne was used). - Delta PDs will also be applied to PD paths corresponding to different macroeconomic and financial scenarios. - Sensitivity analysis on the level of carbon tax (optional). ### Climate Change: Transition Risk — Risks and Reporting Outputs - Risks: - Credit channel risks (delta PDs added to scenario dependent PD paths). All other channels are assumed to remain unaffected. - Delta PDs by bank is the envisaged outcome of the analysis. - Reporting — Format for Results: - Delta PDs by sector. - Delta PDs by bank and (weighted) system-wide average. - Materiality relative to normal/idiosyncratic corporate PDs. ### Banking Sector: Interconnectedness — Institutional Perimeter and Methodology - Institutions included: - All eighteen banks in Chile. - Other major nonbank FIs (subject to data availability). - Data and baseline date: - Source: Supervisory data. - Data as of December 2020 (cut-off). - Methodology: - Interbank and cross-border network model by Espinosa-Vega and Solé (2010). ### Banking Sector: Interconnectedness — Risks, Buffers, Tail Shocks, and Reporting - Risks: - Credit and funding losses related to interbank cross-exposures (and cross-border banking exposures). - Buffers: - Banks’ own capital and liquidity buffers. - Tail shocks — Size of the shock: - Pure contagion: default of institutions. - Fire sale haircuts. - Reporting — Format for Results: - System-wide capital shortfall. - Bank-level capital shortfall. - Number of undercapitalized and failed institutions, and their shares of assets in the system. - Evolution and direction of spillovers. ### Appendix II — Non-Banking Sector Stress Testing Matrix: Mutual Funds and Pension Funds - Institutional perimeter: - Institutions included: - Mutual funds with a large share of bank and corporate bonds. - Pension funds subject to liquidity pressures. - Market share: - 18–42% of mutual funds depending of fund types considered. 18% corresponds to fixed income mutual funds, while the rest comprises possibly mixed funds that also have sizeable holdings of bank and corporate bonds. - 22–35% of pension fund assets subject to frequent switching pressures. - Data Source and Baseline Date: - For mutual funds, data is provided by the CMF. - For pension funds, data is provided by the Pension Superintendency (SP). - The baseline date for stress testing will be end of 2020. - Channels of Risk Propagation / Methodology: - Combine case studies with a historical approach. - Case studies: social unrest period of 2019, and the pandemic shock. - Historical approach: distribution of past redemptions over the last decade, comparison pre-2019 social unrest with the redemptions that followed. - An HQLA approach applied to construct liquidity buffers at individual mutual fund and pension fund level. - Scenarios and Sensitivities: - Scenario analysis: - A redemption shock applied to mutual funds based on historical and case study approaches. - A switching shock out of long-term bonds and into short-term assets applied for pension funds. - A distribution of liquidity shortages will be produced. - Sensitivity analysis: - Reverse test to produce a distribution of the maximum redemption that can be sustained by current liquidity buffers. - Risks and Buffers: - Highly liquid assets likely include cash, certificates of deposit, and government and central bank paper. - Behavioral adjustments: some alternative specifications of HQLA may be explored. - Reporting: - The analysis and results will be included in the Stress-Testing TN. ### Appendix III — Implementation of 2011 FSAP Recommendations (Progress Highlights) - Reduce information gaps, including through a consolidated credit registry and standardized residential and commercial property price indices: - Significant progress due to the merger of the credit registries of banks and retailers. - Develop a strategy to ensure adequate replacement rate for retirees: - 2015 Bravo Commission reform proposals prepared (including addressing low replacement rates) / 2018 submitted to parliament but not enacted. - 2019 Solidary Pension increased to poverty line. - 2020 and 2021 extraordinary withdrawals have severely lowered expected replacement rates. - Strengthen the independence and legal protection of regulatory agencies: - The CMF has operational independence and transparent processes. Budget constraints might hinder supervisory processes. No legal protection as such although CMF senior officials and staff are provided legal defense by the CMF. - Complete the incorporation of Basel bank capital standards: - Legal and regulatory changes that aim to comply with Basel 3 capital framework are issued. They will be implemented starting from December 2021. - Pillar 2 capital requirement was introduced in the regulatory framework in September 11, 2020. - Strengthen enforcement powers of securities regulators: - Legislation from February 2017 (Law 21000) grants powers to the securities regulator (CMF). - CMF law (DL 3538) significantly enhanced legal powers of CMF to supervise securities markets. - Other changes introduced in the Agents law – mandatory blackout periods and whistle blowers. Investment advisors have been included in the CMF perimeter. - Establish legal framework to enable consolidated oversight of financial conglomerates: - CMF has framework of limited supervision of the financial conglomerate; legal framework empowers CMF to exercise full consolidated supervision only over the banking group (from the bank downwards). Parent companies are not effectively supervised and CMF has no access to information on affiliates. - Enhance uniformity in business conduct regulation for asset management services and investment advice: - Legislation from January 2014 (Law 20712) establishes uniform framework for management of third-party portfolios. Investment advisory services addressed under Law 21214. - Introduce comparable transparency standards for fixed income securities traded outside exchanges: - Partly implemented. Addressed in a crowdfunding regulation proposal subjecting Alternative Financial Instruments Transaction Systems to CMF supervision and pre- and post-transaction transparency obligations. - Adopt a comprehensive approach to custodial, clearing, and settlement infrastructure: - Legislation from November 2014 (Laws 20789, 21000) provides coordination and information exchange between the Central Bank, the CMF, the Superintendency of Pensions, and the Ministry of Finance. - Joint policy statement for commitment to comply with PFMIs from 2017; CMF Circular 2237 from 2018 requires compliance with CPMI-IOSCO principles. BCCh 2018 regulation requires designated payment systems full observance of PFMIs. - Further enhance the AML/CFT framework: - FATF review in process; MER by GAFILAT completed in July 2021. - Strengthen legal framework for bank resolution: - Not implemented. There is no statutory resolution process in Chile; liquidation remains the only statutory process when a firm becomes insolvent. - Consider introduction of a premium-based limited deposit insurance system: - Not implemented. There is a MoF guarantee for bank time deposits held by natural persons up to a limited of about US$8,000 and a BCCh guarantee of 100 percent of bank sight deposits. - Examine options to establish framework for dealing with systemic crisis and potential failure of a financial conglomerate: - Not implemented. CMF plans to improve bank recovery planning capabilities and consider how existing CMF powers can be used to support a solvent wind down of a failing bank. ### Appendix IV — Mutual and Pension Fund Stress-Testing: Key Findings and Results - Stress-testing Fixed Income Mutual Funds (Type 3): - Method: - Historic redemptions and asset classification used to construct liquidity buffers for individual funds. - Cumulative distribution functions (CDFs) for redemptions constructed using daily fund flow data. - Only Bank CDs, BCCh Notes, and Treasuries considered for buffers. For Treasuries and Bank CDs with maturity over 90 days, a factor of 0.9 used to account for interest rate risk. Bank bonds excluded due to potential dramatic shift in liquidity under stress. - Redemption percentiles (Date Range / Percentile 1 / Percentile 5 / Percentile 10): - Full Sample: -15% / -6% / -3% - Before Sep2019: -15% / -5% / -3% - From Sep2019: -16% / -7% / -4% - 2010Q4-2018Q4: -19% / -8% / -4% - 2019Q4 – Social Unrest: -28% / -14% / -10% - 2010Q1-2019Q1: -14% / -5% / -3% - 2020Q1 – COVID-19 Shock: -19% / -10% / -6% - Results: - Stress tests show a significant share of fixed income MFs do not hold sufficiently large buffers to meet redemptions beyond the first percentile and could face a liquidity squeeze under tail redemption scenarios. - About 40 percent of Type 3 Fund AUM are held by funds with buffers below the 15 percent level that matches the first percentile of the typical distribution of weekly net inflows. - Stress-testing Type E Pension Funds: - Context: - Many AFPs manage portfolios in a manner closer to MFs due to switching; unrestricted ability to reallocate assets across fund types and activities of social media-based financial advisors have resulted in disruptive coordinated switching mostly between funds A and E. - Fund A is focused on FX equities and is highly liquid; Fund E is focused on long-term local fixed income and faces larger liquidity management challenges. - Pension fund switching percentiles (Date Range / Min / p1 / p5 / p10): - Full Sample: -19% / -12% / -5% / -2% - Until August 2019: -19% / -8% / -3% / -1% - After September 2019: -16% / -13% / -10% / -7% - 2019Q4: -14% / -11% / -7% / -6% - 2020Q1: -14% / -14% / -12% / -8% - Results: - Liquidity buffers are larger than 35 percent for all but one AFP, and larger than 30 percent for all of them. - Liquidity management practices from AFPs are set accordingly with their volatile environment. - Coordinated switching remains a systemic concern; recommended measures include more restrictive switching rules and market mechanisms like fees to eliminate potential for coordinated switching. ### Appendix V — Financial Development and the Pension System: Findings and Policy Recommendations - Key findings: - The funded pension system has contributed substantially to financial sector diversification and stability, and promoted sustained economic growth; it should be maintained while undergoing further transformation. - The funded system is better positioned than the previous “pay as you go” system to withstand demographic challenges and will be instrumental in post-pandemic recovery and long-term development goals. - COVID-19 and withdrawals impact: - Three rounds of emergency withdrawals from pension funds took place in 2020/2021, reducing AUM by at least 25 percent (over US$50 billion) and leaving over 3 million of the 11 million individual accounts empty, worsening future pension prospects. - Policy recommendations: - Avoid additional pension fund withdrawals; increase contributions to improve pension levels. - Additional contributions (of at least the recently proposed 6 percent) are needed to increase the contribution rate and raise the pension replacement rate of middle-class workers to around the minimum wage. Higher contributions should be introduced gradually. - Any new unfunded commitments should be covered within the existing solidarity pillar and funded by general taxation. - If central management of new funds is introduced, strong governance mechanisms are needed, and the existing individual account system should not be undermined. - Replace multifondos investment regulation with target date funds to reduce switching and better align investment portfolios with retirement cohort objectives. - Comparative table (Impact of Pension Reform on Capital Markets in Latin American Countries — Size of market before and after pension reform (In USD million)): - Chile (1980 vs. 2011): 57 / 31,000 / 800 / 40,000 / 72 / 270,000 - Colombia (1993 vs. 2007): 240 / 11,200 / 0.01 / 37 / 7 / 102 - Mexico (1996 vs. 2011): 330 / 21,000 / 2,300 / 18,500 / 73,000 / 409,000 - Peru (1992 vs. 2011): 0 / 5,800 / 0 / 27 / 1,700 / 82,000 *Source: 5. Reporting (chapter), 1chlea2021006 - 5. Reporting* ### Appendix VI. Report on the Observance of Standards and Codes: ### Appendix VI. Report on the Observance of Standards and Codes: Basel Core Principles for Effective Supervision ### Introduction — scope and headline findings - Assessment completed as a stand-alone Report on the Observance of Standards and Codes undertaken by the IMF and the World Bank during March–May of 2021 at the request of the Chilean authorities; reflects regulatory and supervisory framework in place as of the date of completion of the assessment. - Assessment conducted virtually due to the Covid-19 pandemic; timing was extended because of coordination and operational challenges. - First assessment in Chile under the 2012 BCP standards with expanded emphasis on supervisory practices and risk management. - Key supervisory strengths and areas for improvement identified: - Strength: CMF (Financial Market Commission) capably staffed with expertise in monitoring individual risks. - Improvements required in: - strengthening risk management framework; - enhancement of corporate governance standards and supervision; - classification and provisioning of problem loans. - Supervisors constrained by an outdated or incomplete legal framework hindering licensing and adequate supervision of conglomerates. - CMF would benefit from a strengthened corrective actions framework. - Integration note: Transfer of SBIF (former banking supervisor) to CMF is a recent development; integration and restructuring were still underway during the assessment. Recent (March 2021) restructuring of the CMF places supervision of insurance, securities, and banks under the same umbrella. - Pandemic-related priorities: provisioning, classification of performing versus non-performing loans, and collateral valuation. ### Transition to Basel III and regulatory timetable - Existing capital framework follows Basel I (not including the 1996 market risk amendment). - CMF published regulations in 2019 and 2020 aiming to comply with Basel III. - Authorities postponed implementation of Basel III requirements for a year due to Covid-19 and maintained the current general regulatory framework for banking capital requirements until December 2021. - Risk weighted assets will be computed according to the new framework starting from December 2021. - Phase-in period provided until 2025 for capital buffers/requirements (domestic systemically important banks charge, capital conservation buffer, counter cyclical capital buffer). - Pillar 2 framework will fully come into force in December 2023. - Footnote: Pillar 2 capital requirements are introduced in the regulatory framework on September 11, 2020 but have not fully come into force yet. ### Methodology and assessment context - Assessment against BCP methodology issued by the Basel Committee on Banking Supervision (BCBS) in September 2012. - Authorities opted to be assessed against essential criteria. - The 2012 revision expanded the Core Principles: now contain 247 separate essential and additional criteria. - Emphasis in the revised BCPs on supervisors’ powers and forward-looking, early-intervention supervisory practice. - Assessment relied on review of laws, rules, guidance, meetings with CMF, BCCh, FIU, auditing firms, professional bodies, and banking sector participants; authorities provided a self-assessment and confidential supervisory documents. - Ratings are not directly comparable to previous assessments; judgments were required and proportionality was applied given Chile’s financial system sophistication and complexity. ### Institutional and market structure — overview and key statistics - Chile’s financial system characteristics and size: - Financial assets accounted for 300 percent of GDP as of end-2020. - Total banking sector assets reached 323 trillion pesos (161 percent of GDP) by end 2020. - Assets managed by pension and insurance providers: 102 percent of GDP. - Non-bank financial institutions (NBFIs): 66 percent of GDP (include collective investment vehicles and non-bank lenders (NBLs); NBFIs also include non-bank deposit taking institutions such as credit unions and savings and loan associations, which are relatively small). - Total stock market trade stood at 403 billion pesos in 2020 (201 percent of GDP). - Market structure: - Financial system dominated by eight conglomerates combining banking with insurance, pension funds, mutual funds, and other NBFIs; some conglomerates include non-financial businesses and regional activities. - Banking sector composition: 18 private banks (including 9 foreign-owned banks) and Banco del Estado (a state-owned commercial bank). - Market concentration: top six banks account for almost 88 percent of the market (by loans). - Funding composition: long-term bank funding composed of deposit and wholesale funding; bond funding makes up between 15-20 percent of total liabilities for the largest banks in Chile; active foreign investor base in Chilean bank debt. - Banking sector indicators (pandemic impact): - Average return on equity (ROE) at 7.8 percent and return on assets (ROA) at 0.53 percent in December 2020. - Tier-1 ratio at 10.9 percent as of 2020 year-end. - Regulatory capital over risk-weighted assets stood at 14.7 percent (does not yet meet Basel III definition; Basel III to be phased in starting December 2021). - Non-performing loans (NPLs) remained low at below 4.8 percent as of February 2021. - Banking sector FX liabilities constitute 15 percent of total liabilities in 2020 year-end. ### Recent legal, regulatory, and policy developments - 2019 regulatory/supervisory consolidation: integration of CMF and SBIF to improve coordination on financial markets, regulatory perimeter, and conglomerates; aim to strengthen supervision of conglomerates and financial stability coordination including crisis management. - New Banking Law amendments dated December 1, 2019 aim to align Chile’s regulatory and supervision environment with international standards. - Pandemic effect: implementation of Basel III delayed by one year; additional capital needs expected at about $2.3 billion by 2025 (of which about 50 percent for Banco Estado). - Legislative changes: Congress passed legislation enhancing financial portability, improving financial market functioning, facilitating access to financing in local capital market, regulating financial advisors, and strengthening CMF powers to prevent financial market abuse. ### Preconditions for effective banking supervision — macroeconomic and central bank context - Macroeconomic policy framework: - Fiscal policy guided by a structural balance rule; autonomous central bank focused on inflation targeting; floating exchange rate; close coordination among economic authorities. - Central government gross debt-to-GDP ratio at 33 percent of GDP. - Sovereign rating downgrades (S&P and Fitch) to A in March 2021 and A- in October 2020 had limited impact; country maintained fiscal space and steady access to international markets at low rates; spreads returned to pre-pandemic levels. - Central Bank of Chile (BCCh): - Autonomous, technical, and strong; voluntarily underwent an independent external evaluation in 2019 highlighting high standards. - Undergoing a pilot review of its transparency system in light of the new IMF Central Bank Transparency Code. - Monetary policy based on inflation targeting and a floating exchange rate; committed to keep annual CPI inflation around 3 percent most of the time, within a tolerance range of plus or minus one percentage point. - Monetary response to the pandemic described as well-conceived, adequate, and unprecedented in magnitude; helped support liquidity and maintain low interest rates while anchoring inflation expectations. - Authorities did not engage in FX intervention during the pandemic until January 2021, though small interventions were used temporarily during the social unrest episode of 2019. ### Financial stability policy framework, coordination, and crisis arrangements - Institutional responsibilities: - CMF: supervises banks, their subsidiaries, large saving and credit cooperatives, credit card issuers, insurance companies, securities issuers, fund managers, brokers, and financial market infrastructures; covers prudential supervision, market conduct, and surveillance of all major financial institutions. - SP: supervises pension and some social security benefits. - MoF: responsible for preparation of financial sector bills. - BCCh: responsible for monetary policy, normal functioning of internal and external payments, regulatory authority regarding the financial system in specific areas, and lender of last resort role. - Inter-agency coordination: - Financial Sector Supervisory Committee facilitated cooperation and exchange of information but lost importance with integration of SBIF into CMF and formation of Consejo de Estabilidad Financiera (CEF). - Financial Stability Board (Consejo de Estabilidad Financiera or “CEF”) chaired by the MoF and consists of CMF and SP; BCCh is a permanent advisor (not a formal member) with access to and ability to share confidential information and be part of CEF working groups. - CEF can request and share information and commission analysis; its policy or regulatory recommendations to competent authorities are nonbinding. - Room for improving CEF’s role: currently an effective forum for crisis communication and technical coordination but lacks decision-making authority beyond commissioning analysis and sharing information. - CMF and BCCh working on an MoU that will include information sharing arrangements, agreement on stress testing practices and more detail on crisis management protocols, particularly for CMF decisions to place a firm into forced liquidation or BCCh decisions to provide emergency liquidity assistance to a bank experiencing liquidity stress. - Footnote: Authorities reported that the MoU was signed July 5th, 2021. ### Well-developed public infrastructure and legal environment - Chile governed by rule of law configured by the Constitution and laws; right to private property preserved by the constitution. - Rule of law ranked at the top among Latin American and Caribbean countries. - Constitutional process underway: October-2020 Referendum resulted in drafting a New Constitution expected to finish in mid-2022; process anticipated to consider social rights and the role of the State but preserve main pillars of current system. - Financial reporting framework established under the Companies Law No. *Source: Appendix VI. Report on the Observance of Standards and Codes: Basel Core Principles for Effective Supervision (assessment of Chile), IMF–World Bank, March–May 2021.* ### 18.046 of 1981. The Companies Law contains basic requirements for financial reporting for all ### 1chlea2021006 - 18.046 of 1981. The Companies Law contains basic requirements for financial reporting for all ### Accounting and auditing framework - The Companies Law contains basic requirements for financial reporting for all companies in Chile, including requirements for the preparation of financial statements. - The Colegio de Contadores de Chile (CCCH) has the responsibility for setting accounting standards for non-regulated companies. - The CCCH has adopted IFRS and IFRS for Small- and Medium-sized Enterprises (SMEs) since 2013. - The CMF (which absorbed the former SBIF) has adopted IFRS since 2009. - IFRS 9 is not adopted. Financial sector is following provisioning requirements, both for accounting and prudential purposes, that are prescribed by the CMF. - CCCH is responsible for setting auditing standards for non-regulated companies. The Auditing Standards Committee of the CCCH adopts the Chilean Generally Accepted Auditing Standards (NAGA) which, as reported by the CCCH, are the translation of the standards issued by the Audit Standards Board of the American Institute of Certified Public Accountants, which, in turn, are based on the IAS. - The Financial Market Commission (CMF) has the authority to set the auditing standards for entities under their regulation and require application of standards issued by the CCCH. ### Audit firm regulation and supervision - Audit firms are regulated and supervised by the CMF. The CMF is empowered to: - maintain a registry of audit firms authorized to audit companies under their control; - set ethical requirements; - develop an investigative and disciplinary system; - require audit firms to establish quality control mechanisms. - Audit reviews are only carried out when a suspicion or risk is identified. ### Credit data and registries - Credit data needs to be improved in Chile. There is a private credit bureau in the country but it has a lower coverage than the one exhibited by the OECD economies and has significant scope limitations associated with the history and lack of positive information of the debtors. - A public credit registry is administered by the CMF. Two primary products associated with the public registry are: - the "Consolidated Debt File" (recipient: banks); - the "Debt Report" (recipient: debtors). ### Resolution framework and deposit guarantees - Chile has no statutory resolution regime to facilitate the orderly failure of banks; the existing statutory framework relies on forced liquidation which is recognized as unsuitable for managing the failure of a systemic bank or a bank carrying out critical financial functions. - Instead of a deposit insurance scheme, the BCCh guarantees sight deposits and obligations received or contracted by a banking enterprise. - Sight deposits and obligations are those whose payment may be legally demanded in an unconditional manner, immediately, except when the depositor or creditor is another banking enterprise (in such case deposits, loans or obligations shall always be deemed as time obligations). - The current MoF and BCCh deposit guarantee legal arrangements in Chile apply to all banks—domestic and foreign—and have no direct levy cost to those entities whose commercial deposit taking activities are benefiting from a state or central bank guarantee. - The guarantees cover all banks authorized to operate in the domestic market, including branches of foreign banks. ### Main findings: Responsibilities, objectives, powers, independence (CP 1–2) - The CMF is the prudential supervisor in Chile, in charge of prudential regulation and oversight. - The BCCh has certain prudential regulatory responsibilities, particularly regarding liquidity and FX, and there are cross consultations in licensing, solvency, liquidity and corrective measures. - The CMF’s legal mandate does not prioritize prudential supervision relative to its other mandates; CMF mandate encompasses financial stability, market conduct, and market development. - Budget constraints might hinder the effectiveness of supervisory processes. Although the CMF collects levies from supervised entities, its budget depends on MoF approval and must adjust to MoF guidelines focused on austerity and efficiency. - The CMF should have means to attract and retain talent in highly specialized fields (i.e. cyber risk, IT, data science), and strengthen specialized units. - Legal protection for supervisors would merit further enhancements. ### Licensing, changes in control, and acquisitions (CP 4–7) - Supervisors are constrained by an incomplete legal framework for licensing: - No legal provisions relative to individuals that might exert significant influence to be considered shareholders for licensing purposes. - No requirement for information on related parties of significant shareholders during licensing. - Licensing requirements do not encompass verifying the origin of initial capital. - No requirements relative to the ability of shareholders to provide additional financial support as needed. - Licensing process focuses solely on propriety for major shareholders; propriety criteria only are applied to board members; senior management is not subject to fit & proper assessment. - Authorization from the home supervisor is required in case of foreign branches and a "no objection" in case of foreign subsidiaries. - Transfer of significant ownership criteria should be further enhanced: - Related party criteria are not taken into account for the 10 percent threshold that requires authorization. - Lack of regular reporting on those that exert controlling influence, including identities of beneficial owners held by nominees, custodians and vehicles. ### Supervisory cooperation and cross-border supervision (CP 3, 12, 13) - Arrangements provide a framework for cooperation and collaboration with domestic and foreign supervisors and reflect the need to protect confidential information. - Establishment of the CMF in 2019, restructuring of the CMF in March 2021 (to be fully implemented as of December), and finalization of the MoU with the BCCh (still in draft; authorities reported the MoU was signed on July 5th, 2021) will further enhance cooperation arrangements. - The CMF shares information and cooperates with home and host authorities for effective supervision of foreign banking groups and subsidiaries of Chilean banks operating abroad. - Authorities are yet to develop a framework for handling crisis situations. ### Supervisory approach (CP 8–10) - The CMF has a framework for assessing and monitoring risk profiles of banking groups, considering systemic importance and understanding system-wide risks. - A number of techniques and tools are used with dedicated risk units and a wide range of periodically collected data. - More work is needed to realize strong consolidated supervision within the CMF: - Improvements in the legal framework are needed. - Establishment of a unit for comprehensive financial analysis and monitoring of financial conglomerates (2011 FSAP recommendation), coupled with lead examiners and ratings for conglomerates, would be beneficial. - The March 2021 restructuring of the CMF placing supervision of insurance, securities, and banks under the same umbrella will further strengthen sector supervision. - Financial analysis should be strengthened as part of the process. ### Corrective and sanctioning powers of supervisors (CP 11) - The corrective actions framework is somewhat limited in scope and based on either breaches of regulatory requirements or materialized indications of deterioration of the bank. - The somewhat late initiation of corrective measures and their limited scope can potentially affect CMF’s supervisory effectiveness. - Available supervisory tools focus on restricting current activities, additional loans to related parties, and investments, but do not encompass: - imposing more stringent prudential limits and requirements; - restricting or suspending payments to shareholders or share repurchases; - restricting asset transfers; - barring individuals from the banking sector; - replacing or restricting the powers of managers, Board members or controlling owners; - facilitating a takeover by, or merger with, a healthier institution. ### Corporate governance and internal audit (CP 14, 26) - Legal and regulatory framework for corporate governance requires improvement: - Fit & proper criteria for banks’ board of directors involve only integrity; directors’ technical suitability, board’s collective suitability or directors’ time commitment are not governed. - Banks do not require the CMF’s approval when electing directors. The supervisor does not have the power to require changes in the composition of the bank’s Board if individuals are not fulfilling duties. - No CMF best practice guidelines for structure and management of remuneration frameworks or for prudent executive compensation to prevent excessive risk taking. - CMF’s corporate governance supervision practices require improvement: - Assessment process is primarily designed in relation to identified risks and areas; it does not draw concrete conclusions regarding quality of board oversight or corporate governance holistically. - Supervision process does not evaluate a bank's strategy and its relationship to risk appetite in a holistic manner. - Policies and procedures for evaluating internal control, compliance and internal audit functions are adequate, but: - Lack of regulations to guide banks on prudent practices and inclusion of good practices in supervision manuals that are not publicly available increases burden on supervisors. - Clear eligibility requirements for members of an audit committee and head of internal audit should be stated. - Banks should be required to have an adequately staffed, permanent and independent compliance function assisting senior management in effectively managing compliance risks. - The term “compliance function” does not necessarily denote an organizational unit; compliance staff may reside in operating business units or local subsidiaries provided there is a reporting line through to the head of compliance who should be independent from business lines. ### Capital (CP 16) - The current capital framework follows Basel I in Chile which is not compatible with size and complexity of the banking industry. - Capital is required for credit risk only. Chile’s capital definition and credit risk weights have some discrepancies from Basel I. - Pillar 2 capital requirements were introduced in the regulatory framework on September 11, 2020 but include phase-in period until December 2023 for full implementation. - Implementation of Basel III starting from December 2021 will largely address shortcomings of the current framework. ### Credit risk, problem assets, provisions and reserves (CP 17–18) - Banking sector’s NPL ratio is at 4.9 percent as of December 2020 year-end. - The CMF has a specific division with qualified staff knowledgeable in credit risk modelling techniques. - Issues to be strengthened regarding banks’ credit risk management and asset classification and provisioning requirements: - Loan provisioning levels are computed using expected credit loss techniques by banks. - For large commercial loans: credit individual customer-level analysis. - For retail loans (including small corporates): group-level analysis is conducted. - For consumer loans: banks use their own expected loss models. - For other retail and small commercial loans: CMF formed standardized methods providing PD and LGD parameters. - CMF supervisors showed that banks' consumer loans are under-provisioned; CMF will address this by providing standardized method for banks. - Regulatory framework does not provide guidance on definition, identification and treatment of loans subject to restructuring/refinancing: - Inspectors verify existence of specific guidelines for renegotiated, refinanced, extended, restructured, and agreed loans but there are no provisions to guide banks and inspectors on good practices. - Under current framework, if banks refinance group loans before interest or principal is 60 days past due, they will not have to classify loans in the non-performing portfolio. - Regulation states individually assessed borrowers needing a compulsory debt restructuring which reduces or postpones principal or interest payments will be included in nonperforming portfolio, but regulation does not provide explanation or conditions for compulsory loan restructuring. - This could result in problematic loans being categorized as performing using restructuring/refinancing. - Collateral and provisioning: - Value of collateral is important determinant for provisioning for both individually assessed and group loans. - Regulations miss explicit guidance or norms on eligible collateral revaluation for determining provisioning for problem exposures. - Regulations/guidelines do not require collateral to be valued at certain frequencies. In practice, supervisors expect collateral to be revalued every two years. - If revaluation date is more than two years old, supervisors take the face value of collateral for provisioning calculation. - Supervision of banks’ collateral valuation and monitoring processes needs improvement; supervisors conducted two banks’ collateral process reviews in 2019 and 2020. - Absence of recovery information for commercial loans prevents CMF from doing back-testing of bank provisions. ### Risk management (CP 19–25) - CMF’s supervision structure includes specialized risk divisions with highly qualified staff in credit risk, financial risk, operational risk and cyber risk. - Level of personnel in the cyber risk division is not sufficient to conduct effective supervision on this topic in banks. - Although regulatory and supervisory frameworks for individual risks are strong, absence of integrated risk management function and review is perceived as an issue: - Banks generally organize risk management by separate risk units; no regulatory requirement for integrated risk management function. - In some banks the financial risk function reports to the CFO, raising doubt about independence. - Risk functions report to the CEO and do not have direct reporting lines to the board of directors. - Banks are not specifically required to have qualified CROs with sufficient stature, position and authority to oversee risk management activities. ### Disclosures and transparency (CP 27–28) - CMF’s disclosure requirements are sufficient. - CMF discloses comprehensive periodic information (monthly, quarterly, annually) on the banking system on its website enabling public understanding of banks’ situation. - Disclosures could be improved to include remuneration policy and information about all material entities in the group structure. - Supervision could be improved if CMF regularly evaluates timeliness and content of external audit / annual reports for compliance with regulatory parameters. ### Abuse of financial services (CP 29) - CMF has requirements and examination procedures enabling periodic in-depth assessments on banks’ policies and processes related to AML/CFT. - The restructuring process encompasses establishing a specialized team in charge of assessment of AML/CFT which should further strengthen CMF abilities. - Lack of a more robust sanctioning framework could impair the effectiveness of their work. *Source: IMF country report content provided in the supplied PDF excerpt.* ### 2. Independence, accountability, ### 2. Independence, accountability, resourcing and legal protection for supervisors ### Independence and resourcing - The CMF has, to a certain extent, operational independence and transparent processes in discharging their duties and use of resources with a high level of disclosure. - Budget constraints might hinder supervisory processes in the near future. - Levies collected from the banks, although at present exceeding the budget needs, revert in full to the general budget, from which the CMF is granted its approved budget. - The approval of the CMF budget depends on the MoF and the general government budget policies (whereas the BCCh is provided with its own equity, having independence to approve, manage and execute its budget). - Budget constraints are yet to jeopardize the CMF supervisory functions, but resources have been stretched and are to be further challenged by additional needs related to specialized teams and upcoming risks. ### Nomination, removal, and legal protection for officials - The process for nominating the CMF board require the reasons for removal of a CMF board member (if such case materializes) to be publicly disclosed in case of serious breaches (e.g. aspects related to confidentiality of information, undisclosed conflict of interest, fit and proper). - There is no legal protection as such although CMF senior officials and staff are provided legal defense by the CMF. ### Cooperation and collaboration - Arrangements currently in place in Chile provide a framework for cooperation and collaboration with relevant domestic and foreign supervisors and do reflect the need to protect confidential information. - The establishment of the CMF as such in 2019, the subsequent restructuring of the CMF in March 2021, to be fully implemented as of December and the finalization of the MoU with the BCCh (still in draft) will further enhance the arrangements for cooperation and collaboration within Chile. - Authorities reported that the MoU was signed on July 5th, 2021. ### Licensing, permissible activities, and transfer of ownership - Permissible activities of institutions licensed and subject to supervision as banks operating in Chile are clearly defined and the use of the word “bank” in names is controlled. - The law sets out criteria to be applied in the licensing process and grants the CMF the power to reject applications for establishments that do not meet the criteria established by the GBA, although not explicitly in what refers to the business viability. - The licensing process consists of an assessment of the ownership structure and governance of the bank. - There are no legal provisions relative to individuals that might exert significant influence without being a significant shareholder and there is no requirement of information on related parties of significant shareholders during the licensing process. - The licensing requirements do not encompass verifying the origin of funds and do not have requirements relative to the ability of the shareholders to provide additional financial support as needed. - There are propriety criteria applied to board members but not to senior management. No fitness criteria are applied. - Authorization by the home supervisor is required in case of foreign branches and a no objection is asked in case of foreign subsidiaries. - The CMF has the power to review, reject and impose prudential conditions on any proposals to transfer significant ownership or controlling interests above 10 percent held directly or indirectly in existing banks to other parties. - Related party criteria are not applied in such cases so that natural persons and their related parties are considered a single person which could potentially result in a transfer of significant ownership without knowledge or approval by the CMF. - The legal framework does not allow the CMF to reject, modify or reverse changes in significant ownership that occur based on false information; in such cases voting rights are suspended. - Shortcomings include lack of regular reporting on those that exert controlling influence, including identities of beneficial owners held by nominees, custodians and through vehicles that might be used to disguise ownership. - Banks are not explicitly required to report to the CMF any material information that may impact the suitability of shareholders. - Aspects related to the lack of legal powers regarding the parent, and resulting CMF legal limitations in authorizing or impeding transfers of ownership through the holding have been factored in the assessment of CPs 1 and 12. ### Major acquisitions and group restrictions - The CMF can approve or reject major acquisitions or investments by a bank, including establishment of cross-border operations. - Banks’ subsidiaries type of business are limited and confined to financial sector activities or that support the activities of the financial entity. - Mergers, acquisitions, as well as setting up branches or subsidiaries abroad require authorization. - Lack of legal powers regarding the parent and limitations in authorizing or impeding acquisitions or investments within the wider group relate to consolidated supervision limitations (factored in under CP 12). ### Supervisory approach, techniques and tools - The CMF has a framework for assessing and monitoring risk profiles of banking groups, taking into account their systemic importance, maintaining an understanding of risks emanating from banks and the banking system as a whole. - A resolution framework is yet to be established. - The CMF uses a number of techniques and tools to implement its supervisory approach. - Off-site surveillance performed by the supervision and risk units provides for a thorough assessment of individual banks. - On-site examinations are carried out annually for all banks, with more resources being deployed for systemic banks. - A wide array of reports is produced which might merit some streamlining. - The incorporation of the financial analysis unit within the supervision department offers opportunity for reports focusing more on systemic issues, trends and risks build ups. - Authorities meet banks boards occasionally; it is not common practice to have meetings with the board to discuss results of supervisory examinations nor external audits. - There are no procedures in place or practices to meet bilaterally with independent board members. ### Supervisory reporting and validation - The CMF collects a wide range of data from banks and banking groups regularly, both on a solo and on a consolidated basis. - Information is automatically validated, and banks’ internal audit have to make yearly a statement regarding the quality of information provided to the CMF. - Banks and the CMF seem to take prudential reporting seriously and significant sanctions have been applied as a result of poor reporting. - There is no comprehensive independent validation of the prudential returns. - The assessors consider that overlaps in reporting likely occur and some information may no longer be needed. - There is no process in place to periodically review the prudential information collected to determine that it satisfies CMF needs. - Aspects related to consolidated supervision were factored in the assessment of CP 12. ### Corrective and sanctioning powers - The CMF is granted general powers to take action as necessary to protect the safety and soundness of the banking system in Chile. - Annual examinations and the rating system under CP 8 provide a broad basis for the CMF to require banks to address issues found during examinations. - Actual corrective actions are triggered somewhat at a later stage, depending mostly on breaches of regulatory requirements or materialized indications of deterioration of the bank. - The range of supervisory tools available to bring about timely corrective actions is limited, focusing on restricting current activities, additional loans to related parties, and restricting investments. - Available tools do not encompass imposing more stringent prudential limits and requirements, restricting or suspending payments to shareholders or share repurchases, restricting asset transfers, barring individuals from the banking sector, replacing or restricting the powers of managers, Board members or controlling owners, or facilitating a takeover by or merger with a healthier institution. ### Consolidated supervision and home-host relations - The legal framework empowers the CMF to exercise full consolidated supervision only over the banking group, i.e. from the bank downwards. - Parent companies are effectively not supervised or regulated and the CMF has no access to information on affiliates. - CMF has established a framework for the supervision of financial conglomerates focusing mostly on solvency, intragroup exposures and reputational risk. - Shortcomings related to solvency are to be addressed through the supervised entities, i.e. the financial entities. - Banks’ operations abroad are supervised either through on-site visits (subsidiaries) and off-site surveillance through dedicated prudential returns (branches). - Lack of legal supervisory powers related to prudential requirements and enforceability over the parent, lack of access to information on affiliates, and parents’ ability to have all types of investments in non-financial entities are significant shortcomings impairing effectiveness of CMF consolidated supervision. - Risk management and controls of the parent are not under formal scrutiny or regulatory requirements of the CMF. - The CMF shares information and cooperates with home and host authorities for effective supervision of foreign banking groups operating in Chile and subsidiaries of Chilean banks operating abroad. - Local operations of foreign banks are subject to the same requirements of local banks. - Authorities are yet to develop a framework for handling crisis situations. ### Corporate governance, risk management, and internal controls - Suitability requirements and supervisory processes do not include directors' technical suitability, the board’s collective suitability or directors’ time commitment. - Banks do not require the CMF’s approval when electing directors. - The supervisor has no powers to require changes in the composition of the bank’s Board if it believes that any individuals are not fulfilling their duties or there are issues with the suitability of the Board as a collective. - The CMF’s corporate governance assessment process is primarily designed in relation to identified risks and areas; supervisory processes do not draw concrete conclusions regarding the quality of board oversight or corporate governance in general. - Supervisory processes do not evaluate the bank's strategy and its relationship to risk appetite; the bank's risk appetite is evaluated only in relation to certain risks reviewed by supervisors without a holistic view. - There are no best practice guidelines issued by the CMF for overall remuneration frameworks or prudent executive compensation to prevent excessive risk taking. - There is no requirement for the majority of the board to be composed of non-executive members; the legal framework currently requires only 2 nonexecutives. - There is no maximum time limit a board member can stay in the position to be considered as independent. - Regulations do not require systemic banks to establish a risk oversight committee and remuneration committee. - The risk management function reports to the General Manager and does not have direct reporting line to the Board of Directors. - There are no regulatory requirements to ensure sufficient resources, independence, authority, and access to the banks’ board for risk management. - Risk management in banks is organized by risk (credit risk, financial risk, operational risk); no regulatory requirement for an integrated risk management function. - In some banks financial risk function depends on the CFO which raises serious doubt on independence. - Internal audit does not have responsibility to evaluate the overall efficiency of the risk management function. - Banks are not specifically required to have qualified CROs with sufficient stature, position and authority. - The level of senior manager may not provide necessary stature to challenge high level risk decisions and processes. ### Internal capital adequacy and stress testing - Internal capital assessment process (ICAAP) was introduced with Chapter 21-13 published on September 11, 2020; this regulation has not fully come into force yet. - Risks from the macroeconomic environment will be integrated into bank’s risk management process with the start of ICAAP assessments, which started in April 2021. - Banks will conduct stress tests based on scenarios given by the CMF and include results in ICAAP reports. - The CMF has not issued a detailed guideline on stress tests to be conducted under this framework. - The April 2021 stress exercise associated with the ICAAP will not cover market, IRRBB, or liquidity risks; the focus will only be on credit risk. - The April 2022 exercise will include these risks. ### Capital adequacy, credit risk, and problem assets - The current capital framework is based on Basel I which is not compatible with the banking industry’s risk profile and complexity. - Capital is required for credit risk only. - Country’s capital definition and credit risk weights have some discrepancies with Basel I. - Legal and regulatory changes that aim to comply with Basel III capital framework are issued; they will be implemented starting from December 2021. - Pillar 2 capital requirements were introduced in the regulatory framework on September 11, 2020 with phase-in period until December 2023. - Implementation of Basel III starting from December 2021 will largely address shortcomings of the current framework. - The legal and regulatory framework for the credit risk environment is generally satisfactory; main weakness is absence of an independent loan review function in banks. - The CMF has not issued credit risk management guidelines for the banking industry. - The CMF’s RBS framework includes an assessment of management principles, details established in supervision manual, but the supervision manual is not publicly available. - There are no specific regulations requiring banks to prescribe in their credit policy that major risks exceeding a certain amount or percentage of the bank’s capital, or risky exposures outside mainstream activities, be decided by Board or senior management. ### Problem assets, provisions, and collateral valuation - Regulatory framework does not provide guidance on definition, identification and treatment of loans subject to restructuring. - If banks refinance group loans before interest or principal is 60 days past due, they will not have to classify the loans in non-performing portfolio; this could result in problematic loans being categorized as performing using restructuring. - For individual and groups of loans, value of collateral is an important determinant for provisioning levels. - Regulations miss explicit guidance or norms on eligible collateral revaluation for determining provisioning for problem exposures. - Regulations or guidelines do not require collateral to be valued at least with a certain frequency. - Supervisory guidelines for valuation of collateral should be prepared; supervisory evaluation of valuation processes should be conducted regularly (risk-based). - Regulations do not prevent banks to accrue interest for all impaired loans. - Group loans secured by real estate valued at least 80 percent of the credit; C1 and C2 individual loan categories; and group loans until they become six months past due will continue to accrue interest. - Already accrued and not paid interests are not cancelled or subject to provisions. ### Concentration risk, large exposures, and related parties - Legal framework addressing concentration risk and large exposures limits is generally in line with international standards. - With recent amendment of the GBL, a business group limit is included in the legal framework. - Business group definition is comprehensive, but implementation and monitoring of the business group limit is yet to be determined. - All limits are computed on regulatory capital instead of Tier-1 Capital. - Business group limits are set at a 30 percent level, while Basel standard is at 25 percent. - Individual loan limits can be increased to 30 percent of capital in case collateral (wide range considered eligible) is provided. - Forms to monitor groups are not developed or put into effect yet. - With introduction of the ICAAP process in Chapter 21-13 (not fully in force yet) the CMF requires banks to have methodologies to measure all concentration risks. - The legal and regulatory framework for related parties is generally comprehensive. - Reporting of banks on related party exposures are regularly monitored by the CMF; examiners evaluate related party exposures during onsite review. - The related parties limit is calculated only on consolidated level. - Loans to consolidated subsidiaries are exempted from the limit. - Authority has not included provisions to deduct loans which are above limits from capital when assessing capital adequacy, or to require additional collateralization for such exposures. - In practice banks’ lending to related parties are not approved by banks’ board. *Source: 1chlea2021006 - 2. Independence, accountability, resourcing and legal protection for supervisors* ### 21. Country and transfer risks ### 21. Country and transfer risks ### Country and transfer risk framework - CMF regulations adequately capture country and transfer risk. - Banks are expected to classify countries based on their riskiness levels and determine provisions accordingly. - Country risk is evaluated through the supervisory process. - With the change in the Chapter that is planned to come into effect in 2022, the accrual of interest will be stopped when past-dues reach 90 days. ### Market risk - The CMF has adopted appropriate regulation and guidance directing banks to identify, measure, and monitor their market risk exposures. - With the adoption of the Basel III framework, starting from 1 December 2021 banks will be required to allocate capital for market risk as well. ### Interest rate risk in the banking book - Interest rate risk in the banking book (the CMF calls it market risk in the banking book) is material in Chilean banking system. - It is part of the financial risk assessment that the CMF regularly carries out. - Current regulations require banks to have an adequate management process and they establish a measurement scheme and limits; however, these limits are set by the institution’s board of directors. - This risk will not be included in capital adequacy framework until December 2023. ### Liquidity risk - The framework for liquidity regulation, monitoring, and assignment of banks’ responsibilities is set up comprehensively by the BCCh and the CMF. - Review of onsite documents indicated that conclusions regarding liquidity, funding stability, and management processes stopped short of considering other areas of the balance sheet, growth trends, asset quality, and management processes; such issues should be captured and clearly conveyed in examination documents to support supervisory observations. - There is room for improvement of stress testing practices of banks, especially to ensure consistency of their exercises. - The conservatism of the exercise could be strengthened by the CMF guiding the banking industry on severity of the assumptions, through run off assumptions and access to funding sources i.e., no access to wholesale funding in an idiosyncratic crisis. - Given that each bank applies a different set of assumptions for the liquidity stress test, the ease of identifying outliers and detecting weakness in a particular bank is made more difficult requiring more intensive analysis by the supervisor into the inputs. - There is no requirement for the results of the stress test to be submitted to the CMF. - Recommendation: The BCCh should introduce a legal limit for the NSFR. ### Operational risk - The regulatory framework for operational risk management is comprehensive. - The CMF has dedicated Operational Risk Division and Cyber Security Division for the examination of banks’ risks. - However, the number of cyber security experts in the CMF is not sufficient. - The CMF is facing difficulties in attracting and retaining qualified experts. - In some banks technological risk is managed under Operations/Technology Management Department which compromises independence of the risk management function. ### Internal control and audit - Policies and procedures for evaluating internal control, compliance and internal audit functions are adequate. - Lack of regulations to guide banks on prudent practices and the inclusion of good practices in supervision manuals that are not publicly available increase the burden on supervisors. - Regulations do not impose strict eligibility requirements for members of the audit committee and the head of internal audit. - Recommendation: Regular meetings with banks’ audit committees should be part of CMF’s supervision process. - The regulatory framework does not require banks to establish an adequately staffed, permanent and independent compliance function that assists senior management in effectively managing the compliance risks faced by the bank. ### Financial reporting and external audit - Financial statements prepared and published by financial institutions are in compliance with Generally Accepted Accounting Standards in Chile which in turn are in line with the International Financial Reporting Standards (IFRS). - Instead of IFRS 9 the financial sector is following provisioning requirements (both for accounting and prudential purposes) that are prescribed by the CMF. - Financial statements are audited by independent external auditors and the audited financial statements are published along with the explanatory notes and auditors’ opinion annually. - There is potential to improve governance arrangements to effectively oversee the external audit function. - Recommendations: Make necessary legal changes to request external auditors to report all matters that could be of material significance to the CMF; include regular meetings with the external auditors as part of the supervision process; be more active in influencing the scope of an external audit. ### Disclosure and transparency - Banks are required to disclose their financial statements according to Chilean Generally Accepted Accounting Standards, the Chilean version of IAS which in turn are in line with the International Financial Reporting Standards (IFRS), on consolidated basis. - Disclosure requirements for nonfinancial information are generally adequate. - Disclosures could be improved to include information on the remuneration policy and information about all material entities in the group structure. - The supervision process could be further improved if the CMF regularly evaluates the timeliness and content of external audit / annual reports for compliance with regulatory parameters. *Source: 1chlea2021006 - 21. Country and transfer risks* ### 29. Abuse of financial services ### 29. Abuse of financial services ### Assessment — supervisory arrangements and shortcomings - The CMF has requirements and examination procedures that enables them to perform periodic in -depth assessments on banks’ policies and processes related to AML/CFT. The restructuring process encompasses establishing a specialized team in charge of the assessment of AML/CFT. - The lack of a more robust sanctioning framework, specifically designed for AML/CFT can impair, nevertheless, the effectiveness of their work. - Additional aspects would merit further improvement: - a. banks are not explicitly required to report to the CMF suspicious activities in cases where such activities/incidents are material to the safety, soundness or reputation of the bank; - b. within the regulatory framework there is no explicit requirement for banks to have policies and processes that promote high ethical and professional standards; - c. there is no explicit provision in the framework or in examination procedures relative to relationships that turn into high risk; - d. there is no explicit reference to ensuring high ethical and professional standards per se when hiring staff. There is no reference to AML/CFT aspects related to an agency or outsourcing relationship. Files made available to the assessors had no reference to hiring processes or to outsourcing; - e. there are no requirements for banks to establish policies and processes to designate the compliance officer. There is also no reference to a dedicated officer (beyond the compliance officer) to whom potential abuses of the banks' financial services (including suspicious transactions) are reported; - f. there are no explicit provisions relative to dissemination within the bank as for to whom suspicious activities should be reported. ### H. Recommended Actions — overview - 57.Table 2 below lists the suggested actions for improving compliance with the BCPs and the effectiveness of regulatory and supervisory frameworks. - Table 2. Chile: Recommended Actions to Improve Compliance with the Basel Core Principles and the Effectiveness of Regulatory and Supervisory Frameworks contains principle-by-principle recommendations across CPs 1–28, and includes specific recommendations related to AML/CFT under Principle 29. ### Principle 29 — recommended legal and regulatory amendments (exact recommendations) Authorities are recommended to amend the legal and regulatory framework in order to: - have a sanction framework for AML/CFT that would enable the CMF to impose much more sizable fines, as needed. In addition, powers related to the possibility of suspending dividends, restrictions to asset growth, operating in certain business lines and others as detailed and factored in CP 11 would be important tools to better ensure compliance also with the AML/CFT framework. - incorporate regulatory provisions relative to relationships that turn into high risk; - explicitly refer to the need for banks to establish procedures that require high ethical and professional standards when banks are hiring staff. - require that outsourcing relationships take into account AML/CFT; - require banks to establish specific policies and processes to designate the compliance officer; - require banks to appoint a dedicated officer(s) to whom potential abuses of the banks' financial services (including suspicious transactions) are reported; - explicitly require banks to establish and follow clear policies and process for staff to report any problems related to the abuse of banks financial services - explicitly require banks to report to the CMF suspicious in cases where such activities/incidents are material to the safety, soundness or reputation of the bank; - require banks to develop their own internal policies and criteria for CDD beyond what is expressly prescribed in regulation; - have explicit provisions requiring dissemination within the bank as for to whom suspicious activities should be reported. - Additional suggested practice: Authorities should consider requiring banks to include in their internal policies statements reinforcing that that internal communications in good faith should not be in anyway internally punished. ### Cross-cutting supervisory recommendations (contextual items from Table 2 relevant to effectiveness) - The assessment and recommended actions in Table 2 reflect broader supervisory capacity and governance reforms to improve overall effectiveness (examples include recommendations under Principles 1, 2, 3, 5, 6, 8, 9, 10, 11, 12, 14–28). - Shortcomings related to consolidated supervision, corrective actions and resolution have been factored into the assessment of CPs 8, 11 and 12, respectively. *Source: 29. Abuse of financial services — Chile, IMF Financial Sector Assessment (chapter text and Table 2 recommendations).* ### 58. The Chilean authorities appreciate the work done by the IMF and WB, whose teams ### The Chilean authorities appreciate the work done by the IMF and WB, whose teams ### Appreciation of mission and conduct - The Chilean authorities appreciate the work done by the IMF and WB, whose teams showed a high level of knowledge and experience. - The mission was conducted virtually, which meant operational and coordination challenges that were successfully overcome thanks to the IMF, WB, and national teams' professionalism and flexibility. ### General assessment of banking supervision and compliance with BCP - The evaluation results carried out on the banking supervision and regulation process in Chile correctly reflect, in general, the level of compliance with the BCP. - The Chilean banking system is healthy, the management of banks is framed within international standards, and the CMF has legal powers and professional and expert staff to carry out its work. - The transition to Basel III should remain a priority. ### CMF restructuring, coordination, and the role of CEF - The recent restructuring of the CMF, which put under the same umbrella the supervision of insurance, securities, and banks, will further strengthen the supervision of the whole financial sector. - Expected benefits of restructuring: - Better coordination and consistency of regulatory standards and supervision across sector-specific industries. - Improved coordination with BCCh on financial stability issues. - Recognition that there is room for further strengthening the role of the CEF, particularly in coordinating the implementation of macroprudential policy. ### Crisis management coordination - Agreement that coordination should include crisis management, particularly the need to develop a coordination framework with foreign authorities in handling crises situations. ### Resolution regime, deposit insurance, and CMF governance - Recognition of the requirement for an enhanced statutory resolution regime that would facilitate the orderly failure of supervised entities (especially banks) and a full-fledged deposit insurance scheme. - Support for CMF's organic law to: - Incorporate proper legal protection to board and staff beyond legal defense. - Establish an independent and stable financing mechanism for the Commission. ### Regulatory framework for conglomerates and credit data - CMF considers necessary to improve the regulatory framework of financial conglomerates. - Actions taken: - CMF has already approve a Manual for Conglomerates Supervision. - CMF perfected the regulation to include new instructions to the scope, exceptions and information systems for controlling the limit to the total of credits that banks can grant to persons or entities that belong to the same business group. - Agreement that credit data must be improved in Chile. ### Disagreements with FSAP team findings - Disagreement: CMF is constrained by an outdated/incomplete legal framework hindering the licensing process — the authorities see room for more detailed regulation but do not agree with the characterization of constraint. - Strong disagreement: evaluation that the corrective action framework is somewhat limited in scope and based on either breach of regulatory requirements or materialized indications of deterioration of the bank. - The General Banking Act, recently modified in 2019, includes prospective measures and establishes that the CMF could ask for an early regularization plan if there is any indication of financial instability or poor management based on supervisory judgement. - Early intervention comes earlier for systemic banks, given that the systemic requirement is compulsory, not a buffer. - CMF powers include designating a provisional administrator that replaces the powers of the management and board of the bank, imposing higher provisioning recognition and imposing restriction on new credit to related and non-related parties. ### Supervisory process, risk oversight, and specific supervisory priorities - Areas for improvement acknowledged: - Overall board oversight of risk that would require banks to have an adequately staffed, permanent and independent compliance office and an integrated risk management function, both reporting directly to the board. - CMF should issue credit risk management guidelines for the banking industry, including a handbook of good practices. - Priority areas given increased vulnerabilities due to the pandemic: strengthening standards for collateral valuation and developing liquidity stress test for banks. - Disagreement: there is not a holistic assessment of risks at the Supervisor. - RAN 21-13, issued in September 2021, is already in force. - Even when a phase out has been considered for the progressive inclusion of new risks, there is an agenda known to the market. - Said regulation explicitly gives the board responsibility to understand the risks of new products and to define risk appetite and strategies, and this is evaluated by the supervisor. ### Treatment of restructured/refinanced loans and collateral valuation - Strong disagreement that the regulatory framework does not provide guidance on definition, identification and treatment of loans that are subject to restructuring/refinancing. - Authorities state there are public guidance and definitions; the team found gaps, which authorities distinguish from absence of guidance. - Same distinction applies to collateral valuation. - Accounting change: - As of January 2022, the new Compendium of Accounting standards will enter in force to correct, among other things, issues on accrued interest. ### Recent regulatory publications and enforcement scope - Since the end of the mission, CMF has published several regulations that explicitly address gaps identified in this assessment, including: - Thresholds on identifying loans that will be evaluated individually. - Definition of a business group. - Clarification on capital requirements: - As of December 2021 all capital requirement regulation for credit, market, and operational risks to implement the Basel Capital Framework is fully enforced. - This regulation was not included in the assessment. ### Commissioners' dismissal and transparency - Clarification: all possible reasons for dismissal of commissioners are explicitly provided in the Organic Law of the CMF, other than a voluntary resignation. - If any such situation should happen, it is also, by law, a public process. ### Closing position - The authorities welcome the exhaustive analysis carried out by the evaluators and the recommendations. - The authorities are looking forward to implementing the recommendations that are not already addressed by the regulatory changes made in the last months. *Source: Excerpts from the Chilean authorities’ response in the IMF document provided.* --- _Source: https://www.imf.org/-/media/files/publications/cr/2021/english/1chlea2021006.pdf_