Chile´s banking sector: weaker than needed
The economics of Chile are solid: GDP (US$ 280 billion) growth rates are between 4 and 5% per year, it has a balanced public sector that owes no one on net terms – considering central government, state companies and central bank as a whole with 30% of GDP gross debt – and elicits no annual deficit out of central government expenditures that themselves represent approximately 23% of GDP and, in terms of its foreign balance sheet, it is a country that shows an almost balanced investment position (US$ 292 billion in foreign assets and US$ 336 billion in foreign liabilities, or -16% of GDP net external position) with a 4% of GDP current account annual deficit. Furthermore, foreign exchange liabilities in the form of debt amount to US$ 120 billion, transforming the country´s external exposure into a more flexible “equity” oriented position.
It is an open economy, with foreign trade amounting to 57% of its GDP and copper exports explaining half of its US$ 80 billion annual exports. But it also is an economy that has been suffering the effects of too much concentration in too many markets, with a tendency to have less competition and to cartelize within them, whether explicitly or under non cooperative means. The banking sector has been one example of this process, with the biggest three private banks accounting for 50% of loans and 66% of net profits, in a country where banks play a major role in the allocation of credit – as opposed to the US case, where commercial banks explain 17% of total credit (1) – and its dear pricing. From a macroeconomic perspective, its greatest risk – and a very important one for the economy – lies in its undercapitalization.
As of June 2013, total banking assets amounted to US$ 293 billion, loans to US$ 205 billion, demand deposits to US$ 50 billion, time deposits to US$ 129 billion and equity to US$ 23.5 billion, or 8% of total assets, with no accounting adjustments at all. On the other hand, Tier one capital or Basel risk based capital was US$ 30.6 billion and risk weighted assets were US$ 232 billion – under Basel (l) standard -, or 13.2% of them (2). An important reason for this apparently better shaped solvency figure is that Tier one capital includes subordinated-convertible bonds, which represent 30% of core capital, as if they were capital, which they are not. There continues to exist a regulatory mandate for the Chilean Central Bank to guarantee demand deposits which is so ample (3) – including all demand liabilities – that there is no effective gain or it happens too late to be helpful converting these subordinated bonds into equity, a fact which by itself should make these bonds unqualified for Basel risk based equity.
The above figures might not be easy to grasp, but last March 2013 the Chilean Banking Regulatory Agency (Superintendencia de Bancos e Instituciones Financieras) in its Annual Report published a banking solvency summary for many countries, and Chile was shown to be one of the least capitalized for years 2011 and 2012, with solvency ratios only similar to advanced economies where no serious authority would dare to say today he or she oversees a well capitalized banking system – on the contrary, there is a big pressure to fasten up the reinforcement of capital levels -:
(See table in PDF document)
It might be said that economic equity, derived out of publicly traded shares, could be a better measure of capital. It so happens that banks have been losing their valuations relative to book values, from multiples closer to three times down to two times. They are indeed high multiples in absolute terms, but getting downgraded by the market, presumably out of expectations of a more competitive credit market where multiples get closer to one, as in the US. A more conservative approach would consider a convergence to a unitary multiple as a given fact within years, not decades.
To make matters more challenging, last April 2013 the Vice Chairman of the US Federal Deposit Insurance Corporation wrote an article titled “Basel III Capital: A Well Intended Illusion” that follows the inconvenient critique Andrew Haldane, Bank of England officer and author of “The Dog and the Frisbee” raised last year in Jackson Hole, Wyomming, that Basel standards deeply failed when they were needed in 2008 and that a more capitalized banking system, focused under a stronger and plain leverage ratio with less discretion in its definition and estimation as it happens with Basel based parameters would be far better for the sake of financial stability of banking systems. And it offered a troubling picture (see below) of how extremely low banking capitalization equity to assets ratios have historically become in the US compared to between 13 and 16% prior to the founding of the Federal Reserve System in 1913 and the Federal Deposit Insurance Corporation in 1933, or twice present day capitalization rates.
The Chilean banking system seems to be out of tune from these corrective trends and it should better prepare for relevant capital increases. Those undercapitalized and excess return days with wide implicit government guarantees are getting over. It is a big pressure group to deal with, but the economic health of the economy cannot be put at risk by its undercapitalization and probable inability to face without Central Bank or State help deep recessions, as the one we had 30 years ago or the US did 5 years ago. We do not need more taxpayers to be unfairly placed on the line but investors with no implicit or explicit subsidies from the Central Bank or State under a competitive environment and updated regulation.
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[1] See Federal Reserve, Flow of Funds Accounts of the United States, Credit Market Debt Outstanding.
[2] See Superintendencia Bancos e Instituciones Financieras, Chile, Información Financiera.
[3] See Articles 123 and 132 from Chilean Banking Law (Ley General de Bancos).
Manuel Cruzat Valdés
September 6th, 2013
(See graph in PDF document)