Towering ambition

The issue of regulation has risen up on the agenda of Chile’s ongoing capital market reforms in the wake of a major financial test following the crisis at La Polar and as it reasserts its ambition to become a regional financial leader.

“Twin peaks” is a description that might best be applied to the Nevados de Payachata – the impressively symmetrical twin volcanoes of Pomerape and Parinacota in the arid far north of Chile.

But the phrase in fact has come to symbolise the reform of capital markets in the country spearheaded by the finance ministry that passed a landmark in November with the first full working meeting of a powerful new financial stability council.

The Payachata twins offer a metaphor for one vision that regulation should take if it is to balance the need to be dynamic – the volcanoes remain active – yet to provide a stable bedrock for the towering ambition of the country’s financial sector.

Chile is worthy of scrutiny because it was welcomed into the Organisation for Economic Co-operation and Development in late 2009 and has become a model of South American membership following loyally – if not always fully – the organisation’s prescriptions.

Its capital market is one of the largest relative to its size among emerging economies, and capitalisation of the equity market by the end of December 2011 stood at US$270bn. The financial system is well-developed, buoyed by the long maturities available in the fixed-income market. From 1990 until January 2012 the market value of Santiago’s IGPA stock market index, which tracks large companies based in Chile, averaged 7,788.16 points, reaching an historic high of 23,465.63 points in January 2011.

Almost 90% of the fixed-income market is inflation-indexed, meaning that local instruments have yielded strong returns, reducing the allure of equities, and the insurance sector, if still small, has grown steadily with assets at 18% of GDP (compared with 51% for pensions).

Chile’s reforms have arguably reached their zenith under President Sebastián Piñera who came to power in 2010. He hit the ground running, but in June 2011 was given a salutary reminder of the potential cost of failure by the worst credit scandal in years when La Polar, Chile’s fourth- largest retailer, admitted to nearly US$900m in bad credit card loans. In September 2011 it was reported that a criminal investigation had been launched into the company’s accounting and lending practices.

The La Polar case

The La Polar case has highlighted the imperative Chile – and the OECD – are now placing on regulatory themes, and has become a major test of the consumer protection agency Sernac, which is now spearheading a class action by a million consumers. The case is likely to impact on plans to strengthen a consolidated credit register for bank and retail credit to households.

Household indebtedness is a faultline in Chile, doubling over the past 10 years and now hovering at 70% of disposable income. The challenges facing La Polar are the first sign of strains in a demand-driven boom that has pushed a rapidly expanding retail sector to compete for customers with tempting credit offers that take advantage of record-low interest rates.

La Polar has also exposed the potential fragility of Chile’s bond market and caused jitters among international issuers about rules being tightened. The benchmark IGPA (which includes La Polar) and IPSA index of most heavily traded stocks bombed in July.

There are other reasons reform of supervision has become a priority in Chile, not least to propel reconstruction after the devastating earthquake just weeks before Piñera took office. Insurance losses from this earthquake were the second largest ever recorded anywhere in the world.

Leaner and fitter

Underlying the reform process has also been a loftier ambition to transform Santiago into a financial powerhouse. It is not unrealistic: Chile emerged from the “lost decade” of the 1980s leaner and fitter than its neighbours thanks to macroeconomic stability, robust pension funds, and growth driven by conglomerates that have become the exoskeleton of the capital markets.

Chile’s pension expertise, and the size of its copper-related sovereign wealth funds, give the country advantages as a centre for asset management. Its brokers have expanded as regional players in intermediation and investment banking.

Nonetheless, its ambition to achieve regional leadership is based on a fair dose of wishful thinking. International integration remains low, and regional growth has also allowed Brazil to take a lead.

It is this frustrated ambition to be a global player that has driven the successive waves of capital market reform: MK (1994), MK I (2001), MK II (2007), MK III (2009) and most recently MKB (2010).

MK III, which Piñera inherited, revealed growing sophistication in the effort to increase the liquidity and depth of local capital markets, broaden participation, increase competition and integrate internationally. This gave it the benefit of broad political and corporate support: its passage was fast-tracked through congress, not even waylaid by the earthquake.

However, no sooner was its ink dry than a new wave of reforms – MKB, named in a nod to Chile’s bicentenary in September 2010 – was unveiled. This represents a rolling programme of 20 or so bills and rule changes until 2014 based on seven strategic objectives (see Box).

Congress has so far passed two MKB bills reforming taxes on derivatives and tweaking capital markets by tightening oversight of mortgage insurance, encouraging pension AVCs and clarifying the definition of listed securities. The legislature is still discussing rules on fund administration, supervision of securities companies and contracts, maximum interest earnings and commercial data.

MKB speaks even more loudly to Chile’s ambition by adopting the best international practices on supervision. Alongside now routine mantras about increased productivity, liquidity and market access – the agenda pledges to create a regulatory framework that nurtures innovation.

This has been influenced heavily by Chile’s courtship of the OECD. In April last year the organisation made a series of recommendations about Chile’s conservative model of regulation and in January this year hinted that La Polar illustrated the need to speed up reform.

Regulatory reform, the beating heart

Regulatory reform has, therefore, become the beating heart of this phase of the capital markets agenda.

A committee of experts in Chile argued in April 2011 that the underlying philosophy of supervision should shift away from a traditional sectoral model that harked back to 1925. Alongside the central bank (BCCh) have been three regulators for stocks and securities (SVS), banks (SBIF) and pensions (SP). Two bodies have tried to co-ordinate their work – a capital markets committee (CMK) and a committee of superintendencies (CSSF), which was beefed up under MK II – but both lack legally defined objectives, making it hard to supervise conglomerates with fingers in several pies.

Chile’s committee of experts and the OECD have argued that this architecture is deficient because it limits the regulators’ independence and has no co-ordination mechanism to sniff out systemic risks.

“At a time when the world and in particular the developed economies are debating a highly complex situation, especially in Europe, the value of having institutions like this increases and it can be seen as an important step in terms of improving our capacity”

Alternative models are on offer, not least that of a universal, super-regulator. The experts prefer a “Twin Peaks” model – evoking those snow-capped volcanoes, but zooming in on the two main objectives of regulation: ensuring the stability and solvency of supervised institutions and protecting the client by scrutinising market conduct. This foresees a form of power-sharing between two slick new agencies.

They have proposed breaking up SBIF and SVS into two commissions undertaking collective decision-making: CS (solvency) and CCM (market conduct and consumer protection). A top-flight financial stability council (CEF) would be charged with co-ordinating their work and evaluating systemic risk (see chart).

So far, the government has responded with a pick-and-mix approach that props up the existing architecture – SBIF, SVS and SP – but transforms their governance to collegiate. This may be a realistic response to the radical nature of the proposals and a crowded legislative agenda. However, Piñera’s government has enthusiastically embraced the idea of a financial stability council, which it launched in October 2011.

At its inaugural session, finance minister Felipe Larraín said: “At a time when the world and in particular the developed economies are debating a highly complex situation, especially in Europe, the value of having institutions like this increases and it can be seen as an important step in terms of improving our capacity.”

Seen in the round, capital market reform in Chile has been successful, but MKB – and the reform process more generally – has not been without its critics.

The permanent revolution has left providers in a country that values stability breathless. Moreover, reform continues to be led by the state, and the key to success in rival São Paulo has been private sector initiatives such as Novo Mercado, a listing segment of the Bovespa.

It is too early to assess the impact of MKB, but the reaction to MK III offers clues to how this will ultimately be received. While businesses were generally enthusiastic, the Economist called the exercise “a hodgepodge” and the pro-market think-tank Libertad y Desarrollo described its reach as “limited”. Libertad y Desarrollo and others have not been shy about advancing their own wish-list for MKB, banks hate the changes to Sernac, and elements within the conservative UDI, the largest party in congress, are edgy about tax reforms.

These grumbles revive the persistent risk that the private sector’s insatiable appetite for tax cuts and ever less regulation threaten to divert the direction of reform.

The OECD’s verdict has, all the while, reiterated that strengthening the independence of the financial supervisors should be an explicit objective of MKB.

While changes to Chile’s regulatory architecture so far have broadly responded to that call, the MKB timetable remains a movable feast and the government is keeping its options open. In short, the jury is still out on Piñera’s financial revolution.

So while the twin peaks of Payachata continue to offer Chile the potential for gaining a commanding view over South America’s financial landscape – at this stage they remain merely a scenic backdrop.

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