Chile's Risky Absence

The 2007–2009 financial crisis did not affect Chile as severely as it affected other countries. However, that precedent cannot simply be projected into the future. Financial crises will always recur, as will the need to continuously refine the work of financial regulation in order to limit their impact, identify shortcomings, and correct them.

This is precisely what the rest of the world has been doing in recent years. International analysis has produced a series of detailed reports on the causes of the 2007–2009 crisis and has adopted regulatory reforms aimed at preventing new ones. More importantly, those reforms are designed so that, when a future crisis does occur, the financial system can recover swiftly — and without recourse to public funds for bank refinancing.

Little has been discussed in Chile, for example, about the De Larosière Report (2009) — one of the most thorough analyses of the crisis's causes and one of the most influential sources of regulatory reform proposals. According to that document, the 2007–2009 crisis was driven by failures in macroeconomic regulation, which in turn produced a rapid expansion of the credit system and, consequently, excessive liquidity. A significant contributing factor was the surge in investment in high-risk financial instruments — principally subprime instruments — as well as the use of leverage to invest in them.

Equally absent from domestic debate has been discussion of one of the key drivers of the crisis: the systematic underestimation of credit and liquidity risk, and the corresponding misuse of risk evaluation and rating methods by credit rating agencies. A clear example: subprime instruments — inherently high-risk — carried AAA ratings. The role of insurers and reinsurers in this dynamic cannot be overlooked: they reinsured those instruments precisely to secure better ratings for them.

Another factor behind the financial crisis was the inadequate scrutiny and regulation of corporate governance. The De Larosière Report found that compensation and incentive structures within financial institutions had led boards and managers to take increasingly risky decisions in order to boost personal income through performance bonuses.

Insufficient attention was also paid to the rapid expansion of derivatives markets, to off-balance-sheet activities in the financial industry, and to the proliferation of shadow banking and the special-purpose vehicles that facilitated it. All of these contributed to a broad impact across sectors and markets.

Fundamentally, the development of the financial crisis was marked by gaps in financial regulation and supervision, as well as by the absence of norms governing the international insolvency of banks. In response, the international community agreed to raise the minimum capital requirements established under Basel II, giving rise to Basel III. While Basel III is expected to become mandatory from 2018, the European Union had already implemented it by 2013. Countries such as Switzerland and the United States have adopted even more stringent standards.

On the supervision of the financial sector, the European Union restructured its architecture by establishing a body subdivided into four authorities with broad powers. In Switzerland, the supervisory authority holds extensive powers to oversee the financial industry; the same is true in the United States. With respect to bank recovery and resolution, the EU created a common mechanism with the potential for extraterritorial reach; Switzerland already has one in place, and the United States was actively debating its own.

From all of this discussion, critique, and reform, Chile has been absent. By way of example: Chile continues to follow the minimum capital requirements of Basel I (1988); the SBIF (Superintendencia de Bancos e Instituciones Financieras) lacks broad supervisory powers; and no bank recovery and resolution procedure is under active discussion.

Chile is an actor in the international market, yet its financial regulation remains regional. This dichotomy exposes it to future economic crises and to a difficult recovery. The financial system must be understood as the globally interconnected whole that it is. Under that premise, Chile — and Latin America more broadly — has the obligation to observe its environment and implement a deep structural reform in the regulation of financial markets. This will not necessarily prevent or isolate future crises, but it can facilitate a prompt recovery.