Trust is the Key to a Healthy Money Market: Chile’s Experience

In the aftermath of the global financial crisis, the importance of trust in financial markets has come into sharp focus. In Chile, the absence of major bank failures since the 1980s suggests a solid supervisory performance and low banking risk. However, experts warn that in times of crisis, perceptions of bank credit risk and trust between market participants can change rapidly, leading to a more fragmented interbank market.

The Importance of Trust

• In times of crisis, trust is crucial for the smooth functioning of financial markets.
• A lack of trust can lead to a surge in fragmentation, forcing central banks to intervene with funding measures.

Chile’s Experience

Chile’s unsecured money market means that banks may struggle to access liquidity when it is needed most. This lack of trust has led to:

• A more fragmented interbank market
• Increased reliance on central bank intervention
• Potential for excessive risk-taking and complicated exit strategies (as seen during the 2019 social turmoil and COVID-19 pandemic)

Recommendations for Reform

To address these issues, experts recommend developing an interbank repo market that allows for the secured circulation of liquidity within the financial system’s core. This would:

• Incentivize the use of locally-denominated assets over foreign currency debt during times of stress
• Reduce the impact on domestic bond spreads and central bank intervention

Building a Strong Foundation

A developed capital markets offers a solid foundation for this development. Chile’s sovereign debt market is liquid and could be used as collateral for interbank transactions, while:

• Bank bonds and corporate bonds could also be considered as potential collateral in repos
• Electronic trading platforms and securities settlement systems with delivery vs. payment would need to be developed or adapted
• Legal frameworks that support the development of a secured money market would need to be established

Conclusion

Trust is the key to a healthy money market in Chile. By developing an interbank repo market, the country can:

• Reduce its reliance on central bank intervention
• Promote more effective liquidity management
• Support the transmission of monetary policy

By fostering trust and developing a secured interbank repo market, Chile can build a stronger, more resilient financial system.