Banco de Chile Continues to Benefit From High Interest Rates and Inflation but Economic Risks Remain

Equity Analyst

Michael Miller

Banco de Chile’s reputation and long history in Chile have allowed it to attract a large pool of noninterest-bearing deposits, giving it a lower cost of funds than most of its rivals. This funding advantage has contributed to the bank’s impressive profitability, historically delivering returns on equity in the mid to high teens. 

Like its competitors, the bank is making a pivot to more digitally integrated offerings and expanding efforts to reach a large population of unbanked Chileans. While the bank’s efforts in these spaces have found initial success, especially the highly successful introduction of "Cuenta Fan," Banco de Chile will need to continue to invest to position itself for success, particularly as it is not the only major bank in Chile looking to bolster its digital deposit base. 

During the most recent decade, Banco de Chile’s loan book has increasingly tilted toward mortgage and consumer lending, with mortgage loans growing to 31% of total loans by the end of December 2022. Despite initial fears, the bank’s net charge-offs remained low during the coronavirus pandemic as government support and voluntary pension fund withdrawals helped support consumers. That said, credit conditions have begun to weaken, and we expect higher credit costs in 2023. 

Over the last few years Banco de Chile’s net interest income has had to face the headwind of low rates, which compressed the bank’s net interest margins. However, this changed in 2022 as interest rates in Chile rose rapidly, a consequence of the high inflation rates seen in Chile. After hitting a floor of 0.5% during the height of the pandemic, the base rate in Chile has risen to 11.25% by October 2022, supporting the bank's net interest margin. 

Moreover, many of the bank's loans are indexed to inflation, generating additional income for the firm during this period of high inflation in Chile. That said, while the bank benefits from both rising rates and high inflation, the speed and extent to which rates have risen creates economic risk in Chile. The failure of proposed constitution revisions only adds to the uncertainty as another new constitution will need to be written and voted on in 2023.

Business Strategy & Outlook

In our view Banco de Chile has a Narrow Morningstar Economic Moat Rating as the strength of its competitive position has allowed the bank to consistently enjoy returns above its cost of capital. With the absence of any new major competitive threats or trends eroding the bank’s strong competitive position, Banco de Chile’s cost advantages and the implicit switching costs facing its customers should protect the company’s economic moat and allow it to generate excess returns. 

This strength is driven by Banco de Chile’s size and history within the Chilean banking system. Founded in 1893 as a result of a merger that made it the largest bank in Chile, Banco de Chile predates the Chilean central bank by more than 30 years. The firm’s long history as a key bank in Chile gives it powerful brand recognition and the bank remains an important part of Chile’s financial system, particularly in corporate banking. As a result of consolidation overtime, the six largest banks in Chile account for over 85% of total lending and bank deposits. With 16.6% and 16.1% of the country’s loans and deposits respectively in 2020, Banco de Chile is the second largest bank in the country by loans and the third largest by deposits, coming in behind the state-owned Banco del Estado de Chile in deposits and Banco Santander Chile in both. Furthermore, the bank’s reach in the Chilean financial systems extends beyond direct banking services. Banco de Chile has a roughly 24% share of mutual fund assets,16% market share in credit cards by usage, and 13% of the securities brokerage market. The company also provides insurance brokerage services through a long-term agreement with Chubb, giving the bank a significant breadth of service and allowing it to take advantage of cross selling advantages within its business. 

In our opinion, bank moats are typically achieved through cost advantages (either through superior operational cost structure, better funding sources, or superior underwriting), switching costs, and the banking system in which the company operates. Cost efficiency is a strength of Banco de Chile’s, strong expense management has allowed the bank to keep its efficiency ratio in the mid to high 40s as we calculate it, better than most of its peers. Additionally, the bank has seen strong initial success with the rollout of its fully digital FAN accounts. Chile has a limited presence from disruptive fintech firms and much of the transition toward digital banking has come from the traditional players themselves. The bank’s FAN accounts have rapidly become driver of account growth, added more than 630,000 new accounts in its first full year of service. These new accounts are cheaper to open, do not require the same level of service infrastructure, and give the bank the opportunity to cross sell its insurance and investment products to a new audience. As a result of its increasingly digital service model, the firm has significantly reduced its physical footprint, shrinking its branch count from over 400 several years ago to just 272 at the end of September 2021. As a result, we do expect the company’s efficiency ratio to fall as the bank transitions to a more digital service and sales distribution model, though this positive tailwind to the firm’s cost structure will be offset by rising prices as most of the firm’s expenses are indexed to inflation.

Chilean banks benefit from low costs of funding, due in part to checking accounts in Chile generally not paying interest. This allows firms with large existing demand deposit bases to obtain a significant cost advantage over those without. Historically, this has been a particular strong point for Banco de Chile as while the firm is third in deposits, behind Banco Santander Chile and the Chilean state bank, it is the market leader for checking accounts. This provides the bank with a strong tailwind for managing its overall cost of funding as more than 30% of Banco de Chile’s total funding comes from non-interest-bearing sources. That said, this advantage is offset by the cheaper sources of non-deposit funding that some of its competitors have access too, particularly its international rivals. Banco de Chile’s total cost of funds is functionally equal to that of its largest competitor, Banco Santander Chile, leaving the firm with neither an advantage nor a disadvantage in this area versus its largest private opponent. That said, the bank’s large pool of deposits does provide it with a material advantage against potential new competitors to its market. 

Chilean banks also benefit from the convention of issuing loans denominated in special currency called Unidad de Fomento (UF), which is indexed to inflation. If a borrower takes a UF denominated loan out at 4.5% and inflation for the year is 3% then the real interest rate behind the loan is 7.5% as the borrower’s Chilean pesos would have depreciated 3% against the UF denominated loan. The intent behind this system is to protect the financial system and long-term contracts from high inflation, which the country has experienced in the past, but it also has the effect of allowing the major Chilean banks to be direct beneficiaries of inflation. UF-denominated lending has persisted long after the special currency’s creation and the high inflation that inspired it, a sign of the market power of the major banks, as depending on market events this process can be unfriendly to borrowers. The use of UF denominated loans and financing allows the Chilean banks to adjust their inflation exposure up or down by controlling the “gap” between their UF denominated assets and UF denominated liabilities. The more UF assets exceed UF liabilities the more net interest income increases when inflation rises with the reverse being true as well. 

We generally assign switching costs to all traditional banks with meaningful moats. We see switching costs as stemming from economies of scale and scope, which can point to the existence of switching costs for customers as they develop multi-product relationships with a single firm. This remains a core part of the bank’s strategy, as it offers a slew of cash management and non-lending services to its commercial clients as well as investments and insurance products to its retail customers. There is also the inherent inertia against switching once you have already established an account/relationship with a bank. While this effect can be small on an individual basis, in our view it is still relevant for banks holding onto large established customer bases, and we believe Banco de Chile, with one of the largest existing customer bases in Chile, falls into this category. 

From a systemic standpoint we believe that Chile offers a good operating environment, though this has become a point of risk in recent years. Chilean banks are regulated by the Financial Market Commission which was created in 2017 and in 2019 became the primary regulator for the entire Chilean financial system. We generally regard banking regulations in Chile as well thought-out and a simplified regulatory body for the country’s financial system eases compliance. The Chilean central bank has responded well to rising inflation in 2021, rapidly increasing interest rates to 4% by the end of the year, adding to the institution’s credibility. The Chilean economy has recovered well from the COVID-19 pandemic, aided in no small part by surging copper prices, which makes up the backbone of the Chilean mining industry, a sector that can often exceed 10% of nationwide GDP and 50% of exports. This provides Banco de Chile with the triple tailwind of higher inflation, rising rates, and a positive outlook for economic growth. These positive do need to be held against Chile’s politics becoming notably more populist in the aftermath of the 2019 street protests. While the political situation bears monitoring, particularly as the country’s constitution is in the process of being rewritten, given the strength of Banco de Chile’s position and its competitive advantages we believe the firm will continue to out earn its cost of equity, earning the company a narrow moat rating.

Narrow

Economic Moat

Banco de Chile

SM-Chile, is a holding company for Banco de Chile. The parent company of Banco de Chile SA created a commercial bank under the name Banco de Chile and was transferred all its assets and liabilities, excluding subordinated obligation call with the Central Bank of Chile, obligation undertaken following the banking crisis of the years 1982 - 1984 and the consequent bailout carried out by the Central Bank.

SM-Chile

Banco de Chile SA engages in the provision of banking services. It operates through the following segments: Retail, Wholesale, Treasury, and Subsidiaries. The Retail segment consists of consumer loans, commercial loans, checking accounts, credit cards, credit lines, and mortgage loans. The Wholesale segment includes corporate clients and large companies where the product offering focuses on commercial loans, checking accounts and liquidity management services, debt instruments, foreign trade, derivative contracts, and leases. The Treasury segment comprises securities portfolio, derivatives positions, and currency trading. The Subsidiaries segment corresponds to companies and corporations controlled by the bank. The company was founded on October 28, 1893 and is headquartered in Santiago, Chile.

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