Banco de Chile - Q2 2023

Transcript

Operator (participant)

Good afternoon, everyone, and welcome to Banco de Chile's second quarter 2023 results conference call. If you need a copy of the management financial review, it is available on the company's website. With us today, we have Mr. Rodrigo Aravena, Chief Economist and Institutional Relations Officer, Mr. Pablo Mejia, Head of Investor Relations, and Daniel Galarce, Head of Financial Control and Capital. Before we begin, I would like to remind you that this call is being recorded and that the information discussed today may include forward-looking statements regarding the company's financial and operating performance. All projections are subject to risk and uncertainties, and actual results may differ materially. Please refer to the detailed note in the company's press release regarding forward-looking statements. I will now turn the call over to Mr. Rodrigo Aravena. Please go ahead, sir.

Rodrigo Aravena (Chief Economist and Institutional Relations Officer)

Good afternoon, everyone. Thank you for attending this conference call, where we will present the main achievements and financial results posted by our bank during the second quarter of this year. We are glad to host this webcast today in a period where Banco de Chile, once again, showed its unquestionable leadership in the financial industry in the country. Some of the main highlights of this quarter include: first, we posted the highest net income in the industry by achieving a bottom line of CLP 352 billion, equivalent to an ROE of 28%. Therefore, we remain as the most profitable bank in Chile. Second, despite the weak economic cycle, we continue delivering sound asset quality figures.

In the second quarter, we posted a cost of risk of only 0.7% and NPLs of 1.3%, both well below figures posted by the industry. Third, by achieving a CET1 ratio of 13.5%, we continue to be the bank with the soundest capitalization, confirming we are the best prepared for facing challenging economic cycle and further regulatory requirements in connection with the implementation of Basel III in Chile. All these results were accomplished in a period when we carry out important advances in our core strategy priorities, including advances in our digital transformation process and in ESG matters. We will present a deep analysis of all these topics through this presentation. Before moving to these topics, I'd like to share our view on the macro financial environment we have faced and our forecast for this in the following year.

Please go to slide Number 3. The chart on the upper left clearly shows that the overall activity remains weak. In the first quarter, the GDP contracted by 0.6% year-on-year after the 2.3% year-on-year drop in the last quarter of 2022. This recession has largely been explained by the decline in consumption, which went down by 3.8% year-on-year in the first quarter, driven by the substantial fall of 28% year-on-year in durable consumption. Gross investment has also contributed to the negative growth by falling 2.1% year-on-year in the same period. All in all, domestic demand declined by 8% in the first quarter, which was partially offset by the slight recovery of total export.

Available information from the second quarter shows a similar trend as the IMACEC, which is the monthly GDP figure, went down by 1.4% year-on-year. The chart on the upper right displays the evolution of the overall activity sequentially. Generally, the graph shows how the economy has stagnated, as the level of the IMACEC remained below the level posted in December of 2021 due to the important decline in the commerce sector. This negative trend has resulted from several factors, including the normalization of liquidity levels and the contractionary fiscal and monetary policies implemented mainly in 2022. Inflation has also affected disposable income levels, reducing household purchasing power. In this environment, we've seen a gradual increase in the unemployment rate to 8.5% in the second quarter, 70 basis point above one year ago, as shown on the chart on the bottom left.

This has resulted from the greater acceleration in the labor force, which went up by 3% year-on-year, while employment increased by 2.2% year-on-year. The greater dynamism in the labor force has increased the participation rate to 61%, although it remains below the pre-pandemic level. This recession has contributed to reducing macroeconomic imbalances. The current account balance, for instance, improved significantly at the beginning of this year, as the chart on the bottom right displays. In the first quarter, it posted a surplus of $700 million, achieving the highest figure since 2010 and the first positive balance in three years. As a result, the last 12 months balance improved to 0.1% of the GDP to -6.9%.

It is worth highlighting the importance of normalizing the external deficit since it is one of the most relevant sources of macro stability for a country. I'd like now to analyze the evolution of the main nominal figures of the economy. Please move to the next slide, Number 4. The inflation rate has been decreasing, as the upper left chart shows. In June, the annual inflation rate was 7.6%, the lowest since December 2021, while the core CPI, which is the measure that excludes food and energy prices, fell to 6.9%, also the lowest figure in several quarters. These trends have been accompanied by lower annual increases in all the alternative core measures and a lower diffusion index, which represents the proportion of articles that increased prices in the month, which posted a historically low figure of only 42%.

The lower inflation has resulted from different factors, including the subdued activity, which reduced pressures on non-tradable goods, and the combination of the stronger Chilean peso and the lower CPI in trade partners, factors that drove a decline in tradable inflation to 7.3% year-on-year in June, from a peak of 17.3% in August of last year. In fact, as you can see in the chart on the bottom right, the local currency appreciated nearly 7% from one year ago, while the real exchange rate strengthened by 14% in the same period. In this environment, the central bank began an easing cycle in monetary policy by reducing the overnight rate to 10.25%, or 100 basis points, in the meeting held in July.

This is the first cut in the policy rate since early 2020, when the pandemic affected the economy. The press release showed an expansionary bias, as the board signaled further interest rate reduction in the coming meetings. This bias was reinforced by the governor of the Central Bank, who anticipated reductions towards levels below 8% by the end of this year. As a response of the new tone in monetary policy, market interest rates have been anticipating both lower inflation and interest rates, which can be clearly seen in the chart on the bottom right, which shows the recent decline in the nominal 10-year sovereign rate despite the opposite trend observed in global rate. I'd like to briefly discuss our macroeconomic forecast for this and the next year. Please go to the next slide, Number 5.

We expect that the second quarter was the bottom in this negative cycle, with a GDP decline of around 1.4% year-on-year. For the second half, we estimate a gradual recovery of the overall activity, driven by the lower inflation and interest rate. Nevertheless, despite this expected recovery, we continue forecasting a negative growth for the year of around -0.2%. For 2024, we foresee an expansion in line with the potential growth, close to 2%. This combination of factors, such as subdued growth, a stronger currency, and lagged effects of the interest rate hike, is consistent with a further inflation rate decline. In this environment, we have reassessed our prior expectation of inflation for this and the next year.

As such, now we expect headline inflation of 3.8% at the end of this year and 3% in 2024. We believe a lower inflation rate should leave room for the central bank to reduce the interest rate to 7.5% this year and to 4% next year, as the right chart shows. All these forecasts are subject to risk. Given the important integration of Chile into the global economy, it's important to analyze the evolution of its trade partners, such as China, even more after its weaker-than-expected expansion during the last quarter. In the local front, the evolution of lagged factors, such as labor market and political considerations, including discussions related to changes in taxes, pensions, and the constitution, are worth monitoring. Based on this aspect, we acknowledge downside risk in our growth forecast.

Let me now share a brief overview of recent trends in the financial industry. Please go to slide Number 6. This quarter, the banking industry reported a net income of CLP 1.3 trillion pesos, resulting in an ROE of 18.4%, as indicated in the chart on the top left. The year-on-year decline in net income is mainly attributed to lower inflation that went from 4.3% in 2Q 2022 to 1.4% in 2Q 2023, which impacted operating income, as depicted in the chart in the middle of this slide. Furthermore, a rise in loan loss provisions, excluding additional provisions, has affected most banks in the industry, as evidenced by an increase of 16% in the 2Q versus 2Q last year, as shown on the chart to the right.

This is in line with the trend that we have forecasted over the last quarters in relation to the normalization of customer risk profile, which is being reflected by delinquency that rose quickly from 1.4%-2% during the same period. Persistent high interest rate levels, weak economic environment, and political uncertainty have reduced the banking industry loan growth to only 4% nominal year on year, mortgage loans was the main driver of growth, increasing 11% nominal year-on-year, followed by consumer loans that rose 4.9% nominal in the same period. This was partially offset by slight contraction in commercial loans. Looking ahead, we anticipate as economic conditions improve, we should see a potential recovery in loan demand and a more favorable lending environment. Lastly, it's worth mentioning that the composition of the Chilean banking industry assets differs from other regions.

Unlike some geographies, banks in Chile have a significant concentration in loans, accounting for 62.3% of total assets. In terms of financial instruments, including derivatives, these make up only 17.6% of total assets, while the held-to-maturity portfolio constitutes only 3.7%. As a result of this asset composition, the local banking industry in Chile is relatively less exposed to recent financial events that have impacted certain banking players worldwide early this year. A strict and conservative banking regulation, as well as lower reliance on financial instruments and held-to-maturity investments, contribute to a more stable and resilient banking landscape in Chile. It's important to note that today, the amount of financial assets held by the Chilean banking industry is even above average levels since prior to the pandemic.

As banks are currently in the process of replacing FCIC collaterals, which should be totally composed of high-quality liquid assets by the maturity of the obligation. Now, I'd like to pass the call to Paulo, who will go into more detail about Banco de Chile advances and the financial performance.

Pablo Mejia (Head of Investor Relations)

Thank you, Rodrigo. I'd like to begin with our main accomplishments in our key strategic projects. Please go to slide Number 8. Our consistent and outstanding results has been a direct outcome of our effective strategic approach, which places customers, efficiency, and ESG at the core. We've implemented this through an approach of six key priorities, allowing us to surpass our midterm objectives, as evidenced on the right. In the upcoming slides, we will explore the advancements we've made in digital transformation, productivity, and sustainability, illustrating our commitment to progress and excellence in these crucial areas. Let me start with digital banking. Please move to slide Number 9. In recent years, we have dedicated our efforts in constructing a robust front office digital banking ecosystem aimed at enhancing our customers' journey and overall experience. This slide highlights some key components and advances of this ecosystem.

When it comes to digital banking, we cater to various customer segments with tailored options. Cuenta FAN, our pioneering online onboarding service, has been exceptionally successful, attracting over one million users. Moreover, we provide digital accounts for SMEs, teenagers, and offer both digital current accounts in Chilean pesos and in dollars. Additionally, our diverse range of online products enables customers to effortlessly open accounts and manage their finances conveniently at any time without the necessity of visiting a branch. This approach empowers our customers with greater control of their banking experience, putting the power of managing their finances right at their fingertips. We take immense pride in being the pioneers in the Chilean banking industry by establishing a virtual building in the Metaverse, a significant milestone aimed at promoting engagement among young people.

Additionally, we have facilitated SME customers to receive payments through QR codes using our app, demonstrating our commitment to enhancing convenience and efficiency in financial transactions. Furthermore, we continually strive to elevate service quality through the implementation of cutting-edge technologies such as artificial intelligence. By leveraging advanced tools to manage calls, analyze customer behaviors, and gather post-service feedback, we ensure that our customers' needs are met with the utmost efficiency and satisfaction. Our relentless efforts to deliver exceptional customer journeys through digital initiatives have not gone unnoticed. Thanks to our dedication, we've been recognized as a leading bank for customer experience by the esteemed Praxis Xperience Index. This recognition reinforces our commitment to putting customers at the heart of everything we do and providing them with unparalleled banking experience. We continue to strive to improve our efficiency and productivity, which are a key pillar of our strategy.

Please turn to Slide 10 to review recent developments we've made in enhancing productivity and reducing costs. Alongside our efforts in productivity, we have remained firm in optimizing processes and enhancing customer experience. In this regard, we have introduced various changes to our deposit service model to encourage higher digital adoption. As a result, there has been a significant operational and management enhances in our deposit processes, leading to a noteworthy 18% surge in digital channel adoption within the first month, reducing costs and optimizing margins simultaneously. Additionally, we have fine-tuned our cash management sales process for enterprise payment agreements with SMEs, resulting in a substantial 32% annual increase in the stock of active contracts of cash management payment contracts for companies, strengthening client relationships and fostering future growth. Another area of focus on productivity during the last quarter was branch customer service.

The successful improvement in back-office processes resulted in a 50% reduction in branch waiting times compared to the first quarter of 2023. This improvement is essential for ensuring a positive impact on customer experience, promoting loyalty, and fostering a positive image of the bank in their minds of the customers. On the cost reduction front, a comprehensive review of our entire physical infrastructure identified areas for space rationalization, unlocking important and potential savings while ensuring our infrastructure remains efficient and optimized. We are improving our investment planning methodology to ensure that all of our strategic initiatives are aligned with our long-term objectives and driving value creation and long-term sustainability for the bank. Furthermore, we are reviewing our end-to-end procurement process to identify key improvements to be addressed during the renewal of our ERP system, especially the procure-to-pay processes.

We expect that this project will modernize our current system, enabling faster and more automated procure-to-pay processes, streamlining our operations. In conclusion, efficiency and productivity are at the heart of our bank. We firmly believe that by consistently seeking opportunities for improvement and optimizing our operations, we can sustain our leadership in the industry and continue to drive sustainable growth. Please turn to Slide 11. Sustainability has been fundamental for us. As illustrated on this slide, our bank has been actively involved in supporting the community, especially during times of crisis and natural disasters like earthquakes, large-scale fires, among others. In recent years, environmental, social, and governance criteria have become increasingly crucial in shaping our strategic direction. Our ESG journey has shown remarkable progress since 2014.

Notably, we have achieved several milestones, such as enhancing transparency through our annual reports, fostering sustainable finance by establishing an ESG financing framework, and bolstering governance with the creation of ESG-related policies and the establishment of formal sustainability committee led by the CEO, which reports advances regularly to the board. These initiatives, along with numerous other advancements in this domain, have led our performance to be acknowledged and recognized by the leading international ESG rating firms. Our commitment to ESG practices continues to drive positive outcomes and reinforces our position as a responsible and forward-thinking institution. Please turn to Slide 12. During the quarter, we continued to progress in sustainability, and this was recognized by our strong improvement in our annual sustainability ESG rating score, which positioned us once again as the bank with the highest score in the Chilean banking industry.

Additionally, we issued two social bonds overseas, raising over $80 million under our ESG financing framework, with a focus on supporting women-owned enterprises to drive economic growth and to promote gender equality. We also actively promoted entrepreneurship by not only participating in the FOGAPE Chile Apoya programs, but also by being the private bank that granted the most loans to SMEs under this assistant package, and we organized the National Entrepreneurship Contest targeting SMEs, university, and high school students. We also remained committed to providing our employees with knowledge on sustainable finance and climate change through specialized training initiatives, which is crucial in building a workforce that is well-informed and equipped to integrate sustainability principles into all areas of operations, especially risk management. Finally, we actively engaged in the community on several fronts.

We conducted multiple financial education talks to empower individuals with valuable financial knowledge and skills that lead to better financial decision-making within the community. Our reforestation volunteering program also assisted in rehabilitating areas impacted by the summer forest fires, among other activities. All of these initiatives reaffirm our commitment to making a positive impact on society, the environment, and to continue creating long-term value for our stakeholders. Please turn to Slide 14 to begin our discussion on our results. We have a consistent track record of outperformance, and this quarter is no exception. Once again, we recorded an impressive bottom line of CLP 332 billion pesos, equal to an ROAE of 27.6%, greatly surpassing all of our peers, as depicted on this slide.

Our success stems from the strength of our dedicated team and well-crafted long-term strategy that prioritizes sustainable growth with a balanced approach to risk and return, as reflected by our market leading position in terms of capital adequacy and NPLs. As a result, we have established ourselves as the most resilient and sustainable bank in Chile. We expect their long-term ROAE should settle at approximately 18%, but in the short term, ROAE will surpass this range, and we estimate it to reach a level of around 22% in 2023. For 2024, under a normalized scenario, it's reasonable to expect an ROAE of around 18%. This is primarily due to an expected decrease in inflation, lower short-term interest rates, and the normalized level of cost of risk of around 1.2%.

Additionally, it's important to mention that we will repay CLP four trillion of FCIC funding to the Central Bank of Chile for putting further pressure on NIM. Please turn to slides 15. Operating revenues were up 6% when compared to the first quarter of 2023, but fell 12% year-on-year. The annual drop was a product of several drivers associated with market factors, including a sharp decrease in inflation that went from 4.3% in the second quarter of 2022 to 1.4% in the second quarter of 2023. As a reminder, a change of 100 basis points in inflation is roughly CLP 70 billion in net interest income. In addition, revenue generated by Treasury also declined on a year-on-year basis.

These factors were partially offset by a steady 10% expansion of customer income. On a sequential basis, customer income continued growing, posting an increment of 3% quarter-over-quarter because of stronger demand deposit contribution, given the scenario of high interest rates. It's essential to emphasize that quarterly fees grew by 7%. The growth would have been higher if the accounting treatment for income from collection services for overdue loans did not change, as now it's recognized under operating income instead of fee income. This change took effect this year. Taking this into account, fees would have grown 12% year-over-year this quarter, double digits.

The yearly rise in fees was primarily from increased usage of transactional services due to higher use of credit cards as a result of personalized campaigns to promote this method of payment to customers, which, coupled with a larger quantity of credit card users, and by higher checking account commissions due to an increase in the number of current account holders and the effect of inflation on fees. Additionally, there was a boost in insurance brokerage related to an annual increase of 55% in written premiums, in line with the recovery in the level of consumer loan origination and to a lesser extent, to the effect of inflation. On a sequential basis, fees remained relatively flat, with some growth in credit cards and current account administration fees offset by higher commissions paid for electronic transfers and expenses related to our loyalty program, primarily due to exchange rate increases.

In terms of non-customer income, we generated less revenues year-on-year from our UF GAP position due to the sharp drop in inflation during the period versus the same period last year. This was further amplified by higher results managed by our trading and investment portfolio in the second quarter of 2022, as we greatly benefited from the positive impact of interest rate movements in the financial positions held at that point. This was partially offset by income from management of term spreads and interest rate gapping under the current scenario of high short-term interest rates and extraordinary income from the sale of a branch in the metropolitan region, and non-recurring income associated to VAT reimbursements and the reclassification of fee income associated with the collection of services previously mentioned.

On a sequential basis, non-customer income posted an increment of 15% quarter-on-quarter due to higher inflation during the quarter, as well as the previously mentioned tax reimbursements and property sale. The charts on the right demonstrate how our performance has compared to our peers. This quarter, NIM reached 4.6%, significantly surpassing all of our competitors. A similar trend is evident in fees and overall operating income, as indicated in the charts on this slide. Our remarkable comparative performance is a result of our unwavering commitment to our business strategy and our proactive approach to managing risks, all backed by a robust corporate governance standards. Please turn to Slide 16. Banco de Chile is a universal bank catering to clients across all segments in the retail and commercial banking.

As shown in the chart, 65% of our loans are focused in the retail segment, with the remaining 35% in wholesale banking. As you can note, the retail segment participation in the overall portfolio has slightly increased compared to previous quarters due to the weaker loan demand from the wholesale segment. During the pandemic, as for many banks, our growth mainly centered in low risk and low margin products, resulting in a significant shift in the loan mix and the balance sheet structure. However, we anticipate their expansion in the upcoming periods will gradually restore the loan mix to levels that we had before the pandemic in higher margin products, thereby helping to increase loan spreads and offset temporary factors, which are still impacting interest income from loans.

Nevertheless, total loans experienced a 2% annual growth and a 1.6% decline compared to the first quarter of 2023, as illustrated on the chart on the right. In turn, mortgage loans expanded by 9% during the 12-month period, primarily driven by inflation. However, in real terms, residential mortgage loans remained relatively flat due to the weaker demand caused by high long-term interest, the unstable inflation prospects, and a weak economy. In terms of consumer loans, growth was primarily fueled by both originations of installment loans that has allowed us to recover the nominal balance we managed before the pandemic, and an increase in credit card-related loans. This has been based on improved segmentation of customers that has been supported by our business intelligence tools, while enabling us to maintain credit risk at low levels.

These drivers resulted in a notable annual surge of 12%, achieving a market share of consumer loans of around 18%, which represents an increase of 130 basis points over the last 12 months, notably higher than the average in the industry, as shown on the bottom right graph. We expect that the strong growth level in consumer loans will gradually slow to levels slightly above inflation by the year-end, reflecting the current economic situation and customer debt levels, as well as the higher comparison base. Commercial loans experienced a decline of 4% on a yearly basis, primarily due to the adverse effects of the still weak investment, which has been attributable to the remaining uncertainty and elevated interest rates. These economic conditions directly impacted customer demand to seek financing for new projects.

From a concentration standpoint, it's important to highlight the diverse nature of our commercial loan portfolio, covering a wide range of economic sectors, as depicted on the chart on the bottom left. This diversification ensures that we don't have significant dependence or concentration risk in any specific industry, providing a safeguard against potential effects arising from economic contractions in sectors such as real estate, construction, or the ongoing challenges affecting the private health industry. The construction sector, for instance, represents only 2.7% of commercial loans at Banco de Chile, while the house insurance industry represents less than 1%. Nevertheless, we remain vigilant and well prepared to promptly adapt their lending strategies to foster growth with an appropriate relationship between risk and return. Please turn to Slide 17 to discuss our solid balance sheet structure.

Our asset and liability structure are well-diversified and robust, as shown on the chart at the top left. Our primary focus is on commercial banking, with loans being the main revenue source, accounting for 67% of our total assets as of June 2023. It's also worth mentioning that before the pandemic, total loans used to be in the range of 72%-78% of our total assets. We should return to near these figures once the FCIC fundings are totally paid off by June 2024. For this reason, financial instruments make up 15.1% of our total assets as of June 2023, with a minimal 1.7% exposure in held-to-maturity financial instruments, significantly lower than our peers, as indicated on the chart on the right. It's also important to note.

that we're in the process of replacing FCIC collaterals by pledging high-quality liquid assets in lieu of loans, as requested by the Central Bank. Accordingly, the share of financial instruments would continue to increase versus cash or overnight deposits already present in their balance sheet to fully secure the obligation with the Central Bank. In this regard, it's important to note that we shouldn't need to raise additional funds to deal with the expiration of the FCIC. Furthermore, we have managed our balance sheet positions appropriately for the economic cycle, which has provided stability in our results with lower sensitivity to changes in market interest rates and adjusting appropriately our UF position to optimize margins. Moreover, our prudent risk management criteria has proven crucial in navigating through these different economic cycles, making a critical difference between banks and the current environment.

Regarding our liabilities, our main funding source consists of deposits, making up approximately 51% of our assets. Specifically, our ratio of demand deposits to time deposits is gradually approaching their historical levels, as indicated by the chart on the bottom left. It's worth mentioning that our overall customer liquidity, which was present in 2021 and most part of 2022, has been preserved. Instead of keeping these funds in zero interest-bearing accounts, customers have opted to place them in time deposits, which today have very attractive rates. It's also important to highlight that approximately 46% of our total liabilities, excluding equity, relates to retail counterparties, of which deposits represent a huge portion. This reflects that regardless of the high share represented by demand deposits and time deposits, our diversified customer base enables us to reduce liquidity risk.

Likewise, we rely on bonds constituting 18% of our liabilities, which are primarily utilized to finance our mortgage portfolio. This approach is particularly important as it helps reduce liquidity risk, given that bonds provide a more stable funding source compared to time deposits. As for Liquidity Coverage Ratio, we recorded in the third quarter a level of 318%, 218 percentage points above the limit, and in the case of our Net Stable Funding Ratio, we reached a level of 137% in June 2023, 67 points above the regulatory limit. Both of these indicators are well above the levels maintained by our peers and reflect their solid balance sheet structure and prudent term mismatches.

Finally, we have maintained our end of period UF GAP relatively stable due to our expectations of lower inflation for the second half of 2023, as you can see on the chart on the bottom right of this slide. This means that for every 100 basis point change in inflation, we generate approximately CLP 68 billion more in net interest income from our current UF GAP position. It is worth noting that an important part of our UF exposure is structural as it pursues to hedge our equity from inflation in the long term. As such, over the coming quarters, our UF GAP will be determined by both directional positions and inflation index fair value through comprehensive income securities to take advantage of market opportunities and the funding strategy followed by the banking book. Please turn to Slide 18.

Banco de Chile is the most capitalized bank in the industry. As of June 2023, our Basel III ratio was 17.8%, well above the fully loaded Tier 1 limit of 12.25% applying for us, as shown in the table on the right. Regarding CET1, we reached 13.5% this quarter, significantly surpassing our main competitors, as shown in the chart on the bottom left, and well above the fully loaded limit established by the regulator of 8.75%. With these levels of capital, we are easily complying with the fully loaded Basel III requirements. Finally, I want to highlight that during the second quarter, the regulator has established a countercyclical buffer of 0.5% for all banks in the Chilean banking industry to be fulfilled by May 2024.

I want to emphasize that this change has no effect on our strategy or outlook, as we are more than sufficiently capitalized to comply with this. Please turn to Slide 19. In the second quarter of this year, expected credit losses amounted to merely CLP 67 billion, representing a substantial 37% reduction when compared to the same period last year, and a 36% decrease compared to the first quarter of 2023. The year-on-year decline is attributed to the CLP 40 billion of additional provisions established in the second quarter of 2022 compared to this quarter, where we did not set additional provisions.

Additionally, this decline was further boosted by a reduction in commercial loan provisions, resulting from an internal risk ratings improvement for one specific wholesale customer during the second quarter of 2023, as well as lower exposure to the segment due to a decrease in commercial loan exposures. However, the positive impact was partially offset by the increase in credit charges in our retail loan portfolio, which is a result of gradually returning to more normal levels of cost of risk. On a sequential basis, the decline in cost of risk is due to the improvement previously mentioned in commercial loans, as well as lower provisions related to consumer loans, due to higher loan volume expansion and credit cards during the first quarter.

We are confident that the leading level of coverage ratio that we maintained, coupled with the highest level of additional provisions, should provide adequate protection in the event of a prolonged economic downturn and increasing delinquencies, as demonstrated on the chart to the.

Operator (participant)

Thank you very much. We'll be moving to the Q&A part of the call. The first question comes from Mr. Yuri Fernandes from JPMorgan. Please go ahead, sir.

Yuri Fernandes (Equity Research Analyst)

Hey, hey, guys. I have a first question here regarding the sensitivity for, for, for rates. I guess Pablo mentioned in the call, the sensitivity for inflation, I think was $60 billion every 100, but just checking the sensitivity for, for rates here. Also regarding, you know, loan growth, when, when should we see, you know, loan growth accelerating? Because you have some pressure from inflation, you have some pressure from FCIC, and we are seeing, you know, like, very lackluster loan growth in Chile. Just trying to understand what should we expect for 2024. If I may, a final one, very quickly, dividends. What is the, the, the expectation for payout this year if Banco de Chile continue to pay?

I think 100% of the distributable earnings, that last year was around 70% payout on reported earnings. Thank you.

Daniel Galarce (Head of Financial Control and Capital)

Hi, hi, hi, Yuri. We, we had an issue. It just cut off. Let me just finish the last page here, and we'll go into your questions. So if you can turn to slide Number 20. As you can see on the slide on the left, high inflation figures continue to impact total expenses. In nominal terms, operating expenses increased by 12% compared to the same period last year, and remained flat versus the first quarter of 2023. Considering that the average inflation measured in terms of US in the last 12 months was 10.7%, and our expenses grew 1.6% in real terms, this nominal annual increase is primarily influenced by inflation, index line items, and a lesser extent to IT-related expenses.

It's important to note that advances in efficiency across various areas have allowed for significant growth in disbursements allocated to IT-related expenses as a result of our ongoing digital transformation program, which is essential for addressing the transformative changes demanded by digitalization. Regarding the efficiency ratio, we achieved a ratio of 35.4% this quarter, which is well below the industry average and that of our main peers, as shown in the chart on the bottom right. As mentioned earlier in the presentation, this level of efficiency is a result of several initiatives implemented through our productivity plan and cost control measures. Finally, it's worth mentioning that, as previously indicated in our reports, the upward trend of our efficiency ratio towards normalized figures was expected and remains well below the midterm target of 42%. Please go to Slide 21.

Before I answer the, the, the questions now, I just want to recap some of the main points and give some guidance for 2023. After a period of strong growth and record levels of inflation, the Chilean economy is undergoing an adjustment. Accordingly, we expect the current recession to last about the second quarter of 2023, and during the second half of 2023, we should begin to see signs of growth. As a result of the high overnight rate, GDP will continue posting a negative rate for the full year. Nevertheless, this approach of the Chilean Central Bank to control inflation has been very effective, reducing inflation more quickly than expected.

Accordingly, we're estimating that inflation will end the year slightly lower than 4% in December 2023, which is approximately one percentage point down from the level that we saw last quarter. In this environment, given the Central Bank's delay in adjusting the monetary policy, we expect that the overnight rate ending the year below 8% is reasonable. In this context, we've changed our outlook for NIM, reducing the guidance from 4.6%-4.3%. In terms of cost of risk, we expect levels of around 1.2% for the year, with an efficiency ratio of around 38%. This baseline scenario should provide us with a return on equity of around 22% for this year, depending on the evolution of these indicators.

In the current economic landscape and our prudent improvement business strategy has consistently set us apart from our peers, reinforcing Banco de Chile's position as the best bank in terms of profitability, capital, and risk management. Moreover, we're very proud to be recognized as the leading bank in Chile with respect to ESG risk. This acknowledgment reflects our unwavering commitment to sustainable practices and responsible business operations, solidifying our reputation as a trusted and esteemed financial institution within the industry. Our dedication in ESG principles further strengthens our position as a forward-thinking and responsible leader, driving a positive impact and fostering sustainable growth in the market, which is key for our shareholders. Now we'll go into the questions. The first question was from Yuri, dividends.

For what we've seen and where our dividend policy is today is a dividend policy of 60% of distributable net income, which means net income less the effect of inflation on capital, you get to distributable net income. Last year, we distributed, or, or this year versus the prior year's earnings, we distributed around 60%. In the future, depending on the environment, the economy, politics, which affects the industry and the environment, we need to think of Banco de Chile using our capital effectively. We can't rule out changes in the dividend policy or in the dividend payout in the future, taking this into consideration. We can't rule out a similar payout in coming periods.

Rodrigo Aravena (Chief Economist and Institutional Relations Officer)

In that, let me add, yes, one, one quick idea, and Rodrigo Aravena here. In that matter, it's very important to analyze the potential implication of different scenarios of economic growth for the future. Important to remember that Chile is still under a recession. We continue posting negative, year-on-year growth rate of activity. For the next year, even though we're expecting an economic growth of 2%, as we said in the presentation, we have a downward bias in the estimate because there are several sources of risk. That's why the, we, we acknowledge possibility of having a few weak growth for the next quarter. Obviously, it also impacts the perspective of, you know, the growth dividend for, for the future. Growth is still a matter of uncertainty for, for the future.

Daniel Galarce (Head of Financial Control and Capital)

What was that? Can you. Yuri, can you repeat the other questions?

Yuri Fernandes (Equity Research Analyst)

Yeah, sure. It was regarding low growth and dividends, which they are somewhat connected. I'll, I'll do another one here. I think it, it's more important. You, you mentioned, Pablo, I think 1.2 cost of risk, I think, for 2023, and you are running below one, right? It was 0.7 this quarter, and I think the 1Q was around 1%. So my question is: are you thinking that cost of risk will accelerate materially in the second half? How do you see this versus your, your high coverage ratio, right? Because maybe something I was thinking for you is that Banco de Chile could consume the additional part of the voluntary provisions in the coming years, like, basically keeping cost of risk closer to 1, like, like, at lower levels.

I, I don't get, like, the 1.2 seems a little bit too high, given you have such a high coverage ratio and given the first half was below 1% on cost of risk. If you can, you know, add some color on this, would be great. Thank you.

Daniel Galarce (Head of Financial Control and Capital)

Cost of risk should be around this range of 1%. There's a lot of uncertainties still in the Chilean economy and how this can proceed in the future, but around 1% is. It could be slightly higher, but around 1% is reasonable. The medium term, 1.2% is the long-term level for Banco de Chile under a more normalized scenario with a normalized asset quality book, where we have a good relationship between risk and return. Remember that during the pandemic, we had strong growth in low-margin products, SME loans with government guarantees, loans, upper income segments with lower margins.

This has positively impacted the cost of risk temporarily, and this should be normalized in the future, and which should also be noticeable in the NIM. Today, we have a NIM in 4.6%. In the medium term, we should think about levels similar to this, because there's many factors that have to be considered in this unusual scenarios that we've lived in over the last couple of years, which have affected the assets and liabilities in different ways, including the loans, as I mentioned.

Rodrigo Aravena (Chief Economist and Institutional Relations Officer)

Hi, Yuri. I'm Rodrigo Aravena again. Sorry. Yeah, important also to mention the role of the excess of liquidity that we have in previous years, which also was very important in terms of asset quality indicators, et cetera. Basically, what we are assuming for the future is that a further normalization in the total level of liquidity, but additionally, we're expecting a higher unemployment rate for the future. Basically, we are beginning to see a slight increase in the unemployment rate, so they were at level of 8.5%. However, we have different leading indicators anticipating a further deterioration in terms of the employment growth, so we can't rule out that unemployment rate over the next quarter will be around 9%.

We can't rule out the possibility that total unemployment rate will surpass the level of 9%, which is consistent with a normalization of cost of risk as well in the future.

Yuri Fernandes (Equity Research Analyst)

No, super clear, Rodrigo and Pablo. I was thinking that the 1.2 was a full year, but it's clear this is kind of a midterm guidance indication, and not that your full year will be around, around this, this, this level. Thank you very much.

Daniel Galarce (Head of Financial Control and Capital)

Thank you.

Rodrigo Aravena (Chief Economist and Institutional Relations Officer)

Thanks. Thank you.

Operator (participant)

Thank you very much. The next question comes from Juan Ricalde, from Scotiabank. Please go ahead, sir, your line is open.

Juan Ricalde (Analyst)

Hi, congrats on, congrats on the strong results, and thank you for the opportunity to ask questions. My first one is related to financial results, which were very strong in the quarter, around CLP 120 billion. I think that you mentioned the drivers in your remarks, so my question is, going forward, how sustainable these levels are?

Daniel Galarce (Head of Financial Control and Capital)

Hi, this is Daniel Galarce. Regarding financial results, of course, we, we are seeing still some, no, no long-term ratios, of course, and no long-term market factors. Treasury, treasury income, of course, has been quite affected now and probably will be more affected in the future, considering the, the, the, the path that is estimated for, for interest rate in the, in the short term and in the long term as well, and also inflation. Probably we, we are considering a slide in, in, in, in treasury revenues, of course, for the, for the next year, but basically, approaching to the, to the long-term levels, basically. I mean, to the, to the, to a normalized scenario, over the next two, two years, I could say.

Juan Ricalde (Analyst)

That's helpful. Then I have a follow-up on NIM. I think that Pablo made a comment about the NIM expectation in the long term. Can you comment on what level of NIM do you expect for 2024? Please repeat the long-term expectation for NIM. Thank you.

Daniel Galarce (Head of Financial Control and Capital)

With NIM really depends on many factors. There's many factors at play. You have today, inflation that's coming down. We're expecting around 4%, and for the next year, inflation is expected to be at around 3%. That's something important to be considered. For every 100 basis point change in inflation, but the gap that we have today on the balance sheet is about 68, is about between 60 and 70 billion CLP change in net interest income, so something like 15 basis points. We have that. We also have the, the different factors, and the assets that are, that are coming due, loans that are coming due, financial instruments coming due, which will be at higher rates.

This is a positive impact to growth in terms of more profitable products with a stronger economy, should be possible as well. Probably in the ranges of around 4, 4% is reasonable, slightly higher than 4%. We're expecting for this year, 4.3. Next year, slightly lower than that, 4.2 is reasonable to expect in this scenario. Obviously, this depends on the baseline scenario of which you saw in terms of rates and inflation. This could have a change and also on the expectations that Chile returns to growing next year, which should increase the demand for loan growth.

Rodrigo Aravena (Chief Economist and Institutional Relations Officer)

One other important thing to consider here is that for the future, we are expecting a neutral interest rate that will likely be a bit higher compared to the rate that we used to see in the past. For example, before the pandemic, the neutral interest rate in Chile used to be around 3.5%. Now, we're expecting for the long run, an interest rate, this has a little bit higher than 4%, in an environment where the potential growth probably will be 2% or slightly lower for that. Important to consider the different opposite forces that there will be in the future.

Daniel Galarce (Head of Financial Control and Capital)

Prior to the pandemic, net interest margins on average were around 4.5%. We should be in similar levels.

Juan Ricalde (Analyst)

Got it. Thank you for the comments.

Daniel Galarce (Head of Financial Control and Capital)

In the medium, in the medium term, obviously.

Juan Ricalde (Analyst)

Understood. Thank you for the comments.

Operator (participant)

Okay, thank you very much. Our next question comes from Mr. Tito Labarthe from Goldman Sachs. Please go ahead, sir. Your line is open.

Tito Labarthe (Analyst)

Hi, Rodrigo and Pablo, thank you for the call. Thank you for my questions. A couple questions also. Just to think about your profitability going forward, just given all the moving parts, you know, you're coming from a high level of ROE. How quickly does that normalize, you know, as inflation comes down, as interest rates come down, and cost of risk kind of gradually going up? Just to think about, yeah, yeah, that, that, that gradual sort of evolution in ROE and, and thinking about sustainable levels, I think in the past, you know, 18% or so. Is that sort of where should we expect ROE to be next year? Or any color you can give on the ROE trajectory from here?

My second question, I guess, somewhat following up on, on the dividend question, but from a different perspective. You, you have a very high capital ratio, as you've highlighted. What is the optimal capital ratio? I mean, I don't think you need to sustain a 13% core Tier 1, or, or do you think you do? Or, you know, what should that optimal capital level be in a normalized environment? Thank you.

Pablo Mejia (Head of Investor Relations)

Thanks for your question. In terms of ROE, there's a lot of moving parts. For this year, around 22% is reasonable. For next year, around 18% in this, in this baseline scenario, which is our, our long-term level. There, there's many moving parts because, because of the pandemic. On the assets we've had, lower rates than normal because of different products that were originated during this time period, and liabilities as well, there's different moving parts. This makes it challenging to, to, to analyze the banking industry today. However, when we take into consideration all these moving parts that have benefits and, and negative impacts on the balance sheet, we should expect gradually returning to the 18%.

Today, we have had higher rates for longer than we were expecting and with a little bit lower inflation, but this has meant that we have a very strong net interest margin for the year. For next year, this should begin to normalize, and we should have levels of around 18% of ROE, which is in line with our long-term level. In terms of the capital, the capital is. Today, we're very comfortable with the level of capital that we have. We're very comfortable, but we're aware that we have to use our capital efficiently. For this reason, in the future, we have to analyze how much capital is required for the growth that we're anticipating. Today, the growth in Chile is very slow.

As Rodrigo mentioned, the long-term rate of GDP growth is around the 2% level, with elasticity today being closer to 1%, 1.3%, around there, versus the higher levels in the past. This is something that has to be taken into consideration, and the Basel III requirements, Pillar Two, which is possible to be implemented. We just recently had an increase in the requirements for the countercyclical buffer of 0.5%. All this has to be taken into consideration, but we can't rule out a change in similar to what we've had in the past in terms of how much we pay out.

Tito Labarthe (Analyst)

Okay. Thanks, Pablo. I guess just to think, I mean, yeah, 13.5% core Tier 1. Yeah, is there an optimal level in I mean, because 18% ROE, even loan growth picking up, you know, maybe you grow loans 10% a year, you would still be generating capital over time. No, yeah, you're well above the minimum, even with the countercyclical buffer. Yeah.

Speaker 9

Hi, this is Rodrigo Larsen. Regarding regarding capital and, and, and core capital, of course, we have today a 13.5% ratio. We, we, we have, of course, some internal buffers, very important there. Also, we, we basically want to see how it's going to evolve the, the, the implementation of Basel III in Chile. Today, we don't have, for instance, for, for, for, for, for any of, of the, of the banking players, Pillar, Pillar Two, charges, no? We, we, we have to see what's going to happen in the, in the, in the next years.

Additionally, in terms of a target ratio, we don't have a specific figure, but of course, we want to hover in the future, 2 or at least 2 percentage points over the regulatory limits and also the, our internal, our internal buffers as well.

Tito Labarthe (Analyst)

Okay. No, that's helpful. Thank you very much for the call.

Operator (participant)

Thank you very much. Our next question comes from Mr. Ernesto Gabilondo from Bank of America. Please go ahead, sir.

Ernesto Gabilondo (VP and Senior Equity Analyst)

Hi, good morning, Rodrigo and Pablo. Thanks for taking my call. My first question is also a follow-up on NIMs. In the past, you have said that NIMs benefited from higher rates. Considering that rates are starting to go down, what should be the impact for NIMs? Can you remind us the sensitivity to rates for every change of 100 basis points? My second question is on expenses. We saw them growing at double digits this quarter, how should we think about OpEx growth for the full year and next year? My last question is on your effective tax rate. Considering lower inflation levels, where do you see the effective tax rate normalizing? Thank you.

Pablo Mejia (Head of Investor Relations)

Hi. Thanks for the question. In terms of NIM, NIM, there's a lot of moving parts. We have different events that occurred during the last years, which are coming due all at once, so it's very difficult to analyze. We have negative impacts and positive impacts. We have, for example, today, rates coming down, lower inflation, but we also have positive impacts of higher rates on loans being originated during this time of higher rates, and they'll stay higher because of different levels of interest rates that we're seeing today, as Rodrigo mentioned. It's very difficult to isolate one factor from another.

It's true, the lower rates will have a negative effect. We also have positive effects that are occurring at the same time. For this reason, this is the reason why we don't expect a large change from the guidance of this year of 2022 of 4.3%. Next year, we should be around similar levels of around 4.2%. We have different factors that are impacting us negatively and but also positively. The change of 100, You have to take into consideration that the rates went up very quickly over a very short period of time, and we're already seeing reductions. Not the entire loan book is in price at very high rates. Today we have a lot of loans at very low rates, so there's.

It makes the, the calculation more difficult. For a 100 basis point change, if you think of an average rate of the total loan book of 100 basis points, it would be something like 30 basis points over a three-year period. It's about one third of that impact per year. It's a calculation that's very complicated to take into consideration because of, of the quick changes that we've had in the overnight rate. In terms of expenses, if you see the expenses in term, in real terms, our expenses only grew around 1%. We've been very good at managing our expenses and implementing changes in order to control expenses quickly. Remember that all salaries in Banco de Chile are indexed to inflation and adjusted at least twice per year.

Basically, almost all contracts in Chile are indexed to inflation. It's reasonable to expect that inflation plays a major role. We already implemented a large change in, in the, in the footprint of Banco de Chile. We already we made changes in the past, which we haven't. We already made large changes that some of the, the, the, the, the competition is currently doing. If we look at for, for the future, we should think of costs growing around inflation, and we should think of the, the efficiency ratio being, as we showed in the press release and, and, and the conference call, we mentioned, around less than 42%. In terms of taxes, with our baseline scenario of 3% inflation, we should think of around 23%.

Ernesto Gabilondo (VP and Senior Equity Analyst)

Perfect. Thank you very much, Pablo. Just to follow up in terms of the expenses now. You said that cost growth should be in line with inflation next year's. Thinking about this year, that, as you mentioned, has been pressured of, salaries linked to inflation, how should we think about the OpEx growth for this year?

Pablo Mejia (Head of Investor Relations)

It should be, it should be in around the, the, the, the, the, So, so for, for, for next year, in line with inflation.

Ernesto Gabilondo (VP and Senior Equity Analyst)

For this year?

Pablo Mejia (Head of Investor Relations)

It should be around the high single digits growth.

Ernesto Gabilondo (VP and Senior Equity Analyst)

Perfect. Thank you very much.

Operator (participant)

Okay, thank you very much. Our final question for today comes from Neha Agrawal, from HSBC Global Research. Please go ahead, ma'am.

Neha Agrawal (SVP for Regional Sales and Global Payments)

Hi, thank you for taking my question. Congratulations on the solid quarter. For this year, if I'm not wrong, you expect about 22% ROA, which means a meaningful deceleration in the second half of the year. Are you just being conservative, for instance, in your, in your provisioning guidance? Do you expect meaningful slowdown in your margins or any other aspect of the business? My second question is, for next year, the decline in the ROE is mostly coming from the NIM, but we should see an improvement in the other indicators like fee income, and provisions should continue to remain stable. Is that right? Thank you.

Pablo Mejia (Head of Investor Relations)

Thanks. For, for the remainder of the year, we, we have to think that we have a, a reduction in the, the interest rates and inflation. That, that will be impacting the, the bottom line for, for the remainder of the year. That's the main impact that we, we see. In terms of the, the second question, can you repeat?

Neha Agrawal (SVP for Regional Sales and Global Payments)

For next year, the decline in the ROE would be mostly driven by the top line, the NIMs. How should the OpEx and fee income should improve and OpEx should remain under control, and provision should also be stable. Is that the trends that you expect or is there any divergence? Thank you.

Pablo Mejia (Head of Investor Relations)

Provision should normalize to levels of around 1.2, versus this year, which should be around the 1%. That would be the only difference.

Neha Agrawal (SVP for Regional Sales and Global Payments)

That is.

Pablo Mejia (Head of Investor Relations)

Then a little bit lower, inflation and lower rates. Yeah.

Neha Agrawal (SVP for Regional Sales and Global Payments)

Slightly higher tax rate?

Pablo Mejia (Head of Investor Relations)

Sorry?

Neha Agrawal (SVP for Regional Sales and Global Payments)

Slightly higher tax rate for next year.

Pablo Mejia (Head of Investor Relations)

Tax rate, yeah, because of the, the lower, inflation.

Neha Agrawal (SVP for Regional Sales and Global Payments)

Perfect. Perfect. Thank you so much.

Pablo Mejia (Head of Investor Relations)

Thank you.

Operator (participant)

Okay, thank you. Thank you very much. We see no further questions. I'd like to apologize once again for the technical issue that interrupted today's presentation, and I'll pass the line back to the management team for the concluding remarks.

Pablo Mejia (Head of Investor Relations)

Thank you for listening, and we'll see you again in the next quarter results. Thanks.

Operator (participant)

Thank you. This concludes today's conference call. We'll now be closing all the lines. Thank you and goodbye.