Financial Safety Nets: Lessons from Chile

Abstract

Should governments ever override bank regulators who are attempting to close down insolvent financial institutions? An analysis of Chile's history shows that time after time from the 1850s to the 1980s, prudential banking regulations were abandoned during economic crises when attempts to impose tight solvency standards proved impossible to enforce. Chile's current stringent banking regulations may prove more durable, but mounting financial distress is equally likely to lead the government to adopt policies that prevent bank failure but undermine the authority of regulators. Bank regulators, including the central bank, are responsible for creating a financial safety net to protect depositors against loss and for enforcing the rules of prudent behavior that are required for a stable financial system. Because safety nets often additionally cover losses to bank owners and borrowers, the support they offer encourages risk taking by the private sector an action that may promote financial deepening, but at a high budgetary cost to the government. Poorly designed safety nets may have to be suspended during crises to prevent losses from mounting and to limit the government's liability.