Documento de Trabajo: Myths and Facts About Financial Liberalization in Chile: 1974-1982

Nº 128
Octubre 1990
Documento de Trabajo
ISSN (edición impresa) 0716-7334
ISSN (edición electrónica) 0717-7593
Myths and Facts about Financial

Liberalization in Chile: 1974-1982.
Sergio de la Cuadra
Salvador Valdés P.
www.economia.puc.cl
ISSN:0716-7334
PONTIFICIA UNIVERSIDAD CATOLICA DE CHILE

INSTITUTO DE ECONOMIA
Oficina de Publicaciones
Casilla 274 - V, Correo 21, Santiago
MYTHS AND FACTS ABOUT FINANCIAL

LIBERALIZATION IN CHILE:
1974 - 1982
Sergio de la Cuadra (*)

Salvador Valdés Prieto(**)
Documento de Trabajo Nº 128
October, 1990
(*)Ex President of the Central Bank of Chile, ex Minister of Finance.

(**)Professor at the Institute of Economics, Universidad Católica de Chile. Address:
Casilla 274-V, Correo 21, Santiago, CHILE.
INDEX
Page
1. INTRODUCTIÓN 1
2. REAL INTEREST RATE DYNAMICS IN THE CHILEAN

FINANCIAL LIBERALIZATION EXPERIENCE 5
2.1. The Financial Liberalization Step by Step 6
2.2 The Dynamics of Financial Liberalization 13

2.2.1. Asymmetric Portfolio Adjustment Costs 13
2.2.2. Market Development 18
2.3. Coordination Failures in Financial Liberalization:

The Bankruptcy of the Savings and Loans 21
3. A FRAMEWORK FOR THE ANALYSIS OF PRUDENTIAL

REGULATION 24
3.1. Structural Contingent Subsidies 26
3.2. Moral Hazard 29
3.3. Rollover of Unrealized Loan Losses 31
3.4. Self-lending by Business Groups 33

4. PRUDENTIAL REGULATION IN CHILE: 1976-1982 36
4.1. Moral Hazard: The Chilean Experience, 1976-1978 37

4.1.1. Moral Hazard Before Banco Osorno 37
4.1.2. Banking Policy after Banco Osorno's Failure 39
4.2. Rollover of Unrealized Loan Losses: The Chilean

Experience 49
4.2.1. The facts, 1977-1981 50
4.2.2. The Evidence for Unrealized Loan Losses, 1977-1980 54
4.2.3. Checking a Ponzi Ga me by Rollover of Unrealized
Loan Losses 56
4.3. Structural Contingent Subsidies in Chile in 1981 60

4.3.1. Risks Influenced by the Authorities in Chile 60
4.3.2. Evidence on Structural Contingent Subsidies 65
4.3.3. The Cost of Structural Contingent Subsidies 68
4.4. Self-lending by Business Groups in Chile 71

4.4.1. Origin of Chile's large Business Groups 72
4.4.2. Self-loans versus Loans to Independent Parties 75
4.4.3. Monitoring of Business Group Self-loans 76
4.4.4. Abuse of the Informational Advantage 80
4.4.5. The Outcome: Takeover by the Superintendency of
Banks 84
5. LESSONS FOR FINANCIAL LIBERALIZATION AND

PRUDENTIAL SUPERVISION 87
5.1. The Specifics of the Chilean Experience 87
5.2. A Program for Research 88
REFERENCES 90
MYTHS AND FACTS ABOUT FINANCIAL LIBERALIZATION
IN CHILE: 1974-1983 1
1. Introduction
The Chilean experience of financial liberalization in 1974-1982 has claimed the attention of
a host of analysts that have hoped to extract lessons from it. This paper contributes to this
literature by providing detailed analyses and evidence of the main episodes and facts. In
addition, we provide a link with the literature on prudential regulation of banks, an issue that
turns out to be critical for the success of a financial liberalization.
After the 1982-1983 recession a number of analysts have singled out financial system
regulatory failures as an important causal factor. However, most of these analysts take a
macroeconomic approach and do not investigate within the financial sector what were the precise
reasons for failure. This lack of attention to detail has led some of these analysts to wholesale
doubts about the appropiateness of financial liberalization, as in the case of Arellano (1983)1.
We are interested in more precise conclusions, so that we may design successful financial
liberalizations, where a fallback towards financial repression in despair is avoided.
The first important finding of our study is that the conceptual conflict within the Chilean
authorities about whether free banking was feasible and/or desirable was at the root of the
regulatory failure. The group that supported stronger state supervision of banks, as is practiced in
the U.S., could articulate no better argument than a vague difference between the private and
social costs of bankruptcy of banks in support of its position. The dominant authorities inferred
that the best course was to attempt free banking, i.e. to exempt banks from most government
regulations and declare that no bank creditor would be bailed out in case of failure. In fact, Chile
went through a free banking period during 1976. However, policymakers refused to
acknowledge that this policy option was not credible after 1977, year in which the government
bailed out the depositors at five large intermediaries that failed. Meanwhile, the adoption of
prudential regulation was delayed for three years, which proved fatal in the next recession.
Our conclusion is that a country that attempts financial liberalization should not wait until
the academic debate around free banking is settled to adopt prudential regulation. The
authorities should realize that free banking is inexistent in the modern market economies.
Although bank regulation exhibits serious drawbacks in several countries, the search for the
optimal banking strategy should be left for a second stage, after interest rate and credit
liberalization are consolidated.
A second important conclusion is that some of the specific regulatory problems that have
been proposed by more detailed studies as "the fundamental flaw" of the Chilean financial
1 Arellano (1983) asserts that "Liberalization of credit controls.... generated a spiral of

increases in asset prices and interest rates, and of intermediation, because business groups
used bank credit to buy assets."
2 DOCUMENTO DE TRABAJO Nº 128
liberalization process are simply not there. Instead they were the result of the worsening
macroeconomic situation.
For example, Harberger (1985) proposes that rollover of unrealized loan losses allowed
insolvent banks to play a ponzi game over the 1977-1981 period. We find that there was no ponzi
game in the Chilean financial system in 1978-1980, because the banks were able to dilute the old
loan losses that were rolled over with abundant new loans, earning positive profits. We find that
rollover of unrealized loan losses only turned into a ponzi game in 1981 and 1982, as a result of
macroeconomic conditions. Rollover was indeed a critical factor behind the extremely high real
interest rate experience of 1982, which fed back into macroeconomic performance and stopped
only with the regulatory takeover of 1983.
The same happens with allegations that moral hazard was rife in the Chilean financial
system in 1977-1980. This is simply inconsistent with the fact that over this period Chilean banks
reinvested a large proportion of their high profits, even though they were still far above the
minimum capital requirements. The simple fact is that it was not worthwhile for a bank to engage
in moral hazard while it was earning large quasirents allowed by the slow entry into a new, fast-
growing market. However, moral hazard surfaced in 1981 and 1982 because banks experienced
losses, and the Superintendency was still unable to police effectively the loan classification
machinery it had been introducing since mid 1980.
Therefore, a detailed analysis of the financial industry in Chile over 1976-1980 does not
suggest the accumulation of problems that could explain the disaster observed later. Rather, the
conclusion is that something in the macroeconomic management failed in early 1981. The
financial system was found brittle, vulnerable both to rollover of unrealized loan losses and moral
hazard. This brittleness was the result of clearly identified errors in banking policy, made in 1977
and sustained up to 1980. However, if macroeconomic management had been smoother, there
might have been time for the new banking policy approach adopted in 1980 to bear fruit and avoid
disaster.
We found that the most damaging bank regulatory problem ocurred in a different area,
ignored by other authors, which is contingent government subsidies. It was due to the structural
limitations arising from the fact that the supervisory agency depends from the government. This
failure could happen in any country where the government's macroeconomic policies introduce
specific risks, which the supervisory agency cannot stop banks from taking without embarassing
its political masters.
In the case of Chile in 1981, contingent government subsidies took a particularly

insidious form: banks were taking large risks by lending to debtors that were highly exposed to
foreign exchange and interest rate risks but were classified as "able to pay" by banks. Our analysis
identifies the channel for this guarantee as the Superintendency's lack of explicit penalization, in
the loan classification criteria, of debtors with high indicators of credit risk due to exposure to
IN CHILE: 1974-1983 3
foreign exchange and interest rate risk. The Superintendency should not have relied on the banks'
assessments of risk because they were interested parties.
This is not moral hazard, of course. The regulators simply refused to acknowledge the
portion of the foreign exchange and interest rate risks that had been transformed into credit risk. In
practice this allowed banks not to penalize, through a larger risk premium, loans to debtors that
accepted a lot of foreign exchange risk. Therefore, banks lent at subsidized interest rates to
debtors that accepted a lot of foreign exchange and interest rate risk, because those rates did not
take those credit risks fully into account. The Superintendency of Banks could not force banks to
classify loans as risky when the debtor was highly exposed to foreign exchange and interest rate
risk, without embarassing the Minister of Finance and other authorities, who proclaimed publicly
that there would never be a devaluation and that interest rates would fall shortly. In addition, bank
regulators believed the official story, and didn't attempt to observe market indicators of exchange
and interest rate risk. This structural problem of bank regulation worsened the 1982 recession.
As explained in section 4.3, an important part of the bizarre reaction of the Chilean
banking system to worsening economic conditions in 1981 was due to the absence of the beneficial
effects that prudential regulation has on learning by the banks and the public. The lack of interest
of the authorities on prudential regulation over 1977-1980, plus an environment of rapid growth
where safety was not the paramount consideration, allowed the corporate sector to grow used to
keep the ability to shift collateral out of the reach of banks. This ability encouraged a growing
subset of debtors of all sizes to obtain bank loans up to high leverages. This defect in learning,
which could be repeated in any financial liberalization with little emphasis on prudential
regulation, proved critical when the recession hit.
An over-emphasized regulatory problem is the one of self-loans by business groups that

controlled government-insured banks. It is true that in 1981 the Superintendency began a head-
front attack on the self-lending practices of the large local business groups, which was blunted for
a year because of the business groups informational advantage. Of course, the Superintendency
could not have been realistically expected to prevent business groups from profiting from the 1981
contingent government subsidy to exchange rate and interest rate risks during the first year of
implementation of their plan. We find that in 1981 the speculative business groups engaged in
moral hazard only marginally. In 1981 they did not engage in massive moral hazard because the
government was willing to offer contingent subsidies. Business groups did not need to take
advantage of a willing guarantor.
During 1982, however, the speculative business groups attempted to continue drawing on
the government's guarantee without its acceptance. Confronted with large scale moral hazard, the
Superintendency tightened its controls over the business groups. In June 1982 it stopped
preferential rollover of unrealized loan losses for firms affiliated with bank owners. Then, in
January 1983, it took over the banks controlled by them. This was necessary to avoid the
possibility that further self-loans would worsen the recession. This resolve was not present in the
securities markets, however, where the business groups continued obtaining funds without giving
truthful information to investors up to late 1982.
In conclusion, the linkages between macroeconomic performance and banking policy

were much more complex and interesting than what many authors have suggested. The three-year
delay in adopting prudential supervision was critical in allowing the Chilean financial system to
grow up in a fragile way. If loan classification had been imposed in 1977, learning by doing would
have been speeded up and more loan loss provisions would have been made. The corporate sector
would have grown used to safer practices. It is reasonable to expect that in that case self-loans
would have been controlled earlier.
The problem is that in a liberalized financial system there is no obvious need for an
inmediate emphasis on prudential regulation. The reason is that the transitory quasirents allowed
by slow entry into banking make moral hazard unprofitable, even for banks with no accounting net
worth. These quasirents apparently allow the authorities some delay, but the costs of failing to
speed up learning of the prudential aspects of banking are huge and not explicit.
However, we feel that if in Chile learning had been rapid, and the huge contingent
subsidy on exchange rate and interest rate risk had not existed, the world recession and the Latin
American debt crisis would have still forced many Chilean banks into technical failure anyway in
1982 and 1983. The difference is that recovery would have been faster and a simple deferral of
losses would have allowed most bank owners to keep their banks. Another difference is that the
main Chilean business groups would never have grown so large as they did in the 1977-1981
period.
A third area where this paper contributes is in the analysis of the Chilean approach to
finish with financial repression. As we show, abandoning financial repression is a
multidimensional reform where coordination between the different aspects of it affect the result
critically. The main reforms of this type in Chile concerned the elimination of quantitative and
cualitative credit controls, interest rate liberalization in deposits and loans, the reduction of
marginal and average reserve requirements, the authorization of indexation of bank assets and
liabilities at different maturities, the opening of banking to entry, the creation of new instruments
and markets for monetary control, and the uniformation of these reforms across the different types
of financial intermediaries.
IN CHILE: 1974-1983 5
We present the Chilean experience in this area, which exhibits the costs of
insufficient coordination in the liberalization of a repressed financial system. One of the
most notable consequences was the unneeded bankruptcy of the savings and loans in 1975.
The issue of learning by doing in the management of banks after many years in which the
main activity was to comply with the Central Bank's credit guidelines turns out to be
critical again. Finally, we show that the process of financial deepening should be expected
to require relatively high real deposit interest rates for several years, in order to reach the
steady state where the financial sector has attracted the long-run volume of deposits.
The rest of the paper is organized as follows. Section 2 reviews the real interest
rate dynamics in the Chilean financial liberalization, excluding prudential regulation issues.
Section 3 provides a conceptual framework for the analysis of prudential regulation issues.
Section 4 covers the Chilean prudential regulation experience, 1976-1982. The subsections
here include the Chilean experience with contingent government subsidies, with moral
hazard, with rollover of unrealized loan losses, and with the problems raised by self-lending
by business groups that control government-guaranteed banks. Finally, section 5 draws
lessons both for financial liberalization and for prudential regulation.
2. Real Interest Rate Dynamics in the Chilean Financial Liberalization

Experience.
In this section we intend to explain the high level exhibited by the real interest rate
during Chile's financial liberalization in 1974-1980. The approach is basically
microeconomic, in the sense that it emphasizes the behavior over time of the suppliers and
the borrowers of funds, and the production costs of financial services. We start with a brief
description of the liberalization process, stressing events in the banking industry. The
timing and sequencing of deregulation of different controls are discussed with some detail
since it is relevant to the two hypotheses that we propose on the dynamics of the real
interest rate.
Our hypothesis are the following: the first posits a slow adjustment of investors'
portfolio. A small speed of adjustment makes the interest rate to overshoot at the beginning
of the liberalization. The second posits that after many years of financial repression. the
banking industry loses its capacity to intermediate funds efficiently. Hence, when it is
deregulated, it will behave like an infant industry where costs decline through time.
The high level of the interest rate in Chile in the first stage of the financial liberalization is
also due to macroeconomic factors. The 1975-76 recession was perceived as a transitory real income
shock, explaining a large fraction of the rise in the real interest rate in that stage of the Chilean
financial liberalization.
The empirical evidence is consistent with our hypotheses for the 1974-1980 period.
However, they are unable to explain fully the sharp rise of the real interest rate in 1981. This issue
is discussed in section 3.
2.1. The Financial Liberalization Step by Step
Financial liberalization in Chile comprised two policy areas: deregulation of the banking
industry, and development of a securities market. In the first, the main actions were those geared to
phase out a battery of credit controls, such as: credit ceilings; maximum interest rates; reserve
requirements; and ceilings on foreign borrowing by banks. It included also uniformation of
operations and regulations among three types of banks2: commercial, development and financieras.
The basic principle followed in this process was to regulate specific operations without
distinction among institutions; so, the difference between commercial and development banks
disappeared. Financieras, however, were excluded from the checking account market and foreign
trade financing (the idea was to induce them to become banks). In this sense, the Chilean bank
deregulation policy included a shift towards multiproduct banking.
The second area includes all those policy measures intended to establish the basis for
developing a secutiries market. These included the modernization of the legal framework and the
creation of new financial institutions. Important changes were made to several laws that regulate
corporations and public offerings of commercial paper and long term debt (bonds and debentures).
New institutions were introduced to the market, like: Agencias de Valores (market makers for
securities), Mutual Funds, and Private Pension Funds. Other traditional institutions were boosted by
the financial liberalization; among these are: the stock exchange and the insurance industry.
Since this paper deals mainly with the banking industry, our description of the
liberalization process will concentrate on this sector. We start by pointing out the types of
restrictions present at the outset and the timing of their elimination.
(a) Credit ceilings. This tool for monetary control is quite common in countries where the
Central Bank is the main source of financing for public sector deficits; this was the case of
Chile since its Central Bank was created, in 1925. During Allende's socialist government
the public sector deficit increased to 14% of GDP, relying heavily on the money press for
financing it. By the end of 1973, when the military government came into power, inflation
was reaching a rate of 1000% (annualized monthly rate). A deep fiscal reform was done in
1975, eliminating the deficit by 1976; credit ceilings were applied until April 1976. In the
two years previous to the credit liberalization, four stages can be distinguished; they are:
2Uniformation was also extended to some operations of credit and saving cooperatives.
IN CHILE: 1974-1983 7
- January 1974 to September 1974: global limits for the banking system were
established, and sectoral sublimits for: agriculture, non-agriculture and capital goods
credit. This simplified to manageable levels the previous tangle of credit controls.
- October 1974 to December 1974: ceilings were not applied during this quarter.
- January 1975 to July 1975: ceilings were restablished, but banks were allowed to
lend freely the increment in time deposits over the outstanding amount as of
September 1974.
- August 1975 to March 1976: the ceiling is made equal to the outstanding loans as of
July 1975. In April 1976 the authority decides to abandon this tool of monetary
control.
This experience shows that the attempt to liberalize credit on October 1974, before the
required fiscal adjustment, was rapidly aborted --it lasted only one quarter. The reason is
that credit ceilings are equivalent to 100% marginal reserve requirements, which increase
the base to levy the inflation tax. Credit ceilings were reestablished in January 1975, and in
October they became more stringent to assure fiscal equilibrium. Once the fiscal reform
produced its results a sustained liberalization was possible.
(b) Interest rate controls. Maximum interest rates fixed substantially below the market clearing
rate were defended by politicians, in the Chilean case, on two grounds: First, as a way of
subsidizing specific groups of borrowers and, second, as a way to "fight inflation" -- similar
to the argument given for fixing goods' prices.
The nominal rate was much below the on-going inflation, imposing a high tax on time
deposits. Consequently, during the financial repression time deposits were not significant
in relation to GDP (see Table 1).
Until June 1974, maximum interest rates were fixed both for time deposits and loans. The lending
rate was 20 percentage points above the deposit rate. The liberalization started by liberalizing the
deposit rate, while maintaining a ceiling on the rate for loans --this was 115%, annual rate, on 30-
day loans-when inflation was over 400%. In May 1975 the lending rate was also liberalized, and
inmediately went up to impressive levels of 1300% nominal and 246% real. This experience was
short-lived; in October of the same year interest rates for deposits and loans were fixed again. In
January of 1976 interest rates were allowed again to be freely determined in the market. This
policy was maintained until December 1982, when the Central Bank began to intervene the market
"suggesting" a deposit rate to the banks.
TABLE 1
MONETARY AGGREGATES, RATIOS
(percentages)
¡Error! ¡Error! ¡Error!
1940 12.0 1.9 15.8

1950 10.5 0.4 3.8
1960 9.0 1.9 21.1
1970 10.2 0.8 7.8
1973 22.2 0.1 0.5
1975 8.7 2.5 28.7
1980 7.3 12.0 164.4
Source: Central Bank, Indicadores Económicos y Sociales.
Another important event in this process was an Act of May 19743 , by which interest was defined
as "the amount received by the creditor in excess to the capital adequately adjusted by inflation".
This legislation can be singled out as the institutionalization of indexation in the Chilean financial
system4. Indexation was allowed at the beginning only for operations contracted with one year
term or more; in July 1976 this restriction was reduced to 90 days. In September 1977 commercial
banks were allowed to contract using a unit of account indexed to the CPI5. Until then this unit
was used only by mortgage and development banks.
In the same Act it was established that interest rates should be freely determined in the
market, but commercial banks, the State Bank and Savings and Loans were exempted from
this scheme. These institutions were subject to a different timing, described above.
(c) Reserve requirements and interest paid on them.
In the very high inflation context of the Chilean experience, legal reserves on
banks'deposits were intensively used as a way of raising funds by the Central Bank to
finance its own loans; the commercial banks' role was only one of an intermediary between
depositors and the Central Bank.
3Decree Law Nº 455, of May 1974.

4Monetary correction was incorporated to the tax system in 1975.
5On the 10th of each month the daily value of the unit is fixed for the next 30 or 31 days,
according to the inflation rate measured by the CPI in the previous month.
IN CHILE: 1974-1983 9
The policy definition taken in April 1976 establishes a clear cut between financial
repression and financial liberalization. In that month credit ceilings were abolished and a
program for phasing out high reserve requirements (RR) was started.
There had been some previous attempts to cut down RR. In October 1974, RR on 30 - 89
days deposits (RRT1) were reduced from 40% to 8% and the same for RR on 90 days - 1
year deposits (RRT2). In July 1975, reserve requirements on demand deposits (RRD) were
also reduced, fixing them at a uniform rate of 80% --previously there was a base rate of
100% and a marginal rate of 80%. However, in August 1975 there was a policy reversal,
when 30 - 89 days time deposits were subject to a high technical reserve (95% in August,
90% in September and 80% onward)-- a mandatory investment in Treasury bills.
The reduction of RR took place in five stages, which are summarized in Table 2.
TABLE 2
RESERVE REQUIREMENTS
Demand 30-89 days 90 day - 1 year

Deposits Time Deposits Time Deposits
(%) (%) (%)
First Stage: May 76 - December 77

Initial Rates 85 55 55
Final Rates 59 20 8
Second Stage: January 78 - July 78

Final Rates 42 20 8
Third Stage: August 78 - March 79 (No changes)
Fourth Stage: April 79 - December 79

Final Rates 42 8 8
Fifth Stage: January 80 - December 80

Final Rates 10 4 4
Source: Central Bank, Boletín Mensual.
The general idea was to uniform the RR rates on time deposits and to procede faster in the reduction
of RR on longer term deposits. The initial targets were the minimum rates authorized by the law at
that time; these were: 20% on demand deposits and 8% on time deposits; an ammendment reduced
these minimum rates to 10% and 4%, respectively.
When the liberalization program started in May 1976, the RR rates were calculated in such a way
that the lending capacity of the banks in that month was equal to the credit ceiling that was being
eliminated.
The gradual reduction of the rates through the period 1976-1980 was managed according to a credit
program which established targets for credit expansion and for reducing Central Bank lending, i.e.,
substituting commercial bank credit for Central Bank credit. The minimum rates reached in
December 1980 have been maintained since then (on average they are not binding in the sense that
they are quite similar to voluntary reserves).
IN CHILE: 1974-1983 11
The RR reduction program was slow to avoid a steep rise in the money multiplier that
would have jeopardized the parallel process of reducing the inflation rate. However, high
RR meant a heavy tax on funds intermediated by banks and other financial institutions. To
alleviate this situation the Central Bank decided to pay interest on RR on time deposits. The
interest rate paid changed through time in the following way:
May 76 - October 76 : was equal to the return on short term

Treasury bills.
Nov. 76 - December 76 : was equal to 70% of the rate paid on time
deposits.
January 77 - April 77 : was equal to 90% of the rate paid on time
deposits.
May 77 - April 79 : was equal to the rate paid on time deposits.
May 79 - August 79 : was equal to 50% of the rate paid on time
deposits.
September 79 and onward : interest was not paid anymore.
In regard to RR on foreign currency liabilities a distinction was made among two types of
liabilities: deposits and foreign borrowing done by banks, firms and individuals. Through
all the period and until December 1979 the RR rates on foreign currency deposits were:
20% on demand deposits and 8% on time deposits. The rates were reduced to 10% and 4%,
respectively, in January 1980.
Reserve requirements on foreign borrowing were established in April 1978, as part of a

policy designed to restrict this kind of indebtedness. Loans with an average maturity of two
years or less were forbidden; for longer terms the required reserves were:
Average maturity less than 36 months : 25%

Average maturity from 36 to 47 months : 15%
Average maturity from 48 to 65 months : 10%
Average maturity of 66 or more months : 0%
No interest was paid on these reserves, since the idea was to tax this source of finance in a
way that promoted longer term borrowing. This objective was achieved quite successfully,
since most borrowing was done in the longer terms, favoring a maturity structure of the
foreign debt more managable by the Central Bank.
(d) Ceilings on foreign liabilities. Foreign borrowing by banks was limited in terms of their capital
and reserves (CR). Until December 1977 this source of funding was authorized for financing
loans related to foreign trade only. In January 1978 they were allowed to obtain these loans for
any other purpose, but they would have to be used to fund foreign currency loans (FCL) only6.
The evolution of these limits over time is shown in Table 3.
TABLE 3
CEILING ON FOREIGN BORROWING BY BANKS
Date Limit as % of Capital and Reserves

Global Extra
January 74 200% 0
January 75 100% 0
June 76 150% 0
March 78 160% 0
April 78 160% 20%
December 78 180% 35%
April 79 180% 45%
June 79 free free
Source: De la Cuadra and Hachette (1988).
Note: There was no limit on foreign indebtedness for non-bank corporations.
When the FCL were authorized they were limited to 25% of CR, and this sub-limit was
included in the global limit listed above. Starting in April 1978, extra limits were
assigned for FCL with average maturities over 36 months. These were additional to the
25% sublimit and to the global limit (see Table 3).
FCL were also limited in terms of flows. There was a maximum amount that each bank
could lend in one month. These amounts were:
January 78; : 5% of CR.

November 78; the larger of : 5% of CR or US$ 2 mill.
July 79; the larger of : 5% of CR or US$ 1 mill.
February 80; the larger of : 5% of CR or US$ 2 mill.
April 80; free (limited by the legal maximum debt/equity ratio of 20).
Central Bank policy with respect to foreign borrowing by domestic banks was to manage
the growth of this foreign debt. The argument to support this policy was the instability
introduced by volatile capital flows. The supply of foreign capital to the country had
6This means that commercial banks were not allowed to take foreign exchange risk
directly.
IN CHILE: 1974-1983 13
proven in the past to be a unstable function. Hence, the Central Bank's authorities were
trying to smooth the fluctuations of the capital account.
This policy suffered a strong attack from the business community, in general, and from
some academic economists. The first group blamed it for delaying a decline in the interest
rate and for discriminating among borrowers --those better connected had access to cheaper
finance. The second group did not agree with the hypothesis of instability in supply,
although they recognized a justification to tax foreign borrowing on the grounds of an
upward sloping supply of foreign capital.
Finding no support for its stance, the Monetary Authority ended up opening the capital
account without restrictions except for the prohibition of foreign loans with less than two
years average maturity and the tax on foreign loans with maturities between 24 and 65
months. This action took place in April 1980, and was followed by large capital inflows
during that year and 1981.
2.2. The Dynamics of Financial Liberalization7.
The Chilean experience points out towards interesting issues related to the microeconomic
dynamics of a financial liberalization. They have not been dealt with in the literature, in spite of its
importance for the successfull implementation of this policy.
In the case of Chile's financial liberalization, there was: an interest rate overshooting; a
costly market development process that took about five years; and a delayed reaction by the
supervisory authority in the introduction of prudential regulations. We proceed to discuss the first
two issues, and in section 3 we deal with the third one. We will not discuss here the macroeconomic
effects on the interest rate of the deep recession of 1975-1976.
2.2.1. Asymmetric Portfolio Adjustment Costs
Interest rate control during financial repression meant fixing them at nominal levels quite
below market equilibrium, and negative in real terms when inflation was rising; this was the case for
more than thirty years, since 1940, but reached its most extreme form in the early 1970's with
Allende's hyperinflation.
7For a more complete discussion see de la Cuadra and Valdés (1989).

The asymmetry consists in a slow adjustment in the stock-supply of credit --steep flow-
supply-- and a fast adjustment by borrowers-- relatively flatter flow-demand for credit. These
conditions reflect, in our opinion, the most probable reaction of the economic agents when facing a
liberalization.
The cause of this assymmetry is simple: For families that might save in the financial system,
it should take some time to be able and become willing to invest in the new financial assets being
offered by banks. Ability is limited because it is expensive and difficult to mortgage physical assets in
order to generate funds to invest in deposits, especially when the flow loan-arranging capacity of
banks is in its infancy. Willingness is also limited in an environment where inflation risk is very high
and there is a fresh experience of government-imposed losses on depositors (SINAP failed in June
1975 in Chile).
On the other hand, there is a large number of firms and individuals which have had no access
to the credit market during the repressed period. Their speed of adjustment must be very high, because
it is easy for a firm to increase its leverage when it is initially zero. The capacity limit here was
located in the lending side, that is the banks.
The implication is that any financial liberalization should expect that freeing interest rates -
given that interest rate ceilings were the only distortion- should generate an overshooting of the real
interest rate above its long run level as shown in figure (1). This helps to explain the Chilean
experience of high but falling real interest rates.
IN CHILE: 1974-1983 15
FIGURE 1
iM = maximum interest rate.
i* = long-term equilibrium rate
ie = short-term equilibrium rate
In Table 4 we show the interest rate on short term loans (30 - 89 days) in
commercial banks, starting in 1974 and until 1983. The initial year was the last of the
financial repression --the first liberalization attempts started in 1975--, and the final year
corresponds to the deep recession of 1982-1983.
TABLE 4
REAL RATE OF INTEREST ON THIRTY-DAY DEPOSITS 1/
(Annualized)
% % % %
1974 -48.0 1979 19.6

I -74.3 I 40.9
II -54.8 II 14.0
III -21.5 III 6.2
IV -19.6 IV 18.2
1975 0.0 1980 11.4
I -37.2 I 29.8
II -69.0 II 8.7
III 246.1 III 12.7
IV 47.6 IV -2.4
1976 49.4 1981 34.5
I 54.6 I 21.0
II 36.1 II 28.3
III 37.7 III 47.6
IV 75.5 IV 42.6
1977 56.5 1982 31.4
I 105.8 I 49.4
II 58.3 II 45.9
III 32.9 III 31.4
IV 36.1 IV 2.4
1978 45.9 1983 8.7
I 88.0 I 29.8
II 23.9 II 1.2
III 25.3 III 1.2
IV 52.9 IV 4.9
1/ Commercial Banks lending rate, for 30-89 days loans, deflated by the CPI.
Source: Central Bank of Chile, Boletín Mensual.
During the first six quarters real interest rates were highly negative; at this time
maximum nominal rates were fixed by the Central Bank and inflation was 376% in 1974
and 341% in 1975.
IN CHILE: 1974-1983 17
By the end of the second quarter of 1975 interest rate controls were eliminated and
the real rate sky-rocketed, reaching 246% during the third quarter. This episode is quite in
line with the hypothesis about the adjustment costs after liberalization, i.e., the demand for
credit adjusting much faster than the supply. Such different adjustment pace was, in this
case, magnified by the existence of credit ceilings at that time --which were maintained
until March 1976. The unexpected overshooting of the rate scared the authorities, who
returned to fix interest rates in October of the same year. The new maximum rates were
much higher, allowing a real rate of 48% during the last quarter of 1975. This is almost the
same as the market clearing rate that prevailed in 1976.
On January 2nd, 1976 interest rates were completely liberalized, never fixing them
again until late 1982. The market-determined rate found an equilibrium at a very high
level, which was maintained during the next three years; the real lending rates were: 49% in
1976; 57% in 1977 and 46% in 1978; fluctuating in a range of 105% to 24%. The
stubbornly high real rates subsided only in the second quarter of 1979, when the rate fell to
14%; since then it continued declining until it reached a bottom of minus 2.4% in the
fourth quarter of 1980.
This evidence suggest that portfolio adjustment by asset holders, when the
financial market is liberalized after a long repression, may exhibit a lag of three years.
If we look at the outstanding amount of interest bearing deposits issued by

commercial banks (see Table 5), we can observe that the increase between 1975 and 1978
was distributed as follows: 12% in 1976; 25% in 1977; and, 63% in 1978. This distribution
is consistent with the idea of a slow adjustment during the initial year of a liberalization.
TABLE 5
TIME DEPOSITS 1/
(1983 pesos)
Billions ∆%
1974 19.3 1.6

1975 23.5 21.8
1976 38.9 65.5
1977 72.3 85.9
1978 152.6 111.1
1979 168.0 10.1
1980 197.0 17.3
1981 362.0 83.8
1982 383.3 5.8
1983 298.0 -22.2
1/ It includes also passbook accounts.

Source: Central Bank of Chile; Indicadores Económicos y Sociales 1960-1982.
The downward pressure on interest rates that is observed after the third year is explained
in part by the opening to international capital flows that happened in 1978-80. This source of funds
recovers in 1978 and keeps growing in the following years until 1981.
2.2.2. Market Development
Our hypothesis is that at the moment when banks were liberalized, they did not have the
capacity to supply intermediation services efficiently, due to a lack of expertise, qualified human
resources and adequate technology. Such conditions on the banking system should imply high
intermediation costs, represented by a large spread, i.e., the difference between interest rates
charged and paid. On the same grounds, one should expect that bank portfolios should have
turned more risky as a consequence of poor risk evaluation capacity and higher interest rates.
The same limitations faced by the banks were present in the supervisory agency
(Superintendence of Banks). Before liberalization, the main functions of the bank regulators were
to enforce the interest rate and credit controls dictated by the monetary authority; paying no
attention at all to the quality of the banks' assets. So, there was a complete lack of capacity to
control risks assumed by banks; and, prudential regulations were almost absent from the regulatory
body of rules. Neither one could have expected that in the newly liberalized banking system the
public would have been helpful in controlling bank risk, since they had never been exposed before
to such risks. This topic is taken up in section 3 with more detail.
IN CHILE: 1974-1983 19
Bank liberalization after many years of financial represssion is like starting a new
business, behaving similarly to an infant industry --the costs can only be reduced through time by
the learning process. In Chile, bank modernization was expensive. Banco de Chile for example,
spent over US$ 1,5 million in 1978 alone in consulting fees for a reorganization plan bought from
Booz, Allen & Hamilton.
Summarizing, the hypothesis can be stated as: when banks are liberalized the industry
will show high intermediation costs but declining through time. This in turn implies high initial
real lending rates, for a given constant level of deposit interest rates, as shown in figure (2):
FIGURE 2
In addition, the slow reduction in reserve requirements -see 2.1- introduced

another independent reason for a reduction of intermediation costs over time.
Held (1989) has documented how the different elements of intermediation costs fell
over time, supporting the concept of an evolution over time as in Figure 2. These phenomena
should be taken into account in any financial liberalization.
The intermediation costs are estimated by the differential between the lending and the
borrowing interest rates. Since legal reserve requirements were fixed high above voluntary
reserves, it is necessary to deduct the cost of holding such reserves; so the spread is measured net
of reserve cost --net spread (NS).
In Table 6 we can appreciate how the NS evolved from 1976 to 1983. There is a
declining trend from 1977 to 1980; from a very high level (17.4%) to a more "normal" one
(5.2%). This evidence looks similar to the cost function of an infant industry, supporting
the hypothesis that financial repression destroys the productive capacity of the banking
industry. This consideration acquires great importance for the design of a financial
liberalization, because in the learning process the banks can take excess risk without any
notice by an infant supervisory authority.
TABLE 6
ADMINISTRATION COSTS AND SPREADS IN THIRTY DAYS OPERATIONS
(Annualized)
AC* SPREADS AC* SPREADS

% % % % % %
1976 6.9 8.1 1980 4.9 5.2
I 1.2 I 3.8
II 6.7 II 6.8
III 14.3 III 5.7
IV 10.7 IV 4.4
1977 5.9 17.4 1981 4.3 6.3
I 26.8 I 3.4
II 19.3 II 5.3
III 14.3 III 7.2
IV 9.8 IV 9.5
1978 5.7 10.7 1982 3.6 9.6
I 15.9 I 10.0
II 11.2 II 11.0
III 8.1 III 9.3
IV 7.8 IV 8.0
1979 5.1 7.3 1983 2.8 11.0
I 11.9 I 12.4
II 5.5 II 11.2
III 6.8 III 10.8
IV 5.3 IV 9.8
1/ The spread is defined as: NS = iL - iB - C; where iL = lending rate; iB = borrowing
rate; C = interest cost of the legal reserves.
* Average cost, defined as Non Financial operating cost over total assets NS.
Source: For spread Central Bank of Chile, Boletín Mensual.
Administration costs elaborated by Held (1989), Table I-9.
We can observe that during the first year of free interest rates, the spread
did not go up inmediately. It took four quarters to reach a peak. The explanation for this
graduallity may be found in the inexperience of bank managers, not knowing how to price a
new product.
IN CHILE: 1974-1983 21
In 1981 the NS starts to go up following the interest rate trend. One explanation could be that
the higher interest rates incorporated a growing risk premium and, therefore, higher intermediation
costs. The crisis that was starting to develop in this year is consistent with this view.
2.3. Coordination Failures in Financial Liberalization: The bankruptcy of the

Savings and Loans
This subsection will show that financial liberalization is fraught with coordination failures.
This imposes the need for the utmost care in the detailed design of financial liberalizations.
At the start of 1975 the financial intermediaries in Chile were the following: 1) the
commercial banks, all of which continued under government control since Allende's
nationalization; 2) the SINAP (Savings and Loans National System), regulated by the government,
but most of whose members were controlled by the private sector; 3) the large commercial and
development state bank (Banco del Estado); 4) the formal financieras, created during the second
half of 1974, which were privately owned and free to set interest rates and mostly unregulated; 5)
the informal financieras, which had been inadvertently allowed by a 1974 statute that gave to the
Superintendency of Banks the task of policing the intermediation of credit by non-banks, while
this body did not have enough resources for the job; and 6) a few growing and unregulated
financial Cooperatives that operated like formal financieras.
The SINAP exhibited very fast growth during the second half of 1974, but suddenly it lost
the confidence of depositors in January 1975. By June 1975 it had been taken over by the
regulatory authorities because of insolvency. A description of this high-frequency boom-bust cycle
is available in de la Cuadra and Valdés (1989).
There are two main points to explain, the first of which is the reason for the insolvency of
SINAP. There is no doubt that it was due to excessive exposure to interest rate risk. Assets were
long term mortgages earning a fixed CPI-adjusted interest rate, while liabilities were 60 day
deposits earning a CPI-adjusted interest rate. While interest rates were regulated, the authorities
made sure that an appropiate spread was maintained. Later, when the authorities planned an
interest rate liberalization in 1974, they realized that SINAP would fail and announced operating
subsidies to cover the shortfall. In this sense there was no coordination failure in this area of
liberalization. However, the government was unable to keep promises of support for the system
due to the fiscal crisis of 1975.
The second point to explain is the reason for the very fast growth SINAP exhibited during
the second half of 1974, after liberalization and government support were announced. The best
explanation for this is a coordination failure within the government.
The coordination failure happened as follows: the Savings and Loans were unable
to do anything else but increase mortgage lending when the Central Bank decided to return
SINAP's excess reserves in 1974. For one, there was no short term instrument that offered
CPI indexing in the market, apart from the one issued by SINAP itself and the savings
passbooks at Banco del Estado, because deregulation had merely started. Second, the only
short term instruments yielding free nominal interest rates were the liabilities issued by the
newly created financieras, which were much smaller than SINAP, and which exposed
SINAP to inflation risk. Even more important, the SINAP was not allowed to invest in
money market instruments nor savings passbooks at Banco del Estado, because only
mortgages and loans to construction companies were permitted by its statute. Only too late,
in March 26, 1975, SINAP was allowed to lend in the short term for non-housing purposes.
Finally, individual Savings and Loans were unable to return to depositors the funds it could
not use safely by, say, reducing deposit interest rates, because those rates were fixed by the
board of regulators. In conclusion, SINAP had no way of lending those funds at short term
in such a way as to protect itself from interest rate risk.
This episode is then a good example of what financial liberalization might mean
when it is not designed properly: the failure of the long term mortgage intermediaries. At
the start of a financial liberalization, the biggest peril is not moral hazard, but the strains of
an incomplete and uncoordinated liberalization.
In the case of SINAP, the political economy of discoordination was founded in the
conflict of objectives between the board of senior regulators of SINAP, which was heavily
committed to increase the supply of housing, and the authorities that pushed liberalization.
The latter did not realize that SINAP could have been saved if the Central Bank had issued
a CPI-adjusted, fixed interest rate long term bond to mop up the excess reserves of SINAP.
The crisis developed as follows. In mid 1974, the SINAP started to draw on its
excess reserves and to invest feverishly in new housing, first financing construction
companies and then lending to the buyers, at long term. Housing starts by the private sector
increased 50% during the second half of 1974, as compared with the three previous
semesters. As its deposits were exempt of reserve requirements, the banking multiplier
allowed a 100% growth in real terms in SINAP's size during 1974. Starting in August 1st,
1974, SINAP's regulators attempted to limit bankruptcy risk by decreeing a new
requirement on deposits in order to be eligible to indexing, which was a minimum maturity
of 180 days. This was three times the traditional sixty days. Even though financieras'
liabilities became relatively more attractive, depositors continued increasing their deposits
at SINAP. We assign this fact to the effect of the banking multiplier, operating in a semi
repressed market, which increased hugely total investible financial wealth.
IN CHILE: 1974-1983 23
The end of the game ocurred in January of 1975, when depositors began to
withdraw. The detonator was an exogenous event, the steep fall in the world price of
copper, Chile's main export and the government's main source of revenue, that started in
October19748. The fall in the price of copper had two effects: First, a steep recession
began, and many depositors withdrew funds to finance growing inventories. Second, the
shock on the fiscal side put into doubt the government's resolve to honor its guarantee.
Moreover, the way SINAP's crisis was handled set precedents for the future. In
June 1975, after many depositors have fled SINAP and only the ones that believed in
official promises of guarantee remained, the government decided to freeze the 60-day
deposit issued by SINAP. In the next months, those deposit holders were authorized to
withdraw the equivalent of US$ 100 per month per account, while the remainder could be
exchanged for long term bonds whose price in the secondary market fluctuated between
80% and 60% of the face value. It is amazing that holders of other types of SINAP
liabilities, even liquid ones, were not touched. Therefore, the basic rules of precedence in a
bankruptcy were not respected, signalling that the authorities considered themselves
entitled to redistribute wealth according to political priorities in financial intermediary
insolvencies.
A side effect was that government guarantees on deposits lost all credibility.
Note that a high government official had declared in a seminar at the Central Bank in April
of 1974, that one of the most urgent policy measures was:
"....., foreseeing that the free real interest rate might be high, and that SINAP has a
large volume of loans at low fixed real interest rates, the government will subsidize directly
the SINAP to make up the difference, preventing its bankruptcy."9
What became clear for all depositors is that the military government was willing
to force them to pay for losses. For the next 18 months, there would be no implicit
guarantee of bank deposits in Chile, opening a free banking episode.
8 Authors such as Jeftanovic (1976) assign the demise of SINAP to the extension of the
minimum maturity requirement for indexing that took place in August 1st, 1974. However,
that hypothesis is contradicted by the huge increase in deposits at SINAP for 5 more
months after that date.
9 Sergio Undurraga, in Estudios Monetarios III, Banco Central de Chile (1974). This
promise was repeated publicly by the Finance Minister in March 1975.
3. A framework for the analysis of prudential regulation
This section dissects the issues in prudential regulation, to show the different types
of problems that must be addressed. The failure to consider these distinctions permeates the
banking literature, both applied and academic. In addition, this will be useful to analyze the
Chilean experience and to set forth clearly the theoretical framework we are using.
We assume that free banking is not considered viable in this economy, in order to
be able to study the problems posed by deposit insurance as is currently practiced around
the world10. The government can regulate banks in several ways, but regulation is always
conducted in an environment where the government guarantees most bank deposits, either
explicitly or implicitly. Deposit guarantees mean that most depositors do not take into
account the solvency risks of banks when allocating their funds. It is the guarantor, i.e. the
government, who might want to control the use of its guarantee by the banks.
The regulatory problem can take many forms. Most analyses have been restricted
to study the consequences of assymmetry in information or contingent government
subsidies. We posit that some of the problems confronted by bank regulators are of a
different form, especially after taking into account the effect of the main complicating
factors. The following two-way table provides an overview.
10For current practices, see Mc Carthy (1980)

IN CHILE: 1974-1983 25
TABLE 7
A CLASSIFICATION OF PURE BANK REGULATORY PROBLEMS
(YES = the requirement is essential for the presence of that Regulatory Problem)
Result: Structural Moral Rollover

Contingent Hazard of Unrealized
Requirements Subsidies Loan Losses
1. Exogenous Uncertainty YES YES NO

2. Asymmetric Information NO YES YES
3. Inability to assess risks
related to govnmt. policy YES NO NO
4. Inability to denounce
own regulatory errors NO NO YES
Complicating Factors
A. Self-Lending by Business Groups
B. Incompetence of Private Bankers
C. Self-selection towards fraud-prone Bankers
Note: Simple incompetence of Bank Regulators was excluded because the solution for it,
restructuring, is obvious, although difficult to put in practice.
This table shows that moral hazard is only one of the regulatory problems.
Rollover of unrealized loan losses is very important in regulatory experience, and the same
can be said of structural contingent subsidies. Moreover, the table singles out the causes of
each regulatory problem. In practice, these problems usually appear in combination, for
example, structural contingent subsidies plus rollover of unrealized loan losses. The result
is that most real regulatory problems must be attacked simultaneously on several fronts. In
addition, the practical importance of the complicating factors cannot be overemphasized.
The Chilean experience shows this abundantly.
The ultimate causes of the main regulatory problems include facts of the
technology or the economic environment (the first two), and facts that derive from the
institutional setting in which bank regulation is conducted (the other two). In the following
sections we will explain in detail each of these causes, and sketch the likely result of the
existence of each regulatory problem.
3.1 Structural Contingent Subsidies
The issue in this section concerns the incentive effects of giving away a deposit
guarantee, given that all agents have symmetric access to the same imperfect information
about the future. Exogenous uncertainty is a requirement for the guarantee to be valuable in
the market.
As is well understood from modern financial theory (Mayer (1965), Merton

(1977), Marcus (1984)), if the government gives away a valuable guarantee, without
charging a market price for it, then it is offering a contingent subsidy. As with most
subsidies, economic agents have an incentive to ask more of it. For an individual bank that
confronts given market prices, the profit earned is an arbitrage profit, in the sense that by
expanding it can get an unlimited amount of subsidy.
This induces individual competitive banks that are risk-neutral to grow in excess
of what is socially optimal, because they become a vehicle for arbitrage that exploits the
difference between the market value and the lower goverment price of the guarantee. Of
course, decreasing returns to scale in the aggregate eventually limit the expansion of
competitive banks. Banks that earn other rents, monopolistic or otherwise, wheigh the
benefits of getting more of the free guaranty against the risk of losing the bank with its
other rent.
A second aspect of this bank regulatory problem happens when the receiving
banks can take actions that increase the per-unit value of such a guarantee, like increasing
their debt/equity ratio11 and lending to riskier projects. We assume here that these actions
are perfectly observable by the authorities, so that we concentrate on the pure problem of
contingent government subsidies.
The obvious solution to this problem is for the government to charge banks the
market value of the guarantees it provides. Alternatively, the government could drive the
value of that guarantee to zero by limiting the banks' risk of failure through regulation12,
while still giving away the guarantee.
The particular solution of charging the market price for this guarantee may not
work in some cases, even if the government can perfectly observe risk. This happens when
-above some risk level- the bank must reduce the expected return of lending in order to
11 The debt/equity ratio is inversely related to the Net Worth/Assets ratio, through the
formula
D/E = {1 - NW/A}/{NW/A}
12 The best regulations of this type are risk-wheighted capital requirements.
IN CHILE: 1974-1983 27
increase the variance of returns. As Herring and Vankudre (1985) showed, when the
government attempts to limit risk-taking by raising the charge for the guarantee, the bank
reacts optimally by taking even more risk of failure, even though the expected return of
lending is reduced. Obviously, the government is unable to compensate for this last effect
by raising the charge, so an optimal schedule of risk-rated guarantee charges simply does
not exist over the whole range of bank choices. The government is forced to use some
combination that includes maximum individual quotas of risk to manage this situation.
Real world governments follow the last route most of the time. This route, known
as risk-rated capital requirements or risk-rated loan-loss provisioning requirements, is a
conceptually sufficient solution if the market value of the guarantee is basically reduced to
zero. Therefore, this regulatory problem appears to be solved.
However, if that were the case, we would not have included as an important
regulatory problem the one of Structural Contingent Subsidies. The problem we want to
highlight includes as a requirement that the regulators are unable to assess risks related to
government policy. There are structural elements in the workings of the regulatory process
that renders regulators unable to evaluate correctly a subset of risks that affect the solvency
of banks. Therefore, the government continues to give contingent subsidies in this subset of
risks.
The structural problem is that regulators may be unable to use risk-rated capital
requirements with regards to some risks when other government policies would be affected
by putting this suggestion in practice. A well documented example is the failure of the U.S.
government to limit exposure of its international banks to country risk in the late 1970's
(Meigs,1984). In that case Treasury officials wanted to avoid interference with the
recycling of petrodollars, and State Department officials wanted to avoid souring relations
with debtor countries. We suggest below that the Chilean government suffered a similar
problem in 1981, when the Finance Minister decide to bet on maintaining his previous
decision of fixing the exchange rate, even though many expected that this policy would not
be sustainable. It was unthinkable to expect Chilean bank regulators to force banks to
provision more when debtors were more exposed to currency risk, because that would have
undermined their boss's exchange rate policy. We would also argue that in the late 1980's
Federal Reserve regulators have been unable to push capital requirements proportional to
interest-rate risk for U.S. Savings and Loans because the Federal Reserve itself can affect
the outcome of that risk decisively.
Therefore, we posit that one explanation for the continued existence of contingent
government subsidies in banking is that government regulators are unable to assess risks
whose outcome is driven by their superiors' actions or omissions. This problem becomes
acute when the lending bank does not cooperate in the risk assessment process and the
whole burden of assessment falls on regulators. This is a permanent regulatory problem that
is inevitable while bank regulators continue to depend administratively from other
authorities that influence or determine the outcome of the risks that must be assessed. It is
interesting to outline the likely consequences of this situation:
a) A free-entry competitive financial industry transfers the contingent government

subsidy that distorts the system, to both depositors and debtors. In addition, banks can shift
their lending to riskier borrowers, that promise a higher interest payment if they don't fail.
This shift increases the value of each unit of the deposit guarantee, and to exhaust this
larger subsidy the banking system must grow still more. This means increasing the deposit
interest rate and reducing the lending interest rate relatively to the fair lending rate given
the borrower's risk class. However, as this fair lending rate is also growing as banks shift to
higher risk classes, the observed real lending rate may grow too.
b) Meanwhile, borrowers of lower risk classes are excluded from credit markets,
unless they increase their debt/equity ratio enough to be able to offer the large contingent
interest payment which the banks require. For most businesses, increasing their debt/equity
ratio is the easiest way to adapt to bank predilection for risky borrowers that demand large
amounts of credit13.
c) When a recession year is realized, the distorted system exhibits large losses and
failure is unavoidable. The government must honor its deposit guarantee and pay for
misregulation with taxpayers' funds14. If the system is competitive, most banks should fail
under the impact of the recession. Many of the business debtors that had to gear up to avoid
exclusion from credit markets in the previous phase must also go bankrupt.
d) If good years and bad years in the business cycle are serially correlated, and the
realized cycle exhibits a run of good years that create large banking profits, the reaction of
competitive banks is to reduce the larger capital/asset ratio through both larger growth in
lending and higher distribution of earnings to shareholders.
From an empirical point of view, it is not obvious to establish the existence of

structural contingent government subsidies. The first obvious element is that an explicit or
implicit government guarantee on deposits must exist. However, implicit guarantees are
hard to document, as one must interpret the previous record of government bailouts of
failed intermediaries.
13 This theoretical consequence of a distorted, misregulated, financial system has been

overlooked in the deposit insurance literature. It has the potential to multiply many times
the welfare costs of misregulation.
14 Including the inflation tax revenue.
IN CHILE: 1974-1983 29
The second element is lack of enough prudential regulation of the guaranteed

intermediaries. The main methodological problem to produce convincing evidence on this
point is that, after some banks fail, it is easy to assert ex-post that regulation was reckless in
the area which actually led to the failures. As this is too easy, there is a temptation to
describe too many of the realized bank failures as the result of contingent government
subsidies. There is a solution, however. It should be feasible to establish, directly from the
institutional structure, that a structural limitation on regulators' ability to assess some risks
was present.
3.2 Moral Hazard
The moral hazard issue is concerned with asymmetric information. In particular, it

considers the situation where the government is unable to observe the actual risk choices of
the guaranteed bank. The actual outcome of loans depend both of the bank's actions and of
exogenous risk factors, which forbid the inference of the bank actions from the profit
outcomes alone.
Clearly, in this case it is profitable for competitive banks to increase their failure
risk after the guarantee is obtained, but before the state of nature is realized, changing the
basis on which the charge was fairly estimated. Both moral hazard and contingent
government subsidies require the debtor to come near the brink of bankruptcy by increasing
leverage. The difference is that moral hazard implies drawing a contingent subsidy that the
issuer did not want to issue, while contingent subsidies are willingly offered.
It has been proposed that in this case, governments should approach the problem
by adopting a series of procedures to control lending risk which are usually referred to as
prudential regulation. The idea is that, even though bank risk decisions are publicly
unobservable, the government can privately observe those risks much more precisely if it
forces the bank to adopt some administrative procedures, like classification by the bank of
individual loans in a risk scale. Then the government can use its inside information - access
to the bank's records - to prevent the bank from taking excessive risk.
It must be said that as modern banks are a hierachy of executives and teams of
employees, in which each layer must respond to the superior layer, the process of risk
classification is a necessity for honest bank owners. Historically, many of the current
methods of risk classification have been developed by private banks. Therefore, prudential
regulation understood as the participation of bank regulators of the inside information of
banks does not need to impose a big burden, as long as private banks themselves already
use these methods in their own interest. In this sense, moral hazard is regulatory problem
that should not present regulators with unsurmountable difficulties.
However, we will show below that there exist important complicating factors that
can make moral hazard a difficult problem in practice. The first we will focus on here is the
case labeled as incompetence of private bankers. The second is the one labeled as self-
selection towards fraud-prone bankers.
It is not uncommon to find that a subset of private banks do not have an internal
risk classification scheme in place. This may be due to mere incompetence or calculated
fraud. In both cases the private information that the regulators need is fragmented among
executives or employees. Moreover, fraud and incompetence may be linked, because the
incompetence of the board or chief executive may allow fraud by one or more employees.
These complicating factors become massive when the banking system has been
recently liberalized after decades of financial repression, where risk classification schemes
were entirely superfluous. This was the situation in Chile in 1976, and in other developing
countries in the last decade. Self-selection of fraud-prone bankers is a serious risk during
financial liberalization because there is an unusual need to allow more people into banking,
while the segment of potential candidates that is most interested in entering is the more
fraud-prone one.
The likely consequences of moral hazard, given that some complicating factor
makes inside information unavailable to regulators, are mostly the same as in the case of
contingent government subsidies described before, because banks would not be reigned in
by appropiately risk-adjusted capital requirements.
This is also true about the reaction of competitive banks to a run of good years
when profitability is serially correlated. The run of good years raises net worth, and in the
case of moral hazard this reduces the incentive to engage in further moral hazard, unless
asset growth and distributions of earnings reduce the capital/asset ratio. If this ratio is
simply kept constant, the positive correlation in the business cycle means that the incentive
to engage in moral hazard has fallen.
From an empirical point of view, it is not obvious to establish the existence of

moral hazard. As before, the existence of implicit government guarantee on deposits is hard
to establish. The special feature of moral hazard is information asymmetry. For this reason,
it is necessary to document the existence of a substantial information asymmetry in order to
claim that this regulatory problem was empirically important. It is possible to document this
point by checking whether information on risk-taking by banks was or was not available to
the regulators, and by analyzing the reaction of regulators as information became available
to them.
IN CHILE: 1974-1983 31
3.3 Rollover of Unrealized Loan Losses
Up to now, the problem of rollover of unrealized loan losses has not been
acknowledged in the academic literature as an important feature of banking. In a nutshell, it
consists of the continuation of independent operation of a bank after the realized state of the
world is known, given that it led to insolvency15. The case where the economic net worth is
positive, but below the required capital/asset ratio is simply a case failure of risk-rated
capital requirements, which was taken up in 3.1. The negative economic net worth is what
introduces the new elements we consider in this section16.
The point is that bank regulators are able to avoid or postpone bankruptcy
proceedings, and the bank continues operating, even though it is insolvent. This problem is
conceptually different from moral hazard because it does not concern abusing a guarantee
by taking more risk than the one assessed when the guarantee was given. Indeed, the
problem of rollover of unrealized losses may exist even if there is no risk in the economy
after the bank's failure.
Of course, further opportunities for risk taking become available as time goes by,
so in practice this situation may lead to additional risk taking by insolvent intermediaries. In
this case rollover of unrealized loan losses may combine with moral hazard to produce an
explosive mixture.
We have chosen to stress that no further risk taking is required after insolvency, in
order to highlight the independent nature of this regulatory problem, and to simplify the
exposition of its consequences. In addition, this allows us to present a solid foundation for
the concept of a "false demand for credit", raised by several authors17 to explain Chilean
events in the 70's.
The result of the rollover of unrealized losses under certainty is a simple Ponzi
game. The insolvent bank has, by definition, more liabilities than assets, so it must have
operating losses.
15 Therefore, rollover of unrealized loan losses is not a special regulatory problem when
some economic net worth remains. This means that accounting net worth plus goodwill is
positive. In that case, the only effect of rollover of unrealized loan losses under certainty is
that profits are reduced.
16 Negative economic net worth is easily detected: The bank cannot be sold to honest
bankers.
17 See Harberger (1984) and Held (1989). However, the mechanics were outlined first by
Emilio Sanfuentes, cited in Hoy Nº 32, January 4-10, 1978.
a) Assume first that the bank pays and charges market interest rates. Therefore the
bank must incur in operating losses, whose present value is the unrealized loss. However,
the insolvent bank has access to a government guarantee on deposits, which allows it to
cover the negative net cash flow from operations with the issue of new deposits. Therefore,
the size of the deposits at the insolvent bank grows geometrically. The same happens with
the size of the effective liability of the government.
The government's liability is not contingent, but effective. The only problem is
that the liability has not been acknowledged, and this allows the failed bank to continue
operations. A direct implication is that the deposit interest rate must rise over time, in order
to attract the required additional deposits.
A complementary strategy for the bank is to direct part of loan recoveries to

finance part of the operating loss. This means that the volume of healthy loans outstanding
falls over time, restricting credit. By healthy loans we mean the portion of the loan portfolio
that is able to service the current lending interest rate. The rest of the loan portfolio are
simply unrealized losses.
This means that there will be a rising lending rate and a falling volume of healthy
loans, ceteris paribus. The volume of deposits will rise at the rate of interest minus the rate
of reduction of healthy loans outstanding.
These dynamics may be more easily understood by considering the case where the
government acknowledges the loss in the bank and bails it out by buying the bank's loan
losses at face value, paying with a long term bond. The equivalence with rollover of
unrealized loan losses is complete if the government fails to adjust its primary deficit and
meets the interest payments on the long term bond by placing extra treasury bills among
investors. Then it is clear that the government is playing a Ponzi game, because the stock of
additional treasury bills must grow without bound, raising the market interest rate and
crowding out the private sector.
b) If there is competition in banking, and there are enough banks free of the
unrealized loss problem, the spread between the lending and deposit interest rates will
narrow down to efficient operating costs. However, if most banks roll over unrealized
losses, they will have a third source of funds to tap to absorb their operating loss: an
increase in the spread. As long as most banks roll over unrealized losses, and the spread
between the lending and borrowing rates can be sustained at a large enough size, then banks
cease to be insolvent, deposits do not need to grow geometrically, and healthy loans do not
need to be restricted.
The situation is unstable because given a large spread, marginal loans are very
profitable. Then, if high marginal reserve requirements and quantitative credit controls are
IN CHILE: 1974-1983 33
eliminated, or foreign and new domestic banks are authorized to operate, as in a financial
liberalization, competition will lead market interest rates to sustain a margin smaller than
the one required to eliminate operating losses. The weakest banks, that is those with the
larger share of unrecoverable loans under automatic rollover, will be the first to play the
ponzi game described above.
c) The behavior of debtors is also interesting. A regular debtor is squeezed by high

lending rates. Therefore, even with passive behavior, the estimate of its riskiness should be
raised. This means that, by itself, high real lending rates increase the share of unrealized
losses of banks, and accelerate the ponzi game. A further acceleration effect is obtained if
debtors react to high lending rates increasing their leverage and their operating risk. This is
indeed optimal for the subset of debtors that have negative economic net worth and are also
rolling over unrealized losses. They are able to participate in the ponzi game, because the
creditor bank insists in rolling over their debts, even if they are insolvent.
Summing up, the main empirical requirements for the rollover of unrealized losses
hypothesis to be feasible are the following: government guarantee on bank deposits, large
unrealized losses in the loan portfolio of the banking industry, and official reluctance to
take over failed banks.
3.4 Self-lending by business groups
We will show that this is not a pure regulatory problem, but is instead a
complicating factor. A diversified conglomerate of business firms that includes a
government-guaranteed bank will be called a "business group"18.
a) The case of symmetric information.
If there existed a way to evaluate the risk of such a bank, and the government
charged an appropiate fee for the guarantee, the fact that this bank is owned by a business
group would be irrelevant as a first approximation. The situation would be as if the bank
were independent and closely held. Likewise, if the independent bank is owned by many
different shareholders, the situation would be similar to the one where the bank is part of a
conglomerate that exhibits diluted ownership.
A widespread argument against self-lending is that it leads to insufficient

diversification of loans, as too much is lent to an individual debtor (the business group).
This argument is flawed if the debtor is a well capitalized diversified conglomerate that has
invested in many sectors across the economy, as it is obvious that the risk is similar to the
18 In Chile, the term carries the additional requirement that the group is closely held.
market's portfolio. Of course, self-lending is very risky if either the regulator is not well
informed about the actual risk of the conglomerate's debt, or if the conglomerate exhibits a
high consolidated debt/equity ratio.
Some authors have argued that lending to the other firms in the group is subject to
a less rigorous risk evaluation. Such investments are evaluated only once within the
business group, namely in the unit that wants to use the funds, and then the loan is drawn
from the group's bank without further evaluation. For example, the Chilean
Superintendency of Banks argued in 1983 that "there was an unrestricted liason between
banks and their owners, and an unending cycle of loan renewals with interest capitalization
was observed"19.
However, such a procedure for risk evaluation does not imply that the quality of
the evaluation is more relaxed than what an independent bank would require before making
the loan. If that were true, the implication would indeed be far reaching: investments
financed with equity would be subject to a systematic bias in risk evaluation, when
compared to those financed through loans from independent creditors.
Investments financed with equity are not equivalent to investments financed with
the depositing public's money. When a business group draws a loan from its bank, which in
turn draws a deposit from the public, one should ask who is evaluating the risk of that
deposit in representation of depositors. In a setting with deposit insurance and symmetric
information, the Superintendency of Banks does the evaluation, and there is no special
problem with business groups.
b) Taking Assymmetric Information into account
The practice of self-lending by business groups must be analyzed in terms of the

ability of bank regulators to classify self-loans in a risk scale and detect rollover of self-
loans. We want to compare the Superintendency's ability to monitor the risk of self-loans of
a business group, as compared with monitoring the risk of loans to a regular debtor, given
the degree of risk aversion of the bank owners.
As explained before, the usual practice of prudential regulation overcomes most of

the informational asymmetries by adopting a series of procedures to control lending risk
and the debt/equity ratio of banks. Even though bank risk decisions are publicly
unobservable, the government can privately observe those risks much more precisely when
it forces the bank to give it access to its internal risk evaluation procedures.
19 J. Acevedo and G. Ramírez, in Información Financiera, SBIF, March 1983.

IN CHILE: 1974-1983 35
This method largely fails when the bank is part of a business group and self-
lending is allowed20. The reason is that the business group is able to locate the risk-
evaluation procedures for self-loans outside the bank, without losing control over
employees. In addition, the business group has access to a much larger array of (legal)
methods to avoid presenting the true risk of a self-loan to bank regulators. The resulting
inability of regulators to access the private information of banks may be present both when
the business group is closely held and when it is controlled by a remote management that
responds to dilute shareholders.
Chilean experience shows that the business group can avoid the identification of a
loan as a self-loan, by dividing it into smaller pieces, then lending each piece to an
expressly created shell company, and finally having the shell companies to relend the funds
to the unit in the business group that requested the funds. When classifying such a loan
portfolio, the individual loans may fall below the size limit over which loans must be
classified. An alternative method is to ask friends and employees to accept the loan and do
the relending. This method may be defined as evasion from regulatory control through
vertical disintegration.
In addition, the business group can drag its feet when classifying the self-loans. It
is easy to see that if the bank is unabashedly optimistic when evaluating its self-loans, the
Superintendency of Banks is forced to do its own evaluation. It is clear that the
Superintendency might discover insolvency too late when this happens.
Moreover, when the Superintendency attempts its own risk evaluation of self-
loans, it confronts severe informational asymmetries. This is because such an evaluation
must obviously attempt to figure out the solvency and cash flow of the business group taken
as a whole, i.e. consolidating all the shell companies. The problem is complicated further
because non-controlling shareholders in some of the business group's firms must be taken
into account. In addition, the network of holding companies is always changing, and can be
made to change very fast, so the Superintendency cannot put much faith on information
gathered by ordering the regulated bank to inquire some aspect of a debtor holding
company's situation. Finally, these difficulties can be compounded by the incompetence of
the business group's administration, if it does not keep records of its consolidated
situation21.
20 In fact, this difference was so strong in Chile in the 1970's that some authors have
concluded that the only important type of moral hazard is self-lending by business groups.
See Tagle (1988), p. XIX.
21 In the Chilean case, we know that Group Vial did not develop consolidated information
until mid 1981, when it found it was bankrupt. This is common in fast growing business
groups.
The critical regulatory problem is that the regulatory powers of the

Superintendency reach only to the bank, so it has no authority over the successive layers of
holding companies that define the structure of the business group. For example, the powers
of a bank to request information from a debtor are legally limited in most countries.
Therefore, the Superintendency is subject to a loss of control through vertical disintegration
that leaves it unable to monitor for moral hazard or for rollover of unrealized losses.
In conclusion, the problem with self-lending by business groups is not

conceptually different from contingent subsidies, moral hazard and rollover of unrealized
losses. However, implementing prudential regulation when it is present is several orders of
magnitude more difficult than when dealing with independent banks, because the
informational asymmetries are much deeper and the usual regulatory tools are more easily
blunted by a non-cooperative business group. This is true regardless of the ownership
structure of the business group.
4. Prudential Regulation in Chile: 1976-1982
Observers of the Chilean financial evolution have asserted that until 1982 Chile
had a "worst of both worlds" bank regulatory system. The reason offered has been that the
government was issuing a subsidized guarantee, but did not regulate adequately the risks
taken by the guaranteed institutions. This section attempts to be more precise about this, in
order to extract specific lessons about the experience. We find that, on the whole, the
general diagnosis is correct. However, it is also true that the Superintendency of Banks
adopted important steps towards improvement of bank regulation over this period.
Section 4.1 studies pure moral hazard in 1976-1979, with emphasis on the failure
of Banco Osorno. We find that moral hazard was important in Chile in 1976. We show that
there was a serious failure in banking policy in 1977-1980, mainly because important
authorities insisted that free banking was feasible. However, we believe that moral hazard
was not present in those years, because banking was very profitable and was expected to
continue to be so. Nevertheless, this erroneous banking policy made Chilean banking very
fragile.
Section 4.2 studies the hypothesis of a ponzi game in the shape of rollover of
unrealized loan losses in 1977-1981. We find that there was no ponzi game up to 1980,
because real interest rates were smaller than real growth of new loans, and banks enjoyed
positive profits. This means that the load of unrealized loan losses carried from 1978 was
diluted, and banks had positive economic net worth. This does not imply that their
accounting net worth was positive in 1980. However, starting in 1981, there are clear signs
of a ponzi game through the rollover of unrealized loan losses. This was triggered by the
IN CHILE: 1974-1983 37
1981 rise in real interest rates, showing that the Chilean banking system had been
debilitated by not acknowledging loan losses.
We document in section 4.3 that structural contingent subsidies were very

important in Chile in 1981. The Superintendency did not rate bank loans according to the
debtors' exposure to foreign currency and interest rate risks, because the policy of the
Minister of Finance was assure everybody that there was no risk of devaluation whatsoever,
and that international interest rates would fall shortly. This allowed Chilean commercial
banks to take a lot of risk by lending to debtors that assumed these forms of risk.
Symmetrically, this allowed individual debtors to consider that dollar-denominated debt
was cheaper than peso debt, which in fact was true only because banks did not charge an
appropiate risk-premium. In turn, banks did not do so because it was profitable to take risk
and the the Superintendency did not require a downgrading of debtors with high exposure
to currency and interest rate risk. This explains the excessive foreign debt accumulation
experienced in Chile in 1981.
Finally, section 4.4 studies the practice of self-lending by business groups. We

find that they used their informational advantage in 1981 to avoid the new unwinding
requirements imposed on self-loans in mid 1982, and to exploit -like other smaller debtors-
the contingent subsidy on exchange rate and interest arte risk-taking. In addition, they used
their informational advantage to facilitate rollover of losses over 1981 and the first half of
1982. They were unable to continue this practice after mid 1982 because of steeper
regulations and control. Finally, they used their advantage to exploit small investors in the
security markets in the second half of 1982. However, we find no evidence for pure moral
hazard in 1981 and 1982.
4.1 Moral Hazard: the Chilean Experience, 1976-1978.
The moral hazard issue is concerned with asymmetric information, as explained in

section 3. There are three items of evidence that must be met to establish the occurrence of
moral hazard problems. One is the existence of a government guarantee on deposits. The
second is the presence of a significant information asymmetry. The third item allows an
assessment of the extensiveness of the moral hazard problem. It consists of checking the
market-wide consequences of unregulated moral hazard. In this section, we will review the
episode that has been singled out as critical in the literature, the failure of Banco Osorno y
La Unión, and the next three years.
4.1.1 Moral Hazard before Banco Osorno
The privatization of the commercial banks, expropiated by Allende, ocurred in the

middle of the liberalization of interest rates, elimination of credit controls and the
uniformation of regulation across intermediaries. Bids for the banks were asked just after
the freezing of SINAP's short term deposits, in July of 1975. The government offered its
shares with at least 20% of down payment and the remainder over the next two years, with
an interest rate of 8% plus CPI variation22. Most banks were bought by local business
groups. They obtained actual control by February of 1976, so our analysis starts in 1976.
In January 6, 1977, less than a year after privatization, regulators took over one of
the banks sold to business groups, Banco Osorno y La Unión. This was the first failure of a
privately owned bank in Chile since 1926.
In early December of 1976, a spate of ten insolvencies of intermediaries took

place. They started when the manager of financiera "Manuel Rodríguez" (informal) fled to
Buenos Aires. The authorities declared that this was to be expected of informal (non-
regulated) financieras.
But when "Finregio" (a formal financiera) failed a week later because it had
concentrated its lending in only two companies, which were the main shareholders of the
financiera, the public came to realize that supervision was practically inexistent even in
formal institutions. For example, Finregio violated in a grand way article 5 of Resolution 26
of the Superintendency of Banks, that banned loans to owners of more than 10% of
equity23. In the following weeks failed La Familia, Colocadora Central de Valores,
Financiera Gain, Financiera Farema, Financiera El Sendero, Eduardo Montes (informal),
Inversiones Décima Región and Banco Osorno.
The government announced that Banco Osorno's deposits would be backed by the
Central Bank. In addition, the next day the government announced the creation of an
explicit guarantee for small deposits in banks, supervised financieras, and supervised
Savings and Credit Cooperatives. The limit on the guarantee was a CPI-adjustable
amount24 near US$ 2,750 per account. The government also guaranteed ex-post the small
deposits at Finregio and La Familia, and none at the informal institutions.
We will follow our proposed procedure to check empirically if Banco Osorno's

failure was due to moral hazard. The first element to be checked is the existence of a
government guarantee on deposits.
22 This interest rate was substantially below ex-post market rates, so the government was
able to inflate the prices received.
23 See Ercilla Nº 2161, Dec 29-Jan 4, 1977.
24 It was set at 100 Unidades Tributarias Mensuales, which amounted to 175 Unidades de
Fomento.
IN CHILE: 1974-1983 39
The only experience previous to Banco Osorno, apart from the spate beginning in
December 1976 , was the one of SINAP. In that case, the government had initially declared
it would guarantee its liabilities. However, in the event the government did not meet its
promise (see 2.3). As the evidence below shows, this implies that the depositing public did
not believe in government guarantees of deposits, even though there existed a
Superintendency of Banks. In this sense, the first requisite for moral hazard is not met for
the case of Banco Osorno. This fact has been frequently overlooked when studying the
case.
The second element is to check if there existed an asymmetry of information

between the banks and regulators. However, given that there was no guarantee in place, it is
also relevant to check whether depositors had some information about bank solvency. We
show that these assymmetries existed and were substantial.
Therefore, as there is no empirical evidence for the first requisite, we conclude

that the Banco Osorno failure was not the result of moral hazard against the government.
We argue that between the privatization of commercial banks in February 1976 and the
failure of Banco Osorno in January 1977, Chile lived a free-banking episode. This is
because there were no guarantees on bank deposits, there was no prudential regulation
worth telling, there was free entry, and the failure of intermediaries did result in losses to
depositors. However, we will show that the spate of failures of intermediaries was the
outcome of moral hazard against depositors.
Finally, it is interesting to pose the question if moral hazard was a market-wide

phenomenon in 1976. With regards to this, the facts are that real interest rates were falling
rather than rising in late 1976, and that the real volume of deposits was not rising, as moral
hazard theory predicts. This is not surprising, because the dynamics of moral hazard
against the government are quite different from those of moral hazard against depositors,
who can run. The widespread distrust of banks by depositors and the negative vision of the
financial system that can be gleaned from reading the press of the time, and the small
growth of aggregate deposits in 1976, suggest that the public perceived it could become the
subject of fraud.
4.1.2 Banking Policy after Banco Osorno's failure
An important aspect of Banco Osorno's failure is that it exposed the absence of

prudential regulation in Chile in 1976. The Central Bank authorities became suspicious
only after Banco Osorno asked for unusual amounts of emergency credit, in December
197625. Bank regulators began to worry somewhat when they found that Banco Osorno had
experienced an operating loss in November 1976.
At the time, the Superintendency of Banks was supposed to employ up to 120

employees, but only 60 remained because of quits in response to low public sector wages.
Of those 60, only ten were inspectors, and they had to supervise 14 banks and 26 formal
financieras, which was obviously an impossible task.
It was also revealed that Finregio violated the maximum debt/equity ratio of 5.0
applicable to financieras, had lent at long term with short term funds, and had lent without
evaluating the collateral of debtors.
After takeover, the regulators found that Banco Osorno's failure was associated
with the failure, in the previous month, of the informal financiera called "Soc. de
Inversiones Décima Región", controlled by the same business group (Merss. Fluxá and
Yaconi). This business group had used the bank's borrowing capacity to buy several big
firms that the government was privatizing in 1976, like Fundición Libertad, Agencias
Graham, Enagás, and Santiago Centro office building. Banco Osorno had opened off-
balance sheet credit lines to these firms, and issued guarantees to others without registering
them.
Banco Osorno was not abusing any government guarantee. In our view, Banco
Osorno abused the depositing public's confidence that banks were serious institutions. In
fact, during December 1976, as the failures of intermediaries came one after the other, the
depositing public came close to a panic and began to move funds towards the largest banks.
This shows that the public did not believe in government guarantees of deposits. In this
sense, Chilean 1975-1976 financial experience looks like a free banking episode of the 19th
century, before governments regulated banks.
The analogy is confirmed by the fact that, after the failure of Finregio, and in the
middle of rumours about the failure of other banks, the local press informed that Javier
Vial, the president of the Bankers' Association, was trying to form a pool of banks to bail
out Finregio and avoid the public's loss of confidence. This is exactly what the New York
bank cartel did before the formation of the Federal Reserve (Gorton, 1985). A difference is
that, in this case, the government did intervene in the end.
25 See Qué Pasa Nº 354, January 26 1978, which interviewed Mr. Francisco Fluxá. Banco
Osorno asked for a US$ 10 million bridging loan until a hypothetical new foreign partner
invested in Banco Osorno shares.
IN CHILE: 1974-1983 41
Several authors have singled out the Banco Osorno episode as the one that set the
stage for the massive bank failures of 1982 (see Harberger,1984). The argument is that if
depositors at Banco Osorno had suffered some losses, and/or regulators had supervised
banks more strictly, then domestic banks would not have engaged in moral hazard practices
and foreign banks would have been more careful in lending to Chile in1981.
To check this point of view, we review the banking policy stances expressed in the
local press at the time. A columnist that worked at the Central Bank asserted that:
"The financial market is special because bankruptcy produces public alarm.... There is
consensus that the Superintendency must be refurbished to be able to exercise enough
control.... We must rethink the objective of bank regulation. At present, the objective is to
make sure the norms are complied with. But by itself, this doesn't assure the ability to
analize the loan portfolio and its guarantees."26
We see that an important school of thought, which we will call the "State
Supervision School", argued that the government had to guarantee bank liabilities, and that
therefore the government should regulate the risk of failure. An implication was that the
government was right in bailing out Banco Osorno depositors.
However, this view was not shared by important authorities at the Ministry of
Finance and the Central bank, who were not convinced about special bankruptcy costs in
banking. Note that the State Supervision School did not mention moral hazard or
information asymmetry in their arguments. Confronted with this theoretical weakness, these
authorities insisted in a free-banking view of the financial market. They were not convinced
that bank failure was special, and refused to accept that government guarantees should be
involved. The President of the Central Bank, when asked about future bank failures,
answered that:
" The government will respond only up to the small-depositor guarantee, as it did in the
cases of Finregio and La Familia. "27
This answer pretended that only small depositors would be insured in the future,
although it had been obviously untrue for Banco Osorno. This school of thought preferred
to explain the spate of insolvencies around Banco Osorno as the result of poor management
and fraud. Poor management was not for the government to mind, while fraud could be
dealt with by defining white collar crimes more precisely and enabling the affected parties
26 Daniel Tapia, Ercilla Nº 2164, January 19-25, 1977.

27 Alvaro Bardón, interviewed in Ercilla Nº 2164, January 19-25, 1977. The economists at
ODEPLAN were the most consistent opponents of the State Supervision School.
to protect their interests in the courts. Small depositors would be guaranteed only because
they would be unable to inform themselves properly or find it worthwhile to sue in court.
Therefore, for this school the right decision with regard to Banco Osorno would have been
to let it fail28.
The only lesson from Banco Osorno that captured the attention of these
authorities was that it was so hard to make Banco Osorno's executives and directors legally
accountable for what they thought was simple fraudulent conduct.
There was a third school of thought, represented by old-timers at the

Superintendency of Banks. This group asserted that risk-taking by banks could not be
controlled, and that the government should bail depositors out. Therefore, the best policy
was to repress the financial market, assuring a small size and low risks because of lending
at negative real rates.
Summing up, the authorities were of a divided mind on financial policy. The
outcome of bank regulation in Chile was heavily influenced by this underground clash.
After the Banco Osorno episode, the Free banking school obtained legislation that defined
new crimes, but continued to be distrustful of prudential regulation. However, it failed in
withholding the government's guarantee. The State Supervision school obtained some new
powers for the Superintendency and a government guarantee for deposits to keep the
public's confidence, but was unable to implement tight prudential regulation. The Financial
Repression group obtained the government's guarantee for depositors and delayed the
implementation of tight prudential regulation, but could not return the financial market to
repression. The social cost of this incoherent financial regulatory policy was substantial.
The argument set out by Harberger, i.e. that inflicting some losses on Banco
Osorno's large depositors would have avoided the creation of an implicit government
guarantee and the problems suffered in 1982, is not convincing unless we also accept that
free banking is a good idea. In our view, free banking is a risky policy for a country
undergoing financial liberalization. This happens because there are many doubts about the
ability of free banking to manage some externalities without fostering collusion. There is
significant evidence that "free" banking worked well only where it led to the formation of a
bank cartel. In Chile, such a bank cartel would have been dominated by the business
groups, who would have multiplied their lock-out power.
28 It is unlikely that they realized that the result of this policy would have been a bank
cartel, who would have regulated its members.
IN CHILE: 1974-1983 43
Harberger also suggests that an alternative feasible policy after the failure of
Banco Osorno would have been to introduce tight prudential regulation. In our view this is
correct.
In the years after Banco Osorno's failure, the Free Banking school introduced
legislation that defined new crimes. Our sampler29 of those legal reforms includes:
i) It became a crime for a bank manager to omit the accounting of an operation.
ii) It became a crime for a bank director, manager, employees, external auditors, and
agents to "disfigure" balance sheets, books, mail, accounts and other documents.
iii) Extended to financieras the crimes defined for bank managers and directors for the
cases of approval or presentation of a false balance sheet.
iv) Giving false or maliciously incomplete data for the purpose of obtaining a bank
loan became a crime.
v) External auditors would have to examine the accounts of all banks, and their report
would have to be published.
Many authors have overlooked these reforms, and have argued that these crimes
were committed up to 1982. This hypothesis is simply unreasonable for usual loans, if one
takes into account that the penalties included jail. The cases of self-loans and fraud will be
taken up later.
The State Supervision school obtained reforms like the following:
i) The Superintendency of Banks would have a larger budget, and its employees
would obtain salaries above the public sector pay scales. In the future, a council of
ministers would define the wage scale and the number of employees, and
meanwhile, the Central Bank sent 40 employees to help the Superintendency as
inspectors.
ii) The minimum capital for a formal financiera was raised to 75% of the one required
for a bank, in an explicit attempt to reduce the number of financieras and the
regulatory load.
29 The best reference is Errázuriz (1982). The decree laws are Nº 1638 (Dec 30, 1976) and
Nº 2099 (Jan 13, 1978).
iii) Informal financieras were banned by a legal reform, while formal financieras were
prohibited from acting as brokers for commercial paper issued by companies.
iv) The volume of guarantees issued by a bank to each individual client began to be
limited to the same levels applicable to loans. These limits were 5% of capital and
reserves for loans each person and company without collateral and 10% if the
collateral covered the extra 5%. For stock companies and state enterprises, the
limit was 10% without collateral and 25% if the collateral covered the extra 15%.
v) The acceptable collateral for a bank loan was restricted by the exclusion of bills of
exchange and commercial paper.
vi) The Superintendency of Banks was empowered to order the correction of the
accounting value of any investment, when it established that the registered value
was not realistic. However, this power did not cover loans.
An interesting reform was the one that imposed that the liquidator of a bank had to
be designated by the Superintendent of Banks. This reform bears the influence of the State
Supervision school, in that regular liquidators were excluded. However, the need for a
special bankruptcy procedure for banks, which was the natural response to the State
Supervision School preocuppation with "special" bankruptcy costs30, was not attempted by
either school. It turned out to be most unfortunate that the Chilean Banking Law, as other
countries' laws, considered only two avenues for the management of a bank's failure:
liquidation and takeover by the government31.
Finally, we will check which of the schools of thought was supported by the facts.
In the first place, the Free Banking school lamented the ex-post guarantee on all deposits at
Banco Osorno. But on the other hand, the government allowed the regular bankruptcy of
several of the small financieras without intervention. The government also allowed losses to
be inflicted on large depositors at Finregio and La Familia. Later in 1977, the government
allowed large depositors to lose important amounts in the failures of saving and credit
cooperatives Crediclán, SICOOP, Copecrédito, Servicoop, Magicoop, Credibioma, Ignacio
30 This preocuppation is probably well founded. For a bank, liquidation usually means very
large losses, because it ceases to be a going concern and debtors become laggard in
payment because the capital value of their reputation as good payers dissappears.
31 An alternative has been introduced in Chile by the 1986 and 1989 Banking Law reforms,
ten years too late. The need for special bankruptcy procedures for banks has been proposed
by new advances in banking theory, that have influenced the current Chilean banking law
heavily.
IN CHILE: 1974-1983 45
Serrano and Credicon, showing the clout of the Free Banking school. For the Free Banking
school, these episodes showed that there was no government guarantee in Chile.
However, previous authors have overlooked that Banco Osorno was not the only
contradiction suffered by the Free Banking school. During 1977 the government also took
over and refunded cooperatives IFICOOP, SODIMAC, Creditec and Credival, bailing out
all creditors, regardless of size. These rescue operations were critical to establish the
government's reputation in the public's mind. The common characteristic of these
institutions and Banco Osorno was that they were larger than the others, so their failure
would affect much more people. An implication was that their liquidation would freeze for
a long time a substantial amount of the funds of many depositors, and that political support
for the government would suffer. Therefore, in the public's mind, it became clear that
medium-sized and larger banks were in fact guaranteed.
Given this record, it is amazing that the Free Banking school could still argue that
there were no deposit guarantees in Chile. In order to be consistent, it should have
acknowledged that free banking was impossible in Chile after 1977, and prudential
regulation was a necessity. A free banking approach was simply not credible after 1977.
For the public, the State Supervision school was right. For example, a 1977 article,
titled "The Morals of Banco Osorno" asserted that:
"Central Bank assistance to Banco Osorno shows that the authorities do not consider banks
to be similar to other firms, so banks cannot fail. Therefore it is important to move towards
professional supervision, where loans are evaluated in accordance to risk. This means that
the Superintendency of Banks must have a larger budget, and salaries must be higher than
in the rest of the public sector."32
The episode that turned the tide in favour of the State Supervision school was the
one of Banco Español in early 1980, three years later. Since late 1978, banks had to obtain
external audits of their accounts. Price Waterhouse asserted that Banco Español accounts
were representative in 1978, but changed opinion in their report concerning 1979, where
they stated:
"The analysis showed that, regarding a loan portfolio of 37% of total loans, there was no
information that could allow the evaluation of the debtors' capacity to pay. Many of these
debtors had their loans renewed repeatedly, without paying interest nor CPI adjustment at
the moment of renewal."
32 Ercilla Nº 2167, February 9-15, page 21.

Although the loans were documented, as required by the 1978 laws, the bank still
did not collect information to evaluate the risk. The press informed about the consequences
of this report as follows:
"When it had become widely known that Banco Español was going towards takeover by the
government, the owners (Puig business group) sold out to Sahli and Tassara's business
group."33
The point we want to make first is simply that, by 1980, everybody was convinced
that depositors at a failing bank would be bailed out by the government. There was no
alternative for a failed bank but being taken over.
The Free Banking school was never happy to acknowledge its practical defeat and
was slow to press the Superintendency to improve the quality of its supervision. The same
happened with the Financial Repression school, who was in actual command of the
Superintendency, but was unable to block the financial liberalization. One empirical result
was that the Superintendency did not move fast from 1977 to mid 1980. Another result was
that when confronted with the failure of Banco Español, the free banking authorities
refused to take over. Given the authorities' inaction, Mr. Puig sold the bank to Mrss. Sahli
and Tassara, who were not required to inject fresh capital into the bank. The State
Supervision school was shocked.
They reacted strongly to the Banco Español case, as the next sections will show,
and by mid 1980 the State Supervision school had taken over bank regulatory policy in
Chile. However, the doubts about the foundations for the new approach lingered among the
free banking authorities, because the state supervision school continued to base all its action
on unspecified differences between the private and social bankruptcy costs in banks34.
The conclusion is that in 1977-1980 the authorities assumed that free banking was
feasible and refused to acknowledge that that was impossible after the rescues of Banco
Osorno, IFICOOP, SODIMAC, Creditec and Credival. Although they introduced prison
sentences for undocumented loans and other frauds, which improved the workings of the
system in comparison to 1976, they did not acknowledge that prudential regulation and risk
evaluation were necessary, and placed their trust with external auditors. The blockade of
prudential regulation was capped by the authorization of the sale of failed Banco Español to
a business group without capital.
33Ercilla Nº 2333, April 16-22 , p. 22.

34 See Larraín (1979), who was the Intendent of Banks put by the State Supervision School
since late 1979. He simply asserts that "if a bank fails, it must reduce depositor faith in
other banks".
IN CHILE: 1974-1983 47
There is still the question about the market-wide impact of moral hazard in the
period 1977-1979, when both a government guarantee and ineffective prudential regulation
coexisted. It turns out that during this three-year period the Chilean economy exhibited high
GDP growth, so even if moral hazard was practiced, it would not have lead to large scale
insolvency of intermediaries. The states of nature turned out to be good.
For this situation, section 3 predicts rising real deposit interest rates and more
slowly rising real lending interest rates if moral hazard is present. Regarding deposit rates,
an extension of the theory to consider the falling marginal reserve requirements
experienced over this period leads us to expect that real deposit rates should have risen even
faster. The reason is that a reduction in marginal reserve requirements is like eliminating a
tax on intermediation, leading to a reduction in loan rates and an increase in deposit rates.
Of course, the problem with checking if these predictions fit the Chilean data is
that there was a simultaneous financial liberalization under way. It is not easy to
discriminate between the safe liberalization hypothesis and the market-wide moral hazard
one. Both imply rising deposit interest rates and a rising volume of loans.
One difference between the predictions of the two hypothesis lies in that a safe
liberalization implies falling loan rates while moral hazard implies rising loan rates.
However, the opening up to capital inflows prevents a check here. The international
financial liberalization adopted by Chile during this period induced an increase of the net
capital inflow to Chile to a plateau level of US$ 1.1 Billion per semester since the second
half of 1978. This would have induced a reduction in loan interest rates since mid-1978,
hiding the moral hazard dynamics35.
It turns out that the moral hazard hypothesis can be discarded. Recall that moral
hazard of the pure type requires that the bank is willing to fail and lose some capital in the
bad states of the world. The following table shows banking profits and net investment in the
banking sector in Chile:
35 See Edwards (1988) for the data.

Year 1976 1977 1978 1979 1980
Pre-tax Profit/N Worth 2.6%a 8.7%a 18.5% 23.0% 23.5%

Operating profitb/NW -13.8%a 1.1%a 13.5% 17.6% 22.1%
Increase in Net Worth/NWc 5.7% 2.3% 23.8% 16.7% 14.3%
 Increase in NetWorth ct 
( ) 40.3% 86.5% 274.0% 90.1% 62.1%
 Pr e Tax Pr ofit 
 t −1 
capital/asset ratio 24.8% 22.2% 15.1% 13.2% 11.9%
a : This figure is net of tax paid.

b : Defined as Pre-tax Profit minus Other Expenses plus Non Operating Income.
c: figures adjusted for inflation.
Source: elaboration from Held (1989), Tables I-6, I-9 and A-3.
This shows that a substantial proportion of profits were reinvested in the banking
sector in most years. Moreover, in 1978 there was net investment in banking capital that
was almost three times the previous year's profit. Most important, all this happened while
the capital/asset ratio was far above the minimum capital requirement, which at the time
was 4.76%, asociated to a maximum debt/equity ratio of 20.
This is simply inconsistent with the moral hazard story, because it requires that
banks keep themselves at the lowest capital/asset ratio that is allowed. A bank attempting
moral hazard will not reinvest profits or increase bank capital if it has not reached the
minimum capital/asset ratio.
This means that moral hazard was not profitable in the 1977 - 1980 period.
However, it would start to be profitable if banking prospects appeared bleak. Of course,
these figures should be cleaned of the loan losses that may have been rolled over, topic
which is taken up in section 4.2.
The intuition for this result is simple: a financial liberalization makes the banking
sector very profitable even for a bank that operates safely. Transitory rents are large, and it
is convenient to reinvest them in the industry because it offers supernormal profits. An
important implication is that a financial liberalization, which always produces transitory
profits, has a built-in insurance against moral hazard, which is the appearance of transitory
IN CHILE: 1974-1983 49
quasi rents. The problem is that after expansion stops, the weaker banks may be driven into
moral hazard type strategies. Therefore, a liberalizing government has only a limited period
to introduce prudential regulation and absorb learning costs.
In conclusion, it is most likely that the Chilean financial system was not engaging
in moral hazard over 1977-1980, although bank regulation was inexistent and the
government insured deposits, because banking was too profitable for it to be worthwhile.
Of course, the Chilean financial system was a fragile one in early 1980, because under this
regulatory combination moral hazard in a massive scale could be expected in response to
low profit expectations. Chile had an opportunity, up to late 1980, to escape from this
fragility.
4.2 Rollover of Unrealized Loan Losses: the Chilean Experience
We start by checking the requirements for this hypothesis to be feasible. The first
requirement is that the government guarantees deposits. As documented above, the bailout
of all depositors at Banco Osorno and cooperatives IFICOOP, SODIMAC, Creditec and
Credival convinced bank creditors that they were defacto guaranteed by the government.
This requirement was not met before 1977, because financial intermediaries were allowed
to fail.
The second requirement is for the bank to be bankrupt. If this is not so, delay in
acknowledging loan losses simply shows up as a profit rate below normal standards, and no
ponzi game is played. In particular, this hypothesis requires large unrealized losses in the
loan portfolio of the banking industry at the start of the process, in early 1977.
What is forgotten by most analysts is that a bank is bankrupt only if the present
value of its economic profit is negative. Economic losses exist permanently if interest
earned on true loans is below interest paid on deposits. If this is not so, the unrealized loan
losses are absorbed over time and the bank is not bankrupt in an economic sense. It may be
bankrupt in an accounting sense, but there is no ponzi game if profits are positive.
The third requirement is to show that the government was reluctant to take over
failed banks. The structural reasons for this outcome are that a takeover is an
acknowledgement of flawed regulation, and that most authorities that supervise regulators
are unable to obtain independent information on bank solvency.
In Chile, the regulators that took over Banco Osorno and the other big
intermediaries in 1977 justified them by the argument that "previous" regulation was
unsound. This attitude had changed by 1980. The regulatory approach was strongly
questioned by the case of Banco Español. In desperation, the Free Banking school decided
to allow the sale of the bank to Mrss. Sahli and Tassara, who injected no capital. A year and
a half later, in November 1981, Banco Español was taken over because its losses had grown
still more. Therefore, it is clearly documented that regulatory delay was present in Chile
from 1978 to mid 1980, when the Free banking school was dominant.
Given that in 1978-1980 the first and the third requirements are met, the only
remaining question is about the second. Did large unrealized loan losses exist, such that
many banks were suffering economic losses and were economically insolvent? As no
formal examination was practiced on bank portfolios until 1980, there is no quantitative
evidence on this point.
We present other types of evidence now.
4.2.1 The facts, 1977-1981.
In early 1977 the Chilean economy was in shambles. After suffering the ravages
of Allende's populism, the halving of the price of copper in 1975 forced a steep recession,
where GDP fell 12,9%. A strong fiscal contraction, a sharp real devaluation and very high
real interest rates reduced the strength of the recovery, and the economy grew 3,5% in
1976. Therefore, the solvency of most business firms that had survived Allende's drive
towards central planning was clearly reduced in those years, and many of them became
actually insolvent.
On the other hand, several large business firms that had been nationalized by
Allende were privatized by auction over 1976 and 1977. Most of these firms had no
working capital, so they pressed on the financial market in order to finance inventories.
Many of them also had excess manpower, but firing required severance payment of one
month's salary per year served. Rationalization implied even more loans from the banks.
Initially, the high real interest rates recorded in 1975 could be absorbed easily
because the ratio of debt paying market interest rates to equity was very low for most
business firms in late 1974. However, during 1976 the persistence of high interest rates
began to affect the solvency of some business firms. Therefore, it is safe to assume that the
local press reports that insisted on these problems were essentially correct. Consider this
one, dated one year after Banco Osorno's failure i.e. in January 1978:
IN CHILE: 1974-1983 51
"In financial circles it was assured that, according to the Superintendency's revisions, the
volume of loans not serviced in time is between 10% and 15% of the banking system's
portfolio. There is little hope that those debtors will be able to pay."36
In addition, an economist reported in his column that, after studying the balance
sheet of many important companies, he had concluded that the country had entered into a
vicious circle: high real interest rates forced firms to increase their demand for credit, which
in turn kept interest rates high even if the supply of funds rose37. These reports came after
1977's record growth rate of 9,9%, which completed the recovery from the 1975 recession.
However, 1978 turned out to be a good year too: real growth was 8,2%, and 1979
exhibited 8,3% real growth. Real interest rates began to fall, although slowly. In addition,
the reforms to the banking law of early 1978 had required banks, for the first time in Chile,
to publish their financial statements in newspapers of wide circulation. Those statements
would have to be audited externally.
Starting in early 1979, the four main auditing firms in Chile (Langton Clarke,
Price Waterhouse, Deloitte, Haskins & Sells, and Coopers & Lybrand) certified that loan
provisions of the order of 1% of loan portfolios were adequate for most banks38. At the
time, the authorities of the free banking school argued that the presence of these auditors,
who would defend their reputation, assured that any unrealized loss problem would be
discovered and solved. An alternative view, which we subscribe, is that most of these
auditors were either duped or bought off by the bankers who paid their fees. We posit that
the banking policy debate was won by the State Supervision school, and the
Superintendency switched towards direct supervision, in 1980 when it was realized that
external auditors would be unable to enforce adequate banking practices.
The experience of Banco Español is ilustrative. Recall that in April 1980, Price
Waterhouse's report on Banco Español informed that its examination had found that the
bank had no information that might help to evaluate the probability of recovery of loans
adding up to 37% of the loan portfolio. Some interpreted this event as showing that the
external auditing process was uncovering the rotten apples in the banking system, and their
confidence increased. An alternative view is that external auditors had been fooled or
36 Hoy Nº 32, January 4-10, 1978, p. 27.

37 Rolf Lüders, in a column in Hoy Nº 35, January 25-31, 1978.
38 For example, for the year ended in December1979, the auditors required provisions of
0,70% of Banco de Chile's loans, 2,40% of Banco Español's loans, 0,68% of Banco
Austral's loans, 0,43% of Banco de Concepción's loans, 0,15% of Banco de Santiago's
loans, and 0,69% of BHC's loans.
bought off. The fact is that in the following April, after Banco Español was bought by Mr.
Tassara, Price Waterhouse declared that all the problems had been solved, but seven
months later, in November 1981, the Superintendency took over Banco Español to stop
massive fraud.
We compare now the auditors' claims with the Superintendency of Banks' reports
and behavior. The Superintendency had adopted several measures after Banco Osorno's
failure. The first was to introduce new legislation, which was approved in early 1978 and
described above. By late 1978 the Superintendency was concentrating on assuring the
completion of the first year of auditing by external auditors. In March 1979, the
Superintendency prohibited for the first time the accrual of interest on delinquent loans. In
December 1979, it reduced the required general loan loss provision from 2% of loans, to a
number independent of the actual delinquency rate, but linked to "the volume of
outstanding loans and the historical experience of recovery, which may be different for
each bank". Of course, this piece of regulatory behavior should be described as
incompetent.
In February 1980 came the Superintendency's first attempt to classify loans. It

established an experimental system where each bank would have to classify (in a risk scale
from A to D) its 30 largest individual debtors. For each of them the Superintendency
required the opening of a especial folder with the relevant information. Initially, provisions
were not required in relation to the classification. It is impressive to read the
Superintendency's comments on the result of this preliminary exercise :
"It could be appreciated that some institutions didn't have the information necessary to
identify their debtors........ In several institutions, it was verified that the loans were
disbursed without knowledge of the credit needs of the borrower and with absolute
ignorance about the uses to which the funds would be put."39
Note that if a bank can't identify a debtor it means that some loans were undocumented,
which violated the legislation introduced in early 1978. This comment was published a
couple of months after Price Waterhouse's revelations about Banco Español, and its
purpose was to support Price Waterhouse's independent attitude.
These results pulled the Superintendency into action. In June 1980, the
Superintendency requested that the classification be extended to the 80 largest debtors of
each bank. In April 1981 it required the classification of the 300 largest debtors, and
introduced classification procedures for the consumer loan and housing mortgage loan
portfolios.
39 Published as Circular Nº 1686, June 19, 1980.

IN CHILE: 1974-1983 53
In August 1981 the Superintendency obtained the approval by the Military Junta
of a set of draconian reforms to the Banking Law40, which took the banks by surprise.
However, the main purpose of the reform was not to force the realization of hidden losses.
Rather, it redefined the concept of individual debtor, in response to the huge scale of
detected self-lending of business groups. This topic will be taken up in section 4.3, but the
point that is of interest here is that hidden losses -correctly or not- were not perceived by
the Superintendency to be the main legislative problem.
In November 1981 the Superintendency took over eight banks and financieras41,
starting with Banco Español. These financial institutions covered 6-7% of total loans. This
was a result of the loan classification effort started in 1980. Its declared purpose was to put
an end to the rollover of loan losses by these institutions. On the other hand, these takeovers
are proof that the external auditors had been either duped or bought in the previous years,
because they had assured that provisions were reasonable for all these financial institutions.
Economic activity had began to decline only recently, in mid 1981. Of course, takeover
implied that the government assumed the losses and guaranteed all depositors and creditors.
The discredited Free Banking school was still alive within the government,
because its reaction was to introduce a law42 that expanded the explicit government
insurance of small deposits that had operated since 1977. It consisted of an optional
guarantee that could be purchased by each depositor up to some US$ 3,500 in addition to
the original guarantee that was free. The optional guarantee covered only up to 75% of the
loss suffered in that sum. This law was an aberration, because the takeover of eight
institutions in the previous month reaffirmed the widesprad view that the government
insured all bank liabilities. Evidence of this is that very few depositors paid to take the
optional guarantee. However, this confusion in the minds of some of the authorities has
introduced some confusion into the later discussions between economists.
In December 1981, the Superintendency required a general loan loss provision at a

rate of 0,75% of loans, this time independent of the historical experience of recovery43. In
February 1982, the Superintendency requested quarterly classification of the 400 largest
debtors, which on average covered 75% of the banking system's loan portfolio.
40 Law 18022, August 19, 1981.

41 They were Banco Español, de Talca, de Linares, de Fomento del Bío-Bío and
Financieras Cash, De Capitales, Del Sur, and Compañía General Financiera.
42 Law 18080, December 16, 1981.
43 Circular Nº 1764, December 14, 1981.
It was only in March of 1982 when the Superintendency required provisions in

relation to the classification of loans. However, it also gave banks a generous deadline, as
the required provisions would be allowed to be built up linearly for the next 33 months. By
this time, the Chilean economy had entered into the steep 1982 recession.
We finish our review of the evidence by noting that the Chilean banks grew very
fast in 1977-1981, period in which the real size of loan portfolios increased 513%44. In
addition, the economy exhibited strong growth up to 1981, so new loans were profitable
and had the potential to dilute the old bad loans.
4.2.2 The evidence for unrealized loan losses, 1977-1980.
The cualitative evidence presented above can be used to support either of two
alternative hypothesis: One, that unrealized losses were diluted through vigorous growth, so
they were not important by 1980. Two, that the Superintendency of Banks was
irresponsible and incompetent, and those losses continued to be significant45. We will
propose a third interpretation: Rollover of unrealized losses was not important as a
generalized phenomenon until late 1981. However, it was important in a few business
groups, notably in the case of Banco Español.
There are two pieces of evidence that may help to discriminate between these
hypothesis. The first is that when the overall result of the classification procedure came to
be published, it turned out that by June 1982 only 6.03% of loans46 were considered to be
at risk. This means that 1% of B loans, plus 20% of B- loans, plus 40% of C loans plus
100% of D loans added up to 6.03% of all loans47. To put this number into perspective, we
should note that in May 1988, which was considered to be a good year, the volume of loans
at risk in Chilean banks was 5.33% of the portfolio48. The difference is that in late 1981
provisions were only 1.73% of loans, while in 1988 they were 6,08% of loans.
In addition, 1982 was a very bad year, in which GDP fell 14.1%. Banking
indicators worsened very fast in that year, as shown for example, by the percentage of
44 The real growth rates in loans from banks and financieras were: 1977: 76%; 1978:
53,6%; 1979: 31,9%; 1980: 45,9% and 1981: 17,8%. The ratio of loans to GDP rose
from16,6% in 1977 to 50,4% in 1981. See Held (1989).
45 See for example Held (1989).
46 Excluding loans from the institutions taken over in November 1981.
47 Información Financiera, January 1983, in article by Julio Acevedo.
48 Información Financiera, May 1988. There was a change in definitions, as C loans were
provisioned in 60% in 1988.
IN CHILE: 1974-1983 55
delinquent loans. This indicator rose from 2.34% in December 1981 to 6.31% in May 1982.
Therefore, we believe that the volume of loans at risk, as measured by the Superintendency,
was below 6% in December 1981, after the takeover of Banco Español.
This level of net unrealized losses of the order of 4% (a bit less than 6.03%,
minus1.73%) of total loans must be compared with the level of capital and reserves of the
banking system to assess the loss. As accounting capital and reserves were 10.4% of loans
in December 1981, we find that Chilean banks had a real economic capital of some 6.4% of
total loans. As Chilean banks had a loan/asset ratio of 0.774 in 1981, the overall
capital/asset ratio was near 5% in 1981. This system-wide ratio is certainly positive, and
was not small by contemporaneous international standards49.
There is a second piece of discriminating evidence. It is a fact that the

Superintendency became very militant and aggressive during 1981 and took over the banks
it considered to be insolvent after completing the loan classification procedure. However, in
December 1981 the Superintendency required a general loan loss provision at a rate of
0,75% of loans, smaller than the average 1,73% of total provisions that banks had in their
books. This confirms that by late 1981, when the classification procedure was fully in
place, the Superintendency did not believe unrealized losses were a substantial problem
per-se. Note that the Superintendency could have requested a much higher provision
without jeopardizing its position, because the mood was to mop up the troubles bred by the
free banking approach. If it had believed unrealized loan losses was a critical problem, it
would had required a much higher provision, to avoid the distribution of dividends.
Consider now the critiques to these two pieces of evidence. The first set of figures
can be questioned on the grounds that the basic number, i.e the loans at risk for June 1982,
is biased downwards. It is a fact that at least in some important banks the Superintendency
had not reviewed the loan classification of loans made by most banks, and self-loans simply
had not been classified50. The second piece of evidence can be reinterpreted by the fact that
the authorities simply did not know in November 1981 if the banks not taken over were
solvent. The interpretation that loan losses were huge in 1980 cannot be discarded yet. We
turn now to additional evidence on entry, growth and real interest rates.
49 The Book value of equity/ assets ratio of US banks was, in 1980, 3.69% for the 17
international banks, 4.12% for the domestic banks with more than US$5 billion in assets,
and 6.77% for the domestic banks with assets between US$300 million and US$ 1 billion.
See Talley, S., of the Board of Governors, Staff Study Nº 122, February 1983.
50 Günther Held, for Banco de Concepción.
4.2.3 Checking a Ponzi Game by Rollover of Unrealized Loan Losses
This section reviews the Chilean experience in 1977-1980 regarding the most
important consequence of a persistent rollover of unrealized losses: a ponzi game that
creates a vicious circle. Recall that the theoretical implications of a Ponzi game are that real
interest rates rise, healthy debtors suffer a credit squeeze, the real volume of deposits and
debts to others grow geometrically, and banks suffer economic losses in most periods.
Competition, free expansion and new entry into banking accelerate the ponzi game.
It is difficult to measure a Ponzi game in the period 1977-1980 through growth in

deposits in excess of the real interest rate, because there is a good alternative explanation:
Financial liberalization was producing its expected results. By the end of 1980 the Chilean
Loan/GDP ratio had reached 37.6% (Held, 1989), which may be compared with other
developing countries' M2/GDP ratios for 1980: South Korea: 33.7%; India: 38.2%;
Argentina: 23.4%, Taiwan: 66.8%. Germany had in 1960 a M2/GDP ratio of 29.4%51.
Consider entry and expansion of new banks during the period. The Chilean
government allowed the creation of new banks and the opening of branches and
subsidiaries by foreign banks52 since 1974, fact which could have theoretically increased
the likelihood of a ponzi game in 1977-1980. However, during the period, the main entry
was due to domestic banks. The following table puts this discussion into perspective:
51 See McKinnon, 1988.

52 In November 1974, a decree exempted long term foreign investment in banks from the
Andean Pact's limitations.
IN CHILE: 1974-1983 57
TABLE 8
SHARE AND GROWTH OF NEW AND OLD BANKS
(Real terms, end of year)
Year 1976 1977 1978 1979 1980 1981
Total Real Loans 100 176 270 357 520 613
New Banks' Share(%) 1,4% 5,5% 10,3% 19,4% 25,6%

Foreign 0,5% 0,6% 2,3% 3,1% 4,6%
Banco de Santiago 0,9% 4,9% 7,2% 8,4% 8,6%
Other Chilean - - 0,8% 7,9% 12,4%
Real Loans of older Banks 100 174 255 320 419 456
Growth rate of older banks 74,0% 46,6% 25,5% 30,9% 8,8%
Proportion of 1977-1981
growth ocurring in each
each year, for older banks 20,8% 22,8% 18,3% 27,8% 10,4%
Sources: Held (1989), Table I-5 ; and Arellano (1983), Table 8. The large growth of 1980
is due to a big inflow of international bank loans to Chilean banks.
The growth of new entrants was certainly not fast enough to dampen significantly
the real growth of older banks. Therefore, these older banks had the chance, as a group, to
grow out of their unrealized loan losses to some extent by diluting them with new loans, if
the latter were sound. On this point, recall that the moral hazard hypothesis is not supported
for this period, as seen in section 4.1, so we can safely assume that new loans were sound.
Moreover, the growth rate of total real loans fell throughout the period, with the
exception of 1980, suggesting that the process was stable. The proportion of total growth
ocurring each year was falling, with the exception of 1980, the year of opening to
international capital inflows. This is consistent with the view that bank growth was the
result of financial liberalization, and inconsistent with a ponzi game.
In the next Table, we see that real interest rates fell over those years and reached
normal levels by late 1980 This supports the interpretation that a series of high growth
years ate away and diluted the original loan losses.
TABLE 9
DYNAMIC SIMULATION OF MAXIMUM LOAN LOSSES
(end of year, except interest rates)
Year 1976 1977 1978 1979 1980 1981
Total Real Loans 100 176 270 357 520 613
Average Loan interest rate (real)

Held (1989) 46,1% 35,9% 15,8% 11,6% 33,2%
Arellano (1983) 39,4% 35,1% 16,6% 12,2% 38,8%
Maximum sharea of bad loans in:

older banks' portfolio 10% 9,3% 8,6% 7,3% 8,9%
banking system portfolio 10% 8,7% 7,7% 5,9% 6,6%
Sources: Elaboration from Table 8, Held (1989), Table I-8 and Arellano (1983) Table 11.
Arellano uses Cortázar and Marshall's corrected CPI.
Note (a): The size of unrecoverable loans is taken to be an initial 10% of the loan
portfolio, suggested by the press reports of January 1978 cited above, which
grows at the loan interest rate (calculated by Held) in real terms.
IN CHILE: 1974-1983 59
This simple calculation53 shows that the dynamics of loan losses favored dilution
in a larger pool of loans, even though absolute loan losses were able to grow by 134% in
1978-1981. This means that there was no ponzi game by rollover of unrealized loan losses
in Chile until 1980. We have shown already that banks were earning positive economic
profits in this period, so the present value of those earnings was also positive. Moreover, in
the optimistic mood of those years, both banks and bank shares were sold and bought at
high positive prices.
This does not imply that the Chilean banking system was solvent in 1980 in an
accounting sense, because historical accounting that acknowledged loan losses may have
shown a negative accounting net worth. This net worth depends of the initial level of loan
losses. An inverse calculation shows that if one wants to argue that unrealized loan losses
were near 20% of the loan portfolio by the end of 1981, then one must support the notion
that initial unrealized loan losses added up to 30% of the loan portfolio in early 1978.
There is no evidence on how large unrealized loan losses were in early 1978 or
late 1981 . Guesstimates published in the press in early 1978 asserted that 10% to 15% of
loans were not being serviced on time. However, it is easy to see that unrecoverable loan
losses is not equivalent to loans not serviced on time. Our impression is that the high GDP
growth over 1978-1981 probably improved recoverability, but also other problems such as
fraud reduced it.
The conclusion then is that no ponzi game was played in Chile in 1978-1980. We
contradict Harberger (1985), Mc Kinnon (1988) and Held (1989), who have asserted
unrealized loan losses were so large that most of the Chilean banking system was insolvent
during all this period, and most of the growth was a ponzi game all along.
53Held (1989) has proposed an alternative method of estimation of the volume of

unrealized loan losses, which we think is flawed. He starts by taking the average elasticity
of the real volume of bank loans to GDP for developing countries, which is 2.7. Then he
multiplies this elasticity by two, and then assumes that the maximum volume of healthy
loans in 1980 can be estimated by applying this elasticity to the 1978 size of bank loans.
The excess is taken to be bad loans. This procedure is flawed because it ignores the fact that
Chile underwent both a domestic financial liberalization and an opening to international
capital inflows, which the average developing country didn't. In addition, the initial size of
the Chilean banking sector was very small, so growth rates and elasticities are misleading.
Also, the procedure ignores the importance of the initial portion of bad loans, and of the
level of real interest rates.
However, our simulation shows that a ponzi game began to be played in 1981,
because real interest rates were very high and new loans were much smaller. It must be
acknowledged that a portion of this ponzi game was stopped by the November 1981
takeover of Banco Español and others, but they held a small share of the total unrealized
loan losses. The ponzi game started in 1981 continued until late 1982. That year's recession
imposed huge new losses on the economy, and turned sound loans into failures.
In any case, rollover of unrealized loan losses was not the cause of the steep rise in
real domestic interest rates observed in 1981. It was one more consequence, that fed back
into banks' demand for deposits and fueled the initial rise in interest rates. This shows that
although a ponzi game was not played over 1978-80, the existence of unrealized loan losses
increased the sensitivity of the Chilean banking system to exogenous rises in interest rates
and other problems.
In this environment, the Superintendency reacted by introducing a loan

classification scheme. In our opinion, this happened too late to reduce the fragility of the
Chilean banking system. In order to have been effective, the loan classification scheme
should have been in place in late 1977, because in that way the Superintendency could have
forced banks to reinvest all the profits of the good years. This was not done because of the
misguided policy of the free banking school, which only ceded responsibility to the State
supervision school in mid 1980, when it was too late.
4.3 Structural Contingent Subsidies in Chile in 1981
This section presents the Chilean experience with structural contingent subsidies.
This concept was explained in section 3, and basically refers to the fact that bank regulators
may be unable to impose risk-rated provisioning requirements to banks on account of the
set of risks that are heavily influenced by the regulators' superior officers. An understanding
of the Chilean experience on this point requires a brief presentation of the risks under
partial control of the Ministry of Finance.
4.3.1 Risks influenced by the authorities in Chile
We start with a brief macroeconomic overview. In 1981 Chile seeked and

obtained an extraordinary volume of foreign loans, while domestic real interest rates in
peso loans rose towards the 40% annual rate level. Obviously, the increase in the supply of
funds was overwhelmed by an increase in demand. During 1981 the domestic currency
appreciated, and GDP grew by 5.5%. The foreign debt incurred in that year was borrowed
by private domestic banks, and was then relent to the domestic private sector. The next
year, 1982, exhibits the end to the excess level of foreign capital inflows, the continuation
IN CHILE: 1974-1983 61
of a very high real interest rate in peso loans, a large real devaluation, and a depression
where GDP fell 14.1% and unemployment rose by 20 percentage points. The overall ratio
of domestic bank loans to GDP, which was 37.6% in 1980, rose to 50.4% by the end of
1981, and to 71.2% by the end of 1982. By the end of 1982 most of the banking system was
insolvent.
The international debt crisis arrived to Chile in a bizarre way, because it was a
private sector crisis. Contrary to most Latin American governments, the Chilean one did not
borrow abroad in the 1977-1981 period. However, in 1983 the government took over a
large portion of the banking system, and guaranteed the external debt contracted by private
domestic banks. By the end of 1983, the foreign debt crisis had ceased to be a private
sector problem in Chile, because the government was forced by the international bank
cartel to extend its guarantee to commercial banks' foreign debts. From then on, Chile's debt
crisis became like most Latin American countries' crisis. During 1983 GDP fell a further
0.7%.
When analyzing structural contingent subsidies in Chile in 1981-82, we will

concentrate on two risks: exchange rate risk, and interest rate fluctuation risk.
a) Interest Rate Fluctuation Risk
The first element to be considered is Chile's reaction to the extraordinary 1981 rise
of international real interest rates. The analysis is complicated by the excessive willingness
to lend to developing countries exhibited by the international banks in the late 1970's and
early 1980's, before the onset of the debt crisis. A side product of research into the causes
of overlending by international banks54 is the separation of the factors that were peculiar to
Chile in explaining this period's high rate of external debt accumulation, from the factors
that were shared with other developing countries. The following table shows a
decomposition.
54 One of us has argued that the recycling of petrodollars cannot explain by itself the
pattern of international lending experienced in the late 1970's (Valdés, 1989).
TABLE 10
ACTUAL AND EXPECTED LEVELS OF THE TRADE BALANCE FOR CHILE IN
1977-1982.
(millions of US dollars of each year)
Year 1977 1978 1979 1980 1981 1982
Net external Debt 5078 5748 6297 7134 11876 14679

LIBOR- ∆% U.S.WPI 0.5% -0.6% -2.4% 1.5% 10.7% 11.7%
Prudent Trade Balance -178 -224 -296 -285 -71 308
Expected Trade Balance -244 -259 -516 -728 -986 323
Actual Trade Balance -170 -422 -281 -871 -3010 33
Accumulated excess of actual
over Prudent T. Balance -8 189 192 801 3852 4774
Accumulated excess of actual
over Expected T.Balance -74 84 -143 -17 2004 1985
Source: Valdés (1989). The last two lines were accumulated at the LIBO rate.
The "prudent" trade balance is the one required to keep the foreign debt from
exploding in the face of changes in the international real interest rate. The "expected" trade
balance is the one that Chile should have exhibited if it had behaved as the average middle
income oil-importing developing country in those years. The expected trade balance takes
into account the impact of overlending by international banks and the average policy errors
of developing countries, including their slow reaction to the rise in international interest
rates. The last line shows that in 1981 Chile deviated strongly from similar developing
countries' pattern of behavior. The country incurred in a huge excess foreign debt in 1981,
which must be explained by country-specific factors, domestic and external.
Chile's was not a normal55 reaction to the 1981 rise in international real interest
rates, from 1.5% to 10.7%. This rise, if permanent, is a brutal shock to a borrower with no
55There is substantial evidence in favour of the concept that consumers and investors had
excessively optimistic predictions about the future in 1979-1981. This hypothesis is
supported by the extraordinary rise of the local stock market in 1975-1980, and the positive
impact of the free-market structural reforms undertaken in 1975-1981 on investor
IN CHILE: 1974-1983 63
access to long-term fixed-interest rate funds, as was the case of most Chilean companies
and investors. A real interest rate shock of the size of the international rise of 1981, even if
it lasts for only two years, reduces the value of an asset with a constant cash flow by 15%.
On the other hand, if the interest rate rise is short-lived, the shock is much smaller. As we
will see, interest-rate speculation in Chile took the form of betting that the international
interest rate would fall soon.
During 1981, domestic interest rates rose simultaneously with international rates.
The domestic rise was much steeper, however. Real ex-post peso loan interest rates
increased from 12% in the last quarter of 1980 to 35% in 1981. The Finance Minister's
policy stance was the following: there would be a gold-standard type of adjustment to the
excess expenditure observed in early 1981. This excess was due not only to the changed
international interest rates, but also to optimistic expectations about the future and to the
fall in the price of the main export, copper.
It is important then to establish the likelihood of a fast reduction in local interest

rates, as seen from 1981. The Finance Minister's policy stance meant that the domestic
money supply would be driven by the balance of payments. This meant a monetary
contraction as soon as the balance of payments came into deficit, which would raise the
local interest rate because of imperfect capital mobility. The implication was that local
interest rates would stay higher than the international interest rate, even if the latter fell.
Many Chilean debtors reacted to this situation by reshaping their debts so that they would
benefit if international interest rates fell, which meant switching to U.S. dollar-denominated
debts.
This documents that interest rate risk was substantial in Chile in 1981, at least for
the highly indebted corporations and individuals. Although this risk was not under the
control of the Chilean Finance Minister in its international component, he controlled the
domestic component through monetary policy. In addition, the authorities controlled the
access to dollar- denominated funds through the exchange control law. Clearly, the Minister
of Finance influenced strongly both the outcome of the local interest rate fluctuation risk,
and access to the foreign interest rate risk.
b ) Exchange rate risk
psychology. This cannot explain, however, the increase in expenditure observed in 1981,
when international interest rates rose strongly.
One of the legacies of Allende was a budget deficit of 25% of GDP, which was
covered with Central Bank credit. The result was an inflation rate near the 500% (annual)
level in 1973. From 1974 to 1978 the government was successful in eliminating the fiscal
deficit and reducing the inflation rate. The inflation rate reached an annualized level of
29.2% in the fourth quarter of 1978.
The government confronted difficulties to reduce the inflation rate further, and
was alarmed by the rise to 34.6% in the second quarter of 1979. The goverment recognized
that this inflation was not caused by the budget, which was in surplus. The government's
diagnosis was that the Central Bank caused the continuing inflation, because it devalued the
exchange rate continuously on the basis of past inflation. This led the government to
attempt the gold-standard stabilization mechanism, which meant fixing the nominal
exchange rate56. This policy seemed feasible because the 1974-78 reduction in tariffs had
reduced substantially the scope for price rises in internationally tradeable goods. The
nominal exchange rate was pegged to the U.S. dollar in June of 1979.
The convergence of the domestic inflation rate to the international one took a
couple of years. The local inflation rate began to fall only in the first quarter of 1981, to
18.4% annual rate, and achieved the international inflation level the next quarter. Then it
continued falling, to undo the accumulated real appreciation. Convergence was slow and
costly in part because of some rigidities in the labour market, particularly the government-
required full backward indexing of nominal wages to past inflation. The unpredictable
behavior of inflation also helped to confuse investors with respect to the real interest rates
they were contracting at.
There was talk about the need for a devaluation since mid-1980, as a review of the
local press shows. The discussion centered on whether a devaluation of the local currency
would correct the real appreciation that was eroding the tradeables' sector competitiveness,
or would merely be diluted in higher domestic inflation. The rise in the domestic real
interest rate observed in the first half of 1981 was considered by some to be a seasonal
effect plus a simple reflection of higher international interest rates. Initially, others
interpreted this rise as the effect of an inflation prediction error, with the implication that
inflation was finally been eliminated and no devaluation would be necessary, after all.
However, high interest rates persisted. This couldn't be explained as a prediction

error, and made suspect the government's claim of success in stabilization57. Even if
56 There has been an interesting debate on the appropiateness of this policy approach. See
Corbo (1985), Dornbusch (1985) and Edwards (1988).
57After the failure of a large sugar refining company because of heavy speculation in sugar
futures, in May 1981, many investors thought a devaluation was forthcoming.
IN CHILE: 1974-1983 65
stabilization was successful, the large volume of external debt contracted at a floating
interest rate implied a crushing debt-service cost because of the persistently higher
international interest rate. The 1981 fall in the price of the country's main export, copper,
also fueled expectations of devaluation. Imports of durables climbed to record highs. Many
thought that the way to adjust and reduce imports was to devalue. The authorities, however,
insisted in the narrow view that stabilization had been finally achieved, so no devaluation
was necessary. It hoped that a rapid fall in international interest rates would alleviate
adjustment.
This review documents that exchange rate risk was substantial in Chile in 1981.
This means that there was a lot of uncertainty about the time path that the nominal
exchange rate and exchange controls would follow. The selection of time paths had a
substantial effect on the fortunes of individual bank debtors, because the cost of adjustment
to the high international interest rate is shifted and modified by changes in exchange
controls and exchange rate policy. The Minister of Finance controlled directly the outcome
of this risk, through Central Bank intervention in the foreign currency market and through
its power to redefine exchange controls, both of which were eventually used.
4.3.2 Evidence on Structural Contingent Subsidies
In a nutshell, we will argue that the Superintendency could not include into its
loan classification procedure a truly independent assessment of the exposure of bank
debtors to foreign exchange risk and to the domestic and international interest rate risks,
because it would have interfered with official macroeconomic policies. As these risks were
high in Chile in 1981, the institutional constraints on bank supervision allowed part of the
private sector to draw on the government's deposit guarantee at a subsidized price.
This argument takes as given that bank supervisors themselves had the primary
responsibility for assessing these risks. Most banks' assessments could not be relied upon
because, as those same supervisors were claiming and as explained in 4.4, many banks
wanted to present a rosy view of their self-loans. Moreover, a bank could not classify its
loans to independent debtors in proportion, for example, to exposure to exchange rate risk,
without classifying its self-loans in the same way. The banks preferred to insist that most
debtors, independent or not, "had capacity to pay" given the expected course of events,
which was the one espoused by the authorities: no devaluation would be forthcoming and
interest rates would fall rapidly.
Therefore, Chilean bank supervisors had an unusually heavy responsibility over

their shoulders in 1981: they should have claimed that both the supervised banks and their
own superiors were wrong, i.e. that exchange risk and interest rate risk were substantial. If
bank supervisors had taken this responsibility, they should had supplemented the normal
indication to evaluate the "capacity to pay" of debtors with an order to calculate explicit
indicators of that capacity, like the exposures to exchange and interest rate risks.
The evidence suggests that the budding group of bank regulators, overburdened
with the task of identifying self-loans, were willing to believe that those risks were small, as
the official view proclaimed. Therefore, banks were free to draw on the deposit guarantee
by incurring more credit risk, lending to debtors exposed to currency and interest rate risk if
they wished.
Now we turn to the evidence on risk taking by the domestic private sector that
drew on contingent government subsidies. First of all, it is clear from the theory that the
subset of the private sector that would be willing to take this contingent subsidy had to
belong to the set of corporations and individuals that had little true capital to lose if the bet
was unsuccesful. Second, there is the requirement that a significant subset of banks also had
little capital to lose if the bets were unsuccessful.
It is well known that by late 1980 there was an important set of individuals and
corporations that was heavily indebted. We will define this group as the "optimists". They
believed that the fast growth of the last three years could be sustained, so they were willing
to invest with borrowed funds. This group covered small and large firms, and also many
consumers. We define the opposite position as the "conservatives". It included many firms,
of every size up to large business groups. They had been willing to sell their assets at prices
they considered inflated, and some of them had moved funds out of the country.
The reaction of "conservatives" to the rise in international interest rates and the
U.S. recession, given the large Chilean external debt was to prepare for a devaluation by
reducing their dollar debt and increasing peso debt, while reducing expenditure as feasible.
In 1981, Chile experienced capital flight for the first time since the Allende period. On the
other extreme, the reaction of highly indebted "optimists" was to bet that the government
would keep the exchange rate fixed, as promised. The "optimists" hoped that the high 19%
dollar nominal interest rates would fall shortly58. Therefore, "optimists" wished to change
their peso debts into dollar debts in order to bet that foreign interest rates would fall shortly
and that there would be no devaluation59. This was the best alternative open to them, if
creditors agreed, because accepting peso loans at high interest rates meant bankruptcy for
sure.
58 Some would add the hope that the value of the US dollar against the yen and deutchmark
would stop rising. A dollar appreciation inflicted losses on Chile because most of its foreign
debt was denominated in dollars, while only a third of its exports went to the U.S.
59In addition, many investors remembered too well the 1960-1962 Chilean attempt to fix
the exchange rate, that had to be abandoned in the middle of a balance of payments crisis in
which the government bailed out most dollar debtors.
IN CHILE: 1974-1983 67
However, a healthy financial system would have met the optimists' requests for
more credit with clear opposition. This is because their increase in debt is a bet financed by
creditors whose beneficiary in expected value is the debtor. The only way a healthy
financial system would be willing to lend more is at higher interest rates to compensate for
the higher risk. When considering the darkening prospects for the next few years, the
optimal policy was probably not to lend more. Note that the banks themselves were not
exposed directly to exchange risk, because the Central Bank required all banks to match
exactly foreign currency assets and liabilities.
The Chilean banks did not react in this way because of three reasons: first, there
was a significant darkening of profit prospects for the future which reduced the economic
value of many banks. This is supported by the fact that only 8.8% of 1980 pre-tax profits
were added to bank capital during 1981. Second, the existence of a significant portion of
unrealized loan losses that would grow at the interest rate during the coming recession
implied that true capital would be further eroded. This was shown in 4.2. Third, many
banks were owned by business groups that had the ability to shift true capital out of their
bank and out of the reach of the Superintendency. This could happen because in 1981 the
Superintendency was still unable to control self-loans effectively, and did happen because
the business groups found it a profitable strategy. The result is that most banks were left
with little true capital by mid 1981 and found it profitable to draw on the government's
contingent subsidies. Most bankers rushed to offer cheaper dollar-denominated loans
(financed through new external debt) to their customers, hoping that the contingent subsidy
for currency risk would allow them to survive, and absorbing the associated credit risk.
We must recall that this contingent subsidy is valuable only for debtors with little
capital. It is hard to believe that the Chilean private sector had little capital in late 1980,
even considering that in 1977 many were near insolvency, because there had been three
years of vigorous GDP growth. However, experience showed that many corporations and
societies that were indebted with the banks and subject to limited liability had acquired in
1975-77 the less than honorable habit of shifting collateral out of the reach of their
creditors. The banks did not defend the collateral of their loans over 1978-1980 and allowed
this practice to evolve because of five documented facts:
First, they had limited capacity and there was a shortage of qualified personnel, i.e
many banks were still incompetent. Second, the Chilean court system was (and is) so slow
that obtaining full redress is a very costly and lengthy process. Third, many banks were
dominated by business groups that prefered to assign their limited management resources to
shift the collateral of their own self-loans out of the reach of their bank. Fourth, in those
years they experienced rapid growth, so the drive to place more loans tempered
considerably their interest in the design of effective collateral contracts. Fifth, banks
received no stimulus from the Superintendency to adopt loan classification schemes that
provided for a careful evaluation of collateral, because the Free Banking school insisted
that there were enough private incentives for banks to worry about collateral.
In this setting, most banks found that their effective capital plummetted further as
soon as "optimistic" debtors became less willing to pay when the net worth of their
corporations fell. This reinforced the previous perverse incentives to banks. Given this,
banks became even more willing to take the new credit risks derived from exchange rate
and interest rate risks, exploiting the government's guarantee on deposits.
We have shown that the overall situation was as if the government had extended a
foreign exchange risk guarantee to the private sector. Our analysis has identified the
channel for this guarantee. This was the Superintendency's lack of penalization, in the loan
classification criteria, of credit risk due to the foreign exchange risk taken by the debtors.
This is not moral hazard, of course. The government simply refused to acknowledge the
portion of the foreign exchange and interest rate risks that had been transformed into credit
risk. In practice this allowed banks not to penalize, through a larger risk premium, loans to
debtors that accepted a lot of foreign exchange risk. Therefore, banks lent at subsidized
interest rates to debtors that accepted a lot of foreign exchange and interest rate risk,
because those rates did not take those credit risks fully into account.
The outcome of this structural contingent subsidy was that many small and
medium-sized businesses got deeply into debt in 1981. Debts to banks increased during
1981 from 37.6% to 50.4% of GDP, in response to the rise in real interest rates. The
counterpart was an increase in the foreign debt, because domestic deposits did not rise
rapidly. This increase worsened the macroeconomic situation significantly.
In addition, debtor-speculators were offered the easy claim on the government that
they had believed in official exchange rate policy, so they should be helped if a devaluation
did happen. This increased further the value of the contingent subsidy to taking exchange
risk offered by the government. This explains why in 1981 the demand for credit increased
so much that it swamped the increase in supply obtained through the liberalization of
international capital flows, and why this demand was for debt denominated in foreign
exchange.
Finally, many debtors that were initially honest were caught by the huge rise in
domestic interest rates of 1981 and lost most of their equity. Their response was to shift
collateral out of the reach of the banks, arguing that they were merely defending themselves
from the Finance Minister's policy of allowing domestic interest rates to rise to
expropiatory levels. Redistributions of wealth of this size between debtors and creditors
were considered by many to be simply illegitimate.
4.3.3 The Cost of Structural Contingent Subsidies
Starting in 1982, unemployment rises steeply, and consumers realize that they
must stop spending. The recession deepens and deflation becomes a reality. The number of
IN CHILE: 1974-1983 69
employed people fell 22% between mid-1981 and December 1982. A substantial proportion
(160,000 out of 690,000) left the labor force, and 230,000 were employed by the
government in low-wage emergency employment programs.
This becomes relevant by mid-1982, when the fall in GDP is so steep that a
depression is obvious. The government realized that the required real depreciation to undo
the previous appreciation would take several years at current deflation rates. In June 1982 it
finally decided to devalue. Initially, the devaluation was 14%, but in July the peso was left
to float freely, and its price doubled in nominal terms in a few months. By the end of 1982,
the losses that the devaluations inflicted on the holders of dollar-denominated debts had
spread out insolvency across all firm sizes. Capital flight was rife, as the Central Bank
scrambled to reestablish the foreign exchange controls it had been lifting in the last few
years. Debtors attempted to shift their dollar debts to pesos, managing to reduce by 13.4%
their aggregate dollar exposure in the domestic banking system during 1982.
Of course, the sorry state of most debtors meant that banks were having trouble to
recover their loans. Delinquent loans rose from 2.34% of loans in December 1981 to 3.83%
in February 1982, and 6.31% in May. Most delinquent loans turned out to be 100% losses,
so they reduced the net worth of banks. Moreover, a correct estimation of net worth should
substract from capital the "Loans at Risk", estimated from the loan classification procedure.
However, loan loss provisions should be added to net worth. The following table shows the
impact of the recession and speculation with contingent subsidies on the solvency of the
banking system.
TABLE 11
DELINQUENT LOANS AND BANK CAPITAL, 1982
(Billions of Chilean pesos)
Delinquent Loans Sold Capital Loan Loss Net

Month Loans to C. Bank & Reserves Provision Worth(1)
Dec 1981 16.831 - 76.685 5.206 65.060

Jan 1982 21.627 - 76.685 13.359 68.698
Feb 27.164 - 77.484 14.456 64.776
Mar 31.232 - 80.256 15.294 64.318
Apr 41.631 - 81.993 15.294 55.621
May 42.963 - 82.760 16.565 56.362
Jun 45.537 - 89.692 21.000 65.155
July 45.837 8.800 89.559 18.969 53.891
Aug 41.816 23.895 89.626 22.330 46.245
Sep 45.984 28.500 91.405 21.920 38.841
Oct 49.643 33.860 95.800 26.654 38.951
Nov 45.625 40.930 96.854 27.153 37.452
Dec 1982 41.118 41.607 105.035 34.737 57.047
Source: Información Financiera SBIF, several issues.

Note (1): Net Worth is calculated from the other columns as Capital plus Provisions
minus Delinquent Loans minus Loans Sold to the Central Bank. This estimate of
net worth is not precise because it should also substract the loans at risk
estimated by loan classification, and should add the recoverable portion of
delinquent loans and the economic value of intangible assets. For June 1982, the
Loans at Risk were estimated by the Superintendency to be 6.03% of loans
(Acevedo, 1983), i.e some B$ 44.288, which puts effective net worth at B$
20.866 for that date.
This table documents the dramatic reduction in the solvency of the banking system
in 1982. In July 12, 1982, the Central Bank decided to allow banks to defer their losses over
several years, so it began to buy from them the delinquent loan portfolio and loans
classified worst in the risk scale, at face value. The banks, however, had to promise to
repurchase those loans at face value over time, so the scheme did not improve bank
solvency by itself. Banks accepted to commit 100% of their profits to this purpose until the
IN CHILE: 1974-1983 71
portfolio was bought back. The scheme solved a liquidity problem, but also set the stage for
making good the implicit contingent subsidy that the government had offered to speculators
in 1981.
Naturally, in this environment the problem of rollover of unrealized loan losses

presented itself again. The bank debtors that had speculated insisted on obtaining a
rescheduling or at least a rollover. Contrary to the situation in 1975, however, now the
Superintendency had the powers and the machinery in place to classify loans and question
loan renewals. Nevertheless, the authorities confronted steep difficulties to stop
undiscriminated rollover of unrealized losses. As insolvency was widespread, many
thousands of debtors hoped that the government would announce a massive bailout
package. In the meanwhile, they pressed for rollover, and the banks accepted willingly.
The reaction of the authorities to rollover was the "Process of Definition of Bank
Debtor Solvency" of November 1982. Hordes of inspectors and many persons of the
operating staff of the banks revised the banks' evaluations of recovery of their debtors, and
many debtors had to prepare a presentation to their banks to show that they were still
solvent or that they deserved a rescheduling. The explicit purpose of the exercise was to
stop rollover of unrealized loan losses, which had become a public issue because it was
squeezing out the healthy debtors and worsening the problem.
The publicly announced outcome of the evaluation process was the following: a
volume of BCh.$ 110,688 of debts were due by "non-viable" debtors, so their guarantees
would be seized and the banks would have to request their bankruptcy60. In addition, the
volume of debt issued by debtors defined to be "In Problems" only was BCh.$ 315,107, and
they were chosen to get the sought-after rescheduling.
The banks, however, dragged their feet both on guarantee execution and
rescheduling, forcing the authorities to think of alternative mechanisms. They will be
reviewed in the next section.
4.4 Self-lending by Business Groups in Chile.
We defined the complicating factor posed by self-lending in section 3. The

Chilean response to this problem has been, starting in August 1981, to limit drastically the
volume of allowed self-lending by business groups. This strategy imposes some costs in
60 In response, many debtors rushed to accelerate the shifting of collateral out of the debtor
corporation.
terms of resource allocation under perfect information, namely puts a ceiling on business
group indebtedness in the local banking system and forces banks to be independent entities.
However, the approach avoids the large costs that moral hazard can impose in the presence
of substantial asymmetric information. Until 1981, unbounded self-lending by business
groups was a reality in Chile.
It is well known that business groups in some countries of the Far East, notably
South Korea and Japan, are not subject to limits on self-loans. In compensation, however,
the large business groups in South Korea are closely supervised by the government, not
only from a prudential point of view, but also in their investment plans, labor policy and
other operational aspects as well. Japanese business groups were closely monitored by the
government in the 1950's and 1960's (Johnson,1982). In the 1980's they have grown to be
so solvent that moral hazard has been reduced to be a marginal regulatory concern. In this
sense, the Far East countries have not followed the strategy of allowing free self-lending by
business groups either.
4.4.1 Origin of Chile's large business groups.
As a more or less market-oriented economy, Chile has always exhibited a number

of important diversified conglomerates, most of whom included a bank and fall into our
definition of a business group. Most Chilean conglomerates included a bank because during
the financial repression of 1940-1973, the ownership of a bank or savings & loan secured
access to scarce loans at the interest rates below inflation fixed by the authorities.
However, there was an unprecedented growth in the size of business groups in

Chile during the 1976-1981 period. At the time, critics argued that this was the inevitable
result of the shift towards free-market policies, and insisted that industrial concentration
was becoming too high and that the business groups would hijack the political process61.
Now it is clear that these prejudices were unfounded. The business groups grew
unexpectedly fast in Chile in the 1976-1981 period because of three specific government
policies, not because of a bias in free-market economies. These were, first, the decision to
privatize banks before privatizing the industrial firms expropiated by Allende. This policy
allowed relatively small business groups to acquire a bank62. The business groups were
61 See Hoy Nº 145, May 1980, which denounces the "Cruzat-Larraín Empire", and
Dahse(1979).
62 Bids were required to offer a 20% down payment, plus quarterly installments over the
next two years at CPI variation plus 8% annual interest rate, below market rates. These
financial conditions, however, merely allowed the government to claim that a higher price
had been paid.
IN CHILE: 1974-1983 73
thus given access to the public's deposits, which were lent to the group itself and used to
buy the industrial firms privatized by the government between 1976 and 1978. It is clear
that the sequencing of privatization has a profound influence in the industrial structure.
Given the previous policy, the second specific government policy that eased the
way for business groups was to privatize both banks and industrial firms through auctions
to the highest bidder. Given the recession of 1975, the large real interest rates of available
bank loans, and the complete absence of large foreign investors from post-Allende Chile,
these auctions meant that the only competitive bidders were a few local business groups.
The same was done when selling back to the private sector the industrial companies taken
over by Allende. There was no government effort to dilute ownership across tens of
thousands of investors in 1976-1980.
However, what really gave these business groups their clout were the large profits
they made in the 1977-1980 period. A substantial part of these profits were made
arbitraging between the high domestic interest rate and the low foreign interest rate. This
type of arbitrage was possible, in part, because the government maintained in place until
1980 the old set of regulations on international private capital mobility. The other part is the
natural advantage of any large firm that can access the wholesalers of funds directly, i.e. the
possibility of paying lower interest rates for a larger volume of loans63.
As the government decided not to use the government's or the state enterprises'
external borrowing capacity to bring funds to Chile and earn arbitrage profits, competition
was slight. Only a few big industrial companies and banks, dominated by new business
groups, had access to private foreign lending, and this subject to individual quotas strictly
enforced by the Central Bank. Given the high -but falling- local interest rate, the few
business groups that had access to foreign loans could enjoy a large arbitrage rent in 1977-
1980.
In addition, the business groups were able to grow with the economy. This growth
was independent of government policy. A substantial chunk of the business groups' equity
were capital gains in property and share values. These capital gains were impulsed in part
by the reduction of real interest rates over time, but mostly by the expectations of
permanent high growth that became believable as the economy improved over the period.
On the other hand, asset prices were inflated by the new business groups' habit of continued
acquisitions of new businesses at a rate higher than the rate of increase in aggregate real
capital.
63 See Ramos (1988).

In addition, two of these business groups were very successful in obtaining the
goodwill of smaller investors. This allowed them to obtain control of several large loosely
held corporations through the purchase of a relatively small share block. In this way, groups
Vial and Cruzat-Larraín became partners of thousands of smaller local investors and
rentiers in Banco de Chile, Cervecerías Unidas and COPEC, among other companies. This
was not the result of government policy, but merely the reflection of these two groups'
exceptional appeal among rentiers. The possible conflicts of interest between small and
controlling shareholders began to be regulated somewhat late, in the 1981 reform to the
Securities Law. Other business groups did not attempt to lure rentiers and smaller investors.
Most Chilean business groups enjoyed exceptional growth over the period because
of two additional reasons. First, the strong performance of the economy in 1977-1980
generated substantial operating profits in most sectors of the economy. Second, several
large business groups took advantage of the opportunities opened by the reduction of tariff
rates enforced by the government in 1976-1979. They moved rapidly to invest in the newly
profitable export sectors, and prepared to exploit fully the advantages of serving large
foreign markets afforded by their size. It is clear that these possibilities were open to many
Chilean and foreign investors, and not only to local business groups. In fact, many
traditional business groups, medium-sized new groups and small investors also made large
profits in this period because of these reasons64.
What we know about the business group's solvency by the end of 1980 is not very
precise. However, we do know that the consolidated indebtedness of the two largest
business groups was high, with a most likely debt/equity ratio between two and three65. A
confirming point is that, at the time, the managers of the largest business groups used to
argue that high indebtedness was necessary to sustain high growth in developing countries.
For Cruzat-Larraín, the largest group, which controlled assets near US$ 2 billion in 1981, it
has been asserted independently that its controllers' equity was near US$300 million. If
non-controlling shareholders' equity was a similar sum, which seems likely, the solvency
ratio of the group would have been in the range indicated above.
These were high levels of debt because the domestic component was short term
(i.e. expected to be renewed at the interest rate that would prevail in the short term market)
64 Gálvez and Tybout (1985) provide evidence showing that the business groups did better
than similar independent companies, probably because they used better management
techniques.
65 This is equivalent to an Equity/Assets ratio between 0.33 and 0.25. The main holding
companies of the two big groups had an Equity/Assets ratio near 0.50, and the largest
subsidiaries had a similar ratio. In a straight two-level hierarchical structure the
consolidated ratio is the product of both, i.e. near 0.25.
IN CHILE: 1974-1983 75
while the foreign portion was on a floating rate basis. This means that Chile's two largest
business groups were very exposed to interest rate risk. A rise in interest rates would reduce
the value of their fixed assets while keeping the value of their debt. The riskiness of this
exposure was not well understood at the time even within the business groups. In group
Vial, consolidated accounts began to be calculated for the first time in 1981. Incompetence
of private bankers extended to the business groups themselves. This was the natural result
of very fast growth and the rapidity of the shift towards free-market policies in 1975-1980,
which made obsolete many of the old habits of local businessmen and created an acute
shortage of qualified personnel. It was also the result of not taking advantage of the
previous years to impose prudential regulation, whose principles would have forced the
private sector to learn the techniques for risk evaluation.
4.4.2 Self-loans versus Loans to independent parties.
This section attempts to compare self-loans of banks with loans to independent

borrowers in order to examine the hypothesis of preferential access of business groups to
bank borrowing. It is well known that independent borrowers were able to obtain large
loans during financial deepening. Arellano (1983) shows that the ratio of debt to the
domestic banking system to sectoral GDP rose rapidly over 1977-1980 for most sectors. It
is telling that growth was faster for the sectors known to be dominated by small and
medium-sized businesses.
TABLE 12
LOCAL BANK DEBT/GDP AND DEBT/EQUITY RATIOS BY SECTOR
Sector Debt/GDP ratio

1977 1980 ∆(% points)
1. Dominated by Small Firms

Agriculture 20.1 65.6 45.5
Building 8.0 64.3 56.3
Transport 4.2 28.8 24.6
2. Dominated by Large Firms
Industry 20.8 42.5 21.7
Mining 1.5 10.0 8.5
Commercea 25.5 50.6 25.1
a: Commerce is a mixed sector, with many large and small firms.

Source: Arellano (1983), Table 9C.
In addition, the dollar-denominated debt to the local banking industry of the

building sector, which is dominated by medium-sized firms, grew by 284% in 1981, and
agriculture's grew 48% while the peso-denominated debt rose 13% and fell 9%
respectively66. There is ample evidence that even humble consumers speculated by buying
imported consumer durables.
It is also important to compare the financial policy of the large business groups up
to 1980 to the financial policy of smaller debtors and investors. It turns out that large
business groups split on this point, just as smaller investors did. The two largest business
groups, Vial and Cruzat-Larraín, were optimistic about the future and very indebted.
Groups Matte and Angelini, on the other hand, chose a slower growth/lower risk strategy.
In fact, many analysts have concluded that the two largest groups were the largest precisely
because they were willing to incur high debt/equity ratios. For this reason, we will call
these two groups the "speculative" business groups.
A study by Gálvez and Tybout (1985) focuses on this question by examining the
balance sheets of a sample of 177 large non-financial firms, of which 45 were affiliated to
conglomerates, which didn't necessarily include a bank. When analyzing indebtedness,
these authors calculate a "corrected" gearing ratio, which excludes financial investments in
affiliated companies from assets or equity, as the case may be. The reason is that these
investments were in some part reciprocal, so a standard gearing ratio would be misleading.
They find that among large firms, the corrected debt/equity ratio was similar among
independent and conglomerate-affiliated firms in 1980, being 0.89 and 0.92 respectively.
Our conclusion is that until 1980 the two largest Chilean business groups were
more indebted than the average of other businesses, but that this was also true for a
substantial number of smaller investors and independent large firms. As most optimists
were able to incur a high debt/equity ratio, independent of their size, we conclude that the
informational advantage of business groups over the Superintendency of Banks was not an
important factor up to 1980. This is not true for the cases of fraud, mentioned below when
analyzing the November 1981 takeovers by the Superintendency.
4.4.3 Monitoring of Business Group Self-loans.
As shown in the theoretical section, self-lending by business groups may become

a problem mostly because the risk of such loans is much harder to evaluate for the
Superintendency of Banks than he one of ordinary loans. Therefore, in order to propose that
self-lending by business groups was important in Chile in 1981 and 1982, we must first
document the extra difficulties encountered by the Superintendency because of self-lending.
66 See Arellano(1983), Tables 9A and 9B.

IN CHILE: 1974-1983 77
The evidence on the difficulties encountered by the Superintendency of Banks to

evaluate the risk of self-loans begins to accumulate in 1980. Recall that in April of 1980
Price Waterhouse revealed the lack of information at Banco Español on 37% of the loan
portfolio. The Superintendency was shocked, and supported Price Waterhouse in its June
1980 statement. It was known later that the Superintendency found that many of the loans
for which information did not exist were self-loans to the banks' owners. During that year
the Superintendency thought that the main problem with self-loans was that fraud became
harder to detect. It was worried that some banks had been subject to fraud through self-
loans, but this problem was thought to affect only a small portion of the banking system.
By early 1981, there was growing animosity against business groups within the
military government. Their power and influence were feared by the military, and suspicion
reached its climax when they found out that the largest business groups would dominate the
newly created pension fund management industry. The political opposition had been in
campaign against the power of business groups since mid-1980. In this setting, the
Superintendency of Banks began to attempt the construction of a map of the holding
companies of all important business groups in Chile. On the other hand, in March 1981 the
Superintendency of Securities began to force public companies to reveal all their dealings
with affiliated companies.
In August 19, 1981, the Superintendency of Banks surprised business groups as it

obtained the approval of a reform to the Banking Law that changed the approach towards
self-lending. The new law stated that:
"....it will be understood that a bank is managed in a defficient way if it has

not diversified its loans away from persons and societies linked to the bank
through ownership or management, directly or indirectly."
The new law gave new powers to the Superintendent with respect to banks
"managed in a defficient way", like the power to ban the extension or renewal of specific
loans, and the power to prevent the bank from lifting guarantees in the case of self-loans.
The new law informed business groups that self-lending could be stopped by the
Superintendency at any moment. It must be noted that these powers were excessive in the
sense that bankers had no way to appeal to a court, illustrating the backlash that a disregard
for prudential regulation can generate further on.
In addition, the reform introduced a diversification requirement on bank

investments, by which a bank could not invest more than 30% of its capital in the securities
of each issuing society. Finally, the law forbade banks from owning shares in other
companies, except as a result of underwriting, and shares ceased to be acceptable
guarantees.
A month later, the Superintendency established specific guidelines to define self-

loans67, which also limited drastically the maximum volume of self-loans by business
groups that would be allowed. If the scheduled limit was not met, the Superintendency
would declare the bank in a state of "defficient management". The formal channel through
which the Superintendency proceeded was to tighten the diversification requirement on
loans, by redefining what an individual debtor was. This approach has confused some
analysts, because the Superintendency seemed to be worried about diversification per se.
Before the new law, an individual debtor was a society or person. After the
reform, an individual debtor included all the societies where the debtor had more than 50%
of ownership or control, plus the prorated share of debts of societies where the debtor
owned or controlled between 50% and 10%. Considering that a bank would be able to lend
at most 25% of its capital to any one debtor, and that at the time self-loans were between 2
and 5 times capital for the largest business groups, this implied a drastic cut in the volume
of allowed self-loans to business groups. For this reason, the package of reforms provided
that the new limitation on self-lending would be required only from January first, 1982. In
practice, only in February 8, 1982, banks were required to send to the Superintendency a
list of debtors affiliated to the bank. There was no explicit timetable for adjustment at this
time, so by default business groups were expected to disengage from self loans in few
months only.
The reaction of the largest business groups to the new limitations was to evade
them. They realized that under the new rules a participation of less than 10% in a society
made it eligible for self-loans. Also, only direct ownership ties were considered in the
official definition of self-loans. Therefore, the first reaction was to increase the density of
the network of shell companies, in order to keep the direct participation of the group in
shell companies at 9,9%.
In second place, the business groups adopted the tactic of continuous creation and
dissolution of shell companies, which increased the difficulty of the Superintendency's task.
A third reaction of business groups was to link up and replace self loans for new
loans to other business groups, in exchange for the same treatment by the other business
67 Circular Nº 1753, September 14, 1981.

IN CHILE: 1974-1983 79
group's bank68. Although this was criticized at the time69, it was inevitable given the
excessive size of the self-loans. More deeply, this reaction at least allowed the
Superintendecy to rely partially on an independent risk evaluation: the one of the other
business group. In effect, a sound business group would not want to engage in this linkage
with an unsound business group.
A fourth reaction was to take advantage of the recent authorization to Chilean

banks to lend abroad. The way to do it was for the Chilean bank to lend to a foreign person,
such as a Cayman Islands society, which would bring the money back to Chile, and lend it
to the other firms in the business group.
A fifth method of evasion was to use the authorization to establish bank

subsidiaries abroad. Group Vial was the only one to use this route: Banco de Chile and
Banco BHC, affiliated to Vial, established subsidiaries in Panama, Uruguay and New York.
The panamanian subsidiary drew its funds from BHC's loans, and then lent directly to the
other firms in Vial's business group. The uruguayian subsidiary got loans from Banco de
Chile and then lent to the Vial firms in Chile. Of course, this subsidiary engaged in moral
hazard against the uruguayian government too.
The evasion of regulation during 1981 allowed business groups to delay

adjustment through the use of more debt. The study by Gálvez and Tybout (1985) finds that
their corrected debt/equity ratio for large firms rose from 0.78 in 1980 to 0.89 in December
1981 for independent firms, while it rose from 0.92 in 1980 to 2.57 in December 1981 for
firms affiliated to conglomerates70.
In conclusion, the Chilean Superintendency achieved some reasonable loan

classification ability during 1982, two years after it adopted the policies proposed by the
State Supervision School. Tagle (1988) acknowledged that the difficulties in supervision
ran deep even during 1982. For example, he states that even in 1983, one year after self-
lending by the largest Chilean business groups had stopped, the Superintendency continued
68 This practice was known as "back to back loans". The net effect is that the effective
capital base of the banking system is smaller than what a case-by-case analysis would
suggest. In the most favourable case, in which the loan to the other business group is
secured by a lien on real assets that can be inspected by the Superintendency, the practice
still allows business groups to sidestep the rule that bank capital must be supplied in cash or
securities approved by the Superintendent.
69 Some argued that this practice was due to collusion among the large Chilean business
groups. However, this is incorrect, because evading regulation is privately profitable in an
atomistic market as well.
70 The last figure does not exclude outliers in their sample.
finding that loans that it thought had been given to independent parties were in fact self-
loans. This led to a 10% real increase in the estimated volume of self-loans in 1983.
This documents how difficult it was for Chilean bank regulators to overcome the
informational assymmetry in the case of self-loans by business groups.
4.4.4 Abuse of the informational advantage.
This section will review possible motives of the large business groups to engage in
moral hazard or rollover of unrealized losses. The difficulties for supervision described
above can be interpreted in two ways. The most popular is that the business groups
attempted to evade prudential regulation to engage in moral hazard and rollover of
unrealized losses. A theoretical alternative is that the business groups were forced to find a
way to obtain the time required to reduce the stock of self-loans without having to pay
excessive prices to the new creditors or to accept low prices when selling assets. The need
for a timetable for disengagement from self-loans is clear from the fact that in June 1982
the Superintendency created a two-year timetable, which was extended in 1984 for six more
years in acknowledment of the fact that the 1982-1983 recession was much deeper than
anticipated71.
It is critical to separate the analysis of 1981 from 1982, because in the latter year a
steep recession - GDP fell 14.1% in 1982 - reduced the solvency of most Chilean firms,
including business groups. For example, a finding that the debt/equity ratio of business
groups was too large in December 1982 cannot be considered good evidence of moral
hazard, because the recession may have wiped out the group's equity exogenously. One
piece of evidence that would allow us to choose from these alternative hypothesis is a risk
evaluation of self-loans versus ordinary loans, for 1981. However, the Superintendency has
never published the information it had at the time, while business groups never published
their consolidated balance sheet.
A complementary way to proceed is to check what happened to investment plans

in 1981, in response to very high real interest rates. Gálvez and Tybout (1985) find that
independent firms reduced the rate of addition to fixed capital from 7% in 1980 to -6% in
1981, while firms affiliated to conglomerates reduced it from 11% in 1980 to 8% in 1981.
This means that firms affiliated to conglomerates adjusted their investment plans by too
little in reaction to the rise in interest rates, and financed their continued expansion with
additional debt. This suggests that business groups were not willing to submit to the
requirements of disengagement of self-loans as soon as possible, because if that were true
they should have reduced investment by much more.
71 See Tagle (1988) p. XV.

IN CHILE: 1974-1983 81
We review now if the speculative Chilean business groups had a good motive to
engage in moral hazard, and in rollover of unrealized losses, in 1981. First, we check the
feasibility of moral hazard. During 1981, overall local indebtedness increased substantially
in the Chilean private sector, from 37.6% to 50.4% of GDP, as a counterpart of the
accumulation of foreign debt. If we keep equity constant, this rate of growth of debt implies
increases in debt/equity ratios from 2 to 2.7 or from 3 to 4. In 1981 there was also a steep
rise in real interest rates that reduced equity substantially. The share price index in the
Santiago Stock Exchange fell 27% in real terms during 1981. Assuming a conservative
15% reduction in asset values, we get that market-value debt/equity ratios rise from 2.7 to
6, and from 4 to16. Clearly, after suffering these losses both moral hazard and exchange
guarantee seeking may become a profitable mode of behavior, given the informational
advantage enjoyed by business groups.
The evidence shows that the business groups took advantage of their informational
advantage over bank regulators in order to be able to draw implicit government subsidies
for speculating against a future devaluation, as other speculators did. Their informational
advantage made the new guidelines on self-loans non-binding during 1981.
However, it is misleading to assert that self-lending was the main factor behind the
excessive foreign debt accumulation experienced by Chile in 1981. Self-lending by the
speculative business groups merely allowed them the extra bonus of continuing their
investment programmes. The other effect of the informational advantage was to delay the
effects of the new regulation. This delay allowed them, first, to avoid inmediate unwinding
of self-loans, and second, to draw on the government's contingent subsidy on foreign
exchange and interest rate taking. The contingent foreign exchange and interest rate risk
subsidy was being offered to other investors as well, and it was this what wrecked the
macroeconomic balance.
We conclude that up to 1981, speculative business groups engaged in moral

hazard only marginally. The business groups did not need to engage in moral hazard in
1981, because something better was available: to bet that there would be no devaluation and
interest rates would fall shortly. Both moral hazard and contingent government subsidies
require the debtor to come near the brink of bankruptcy by increasing leverage. The
difference is that moral hazard implies drawing a contingent subsidy that the issuer did not
want to issue, while contingent subsidies are willingly offered. Therefore, if the speculative
business groups had used their waning informational advantage to avoid an hypothetical
guideline that forced provisioning in account of foreign exchange risk and interest rate risk,
then they probably would have chosen to engage in moral hazard. This was not the case in
Chile in 1981, but as we will see, it was in 1982.
Now we check the feasibility of rollover of unrealized losses by abuse of the

informational advantage implicit in self-loans. The question is the following: given that
losses were large both for small entrepreneurs and for big business groups, did the latter
obtain special treatment by taking advantage of their informational advantage over the
Superintendency ?
We believe that rollover of losses by business groups during 1981 and the first
half of 1982 is a fact. However, it happened together with generalized rollover by all types
of investors. Most analysts believe it was available to a greater extent to the groups'
companies. However, this means that the share of self-loans in banks in early 1981 was
smaller than the one documented below for June 1982.
The following table shows the level of self-loans and their evolution in the second
half of 1982.
TABLE 13
SELF-LOANS AND ROLLOVER OF UNREALIZED LOSSES BY BUSINESS GROUPS
Self-Loans as % of Total Loans

Business Financial June December February
Group Institution 1982 1982 1983
Cruzat-Larraín B. de Santiago 44.1 42.3 45.8

B. Colocadora 23.4 23.8 24.4
BHIF 28.2 18.5 18.9
Vial-BHC B. de Chile 16.1 18.6 19.7
BHC 17.1 18.5 n.a.
Morgan-Finansa 7.2 n.a. 6.8
Yarur B.Crédito e Inv. 8.6 11.9 12.0
Errázuriz B.Nacional 29.1 25.7 30.1
Edwards B. de A.Edwards 15.9 14.9 15.4
Matte BICE 4.0 4.0 5.5
Concepción B.Concepción 17.0 12.2 12.0
Sudamericano B.Sudamericano 13.0 14.8 16.2
Internacional B.Internacional 20.1 16.9 25.9
Source: Información Financiera, December 1982, February 1983, July 1988.
This Table shows that self-loans were very high at the initial stage, but that they
did not rise substantialy in the second half of 1982. This means that the Superintendency
succeeded in preventing business groups from using their informational advantage to roll
over their unrealized losses in a preferential way in the second half of 1982. The reason is
IN CHILE: 1974-1983 83
that the Superintendency had, by this time, attained the ability to estimate the consolidated
solvency of business groups.
We review now other regulatory problems related to the informational advantage

of business groups, in other segments of the financial system. In 1982, the Cruzat-Larraín
business group began to use its control of the mutual fund industry to channel the funds it
obtained from thousands72 of small investors to lend to the groups' companies and
holdings. The funds' shareholders were kept happy by the large increases in the prices of
several securities held by the mutual funds. It was soon found out, however, that the group
was manipulating the price of those securities, issued by the same group's firms. In
addition, many of the mutual funds publicized their 1982 shift to fixed income securities,
stressing the reduced risk, but shareholders failed to realize that these securities were
mostly commercial paper issued by the group's largest companies, including some very
indebted holding companies.
The larger firms of the group financed the rollover of unrealized losses through
the sale of commercial paper to medium-sized73 investors and to mutual funds. This raised
real interest rates in commercial paper to very high levels by late 1982. The critical problem
was that investors didn't have access to any estimate of the consolidated balance sheet of
the main business groups, so they were unable to rely on a serious risk evaluation. Smaller
investors and companies did not have access to this type of rollover of losses.
Unfortunately, the speculative business groups succeeded in fooling the public in

the security markets, by drawing on the confidence the public had developed in well known
company names. This happened even though the 1981 reforms to the Securities Law and
the Joint-Stock Companies Law had restricted the scope for those practices. For example,
the timely disclosure of relevant information was required of high company executives.
Unfortunately, the Superintendency of Securities failed miserably in making sure that
investors had access to the relevant information. As examples, it never required business
groups to publish their consolidated balance sheet, and failed to generate enough
information about the riskiness of the commercial paper sold by holding companies to
mutual funds.
72 In December 1982 there were 131,017 shareholders at mutual funds.

73 The minimum denomination for commercial paper had been set in 1977 in 350 UF.
4.4.5 The outcome: Takeover by the Superintendency of Banks.
We finish this section on self-lending by business groups by documenting the end

of the two speculative business groups. In June 1982, using the new powers obtained in
1981, the Superintendency announced a new limit on self-loans to 5% of total loans, i.e. to
100% of capital and reserves. All banks were forced to present "Diversification Plans"
within 45 days. The target would have to be met in five semesters, with the first 20% due
by December 1982. Two weeks later, the target was changed to a complete ban of self-
loans to shell companies, and the limit to self loans to productive74 companies was reduced
to 2,5% of total loans.
Apparently, the reason for this tightening was to strengthen the Superintendency
in the negotiations it had opened with Vial's business group. The authorities wanted the
payment of some of the debts owed to Banco de Chile with shares in the group's productive
firms. However, Vial did not fulfill his commitments and refused to handle over control of
Banco de Chile, opening a period of several months of hard bargaining. Nevertheless, Vial
had lost effective control. The devaluation of the peso in this period made sure that his
group was bankrupt.
Recall now that after the November 1982 Process of Solvency Definition, the
authorities found that banks were unwilling to reschedule selectively on the basis of a case-
by-case analysis of debtors, and prefered to roll over all loans. This put pressure on the
authorities to stop rollover of losses.
In January 7, 1983, a large paper-pulp firm of the Cruzat-Larraín group announced

it could not continue servicing its debts. The group had been unable to survive the recession
on its own, and the only question left was if the authorities considered the group to be "non-
viable" or "in problems". In the second case it would have deserved a rescheduling
according to the November 1982 rules.
The authorities answer came in January 13, 1983, when the Superintendency took
over the flagship banks of both speculative groups, and declared the forced liquidation of
another three banks. The Finance Minister argued that the solvency of all banks had been
reviewed with the risk classification procedure of the Superintendency, including the results
of the Process of Solvency Definition of November 1982. They had found that banks
clustered in three groups:
First, banks whose estimated losses were less than 100% of capital and provisions,
so still had a positive net worth. Second, banks that had losses between 100% and 200% of
74Means non-holding company.

IN CHILE: 1974-1983 85
capital and provisions. These banks were taken over because they had negative net worth,
and included five banks: Banco de Chile (Vial), Banco de Santiago (Cruzat-Larraín), Banco
Colocadora Nacional de Valores (Cruzat-Larraín), Banco de Concepción, and Banco
Internacional (two other smaller business groups). Third, the institutions whose estimated
losses were above 200% of capital and provisions were liquidated. These banks were Banco
Hipotecario BHC (Vial), Banco Unido de Fomento (owned by a consortium of foreign
banks) and financiera Ciga.
Of course, the estimate of solvency of these banks included an assessment of the

solvency of the speculative groups. For example, Banco de Santiago's solvency depended
of the estimated recovery of the amazing 45% of loans it had placed with its own business
group.
At this point, a different element entered the analysis: the authorities had become
convinced that the existence of business groups, where banks and productive firms were
managed jointly, was one of the important sources of the excess debt burden in the Chilean
private sector (see Lüders, 1985). This judgement was shared by other students of the
situation (Díaz-Alejandro, 1985, p.13). The analysis of this paper has shown that this was
not exactly the case, because a substantial part of the excess debt burden was caused by the
implicit goverment subsidy to foreign exchange and interest rate risk taking during 1981.
We agree however, with the diagnosis that the informational advantage of business groups
could be countered in 1982, when the speculative ones clearly used it, only by takeover of
the flagship banks and the main holding companies. They could roll over their losses to a
larger degree than smaller debtors, which caused a part of the excess debt burden.
This was the analysis that led the authorities to complement the takeover of the
speculative business groups' flagship banks (de Chile and de Santiago) with a planned
acquisition of control of the large companies that had been controlled by these business
groups. In practice, this control was achieved by a refusal to renew the thirty-day peso loans
that these firms owed to their previously affiliated banks. This forced these industrial
companies into bankruptcy proceedings, and the creditors' commitees came to be
dominated by the representatives of the flagship banks. In this way, the goverment took
over the two speculative business groups, achieving an unexpected nationalization. The
result for the banking system's balance sheet was the following:
TABLE 14
DELINQUENT LOANS AND BANK CAPITAL, 1983
(Billions of Chilean pesos)
Delinquent Loans Sold Capital Loan Loss Net

Month Loans to C.Bank &Reserves Provision Worth
Dec 1982 41.118 41.607 105.035 34.737 57.047

Jan 1983 47.704 37.535 102.941 35.753 53.455
Feb 86.650 37.514 103.105 47.201 26.452
Mar 103.667 37.548 103.105 48.934 10.824
Apr 110.592 38.524 103.115 50.480 4.479
May 116.889 38.480 103.254 53.549 1.434
Jun 126.867 36.915 104.277 55.367 -4.138
Jul 132.781 41.662 104.793 55.394 -14.256
Aug 109.144 71.343 105.869 52.512 -22.106
Sep 108.399 85.434 106.993 56.465 -30.375
Oct 90.024 112.095 107.462 55.465 -38.697
Nov 88.724 117.695 108.289 57.528 -40.602
Dec 1983 92.190 109.675 127.714 61.963 -12.188
Source: Información Financiera SBIF, several issues.
Some leaders of the two speculative business groups have argued that they should
have been treated as smaller debtors "with problems" were, receiving a long term
rescheduling financed with the concurrent subsidy. However, they forget that in order to
claim subsidies from the political system one must not have committed abuses against other
citizens.
In late 1982 and during 1983 the Chilean authorities had the information, the will
and the power to stop rollover of unrealized losses and moral hazard. In the end, the
speculative business groups proved to be no match for the Superintendency of Banks and
the authorities. If the government had not offered willingly contingent subsidies fo foreign
exchange and interest rate risk-taking, the Chilean macroeconomic performance would
have been much better in 1981-1983.
IN CHILE: 1974-1983 87
5. Lessons for Financial Liberalization and Prudential Supervision
The Chilean experience offers important lessons for both financial liberalization
and bank regulation. We can divide them among two headings:
5.1 The specifics of the Chilean experience.
This paper contains the most detailed presentation of the Chilean experience
allowing an assessment of banking policy over the different episodes and across different
regulatory issues.
Dismantling the institutions of financial repression was not a simple task. The
dynamics are complex, apparently leading to a high initial real interest rate, which falls
over time. It is difficult to arrange the required degree of coordination in reform, as the
failure of the Chilean Savings and Loans industry in 1975 shows.
A specific Chilean problem was the theoretical discussion about the appropiate
framework for the banking system after liberalization. The group within the government
that favoured free banking imposed its views in early 1976, and Chile experienced a full
year of free banking because confidence in government deposit guarantees were shattered
by the government's 1975 failure to honor promises to guarantee depositors in the Savings
and Loans. An important lesson from Chile is that until significant evidence in support of
free banking is accumulated, a realistic approach towards financial liberalization should
assume that the goal is a banking system subject to prudential regulation by the
government.
However, this group insisted on free banking after 1977, when it became
incredible because of the government's support for depositors at five large financial
institutions. Given this support, the only sensible route was to adopt prudential regulatory
practices, but this was not done until 1980, after the Banco Español fiasco. Thus, three
years of potential learning were lost, and the natural protection against moral hazard and
rollover of unrealized loan losses offered to liberalizing financial systems by the quasirents
earned during the expansion period were dilapidated.
Then, the failure to learn on time was paid for dearly in 1981-82. We find that the
main culprits of the 1981-1983 bankruptcy of most of the Chilean financial system were the
following:
First, the steepness and depth of the depression of 1982 and 1983, which by itself
forced many debtors into insolvency, bringing down with them the banks. A GDP reduction
of 14.1% in 1982, followed by another reduction of 0.7% in 1983 was obviously
unexpected. Moreover, the rise in international real interest rates from 1.5% in 1980 to
10.7% in 1981, to remain high thereafter, were also critical to force into bankruptcy many
Chilean firms. Other exogenous macroeconomic factors were influential too, like the fall in
the terms of trade, and the overlending by international banks in 1979-81.
Second, the most important reason for the bizarre behavior of the macroeconomy
in 1981 and 1982 was the willing offering by the government of guarantees on exchange
rate and interest rate risk. The private sector took advantage of those guarantees, and this
fed back into the macroeconomy, deepening the recession. These guarantees could have
been withheld if bank regulators had had enough experience, and if private banks had been
schooled in the discipline of risk evaluation and collateral control since 1977.
On the other hand, our detailed analysis shows that several purpoted regulatory
problems in Chile 1974-1982 are mythical. The main one, a ponzi game through rollover of
unrealized loan losses, was not present in 1978-1980, as many have asserted. However, it
did become important in 1981 and 1982, though, because of the other problems listed
above. In the same way, moral hazard by banks was simply not there in 1978-1980, but
became increasingly important over 1981 and specially 1982.
The case of self-loans by business groups is more complex. This is certainly a

pernicious practice, but for different reasons from the ones usually proposed. Up to 1980,
the speculative business groups followed a financial policy similar to many smaller groups
and individual investors', and went bust together with many of them. During 1981 the
speculative business groups were able to use their informational advantage to delay the
implementation of new rules that would destroy their access to self-loans, but engaged in
little moral hazard and rollover of unrealized losses. To the extent that the two largest
speculative business groups used their waning informational advantage over regulators to
roll over their self-loans more freely than independent debtors, they worsened the real
interest rate rise of 1981 and squeezed out more creditworthy independent debtors.
After mid 1982, the speculative business groups attempted moral hazard and
rollover of unrealized losses in a big scale, but were promptly stopped by the bank
regulatory authorities, who were able to take over them easily in early 1983. However, the
speculative business groups used their informational advantage to dupe small investors in
the security markets in the second half of 1982, forcing losses upon many of them.
5.2 A Program for Research
Among the most important points that require further exploration in the area of
financial liberalization and prudential regulation are the following:
First, the dynamics of financial liberalizations are virtually unknown. We suggest

the importance of asymmetric portfolio adjustment costs, and of the costs of market
IN CHILE: 1974-1983 89
development, in which we include learning by doing. The issue of coordination between the
different reforms that conform a financial liberalization package is important also.
Second, experience shows that prudential regulatory issues are much more
complex and varied than what the literature would suggest. We propose a framework for
analysis that stresses the difference between structural contingent subsidies, moral hazard
and rollover of unrealized losses. The dynamics of these types of behavior are virtually
unexplored. They may yield interesting insights for banking policy.
Third, the complicating factors of incompetence of (some or many) private

bankers and self-lending by business groups deserve special study, especially for
applications to financial liberalizations. Learning by doing by regulators, banks and debtors
may affect the dynamics fundamentally.
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Vinculados a la Propiedad o Gestión de las Instituciones Financieras", Información
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Nº 128

Myths and Facts about Financial

PONTIFICIA UNIVERSIDAD CATOLICA DE CHILE

MYTHS AND FACTS ABOUT FINANCIAL

Sergio de la Cuadra (*)

Documento de Trabajo Nº 128

(*)Ex President of the Central Bank of Chile, ex Minister of Finance.

2. REAL INTEREST RATE DYNAMICS IN THE CHILEAN

2.1. The Financial Liberalization Step by Step 6

2.2 The Dynamics of Financial Liberalization 13

2.3. Coordination Failures in Financial Liberalization:

3. A FRAMEWORK FOR THE ANALYSIS OF PRUDENTIAL

3.1. Structural Contingent Subsidies 26

3.2. Moral Hazard 29

3.3. Rollover of Unrealized Loan Losses 31

3.4. Self-lending by Business Groups 33

4.1. Moral Hazard: The Chilean Experience, 1976-1978 37

4.2. Rollover of Unrealized Loan Losses: The Chilean

4.3. Structural Contingent Subsidies in Chile in 1981 60

4.4. Self-lending by Business Groups in Chile 71

5. LESSONS FOR FINANCIAL LIBERALIZATION AND

5.1. The Specifics of the Chilean Experience 87

5.2. A Program for Research 88

1 Arellano (1983) asserts that "Liberalization of credit controls.... generated a spiral of

In the case of Chile in 1981, contingent government subsidies took a particularly

An over-emphasized regulatory problem is the one of self-loans by business groups that

In conclusion, the linkages between macroeconomic performance and banking policy

2. Real Interest Rate Dynamics in the Chilean Financial Liberalization

2.1. The Financial Liberalization Step by Step

1940 12.0 1.9 15.8

Source: Central Bank, Indicadores Económicos y Sociales.

(c) Reserve requirements and interest paid on them.

3Decree Law Nº 455, of May 1974.

Demand 30-89 days 90 day - 1 year

First Stage: May 76 - December 77

Second Stage: January 78 - July 78

Third Stage: August 78 - March 79 (No changes)

Fourth Stage: April 79 - December 79

Fifth Stage: January 80 - December 80

Source: Central Bank, Boletín Mensual.

May 76 - October 76 : was equal to the return on short term

Reserve requirements on foreign borrowing were established in April 1978, as part of a

Average maturity less than 36 months : 25%

Date Limit as % of Capital and Reserves

January 78; : 5% of CR.

2.2. The Dynamics of Financial Liberalization7.

2.2.1. Asymmetric Portfolio Adjustment Costs

7For a more complete discussion see de la Cuadra and Valdés (1989).

iM = maximum interest rate.

i* = long-term equilibrium rate

ie = short-term equilibrium rate

1974 -48.0 1979 19.6

Source: Central Bank of Chile, Boletín Mensual.

If we look at the outstanding amount of interest bearing deposits issued by

1974 19.3 1.6

1/ It includes also passbook accounts.

2.2.2. Market Development

In addition, the slow reduction in reserve requirements -see 2.1- introduced

AC* SPREADS AC* SPREADS