Order Code RS22961

September 29, 2008

The U.S. Financial Crisis: Lessons From Chile

J. F. Hornbeck
Specialist in International Trade and Finance
Foreign Affairs, Defense, and Trade Division

Summary

Chile experienced a banking crisis from 1981-84 that in relative terms had a cost
comparable in size to that perhaps facing the United States today. The Chilean Central
Bank acted quickly and decisively in three ways to restore faith in the credit markets.
It restructured firm and household loans, purchased nonperforming loans temporarily,
and facilitated the sale or liquidation of insolvent financial institutions. These three
measures increased liquidity in the credit markets and restored the balance sheets of the
viable financial institutions. The Central Bank required banks to repurchase the
nonperforming loans when provision for their loss could be made and prohibited
distribution of profits until they had all been retired. Although the private sector
remained engaged throughout the resolution of this crisis, the fiscal costs were,
nonetheless, very high.

The U.S. Congress is contemplating a $700 billion government assistance package

to arrest the financial crisis in the United States. President Bush argued that failure to
enact legislation quickly could result in a wholesale failure of the U.S. financial sector.
As discussion of the Administration’s plan unfolded, however, questions in Congress
arose over issues of magnitude and management of the “bailout,” the need for oversight,
and the possibility that less costly and perhaps more effective alternatives might be
available.

In this light, Chile’s response to its 1981-84 systemic banking crisis has been held
up as one example. The cost was comparable relative to the size of its economy to that
facing the U.S. Government today. In 1985, Central Bank losses to rescue financially
distressed financial institutions were estimated to be 7.8% of GDP1 (equivalent to
approximately $1 trillion in the United States today). The policy options Chile chose had
similarities as well as differences from those contemplated in the United States today.
Their relevance is debatable, but they do highlight an approach that succeeded in

1
Bosworth, Barry P., Rudiger Dornbusch, and Raúl Labán, eds. The Chilean Economy: Policy
Lessons and Challenges. Washington, D.C. The Brookings Institution. 1994. p. 41.
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eventually stabilizing and returning the Chilean banking sector to health, while keeping
the credit markets functioning throughout the crisis.

Comparing Financial Crises

The seeds of the Chilean financial crisis were much different than those in the United
States. Nonetheless, in both cases, the financial sector became the primary problem, with
policy makers concerned over the prospect of a system-wide collapse. Chile’s problems
originated from large macroeconomic imbalances, deepening balance of payments
problems, dubious domestic policies, and the 1981-82 global recession that ultimately led
to financial sector distress. Although most of these are not elements of the U.S. crisis,
there are a number of similar threads woven throughout both cases.

Broadly speaking, both countries had adopted a strong laissez-faire orientation to

their economies and had gone through a period of financial sector deregulation in the
years immediately prior to the crisis. A group of scholars characterized Chile’s
orientation toward the financial sector as the “radical liberalization of the domestic
financial markets” and “the belief in the ‘automatic adjustment’ mechanism, by which the
market was expected to produce a quick adjustment to new recessionary conditions
without interference by the authorities.”2

In both cases, given the backdrop of financial sector deregulation, a number of

similar economic events occurred that ultimately led to a financial crisis. First, real
interest rates were very low, giving rise to a large expansion of short-term domestic credit.
With credit expansion came the rise in debt service, all resting on a shaky assumption that
short-term rates would not change. In both cases, but for different reasons, rates did rise,
causing households and firms to fall behind in payments and, in many cases, to default
on the loans.3 The provision for loan losses was inadequate causing financial institutions
to restrict credit. Soon, many found themselves in financial trouble or insolvent, resulting
in the financial crisis. Chile’s response may prove useful as policy makers evaluate
options.

The Chilean Banking Crisis of 1981-84

Following the coup against socialist President Salvador Allende in 1973, General
Augusto Pinochet immediately re-privatized the banking system. Banking regulation and
supervision were liberalized. Macroeconomic conditions and loose credit gave way to the
economic “euphoria of 1980-81.” The exuberance included substantial increases in asset
prices (reminiscent of a bubble) and strong wealth effects that led to vastly increased
borrowing. The banking system readily encouraged such borrowing, using foreign capital,
that because of exchange rate controls and other reasons, provided a negative real interest
rate. From 1979 to 1981, the stock of bank credit to businesses and households nearly

2
Ibid., p. 8 and 339.
3
In the case of Chile, longer maturities were not widely available so debt had to be rolled over
regularly. In the United States, various types of adjustable-rate mortgages given to high-risk
borrowers eventually led to massive defaults when interest rates and payments ballooned. The
financial problem facing U.S. institutions was compounded by the highly complex and arguably
poorly understood securitization of these mortgages.
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doubled to 45% of GDP. This trend came to a sudden halt with the 1981-82 global
recession.4

The financial sector found itself suddenly in a highly compromised position. Weak
bank regulations had allowed the financial sector to take on tremendous amounts of debt
without adequate capitalization. Debt was not evaluated by risk characteristics. Most
debt was commercial loans, but banks also carried some portion of consumer and
mortgage debt. As firms and households became increasingly financially stressed, and
as asset prices plummeted, the solvency of national banks became questionable. Two
issues would later be identified: the ability of borrowers to make debt payments, and more
importantly, the reluctance of borrowers to do so given there was a broadly-held
assumption that the government would intervene. By November 1981, the first national
banks and financial institutions that were subsidiaries of conglomerates failed and had to
be taken over by regulatory authorities.5

Most debt was short term and banks were in no position to restructure because they
had no access to long-term funds. Instead, they rolled over short-term loans, capitalized
the interest due, and raised interest rates. This plan was described by one economist as
an unsustainable “Ponzi” scheme, and indeed was a critical factor in bringing down many
banks as their balance sheets rapidly deteriorated. From 1980 to 1983, past-due loans rose
from 1.1% to 8.4% of total loans outstanding. The sense of crisis further deepened
because many of the financial institutions were subsidiaries of conglomerates that also
had control over large pension funds, which were heavily invested in bank time deposits
and bank mortgage bonds. In the end, although the roots of the banking crisis were
different than those in the United States, the Chilean government faced the possibility of
a complete failure of the financial sector as credit markets contracted.6

The Government Response

The Central Bank of Chile took control of the crisis by enacting three major policies
intended to maintain liquidity in the financial system, assist borrowers, and strengthen
lender balance sheets. These were: 1) debt restructuring for commercial and household
borrowers; 2) purchases of nonperforming loans from financial institutions; and 3) the
expeditious sale, merger, or liquidation of distressed institutions.7

4
Ibid., p. 38 and Barandiarán, Edgardo and Leonardo Hernández. Origins and Resolution of a
Banking Crisis: Chile 1982-86. Santiago: Central Bank of Chile. Working Paper No. 57.
December 1999. pp. 13-14.
5
Barandiarán and Hernández, op. cit., pp. 20-22.
6
Ibid., pp. 15-18 and 21-23 and Bosworth, Dornbusch, and Labán, op. cit., p. 339.
7
Barandiarán and Hernández, op. cit., p. 20-23. In addition, because a portion of the debt in
Chile was dollar denominated, the government created a preferential exchange rate program to
help repay those debts, the value of which had balooned on the balance sheets of corporate and
household debtors because of the 1982 peso devaluation. Because this issue is not germane to
the U.S. situation, it is not further discussed. The preferential exchange program nonetheless
represented a large subsidy that the government of Chile had to absorb.
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Debt Restructuring. From the outset of the rescue plan, the Chilean Central Bank
considered providing relief to both debtors and lenders. There were two rationales. First,
as a matter of equity, there was a sense that households as well as firms should be helped.
Second, to maintain a functioning credit market, both borrowers and lenders needed to be
involved. The Central Bank decided to restructure commercial, consumer, and mortgage
loans. The goal was to extend the loan maturities at a “reasonable” interest rate. The
debtor was not forgiven the loan, rather banks were given the means to extend the
maturities of the loans to keep the debtor repaying and the credit system functioning.
Restrictions were in place. Eligible firms had to produce either a good or service,
eliminating investment banks that held stock in such firms. Only viable businesses were
eligible, forcing the bankruptcy procedures into play where unavoidable. To keep the
program going, the loan conditions of each subsequent iteration of the program became
easier: longer maturities; lower interest rates; and limited grace periods.8

The program allowed Central Banks to lend firms up to 30% of their outstanding
debt to the banking system, with the financing arrangement working in one of two ways.
At first, the Central Bank issued money, lent it to debtors, which used it to pay back the
bank loans. Later, the Central bank issued money to buy long term bonds from the banks,
which used the proceeds to restructure the commercial loans. Variations of this process
were applied to consumer and mortgage debtors. In cases where loans were made directly
from the Central Bank to the debtor, repayment was expected usually beginning 48
months after the loan was made. The fiscal cost was significant, approximating 1% of
GDP in 1984 and 1985.9

Restoring Bank Balance Sheets. This program was more controversial and
had to be adjusted over time to be effective. The key idea was to postpone recognition
of loan losses, not forgive them. It relied on identifying nonperforming loans and giving
banks time to provision against them, without risking insolvency. The process has been
variously characterized as the Central Bank taking on bad debt through loans, purchases,
or swaps. All three concepts play some part of this complex, largely accounting-driven
arrangement.

Initially, this program was described as a sale, although there was no exchange of
assets. The Central Bank technically offered to “buy” nonperforming loans with non-
interest bearing, 10-year promissory notes. Banks were required to use future income to
provision against these loans and “buy” them back with the repurchase of the promissory
notes. In fact, they were prohibited from making dividend payments until they repaid the
Central Bank in full. The banks, though, actually kept the loans and administered them,
but did not have to account for them on their balance sheets. This arrangement was
intended to encourage banks to stop rolling over non-performing loans, recognize the truly
bad ones, and eventually retire them from their portfolios. The banks benefitted by
remaining solvent and gaining time to rebuild their loan loss reserves so to address

8
Ibid., pp. 25-29.
9
Ibid., pp. 25-26. There was also a cost in expanding the money supply, but the macroeconomic
effects proved limited and are not addressed here.
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nonperforming loans. The credit market was served by banks being able to continue
operating with increased funds from released loan-loss reserves.10

This program did not work as hoped at first and had to be adjusted. The Central
Bank allowed more time for banks to sell nonperforming loans and also permitted a
greater portion of their loan portfolios to qualify. It also began to purchase these loans
with an interest-bearing promissory note. The banks, however, actually repaid the
interest-bearing note at a rate 2 percentage points below that paid by the Central Bank to
the banks. This added differential was sufficient incentive for the banks to sell all their
bad loans to the Central Bank, beginning a process of identifying good loans and allowing
for the eventual retirement of bad loans from the balance sheets (and the banking system).
The cost to the Central Bank increased, but by 1985, the portfolio of non-performing
loans at the Central Bank began to decline and was eventually eliminated.11

Restructuring Distressed Banks. A major goal of government actions was to

ensure that bank owners and creditors were not absolved of responsibility to help resolve
the crisis, including using their own resources to absorb some of the costs. The
government worked closely with all financial institutions to impose new risk-adjusted
loan classifications, capital requirements, and provisioning for loan losses, which would
be used to repurchase loans sold to the Central Bank. The banks, through the Central
Bank purchase of substandard loans, were given time to return to profitability as the
primary way to recapitalize, and became part of the systemic solution by continuing to
function as part of the credit market.

A number of banks had liabilities that exceeded assets, were undercapitalized, and
unprofitable. Their fate was determined based on new standards and they were either
allowed to be acquired by other institutions, including foreign banks, or liquidated. The
“too big to fail” rule was apparently a consideration in helping keep some institutions
solvent. A total of 14 financial institutions were liquidated, 12 during the 1981-83 period.
In most cases, bank creditors were made whole by the government on their deposits with
liquidated banks. For three financial institutions that were closed in 1983, depositors had
to accept a 30% loss on their assets.12

Possible Lessons from Chile’s Bank Crisis

The overriding goal of a strategy to correct systemic crisis in the financial sector is
to ensure the continued functioning of credit markets. Chile succeeded in accomplishing
this goal and restoring a crisis-ridden banking system to health within four years. The
single most important lesson of the Chilean experience was that the Central Bank was
able to restore faith in the credit markets by maintaining liquidity and bank capital
structures through the extension of household and consumer loan maturities, the
temporary purchase of substandard loans from the banks, and the prompt sale and
liquidation of insolvent institutions. Substandard loans remained off bank balance sheets

10
Ibid., pp. 29-30 and Bosworth, Dornbusch, and Labán, op. cit., pp. 41 and 340.
11
Ibid.
12
Barandiarán and Hernández, op. cit., pp. 40-46 and Bosworth, Dornbusch, and Labán, op. cit.,
p. 402.
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until the viable institutions could provision for their loss from future profits. Other losses
were covered by the government.

In addition, a number of other insights emerged from the Chilean crisis:

! The market could not resolve a system-wide failure, particularly in the

case where there was a high expectation of a government bailout.

! The expectation of a bailout became self-fulfilling and increased the cost.

! Appropriate prudential supervision and regulation were critical for

restoring health and confidence to the financial system. Observers
lamented the a priori lack of attention to proper regulation.

! Private institutions that survived shared in the cost and responsibility to

resolve the crisis to the apparent long-term benefit of the financial sector.

! The fiscal cost of the three policies discussed above was high.
Liquidating insolvent institutions had the highest cost followed by the
purchase of non-performing loans and rescheduling of domestic debts.
The strategy, however, is widely recognized as having allowed the
financial system and economy to return to a path of stability and long-
term growth.