They are thus peculiarly vulnerable to a loss of confidence, individually and as a group. The potential for contagion – the threat that trouble in one bank will result in a run on others that might endanger the system as a whole – makes monitoring banks’ solvency and liquidity a core activity for central banks. Whether responsible day-to-day for supervision or not, central banks still need to stand ready to act as lender of last resort. However, any such operation must be carefully considered. Any decision to support an institution, particularly in circumstances of underlying insolvency, creates a moral hazard that undermines market discipline. Designing effective arrangements for restructuring financial institutions is thus a particular challenge – there is a need to act quickly and finally; intermediate arrangements are much more difficult to sustain. The challenge is complicated by the degree to which financial markets are now global and financial groups operate in a number of different jurisdictions. The G30 report on international financial insolvencies, published in March 1998, raised several themes that are rather similar to those relating to cross-border corporate insolvencies. In particular, it emphasised that a close degree of international co-operation was necessary to prevent the disorderly failure of a bank or insurance company. Effective co-operation would help to bring about a reorganisation or if necessary an orderly disposal of assets, and avoid the delays, uncertainties and loss of value often associated with formal legal proceedings.

Several factors contributed to the deterioration of the macroeconomic environment in 1982. External interest rates rose, the availability of external credit decreased, and terms of trade worsened in the wake of the escalation of oil prices. This put enormous pressure on the Chilean peso—which had been under a fixed exchange rate scheme since 1979—. This regime broke down dramatically and spread to almost all business sectors, given large FX exposures, and heavily leveraged financial conglomerates. All these factors interacted with one another to become an outright banking crisis. But, whatever the causes of the crisis, unsustainable debt was mostly explained by internal vulnerabilities: inappropriate regulation, weak supervision, and lack of attention to excessive credit growth, leveraged on a fixed exchange rate scheme. Although the first aid took the form of “emergency loans” by the Central Bank to commercial banks, during the following year conditions deteriorated rapidly enough to lead to the intervention of 11 banking institutions. Another 8 were added in 1983, including the two largest banks in the system. In all, the intervened institutions represented 60% of total credit. All directors and executives of these institutions were, removed from their posts, and replaced by provisional administrators. Measures to fight the crisis aimed at the liquidation of non-viable banking entities, improvement of balance sheets of viable entities through the purchase of deteriorated portfolios, and the reduction of financial burden of bank borrowers through debt reprogramming and preferential exchange rates. In 1985, this extended to the recapitalization of the intervened banks, through the so-called “popular capitalism” program.