Financial safety nets and incentive structures in Latin America

The literature on safety nets has become technically more precise by drawing on advances in contract theory and optimal governance structure. This paper begins with a treatment of some aspects of the theory. The author's approach draws more on institutional economics, and more precisely on the approach taken by Kindleberger (1978), in the sense that he believes the design of good financial safety nets for Latin America depends upon an understanding of the way that formal ex-ante safety nets have broken down during times of crisis over the past one hundred years. In this paper then author explores issues surrounding safety nets for financial systems in small open economies like those in Latin America. The starting point in Section 2 is the idea that asymmetric information will generally restrict the scope for lending to potential borrowers. Section 3 shows that government regulation of financial intermediaries can frequently lower the cost of lending. Section 4 discusses the creation of central banks in Latin America in the 1920s as an innovation to promote financial deepening. Section 5 shows that the extension of the safety net to depositors is a relatively new and untested development. Section 6 concludes with a discussion of the design of safety nets that takes into account the principles developed in the paper.