I played around a bit with this setting combined with debug flag which emits debug traces and this feature appears to be quite useful:
The files option creates individual files for all the encoding so you have a file for 1252, 932, normalization etc.
And the best part: Based on the traces it does lazy load the folder so it will only load the encodings that are requested - no huge shift-jis in memory when only western europe is used. This can easily safe a 1 MB of RAM on low mem devices like the Wii :).