The traditional approach to the central bank's lender of last resort function emphasizes the trade-off between being too ‘tough’, and thus increasing the likelihood that the failure of a single bank hampers the confidence in the whole banking system, and being too ‘soft’, thereby creating incentives for banks to take on excessive risk. In contrast with this view, we show that a central bank, by announcing and committing ex-ante to bail out insolvent institutions in times of adverse macroeconomic conditions, can create a risk-reducing ‘value effect’ that outweighs the moral hazard component of the policy, and thus lowers bank risk.

I demonstrate that ratings-based capital rules, including both the current Basel Accord and its proposed revision, can be reconciled with the general class of credit value-at-risk models. Each exposure's contribution to VaR is portfolio-invariant only if (a) dependence across exposures is driven by a single systematic risk factor, and (b) no exposure accounts for more than an arbitrarily small share of total portfolio exposure. Analysis of rates of convergence to asymptotic VaR leads to a simple and accurate portfolio-level add-on charge for undiversified idiosyncratic risk. There is no similarly simple way to address violation of the single factor assumption.

We investigate the effects of technological change, deregulation, and dynamic changes in competition on the performance of US banks. Our most striking result is that during 1991–1997, cost productivity worsened while profit productivity improved substantially, particularly for banks engaging in mergers. The data are consistent with the hypothesis that banks tried to maximize profits by raising revenues as well as reducing costs. Banks appeared to provide additional or higher quality services that raised costs but also raised revenues by more than the cost increases. The results suggest that methods that exclude revenues when assessing performance may be misleading.

There is considerable heterogeneity in the development of derivatives markets in different countries. The question is: why? This paper addresses this question in the context of major derivatives markets in Latin America. The largest derivatives exchanges in Latin America are located in Argentina, Brazil, and Mexico. In addition, over-the-counter (OTC) markets exist in Chile and Peru. Excluding Peru, Chile's derivatives market is to date the least developed. We show that this is due to regulatory constrains and illiquidity. Domestic transactions are OTC, and consist mostly of exchange rate forwards. Recent changes in the Central Bank of Chile's exchange rate policy have not had a considerable impact on the aggregate trading volume of forwards. However, amendments made to the Law of Capital Markets in 2001 bring the possibility of having a more developed derivatives market in the future

What are the causes and consequences of commonality in liquidity? We examine this issue using a model of liquidity trading in which liquidity shocks are decomposed into common (systematic) and idiosyncratic components. We show that common liquidity shocks do not give rise to commonality in trading volume. Indeed, trading volume is independent of systematic liquidity risk, and this risk is always priced irrespective of market liquidity. In contrast, idiosyncratic liquidity shocks create liquidity demand and volume, and investors can diversify their risk by trading. Hence, pricing of the risk of idiosyncratic liquidity shocks depends on market liquidity, with idiosyncratic liquidity risk being fully priced only in perfectly illiquid markets. While trading volume increases with the variance of idiosyncratic liquidity shocks, price volatility increases with the variance of both idiosyncratic and systematic liquidity shocks. Surprisingly, our results are largely independent of the number of different securities traded in the market. When asset returns are uncorrelated, there is no transmission of liquidity across assets even when investors experience common liquidity shocks, suggesting that such liquidity shocks may not be the source of commonality in liquidity across assets detected in the literature. However, under limited conditions, more liquid securities can act as substitutes for less liquid securities. Overall, our findings suggest that common factors in liquidity may be the outcome of covariation in investor heterogeneity (e.g., as measured by co-movements in the volatility of idiosyncratic liquidity shocks) rather than of common liquidity shocks. Moreover, we find that different liquidity proxies measure different things, which has implications for future empirical analysis.

There is considerable heterogeneity in the development of derivatives markets in different countries. The question is: why? This paper addresses this question in the context of major derivatives markets in Latin America. The largest derivatives exchanges in Latin America are located in Argentina, Brazil, and Mexico. In addition, over-the-counter (OTC) markets exist in Chile and Peru. Excluding Peru, Chile's derivatives market is to date the least developed. We show that this is due to regulatory constrains and illiquidity. Domestic transactions are OTC, and consist mostly of exchange rate forwards. Recent changes in the Central Bank of Chile's exchange rate policy have not had a considerable impact on the aggregate trading volume of forwards. However, amendments made to the Law of Capital Markets in 2001 bring the possibility of having a more developed derivatives market in the future