Knowledge that Transforms

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.

Using a unique set of banking data containing both originally-reported and subsequently-revised financial variables, we study accounting restatements. Our results indicate the worse a bank's financial condition, the more likely it is for originally-reported data to understate financial losses. Also, we find supervisory exams have an important role in uncovering financial problems and prompting accounting restatements to correct loss underreporting. While revisions are directly related to financial difficulties, exam-based restatements are evident at even the earliest stages of deterioration, indicating substantial accounting misstatements—at both banks and other types of companies—can occur well outside severe business circumstances.

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.