Empirical evidence suggests that banks hold capital in excess of regulatory minimums. This did not prevent the financial crisis and underlines the importance of understanding bank capital determination. Market discipline is one of the forces that induces banks to hold positive capital. The literature has focused on the liability side. We develop a simple theory based on monitoring to show that discipline from the asset side can also be important. In perfectly competitive markets, banks can find it optimal to use costly capital rather than the interest rate on the loan to commit to monitoring because it allows higher borrower surplus.

When liquidity plays an important role as in financial crises, asset prices may reflect the amount of liquidity available rather than the asset's future earning power. Using market prices to assess financial institutions' solvency in such circumstances is not desirable. We show that a shock in the insurance sector can cause the current market value of banks' assets to fall below their liabilities so they are insolvent. In contrast, if values based on historic cost are used, banks can continue and meet all their future liabilities. We discuss the implications for the debate on mark-to-market versus historic cost accounting.

We develop a simple model of the interbank market where banks trade a long term, safe asset. When there is a lack of opportunities for banks to hedge idiosyncratic and aggregate liquidity shocks, the interbank market is characterized by excessive price volatility. In such a situation, a central bank can implement the constrained efficient allocation by using open market operations to fix the short term interest rate. It can be constrained efficient for banks to hoard liquidity and stop trading with each other if there is sufficient uncertainty about aggregate liquidity demand compared to idiosyncratic liquidity demand. AbstractWe develop a simple model of the interbank market where banks trade a long term, safe asset. When there is a lack of opportunities for banks to hedge idiosyncratic and aggregate liquidity shocks, the interbank market is characterized by excessive price volatility. In such a situation, a central bank can implement the constrained efficient allocation by using open market operations to fix the short term interest rate. It can be constrained efficient for banks to hoard liquidity and stop trading with each other if there is sufficient uncertainty about aggregate liquidity demand compared to idiosyncratic liquidity demand. JEL Codes: E43, E58, G01, G12, G21.

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This paper investigates the African financial development and financial inclusion gaps relative to other peer developing countries. Using a set of variables related to financial development and inclusion, we first estimate the gaps between African countries and other developing countries with similar degrees of economic development. Then, we explore the determinants of financial development and inclusion and find that population density appears to be considerably more important for financial development and inclusion in Africa than elsewhere. We then show evidence that a recent innovation in financial services, mobile banking, has helped to overcome infrastructural problems and improve financial access. JEL CODES: G2; O1; R2.

Some have argued that recent increases in credit risk transfer are desirable because they improve the diversification of risk. Others have suggested that they may be undesirable if they increase the risk of financial crises. Using a model with banking and insurance sectors, we show that credit risk transfer can be beneficial when banks face uniform demand for liquidity. However, when they face idiosyncratic liquidity risk and hedge this risk in an interbank market, credit risk transfer can be detrimental to welfare. It can lead to contagion between the two sectors and increase the risk of crises.

What caused the crisis? Initially many thought that it was due to incentive problems in the U.S. mortgage industry. However, after the large economic meltdown following Lehman Brothers' bankruptcy in September 2008, it seems that much more was going on. We argue that there was a bubble in real estate prices in the United States and a number of other countries. The main causes of the bubble were loose monetary policy, particularly by the United States Federal Reserve, and global imbalances. The combination of cheap credit together with the easy availability of funds contributed to create the bubble. Many other factors such as subprime mortgages, weak regulatory structures, and high leverage in the banking sector exacerbated the effects of the crisis. We consider possible reforms aimed at minimizing the occurrence of future crises in the governance structure of central banks, measures to reduce global imbalances, and changes in banking regulation.

Empirical evidence suggests that banks hold capital in excess of regulatory minimums. This did not prevent the financial crisis and underlines the importance of understanding bank capital determination. Market discipline is one of the forces that induces banks to hold positive capital. The literature has focused on the liability side. We develop a simple theory based on monitoring to show that discipline from the asset side can also be important. In perfectly competitive markets, banks can find it optimal to use costly capital rather than the interest rate on the loan to commit to monitoring because it allows higher borrower surplus.