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Marking to Market, Liquidity and Financial Stability

Marking to Market, Liquidity and Financial Stability. Guillaume Plantin Haresh Sapra Hyun Song Shin. 12 th International Conference IMES, Bank of Japan May 30-31, 2005. Themes. Mark-to-market accounting impacts on financial stability

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Marking to Market, Liquidity and Financial Stability

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  1. Marking to Market, Liquidity and Financial Stability Guillaume Plantin Haresh Sapra Hyun Song Shin 12th International Conference IMES, Bank of Japan May 30-31, 2005

  2. Themes • Mark-to-market accounting impacts on financial stability • The phenomenon of “reaching for yield” (much discussed at the moment) owes much to marking to market. • Monetary policy has far-reaching implications for financial stability

  3. Case for Marking to Market • Market price reflects current terms of trade between willing parties • Market price gives better indication of current risk profile • Market discipline • Informs investors, better allocation of resources

  4. What about volatility? • If fundamentals are volatile, then so be it. • Market price is volatile… • …but it simply reflects the volatility of the fundamentals

  5. Theory of the Second Best • When there is more than one imperfection in an economy, removing one of them need not improve welfare. • In the presence of other imperfections (agency problems, feedback, etc.) marking to market need not be welfare improving.

  6. Dual Role of Market Prices • Two roles of market price • Reflection of fundamentals • Influences actions • Reliance on market prices distorts market prices Prices Actions

  7. Balance Sheet Propagation • Accounting numbers influence financial institutions’ decisions • They provide certification, and hence provide justifications for actions • Emphasis on management accountability and good corporate governance sharpens these incentives • Marking to market creates externalities in the form of balance sheet spill-over effects

  8. Simplified Financial System Households Financial Intermediaries Pension Funds

  9. Households Assets Liabilities Property Net Worth Mortgage Other assets

  10. Financial Intermediaries Assets Liabilities Mortgage Net Worth Bonds Other Assets

  11. Pension Funds Assets Liabilities Bonds Net Worth Pension Liabilities Cash

  12. Bonds • Bonds issued by financial intermediaries are perpetuities • Price p, yield r • Duration is

  13. Pension Liabilities duration Duration of bond Duration of pension liability Price of bond

  14. Pension Funds • Pension funds are required to mark their liabilities to market (e.g. FRS 17). • Pension funds are required to match duration of liabilities with assets of similar duration

  15. Pension funds’ demand for bonds Price of bonds duration of bonds demand for bonds duration of pension liabilities

  16. Weight of Money into Property • Financial intermediaries accommodate increased demand for bonds by new issues of bonds • Households are always willing to increase borrowing • Increase in balance sheet size of financial intermediaries

  17. Property Market “Cash in the market” pricing (Shapley-Shubik) supply

  18. Property Price as Function of Bond Price p increase bond issue v increase v(p) p

  19. Credit Quality • Credit quality of bonds depends on household net worth v increase + net worth p increase

  20. Bond Price as Function of Property Price p(v) v

  21. h(v) Define h(.)as inverse of v(p) p p(v) v

  22. Step Adjustment:Fall in Treasury Yields h(v) p p(v) p(v) v

  23. Link between Credit SpreadTreasury Yields • As price of risk-free perpetuity increases, the credit quality of bonds improves • link between level of yields and credit spreads • Monetary policy has financial stability implications

  24. Contrast with Historical Cost Accounting Regime p h(v) p(v) p(v) v

  25. Step Adjustment:Property Price Fall h(v) p p(v) new equilibrium v

  26. Property as Sole Real Asset • In this simplified model, the only asset propping up the financial system is property • Property price can be rationalised in terms of present value of future housing services • But “housing service” is not fungible. • It cannot be used to meet mortgage liabilities

  27. Channels of Contagion The main channel of propagation is change in asset prices (property, bond) Even without “domino effect” of defaults contagion can be potent (Cf. European insurers, summer 2002) Counterparty risk will reinforce the price effects

  28. s s(v) d(v) v

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