Marking to Market, Liquidity and Financial Stability

Guillaume PlantinHaresh Sapra

Hyun Song Shin

12th International ConferenceIMES, Bank of Japan

May 30-31, 2005

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

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

What about volatility?

• If fundamentals are volatile, then so be it.

– Market price is volatile…

– …but it simply reflects the volatility of the fundamentals

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.

Dual Role of Market Prices

• Two roles of market price– Reflection of fundamentals – Influences actions

• Reliance on market prices distorts market prices

Actions Prices

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

Simplified Financial System

Households

Financial Intermediaries

Pension Funds

Households

Assets Liabilities

Property

Other assets

Net Worth

Mortgage

Financial Intermediaries

Assets Liabilities

Mortgage

Other Assets

Net Worth

Bonds

Pension Funds

Assets Liabilities

Bonds

Cash

Net Worth

PensionLiabilities

Bonds

• Bonds issued by financial intermediaries are perpetuities

• Price p, yield r

• Duration is/dp dr

pp

Pension Liabilities

1 2 3

Duration of bond

Duration of pension liability

Price of bond

duration

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

Pension funds’ demand for bonds

Price of bonds

demandfor bonds

durationof bonds

duration of pension liabilities

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

Property Market

“Cash in the market” pricing (Shapley-Shubik)

supply

vv

Property Price as Function of Bond Price

p increase bond issue v increase

v(p)

p

Credit Quality

• Credit quality of bonds depends on household net worth

v increase + net worth p increase

Bond Price as Function of Property Price

p(v)

v

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

p

v

h(v)

p(v)

Step Adjustment:Fall in Treasury Yields

p

v

h(v)

p(v)

p(v)

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

Contrast with Historical Cost Accounting Regime

p

v

h(v)

p(v)

p(v)

Step Adjustment:Property Price Fall

p

v

h(v)

p(v)

new equilibrium

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

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

v

s

s(v)

d(v)