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Marking to Market, Liquidity and Financial Stability
Guillaume PlantinHaresh Sapra
Hyun Song Shin
12th International ConferenceIMES, Bank of Japan
May 30-31, 2005
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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
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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
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What about volatility?
• If fundamentals are volatile, then so be it.
– Market price is volatile…
– …but it simply reflects the volatility of the fundamentals
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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.
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Dual Role of Market Prices
• Two roles of market price– Reflection of fundamentals – Influences actions
• Reliance on market prices distorts market prices
Actions Prices
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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
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Simplified Financial System
Households
Financial Intermediaries
Pension Funds
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Households
Assets Liabilities
Property
Other assets
Net Worth
Mortgage
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Financial Intermediaries
Assets Liabilities
Mortgage
Other Assets
Net Worth
Bonds
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Pension Funds
Assets Liabilities
Bonds
Cash
Net Worth
PensionLiabilities
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Bonds
• Bonds issued by financial intermediaries are perpetuities
• Price p, yield r
• Duration is/dp dr
pp
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Pension Liabilities
1 2 3
Duration of bond
Duration of pension liability
Price of bond
duration
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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
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Pension funds’ demand for bonds
Price of bonds
demandfor bonds
durationof bonds
duration of pension liabilities
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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
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Property Market
“Cash in the market” pricing (Shapley-Shubik)
supply
vv
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Property Price as Function of Bond Price
p increase bond issue v increase
v(p)
p
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Credit Quality
• Credit quality of bonds depends on household net worth
v increase + net worth p increase
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Bond Price as Function of Property Price
p(v)
v
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Define h(.) as inverse of v(p)
p
v
h(v)
p(v)
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Step Adjustment:Fall in Treasury Yields
p
v
h(v)
p(v)
p(v)
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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
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Contrast with Historical Cost Accounting Regime
p
v
h(v)
p(v)
p(v)
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Step Adjustment:Property Price Fall
p
v
h(v)
p(v)
new equilibrium
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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
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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
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v
s
s(v)
d(v)