Marking to Market: Panacea or Pandora’s Box? Guillaume Plantin Haresh Sapra Hyun Song Shin

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 the 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 (illiquidity, agency problems, etc.) marking to market need not be welfare improving.

“Artificial” Volatility Dual role of market price –Reflection of fundamentals –Influences actions Reliance on market prices distorts market prices Actions Prices

Three Notions of Value Fundamental value v Book value Market price

Fundamental Value v Not contractible But firm has good information on v –v is common knowledge (base case) –v is observed with negligible noise (main model)

Book Value Book value determined by past decisions (exogenous to model) Common knowledge at time of decision Contractible

Market Price Market price Lower ability to extract value Limited absorption capacity

Interpretation of Strategic Effects Marketable assets and possibility of “liquidity holes” Hedging credit risk against spike in spreads –Loan sales –Credit derivatives –“reach for yield”

Horizon Mismatch Manager chooses at date 0 –Sell asset (buy default protection) –Hold asset Aims to maximize date 1 accounting value –depends on accounting regime in place But asset may be long-lived…

Duration of Asset Date 0Date 1Date 2 Sell or hold probability d cash flow v probability 1– d cash flow v

Date 1 Accounting Values (as seen from decision date) HoldSell historical cost mark to market

Historical Cost Regime Sell when v is high relative to –accounting value is excessively conservative Sell when others hold –actions are strategic substitutes –self-stabilising

Mark to Market Regime Sell when v is low relative to –market price is excessively volatile Sell when others sell –actions are strategic complements –multiple equilibria when v is common knowledge

Global Game Firm observes v with small noise Take limit as noise tends to zero Unique equilibrium –Fundamental uncertainty dissipates but strategic uncertainty remains

Shape of Strategic Uncertainty in Global Game Conditional on being at switching point, what is the density of s? Answer: In the limit as noise tends to zero, s is uniformly distributed on [0, 1] –Morris and Shin (2003)

“I am the marginal player. What is the probability that proportion z or less have signal lower than me?” –(i.e.) What is F(z), the value of the cumulative distribution function of s evaluated at z? v x z v*x* F(z) x*v*

Answer: F(z) = z Cumulative distribution function is the identity function So, density over s is uniform

Historical Cost Regime Sell when v is high Hold when v is low Interior solution for intermediate v

Mark to Market Regime Hold when v is high Sell when v is low Unique equilibrium in switching strategies

Equilibrium Date 1 Price

Equilibrium Loss

Effect of Duration

Effect of Illiquidity

Marking to Market is Superior when Asset is Liquid –minimise feedback through strategic complementarity Junior –limited downside potential, large upside (e.g. stocks) Short-lived –minimise effect of horizon mismatch

Damage from Marking to Market is Large when Asset is Illiquid –Stronger strategic effects Senior –limited upwide, large downside (e.g. loans, insurance liabilities) Long-lived –Greater horizon mismatch

Winners and Losers Political Economy of IAS 39 Banks and insurance companies have been the most vocal critics. Institutional investors, securities regulators and auditors have been the most vocal supporters.