1. 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

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 Actions Prices

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 Other assets Net Worth Mortgage

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

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

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

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

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 demand for bonds duration of 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)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)p(v) v

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

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

23. Link between Credit Spread Treasury 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 v h(v)h(v) p(v)p(v) p(v)p(v)

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

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