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
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
Actions
Prices
• Reliance on market prices distorts market
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
Net Worth
Other assets
Mortgage
Financial Intermediaries
Assets
Liabilities
Net Worth
Mortgage
Bonds
Other Assets
Pension Funds
Assets
Liabilities
Bonds
Net Worth
Cash
Pension
Liabilities
Bonds
• Bonds issued by financial intermediaries are
perpetuities
• Price p, yield r
• Duration is
dp / dr

p
p
Pension Liabilities
1  2  3 
duration
Duration of bond
Duration of pension liability
Price of bond
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
duration
of bonds
demand
for 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
v
v
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
h(v)
p(v)
v
Step Adjustment:
Fall in Treasury Yields
p
h(v)
p(v)
p(v)
v
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
Contrast with Historical Cost
Accounting Regime
p
h(v)
p(v)
p(v)
v
Step Adjustment:
Property Price Fall
p
h(v)
p(v)
new equilibrium
v
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
s
s(v)
d(v)
v