Financial System Liquidity, Asset Prices and Monetary Policy

1
Financial System Liquidity,Asset Prices and
Monetary Policy

• Hyun Song Shin
• 2005 Reserve Bank of Australia conference
• July 11-12, 2005

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Background

• Monetary policy works through financial markets
• Seen through lens of IS curve
• Central bank controls directly only overnight
  rate
• But can influence long rates through expectations
  of future path for short rates
• Affects consumption, investment...

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Tinbergen-style Separation

• Price/output stabilisation
• Monetary policy
• Financial stability
• Prudential/supervisory policies

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Tinbergen-style Separation

• Price/output stabilisation
• Monetary policy
• Financial stability
• Prudential/supervisory policies

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Tinbergen-style Separation

• Price/output stabilisation
• Monetary policy
• Price/output stabilisation
• Prudential/supervisory policies

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Unwinding Financial Excess

• Output costs of financial crises
• Fiscal costs of financial sector restructuring
• Asymmetry of mechanisms
• on the way up
• on the way down

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Asset prices
Debt
Monetary Policy
Balance sheet strength
Spreads
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Pricing claims in a system setting

• Some assets (e.g. loans) are claims on other
  parties
• Value of my claim against A depends on value of
  As claims against B, C,...
• But B or C may have claim against me

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Price of Debt/Claim
price of debt
face value
assets
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System
Or, more simply
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Pricing claims

• Tarskis fixed point theorem increasing
  function on complete lattice has largest and
  smallest fixed point.
• ensures uniqueness

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Indebtedness and Spreads

• Suppose affects
• Spread can fall as debt rises
• De-leveraging can lead to rise in spreads

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Feedback

• Balance sheet strength determines lending capacity

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Feedback
Stronger balance sheets
Increased debt
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Simplified Financial System
Young Households
Old Households
Banks
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Young Households Balance Sheet
Assets
Liabilities
Net worth
Property
Mortgage
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Banks Balance Sheet
Assets
Liabilities
Net Worth
Mortgage
Deposits
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Old Households Balance Sheet
Assets
Liabilities
Deposits
Net worth
Property
Equity
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Duration of Assets and Liabilities
Value
Mortgage Value
Deposit Value
Treasury Prices
loose monetary policy
tight monetary policy
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Property Price
Property Price
Supply of property from old
property stock held by young
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Property Price as Function of Mortgage Price
Property price, v
Mortgage price p
Bank lending
Banks net worth
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Mortgage Price as Function of Property Price
p(v)
v
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• Define h(.) as inverse of v(p)

h(v)
p
p(v)
v
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Step AdjustmentFall in Treasury Yields
h(v)
p
p(v)
p(v)
v
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Another Scenario...
Households
Fannie Mae
Pension Funds
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Households
Assets
Liabilities
Property
Net Worth
Mortgage
Other assets
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Fannie Mae
Assets
Liabilities
Mortgage
Net Worth
Bonds
Other Assets
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Pension Funds
Assets
Liabilities
Bonds
Net Worth
Pension Liabilities
Cash
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Bonds

• Bonds issued by Fannie Mae are perpetuities
• Price p, yield r
• Duration is

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Pension Liabilities
duration
Duration of bond
Duration of pension liability
Price of bond
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Pension Funds

• Pension funds mark their liabilities to market
• Pension funds match duration of liabilities with
  assets of similar duration

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Pension funds demand for bonds
Price of bonds
duration of bonds
demand for bonds
duration of pension liabilities
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Weight of Money into Property

• Fannie Mae accommodates increased demand for
  bonds by new issues of bonds
• Cash proceeds lent out to households
• Money flows into property sector
• Property price rises...

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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)

h(v)
p
p(v)
v
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Step AdjustmentFall in Treasury Yields
h(v)
p
p(v)
p(v)
v
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Nature of Property Wealth
Property Price
Supply of property from old
property stock held by young
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Nature of Property Wealth

• Is housing net wealth?
• Suppose increased debt reduction in
  spreads
• How is this possible without increase in net
  wealth?
• Culprit is marking to market

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Reversal

• New mechanisms on the way down
• Asymmetric nature of debt
• Easy to build up
• Not so easy to extinguish
• Importance of bankruptcy regime (Cf. Hong Kong)

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Scenario

• Suppose defaulting borrowers can return the keys
  and walk away...
• Banks hold property directly
• Banks mark property to market

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Bank Balance Sheet
Assets
Liabilities
Deposits
Property
Other assets
Net Worth
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Capital Adequacy Ratio
top net worth
bottom marked-to-market assets, after
s sale of property
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Sales function s(p)

• When capital adequacy constraint binds, bank i
  sells property

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s
New equilibrium
s(v)
d(v)
v
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What has changed?
Short term incentives
Stronger balance sheets
Increased debt
Marking to market
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Changing Nature of Monetary Policy

• Monetary policy works by manipulating asset
  prices
• Repercussions for wider financial system
• Is the IS view of monetary policy sufficient?
• Financial stability is also about output/price
  stabilisation
• Costs of getting it wrong are large