Financial System Liquidity, Asset Prices and Monetary Policy
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Transcript of Financial System Liquidity, Asset Prices and Monetary Policy
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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
SpreadsBalance sheetstrength
Monetary Policy
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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 A’s claims against B, C,...
• But B or C may have claim against me
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Price of Debt/Claim
face value
ix
price of debt
assets
iaix
, ,i i i ix f x a x v
ix
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System
1 1 1 1
2 2 2 2
, ,
, ,
, ,
; ,
n n n n
x f x a x v
x f x a x v
x f x a x v
x F x x v
Or, more simply
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Pricing claims
• Tarski’s fixed point theorem: increasing function on complete lattice has largest and smallest fixed point.
• ensures uniqueness0 / 1i idf da
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Indebtedness and Spreads
xx
v
• Suppose affects – Spread can fall as debt rises – De-leveraging can lead to rise in spreads
x v
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Feedback
xx
v
• Balance sheet strength determines lending capacity
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Feedback
x xStrongerbalance sheets
Increaseddebt
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Simplified Financial System
Young Households Old Households
Banks
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Young Households’ Balance Sheet
Assets Liabilities
MortgageProperty
Net worth
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Banks’ Balance Sheet
Assets Liabilities
Net Worth
Deposits
Mortgage
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Old Households’ Balance Sheet
Assets Liabilities
Net worth
Deposits
Property
Equity
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Duration of Assets and Liabilities
TreasuryPrices
Value
DepositValue
MortgageValue
loose monetary policy
tight monetary policy
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Property Price
Property Price Supply
of propertyfrom old
property stockheld by young
v
v
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Property Price as Function of Mortgage Price
Property price, v
Mortgage pricep
Bank lending
Banks’ net worth
v p
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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)
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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Another Scenario...
Households
Fannie Mae Pension Funds
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Households
Assets Liabilities
Property
Other assets
Net Worth
Mortgage
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Fannie Mae
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 Fannie Mae 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 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
demandfor bonds
durationof 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)
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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Nature of Property Wealth
Property Price Supply
of propertyfrom old
property stockheld by young
v
v
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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
Net Worth
DepositsProperty
Other assets
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Capital Adequacy Ratio
*i i
i i
pe Dr
p e s
top: net worthbottom: 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
*
*
1min ,
i i
i i
ii
r pe Ds p e
r p
s p s p
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v
s
s(v)
d(v)
New equilibrium
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What has changed?
x xStrongerbalance sheets
Increaseddebt
Short term incentives
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