Financial System Liquidity,Asset Prices and Monetary Policy

Hyun Song Shin

2005 Reserve Bank of Australia conference

July 11-12, 2005

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...

Tinbergen-style Separation

• Price/output stabilisation– Monetary policy

• Financial stability– Prudential/supervisory policies

Tinbergen-style Separation

• Price/output stabilisation– Monetary policy

• Financial stability– Prudential/supervisory policies

Tinbergen-style Separation

• Price/output stabilisation– Monetary policy

• Price/output stabilisation– Prudential/supervisory policies

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”

Asset prices Debt

SpreadsBalance sheetstrength

Monetary Policy

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

Price of Debt/Claim

face value

ix

price of debt

assets

iaix

, ,i i i ix f x a x v

ix

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

Pricing claims

• Tarski’s fixed point theorem: increasing function on complete lattice has largest and smallest fixed point.

• ensures uniqueness0 / 1i idf da

Indebtedness and Spreads

xx

v

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

x v

Feedback

xx

v

• Balance sheet strength determines lending capacity

Feedback

x xStrongerbalance sheets

Increaseddebt

Simplified Financial System

Young Households Old Households

Banks

Young Households’ Balance Sheet

Assets Liabilities

MortgageProperty

Net worth

Banks’ Balance Sheet

Assets Liabilities

Net Worth

Deposits

Mortgage

Old Households’ Balance Sheet

Assets Liabilities

Net worth

Deposits

Property

Equity

Duration of Assets and Liabilities

TreasuryPrices

Value

DepositValue

MortgageValue

loose monetary policy

tight monetary policy

Property Price

Property Price Supply

of propertyfrom old

property stockheld by young

v

v

Property Price as Function of Mortgage Price

Property price, v

Mortgage pricep

Bank lending

Banks’ net worth

v p

Mortgage Price as Function of Property Price

p(v)

v

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

p

v

h(v)

p(v)

Step Adjustment:Fall in Treasury Yields

p

v

h(v)

p(v)

p(v)

Another Scenario...

Households

Fannie Mae Pension Funds

Households

Assets Liabilities

Property

Other assets

Net Worth

Mortgage

Fannie Mae

Assets Liabilities

Mortgage

Other Assets

Net Worth

Bonds

Pension Funds

Assets Liabilities

Bonds

Cash

Net Worth

PensionLiabilities

Bonds

• Bonds issued by Fannie Mae are perpetuities

• Price p, yield r

• Duration is/dp dr

pp

Pension Liabilities

1 2 3

Duration of bond

Duration of pension liability

Price of bond

duration

Pension Funds

• Pension funds mark their liabilities to market

• Pension funds match duration of liabilities with assets of similar duration

Pension funds’ demand for bonds

Price of bonds

demandfor bonds

durationof bonds

duration of pension liabilities

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...

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

v

h(v)

p(v)

Step Adjustment:Fall in Treasury Yields

p

v

h(v)

p(v)

p(v)

Nature of Property Wealth

Property Price Supply

of propertyfrom old

property stockheld by young

v

v

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

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)

Scenario

• Suppose defaulting borrowers can return the keys and walk away...

– Banks hold property directly

– Banks mark property to market

Bank Balance Sheet

Assets Liabilities

Net Worth

DepositsProperty

Other assets

Capital Adequacy Ratio

*i i

i i

pe Dr

p e s

top: net worthbottom: marked-to-market assets, after

s sale of property

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

v

s

s(v)

d(v)

New equilibrium

What has changed?

x xStrongerbalance sheets

Increaseddebt

Short term incentives

Marking to market

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