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
