1. Financial System Liquidity, Asset Prices and Monetary Policy Hyun Song Shin 2005 Reserve Bank of Australia conference July 11-12, 2005

2. 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...

3. Tinbergen-style Separation Price/output stabilisation –Monetary policy Financial stability –Prudential/supervisory policies

4. Tinbergen-style Separation Price/output stabilisation –Monetary policy Financial stability –Prudential/supervisory policies

5. Tinbergen-style Separation Price/output stabilisation –Monetary policy Price/output stabilisation –Prudential/supervisory policies

6. 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”

7. Asset prices Debt Spreads Balance sheet strength Monetary Policy

8. 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

9. Price of Debt/Claim face value price of debt assets

10. System Or, more simply

11. Pricing claims Tarski’s fixed point theorem: increasing function on complete lattice has largest and smallest fixed point. ensures uniqueness

12. Indebtedness and Spreads Suppose affects –Spread can fall as debt rises –De-leveraging can lead to rise in spreads

13. Feedback Balance sheet strength determines lending capacity

14. Feedback Stronger balance sheets Increased debt

15. Simplified Financial System Young HouseholdsOld Households Banks

16. Young Households’ Balance Sheet AssetsLiabilities Mortgage Property Net worth

17. Banks’ Balance Sheet AssetsLiabilities Net Worth Deposits Mortgage

18. Old Households’ Balance Sheet AssetsLiabilities Net worth Deposits Property Equity

19. Duration of Assets and Liabilities Treasury Prices Value Deposit Value Mortgage Value loose monetary policy tight monetary policy

20. Property Price Property Price Supply of property from old property stock held by young

21. Property Price as Function of Mortgage Price Property price, v Mortgage price p Bank lending Banks’ net worth

22. Mortgage Price as Function of Property Price p(v)p(v) v

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

24. Step Adjustment: Fall in Treasury Yields p v h(v)h(v) p(v)p(v) p(v)p(v)

25. Another Scenario... Households Fannie Mae Pension Funds

26. Households Assets Liabilities Property Other assets Net Worth Mortgage

27. Fannie Mae Assets Liabilities Mortgage Other Assets Net Worth Bonds

28. Pension Funds Assets Liabilities Bonds Cash Net Worth Pension Liabilities

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

30. Pension Liabilities Duration of bond Duration of pension liability Price of bond duration

31. Pension Funds Pension funds mark their liabilities to market Pension funds match duration of liabilities with assets of similar duration

32. Pension funds’ demand for bonds Price of bonds demand for bonds duration of bonds duration of pension liabilities

33. 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...

34. Property Price as Function of Bond Price p increase bond issue v increase v(p)v(p) p

35. Credit Quality Credit quality of bonds depends on household net worth v increase + net worth p increase

36. Bond Price as Function of Property Price p(v)p(v) v

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

38. Step Adjustment: Fall in Treasury Yields p v h(v)h(v) p(v)p(v) p(v)p(v)

39. Nature of Property Wealth Property Price Supply of property from old property stock held by young

40. 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

41. 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)

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

43. Bank Balance Sheet AssetsLiabilities Net Worth DepositsProperty Other assets

44. Capital Adequacy Ratio top: net worth bottom: marked-to-market assets, after s sale of property

45. Sales function s(p) When capital adequacy constraint binds, bank i sells property

46. v s s(v)s(v) d(v)d(v) New equilibrium

47. What has changed? Stronger balance sheets Increased debt Short term incentives Marking to market

48. 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