Marking-to-Market: Panacea or Pandora’s Box?

Referee Finance Team

Marking-to-Market: Panacea or Pandora’s Box?

Guillaume Plantin, Haresh Sapra, Hyun Song Shin

The choice of a measurement regime for financial institutions is one of the most important and contentious policy issues in the financial services industry. Proponents of marking to market argue that the market value of an asset or liability is more relevant than historical cost because it reflects the amount at which that asset or liability could be bought or sold in a current transaction between willing parties. This system would therefore lead to better insights into the risk profile of firms currently in place so that investors could exercise better market discipline and corrective action on firm’s decisions.

This study has developed a parsimonious model that compares a measurement regime based on past prices (historical cost) with a regime based upon current prices (mark to market). The historical cost regime is inefficient because it ignores price signals. The model centers on the decision of the manager of a bank who aims at maximizing the expected earnings of the bank. In order to maximize the expected earnings of the bank, the manager has to decide whether to securitize a given loan portfolio before the bank’s earnings are reported, or to hold the portfolio in the bank’s balance sheet. The focus of the analysis is on the relationship between the measurement regime and the impact of the feedback loop between decisions and prices. The techniques from the theory of global games are applied to arrive at a unique equilibrium outcome .The global game approach modifies the payoffs by introducing a small noise in the signals received by the agents. The paper discusses whether marking to market leads to the emergence of an additional, endogenous source of volatility that is purely a consequence of the accounting norm, rather than something that reflects the underlying fundamentals. The study further examines whether the issues of measurement have a far-reaching influence on the behavior of financial institutions, and determine to a large extent the efficiency of the price mechanism in guiding real decisions.

The model highlights the interesting interplay between liquidity and the measurement regime The study show that the historical cost regime may dominate the mark to market regime when assets have a long duration, trade in a very illiquid market, or feature an important downside risk The study shows that illiquidity which implies the sensitivity of the price of an asset to the decisions of other financial institutions leads to strategic complementarities that destabilize prices by creating endogenous risk. Marking to market overcomes the price insensitivity by extracting the information conveyed by market prices, but it also distorts this information for illiquid assets such as loans, privately placed bonds and insurance portfolios that trade in illiquid OTC markets.

The study finds that the damage done by marking to market is greatest when claims are (i) long-lived, (ii) illiquid, and (iii) senior. These are precisely the attributes of the key balance sheet items of banks and insurance companies. The results therefore shed light on why banks and insurance companies have been the most vocal opponents of the shift to marking to market.