Price Discovery and Accounting Under Stress

Abstract

We develop a general equilibrium model to investigate the adverse effects of liquidity risk on price discovery and to examine the interaction of (externally or internally imposed) solvency requirements for financial institutions with the accounting measurement for financial assets in markets under stress. The model develops liquidity demand and supply curves generating two types of general equilibria: liquid and illiquid. We then investigate the adverse feedback effects in the illiquid equilibrium in response to banks selling risky assets to satisfy solvency requirements. Our model captures negative externalities of other banks responding to a liquidity shock with precautionary hoarding and predicts that the potential of bank runs reduces the motivation to hoard. Model results further suggest that applying mark-to-market accounting in the illiquid equilibrium can lead to loss spirals transforming a bank’s illiquidity problem to one of insolvency. We discuss several policy implications for the role of fair value accounting in linking liquidity and solvency problems of banks during times of market stress.

Keywords: Liquidity risk, mark-to-market, fair value accounting, general equilibrium, financial institutions, bankcuptcy

JEL Classification: D58; D62; G21; G24; G28; G33; M41