Price Discovery and Accounting Under Stress

52 Pages Posted: 19 Feb 2016 Last revised: 15 Jul 2016

See all articles by Amir Amel-Zadeh

Amir Amel-Zadeh

University of Oxford - Said Business School

Dai Li

University of Cambridge - Judge Business School

Date Written: July 14, 2016

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

Suggested Citation

Amel-Zadeh, Amir and Li, Dai, Price Discovery and Accounting Under Stress (July 14, 2016). Available at SSRN: https://ssrn.com/abstract=2733944 or http://dx.doi.org/10.2139/ssrn.2733944

Amir Amel-Zadeh (Contact Author)

University of Oxford - Said Business School ( email )

Park End Street
Oxford, OX1 1HP
Great Britain

Dai Li

University of Cambridge - Judge Business School ( email )

Trumpington Street
Cambridge, CB2 1AG
United Kingdom

Register to save articles to
your library

Register

Paper statistics

Downloads
87
Abstract Views
633
rank
295,196
PlumX Metrics