17 Nov 2010
Marking-to-market banks by Dr Alex Pilato
When only part of a balance sheet is marked-to-market and the other is not, not only an entity (bank or corporate or pension fund) will have two fundamentally different and incompatible risk measures, but it will also create a gigantic liquidity exposure. Any market disturbance could result in financial failure even though the entity could well be economically solvent.
Hence there is a fundamental difficulty in managing cash flows-at-risk when combined with values-at-risk. Banks tried to do it and failed. Banks are a source of systemic risk, end users are not. So the authorities will increase financial stability through simplifying risk management at banks by forcing them to mark-to-market their entire balance sheet (i.e. no exceptions!). Marking to market end users (e.g. either by forcing them to go through central clearing counterparties or indirectly by forcing banks trading with end users to require cash collateral) will only result in the end users having to cope with the complex management of cash flows-at-risk combined with values-at-risk (as banks do) and will do nothing to reduce systemic risk (on the contrary) because they were never the source of it.
A marked-to-market banking system combined with a more developed end user to end user OTC market that does not rely on the banking system for liquidity should provide greater financial stability.