BIS Review 28/2010  By acting in this way, marking to market has the potential to serve as an amplifier of stress in the financial system. 19 Other things equal, it could result in sharper and more severe asset price falls than in the past, accompanied by greater institutional stress. It could exaggerate excess volatility and misalignment. Marking to market may not just be a casualty of the failure of EMH; it may also be a cause. Hyun Shin has likened the destabilising dynamics of mark to market to the unstable oscillations of London’s Millennium Bridge at the time it opened. In finance, these adverse dynamics have a much longer historical pedigree. In their classic monetary history of the United States, Friedman and Schwartz assigned mark to market a key role in propagating banking failure during the Great Depression. 20 The evidence of such dynamics during this crisis is more mixed. Some studies have claimed this effect was limited to banks with large trading portfolios; 21 others that it has been significant and wide-ranging across the financial sector. 22 Perhaps the truth lies somewhere in between, with some market and institutions affected and others immune. Chart 8 plots commercial property values in the UK since 1920. There are five discernible boom and bust cycles in commercial property, signified by the dotted lines. Chart 9 looks at the cumulative falls in value during the bust. In four of the cases, the bust was similarly timed and sized.
During this crisis, the precipitate rise in liquidity premia and fall in asset prices may have called into question the viability of many banks had their assets been fair-valued. Consider again the banking book of UK banks on a mark to market basis. Chart 7 shows the loss of value on this book, which would have peaked at over £ billion during the early months of 2009. The total capital resources of UK banks at that time were around £ billion. In other words, the UK banking system in aggregate would have been technically insolvent on a mark to market basis. The recent recovery in asset prices has been almost as remarkable as the preceding fall. It has meant UK banks were back in the black within a matter of months.   “Liquidity and fire-sales”  The act of marking to market may itself have a bearing on asset price dynamics. This arises because of its potential effects on banks’ behaviour. If swings in perceived solvency cause banks to sell assets, these fire-sales may themselves add to downward pressures on asset prices. Under mark to market, these pressures are felt by all institutions, not just the seller. In effect, fire-sales by one firm have negative externalities for all others. And as other banks adjust their own balance sheets in response, there is a risk the downward dynamic is perpetuated. 18  8  Khan (2009).