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Valuation of Illiquid Assets on Bank Balance Sheets

Nauta, Bert-Jan (2013): Valuation of Illiquid Assets on Bank Balance Sheets.

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Abstract

Most of the assets on the balance sheet of typical banks are illiquid. This exposes banks to liquidity risk, which is one of the key risks for banks. Since the value of assets is determined by their risks, liquidity risk should be included in valuation. This paper develops a valuation framework for liquidity risk. It is argued that the liquidity risk that illiquid assets on bank balance sheets are exposed to, is the risk of being liquidated at a discount in a liquidity stress event (LSE). This may be contrasted to extensions of CAPM including liquidity risk, where liquidity risk is considered to be the risk of changes in liquidity of a security. The main result is that the discount rate used for valuation includes a liquidity spread that is composed of three factors: 1. the probability of an LSE, 2. the severity of an LSE, and 3. the liquidation value of the asset.

The liquidity risk of a bank is determined mainly by its funding composition. An interesting connection to funds transfer pricing and funding valuation adjustment exists for a special bank balance sheet where the income from liquidity spreads and the costs of funding are equal. In particular, in this case the valuation adjustment due to liquidity risk is proportional to liquidity of the asset and the funding valuation adjustment.

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