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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 a typical bank are illiquid. This exposes the bank 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 their valuation. Although in the literature models have been developed to include liquidity risk in the pricing of traded assets, these techniques do not easily extend to truly illiquid or non-traded assets. This paper develops a valuation framework for liquidity risk for these illiquid assets. Liquidity risk for illiquid assets is identified as the risk of being liquidated at a discount in a liquidity stress event (LSE). Whether or not an asset is liquidated depends on the liquidation strategy of the bank. The appropriate strategy for valuation purposes is shown to be a pro rata liquidation. 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.

As an example the model is applied to the balance sheets of Barclays and UBS. It is noted that for both banks the compensation required for liquidity risk forms a significant part, approx. 15%, of their net operating income.

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