Discounting Cashflows from Illiquid Assets on Bank Balance Sheets

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. An important element of the framework is the definition and derivation of an optimal admissible liquidation strategy that describes the assets a bank will liquidate in case of a liquidity stress event (LSE). The main result is that the discount rate includes a liquidity spread that is composed of three elements: 1. the probability of an LSE, 2. the severity of an LSE, and 3. the liquidation value of the asset. The framework is illustrated by application to a stylized bank balance sheet.