Valuing Financial Assets with Liquidity Discount: An Implication for Basel III

The unprecedented financial crisis in 2007 and 2008 and the largest bankruptcy in U.S. history prompted expedited regulation in the financial industry. A new Basel Accord has been proposed to further regulate the main risk that caused the crisis: liquidity risk. In a recent article, Chen [2012] presents a liquidity discount model in which financial securities can be evaluated with substantial discounts at the presence of a liquidity squeeze in the marketplace. In this article, we adopt this model to evaluate a selection of the 23 largest U.S. financial institutions (assets over $100 billion) to investigate the liquidity impact during the crisis period. We calibrate the model to market information such as market capitalization and volatility. We find that the model can provide significant predictive power of a bank’s liquidity health.