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  • Writer's pictureWilliam Webster

Valuations


Asset valuation is of major importance to banks. It is required for a host of reasons including statutory reporting, credit exposures, liquidity, capital and P&L. However firms often get different results. The magnitude of which may be trivial or material. Subjectivity is often to blame. You would expect that for liquid assets such conjecture would be minimal. For example valuing on-the-run G7 debt isn’t complex is it? Other than bid-offer spreads and the time of day it is done what more is there to discuss? But there is a complication – liquidity. In today’s market we have been lulled (partly by regulation) to assume that government debt is always liquid. What seems to be missing is the question concerning how much selling volume the bond market can absorb on a bad day. Given market makers have largely disappeared probably not much as we might expect. In the past I would have thought that quoted market prices were the best measure of value. But today government debt has ballooned and banks’ trading books are stifled. It therefore seems that bond markets are an accident in the making. Perhaps for the buy and hold investor the potential price volatility is of less a concern. Whilst it may be painful to watch prices falling, coupons and principle will be received (unless there is default). However those reliant on converting bonds to cash at any given instant may get a nasty surprise. Structural changes have magnified potential price volatility. The only way out is for central banks to “sit on the bid”. Aka support the market. Their willingness and ability to participate to the required extent is unknown. The simple conclusion is that even for prime quality assets if you need to liquidate in a hurry current market prices are not necessarily good indicators of what you will get. In other words cash is king.

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