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Capital quality and the illiquidity premium – The link between the illiquidity premium and capital quality

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Article by Malcolm Kemp – 27 May 2010

Copyright (c) Malcolm Kemp 2010

 

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3.            The link between the illiquidity premium and capital quality

 

The fundamental point that I want to highlight is that any reduction in the value placed on liabilities by incorporation of an illiquidity premium also has a similar dynamic. This arises from the inherent nature of illiquidity. An asset (or liability) is deemed illiquid if it is (or will be) difficult to buy or sell at approximately its (mid) market price in a timely manner. The reduction in liability values arising from incorporation of an illiquidity premium creates a balance sheet effect equivalent to an increase in the entity’s capital base. It can therefore be thought of as a type of ‘capital’. But it is a type of capital that is likely to be less helpful in a gone concern situation than in a going concern one.

 

In a stressed, gone concern, situation, an entity is likely to have lost control of its own destiny. It will, most probably, be forced to liquidate its assets and liabilities quickly or to be an involuntary transferor of them to some centralised protection scheme (or government) that will generally not want to overpay for the assets or to undercharge for the liabilities it is taking over. In short, its liquidation is likely to involve some element of fire-sale, meaning that the entity in question is unlikely to be able to access all (or even, possibly, any) of the capitalised value of future illiquidity premiums that it might otherwise have expected to receive on its illiquid asset and liability portfolio.

 

The implication is that there should be some restriction on the ability of entities to use the ‘asset’ arising from an illiquidity premium to meet its overall capital requirements. For entities with well diversified and robust capital structures, there would be little impact from such a proposal. But for entities where the ‘asset’ concerned formed too large a proportion of the overall capital base the impact would be larger.

 

This, I would argue, merely reflects economic reality. An entity will only in practice be able to benefit fully from the supposed illiquidity premium if it can stay the course over the time-span during which this premium will accrue. To do so, it needs to have access to sufficient sources of capital able to protect it against a gone concern situation. It is these types of situation that are or ought to be the primary focus of regulators, customers and governments (and hence actuaries) when assessing an entity’s overall capital adequacy status.

 


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