The goal of this paper is to study the relationship between liquidity in asset markets and economic fundamentals. To do so, we consider a setting in which firms have private information regarding the quality of their investment opportunities, which they must fund by issuing assets in financial markets. In this context, liquidity is defined as the ease of translating the future values of assets into current market prices. An illiquid economy is thus characterized by the fact that available assets are mispriced, in the sense that their price differs from the discounted value of the payments that they entail.
The main lesson that emerges from this perspective is that assets in the economy should not be assumed to be liquid or illiquid per se. Instead, the extent to which asset markets are liquid is determined in equilibrium by the leverage decisions of firms, which are in turn affected by the presence of asymmetric information and the underlying economic fundamentals. Lack of liquidity is therefore an equilibrium result that may not must appear.
The New Basel Accord will allow internationally active banking organizations to calculate their credit risk capital requirements using an internal ratings based (IRB) approach, subject to supervisory review. One of the modeling components is loss given default (LGD), the credit loss incurred if an obligor of the bank defaults. The flexibility to determine LGD values tailored to a bank’s portfolio will likely be a motivation for a bank to want to move from the foundation to the advanced IRB approach. The appropriate degree of flexibility depends, of course, on what a bank knows about LGD broadly and about differentiated LGDs in particular; consequently supervisors must be able to evaluate “what a bank knows.” The key issues around LGD are: 1) What does LGD mean and what is its role in IRB? 2) How is LGD defined and measured? 3) What drives differences in LGD? 4) What approaches can be taken to model or estimate LGD? By surveying the academic and practitioner literature, with supportive examples and illustrations from public data sources, this paper is designed to provides basic answers to these questions. The factors which drive significant differences in LGD include place in the capital structure, presence and quality of collateral, industry and timing of the business cycle.
The New Basel Accord, expected to be implemented at year-end 2006, will require internationally active banks to use more risk sensitive methods for calculating credit risk capital requirements (Pillar 1 of the New Basel Capital Accord, or “Basel 2”). This paper discusses a key technical component of the Accord, “loss given default” (LGD) for corporate exposures.
Basu (1997) defines conservatism as the accountant’s tendency to require a higher degree of verification for recognizing good news in earnings than for bad news. Since annual unexpected returns capture news arrival during the year, this definition has implications for the earnings-return relation. In a regression of annual earnings on returns, Basu (1997) predicts and finds that earnings respond more to negative returns (bad news) than positive returns (good news). He calls this differential response the asymmetric timeliness of earnings and uses it as a measure of conservatism.
Since Basu (1997), a significant number of studies use his asymmetric timeliness of earnings conservatism measure. Many of those studies use this Basu measure exclusively, rather than using a variety of conservatism measures. Prominent examples are Ball, Kothari and Robin (2000), Ball Robin and Wu (2003) and Pope and Walker (1999), all of which study differences in conservatism across countries. Other studies use a variety of conservatism measures. For example, Givoly and Hayn (2000) use the Basu and other measures to draw conclusions on trends in conservatism through time. Studies using multiple measures tend to generate consistent results across measures (see Watts, 2003b).
