DEFINITION OF ‘LIQUIDATION DIFFERENTIAL’
The loss in value of an asset after it has been placed in receivership or liquidation. The liquidation differential represents an additional loss a failed asset would experience, and is related to the information cost that parties interested in purchasing the assets of a failed bank would face when researching the asset.
INVESTOPEDIA EXPLAINS ‘LIQUIDATION DIFFERENTIAL’
Investors are a skeptical lot when it comes to buying and selling assets, and this is especially the case when the asset is being held by a bank that went bust. The Federal Deposit Insurance Corporation, or FDIC, faced a daunting task in the 1980s and early 1990s. A number of financial institutions had failed, and these assets were put in the hands of the FDIC. When determining how to dispose of these assets, the FDIC has to consider different methods and strategies it could use when liquidating assets that it did not sell during the resolution process.
The FDIC noted that assets from failed banks took a hit after the asset was placed in receivership. The estimate was that any party interested in purchasing the asset was more skeptical because the previous owner collapsed, that the potential owner needed to conduct substantial due diligence in order to ensure that the asset was properly evaluated (referred to as the “information cost”), and that the assets had a stigma attached to them. Parties interested in purchasing these assets from receivers knew that they were in a powerful position because the receivers wanted to wind down the failed financial institution as quickly and painlessly as possible. The cost of receivership, including legal fees and operational costs, further increased the liquidation differential.
Receivership organizations, especially those operated by the government, also want to make sure that the assets of failed banks are resolved as quickly as possible in order to minimize the disruption to local communities. This is especially important when small communities lose their banks, since they may not have another option when it comes to obtaining loans and depositing savings.