Remember the Difference Between Solvency and Liquidity

Liquidity can be thought of as going shopping without your wallet. No cash means no purchases. As long as you can go home or to an ATM to get cash you are only in a problem constrained by liquidity. Think of taking money out of your checking account as “liquifying” your assets.

Banks conversely sit on tons of financial assets. Unlike your checking account not all those assets are cash. When bank customers ask for a lot of cash, and the bank does not have or cannot borrow the cash to meet those requests it is also said to have a liquidity problem. This generally happens when a banks largest institutional customers lose confidence in their cash deposits with the bank. Takes a lot of concern for this to happen. As cash dries up counter-parties who had offered open lines of credit (repos) also scale back their exposure and in combination these forces amplify one another feeding fear and panic to stop lending to and stop depositing in the bank.

Consider it a liquidity problem so long as you (or the bank) are/(is) still paying all bills, think mortgage, rent, utilities, employees, etc….

Solvency problems occur when you can no long afford to pay your bills. In this situation your obligations exceed your assets and presumably you’ve already tapped your home equity, credit cards, family and friends as a “temporary” solution. For individuals this generally happens when they can no longer pay the rent – assuming the last choice is to have to leave your home. When you become insolvent your are effectively bankrupt.

For institutions this happens when their assets, liquid or not no longer no longer match liabilities. With banks and other financial institutions the problem is amplified and exacerbated by the fact that they operate with so much leverage (debt). Imagine for a moment that your mortgage went from being a fraction of your home’s value to beginning a multiple of it. Banks operate with debt that can exceed 10 times the assets they carry on their balance sheets. Some banks have operated with as much as 60 times. So consider for a moment how quickly insolvency can follow a liquidity problem when the banks counter-parties scale back loans to the bank. This leads to furious assets sales and or bankruptcy. Note that insolvency can be precipitated by liquidity issues particularly when the institution is forced to sell assets at discounts to intrinsic value to raise cash.

Our recent stock market decline was at least in part due to banks delevereging (selling assets). The dramatic increase in volatility and lower prices induces more selling mostly from other leveraged investors first. We are currently at the and of the first round of deleveraging.

If the banks in Europe (more particularly) don’t come to solutions to prevent insolvency market participants will further the liquidity crisis by cutting more loans and continuing to remove deposits.

There have been wide reports that large sums of money have been moving from European banks to American banks. The irony is that if a European bank fails, like Lehman did, we do not know what the knock on effects will be throughout the global banking system. Presumably banks in the US have lowered their leverage and should be better protected from this type of contagion. However as banks stocks drop they are forced to sell asset or dilute equity holder to raise more capital. Weaker players will be at risk.

From the Economist:

“Today’s operation is a bandage, not a cure. The liquidity problems in Europe’s banks are rooted in fears of insolvency. Putting those fears to rest will require aggressive recapitalisation so that the banks can withstand plausible scenarios of European sovereign default. And of course, that means Europe must also accept the inevitability of such default while ring-fencing fundamentally sound countries like Italy and Spain. (Read the extensive coverage in this week’s issue, available online today.)”

http://www.economist.com/blogs/freeexchange/2011/09/financial-markets?fsrc=scn/tw/te/bl/solvencycanwait

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One Response to Remember the Difference Between Solvency and Liquidity

  1. Rainbolt says:

    Incredible points. Sound arguments. Keep up the great work.

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