Bank of England on solvency and liquidity

Nice communication piece by the Bank of England by talking about solvency and liquidity:

The article explains that a bank’s capital base and its holdings of liquid assets are both important in helping a bank to withstand certain types of shocks. But, just as their natures as ‘financial resources’ differ, so does the nature of the shocks they militate against. The article addresses some misconceptions about capital and liquidity, explains the important differences between the two resources and describes where they sit on a bank’s balance sheet, using clear visual examples.

Go give it a read, it is neat.

Note:  Liquidity is about the mismatch between the length of maturity on assets and liabilities.  Solvency has a bunch of interesting issues to think about – with a strictly free market without information considerations we may not really care.  However, the lack of knowledge (namely asymmetric information in the face of liquidity mismatch) about whether a bank is truly solvent creates as issue.  We think about “solving” this with bank insurance – but this in turn changes the way banks and other financial institutions behave, and the way that risk is treated by depositors, lenders, and financial institutions as a foil between them.  This is where we come in talking about moral hazard!

Note to note:  By calling financial institutions a foil, I am not claiming anything like “deposits make loans” or “loans make deposits” – that would be a red herring.  The simple fact is assets and liabilities have to meet – and banks set assets and liabilities based upon expected risk and rates of return given the institutional and regulatory structure.

  • HJC

    Hi Matt, one thing they don’t really cover sufficiently is the necessity of the lender of last resort – how, in a crisis when there is no market liquidity, there will not be enough ‘liquid assets’ to support the system and that it’s only the central bank that can create them. They should make this point more often, then hopefully we wouldn’t get so many misinformed ‘bail out’ comments!
    By the way, if you haven’t read Perry Mehrling’s ‘New Lombard Street’, then I would well recommend it.

    Cheers

    • Hey,

      True true, at a point in time when there is an issue of liquidity it seems strange to call this a bailout – but if the existence of a LOLR that will cover off issues based on liquidity mismatch may lead retail banks to create a “larger than optimal” mismatch between the term structure of assets and liabilities. I think they may have touched on that, but perhaps they should have been more explicit about the usefulness and essential nature of the LOLR function.

      “By the way, if you haven’t read Perry Mehrling’s ‘New Lombard Street’, then I would well recommend it.”

      Ahh thank you, I will keep that in mind. I have so many books I should be reading now that I should really find a way to dedicate an entire year to just reading 😉

      • HJC

        I know what you mean, it’s very easy to buy books faster than you can read them. Unlike ‘Stigum’s Money Market’, which Mehrling himself recommends, ‘The New Lombard Street’ is quite short: ~1000 vs ~139 pages respectively.