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.