Lecture 2 - Liquidity and Solvency Flashcards
Liquidity and Solvency
Bank’s Liquidity
Cash - this can be used to pay back depositors (left side of balance sheet)
Bank’s Solvency
Equity capital (Right side of balance sheet)
Equity Capital
The value of the bank’s assets - the value of the bank’s liabilities.
A bank is insolvent when:
Liabilities > Assets
How is equity capital raised?
either by getting an outside investment or making a profit and retaining the earnings.
Equity Capital - shareholders
is considered “the shareholders’ funds” - it tells you what fraction of the banks assets can be considered to be owned by the shareholders rather than owed to creditors.
A bank with negative equity capital is considered:
an insolvent bank - its assets do not cover its liabilities
Market value of a bank
is calculated as what it would take to buy all the bank’s shares on the stock market.
Market value of a bank has traditionally been greater than the book value listed in its accounts. Is this still the case?
Market value > book value.
No in recent years investors think bank assets are going to be worth less than stated in the bank accounts.
i.e. book value > market value.
A bank with low cash than equity capital is:
highly solvent and is not liquid
A bank with high cash and low equity capital is:
low solvency and is liquid. It has lots of cash to meet the demand for redemption of deposits. but if they lose 2% of their assets they will become insolvent.
Why solvency and liquidity problems can occur together:
Large withdrawals occur because depositors believe the bank is insolvent. These redemptions exhaust the bank’s liquid assets and financial markets also don’t trust the bank and won’t lend to them, then the bank will run out of liquid assets. The possibility that the bank has a solvency problem turns into a liquidity problem. Often banks will then turn to the government for help.
Why solvency and liquidity problems can occur together:
Alternatively, banks that need to sell assets quickly because of liquidity problems may have to incur losses on these sales, so a liquidity problem turns into a solvency problem.
Liquidity regulations
1.reserve requirements - minimum fractions of deposits that must be kept in cash or balances at a central bank.
2. Regulations to limit maturity mismatch - restrictions have generally been removed.
3. New rules to ensure banks have enough liquid assets to withstand substantial withdrawals.
Solvency Regulations - (Capital Adequacy Requirements)
Regulations on how much equity capital a bank must have. The bigger the bank, the more equity capital required.
