Why insolvency precedes illiquidity in banking. to be looked at. Illiquidity, or to be Illiquid, is when an institution e. g. a bank are struggling to meet their obligations in time. They can have assets to meet their obligations, but they are having problems realizing them in to cash in time to pay creditors. usually this can be solved with a short- term loan. But If banks are not able to get a loan or provide cash In any other way to pay creditors, they are seen as illiquid.
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Insolvency, or to be insolvent, is when a bank is in the situation where it’s otal value of assets are less then the banks total liabilities. Usually when a bank Is getting Illiquid, It Is because the money marked is dry, or there is a bank-run against the bank. The money marked can be dry for different reasons. It could be dry, either in general, or for a specific bank. If the money marked is dry in general, it is usually caused by extraordinary shocks in the financial marked that Is hard to predict In advance.
An example can be when Lehman Brothers went insolvent In September 2008, causing a shock in the financial marked that resulted In eneral fair. Nobody would lend out money In the interbank- marked, unless they got a high compensation for the risk, in terms of high interest. So in praxis, the money marked was dry. The money marked can also dry out for a specific bank. This could happen if there are roomers about a bank being insolvent, or the stock price is dropping rapidly.
If a bank is exposed to bad loans or financial instruments, then other banks risk of lending out money to the bank increases, so the interest demanded from other banks then gets to high to be sustainable, and In praxis, the ank Is then excluded from the money marked and will quickly be Illiquid if it doesn ‘t get help from other sources, like the central bank which is called the “lender of last resort” since this is thelast option the bank has to get liquidity.
Page 2 Why insolvency precedes illiquidity in banking Essay
But the ultimate liquidity crlsls for a bank Is when all their depositors at the same time tries to withdraw their money or transfer their deposits by wire to another bank. This Is called a bank-run. That is what happened to NorthernRock in 2007. There were roomers reversing about the bank being in seriously trouble, especially regarding the anks large amount of mortgages. A bank run then started, and wlthln hours losses approached 2 billion dollars. The central bank then had to step in as the “lender of last resort”, The central banks main tasks, is to maintain financial stability.
In cases of insolvency, the central bank usually tries to negotiate with other banks and find someone that could be interested in a takeover. But with large banks, this can be more difficult. Northern Rock was taken over by Richard Branson, and re-named as Virgin Money. But the “bad loans” were left out and is still kept by the government. In Lehman Brothers case, a similar agreement could not be made, and it went bankrupt. Banking is in a huge scale based on trust, and similar for both cases was that lack of tOf2 fear in the marked.
It can be argued that they both most likely would have been insolvent in the future anyway. But they both went illiquid, and because of that insolvent. As mentioned above, when Lehman Brothers collapsed the interbank marked and the money marked dried out. This was because none of the banks trusted each other, because nobody knew who was exposed to this huge bankruptcy. Solvent banks that needed short- term loans could not get this, and the central banks than needed to step in and provide liquidity.
If the central banks had chosen not to step in and help banks during this period, solvent banks that were not able to get loans would eventually turned insolvent because of illiquidity. There seems to be a very tight connection between illiquidity and insolvency, and with no intervention from the central banks or governments illiquidity will eventually lead to insolvency. So It looks like in most cases illiquidity seems to precede insolvency, and not opposite.See More on Bank