Liquidity versus Solvency

Liquidity and solvency are similar but quite different. Both terms, and more specifically their counterparts illiquidity and insolvency, have been used quite often over the last couple of years. Here is a quick breakdown of the differences using a very simplistic bank analogy.

A bank is illiquid if they are not able to provide money owed to depositors in a timely manner. Let’s say the bank takes a deposit for $10,000 into a 1 year GIC. Let’s then say they turn around and lend it to a reputable borrower with a perfect credit score who is absolutely going to be able to pay the loan back. The loan is also for 1 year. If the depositor has an emergency and needs to get their money early, perhaps they agree to pay a penalty to cash in the GIC. But because the bank has loaned the money out and is only getting it back in twelve monthly instalments they can only provide part of the $10,000 right now. The depositor will have to wait until the borrower pays back the loan before they can get their money. Note that this simple example assumes a full reserve banking system and no other depositors or borrowers. But basically, the bank has the ability to get the depositor their money back, just not right now. This is a liquidity issue.

Take the same scenario, but this time the borrower took the loan and used it to bet on a horse. The bet lost and the borrower is unable to pay back the loan. The loan has gone bad. The bank owes $10,000 plus interest to the depositor but does not have the ability to ever pay him back his money. The bank is insolvent. Insolvency is when liabilities exceed assets. (In banker speak, loans are assets and demand deposits like chequing accounts and GICs are liabilities.)

Just to mess with you, sometimes people refer to illiquidity as “cash flow insolvency”.

Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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    Our economy has problems of solvency which are causing liquidity issues. The Fed is trying to solve the liquidity issues. But because we are not solving the solvency issues, liquidity issues will keep poping up again. The Fed will “try” to help the solvency issues by lowering the rates, hoping the banks can make bigger profits on their good customers, since banks are not passing along the lower interests. Bank customers get screwed by paying high interest and by earning little interest in their savings. So, who’s helping the average Joe? The average Joe is at the root of all the problems. If Joe is insolvent, he can’t pay his mortgage or his credit card, which makes banks insolvent, which causes liquidity problems :) Liquidity issues are simply a simptom of our problems. To really fix liquidity for good we’ll have to fix solvency. This is a hard process that will take time. The Fed is helping in some ways and obstructing in other ways.

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