Question

Examine the role of liquidity in banking. How is liquidity linked to capital/solvency?

Answer 1

Liquidity refers to the ability of the banks to meet its short term obligations. It indicates bank's ability to honor all the short term obligations. The functioning of the bank is dependent upon its liquidity. Imagine a situation, where you walk in a bank to withdraw your deposit, and the bank says it does't have money to give it to you. Liquidity therefore ensures that the bank functions smoothly. It adds to the ability and credibility of the bank.

Solvency refers to the bank's ability to honor it's long term obligations. It means whether bank is able to pay its long term debt obligations.

While liquidity is required for day to day functioning, solvency is required for sustenance.

Liquidity ensures that a bank is able to meet all its statutory capital reserves maintenance requirement such statutory liquidity ratio and cash reserve ratio. Liquidity in the long run ensures solvency. It's unlikely that a bank which is facing liquidity cruch will remain solvent in the long run.