Question

1. What’s the difference between a liquidity crisis and a solvency crisis? When Lehman Brothers went under, its debts (liabilities) were much greater than its assets. Did Lehman Brothers experience a solvency or a liquidity issue?

Answer 1

A liquidity problem (crisis) occurs when a firm (or country) is experiencing a temporary cash flow problem. Its assets are larger than its debts, but some assets are illiquid (e.g. it takes a long time to sell a property. A bank can not immediately claim a mortgage loan back) So, while the assets are larger than debts in principle, they can not fulfill their actual payment requirements.
A solvency crisis comes about when a country has debts it can not meet through its assets. That is, even if it could sell all its assets, its debts would still not be repaid.

When Lehman Brothers went down, his debts (liabilities) were considerably greater than his assets. Thus, although the Federal Reserve had access to temporary funds, this access to liquidity could not solve the underlying problem that it could not meet its liabilities.

The U.S. government declined to bail out Lehman Brothers, who found it impossible to roll over their market borrowings. Instead, the Wall Street bank had been allowed to go bust. That failure of a systemically important financial institution with liabilities of some $700bn (£538bn) created a seismic shock for the entire global financial system. The global money markets froze, and in most of the developed world, banks and insurance companies suddenly found that they could not borrow either.

Central banks have been forced to lend to banks on a massive scale to avoid a wave of systemic bankruptcies in the financial sector much greater than Lehman. Such a general collapse would have meant unpaid wages around the world, unoperating cash machines and, in all probability, total panic.

Financial crises have historically tended to come in unexpected forms. If one knew where, when or how they would happen, early preventive action might be taken. A very well capitalized global banking system is the best, perhaps the only real, insurance against the sort of catastrophic system-wide collapse in trust that materialized in September 2008.