Question

How is illiquidity different from insolvency? Show each scenario using two separate balance

sheets for a commercial bank.

Answer 1

illiquidity : A liquidity issue occurs when a firm has a temporary cashflow problem. Its assets are greter than debt but in illiquid form. The illiquid assets would take time to pay debts in required time periode.e.g seeling house or land, a bank cannot demand suddenly mortgage loan back.

Insolvancy: Insolvancy is poped up when country or company cannot meet the required debts through his current assets. That means the debts are greater than the assets.

Show each scenario using two separate balancesheets for a commercial bank.

Liquidity: The basic business model of banks is to buy risky long term assets using money borrowed in short term.

Sometimes depositor want to earn more cash from the bank than what they had deposit, in such scenario, Banks can sell their assets to raise cash but this probably means taking loss. Better, if possible, to use those assets as collateral to borrow from others. The theoretical justification for having “lenders of last resort” (central banks) that are willing to make short-term loans in exchange for collateral is that at least some of these failed bankers were right.

Either way, the amount of cash a bank can raise depends on how much its assets are worth. The problem for a bank desperate for liquidity is that nothing is inherently “worth” anything (at least from a financial perspective). Value is contingent, not fixed.

The Fair price of an office building or a mortgage backed securities depend on what happenes with other external factors like, echnological progress, inflation, employment, population growth, regulation, migration, commodity supplies, and geopolitics. Anyone attempting to determine the “fair” price also has to contend with the risk that any of her embedded assumptions could be wrong. This situations leads to solvancy crisis. Example like Lehman brothers.

This all above scenario suggests the bank should have separate balancesheet for insolvancy and illiqidity.