Question

a. What is the difference between a bank that is insolvent and one that is illiquid? Does the difference matter? Use examples to explain your answers.

b. Suppose you are the lender of last resort and a bank approaches you for a loan. You examine that the bank has $1,000 million in assets, mostly in long-term loans, and $800 million in liabilities. It is experiencing usually high withdrawal rates on its demand deposits and is requesting a loan to get through the period of difficulty. Would you grant the loan? Explain your choice.

Answer 1

a) Yes the difference between Insolvent Bank & illiquid bank matters.

Insolvent Bank means the bank doesn't have enough assets or adequate financial coverage to pay off its liabilities or it doesn't have enough cash reserves to pay off the depositors money.

Example : Lehman Brothers, Largest Investment bank becomes insolvent because it doesn't have enough assets or financial coverage to cover its liabilites at the time depositors demand.Finally it becomes insolvent.

illiquid Bank means the bank have adequate assets to pay off its all liabilities but due to financial/market constraints there is a difficult/much hardship in paying of its liabilities and it needs federal or other market players financial assistance to support its liquidty position.

Example : Bear Stearns, during 2008 financial crisis its assets base was stronger than liabilities and it has lot of homes as collaterals in its assets side.But due to financial crisis it is in severe hardship to pay the liabilities. J.P morgan chase with the help of federal government support rescued the Bear stearns bank from bankruptcy.illiquid bank doesn't always end in Bankrupt.

b) As an Lender of last resort, I will provide the loan assistance/financial support to that particular bank in this liqudity crisis.As an lender of last resort, it has more important responsibility of maintaining economical and finacial stability in the home country of its operation.Since the bank failure of one case may leads to panic withdrawal of cash deposits from other banks and it may leads to large level of bank failures or banking collapses in near term and it may creates financial uncertainity.In this case it is illiquid bank and it has more assets than liabilities and assuming the credit quality of the bank is also good and for greater good of all financial and Banking Insitiutions, I will grant the loan to this particular illiquid bank.