Banking and Financial Markets : A Risk Management Perspective

Prof. P C Naryan

Week 1

Overview of Liquidity and Solvency – Part 1

In this session, we will look at liquidity and solvency, and why these issues are so different and
far more important in the context of banks and financial market entities that deal in financial
assets, when compared to manufacturing and distribution companies that deal in real assets.

Any entity, be it in the business of managing financial assets or real assets is said to have a
liquidity problem when its cash outflows exceeds its cash inflows. In the case of companies
dealing in financial assets, for example, cash outflows could include disbursement of fresh
loans, investment in purchase of bonds and other securities, interest paid to depositors,
repayment of maturing deposits, etc.; and cash inflows would include fresh deposits from
customers, interest income from loans, proceeds from sale of bonds, repayment of loans by
borrowers, and so on.

Solvency, on the other hand, refers to the ability of any entity, be it in the financial assets or
real assets business to draw on its net worth, i.e., equity plus retained earnings to support and/or
overcome sudden erosion in the value of its assets. While liquidity issues are more common,
and in some cases, cyclical in nature, solvency problems are more deep-rooted and if left
unattended could result in the eventual liquidation of the firm altogether.

It may be appropriate to mention here that liquidity issues that remain unresolved for an
extended period of time could inevitably translate into solvency issues for the firm. In this
course, we will focus on liquidity and solvency issues pertaining only to entities in banking
and financial markets, i.e., entities that deal in financial assets. We will refer to them, hereafter,
as financial asset companies.

Let's look at a few examples to understand the issue of liquidity and solvency in the context
offinancial asset companies and how they can be proactively managed. I have presented here a
simplified abridged version of the balance sheet, i.e., the assets and the liabilities of a financial
assets company. As you can see, the asset side of the balance sheet comprises cash 24 million,
loans 96 million, and investment in government securities 15 million. The total adds up to a
135 million. This is supported on the liability side by deposit from customers of 120 million
and equity capital of 15 million.

© All Rights Reserved. This document has been authored by P C Narayan and is permitted for use only within the course Banking and Financial
Markets : A Risk Management Perspective delivered in the online course format by IIM Bangalore. No part of this document, including any
logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.
 Banking and Financial Markets : A Risk Management Perspective

Prof. P C Naryan

Week 1

Let us say some customers of that financial asset company suddenly decide to withdraw 15
million of their deposits. The deposit figures on the liability side of the balance sheet would,
therefore, reduce from 120 million to 105 million. This reduction in deposits can easily be met
by the financial assets company from out of its cash reserves of 24 million on the asset side.

In other words, the reduction in deposits of 15 million from 120 million to 105 million on the
liability side will be offset on the asset side by a corresponding reduction in cash reserve from
24 million to 9 million, that cash being used by the bank to pay off the depositors who wish to
withdraw their funds from the bank.

Alternatively, this financial asset company could actually borrow 15 million in the short-term
money market to meet its deposits outflow of 15 million. The third possibility could be for the
financial asset company to sell off its holdings in government securities to the extent of 15
million, to meet the deposits outflow of 15 million.

The important lesson, therefore, from what we have seen in the last few minutes is the first
lesson in managing liquidity. If a bank has ample cash reserve or has adequate liquid securities
that can be turned into cash quickly or has a credibility to borrow short term in the money
market, the liquidity problem can be overcome quickly and will not have a serious impact on
that company going forward. Thus far, we looked at facets of managing liquidity in the
financial asset company.

In the next session, we will look at facets of managing solvency in financial asset companies.

© All Rights Reserved. This document has been authored by P C Narayan and is permitted for use only within the course Banking and Financial
Markets : A Risk Management Perspective delivered in the online course format by IIM Bangalore. No part of this document, including any
logo, data, illustrations, pictures, scripts, may be reproduced, or stored in a retrieval system or transmitted in any form or by any means –
electronic, mechanical, photocopying, recording or otherwise – without the prior permission of the author.