# **SECTION 1: INTRODUCTION: MOTIVATION & DEFINITION OF TERMS**

1. Liquidity and solvency have been called the “heavenly twins” of banking.<sup>1</sup> Since these “twins” interact in complex ways, it is difficult—particularly at times of crisis—to distinguish between them, especially in the presence of information asymmetries<sup>2</sup> . An insolvent bank can be liquid or illiquid, and a solvent bank may be at times illiquid. In the latter case, insolvency is not far away, since banking is grounded in information and confidence, and it is confidence which in the end determines liquidity. In other words, liquidity is very much endogenous, determined by the general condition of a bank, as well as the perception of it by the public and market participants.

2. _Illiquidity_ and _insolvency_ are not interchangeable terms but very different, although related, concepts. From an accounting point of view, a bank is balance sheet _insolvent_ when its total liabilities exceed its total assets (negative net assets) and, therefore, it has no option but to default on some obligations, leading the bank into receivership, intervention or bankruptcy. On the other hand, a bank is _illiquid_ when it has a specific liquidity problem or experiences a liquidity crisis and it cannot obtain the funding needed, in a timely form, at market prices, to meet its obligations when due. Thus, insolvency reflects a structural and stock financial problem, while illiquidity refers to a point in time cashflow and pricing problem. One major issue for creditors, central banks and supervisors is that it is difficult to know if a bank is illiquid because it is insolvent or not. Moreover, illiquidity could also rapidly lead into insolvency if the problem is not addressed quickly and effectively in order to reassure depositors and other creditors.

3. Why is it important to make the difference between these two terms clear? The difference is important because policy actions to address a liquidity or insolvency crisis vary dramatically and, therefore, assessing the underlying problems of banks becomes crucial. Insolvency applies to individual banks or to systemic problems. In the 2007-2008 financial crisis, the underlying problem of some financial intermediaries heavily invested in sub-prime mortgages was a solvency problem, which was also translated into a liquidity crisis in view of the uncertainty about asset values and counterparty risks which raised, dramatically, market liquidity risks. Some banks were highly leveraged (often through ‘off-balance’ sheet special purpose vehicles—SPVs—structured investment vehicles—SIVs—or conduits), having securitized products which defaulted, creating not only a structural solvency problem (for the SPVs) but also a liquidity crisis for the bank as some of these vehicles required additional liquidity support. The large “shadow” banking system in the form of off-balance sheet vehicles posed extraordinary liquidity demands on banks at the worst possible time. Some of these transactions were financing long term, low quality credit with short-term funds, at a time when market liquidity was abundant and continuous refinancing was possible. Once liquidity tightened and even started to freeze, and market liquidity risk skyrocketed, participants started

> 1 Goodhart, Charles, ‘Liquidity Risk Management’, _Financial Stability Review_ -- Special Issue on Liquidity, Banque de France, No. 11, February, 2008.

> 2 Information asymmetry occurs when one party has more or better information than the other, creating an imbalance of power, giving rise to adverse selection and moral hazard.

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