Monday, September 22, 2008

Insolvent or Illiquid?

Suppose I run a bank with $X of assets, $95 of liabilities and $5 of equity. My assets are of long maturity, but my debt is short term.

Someone asks me the value of my assets. I check the market, and the current offer is $80.

If I can provide more information on my assets, and/or wait until more buyers show up, I think I can get a higher offer.

Am I insolvent, or is this a liquidity problem?

This is rather key to the government's plan. If the institutions are insolvent, this plan will cost the taxpayers. If the underlying problem is illiquidity, the cost will be minimal or negative.

This line of reasoning also suggests the similarity between the classic old commercial banking problem of lending long and borrowing short to the problem that investment banks face today. We never had a problem, I think, of having the Fed stand ready to help out commercial banks that were illiquid -- if their short term depositors demanded money, and they could not sell their long term assets at immediate prices to cover deposits, then the Fed would step in.

We just never imagined that the illiiquidity problems would be so systematic and that commercial banks had pushed this problem on to someone else.

1 comment:

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can you explain me the concept of illiquid ? I don't understand it at all