Distinction between Liquidity and Solvency in Banking - Coursework Example

Distinction between liquidity and solvency in banking Liquidity in banking Liquidity in banking can be defined as a measure to which a firm or a person can convert assets to cash. Liquidity assets are those assets that can be converted to cash in a quicker way so that the financial obligations can be accomplished. Some of examples of liquid assets are cash, government debt and reserves from banks (Viral and Lasse 63). On the other hand, solvency in banking entails the degree to which the current assets of individual or a banks or any other business exceeds the current assets liabilities. The purpose of solvency is to meet long term fixed expenses with an aim of long term expansion and growth (Zietlow et al 37). Solvency is a policy issue for all financial institutions on what they decide on the average capital charges that are set. It can also be termed as survival means of the banks and this policy is the current and possible future G10 bank regulation. To experience economic solvency, then banks must make sure that capital setting decisions are made. Investors normally wait for the banks to be in solvency state where they will venture in the market so that profit may be experienced thus greater tolerance for the credit defaults. One of the advantages of liquidity in banking is that deposit inflows provide loan demands thus a decline in the market liquidity is experienced. Through the use of insurance coverage, the firm is insured against systematic decline in the market liquidity at lower cost making the institution to be more aggressive in the market. The monetary policy tools used are advantages to the economy since liquidity creates economic growth. The main disadvantage of liquidity is when a country experience liquidity glut it will mean that inflation is going to be experienced making it hard for the country to be stable thus making it difficult to achieve the objectives set by the country in terms of growth rate. Solvency in banking on the other hand is advantageous in that through the use of reserves and equity the growth and stability of a nation is attained. Financial crisis will be eliminated in the economy making sure that the investors enjoy the market throughout the period of solvency (Gaist 11). Inflation is controllable due to the use of reserves. The disadvantage is that during the period where regulatory board is controlling capital in the economy investors will have to experience shortage of fund and it can even go to an extent of losses to be incurred. For any financial institution to operate efficiently, then enough liquid assets must be available so that current obligations can be met. Liquidity in other term can be defined as the ability of current assets to meet current liabilities thus making the organization to meet the objective set. Liquidity includes cash, credit and equity but in most cases the use of credit is preferred by many organizations such as bank rather than cash. The reason behind this is because many financial institutions that do a lot of investments in many countries do prefer to carry the transaction using borrowed cash (Yakov and Haim 17). Traditionally, many of the consumers who carried business transactions preferred credit cards rather than cash since they were concerned with interest rates that normally make the business or the firm to be stable in the market though liquidity is measured by the money supply in the country. In United States, the Federal Reserve manages liquidity with the monetary policy tools, the most important tool that it normally use is fed funds rate which is normally concerned with short term interest rates. The use of open market is another tool that is used. It affects the liquidity of the country, for example, when fed fund rate is low, then the capital is easily available to the banks and other financial institutions. Low rates in United States are recommended since they reduce the risk of borrowing because the return of the fund must be higher than the interest rate (Bucay and Rosen 15). When low rates are experienced in the country, then investments in the country are encouraged and this makes liquidity to create economic growth of United States. High liquidity in the country means that a lot of capital is available but liquidity problem may be experienced when US experience too much capital and investments are too few thus leading to inflation (Wood 13). When investors perceive that the prices of commodities will rise, they normally buy goods in large quantity so that they can make profit in future. When the prices of assets increase, then irrational exuberance is experienced making cheap money to chase fewer goods in a country. When liquidity glut is experienced in a country, it will mean that more of the capital will be invested in bad projects resulting to the country not to pay the expected return making the assets to be worthless (Asarnow and Edwards 24). This implies that companies or banks will have to withdraw investment funds and this is the reason why investors will scramble in the market to sell their goods before the prices drop further. The phase of the business cycle leads to contraction and the countries will have to experience recession that happens to mortgage backed securities. On the other hand, constrained liquidity means that capital is not available at high amount which is the opposite of glut liquidity which is experienced when capital is available in large quantity. Constrained liquidity is expensive and is normally accompanied by high interest rates, this will be as a result of banks and other lenders not providing loans to the investors and this will mean that banks will become risk averse since they will be experiencing bad loans in their books which are not paid by the investors making it hard for the banks to keep on with their business. Liquidity trap is experienced in the country when the Federal Reserve monetary policy does not create more capital for investments and this normally happens when there is bad recession. Financial institutions and businesses cannot thrive in this environment since they are afraid to spend a lot no matter how much credit available. Businesses are not operated and families lose their jobs or employment rate is low since no creations of jobs based on the fact that families and other businesses in operation hold their income, pay off debts and others will save instead of spending. The flow of capital is low and this makes the businesses to be afraid making the demand to fall more and this is the reason they cannot employ or invest making the country to be in trap. Banks and other capital lenders will also hold their cash and thus the likely hood of lending is low. Further if deflation is experienced then the financial institutions will have to wait further before spending until the vicious cycle has stopped since the economy is under the liquidity trap. For countries to be out of liquidity trap, they must make sure that the investors are going to buy a lot of assets so that they can hold them for long enough to outlast the slump. The second solution is to make sure that the government supports economic growth and thus increasing defense spending or the interest rate cut. Thirdly, is to establish more financial institutions thus creating a totally new market. Businesses normally use liquidity ratios so that they can measure financial health for example the use of current ratio where it is attained when the current assets are divided by the current liabilities. This means that all leading financial institutions together with other businesses can pay their dept either short term or long term dept with the capital that is achieved from the sale of the assets. Quick ratio normally uses the current ratio and will not include the dept rather will use cash. Cash ratio means that the bank or other businesses will use their cash to pay off their debt, if the cash ratio is high, then the bank and other businesses will be able to pay debt since liquidity is available in large amount. The Chinese are expanding in term of businesses where they are increasingly concerned about the consequences that are slowing down the economic growth which is emanating from insolvency which has an effect on the economic growth thus not being viable in the leading financial institutions. Insolvency can only be protected in a country like China by the use of deposit insurance system that will protect investors so that economic growth can be achieved. Since solvency in banking must be considered so that investors will not lose confidence in the bank deposits, then banks are subjected to reserve requirements, loan to deposit ratios and other rules (Gatev and Philip 41). The reason behind this is to make sure that banks have sufficient cash to meet their demand and that of the customers. Banks in China are known to be failures and this is the reasons why they operate under the control of the government. Solvency standard is an important issue that most financial authorities will have to decide at which level average capital charges should be set. The decision is made to make sure that there is survival probability for banks though they normally employ credit risk. The survival probabilities of banks is normally used to regulate the capital with the levels of economic making sure that capital that is active in the banks is hold. This is done to ensure that fund is monitored and no cases of inflation will be experienced in the country like China and other countries that are expanding in terms of economic growth. The rules that are set by G10 countries are important decision which ensures that the average level of capital in the countries is able to survive in over one year with a high probability of 99.0% and 99.9%. Solvency standards are better in banking since the use of capital is regulated using different methodologies for example in 1988, Basel Accord was signed to make sure that capital choices which the international banks of G10 use to regulate capital policies so that growth can be experienced making sure that stability of countries will be the key agenda for those countries. The reason is to make sure that market discipline to the banks is achieved and this can only be done by excess of the regulatory minimum. This makes the investors from different countries to realize the importance of access to banks. Markets make it simpler for the investors to survive in the market without problems like inflation and other growth traps that are experienced by different countries. This can only be achieved if banks are given the mandate to maintain high levels of capital in order to obtain sufficient access to credit market. This is important to the banks since it will mean that countries will have high growth rate since high rates are experienced if credit markets are available, the use of Swap and interbank is normally encouraged in the current business arena so that growth will be experienced. The central banks and other regulatory bodies are the only ones who can be used and rescue financial system of the countries since financial crisis that is experienced in the countries is as a result of provision of liquidity. To make sure that financial crisis is not experienced in countries; governments of different countries need to back recapitalization and the stress tests like the holding of the capital by the monetary institutions and banks which in return will make the banks to be solvent. For example, in a country like US, America Federal Reserve is normally involved in the solvency of the banks. As a lender, the Federal Reserve will lend unlimited amount of currency to the banks and since it is responsible of printing the currency it will not allow other banks ECB to print currency on their behalf (Wicker 47). To obtain solvency in the banks the Federal Reserve will be the main suppler of the currency to all the banks which will be supplied in limited supply and the monetary policy must be part and parcel of decision making (Wueschner 29). The Federal Open Market Committee will be the one to approve the printing of dollars and swap lines and this must be done in one year. The reason behind this is to make European stocks markets and bank stocks borrow dollars to make dollar loans and thus acquiring finance dollar denominated inventory which makes the banks solvency to be held and thus achieving solvency banking (Marrs 13). The likelihood of banks to fail due to the use of regulators is low since the regulations ensures that the capital is controlled in a manner that will not cause financial crisis and inflation which make the country economic capability to be lowered thus making sure that no growth rate will be experienced and if any only small percentage will be experienced. The need to protect small investors and other banks effects that may lead to failure of small businesses to advance can be achieved through capital requirements. On the other hand, capital requirement may lead to efficiency costs on the leading financial sectors so balance between the small business operators and financial sectors must be maintained to make sure that economic growth is achieved. To measure the capital requirement, then there is need for one to balance trade off between the small business owners and the financial sector so that appropriate solvency standards will be arrived at in a simpler manner (Nickell and Perraudin 26). To make sure that economy will not deteriorate and banks operate freely, then useful means to raise the regulatory actions will go in hand with credit quality of the banks. This will mean that banks are able to publically operate close to the regulatory minimum which will be later important to the country economic growth and stability of the residents. For solvency standards in the bank to be experienced then equity and reserves must be used and suitable risk model need to be part and parcel of the decisions that are made so that economic growth is achieved. Summary of the differences between the liquidity and solvency in banking One of the major distinctions between liquidity and solvency is that liquidity looks at how banks or an individual can convert assets to cash in a quicker way so that current financial obligation can be achieved. While on the other hand, solvency entails the degree to which current assets relating to the bank or an individual or any other business will exceed the current assets liabilities. Liquidity solvency aims at meeting long term fixed expenses with an objective of expanding and growth. While liquidity employs quite a number of monetary tools to regulate economy, solvency significantly relies on reserves to achieve an economic stability. Liquidity problem occurs when a bank does not have enough cash to meet the demand of its customers. On the other hand, solvency problem is experienced when banks obligations exceeds its assets. Solvency problem occurs mostly due to the fact that banks and other financial institutions operate with high debt. Works Cited Asarnow, E and Edwards, D. Measuring loss on defaulted bank loans: a 24-year study, Journal of Commercial Lending, 2006, pp 11-67. Bucay, N and Rosen, D. Applying portfolio credit risk models to retail. London: Sage.2001.Print. Gaist, A. Igniting the Power of Community: The Role of CBOs and NGOs in Global Public Health. London: Springer, 2009. Print. Gatev, E and Philip E. Banks Advantage In Hedging Liquidity Risk: Theory and Evidence From The Commercial Paper Market, Journal of Finance, 2006, (2), pp 9-71. Marrs, J. Secrets of Money and the Federal Reserve System. Rule by Secrecy, 2000. 64–78.Print. Nickell, P and Perraudin, W. How much bank capital is needed to maintain financial stability? forthcoming Bank of England working paper, 2001. Print. Viral, A and Lasse P. Asset pricing with liquidity risk. Journal of Financial Economics 77, 2005. Wicker, E. 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