Liquidity, solvency, and bank capital

Liquidity is the capacity to meet a payment when it falls due. Solvency is the condition in which an institution’s assets are worth enough to cover its obligations. Bank capital supplies loss-absorbing funding; it is not a separate stock of cash reserved for withdrawals.

Payment timing and asset value are different tests

Take a bank with $110 million of assets and $100 million of liabilities. On those valuations, it has $10 million of equity. Suppose only $2 million of its assets are immediately available cash, while $8 million of deposits must be paid today.

The bank has a $6 million immediate funding need despite its positive equity. The other assets might be valuable loans whose borrowers will repay over years. Their value does not make their future payments available today.

The reverse is also possible. A bank can hold enough cash to pay today while losses elsewhere leave total assets worth less than total liabilities. Payment capacity over one interval does not establish solvency.

Market liquidity and funding liquidity connect assets to cash

Market liquidity concerns selling an asset in a specified amount and time without a material price concession. Funding liquidity concerns obtaining cash through borrowing or other funding sources when required.

An asset sale supplies cash by transferring ownership. Borrowing against collateral supplies cash while creating a repayment obligation. The available amount depends on price, collateral eligibility, haircuts, contractual conditions, currency, and the time needed to complete the transaction.

A facility available tomorrow cannot settle an obligation due this morning. Cash in one legal entity cannot cover another entity’s payment unless it can be transferred lawfully and in time.

A forced sale can turn a liquidity shortage into a capital loss

Return to the bank with $10 million of equity and a $6 million cash shortfall. Suppose it sells an asset carried at $8 million for $6 million. The sale supplies the missing cash but realizes a $2 million loss.

Before the deposit payment, assets fall to $108 million and equity to $8 million. Paying $8 million of deposits then reduces both assets and deposit liabilities by $8 million. The withdrawal itself does not cause another equity loss; the discounted sale did.

Repeated forced sales can exhaust capital. A funding problem and a solvency problem remain distinct even when one causes the other.

Capital ratios do not certify payment capacity

Accounting equity is assets minus liabilities under the reporting framework. Regulatory capital uses defined eligible instruments and adjustments, with requirements tied to the applicable framework. Neither number states how much cash can reach a particular payment system today.

Liquidity measures also have boundaries. A coverage ratio tests specified resources against specified outflows over a stated horizon. It does not establish every intraday, currency, or legal-entity funding need.