- The collapse of Silicon Valley Bank continues to cause market tensions
- And rising interest rates could increase the risk of future crises
What is the difference between solvency and liquidity?
In simple terms, liquidity is a measure of ‘flow’: does an institution have enough short-term funds on hand to meet its immediate financial obligations and avoid default? Solvency, on the other hand, is a ‘stock’ measure, and requires an institution to be able to pay its debts over the medium and long term. To be solvent, an institution’s assets need to exceed its liabilities.
This means that liquidity crises are usually more easily fixed. Central banks can act as a lender of last resort, ensuring that institutions can meet their short-term obligations. Analysts at Capital Economics note that “while liquidity crises can cause turmoil in financial markets, the hit to the real economy is often limited if policymakers respond quickly”.
Solvency crises can be worse. Here, the value of an institution’s assets falls below that of its liabilities, creating financial losses that have to be borne somewhere in the system. If this happens on a large enough scale it can "impair the entire system of financial intermediation and credit creation, which in turn can cause a sharp contraction in the real economy”, in Capital Economics' words. Resolution is also more complicated: solvency crises often require the government to absorb the losses and recapitalise parts of the financial system.
Recent crises: GFC, LDI and SVB
The recent collapse of Silicon Valley Bank (SVB) was primarily a liquidity crisis. Over the past few years, the bank had invested its growing deposits in long-term government bonds, whose prices plummeted as interest rates rose. As clients came to withdraw their deposits, the bonds had to be liquidated, meaning it had to realise some of those losses.
In short, the crisis stemmed from a mismatch between the bank’s deposit liabilities and its long-term bond assets. SVB sustained losses on some of those positions as it tried to sell them to meet deposit withdrawal demands, Capital Economics believes “it collapsed because of a liquidity crisis rather than solvency problems”. Others will say the bond losses suggested a solvency issue.
The LDI crisis in the UK last year was primarily a liquidity crisis – the higher bond yields triggered by the mini-Budget should actually have improved the solvency DB pension schemes. The immediate effect, however, was to cause lenders to demand more collateral against hedged positions – obligations that schemes struggled to meet in the short term. The global financial crisis, on the other hand, was triggered by credit losses on lending to households and corporations, which threatened the solvency of the US (and global) financial system.
But liquidity and solvency crises can all too easily overlap. In a liquidity crisis, a bank may resort to fire sales of assets to raise cash, which can result in losses that then impair solvency. The institution may also find itself facing higher funding costs, which reduce profits and hamper the accumulation of capital buffers. What originates as a liquidity crunch can quickly spiral into something worse.
Confidence and contagion
By most measures, the banking system is in relatively good shape, with most banks retaining enough capital to weather incoming storms. But deposit runs and the resultant fear don't always pay attention to fundamentals. In a digital era, it is much easier to make a quick withdrawal. And a rush of decisions like these can create a new reality, in which deposit flight does alter fundamentals and destabilise the system.
In the aftermath of the collapse of SVB, the bank of choice for many tech start-ups in the UK as well as the US, chancellor Jeremy Hunt said that the UK had faced “a situation where we could have seen some of our most important companies, our most strategic companies, wiped out and that would have been extremely dangerous”.
Forcing an interest rate rethink
Beyond the immediate financial stability concerns, the collapse of SVB shone a spotlight on the impact of sharp interest rate hikes. As the saying goes, the Fed tends to raise rates until something breaks. The phrasing has proved true again this time – although whether this will hasten an end to the central bank’s hiking cycle is still up for debate.
Axa group chief economist Gilles Moec noted that the episode “is likely to trigger more prudence at the Fed in the field of monetary policy”, adding that macro-financial developments can act as a “harbinger of difficulties in the real economy”. While SVB did not trigger a financial crisis, it is an early warning that higher interest rates are starting to hurt, and to break things.
