Banks typically fail because they have too little cash on hand to meet payment demands (a liquidity problem) or asset values are too low to pay back their debts (a solvency problem). Traditionally, it’s assumed that adding liquidity risk to solvency risk can only make matters worse, but that is not necessarily the case. In fact, new research shows there are circumstances in which liquidity risk can help to mitigate solvency risk.
Introduction
Banks typically fail for at least one of two reasons: insolvency, when the total value of a bank’s assets is not enough to pay its debts, or illiquidity, when a bank is unable to turn sufficient assets into cash quickly enough to keep up with payment demands. The latter scenario can be triggered by a sharp increase in depositors rushing to withdraw their funds, called a ‘run’, or when creditors call in their loans and the bank has to sell assets quickly to pay up.
The 2008 financial crisis shows how this can play out in practice. Lax lending standards led banks to give mortgages to people who couldn’t repay them on the assumption that house prices would continue rising, so even if some borrowers defaulted on their payments, the bank could still turn a profit by selling the house.
However, as the market became flooded with houses for sale, house prices started to drop below the mortgage value. Banks started to lose money and confidence, and stopped lending, including to each other, which restricted the amount of liquid assets held by many institutions.
In the years since, regulators have taken a firmer hand, introducing additional requirements to guard against the risk of banks defaulting. For instance, the UK’s Prudential Regulation Authority (PRA) now imposes requirements on both liquidity and capital adequacy. Such oversight aims to ensure banks are able to survive runs, repay their debts, and absorb losses when they arise.
It is intuitive that adding liquidity risks to solvency risks increases the chance of a bank defaulting on its debts, but that’s not necessarily the case. While this line of thought seems to make sense at first, new research shows that there are circumstances in which liquidity risk may actually help to mitigate solvency risk.
When two risks make a right
To show how liquidity risk and solvency risk interact, I published a new financial model that derives the joint probability of bank default due to illiquidity or insolvency (the full article is freely available at https://doi.org/10.1016/j.econlet.2025.112581). The findings suggest that if a bank survives a liquidity run, the resulting contraction of its balance sheet can actually reduce its post-run insolvency risk.
Why? Because a smaller asset base suffers less damage from negative shocks to asset returns.
For instance, if a bank has £1 billion in assets and £800 million in debt, a ten percent shock would lose £100 million, leaving the bank with £900 million in assets, £800 million in debt, and a debt to assets ratio of 89%. However, if that same bank had shrunk to £600 million in assets and £400 million in debt following a liquidity crisis, a ten percent shock would only generate a loss of £60 million, leaving the bank with £540 million in assets, £400 million in debt, and a comparatively healthier debt to assets ratio of 74%. In effect, the contraction slows the bank’s possible movement towards the point where its assets are so devalued that it can no longer pay its debts. Whilst to some this result may seem obvious, its importance is that it links liquidity risk with solvency risk, showing that liquidity risk acts as a counterweight to solvency risk as long as a bank survives unexpected cash outflows.
This relationship also applies in situations where a bank faces liquidity pressure not caused by a run; for instance, when there is a non-rollover of debt and the bank has to convert assets to cash so it can pay outgoing creditors.
Rethinking risk management
A deeper understanding of how risks interact presents an opportunity for banks and regulators to fine-tune how they respond to financial stress.
Most significantly, this simple yet important result suggests that the intense pressure banks face to de-risk after a run may be overstated. Currently, it’s common practice for banks to assess the severity of each type of risk and set equity aside to guard against solvency risk accordingly. But the assumption that multiple risks are always a compounded threat, without sufficient recognition given to how sometimes one risk helps to mitigate another, may cause them to set aside more equity than they need to.
Reducing the pressure on banks to de-risk after experiencing liquidity challenges could encourage them to continue lending to the real economy in the wake of a run without compromising their stability. A revised understanding of joint liquidity-solvency risks should also be integrated into stress tests run by banks and regulators. As the financial sector continues to be impacted by geopolitical, environmental, and social uncertainties, these tests must adopt an approach to evaluating resilience that embraces the complexity of interactions between risks.
This new liquidity-solvency model offers banks a light at the end of the tunnel by reframing how risks are perceived. Rather than seeing every challenge as putting banks further on the back foot, edging closer to default and failure, it proves that surviving liquidity problems can increase resilience, proving the adage that what doesn’t kill you can indeed make you stronger.
About the Author
Dr Kenneth Baldwin is a Senior Lecturer in the Department of Economics at Nottingham Business School, Nottingham Trent University (NTU). His research focuses on the intersection of finance and economics, including banking regulation and asset pricing. Prior to working in academia, he spent over two decades working at investment banks in senior risk management roles.
