Question

How are liquidity and leverage related to the risk of insolvency for a bank? How are they related to the returns to shareholders of a bank?

Answer 1

The relationship between liquidity and leverage and the risk of insolvency is very critical from the risk management perspective of a bank. Every bank has asset liability management committee which takes care of these things. Generally higher the liquidity of the bank assets that means that bank can sell its asset more easily at its fair value during the time of distress and can meet its liability, so higher the liquidity lower would be the risk of insolvency, lower the liquidity of bank assets, there is high probability that bank assets will turn into bad debt and higher the risk of insolvency. For leverage, up to a certain point having leverage in the balance actually helps in enhancing the return to its but beyond a point if leverage increases and the economic environment took an unexpected turn there is high probability that bank will incur huge losses and the bank will become insolvent.

From the perspective of shareholders, if assets are highly liquid then it would be a beneficial situation for them because higher liquidity means bank assets are of high quality and they will yield good profit for the shareholders and if they want to sell their stake in the bank, they can easily do that. Low liquidity is normally not desirable by the bank. Again, leverage does magnify the return on equity for shareholders, so up to a certain point leverage does benefit the shareholders but beyond a point leverage increases the distress cost and there is high probability that if economy goes into recession the bank will become insolvent.