Solvency Risk and Liquidity Risk of a Bank Differences

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Executive summary

This report has been developed to communicate the differences between solvency risk and liquidity risk of a bank. There are details that indicate the relationship that exists between the solvency risk and liquidity risk with the credit risk. This report has the details of the effects which credit risk has on the solvency and liquidity risk. This report also has indicated the dynamic provisioning and how it can be used by a bank to minimize the solvency risk. The ways in which the solvency risk can be controlled by proper utilization of internal systems +have been covered. There are also ways in which the financial regulators have been put in place so as to control the solvency risk. The problems also which affect the effective regulation and control of the solvency risk in a bank have also been indicated. The aim of this report is to identify the meaning of the solvency risk, liquidity risk, credit risk, dynamic provisioning, and the effective control of the solvency risk besides the problems which the bank encounters in the process.

The solvency and liquidity risk have been discussed with reference to the possible threats that it poses to a bank. They are likely to affect its survival. Though the financial risks that a company experience ranges from one variety to the other, they are related in one way or another. There are therefore varied measures and diverse systems that are likely to be applied in a bid to deal with the different types of risks. How these measures and systems are put in place so as to control the financial risks has been discussed in this report.

Solvency risk and liquidity risk

The solvency risk is a situation where the bank is not in a position to meet its debt obligations. It relates to the poor performance of the bank which leads to the bank being declared bankrupt. The solvency of the bank relates to the lack of the ability to settle all its financial debts such as to their creditors, and customers’ interests on the deposit, among others.

Liquidity on the other hand is the lack of cash by the company to meet its financial obligation. This is the inability of a bank to settle its expenses. This is the ability of the bank to settle out their financial obligations there and there without any external borrowings. This mostly affects the short-term liabilities. The bank’s ability to settle out its entire obligation refers to the bank’s good performance and credit worth even from other financial institutions. The liquidity risk is established as the funding crisis of the bank. This is the inability of the bank to fund any kind of its liabilities and any expansion projects.

The solvency risk and the liquidity risk are closely related and can be handled well by effective financial management. When a company is not in a position to meet its financial obligations, whether debts or expense, then it’s at risk of collapsing or rather being declared bankrupt. The solvency risk is the one that is mostly considered to be the riskiest. This is because, with the liquidity risk, a company can seek financial assistance so as to pay for its expenses in cash. On the solvency risk, there are no good records that can be presented to other financial institutions which can convince them that they are in a good financial position. This is because the company’s inability to settle its debts means that the liabilities are more than the assets hence it’s not being managed well. This will prompt the lending institution to avoid lending to such poor-performing companies hence there is a likelihood of the company collapsing due to the solvency risk.

Credit risk is the inability of the borrower to honor the contract. In a bank, this relates to the banks’ amount which has been lent to their esteem customers who subsequently default to make payment. This will lead to the company not being in a position to meet its obligations as it’s the main asset to the bank. Loans are the main assets to the bank and hence it’s the main revenue generator. Credit risk affects the solvency and liquidity of the banks in a greater way which will even affect the company’s performance. The default by the customers to meet their obligations will directly affect the company on the settlement of its liabilities (Saunders and Cornett 103).

The liabilities will be pushed up with respect to the bank’s lack of cash inflows. The banks always depend on the money they lend hence any default by the customers to repay will really affect their debts payment and any other expense which they have to settle. It’s through the effective management of credit risk that the company will be able to settle out all its financial obligations. The bank normally projects and times the repayment of such loans with the settling of a particular debt or meeting of its expenses. If there is any default hence the bank will not be able to meet its requirement hence the credit risk really affects the solvency and the liquidity risk.

Dynamic provisioning

The nature of dynamic provisioning is that it’s an approach technique which banks use so as to identify the loan losses and its associated returns. There is use of a strong principle which relates to the provisions on the unpaid loans which are matched with the particular time in relation to its projected long run duration and the projected loss. This provisioning strongly relays on the economic position of the company as opposed to the current approach. The loss which arises from the defaulters of loan repayment affects the profit and loss of the company. The dynamic provisioning is used to come up with an expectation or a reserve for the loan which has been taken up to the period when it’s repaid. In the applications of the dynamic provisioning, the loss which has been established will be built up if less than what was being expected. There is also drawing down of the reserves in the periods when the losses were too high beyond the expectation of the company (Carol and Sheedy 112).

Most banks currently use it for accounting purposes which enables the bank to effectively manage its finances. Through the dynamic provisioning, the bank will be able to utilize the provisions which have been made on any losses for accounting reasons as a contribution to the losses. This is where the bank has factored in the provisions in its financial statements so as to fully cater for the expected loss in the books of accounts. This means that the bank would be able to factor in its income net of the contributions which have been made for take care of the predicted losses. This also indicates that there is no utilization of the income as a net of the real losses which have been made by the bank.

This will enable the bank to utilize the loss amount which had been set aside to take care of it. This means that the bank will be able to meets its own obligations since there is already a loss provisions which absorbs the loss which has been realized by the bank. This is where the bank is able to utilize the amounts which had been accumulated for instances of the actual realization of the loss. This is a safe way in which a bank will be able to avoid the solvency risk since it has already considered the defaulting of the loan repayment hence it will not be able to be declared insolvent. This principle of dynamic provisioning is very important to the realization of the continuity of the bank activities and retaining the confidence of the customers and the investors. The bank should be able to utilize the bank’s equity capital in meeting the loss which had not been speculated. The loss which had been provided for or which the bank was expecting should be covered by the use of the lending margin. This will eliminate the insolvency of the bank (Babu 101).

Effective management of liquidity risk

A risk in a banking institution is a means which enhances the bank’s ability to be affected and be well managed. If the risk in a financial institution was not being experienced, then the management of the financial institution would have been so simple. It’s the risk that actually enhances the financial behavior of the bank.

Product range

The bank should ensure that there are various products which it deals with so as to spread the risks and hence minimize the liquidity risk. The bank also should ensure that the various products which it offers such as the savings from all kinds of customers either the retail or individual. The products also should include the current accounts from all the various customers in the population even the corporate sectors. There should also be the retail corporate.

Deposit concentration

The bank should ensure that it maintains the customers’ deposits at a certain level which will ensure the bank will not be challenged over it in the realization of the short-term financial obligations. The customers who make the deposits also should be increased through intensive marketing of the various products of the banks so as to have access to the various customers who need the services of the company. This will ensure that the short-term liabilities can be utilized by the bank in establishing other forms of money which will be of great significance to the bank from the financial abilities point of view.

Deposit administration

There should be proper administration of the deposits which have been made by the customers. These include the management of the interest which is to be paid on such deposits. This will reduce the chances of the bank underutilizing the availability of the deposits. There should also be minimal access of the staff to the customers’ accounts so as to ensure that there are effective controls that regulate the flow of cash. The liquidity of the bank is very important and at all times it’s should be maintained.

Management policies

The bank should also be in a position to instill excellent policies which ensure that there is adequate management of the resources it has so as to be productive as much as possible. There should be a management structure that will ensure that there is also an effective means which justify the use and access to the banks’ funds. The management policies of liquidity will ensure that there are manageable heights of the risk exposure. This will be more meaningful to the bank as there will be an efficient way of stabilizing the bank’s liquidity. The policies also should cover well planning of the banks’ abilities in the handling of emergencies such as financial crises. The policies should be able to ensure that the bank is not overshadowed by the lack of effective policies to withstand the economic crisis storm. There should always be alternative options in the handling of the liquidity risk by the company management so as to fully be in a position to continue with the bank’s operations.

Liquidity ratios

The bank should utilize the various financial ratios which relate to the liquidity of the bank. The bank should be in a position to know the financial position of the banks’ operations. The bank management should be in a position to establish how to conduct its operations without any interference from the lack of accountability of the bank’s progress. The ratios are very important to identify the liquidity of the banks especially with regards to the assets which it has. The assets which the company is using should be periodically assessed so as to identify the ability of it being converted to cash so as to meet the short-term financial obligations.

There should be active internal sections that handle the issues which relate to the conversion of the currencies in the bank. This will ensure that the foreign and the local currency are convertible to one another so as to ease any challenges associated with the use of the money. There should be a backup strategy for all the currencies that the bank is using so as to create an enabling environment for currency transactions.

Financial regulator

Liquidity risk will be controlled by the bank through various ways which will ensure that the financial behavior of the bank is within the limits which have been well managed. The bank should affect the capital reserve in the central bank so as to utilize it in case there is a serious need for it. The liquidity risk is a serious matter that may cost a lot to the banking institution hence having a capital reserve at the central bank is essential. This is also a measure which has been set by the central bank for the entire bank so as to be able to carry o all its activities effectively. The reserve also will enable the bank to seek a loan from the central bank without any further security being used. This capital requirement is very important to the bank as it enhances the ability of the bank to meet its own short-term and long-term financial obligations. The liquidity risk will actually be controlled by the capital requirement at the central bank since the capital base of the bank is diversified (Jorion 89).

The capital requirement also will enable the bank to take a loan from the central bank at a lower lending rate which will enable the bank to lend to its customers at a higher rate thereby raising more money which will be of great use to the bank in meeting its financial obligations. The reserve which the bank shall maintain is very important in the utilization which will enhance the bank’s access to liquid cash which be used in funding the short term liabilities. The bank also is able to come to terms with the avoidance of the retail customers rushing to make withdrawals of all their money which they had kept in the bank as savings. The bank also will be able to use the savings of the customers as the short-term liabilities in the execution of its short-term financial obligations.

Ineffective control by the liquidity risk

The bank may fail to effectively control the liquidity risk mainly because of factors that are not within their control. This includes the foreign currencies which are most not easily converted to the local currencies. This affects the bank’s liquidity. The various presences of different currencies in the country make it difficult for the bank to transact effectively hence affecting the liquidity position of the bank. This is as a result of the local currency being hard to be convertible to the other currencies and vice versa.

There is a lack of confidence in the bank by the customers and the fund market. This is very risky to the bank and it really threatens the effective management of the bank’s liquidity. The bank also may over-depend on the liabilities which will result in serious effects on the bank’s assets securities. These securities are mostly those of short term hence the bank will be in a situation that will be inappropriate to meet the short term financial obligations. This also will make the bank fully fund the long-term securities thus affecting the short-term liquidity. This is a very serious matter hence there should be in-depth concern by the bank to fully support the liabilities management so as to reduce its dependence, hence increasing the funding of the short term assets with short term maturities (Madura 145).

The rising competition in the money market has also contributed a lot to the banks’ ability to meet their short-term financial obligation. This tempts the bank to acquire funds that are very expensive. This has a direct effect on the bank’s ability to effectively manage its credit services. This relates to the bank’s measures that are weakly being implemented such as decreasing the standards of credit so as to invest in loans and securities which are highly profitable. This may result in a negative impact hence affecting the short-term operations of the bank.

Works cited

Babu, Ramesh. Financial Markets and Institutions. New Jersey: Concept Publishing Company, 2006.

Carol, Alexander and Sheedy Elizabeth. The Professional Risk Managers’ Guide to Financial Markets. New York: McGraw Hill Professional, 2007

Jorion, Philippe. Financial Risk Manager Handbook. New Jersey: John Wiley and Sons, 2009

Madura, Jeff. Financial markets and institutions. 8th ed. New York: Cengage Learning, 2008

Saunders, Anthony and Cornett Marcia Millon. Financial markets and institutions: an introduction to the risk management approach. 3rd ed. New York: McGraw-Hill/Irwin, 2007.

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