Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Types of bank failure


Economists draw a distinction between those businesses that are in trouble due to being insolvent and those that have liquidity problems:


Insolvent: A business is insolvent when all its assets combined aren’t sufficient to cover its liabilities. For example, suppose you own a bakery that owes £1 million to Jessica. If you’re unable to pay her even after selling all the bakery’s assets (the building, the oven, unpaid invoices and so on), we’re sorry to tell you that your business is insolvent.


Liquidity: A business has liquidity problems when it has short-term cash flow problems. Cautious Bank seems to have more of a liquidity problem than a solvency problem.


Cautious Bank’s problem

To understand why Cautious Bank’s issue is liquidity, imagine that its total

deposits stand at £10 million and its reserve ratio is 0.5 (see the earlier

‘Discovering what happens when you put your money in the bank’ section for

more on the reserve ratio). In other words, the bank has £5 million in reserves and has loaned out £5 million. Before moving on, just spend a minute thinking about Cautious Bank’s assets and liabilities.

Are Cautious Bank’s £10 million of deposits an asset or a liability? They’re a liability, because at any time depositors can turn up and ask for their money back. What assets does the bank have in order to meet this liability? Well, it has reserves of £5 million and £5 million of loans. If Cautious Bank has done a good job in allocating the loans, they should be worth more than £5 million, because they’re likely to be repaid and earn the bank a healthy return. Suppose that the bank considers them to be worth £6 million.

Table 14-1 outlines Cautious Bank’s assets and liabilities.


Table 14-1 Cautious Bank’s Balance Sheet