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

Assets Liabilities

£5 million reserves £10 million deposits

£6 million loans

Inspecting the table shows clearly that Cautious Bank’s assets are worth more than its liabilities. This is good news – Cautious Bank certainly isn’t insolvent. Why, then, is it suffering financial difficulties?

Looking at its assets, you notice that they differ in their liquidity:


A liquid asset is one that’s easy to turn into cash.


An illiquid asset is one that’s difficult to turn into cash.

Cautious Bank’s reserves are liquid by definition – they’re cash! But what about the loans it’s made? These are certainly valuable assets; however, the loans won’t be paid back until perhaps many years into the future. Moreover, the bank can’t use them to pay a depositor who wants to make a withdrawal. Just imagine going to your bank to make a withdrawal and being told ‘Sorry, we’ve run out of cash, but take this loan that will pay you back in a year’s time’!

One possible solution is that Cautious Bank sells the loans to someone else. The problem is, in these circumstances, it’s unlikely to get a good price. In this distressed state, potential buyers of the loans know that Cautious Bank is desperate for cash, which substantially weakens its bargaining position. Furthermore, potential buyers may not know the quality of the loans and assume that because Cautious Bank is in trouble, the loans are of low quality – that is, less likely to be repaid.


Catching a Cold! Systemic Risk

In this section we show that financial institutions are connected to one another in a complex web of transactions. As a result, problems in one financial company can quickly spread to others – like a financial virus.

The transmission of problems from one financial institution to another is called financial contagion, because, just like a cold, financial problems are contagious!

We describe the nature of this systemic risk and the dangerous phenomenon of a cascade of business failures. We also include the story of one famous company failure as illustration.