The liquidity gap

Regulators are increasing their focus on liquidity risk in response to the financial crisis, but there are questions about whether capital is an effective mitigant for liquidity risks and the nature of the relationship between liquidity risk and bank solvency. Roy Choudhury, Peter Marshall and Hovik Tumasyan look at the interdependencies between solvency and liquidity risk within a bank’s risk management framework

Solvency and liquidity are the two core pillars of banking. Solvency risks arise from the credit creation and investment function in banking, as some obligors may default and some investments may lose their value, resulting in unexpected losses. Liquidity risks arise from the maturity transformation function in banking – specifically, banks borrow at a short duration from depositors or markets, and lend at a long duration to borrowers or invest in illiquid securities. In most banks, solvency and