Definitions of Liquidity, Solvency, Leverage, and Debt

Banks and People (part 1 of 3)

The first laws of library science are:
For every reader a book.
For every book a reader.

The first law of economics, the “law of supply and demand” is:
For every seller a buyer.
For every buyer a seller.

In other words, you can’t have a “market transaction” without both a buyer and a seller.

Keep these laws in mind as we explore the relationship between banks and people.

People put money in the form of “cash” into banks. This cash is called “deposits” by the bank. Banks use deposits to earn more cash for themselves from other sources. This is how they survive. People use banks as long as banks keep their money “safe.” And sometimes people make deposits because banks pay people cash for their deposits. This is called “interest” on their bank deposits.

The relationship between people and banks is that simple. Banks and people buy and sell (i.e., borrow and loan) cash from each other. Where it gets complicated is in how banks use the cash they get from people.

When banks began failing faster, two supposedly opposite reasons for the failures were raised: liquidity and solvency.

“Liquidity” is the ability to get your money fast.
“Solvency” is having money to get–solvency is having enough to pay the bills.

So did the banks lack liquidity? Or did the banks lack solvency? I feel this is a false dichotomy. Taoist philosophy from ancient China shows us a way out of either/or thinking traps such as this one. Liquidity and Solvency are not opposites. They simply belong to two pairs of opposites. These pairs are:

Liquidity vs Leverage (or “Illiquidity)
Solvency vs. Debt (or “insolvency” )

Liquidity typically applies to Assets. “Assets” bring in money, they’re “incomes.”
Solvency applies to Debits. “Debits” cost you money; they’re “outgoes.”

To understand the term leverage, think “lever-aged” Imagine yourself using a lever to slowly raise and lower heavy piles of money that go up and over your head. Consider what happens if something goes wrong and the lever slips.

In Part II we’ll look at how these definitions of this pair of opposites apply to people and to banks. We’ll show what happened during the financial crisis. In Part III we’ll examine the roles our government is playing and show how different parts of our government are working against each other in trying to remedy the financial crisis.

Copyright © 2009 Nancy K. Humphreys

1 comment so far ↓

#1 Our Government: A Business Without Assets? | Brucenomics on 02.11.10 at 3:45 pm

[…] What are debits and assets? Roughly speaking, debits (sometimes called “liabilities“) are things that take money out of your pocket and assets are things which put money into your pocket. (If you remember, I talked more about this pair of opposites in my previous blog, “Part I: Banks and People.”) […]

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