“liquidity crisis” or a “solvency crisis” – 2008

I have been reading Noah Smith  work and found very interesting, sharing the  2008,  financial crisis that was unfolding, there was a big argument as to whether the crisis was a “liquidity crisis” or a “solvency crisis”. It’s a very important distinction. A “liquidity crisis” is when banks (or similar finance companies) are financially in the black – their assets are greater than their liabilities – but they can’t get the cash to keep paying their bills in the short term. A bank run is the classic example of a liquidity crisis – even if the bank could eventually pay everyone back, it can’t pay them back all at once, so if people get scared and all try to withdraw their money in a rush, they force the bank to collapse. A “solvency crisis”, on the other hand, is when finance companies are actually bankrupt, and no amount of short-term borrowing will change that fact.

This question has important policy implications in a financial crisis. If companies are illiquid but solvent, you just need to have the Fed lend them money to tide them over until liquidity comes back. If they’re insolvent, you either need to bail them out, or help them into an orderly bankruptcy, in order to reduce systemic risk caused by disorderly failure.

Some prominent thinkers have endorsed the idea that the 2008 crisis was a liquidity crisis, created by a “run” on repo securities. People who have promoted this idea include Gary Gorton, Robert Lucas and Nancy Stokey, and John Cochrane. The model they have in mind is the Diamond-Dybvig model, the classic model of bank runs. Instead of people rushing to the bank to withdraw their deposits, the idea goes, repo customers conducted a fire sale of repo securities, preventing banks from being able to borrow short-term.

But others disagree. They claim that the reason banks’ liquidity dried up was simply that the market realized that the banks were insolvent – that the mountains of housing-backed securities on the banks’ balance sheets was in fact worth a lot less than most people had previously thought. These dissenters include Paul Krugman, (who favored bank nationalization), and also Anna Schwarz. They also implicitly include those who think that “Too Big to Fail” was at the heart of the crisis. If the crisis was caused by banks taking excessive risks because they knew they would be bailed out in the case of insolvency (“moral hazard”), that implies that the big banks we bailed out were, in fact, insolvent. The “TBTF” argument has been advanced by proponents of stricter regulation, including Simon Johnson and James Kwak, Paul Volcker, and Jeffrey Lacker.

Source : Noahpinion