A bank can be worth more than it owes and still close on a Friday afternoon. A racing team can lead the championship and still not start on Saturday. Same problem, two costumes.
Learning objectives. After this week you can (1) read a bank balance sheet and its capital ratio; (2) tell liquidity from solvency; and (3) explain the maturity mismatch.
Remember this: solvency is whether you can pay eventually. Liquidity is whether you can pay today.
1) The balance sheet
| Assets | $M | Liabilities & Capital | $M |
|---|---|---|---|
| Reserves (cash) | 10 | Deposits | 90 |
| Securities (bonds) | 10 | Capital (equity) | 10 |
| Loans | 80 | ||
| Total | 100 | Total | 100 |
Capital Ratio = Capital ÷ Assets
Here 10 ÷ 100 = 10%. Capital absorbs losses first; depositors are safe while it lasts. Reserves are the most liquid asset on the sheet.
2) Two ways to fail
- Insolvent: liabilities exceed assets. If loans lose $12M, assets drop to $88M against $90M of deposits, and capital is 10 − 12 = −$2M. The bank needs new capital.
- Illiquid: assets exceed liabilities, but there isn't enough cash today. Depositors ask for $15M; reserves are $10M. The $5M gap means selling assets fast, often at a loss, or borrowing. The central bank's lender-of-last-resort loans exist for this case.
3) The maturity mismatch
Banks borrow short and lend long. Deposits can leave tomorrow; loans run for years. It pays in normal times because long rates usually sit above short rates (Week 8's upward curve). It is risky because a jump in short rates raises funding costs at once while fixed loan income stays put, squeezing profit, and because sudden withdrawals can force long assets to be sold at a loss. Matching the two sides of the sheet is called asset-liability management.
4) Your team has the same two tests
Liquidity: budgets reset to zero each race week and Winnings arrive only after the race, so Saturday must be funded from the bank you have now. Solvency, team style: can your bank cover your planned spending for every race left?
Example. A team holds $23M with 4 races left and plans $8M a race. It needs 4 × 8 = $32M, so it is $9M short. It can fund this week easily; it cannot fund the season at this pace unless Winnings close the gap. The two tests pull against each other: hoarding cash keeps you liquid, but it can starve the spending that earns Winnings.
Quick self-check
(a) A bank has $10M of reserves and faces a $15M withdrawal, but assets exceed liabilities. Illiquid or insolvent? (b) A bank has $100M of assets and $10M of capital. Capital ratio? (c) A $60M bank planning $12M a race can fund how many races before any Winnings? (Answers: illiquid; 10%; 5.)
Common mistakes
- Treating the two tests as one. A loan fixes illiquidity; only capital fixes insolvency.
- Checking only this week. A gap four races out is easy to see now and hard to fix later.
- Confusing profit with cash. Points in the standings do not fund race day.
This week in the arena
Write your team's treasurer's report: bank, this week's planned spend, and your season need (planned spend × races left, counting this one). Is there a surplus or a gap, and how big?