Solvency and Liquidity Risk, Controling, Financial Regulators and the Main Problems

Solvency and liquidity risk

Solvency and liquidity risk are both forms of financial risk and they both have significant effect in the performance and the going concern of the company. However the two forms of financial risks differ in some respects. Firstly, liquidity risk is experienced when the company is unable to meet its short term financial obligations or expenses as and when their payment date is due (Crockford, 1986, 65). In other word the company is running out of cash. Solvency risk on the other hand is the risk that the company might not be in operation to the foreseeable future. This is normally evident where a company’s total liabilities exceed total asset, thus making it technically insolvent. Solvency risk is considered more detrimental to the financial position of the company than the liquidity risk in the sense that if a company does not have cash, it is capable of borrowing cash to cater for the expenses but it cannot get a loan when it is having solvency risk. A company or any other organization experiencing liquidity risk but it is solvent is capable of getting a loan from financial institutions because the lenders consider solvency in order to give loans. The other difference is that since the solvency risk is the inability of the company to meet financial obligations due to the lenders, it leads to insolvency proceedings (Hachmeister, 2007, 9). In this case the legal action is taken against the insolvent entity and it may be decided that the asset be sold to pay debts due to lenders. For liquidity risks, the legal action may not be taken against the entity because the company can borrow to finance its financial obligations in the short run.

The causes of the two kinds of risks are also different. The liquidity risk is caused mostly by market failure whereby the company is unable to liquidate its assets. There are no buyers for the assets that the company is willing to sell in order to get cash. If also the market the company relies on is suffering liquidity problems the company will also suffer the same. In case of sudden cash outflows, the company is also likely to suffer liquidity risk. This is because the company is left with no or limited cash and cannot adequately meet its financial obligations. In case of decline in credit rating, the amount of loan the company is worthy to get from the lenders decreases and liquidity risk arises. Solvency risk on the other hand is caused by poor cash management such that the company is unable to pay its lenders. The liabilities exceed the assets and the company becomes insolvent. The company can therefore not pay off debts because it has no cash and the only way out is to liquidate the remaining assets in order to pay off debts. In case the projected cash flow decreases, the company will be able to honor its budget of paying the lenders. The expected cash flow may not be realized in full but the debts have to be settled fully. The company will therefore be insolvent and may be liquidated. Cash expenses may also increase beyond the planned figure but the cash flows remains the same. This means that more cash will be spent and less is left which may not be enough to pay off debts. The company will in this case have solvency risk because it can not pay off its debts.

Credit risk

A credit risk also called default risk arises when a borrower defaults a debt due to an investor. The investor suffers loss in several ways like increased debt collection costs and reduced cash flows. According to Altman & Saunders (1997, 1737), the investor also loses the invested amount (principle) together with the interest. These kind of loses happens in situations like where the insolvent bank fails to pay the depositors their money or an insolvent insurance company fails to honor policy obligations among others. Credit risk may result to both the solvency risk and the liquidity risk. Increase in cash expenses due to increased cost of debt collection will leave the company with little or inadequate cash to pay off debts and other financial obligations (Crockford, 1986, 36). This will result to solvency risk and liquidity risk respectively. There are also reduced cash inflows which will cause liquidity risks. The loss of the amount invested together with the interest will mean that if the money invested was borrowed, there will be no cash to pay the lenders and the cash inflows are further cut short due to lost interest rate.

The nature of dynamic provisioning

Dynamic provisioning is a strategy used mostly by the financial institutions where they accumulate loss reserves in times of good economic terms so as to be well positioned if losses occur during bad economic times. It is a macro prudential strategy that has become rampant with many banks in the world (Fiona & Ian, 2002, 128). The strategy encourages banks to accumulate reserves in times of plenty so that if in future they start making loan losses, they will have a fund to draw on. According to Saurina (2009, p. 1), the system of dynamic provisioning was and has been applied in Spain since year 2000 and has helped the banks to weather economic downturns and bank crisis. The banks in Spain were advised to be more conservative as far as their books of accounts are concerned. Dynamic provisions are means of catering for losses on loans but which are not yet established. They account for about 10 percent of operating income that banks realizes every financial year (Saurina, 2009, p. 1). Provisions are made depending on the expected amount of loss. For banks, they do provisions for loans depending on the expected amount of loss related to loans. If the actual loss falls below the expected amount, there is always stock of provisions which is utilized in cases where the actual loss exceeds the provisions for that particular period. This also ensures that the income statements are not much distorted in cases of higher losses than what is provided for. The resulting difference in this case is catered for by the existing stock of provisions. As per historic cost accounting, the provisions are made depending on the losses that are incurred and recognized as at the balance sheet date. In other words, the provisions for loan losses are determined as per the current information. For instance, the bank may discover that the creditworthiness of the borrower has gone down and therefore the amount he borrowed may not be recovered in full. The bank will therefore provide for the amount that is expected to be lost.

Banks expects that each year, a certain amount loss will be incurred as some borrowers will not be able to settle their debts in full (Fiona & Ian, 2002, 129). The provision for these losses are therefore made yearly out of the profit realized during that financial year. The UK banks have some formal rules that guide provisioning. Concerning advances, the British Banker’s Association (BBA) has the following rules. BBA rules that the amount of provision made will be equivalent to what the bank expects to equate the carrying charge to the final realizable value. Provision should also be made only in the event that the available information suggests impairment of the advances. There is also general provisioning that suggests impairment of the advances though not yet established (Knight, 2003, 38). The past experience is used to determine the amount of provisioning that should be done on the advances. According to international accounting standards (IAS) 39, the loan will only be considered impaired if the lender cannot collect either part of it or the whole of it.

According to Saurina (2009, p. 2), dynamic provisions acts as a buffer in the event the credit losses occur. This minimizes the implications of credit risk which occurs when loans becomes irrecoverable. The solvency risk is also reduced because the banks will have enough funds in form of provisions stock which can be used to pay off bank debts.

Controlling liquidity risk

Control of liquidity risk within banks calls for integration of decisions of multiple sections of the bank. The internal system of banks must be well equipped to control liquidity risks. The financial regulators also have a big role to play in controlling liquidity risk. They have to vet the financial decisions made by the bank that might culminate into liquidity risk. Financial regulators should be well aware of the factors that may cause liquidity risk so that they can fight against them. However, banks do encounter various problems in their attempt to control liquidity risk. In this section, we shall discuss the ways in which the internal system of banks can help reduce the occurrence of liquidity risk. We shall also discuss the role of financial regulators in controlling liquidity risk. Finally we shall look at the problems of controlling liquidity risks.

Internal system within banks and liquidity risk

Proper control of liquidity risk enables the banks to pay for the financial obligations when their payment is due. For the internal system of banks to be able to fully control liquidity risk, they should have better communication system to enable effective flow of information. This will help improve intraday liquidity visibility such that any problem in liquidity will be noticed earlier. This mechanism involves gathering information from all the internal systems about liquidity regularly and ensures that it is at the right level.

There is also need for intraday system of liquidity management instead of the previously used end-of-day system. The system should come up with a transaction data warehouse that will enable all the transactions to be vetted on intraday basis (Berger & Davies, 1998, 132). This strategy will also help in improving the capability of liquidity forecasting. The accumulation of liquidity problems will be avoided through intraday liquidity checking system.

The other internal control measure of the liquidity risk is through improving the liquidity ratios. The liquidity ratios are the current ratio and the quick/acid test ratio which in a financially sound company must always be 1:2 and 1:1 respectively. The internal system should establish a system which will increase the credit payment period and reduce debtors collection period. This will mean that the company will have more grace period to pay the creditors. The company in this case will be able to determine the amount of bad and doubtful debtors long before the amount due to the creditors fall due. There will be enough time to plan on how to pay the creditors. The provisions for bad and doubtful debts should also be effected so that the company will be able to balance the creditors and the debtors. Provisions should be made on annual basis so that the every year the bad and doubtful debts arising are dealt with as appropriate.

The internal control system should also diversify the liquidity providers so that the bank will easily obtain liquidity in case of liquidity crisis (Culp, 2001, 28). This measure offers the bank alternative sources of liquidity in case one provider refuses or is unable to provide.

Financial regulators and liquidity risk

Financial regulators supervise the financial institutions to ensure that their activities are commensurate with the acceptable code of financial behavior. Financial regulations are the codes of conducts that every financial institution is subjected to and is obliged to comply to. These include requirements and guidelines that are meant to ensure there is sound integrity in the financial system. Financial regulators have a big role to play in controlling liquidity risk. According to Knight (2003, 19), the regulators provide opportunities for the banks to sue the borrower who refuses or fails to pay the loan advanced to him. The regulators also regulate credit availability in order to ensure that the bank does not over lend and be unable to meet its short term obligations. The central bank for instance regulates lending by commercial banks through increasing the reserve ratio. When the reserve ratio is increased, the banks will have little credit to lend. This ensures the banks have enough cash to pay the creditors and meet other short term financial obligations.

According to Talor (2008, 1), the creditors are also expected by the regulators to be aware of the creditworthiness of banks before they deposit their money or before they create any other form of credit to banks. The regulators ensure that the banks are audited and their financial positions assessed so that the creditors can be cautioned. Banks are also expected to prepare financial statements according to the stipulated procedures so that the creditors can also be cautioned.

The main problems that a bank may have in controlling liquidity risk effectively

One of the problems that are encountered by banks in controlling liquidity risk is reluctance of banks in accepting liquidity risks. Banks do not accept that they are experiencing liquidity crisis because they do not want to be exposed of their statues. This is delaying the control of the risk and therefore many more cases are still arising.

According to Deventer and colleagues (2004, 19), most banks also do not have a strong internal system that is capable of dealing with the issue of liquidity on intraday basis. Most banks use end-of-day approach which may not be very effective in dealing with the liquidity risk.

For banks that have adopted intraday liquidity risk management, they encounter problems in maintaining it. The system is costly and banks may find it a big financial burden to them especially where the liquidity risk does not occur but the system has to keep running. If the banks experience a long period without liquidity risk, it might be assumed that the trend will continue and the system may be abandoned.

The issue of contingency funding also is a big problem to many banks. Contingency plans funding becomes a problem because it is based on historical data which may lead to underestimation or overestimation. According to Culp (2001, 23), underestimation can be dangerous because the bank will underestimate its liabilities and this may accelerate the liquidity risk.

Conclusion

Liquidity risk and the solvency risks should be highly controlled because their occurrence is harmful to the company performance. The concept of dynamic provisioning could be applied to reduce liquidity risks in banks. Banks should devise mechanisms to deal with the risks in case they arise.

Reference List

Altman E. & Saunders A. 1997. Credit risk measurement: Developments over The last 20 years. Journal of Banking and Finance, 20, pp 1721-1742.

Berger A. & Davies S. 1998. The Information Content of Bank Examinations. Journal of Financial Services Research, 14(2), pp 117-144.

Crockford N. 1986. An Introduction to Risk Management (2nd Ed.). London: Woodhead-Faulkner

Culp CL. 2001. The Risk Management Process. Hoboken: Wiley Finance.

Deventer V., Donald R., Kenji I. & Mark M. 2004. Advanced Financial Risk Management: Tools and Techniques for Integrated Credit Risk and Interest Rate Risk Management. Hoboken: John Wiley and Sons Inc.

Fiona M. & Ian M. 2002. Dynamic provisioning: issues and application. Financial Stability Review: December 2002 BCBS (2002). 14(1), pp 128-132.

Hachmeister A. 2007. Informed Traders as Liquidity Providers. German: DUV

Knight S. 2003. Forecasting Volatility in the Financial Markets. London: Butterworth-Heinemann

Saurina J., 2009. Made in Spain and working well. UK: Financial World.COM. Web.

Talor M. 2008. Revisiting Basel. Financial World. UK: Financial World Online. Web.