AYALA, FRENCH, D.

1. Why is there a need for banks to be solvent at all times?  What are the consequences if
banks have problem on liquidity?

 A financial institution's liquidity indicates its capacity to fund assets and pay debts. It is
crucial to have enough money on hand to cover consumer withdrawals, account for
balance sheet changes, and finance expansion.
 A liquidity problem arises when an otherwise solvent business lacks the liquid assets—in
cash or other highly marketable assets—necessary to pay its short-term obligations. Loan
repayment, continuous operational expenses, and staff compensation are just a few
examples of obligations.
 The company may have sufficient assets in the long run to cover all of these obligations,
but if it lacks the cash to make payments when they are due, it will default and may
eventually file for bankruptcy as its creditors seek repayment. The mismatch between the
maturities of the business's assets and the liabilities it has undertaken to finance those
investments is typically the basis of the issue.
 As a result, there is a cash flow issue because the projected revenue from the company's
numerous projects does not materialize as quickly as expected or in large enough
quantities to cover the payments required for the appropriate financing.

2. What is Bank Liquidity and how do bank manage it?

 The ability of a bank to promptly pay its debts and other short-term financial and business
obligations with cash and other assets is known as liquidity. The amount of capital a bank
has determines its ability to withstand losses.
 Cash and other assets that may be swiftly turned into cash if necessary to meet financial
obligations are referred to as liquid assets. Government bonds and central bank reserves
are typical examples of liquid assets. A financial institution needs to have adequate liquid
assets to cover depositor withdrawals and other short-term obligations in order to remain
viable.
 The gap between all of a company's assets and liabilities is known as capital. To absorb
losses, capital serves as a financial buffer. To be solvent, a company's assets must be
worth more than its obligations.
 The home finances of a normal family serve as an example for these two ideas. Liquid
assets, such as cash in a checking or savings account that may be utilized to swiftly and
easily pay expenses, might be included in the family's assets. So, a measure of the
family's liquidity position would comprise the amount of cash on hand, the checking
account balance, and some other investments like money market funds.
 The family's assets don't simply consist of liquid ones; they also comprise their house and
possibly other investments that aren't liquid but might nevertheless be rapidly sold to
realize their value.
 The difference between the value of the family's assets (both liquid and non-liquid) and
the family's liabilities, or the money it owes, such as a mortgage, would be a measure of
the family's capital position.
 Due to insufficient capital, a shortage of liquidity, or a combination of the two, banks have
failed or needed government aid over time.

3.  What happens if the bank has too much liquidity?

 Excess liquidity is often defined as the amount of reserves deposited with the central
bank by deposit money institutions plus cash in vaults above the required or statutory
level. Yet, the excess liquidity as assessed may just represent the liquidity held for
safety. In other words, commercial banks' optimizing behavior may contribute to the
buildup of non-remunerated reserves. Is it possible for involuntarily surplus liquidity to
persist in equilibrium rather than merely being a brief departure from the ideal balance
sheet structure of commercial banks? Why do commercial banks not increase lending
or invest in government securities if they have more liquidity than they need? One
argument might be because these economies are in a liquidity bind. Banks have a
larger yield on reserves than they do on loans under the typical liquidity trap, when the
rate of return on lending is too low to pay intermediation costs (and where bonds and
reserves are perfect substitutes). Hence, a central bank's monetary expansion simply
results in an increase in surplus reserves, even above banks' prudential needs.

 Even if commercial banks are unable or unwilling to increase lending, one would still
anticipate that banks will buy government bonds to pay off any surplus reserves since
these have a greater yield than deposits. As commercial banks reach a point of
indifference, where the prudential return on reserves equals the return on bonds, the
spread between the return on bonds and reserves should narrow as they continue to
purchase bonds. Under this situation, involuntary excess reserves shouldn't happen
unless the economy is in a liquidity trap and bond yields drop to zero.

 This ought to be the case even if the general public outside of banks does not own
bonds. The central bank can effectively manage the amount of bonds owned by the
banking sector if banks are the only holders of bonds. But, in this instance, banks'
competition for bonds should guarantee that bond rates eventually decline when
bonds are rolled over to a point of indifference between both bonds and reserves. As a
result, the presence of an equilibrium with involuntary surplus liquidity and a vibrant,
vibrant bond market cannot coexist.