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When Lehman Brothers went under, its debts (liabilities) were
much greater than its assets. Therefore, even though it had access to temporary
funds from the Federal Reserve, this access to liquidity couldn’t solve the
underlying problem that it couldn’t meet its liabilities.The
asset and liability structure is important for banks in order to maximise profitability,
increase effectiveness and stability and minimise risk. With afaultystructure the
banks may be in a vulnerable position when there are changes in interest rates,
inflation, banking legislationsand global economy.Asset/liability management has become a complex endeavour.
Knowledge of the different factors that take upon this aspect of risk
management is crucial to find appropriate solution. Accurate asset allocation accounts not
only for the growth of assets, but also addresses the nature of a banks
conditions,sovereign and financial market tensions and monetary policies can
change rapidly, as shown by the 2008 financial crisis, andit is important to ensure
asset quality and profitability in response to the changing environment.In the case
of commercial banks, they make their profits by taking small, short-term liquid
deposits from savers and putting these into larger, longer maturity loans e.g.
mortgages or business loans. But in order to minimise risk, banks have to
diversify their assets, since they can’t put all their funds into long-term
loans, as that would put them into a weak position if the loans went bad. Thus,
banks diversify their assets, putting funds into long-term and short-term
loans, offshore securities, gold, cash etc., and they effectively reduce risk,
improve their liquidity, and in the situation that there is a market downturn
they will have a better chance of survival. As for investment and universal banks, they
generally have more assets in trading, reverse repo finance and less in loans.
The same distinction is on the liability side, where commercial banks tend to
have mostly deposits, universal and investment banks typically have mostly repo
finance, trading and other debt.   As we can see, the liabilities and
assets of financial institutions can be quite complex. To manage risks that
arise because of mismatches between assets and liabilities the Asset-liability
management (ALM) strategies are used.They minimise risk, loss of profit and help
banks increase their asset value. These include the use of interest rate risk
management and hedging, using financial futures, swaps, options and the use of
derivatives. Using these techniques banks can understand asset and liability
structures better, operate with less risk, more efficiency and profitability.

supply is the total quantity of liquid assets available in a country’s economy
at a particular time. It is used for controlling interest rates, inflation and increasing
or decreasing the flow of money. The central bank controls the money supply
using methods such as selling government bonds, increasing the interest rate at
which banks borrow from the central bank and increasing reserve requirements.

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decrease in money supply typically increases interest rates, which in turn reduce
the purchasing power, consumption and investment expenditures, net exports and
government purchases, resulting in a decrease in aggregate demand. This is
called a contractionary monetary policy and is used in accordance with other
government or central bank policies.Solvency
and liquidity both refer to the financial health of a company or a bank,
however solvency refers to the ability to meet its debt and other obligations,
whereas liquidity is the ability to raise cash quickly. Both of these are
equally important, and financially healthy banks both possess decent liquidity
and are solvent. However,
there are situations where a bank may undergo a liquidity issue and if it can’t
pay its short-term debts it may have to sell off assets, just to get the funds
they need. On the other hand, if a bank faces insolvency it means even if it
could sell off all assets and withdraw their loans, for example – mortgages, it
still wouldn’t be able to meet its liabilities.A
good example of solvency and liquidity issues is The Financial Crisis of 2008.
Analysts argued if it was a liquidity crisis or a solvency crisis. Those who
endorse the idea that it was a liquidity crisis argument that it was a “run” on
repo securities. John Cochrane, Robert Lucas, Nancy Stokey and others suggest
that instead of running to withdraw their money, repo customers started a fire
sale of repo securities and prevented banks from borrowing short-term. This has
been characterized by the Diamond – Dybvig model. On the contrary, Paul Krugman
and Anna Schwarz suggest that the reason there was a liquidity issue is because
the market realised that most banks were facing insolvency. Some banks had
liquidity and could afford to help others, but were too afraid that the most
banks were insolvent and so decided to accumulate as much capital as possible,
even though lending short-term money out to other banks is considered very safe
– almost as safe as lending to the government.The
Federal Reserve Bank had to help the banks in trouble and in Section 13-3 of
the Federal Reserve Act it is stated: “In unusual
and exigent circumstances the Fed could lend to any institution, as long as the
loan was secured to the satisfaction of the Federal Reserve Bank.” This of
course meant that banks have to be solvent. During that time many banks faced
liquidity crisis because money markets “dried up” and many banks couldn’t get
access to enough cash. In this case Central Banks offer short term liquidity in
cash injections to ensuring the liquidity issue doesn’t turn into an insolvency
crisis. But what to do with the banks that are facing insolvency?Because Central Banks were helping with liquidity problems and not
insolvency,     Since the financial crisis, the government and central banks
implemented new laws and regulations which helped to deal with liquidity and
solvency problems. The biggest change implemented could be easily identified as
regulations, more specifically – stress tests. Small control was replaced with
tight supervision and banks were required to make more regular and thorough
analysis. JP Morgan increased the number of employees working on stress testing
and liquidity control by around 44% to 43,000, from 2011 to 2015 and it keeps
growing.Another big change is more demanding capital requirements and liquidity
rules. To manage liquidity issues and keep banks safe from another crisis
central banks improved international laws, known as Basel III, have made banks
to collect and stock up their convertible debt and equity. How this helps the financial
institutions, central banks, governments and the economy is if banks face a
troubling liquidity issue it can still “soak up” the worst of it.

As said by the Bank of international Settlements
in Basel it shows that 30 of the world’s “most important and
globally influential backs” increase their equity by around €1trn),
largely through retained earnings.It
was effectively a loan to an Investment Bank ; liquidity assistance is not
normally given to such institutions, just to commercial banks. See the Cechetti
paper for details of the regulations under which this was permitted.

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