any company that cannot pay its creditors if and when funds are due is insolvent. This is the definition of insolvency.

In Wikipedia, it explains: Insolvency means the inability to pay one’s debts. This is defined in two different ways: Cash flow insolvency – unable to pay debts as they fall due; Balance sheet insolvency – having negative net assets: liabilities exceed assets.

In fact, the vast majority of companies that are declared insolvent in the U.S. and the U.K. are declared insolvent because of insufficient cash flow (liquidity). General Motors has been insolvent from a balance sheet perspective for a long time and still operates as a going concern. See my post “Solvency.”

But, you are right about this being a question of understanding whether firms are suffering from liquidity problems or true insolvency. That is what I set out to clarify in that post. This was days before the Lehman bankruptcy and I said:

“One problem with financial crises is that perfectly healthy companies, perfectly healthy financial institutions can go bankrupt just because they temporarily lack the funds to pay their creditors. This is what the lack of liquidity in our financial system can do. The real problem of crisis is that healthy institutions are often dragged down with unhealthy ones, leading to a dead weight loss and a negative feedback loop in the real economy.”

This is what we must avoid. But for the truly insolvent bank — and there are many — yes the leverage and lack of capital adequacy are very much at issue here as we shall see when we get more credit writedowns on other classes of debt.

So, what we have here is a crisis that starts with liquidity problems (Northern Rock and Lehman Brothers, for example) making it difficult to know who is actually truly insolvent. The question is who is hiding the ball and who is actually ok. That is the problem with an ad hoc approach it drags the good down with bad, leading to liquidity problems for everyone and unnecessary bankruptcies that lead to dead weight losses for the economy.

See my posts “Back to the real economy” and “The U.S. financial system is effectively insolvent” for more of what I have to say on this topic.

Edward

fractional reserve banking is a liquidity issue. i.e. if everyone wants to redeem their deposits at once, the bank will not be able to liquidate its loans and other assets (at fair value) in time to raise the necessary cash. the inability of a bank to do this does not mean that it is insolvent, just that its assets are illiquid. moreover, liquidity has not been the key issue in this crisis, although a liquidity crisis has been a symptom of the crisis. there has been no depositor run on any major bank, mainly because private depositors are largely insured by the government already. there has been a run on short-term funding of banks in the inter-bank market. but this has not of its own brought any bank down, thanks to the fed fulfilling its role of lender of last resort.

the real issue in this crisis is one of solvency – i.e. the value (even if held to maturity and not marked to market) of banks’ assets is insufficient to repay their obligations. the relevant piece of bank legislation is therefore not the reserve ratio but the capital adequacy ratio. banks became ludicrously overleveraged prior to the crisis, using accounting loopholes, dodgy credit ratings, black-box prixing models with grossly inadequate assumptions about correlation and the like, and off-balance-sheet investment vehicles, all in order to take on more and more risk while still meeting the letter of the basel 2 capital adequacy requirements.