Liquidity vs Solvency Risk

Liquidity is ‘can you pay today’; solvency is ‘are you worth more than you owe’.

Explanation

Liquidity crises can kill solvent entities if funding dries up or assets cannot be sold without huge haircuts.

Solvency problems are structural: liabilities exceed assets under realistic marks.

Good risk systems separate the two and monitor both simultaneously.

liquiditysolvencyfundinghaircuts

Interactive visualisation

Solvency asks whether assets exceed liabilities after realistic marks. Liquidity asks whether you can meet near-term obligations with cash or cash-like resources. A firm can be solvent but illiquid, or liquid but structurally insolvent.

Equity cushion as % of liabilities: 20%Fraction of assets held in liquid form: 40%Haircut on liquid assets (funding or fire-sale): 20%Mark-to-market shock on illiquid assets: -20%Short-term liabilities as % of total: 40%

Numbers

Initial assets ≈ 120.0

Liabilities ≈ 100

Equity (start) ≈ 20.0

Assets after marks ≈ 96.0

Equity (after marks) ≈ -4.0

Cash today ≈ 38.4

Short-term liabilities ≈ 40.0

Solvency status: insolvent (A < L)

Liquidity status: illiquid (cash < short-term L)

Interpretation

Solvency compares marked assets with total liabilities. You can be solvent in the left panel (green assets bar above the liabilities bar) but still fail the liquidity test in the right panel if cash today is below short-term obligations.

Increase haircuts or reduce the liquid asset share: solvency may still hold, but liquidity fails. Increase the asset shock: both solvency and liquidity can fail. Good risk management tracks both dimensions simultaneously instead of treating them as the same problem.