Answer to Question #191750 in Finance for Sheyan patel

Question

In the 2008 global financial crisis many banks faced both a liquidity shock and a solvency shock. Discuss the main causes of each of these shocks and explain how regulators and governments responded to the illiquidity/insolvency faced by banks.                                                                                      (25 marks)

Answer 1

Liquidity shock was caused by the negative economic shocks and normal cyclical changes in the economy that made the bank unable to meet short-term financial obligations. Insolvency shock was caused by bad loans and investment which later turned to be bad debts that the banks could not settle with their assets.

Regulators and the government responded to liquidity shock by acquiring securities which could be sold to meet minimal risks. On the other hand, they handled insolvency shock by setting conditions on how to locate loans and also raising more equity through dividend reinvestment plans.