The liquidity gap

Solvency and liquidity are the two core pillars of banking. Solvency risks arise from the credit creation and investment function in banking, as some obligors may default and some investments may lose their value, resulting in unexpected losses. Liquidity risks arise from the maturity transformation function in banking – specifically, banks borrow at a short duration from depositors or markets, and lend at a long duration to borrowers or invest in illiquid securities. In most banks, sol