ABSTRACT
A bank is solvent so long as the total value of its assets exceeds the total value of its liabilities. A bank can remain solvent if it can take care of the risks it faces. These are of two types: diversifiable risks and non-diversifiable risks. It is, in principle, easy and straightforward to take care of the former risks. All that a bank needs to ensure is that its asset portfolio consists of assets whose returns are not correlated. This is the standard argument for diversification. Non-diversifiable risks in banks cannot be tackled that easily. For some non-diversifiable risks, bank capital is needed. For others, liquidity is needed. We will see why both capital and liquidity are important. We will deal with capital briefly in this chapter. We will treat liquidity at length in the rest of this book, given that the focus of the book is on banking crises and liquidity.
