The Impact of Liquidity Risk on Commercial Banks' Solvency: A Case Study and Theoretical Analysis

Abstract

Liquidity risk affects a bank's ability to fulfill short-term obligations, while solvency reflects its capacity to absorb losses with its own capital. This paper takes Northern Rock as a case study to examine how liquidity shocks transmit to solvency risk, particularly under a business model heavily reliant on wholesale funding. The results indicate that liquidity disruptions forced banks to conduct asset fire sales, eroding asset values and weakening capital adequacy. Collapsing market confidence raised funding costs and further intensified financial pressure, creating a downward spiral that eventually triggered bank failure. Compared with large commercial banks, small and medium-sized institutions with fragile capital bases and limited funding sources are more vulnerable to liquidity shocks. The Northern Rock case highlights the importance of optimizing stable funding structures and effectively establishing liquidity management. It also suggests that regulators should strengthen early warning systems and intervene earlier to prevent it from becoming systemic solvency risk.