There are various causes given for the global financial crisis depending on whether the commentator is an orthodox economist or a Statist populist.

There are two relevant factors to be considered. Firstly there is the liquidity issue and secondly the issue of solvency. All financial institutions keep only a certain portion of their capital in the form of cash or near cash assets. They invest the rest in other high yielding assets which provide high returns but which also carry certain risks. Some financial institutions also accept deposits from their customers repayable on demand as In the case of banks or for a fixed period.

Deposits repayable on demand are tightly regulated. So no financial institution other than a bank has the capacity to repay a deposit on demand. The banks have determined through experience how much cash they must keep in their vaults or held in liquid securities. But this is for normal demand. If an abnormal demand arises for repayment then they need to go to the Central Bank which is the lender of last resort to borrow cash against government securities they hold in their portfolio. So there can be runs on any financial institution including a bank to withdraw cash. If the institution is unable to meet all such demands it will have to close doors for the time until it obtains cash from the Central Bank to pay out to all its depositors demanding repayment.

The fact is that the depositors’ money is invested by the institution in a variety of assets such as land and property and loans secured by mortgages of property. There may be leases where the institution has a lien on the vehicles leased. So in practice the financial institution keeps only a minimum amount of cash and near cash which it considers prudent to meet the demand for repayment by the depositors. The price at which a buyer will come forth is the Bid Price and the price to bring forth a seller is the Asking Price. The measure of liquidity is the inverse of the spread between Bid and Asking Prices.

Our own problems of liquidity and solvency stem not directly from the global financial crisis but rather from the recession which is a consequence of such crisis. Of course foreign investors in our government bond market and stock market have lost out because of the loss of confidence and the need to repatriate funds to cope with problems back home. They also were afraid of the risk of rupee depreciation by which they would lose their original capital without any compensation by way of higher interest rates. Apart from this it is the global recession that has affected us. The depreciation of their currencies by our competitors and Russia has also appreciated our currency in our tea markets and made us uncompetitive. So we have lost part of our export earnings and there is a danger of our losing market share permanently as our consumers get used to the products of our competitors. The decline in oil prices has made synthetic rubber competitive with our natural rubber and posed a threat to our export earnings from rubber.

Our present financial crisis really began with the collapse of the Golden Key Credit Card Co, a member of the Ceylinco Group. What happened is not entirely clear. But I would suspect that apart from any allegations of fraud, the real cause is the failure to manage risks adequately. There is always the risk of default by credit card customers and prudent risk analysis requires determining the probability of default based usually on the normal curve. Since the Ceylinco Group had a habit of inter-group borrowing and lending operations irrespective of any evaluation of such transfers from the point of view of their returns, confidence in the stronger members of the Group may also be adversely affected.

The collapse of an Insurance company in USA has shown that even such companies have to manage their risks prudently when engaging in non-insurance business.

The second factor in the present financial crisis is solvency. Under the Company Law auditors are required to certify whether a company is a going concern. The new Company Law holds Directors personally liable if the company carries on trading knowing that is not a going concern and putting creditors at risk.   Solvency tests are not complicated and even the average citizen can apply them to the book values of the company accounts. Companies are required to value their assets according to current market values rather than historic costs. So company accounts should reflect whether a company is solvent or not.

But there are plenty of accounting fudges resorted to by companies and this is where the regulators should hold the auditors to account. How independent are the auditors who have to certify the accounts and also to satisfy the Directors who pay them their fees? Independent people are a scarce commodity in our country. But what we have is not outright or permanent insolvency. Solvency in a company signifies ability to discharge any of its obligations on the date it falls due. It means that the debtor has sufficient assets in cash or in such other forms that can with virtual certainty converted into cash by the due date.

When sufficient assets are available, but in forms that converting them into cash on reasonable terms takes longer than required, we may speak of temporary insolvency. Temporary insolvency has the characteristic that when the asset is sold and converted into cash, the company be in a position to redeem its obligations although belatedly. Such contingencies are different from absolute insolvency, when the debtor simply lacks sufficient assets in any form or when the probability of converting them into cash is very small or very remote in time.

The other day my wife asked me about the stability of a certain Finance Company. I told her that I had seen the balance sheet and income statements and that I have no fears. But she poured scorn on my judgment and withdrew her money the next day. It was irrational behavior on her part. It is in such situations that the CB is expected to act as a lender of last resort. But the CB lends only to banks and that too only against the pledge of Treasury securities

How should the Central Bank act in a crisis?

Central banking evolved in Britain and USA to deal with financial crises arising from the lack of liquidity. After the banking crisis of 1844, the Bank of England recognized its role as a lender of last resort. The need for a similar role and an institution to carry it out led to the Federal Reserve System of USA being set up in 1903. But both in Britain as well as the USA the two central banks were subordinate to the Gold Standard. They were to be "lenders of last resort" and not to take the initiative in monetary affairs. They were also to be independent of political influences.

The Fed Banks’ principal function was to rediscount—that is, make loans—to their member banks when the banks were short of liquidity. In keeping with the idea of a  "lender of last resort," the Fed’s discount rate was always supposed to be above current market rates. Bankers and politicians accepted this principle for commercial bank and central bank operations. Just as the gold standard automatically provided for the monetization of gold on fixed terms—at that time, $20.67 per ounce—so the Fed Banks were to lend money to their member banks on "eligible paper." Such paper was to be limited to short-term self-liquidating loans, bills, discounts, and advances that had appeared in conjunction with the production and marketing of real goods.

This rubric, at the time known as the "commercial credit theory of banking," is also called "the real bills doctrine" and was a key factor in Federal Reserve policy for the first twenty years of the Fed’s existence. Unlike gold, which the owner could convert into money precisely according to the mint price of gold, the dollars that Fed Banks could lend to member banks on "eligible paper," or "real bills," were not specified by any formula or law.