A type of risk that corresponds to the potential inability of a firm to meet its long-term financial obligations on a timely basis. Solvency relates to a firm’s ability to service its debt and meet its obligations over the long run. If meeting such maturing obligations would result in a negative net worth for an firm, then it is said to be facing solvency problems. In which case, the value of its assets would be less than the amount of its liabilities.
Solvency risk may arise when a bank suffers certain losses because of a deteriorated capital base. Deterioration may impact its assets because of the write-offs on securities, loans, or other bank activities, and hence it capital would not be sufficient to cover those losses. An insolvent bank would be unable to meet its obligations, and therefore it would default and loses its franchise value. Banks can mitigate solvency risk by maintaining an adequate buffer of capital, so that in case of losses, the bank can absorb these losses using its capital buffers, and accordingly can maintain its solvency.
