Definition of a Liquidity Crisis

Crossville TN

Description

Individual financial institutions are not the only ones who can have a liquidity problem. When many financial institutions experience a simultaneous shortage of liquidity and draw down their self-financed reserves, seek additional short-term debt from credit markets, or try to sell-off assets to generate cash, a liquidity crisis can occur. Interest rates rise, minimum required reserve limits become a binding constraint, and assets fall in value or become unsaleable as everyone tries to sell at once. The acute need for liquidity across institutions becomes a mutually self-reinforcing positive feedback loop that can spread to impact institutions and businesses that were not initially facing any liquidity problem on their own. Entire countries—and their economies—can become engulfed in this situation. For the economy as a whole, a liquidity crisis means that the two main sources of liquidity in the economy—banks loans and the commercial paper market—become suddenly scarce. Banks reduce the number of loans they make or stop making loans altogether. Because so many non-financial companies rely on these loans to meet their short-term obligations, this lack of lending has a "ripple effect" throughout the economy. In a trickle-down effect, the lack of funds impacts a plethora of companies, which in turn affects individuals employed by those firms. A liquidity crisis can unfold in in response to a specific economic shock or as a feature of a normal business cycle. For example, during the financial crisis of the Great Recession, many banks and non-bank institutions had significant portions of their cash come from short-term funds that were put towards financing long-term mortgages. When short-term interest rates rose and real estate prices collapsed, such arrangements forced a liquidity crisis. A negative shock to economic expectations might drive the deposit holders with a bank or banks to make sudden, large withdrawals, if not their entire accounts. This may be due to concerns about the stability of the specific institution or broader economic influences. The account holder may see a need to have cash in hand immediately, perhaps if widespread economic declines are feared. Such activity can leave banks deficient in cash and unable to cover all registered accounts.