What is a liquidity crisis?
A liquidity crisis is a financial situation characterized by a lack of liquidity or assets easily convertible into cash available in many companies or financial institutions simultaneously. In a liquidity crisis, liquidity problems in individual institutions lead to an acute increase in demand and a decrease in the supply of liquidity, and the resulting lack of available liquidity can lead to widespread failures and even bankruptcies.
Key points to remember
- A liquidity crisis is a simultaneous increase in demand and a decrease in the supply of liquidity in many financial institutions or other businesses.
- At the root of a liquidity crisis, there is a general mismatch in maturities between banks and other businesses and the resulting lack of cash and other liquid assets when they are needed.
- Liquidity crises can be triggered by large and negative economic shocks or by normal cyclical changes in the economy.
Understanding a liquidity crisis
The mismatch of maturities between assets and liabilities, as well as the resulting lack of cash flow, are generally the cause of a liquidity crisis. Liquidity problems can arise in a single institution, but a real liquidity crisis generally refers to a simultaneous lack of liquidity in many institutions or in an entire financial system.
Liquidity problem of a single company
When an otherwise solvent company does not have the liquidity – cash or other highly marketable assets – necessary to meet its short-term obligations, it faces a liquidity problem. Obligations may include repaying loans, paying current operating invoices, and paying employees. These businesses may have enough total assets to meet all of these long-term needs, but if they do not have enough cash to pay them when they fall due, they will default and could eventually go bankrupt when the creditors request reimbursement. The root of the problem is usually a mismatch between the maturity dates of the investments the company has made and the liabilities it has incurred to finance its investments. This creates a cash flow problem, where the expected income from the company’s various projects does not arrive early enough or in sufficient volume to make payments to the corresponding financing.
For businesses, this type of cash flow problem can be entirely avoided by choosing investment projects whose expected income sufficiently matches the repayment plans of any related financing to avoid any missed payments. Alternatively, the company can try to match maturities on an ongoing basis by contracting additional short-term debt with lenders or by maintaining a sufficient self-funded reserve of liquid assets (in fact, relying on shareholders) to make payments when they fall due. . Many companies do this by relying on short term loans to meet the needs of business. Often, this funding is structured over less than a year and can help a company meet payroll and other demands.
If a business’s investments and debt do not match the due date, additional short-term financing is not available, and self-funded reserves are insufficient, then the business will either have to sell other assets to generate cash, called liquidation assets, or face default. When the business faces a shortage or liquidity, and if the liquidity problem cannot be resolved by liquidating enough assets to meet its obligations, the business must declare bankruptcy.
Banks and financial institutions are particularly vulnerable to this type of liquidity problem because a large part of their income is generated by long-term loans on mortgages, real estate investments and short-term loans on accounts. depositors. The mismatch of maturities is a normal feature and inherent in the economic model of most financial institutions, and they are therefore generally in a continuous position of having to obtain funds to meet their immediate obligations, either through a additional short-term debt, self-funded reserves, or liquidation of long-term assets.
Individual financial institutions are not alone in having a liquidity problem. When many financial institutions experience a simultaneous shortage of liquidity and draw on their self-funded reserves, seek additional short-term debt in the credit markets, or attempt to sell assets to generate cash, a liquidity crisis can occur. Interest rates rise, minimum reserve limits become a constraint, and assets lose value or become unsaleable as everyone tries to sell at the same time. The acute need for liquidity between institutions becomes a mutually reinforcing, positive feedback loop that can spread to institutions and companies that did not initially experience any liquidity problems.
Entire countries – and their economies – may find themselves engulfed in this situation. For the economy as a whole, a liquidity crisis means that the economy’s two main sources of liquidity – bank loans and the commercial paper market – suddenly become scarce. Banks reduce the number of loans they make or stop lending altogether. Since many non-financial companies depend on these loans to meet their short-term obligations, this lack of credit has a ripple effect throughout the economy. In a trickle-down effect, the lack of funds affects a plethora of businesses, which in turn affects the individuals employed by these businesses.
A liquidity crisis can occur in response to a specific economic shock or as a characteristic of a normal business cycle. For example, during the Great Recession financial crisis, many banks and non-bank institutions saw a significant portion of their cash flow from short-term funds that were used to finance long-term mortgages. When short-term interest rates rose and house prices plummeted, such arrangements caused a liquidity crisis.
A negative shock to economic expectations could prompt holders of deposits with one or more banks to make sudden and large withdrawals, if not all of their accounts. This may be due to concerns about the stability of the specific institution or to wider economic influences. The account holder may see a need to have money on hand immediately, perhaps if there is concern about a general economic decline. Such activity can leave banks deficient in cash and unable to cover all registered accounts.