A Liquidity Crisis: What Is It?

A liquidity crisis is a financial circumstance where numerous businesses or institutions lack readily convertible assets or cash. During a liquidity crisis, individual institution-specific issues with liquidity cause a sharp rise in demand and a fall in the supply of liquidity. The lack of accessible liquidity that results can cause widespread defaults and even bankruptcies.

Recognizing a Crisis in Liquidity

Mismatches between the maturities of assets and liabilities frequently result in liquidity crises, which cause improperly scheduled cash flow. A severe liquidity crisis, however, is typically defined as a simultaneous lack of liquidity affecting numerous institutions or the entire financial system. Liquidity issues can arise at a single institution.

One Issue with Business Liquidity

A liquidity problem arises when an otherwise solvent company lacks the liquid assets—cash or other highly marketable assets—necessary to satisfy its immediate obligations. Repaying loans, covering continuing operating expenses, and paying staff are some of the obligations.

These businesses have enough overall assets to cover these obligations. Still, if they have the money to pay their debts on time, they will stay caught up and may even file for bankruptcy when their creditors demand payment. The primary cause of the issue typically stems from an imbalance between the maturities of the company’s investments and the liabilities it has taken on to fund those investments.

This creates a cash flow issue since the projected income from the company’s many initiatives needs to come in more quickly and in larger quantities to cover the payments for the associated loans.

Businesses can avoid this kind of cash flow issue by selecting investment projects whose projected revenue closely aligns with the payback schedules for any associated funding, preventing any payments from being missed.

Alternatively, the company can attempt to match maturities continuously by either taking on more short-term debt from lenders or keeping enough liquid assets on hand to cover payments as they become due (essentially depending on equity holders). This is something that many companies do by depending on short-term borrowing to cover their demands. Usually, with a duration shorter than a year, this funding can assist a business in paying its employees’ salaries and other obligations.

Businesses will either have to liquidate assets—sell other assets to raise cash—or risk default if their debt and investments have different maturities, there is no other source of short-term funding, and their self-financed reserves are insufficient. The corporation must file for bankruptcy when faced with a lack of liquidity, and the issue cannot be resolved by selling off enough assets to pay its debts.

Banks and other financial organizations are especially susceptible to liquidity issues since their income comes from short-term borrowing from depositor accounts and long-term loans for capital investments like home mortgages. Most financial institutions constantly need to secure funds to meet immediate obligations, either through additional short-term debt, self-financed reserves, or the liquidation of long-term assets, as maturity mismatching is a standard and inherent part of their business models.

Financial Crisis

Liquidity issues can affect more than just specific financial institutions. A liquidity crisis can arise when numerous financial institutions simultaneously lack liquidity. They deplete their self-financed reserves, look for more short-term debt from credit markets, or attempt to sell off assets to raise cash. As everyone attempts to sell at once, assets lose value or become unsaleable, interest rates rise, and the minimum needed reserve limits become legally binding restrictions.

The acute liquidity crisis many institutions are experiencing can create a positive feedback loop that is mutually reinforcing and can affect organizations and companies that were not experiencing liquidity issues before.

This kind of thing can potentially consume entire nations and their economies. A liquidity crisis affects the entire economy when bank loans and the commercial paper market, the two primary sources of liquidity, abruptly become scarce. Banks either decrease their loan volume or cease lending entirely.

Because so many non-financial businesses depend on these loans to cover their immediate needs, the economy as a whole is impacted when lending is reduced. The deficiency of finances has a cascading effect on numerous businesses, affecting the workers employed by those businesses.

A liquidity crisis may occur as a regular part of a business cycle or as a reaction to a particular economic shock. For instance, a sizable portion of the cash that numerous banks and non-bank institutions held during the Great Recession came from short-term funds used to pay for long-term mortgages. The drop in real estate values and the rise in short-term interest rates prompted a liquidity crisis.

Depositors with one or more banks may be compelled to make abrupt, sizable withdrawals or close their whole accounts in case of a negative shock to economic expectations. This can result from worries about the institution staying stable or more general economic factors. If the account holder fears a broad economic downturn, they may need cash on hand right now. Banks may find themselves cash-strapped and need help funding all their registered accounts.

Conclusion

• A liquidity crisis occurs when there is a rise in demand for liquidity while there is a decrease in availability across multiple financial institutions or other organizations.
• Widespread maturity mismatches among banks and other businesses result in a lack of cash and other liquid assets when needed, which causes a liquidity crisis.
• Significant adverse economic shocks or normal cyclical economic fluctuations can generate liquidity crises.