Liquidity Crisis

Liquidity Crisis

In financial economics, liquidity is a catch-all term that may refer to several different yet closely related concepts. Among other things, it may refer to Asset Market liquidity (the ease with which an asset can be converted into a liquid medium e.g. cash); Funding liquidity (the ease with which borrowers can obtain external funding) Balance Sheet or Accounting liquidity (the health of an institution’s balance sheet measured in terms of its cash-like assets). Additionally, some economists define a market to be liquid if it can absorb liquidity - trades (sale of securities by investors to meet sudden needs for cash) without large changes in price. Liquidity Crisis refers to drying up of liquidity, which could reflect a fall in asset prices below their long run fundamental price; or deterioration in external financing conditions; or a reduction in the number of market participants or simply difficulty in trading assets.

The above mentioned forces mutually reinforce each other during a liquidity crisis. Market participants in need of cash find it hard to locate potential trading partners to sell their assets. This may result either due to limited market participation or because of a decrease in cash held by financial market participants. Thus asset holders may be forced to sell their assets at a price below the long term fundamental price. Borrowers typically face higher loan costs and collateral requirements, compared to periods of ample liquidity, and unsecured debt is nearly impossible to obtain. Typically, during a liquidity crisis, the interbank lending market does not function smoothly either.

Several mechanisms operating through the mutual reinforcement of Asset Market Liquidity and Funding liquidity can amplify the effects of a small negative shock to the economy and result in lack of liquidity and eventually a full blown financial crisis.