Liquidity crisis

In financial economics, a liquidity crisis refers to an acute shortage (or "drying up") of liquidity. Liquidity is a catch-all term that may refer to several different yet closely related concepts. Among other definitions, it may refer by 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), 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. This shortage of liquidity could reflect a fall in asset prices below their long run fundamental price, deterioration in external financing conditions, 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.

One of the earliest and most influential models of liquidity crisis and bank runs was given by Diamond and Dybvig in 1983. The Diamond–Dybvig model demonstrates how financial intermediation by banks, performed by accepting assets that are inherently illiquid and offering liabilities which are much more liquid (offer a smoother pattern of returns), can make banks vulnerable to a bank run. Emphasizing the role played by demand deposit contracts in providing liquidity and better risk sharing among people, they argue that such a demand deposit contract has a potential undesirable equilibrium where all depositors panic and withdraw their deposits immediately. This gives rise to self-fulfilling panics among depositors, as we observe withdrawals by even those depositors who would have actually preferred to leave their deposits in, if they were not concerned about the bank failing. This can lead to failure of even ‘healthy’ banks and eventually an economy-wide contraction of liquidity, resulting in a full blown financial crisis.

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