A liquidity squeeze occurs when a financial event sparks concerns among financial institutions (such as banks) regarding the short-term availability of money. These concerns may cause banks to be more reluctant to lend out money within the interbank market. As a result, banks will often impose higher lending requirements in an effort to hold onto their cash reserves. This cash hoarding will cause the overnight borrowing rate to spike significantly above its benchmark rate and, as a result, the cost of borrowing will increase.
In the face of higher interest rates, individual investors will often liquidate their holdings in riskier investments. This mass liquidation of investments puts a further strain on the amount cash available to financial institutions. If left unchecked, a liquidity squeeze could result in a scenario in which banks make it extremely difficult for all but individuals with the best credit scores to get a loan. Furthermore, mutual funds and hedge funds might also restrict investor withdrawals.
For example, a liquidity squeeze occurred as a result of the subprime meltdown that took place at the beginning of 2007. Essentially, low interest rates, banks' lax lending practices, the U.S. housing bubble from 2001-2005 and a dramatic increase in collateralized debt obligations (CDOs) with a high concentration in subprime mortgages set the stage for the liquidity squeeze that ensued. Housing prices crashed in August of 2006, fueling a drastic increase in the number of foreclosures. The consequences of this increase in foreclosures reverberated through to the lenders, hedge funds and investors, which collectively lost billions of dollars. As a result, banks began to hold onto their reserves more tightly, causing the U.S. interbank rate to jump drastically. Furthermore, investors put more pressure on capital liquidity as they withdrew funds from hedge funds and other investments that held subprime mortgage assets. (For more on how this happened, read The Fuel That Fed The Subprime Meltdown.)
Ultimately, the Federal Reserve, the European Central Bank and other central banks stepped in August of 2007 and attempted to rectify the situation by injecting billions of dollars into various money markets in an attempt to increase liquidity and stabilize foreign exchange rates.
For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.