What is a Liquidity Crisis
A liquidity crisis is a negative financial situation characterized by a lack of cash flow. For a single business, a liquidity crisis occurs when the otherwise solvent business does not have the liquid assets (i.e., cash) necessary to meet its short-term obligations, such as repaying its loans, paying its bills and paying its employees. If the liquidity crisis is not solved, the company must declare bankruptcy. An insolvent business can also have a liquidity crisis, but in this case, restoring cash flow will not prevent the business's ultimate bankruptcy.
BREAKING DOWN Liquidity Crisis
For the economy as a whole, a liquidity crisis means that the two main sources of liquidity in the economy—banks and the commercial paper market—severely reduce the number of loans they make or stop making loans altogether. Because so many companies rely on these loans to meet their short-term obligations, this lack of lending has a ripple effect throughout the economy, causing liquidity crises at a plethora of individual companies, which in turn affects individuals.
How the Effects of a Liquidity Crisis May Spread
A liquidity crisis can unfold in several ways. Economic concerns might drive the deposit holders with a bank or banks to make sudden, large withdrawals, if not their entire accounts. This may be due to concerns about the stability of the specific institution or broader economic influences. The account holder may see a need to have cash in hand immediately, perhaps if widespread economic declines are feared. Such activity can leave banks deficient in cash and unable to cover all registered accounts.
Prior economic crises in the United States exposed certain practices by institutions that contributed to liquidity issues. For example, some banks had significant portions of the cash come from short-term funds that were put towards financing long-term mortgages. When the real estate collapsed, such arrangements forced certain institutions to face liquidity crises.
If a government is confronted with a liquidity crisis and lacks the funding to pay for its obligations and debts, it might take on austerity measures, thus cutting spending drastically. Such actions can, in turn, affect the public as there would be less money in the overall economy. The lack of cash flowing from government sources can affect small businesses, for instance, that rely on loan financing to help them cover growth costs as they conduct business. This can result in businesses closing temporarily or even permanently, spikes in unemployment due to those closures, and an erosion of economic growth within the country.