Liquidity Crisis

The liquidity of an asset refers to the ease and quickness with which it can be converted into money or other goods and services. An asset that can be quickly sold for money at low cost is a liquid asset. Money is the most liquid of all financial assets since it can be quickly exchanged for goods and services. Liquidity crises usually indicate difficulty in converting nonmonetary assets, particularly financial assets, into cash either by selling the assets or by using them as collateral.

Individual firms are said to face a liquidity crisis when they cannot obtain short-term financing. A retailer who cannot obtain short-term loans to purchase inventories or obtain goods on credit from suppliers is said to suffer a liquidity crisis. A liquidity crisis for a particular firm indicates that creditors worry about the firm’s ability to pay. The failure of an anticipated loan to come through or sudden and unexpected onetime expenditures can leave a firm with a liquidity crisis. For an individual firm, a liquidity crisis may be virtually synonymous with a credit crunch.

The more serious liquidity crises can put an entire financial sector under severe pressure, can have wide macroeconomic dimensions, and usually requires government or central bank action to resolve. In the course of business, financial institutions accept claims against themselves that are liquid. In the case of banks, depositors can withdraw their money any time. The claims that financial institutions accept against themselves are offset by claims that financial institutions accept against others. Financial institutions cannot demand payment on these claims against others as quickly. A bank must redeem a bank deposit on demand but it cannot demand early repayment of loans. A wave of depositors withdrawing money from a financial institution can force that institution into a liquidity crisis even if all its outstanding loans are sound and have an excellent chance of repayment.

In the late 1980s, thrift institutions in Texas went through a severe liquidity crisis that virtually wiped out the savings and loan (S&L) industry. The S&L institutions first encountered difficulty with troubled loan portfolios. The crash in oil prices plunged the Texas real estate market into a deep slump, substantially reducing the value of collateral that S&Ls held against loans. A string of well-publicized failures of Texas S & Ls caused worried depositors to start pulling their money out.

There was never a run on these institutions, probably because S&L deposits had deposit insurance. It was a slow, steady withdrawal. Pension funds and other large customers began pulling money out. Texas S&Ls began accepting deposits put together by brokers at interest rates well above the rates paid by thrifts in other states. Regulators tried to broker funds from stronger thrifts to weaker ones, but the effort was not sufficient. The large number of failures in Texas and elsewhere bankrupted the Federal Savings and Loan Insurance Corporation that insured deposits at S & Ls. Congress enacted a multimillion dollar bailout to meet the claims of deposit insurance.

In 2008, the United States experienced a liquidity crisis that threatened to bring down an entire financial system. Financial institutions were holding mortage-backed securities, including securities backed by mortgages extended to borrowers with credit problems. Financial institutions purchased these mortgages by borrowing short term in credit markets. When the default rate on these mortgages rose above expected levels, the market value of these securities plummeted. Financial institutions were left unable to borrow short term and unable to sell mortgage-backed securities for cash. As an emergency measure, the U.S. central bank, The Federal Reserve System, began granting loans based on other kinds of collateral than government bonds.