Liquidity Crisis

A liquidity crisis occurs when businesses or financial institutions lack sufficient cash or easily convertible assets to meet short-term obligations. When many firms face this problem at once, it can escalate into system-wide instability, defaults, and bankruptcies.

Key takeaways

• A liquidity crisis is a simultaneous shortage of short-term cash or liquid assets across many institutions.
• The usual root cause is maturity mismatch: long-term assets financed by short-term liabilities.
• Triggers include economic shocks, market panics, and normal cyclical downturns.
• Rapid, collective attempts to sell assets or borrow can push asset prices down and tighten credit further, spreading the crisis.

What causes a liquidity crisis?

1. Maturity mismatch
2. Firms (especially banks) fund long-term loans with short-term deposits or wholesale funding. If short-term funding dries up, they cannot easily convert assets to cash without heavy losses.
3. Economic shocks or loss of confidence
4. Negative news, falling asset prices, or fear about solvency can prompt large withdrawals or a refusal by lenders to roll over short-term funding.
5. Market freezes and fire sales
6. When many institutions try to sell similar assets simultaneously, prices drop and buyers vanish, reducing the assets’ marketability.

How a liquidity crisis unfolds

• An initial shock raises demand for cash and reduces the supply of available funding.
• Institutions draw down reserves, seek short-term loans, or sell assets.
• Asset prices fall and funding costs rise, creating a positive feedback loop.
• Credit markets contract—banks cut lending and commercial paper markets seize up—spreading shortages across the economy.

Effects on the economy

• Reduced lending disrupts payrolls, supplier payments, and business operations.
• Nonfinancial firms reliant on short-term credit face defaults and layoffs.
• Wider economic activity can slow sharply, potentially tipping the economy into recession.

Example

A company owes $10,000 next month but has only $2,000 in cash and $1,000 in quickly marketable securities. Other assets worth $10,000 exist but cannot be sold for three months. Without new borrowing to cover the $7,000 gap, the company faces a liquidity crisis despite being solvent on paper.

How to resolve and prevent liquidity crises

Short-term responses
* Obtain emergency borrowing (bank lines, repo markets, central bank facilities).
Sell liquid assets where possible, accepting potential price concessions.
Negotiate short-term extensions with creditors.

Medium- and long-term prevention
* Match asset and liability maturities more carefully.
Maintain adequate liquidity buffers (cash and high-quality liquid assets).
Diversify funding sources to avoid dependence on a single short-term market.
Manage cash flow: shorten accounts receivable, extend accounts payable, control costs.
Regulatory measures (for banks): liquidity coverage ratio, stress testing, access to lender-of-last-resort facilities.

Bottom line

A liquidity crisis is not always about insolvency—it’s about timing. When many institutions cannot access cash quickly, market functioning and lending collapse, amplifying economic damage. Proper liquidity management, diversified funding, and timely policy responses are critical to preventing and containing such crises.

Further reading

Selected research and historical overviews:
* Bleakley, Hoyt & Kevin Cowan, “Maturity Mismatch and Financial Crises: Evidence from Emerging Market Corporations,” Journal of Development Economics (2010).
Yang, Liu, et al., “Banks’ Maturity Mismatch, Financial Stability, and Macroeconomic Dynamics,” Economic Research (2021).
Federal Reserve Bank of Minneapolis, “Liquidity Crises” and historical accounts of the Great Recession.