Liquidity Crisis

A liquidity crisis is a sudden, widespread shortage of cash and of assets that can be sold quickly, in which banks, companies or whole markets cannot raise the money they need to meet payments, even though many of them may be solvent. Lenders stop lending, investors rush to sell, and assets that normally change hands easily can only be sold at steep discounts. Such crises usually spread from a few institutions to the wider financial system.

A liquidity crisis differs from a solvency crisis, in which debts genuinely exceed assets, although the two feed each other: selling at fire-sale prices can turn a cash shortage into real losses. It is also broader than the liquidity risk faced by a single firm. When it centres on dollars borrowed outside the United States it becomes a squeeze on dollar funding, and when it hits a country's exchange rate it can turn into a currency crisis.

Picture a town where people keep most of their savings in houses and only a little in cash. On a normal day that works: anyone who needs money can borrow from a neighbour or sell a house within weeks. Then a rumour spreads that the town's main factory will close. Everyone wants cash at once, nobody wants to lend, and houses that sold in a week last month now find no buyer at a sensible price.

On paper nobody in the town is poorer than they were the day before, yet almost nobody can pay their bills. That is the heart of a liquidity crisis: trust vanishes, and with it the willingness to lend or buy. The usual cure is an outsider with deep pockets, in modern economies the central bank, who lends against sound assets until calm returns.

The liquidity that markets take for granted can disappear through several linked channels:

• Funding runs. Depositors or short-term lenders pull their money, as in a classic bank run or a run on a money market fund or the repo market.
• Fire sales. Firms dump assets to raise cash, pushing prices down and forcing other holders to sell in turn.
• Collateral calls. Falling prices trigger a margin call on leveraged positions, demanding more cash just when it is scarcest.
• Hoarding. Banks keep cash rather than lend it to each other, so interbank rates jump above the central bank's policy rate.

The 2008 financial crisis became a global liquidity crisis after losses on US subprime mortgages made banks distrust one another. Interbank lending seized up in August 2007, Northern Rock suffered the first run on a British bank since the 19th century that September, and the bankruptcy of Lehman Brothers on 15 September 2008 set off runs on money market funds and short-term funding markets. In March 2020, as the COVID-19 pandemic spread, investors scrambled for cash in what became known as the dash for cash, selling even US Treasury securities, normally the most liquid assets in the world, until the Federal Reserve bought Treasuries in very large amounts. In the UK the September 2022 gilt sell-off forced pension funds using leveraged hedges to sell assets for cash. In March 2023 Silicon Valley Bank faced about 42 billion dollars of withdrawals in a single day and failed on 10 March, the largest US bank failure since 2008.

Walter Bagehot's 1873 book Lombard Street set out the classic rule: in a panic the central bank should lend freely, against good collateral, at a high rate. Modern central banks act as lender of last resort through discount-window loans, emergency facilities and asset purchases. Because so much of the world's borrowing is in dollars, the Federal Reserve also supplies dollar liquidity abroad through each central bank swap line it holds with other central banks, used heavily in 2008 and 2020. After Silicon Valley Bank failed, the Fed created the Bank Term Funding Program on 12 March 2023, lending to banks for up to a year against Treasuries and other eligible securities valued at par. Critics argue that such rescues create moral hazard, encouraging firms to hold too little liquidity in the expectation of support.

After 2008, Basel III added two liquidity standards for banks. The Liquidity Coverage Ratio requires enough high-quality liquid assets to cover 30 days of stressed outflows, and the Net Stable Funding Ratio limits reliance on short-term funding. Money market fund reforms, central clearing of derivatives and regular stress tests target the non-bank system. Central banks also keep standing facilities open in calm times, such as the Federal Reserve's Standing Repo Facility created in July 2021, so that banks can turn Treasury securities into cash on demand without the stigma of emergency borrowing. Deposit insurance reduces the reason for small savers to run, although uninsured deposits, which made up most of Silicon Valley Bank's funding, remain vulnerable.

• Bank Term Funding Program (Federal Reserve)
• Basel III: international regulatory framework for banks (BIS)