A liquidity crisis can have terrible financial consequences for individuals, businesses and the overall economy. Before we can explore liquidity crises further, we must spend time understanding what ‘liquidity’ actually means.
Grasping the concept of liquidity can be a bit tricky. That’s because its meaning changes depending on the context in which it is being discussed. Broadly, there are three types of liquidity:
- Market liquidity: the ease with which an asset can be sold quickly into deep markets at a predictable price.
- Funding liquidity: the ease with which borrowers can obtain external financing.
- Accounting liquidity: the ease with which an individual or company can meet their short-term debts as they fall due.
Ultimately, cash is the common thread between all these versions of liquidity. That’s because cash is the world’s most liquid asset.
When an asset is described as being highly liquid, it means that it can be converted into cash (i.e. liquidated) relatively easily. Some other examples of liquid assets are government bonds; bitcoin and some other cryptocurrencies; and publicly listed stocks.
The opposite of a liquid asset is an illiquid asset. Assets that are relatively hard to liquidate are described as illiquid. Examples of illiquid assets include unlisted retail and commercial property; infrastructure (e.g. airports, toll roads, ports); private equity; private debt; and credit.
When you invest in illiquid assets, you typically generate a greater return relative to liquid assets. This is due to something called an ‘illiquidity premium’. This is essentially an extra amount of compensation for taking on the additional risk that comes with investing in an asset that’s hard to liquidate.
So, we now know that there are multiple types of liquidity. We also know what it means to call an asset ‘liquid’. We can now have a go at defining liquidity: Liquidity refers to the availability of liquid assets to a market, borrower, company, or individual.
Liquidity Crisis: A Deeper Dive
Now that we have a basic understanding of liquidity, we can now move on to learning all about liquidity crises and why they are so bad.
A liquidity crisis is a situation where there is a shortage in liquidity. A liquidity crisis can happen as a result of an economic shock. (In economics, a shock is an unexpected or unpredictable event that affects an economy. Examples include natural disaster, military war and pandemic of disease.)
In most liquidity crises, fear and uncertainty play a major role. This can result in a mutually reinforcing liquidity spiral—or a ‘liquidity black hole’—especially between market liquidity and funding liquidity.
If nothing is done to fix the liquidity crisis, you can get situations where liquidity can evaporate entirely in certain markets and sectors of the economy.
What’s So Bad About a Liquidity Crisis?
If we explained all the ways liquidity crises are bad, you’d be stuck reading this resource for hours. Just know this: When liquidity evaporates, the economy and financial markets do not function anywhere near the level they otherwise do.
In times of a liquidity crisis, having cash suddenly becomes a lot more important. Investors rush to liquidate stocks and bonds, which drives down asset prices and company valuations. Banks close funding channels and become a lot more selective with respect to issuing loans.
If a widespread liquidity crisis were to be left to fix itself, a distressing period of economic recession would be highly likely.
How Does a Liquidity Crisis End?
When it comes to fixing a liquidity crisis, it is usually up to central banks and, to a lesser extent, governments. International financial institutions such as the International Monetary Fund (IMF) and New Development Bank (NDB) can also play pivotal roles in resolving liquidity crises.
The reason a central bank can fix a liquidity crisis is because one of its functions is to serve a lender of last resort (LOLR). A LOLR provides liquidity to a financial institution which finds itself unable to obtain sufficient liquidity through sources such as the interbank lending market—a market in which banks lend funds to one another for a specified term.
Examples of forms of emergency liquidity injections include secured lending (i.e. repo), unsecured lending, and securities purchases. Repo is the most common way that liquidity is provisioned by central banks.
In principle, a liquidity crisis can always be resolved by a central bank because it can continue to exchange base money for less liquid assets until the crisis passes. – Ian Harper, Reserve Bank of Australia (Discussion on Liquidity, Financial Crises and the Lender of Last Resort – How Much of a Departure is the Sub-prime Crisis?)
Want to learn more about what central banks do? Head to our ‘What is Quantitative Easing (QE)?‘ resource.