Definition of liquidity crisis

A situation where depositors demand larger withdrawals than normal and banks are forced to borrow funds at an elevated interest rate. A liquidity crisis is usually unpredictable and can be due to either a lack of confidence in the specific bank, or some unexpected need for cash. Liquidity crises can ultimately result in ‘a run on a bank’ and even the insolvency of the bank.

Example

According to the Treasury report, Northern Rock, the first bank failure in the 2007-8 banking crises followed a ‘reckless business model’ where nearly 30% of its funding was bought-in short-term wholesale funds that were used to finance long-term mortgage business.

The bank was over-dependent on liability management to finance its credit business.  This is a process where banks manage liabilities, for example customer deposits, and borrow funds when needed from the markets for interbank deposits, large-sized time deposits and certificates of deposit (CD).

When wholesale funding dried up the bank had a liquidity crisis that rapidly turned into a capital crisis.[1]