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In financial economics, a liquidity crisis refers to an acute shortage of liquidity. Liquidity may refer to market liquidity , funding liquidity , or accounting liquidity. Additionally, some economists define a market to be liquid if it can absorb "liquidity trades" without large changes in price. This shortage of liquidity could reflect a fall in asset prices below their long run fundamental price, deterioration in external financing conditions, reduction in the number of market participants, or simply difficulty in trading assets.
The above-mentioned forces mutually reinforce each other during a liquidity crisis. Market participants in need of cash find it hard to locate potential trading partners to sell their assets. This may result either due to limited market participation or because of a decrease in cash held by financial market participants. Thus asset holders may be forced to sell their assets at a price below the long term fundamental price. Borrowers typically face higher loan costs and collateral requirements, compared to periods of ample liquidity, and unsecured debt is nearly impossible to obtain. Typically, during a liquidity crisis, the interbank lending market does not function smoothly either.
Several mechanisms operating through the mutual reinforcement of asset market liquidity and funding liquidity can amplify the effects of a small negative shock to the economy and result in lack of liquidity and eventually a full blown financial crisis.