Liquidity Crisis and Insolvency
When the Credit crisis hit, many banks faced a liquidity crisis. This means they didn’t have access to enough cash in the short term. They had assets, but, they were tied up in long term loans. If a bank lends a £100,000 mortgage to someone, it can’t ask the homeowner to sell house and payback mortgage straight away.
Many banks faced a liquidity crisis because they had got used to borrowing money on the ‘money markets’ Short term borrowing was cheap. But, after the crisis hit, money markets dried up and many banks couldn’t get access to enough cash. This is a liquidity crisis, which can cause panic as it might appear the banks are unable to meet their commitments.
In this case, it is helpful for governments / Central Bank to offer short term liquidity. By offering cash and short term injections of money, the Central Bank ensures people have faith in the banking system. It prevents everyone lining up outside their bank to withdraw cash (like Northern Rock). In theory, this intervention will only need to be temporary. The banks aren’t insolvent, they just have a short term liquidity problem.
If governments / Central Bank didn’t maintain cash flow, it could lead to a catastrophic bank run, where everyone goes to get out their cash. The great number of bank collapses was one of main reasons for Great Depression.
Many banks faced a liquidity crisis because they had got used to borrowing money on the ‘money markets’ Short term borrowing was cheap. But, after the crisis hit, money markets dried up and many banks couldn’t get access to enough cash. This is a liquidity crisis, which can cause panic as it might appear the banks are unable to meet their commitments.
In this case, it is helpful for governments / Central Bank to offer short term liquidity. By offering cash and short term injections of money, the Central Bank ensures people have faith in the banking system. It prevents everyone lining up outside their bank to withdraw cash (like Northern Rock). In theory, this intervention will only need to be temporary. The banks aren’t insolvent, they just have a short term liquidity problem.
If governments / Central Bank didn’t maintain cash flow, it could lead to a catastrophic bank run, where everyone goes to get out their cash. The great number of bank collapses was one of main reasons for Great Depression.
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