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What is a Liquidity Crisis?

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  • Written By: Malcolm Tatum
  • Edited By: Bronwyn Harris
  • Last Modified Date: 17 September 2016
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Sometimes referred to as a cash flow problem, a liquidity crisis is a situation in which a business or individual temporarily does not have cash on hand to meet current expenses, and does not have assets that can be immediately liquidated to settle those debts. While it is not unusual for companies and households to experience brief periods where a crisis of this type takes place, a liquidity crisis that is ongoing may eventually lead to a situation where bankruptcy is a viable option. There are a few ways to handle a liquidity crisis, even if there are not liquid assets that can be converted quickly to handle the temporary lack of cash flow.

One option to handle a liquidity crisis is to reduce expenses until additional income can be generated to cover debt that is currently due. This is an approach that often takes place in the household. For example, if cash reserves are low during the last week of the month, the family may choose to forego certain activities such as eating out or ordering fast food for delivery. Instead, they prepare meals using whatever is in the kitchen pantry. The austerity continues until the next paycheck is received, the bills are paid, and there is money left over to resume enjoying meals out.

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Another approach to a liquidity crisis is to seek assistance from an outside party. Here, the idea may be to take out a short-term loan in order to pay current bills by their due dates, thus avoiding the accumulation of any late fees or penalties. Short-term business loans for periods of thirty to sixty days may be used in situations like this. For households, taking out a payday loan will often accomplish the same end.

There is also the possibility of working out alternative payment arrangements with creditors. Companies sometimes employ this process when they have accounts receivable that are outstanding, but are expected to be submitted within a short period of time. Here, the company contacts the creditors and arranges for an extension on the due date. Often, this allows the company to avoid the application of late fees, and also renders the need to take out a short-term loan unnecessary. Assuming the company does not experience the same liquidity crisis each month, and has a solid history with the creditor, there is every chance that an alternative arrangement for payment can be reached.

It is important to note that while anyone can experience a liquidity crisis from time to time, ongoing issues with cash flow are indicative of a more serious issue. When this is the case, individuals as well as businesses should revise their budgets so they are more in line with the average amount of income generated each month, taking care to arrange due dates so that the incremental flow of cash can allow for debt to be paid in a timely manner. By employing this type of strategy, the chances of avoiding a liquidity crisis are greatly enhanced.

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SteamLouis
Post 3

I have homework on this topic and I need to know how banks avoid liquidity crises. I think they sell their loans and borrow from other banks. Am I missing anything?

bluedolphin
Post 2

Wasn't the mortgage crisis of 2008, a liquidity crisis?

People had bought homes in the previous years because of low prices. But they didn't realize that real estate doesn't have a fixed value. So when real estate lost liquidity, mortgages went up and people were not able to pay. Many people lost their homes and the economy was greatly affected. My uncle also lost his home during this time. It was heartbreaking.

serenesurface
Post 1

Sometimes investors also sell illiquid assets when they are in dire need of cash. An illiquid asset doesn't always have to be an asset that cannot be sold immediately. Sometimes it means an asset that cannot be sold immediately without lowering the price.

If an investor is in a very bad situation, he or she may choose to sell an asset at a much lower price than normal to get some cash. Real estate, valuable art and certain bonds are examples of illiquid assets. I think that this is a better option for liquidity management than taking loans, especially if the incoming money is going to prevent bankruptcy.

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