A liquidity crisis occurs when financial institutions, markets, or even entire economies face a severe shortage of cash or easily tradable assets, making it difficult to meet short-term obligations. This can happen when investors and lenders suddenly lose confidence, leading to a rush to withdraw funds or sell assets, further drying up liquidity.

Effects on Financial Markets:
Market freezes – Buyers disappear, causing asset prices (stocks, bonds, real estate) to plunge rapidly.

Bank Runs & Collapses – If banks can’t cover withdrawals, they may fail (e.g., Lehman Brothers in 2008).

Credit Crunch – Lenders stop issuing loans, hurting businesses and consumers.

Fire Sales – Forced asset sell-offs at deep discounts worsen losses.

Contagion Risk – One institution’s failure can spread panic across the system.

Examples:
The 2008 Financial Crisis saw liquidity vanish in mortgage-backed securities.

March 2020 saw a liquidity crunch in U.S. Treasuries during the COVID-19 panic.

Central banks often intervene by injecting cash (quantitative easing) or acting as lenders of last resort. Without swift action, a liquidity crisis can spiral into a full-blown financial meltdown.