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The working definition of a liquidity crisis that has prevailed during most of my professional career has emphasized the short-term nature of such a crisis. The financial crisis in Europe does not match this definition!

Historically, a liquidity crisis occurs when there is a change in expectations in the financial markets that causes the buy-side of the market to re-evaluate values. The re-evaluation is always on the down-side and buyers do not re-enter a market until they re-gain some confidence as to where prices should be set. Until that confidence is re-gained, market prices can be in free-fall.

A classic case is that of the financial crisis that occurred in 1970 that was related to the commercial paper market. The shock that hit the market: the credit rating of the Penn Central's commercial paper was downgraded. The downgrade surprised the market because the financial condition of the Penn Central had been assumed to be solid until the downgrade was announced.

Market participants responded by questioning the ratings on other issuers of commercial paper. If a company, like Penn Central, that was carrying a high credit rating could be downgraded what other companies might face the same fate.

As a consequence of this downgrade, companies issuing commercial paper could not roll-over their debt and therefore had to go into their commercial banks and draw on their "backup" lines of credit to cover maturing debt.

The commercial banks were then faced with selling their "liquid" assets in order to fund the lines of credit. The money markets faced a downward spiral of prices as participants wondered about where prices should be set in the commercial paper market and in the market for short-term Treasuries. This, to me, is a classical example of what a liquidity crisis is all about.

How does one combat a liquidity crisis? This is where the central bank comes in. A central bank combats a liquidity crisis by providing sufficient liquidity to the financial markets so that selling assets, like Treasury securities, ceases and order is restored to the pricing process.

Historically, the vehicle used to accomplish this outcome has been the discount window of the Federal Reserve. In the case of the Penn Central crisis, the Federal Reserve threw open the discount window and stated that any bank needing liquidity to cover draw-downs on their backup lines of credit could come to the discount window and borrow what they needed.

The caveat on this opening of the discount window was that the borrowings were only to last for a short time until the crisis past. It was generally expected that the situation would resolve itself within about four weeks.

A liquidity crisis is a short-term phenomena! A liquidity crisis occurs because market participants, on the buy-side, do not have sufficient information to set prices…hence, the demand-side of the market is extremely weak.

I have constantly argued over the time that I have been writing this blog (started February 2009) that government officials were wrong to consider the sovereign debt crisis in Europe and the ensuing banking crisis as a "liquidity problem" and not a "solvency problem."

The problem has been that the market may not know exactly where the prices of financial assets should be, but they do know that these prices are below the value at which governments and banks carry the assets. The owners of the assets will not sell them because it would bankrupt the institution. But, this is not a "liquidity problem" in the classical sense. The problem is connected with the solvency of the institutions.

The officials in Europe (I will not call them leaders) have attempted to treat their problems as a liquidity problem. Their responses to the financial markets has constantly been to provide troubled governments and financial institutions sufficient liquidity to work their problems out thereby "kicking the solution to their problems down the road."

Now, even the "liquidity solutions" are coming back to further weaken these institutions. Note the description in the New York Times about the liquidity provided to European banks by the ECB.

"At the root of Spain's crisis has been a drastic flight of foreign capital from the country - one that, paradoxically, has been accentuated by the European Central Bank's program of providing low-cost three-year loans to European banks so that they might buy their governments' bonds."

When the central bank created that program late last year, and dispensed two rounds of loans within a few months, it was credited with having done much to ease Europe's crisis.

In the case of Spain, while the program bought time, it has made the country's underlying problems worse. Spanish banks have by far been the most aggressive participants in the cheap-loan program, having borrowed more than 300 billion euros from the central bank. And much of that money was spent on Spanish government bonds.

In the short term, those bond purchases helped the government by bringing down interest rates - by reducing Madrid's cost of borrowing. But as a result, Spanish banks now own a larger share, about 67 percent, of their own government's debt than the banks of any other country in the euro zone, according to research by BNP Paribas.

Now the value of those bonds is declining - prices fall as yields rise - and further weakening Spanish banks."

In my experience in working with failing institutions, those running the failing institutions continue to deny the reality of their problems by ignoring the reality of their insolvency and by pointing their fingers at any other possible cause of the failure in order to hang onto their illusions.

We hear, "the problem is caused by greedy speculators"; "the problem is just a problem of liquidity"; "the problem is the Germans"; and so on and so forth!

Just having returned from two weeks in Rome, I can't get the image of Nero playing the fiddle while Rome burned out of my mind. The fiddle-playing of the European officials has allowed them to suppress the real issues that have to do with the solvency of their governments and their banking institutions and the reform and restructuring that needs to be gained in their cultures. As long as this denial continues the issues will not be resolved.

Source: Europe's Problems Have Really Been Connected With Insolvency, Not Liquidity