Market participants in need of cash find it hard to locate potential trading partners to sell their assets.
Borrowers typically face higher loan costs and collateral requirements, compared to periods of ample liquidity, and unsecured debt is nearly impossible to obtain.
This can lead to failure of even 'healthy' banks and eventually an economy-wide contraction of liquidity, resulting in a full blown financial crisis.
[3] Diamond and Dybvig demonstrate that when banks provide pure demand deposit contracts, we can actually have multiple equilibria.
In an attempt to maintain its leverage ratio, the financial institution must sell its assets, precisely at a time when their price is low.
Both these effects cause the borrowers to engage in a fire sale, lowering prices and deteriorating external financing conditions.
[2][5] Apart from the "balance sheet mechanism" described above, the lending channel can also dry up for reasons exogenous to the borrower's credit worthiness.
For instance, banks may become concerned about their future access to capital markets in the event of a negative shock and may engage in precautionary hoarding of funds.
Additionally, the fact that most financial institutions are simultaneously engaged in lending and borrowing can give rise to a network effect.
In a setting that involves multiple parties, a gridlock can occur when concerns about counterparty credit risk result in failure to cancel out offsetting positions.
In the subprime mortgage crisis, rapid endorsement and later abandonment of complicated structured finance products such as collateralized debt obligations, mortgage-backed securities, etc.
Expost policy intervention: Some experts suggest that the central bank should provide downside insurance in the event of a liquidity crisis.
Such 'asset purchases' will help drive up the demand and consequently the price of the asset in question, thereby easing the liquidity shortage faced by borrowers.
Ashcraft, Garleanu, and Pedersen (2010) argue that controlling the credit supply through such lending facilities with low margin requirements is an important second monetary tool (in addition to the interest rate tool), which can raise asset prices, lower bond yields, and ease the funding problems in the financial system during crises.
Open economy extensions of the Diamond–Dybvig Model, where runs on domestic deposits interact with foreign creditor panics (depending on the maturity of the foreign debt and the possibility of international default), offer a plausible explanation for the financial crises that were observed in Mexico, East Asia, Russia etc.
These models assert that international factors can play a particularly important role in increasing domestic financial vulnerability and likelihood of a liquidity crisis.