This article derives a theory of the origins of liquidity crises. The basic idea, which was put forth before the recent global financial crisis, is that liquidity spirals amplify a shock to thesystem, leading to a breakdown of market liquidity, a sharp drop in prices, and large losses by key banks and traders. Liquidity spirals evolve as follows: Banks and financial intermediaries have aninitial shock to their funding, for instance, a loss on some of their security positions. This makes them reduce their trading and take smaller positions, which reduces market liquidity as orderimbalances become more difficult and costly to absorb for market makers. The reduced market liquidity and associated increased volatility make it riskier to finance security positions and lead to increased margin requirements, which are set endogenously in the model (and, of course, in the real world). This is because margin requirements are set to make the lender relatively immune against a scenario in which the borrower defaults and, at the same time, the asset price drops. Since larger volatility increases the risk of a large price drop and higher illiquidity makes it costly to sell the collateral in case of default, both of these effects push lenders to increase their margin of safely, that is, the margin requirement. When margin requirements rise, intermediaries face exacerbated funding problems and are forced to de-leverage and divest their positions.

In summary, funding problems lead to market illiquidity, and market illiquidity worsens funding problems, creating an adverse feedback loop that makes the markets spiral into crisis. During the recent liquidity crisis, global central banks recognized the liquidity spirals that deteriorate market and funding liquidity. In a speech on liquidity provision on May 13, 2008, the Chairman of the Federal Reserve Board Ben Bernanke said:

In recognition of the importance of alleviating liquidity-spiral problems for financial stability, Chairman Bernanke also said: