Case Study 2: Liquidity Shortages in the Wake of September 11th, 2001 Terrorist

Attacks

Due to the attack on the financial system and the Twin Towers in New York, September 11 th,
2001, nearby banks experienced a brief period of severe scarcity of funds, since they were
unable to track their deposits and payments. Like a domino effect, this problem took over
many financial institutions in New York, and they were unable to make payments and the
entire financial system crashed.

The crisis was enlarged because there was a sharp drop in the amount of money moving
through Fed Wire, because firms that were impacted by the attacks were not confident that
they'd acquire the cash they needed, so they ceased transferring reserves to other banks.
Several banks that were involved in interbank trading on September 10 were unable to repay
the amounts on September 11. Furthermore, several financial institutions in the vicinity of
Ground Zero were unable to connect with their consumers to explain what was going on.
They were also unable to update their records or deliver the securities that they had promised
to their clients. However, soon the system started to recover, and by September 14 th
everything was pretty much back to normal. This was due to the Fed’s quick response and
their role of the “Lender of Last Resort”. The Federal Reserve announced the availability of
loans via its discount window at 10 am on September 11th. At the same time, they temporarily
halted overdraft fines and increased its open market operations to inject additional funds into
the money market. On September 12th, discount window loans increased from a daily average
of around $100 million to more than $45 billion, while the Fed's open-market trading desk
increased its trading activity from a relatively usual $3.5 billion to almost $38 billion. The
liquidity issue was quickly resolved because to the Fed's rapid response and the desire of
many bank managers to reestablish communications ties with their clients.

In a situation like this, however, the banks are pretty much helpless in managing liquidity. An
issue such as this, arise from completely unseen and unpredictable circumstances. Thus, even
if these banks have proper liquidity management in place, they will still be unable to avoid
this crisis. Along with this, it is important to note that the system crashed due to attacks on the
technical infrastructure as well, and this could not have been prevented by any way. The
quick action by the Fed was needed, which allowed this crisis to not be prolonged for too
long.

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