Financial panics are events that blur the line between liquidity and solvency. A firm is solvent if its revenues (in a discounted presentvalue sense) exceed its expenditures. A firm is liquid if it is able to raise enough funds – either by borrowing or by selling assets – to pay its current costs.
In a financial market that is functioning well, solvent firms are typically liquid because they can borrow against their future profits. During a financial panic, however, lenders feel unable to assess the future profits and/or collateral of borrowers. Borrowing becomes highly constrained, credit markets cease to function as well, and even highly solvent firms may become illiquid.