A credit crunch (also known as a credit squeeze, credit tightening or credit crisis) is a sudden reduction in the general availability of loans (or credit) or a sudden tightening of the conditions required to obtain a loan from banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rates. In such situations, the relationship between credit availability and interest rates changes. Credit becomes less available at any given official interest rate, or there ceases to be a clear relationship between interest rates and credit availability (i.e. credit rationing occurs). Many times, a credit crunch is accompanied by a flight to quality by lenders and investors, as they seek less risky investments (often at the expense of small to medium size enterprises).

Causes

A credit crunch is often caused by a sustained period of careless and inappropriate lending which results in losses for lending institutions and investors in

debt Debt is an obligation that requires one party, the debtor, to pay money or other agreed-upon value to another party, the creditor. Debt is a deferred payment, or series of payments, which differentiates it from an immediate purchase. The ...

when the loans turn sour and the full extent of bad debts becomes known. There are a number of reasons why banks might suddenly stop or slow lending activity. For example, inadequate information about the financial condition of borrowers can lead to a boom in lending when financial institutions overestimate creditworthiness, while the sudden revelation of information suggesting that borrowers are or were less creditworthy can lead to a sudden contraction of credit. Other causes can include an anticipated decline in the value of the

collateral Collateral may refer to: Business and finance * Collateral (finance), a borrower's pledge of specific property to a lender, to secure repayment of a loan * Marketing collateral, in marketing and sales Arts, entertainment, and media * ''Collate ...

used by the banks to secure the loans; an exogenous change in monetary conditions (for example, where the

central bank A central bank, reserve bank, or monetary authority is an institution that manages the currency and monetary policy of a country or monetary union, and oversees their commercial banking system. In contrast to a commercial bank, a central b ...

suddenly and unexpectedly raises

reserve requirement Reserve requirements are central bank regulations that set the minimum amount that a commercial bank must hold in liquid assets. This minimum amount, commonly referred to as the commercial bank's reserve, is generally determined by the centra ...

s or imposes new regulatory constraints on lending); the

central government A central government is the government that is a controlling power over a unitary state. Another distinct but sovereign political entity is a federal government, which may have distinct powers at various levels of government, authorized or dele ...

imposing direct credit controls on the banking system; or even an increased perception of risk regarding the

solvency Solvency, in finance or business, is the degree to which the current assets of an individual or entity exceed the current liabilities of that individual or entity. Solvency can also be described as the ability of a corporation to meet its long-t ...

of other banks within the banking system.''Is There A Credit Crunch in East Asia?''
Wei Ding, Ilker Domac & Giovanni Ferri (World Bank)

Easy credit conditions

Easy credit conditions (sometimes referred to as "easy money" or "loose credit") are characterized by low interest rates for borrowers and relaxed lending practices by bankers, making it easy to get inexpensive loans. A credit crunch is the opposite, in which interest rates rise and lending practices tighten. Easy credit conditions mean that funds are readily available to borrowers, which results in asset prices rising if the loaned funds are used to buy assets in a particular market, such as real estate or stocks.

Bubble formation

In a credit bubble, lending standards become less stringent. Easy credit drives up prices within a class of assets, usually real estate or equities. These increased asset values then become the collateral for further borrowing. During the upward phase in the credit cycle, asset prices may experience bouts of frenzied competitive, leveraged bidding, inducing

inflation In economics, inflation is an increase in the general price level of goods and services in an economy. When the general price level rises, each unit of currency buys fewer goods and services; consequently, inflation corresponds to a reduct ...

in a particular asset market. This can then cause a speculative price " bubble" to develop. As this upswing in new debt creation also increases the

money supply In macroeconomics, the money supply (or money stock) refers to the total volume of currency held by the public at a particular point in time. There are several ways to define "money", but standard measures usually include currency in circul ...

and stimulates economic activity, this also tends to temporarily raise economic growth and employment. Economist Hyman Minsky described the types of borrowing and lending that contribute to a bubble. The "hedge borrower" can make debt payments (covering interest and principal) from current cash flows from investments. This borrower is not taking significant risk. However, the next type, the "speculative borrower", the cash flow from investments can service the debt, i.e., cover the interest due, but the borrower must regularly roll over, or re-borrow, the principal. The "Ponzi borrower" (named for Charles Ponzi, see also Ponzi scheme) borrows based on the belief that the appreciation of the value of the asset will be sufficient to refinance the debt but could not make sufficient payments on interest or principal with the cash flow from investments; only the appreciating asset value can keep the Ponzi borrower afloat. Often it is only in retrospect that participants in an economic bubble realize that the point of collapse was obvious. In this respect, economic bubbles can have dynamic characteristics not unlike Ponzi schemes or Pyramid schemes.

Psychological

Several psychological factors contribute to bubbles and related busts. *''Social herding'' refers to following the behavior of others, assuming they understand what is happening. As

John Maynard Keynes John Maynard Keynes, 1st Baron Keynes, ( ; 5 June 1883 – 21 April 1946), was an English economist whose ideas fundamentally changed the theory and practice of macroeconomics and the economic policies of governments. Originally trained in ...

observed in 1931 during the Great Depression: "A sound banker, alas, is not one who foresees danger and avoids it, but one who, when he is ruined, is ruined in a conventional way along with his fellows, so that no one can really blame him." *People may assume that unusually favorable trends (e.g., exceptionally low interest rates and prolonged asset price increases) will continue indefinitely. *Incentives may also encourage risky behavior, particularly where the negative consequences if a bet goes sour are shared collectively. The tendency of government to bail out financial institutions that get into trouble (e.g., Long-term Capital Management and the subprime mortgage crisis), provide examples of such

moral hazard In economics, a moral hazard is a situation where an economic actor has an incentive to increase its exposure to risk because it does not bear the full costs of that risk. For example, when a corporation is insured, it may take on higher risk ...

. *People may assume that "this time is different", which psychologist Daniel Kahneman refers to as the ''inside view'', as opposed to the ''outside view'', which is based on historical or better objective information. These and other

cognitive biases A cognitive bias is a systematic pattern of deviation from norm or rationality in judgment. Individuals create their own "subjective reality" from their perception of the input. An individual's construction of reality, not the objective input, m ...

that impair judgment can contribute to credit bubbles and crunches.

Valuation of securities

The crunch is generally caused by a reduction in the market prices of previously "overinflated" assets and refers to the

financial crisis A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and man ...

that results from the price collapse. This can result in widespread foreclosure or bankruptcy for those who came in late to the market, as the prices of previously inflated assets generally drop precipitously. In contrast, a

liquidity crisis In financial economics, a liquidity crisis is an acute shortage of ''liquidity''. Liquidity may refer to market liquidity (the ease with which an asset can be converted into a liquid medium, e.g. cash), funding liquidity (the ease with which borrow ...

is triggered when an otherwise sound business finds itself temporarily incapable of accessing the bridge finance it needs to expand its business or smooth its cash flow payments. In this case, accessing additional credit lines and "trading through" the crisis can allow the business to navigate its way through the problem and ensure its continued

and viability. It is often difficult to know, in the midst of a crisis, whether distressed businesses are experiencing a crisis of solvency or a temporary liquidity crisis. In the case of a credit crunch, it may be preferable to " mark to market" - and if necessary, sell or go into liquidation if the capital of the business affected is insufficient to survive the post-boom phase of the credit cycle. In the case of a liquidity crisis on the other hand, it may be preferable to attempt to access additional lines of credit, as opportunities for growth may exist once the liquidity crisis is overcome.

Effects

Financial institutions facing losses may then reduce the availability of

credit Credit (from Latin verb ''credit'', meaning "one believes") is the trust which allows one party to provide money or resources to another party wherein the second party does not reimburse the first party immediately (thereby generating a debt) ...

, and increase the cost of accessing credit by raising interest rates. In some cases lenders may be unable to lend further, even if they wish, as a result of earlier losses. If participants themselves are highly leveraged (i.e., carrying a high debt burden) the damage done when the bubble bursts is more severe, causing

recession In economics, a recession is a business cycle contraction when there is a general decline in economic activity. Recessions generally occur when there is a widespread drop in spending (an adverse demand shock). This may be triggered by various ...

or depression. Financial institutions may fail, economic growth may slow, unemployment may rise, and social unrest may increase. For example, the ratio of household debt to after-tax income rose from 60% in 1984 to 130% by 2007, contributing to (and worsening) the Subprime mortgage crisis of 2007–2008.

Historical perspective

In recent decades credit crunches have not been rare or black swan events. Although few economists have successfully predicted credit crunch events before they have occurred, Professor Richard Rumelt has written the following in relation to their surprising frequency and regularity in advanced economies around the world: "In fact, during the past fifty years there have been 28 severe house-price boom-bust cycles and 28 credit crunches in 21 advanced Organisation for Economic Co-operation and Development (OECD) economies."

References

Bibliography

* George Cooper, ''The Origin of Financial Crises'' (2008: London, Harriman House) * Graham Turner, ''The Credit Crunch: Housing Bubbles, Globalisation and the Worldwide Economic Crisis'' (2008: London,

Pluto Press Pluto Press is a British independent book publisher based in London, founded in 1969. Originally, it was the publishing arm of the International Socialists (today known as the Socialist Workers Party), until it changed hands and was replaced ...

), {{Financial crises Credit Debt Financial crises United States housing bubble 2000s slang 2000s neologisms