Credit Crunch - Background and Causes

Background and Causes

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 used by the banks to secure the loans; an exogenous change in monetary conditions (for example, where the central bank suddenly and unexpectedly raises reserve requirements or imposes new regulatory constraints on lending); the central government imposing direct credit controls on the banking system; or even an increased perception of risk regarding the solvency of other banks within the banking system.

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 when the loans turn sour and the full extent of bad debts becomes known. Careless lending tends to occur more often in fragmented, competitive credit markets in which lenders may compete with one another for market share and revenue by relaxing standards; by contrast, concentrated credit markets tend to have tighter standards and greater stability.

Financial institutions facing losses may then reduce the availability of credit, 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.

The crunch is generally caused by a reduction in the market prices of previously "overinflated" assets and refers to the financial crisis that results from the price collapse. This can result in widespread foreclosure or bankruptcy for those investors and entrepreneurs who came in late to the market, as the prices of previously inflated assets generally drop precipitously. In contrast, a liquidity crisis 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 solvency 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.

A prolonged credit crunch is the opposite of cheap, easy and plentiful lending practices (sometimes referred to as "easy money", "loose credit", or "malinvestment"). During the upward phase in the credit cycle, asset prices may experience bouts of frenzied competitive, leveraged bidding, inducing inflation 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 and stimulates economic activity, this also tends to temporarily raise economic growth and employment.

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.

As John Maynard Keynes 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."