Credit crunch
Encyclopedia
A credit crunch is a reduction in the general availability of loan
s (or credit
) or a sudden tightening of the conditions required to obtain a loan
from the bank
s. A credit crunch generally involves a reduction in the availability of credit
independent of a rise in official interest rate
s. In such situations, the relationship between credit availability and interest rates has implicitly changed, such that either 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).
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 requirement
s 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 debt
s 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 entrepreneur
s 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 scheme
s or Pyramid scheme
s.
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."
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
s (or credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
) or a sudden tightening of the conditions required to obtain a loan
Loan
A loan is a type of debt. Like all debt instruments, a loan entails the redistribution of financial assets over time, between the lender and the borrower....
from the bank
Bank
A bank is a financial institution that serves as a financial intermediary. The term "bank" may refer to one of several related types of entities:...
s. A credit crunch generally involves a reduction in the availability of credit
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
independent of a rise in official interest rate
Interest rate
An interest rate is the rate at which interest is paid by a borrower for the use of money that they borrow from a lender. For example, a small company borrows capital from a bank to buy new assets for their business, and in return the lender receives interest at a predetermined interest rate for...
s. In such situations, the relationship between credit availability and interest rates has implicitly changed, such that either 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).
Background and causes
There are a number of reasons why banks may 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 collateralCollateral (finance)
In lending agreements, collateral is a borrower's pledge of specific property to a lender, to secure repayment of a loan.The collateral serves as protection for a lender against a borrower's default - that is, any borrower failing to pay the principal and interest under the terms of a loan obligation...
used by the banks to secure the loans; an exogenous
Exogenous
Exogenous refers to an action or object coming from outside a system. It is the opposite of endogenous, something generated from within the system....
change in monetary conditions (for example, where the central bank
Central bank
A central bank, reserve bank, or monetary authority is a public institution that usually issues the currency, regulates the money supply, and controls the interest rates in a country. Central banks often also oversee the commercial banking system of their respective countries...
suddenly and unexpectedly raises reserve requirement
Reserve requirement
The reserve requirement is a central bank regulation that sets the minimum reserves each commercial bank must hold of customer deposits and notes...
s or imposes new regulatory constraints on lending); the central government
Central government
A central government also known as a national government, union government and in federal states, the federal government, is the government at the level of the nation-state. The structure of central governments varies from institution to institution...
imposing direct credit controls on the banking system; or even an increased perception of risk regarding the solvency
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-term fixed expenses and to accomplish long-term...
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
Debt
A debt is an obligation owed by one party to a second party, the creditor; usually this refers to assets granted by the creditor to the debtor, but the term can also be used metaphorically to cover moral obligations and other interactions not based on economic value.A debt is created when a...
when the loans turn sour and the full extent of bad debt
Bad debt
A bad debt is an amount that is written off by the business as a loss to the business and classified as an expense because the debt owed to the business is unable to be collected, and all reasonable efforts have been exhausted to collect the amount owed...
s 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
Credit (finance)
Credit is the trust which allows one party to provide resources to another party where that second party does not reimburse the first party immediately , but instead arranges either to repay or return those resources at a later date. The resources provided may be financial Credit is the trust...
, 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
Financial crisis
The term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...
that results from the price collapse. This can result in widespread foreclosure
Foreclosure
Foreclosure is the legal process by which a mortgage lender , or other lien holder, obtains a termination of a mortgage borrower 's equitable right of redemption, either by court order or by operation of law...
or bankruptcy
Bankruptcy
Bankruptcy is a legal status of an insolvent person or an organisation, that is, one that cannot repay the debts owed to creditors. In most jurisdictions bankruptcy is imposed by a court order, often initiated by the debtor....
for those investors and entrepreneur
Entrepreneur
An entrepreneur is an owner or manager of a business enterprise who makes money through risk and initiative.The term was originally a loanword from French and was first defined by the Irish-French economist Richard Cantillon. Entrepreneur in English is a term applied to a person who is willing to...
s who came in late to the market, as the prices of previously inflated assets generally drop precipitously. In contrast, a liquidity crisis
Liquidity crisis
In financial economics, liquidity is a catch-all term that may refer to several different yet closely related concepts. Among other things, it may refer to Asset Market liquidity In financial economics, liquidity is a catch-all term that may refer to several different yet closely related...
is triggered when an otherwise sound business finds itself temporarily incapable of accessing the bridge finance
Bridge financing
Bridge financing is a method of financing, used to maintain liquidity while waiting for an anticipated and reasonably expected inflow of cash. Bridge financing is commonly used when the cash flow from a sale of an asset is expected after the cash outlay for the purchase of an asset...
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
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-term fixed expenses and to accomplish long-term...
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
Mark to market
Mark-to-market or fair value accounting refers to accounting for the fair value of an asset or liability based on the current market price of the asset or liability, or for similar assets and liabilities, or based on another objectively assessed "fair" value...
" - and if necessary, sell or go into liquidation
Liquidation
In law, liquidation is the process by which a company is brought to an end, and the assets and property of the company redistributed. Liquidation is also sometimes referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation...
if the capital
Financial capital
Financial capital can refer to money used by entrepreneurs and businesses to buy what they need to make their products or provide their services or to that sector of the economy based on its operation, i.e. retail, corporate, investment banking, etc....
of the business affected is insufficient to survive the post-boom phase of the credit cycle
Credit cycle
The credit cycle is the expansion and contraction of access to credit over the course of the business cycle. Some economists, including Barry Eichengreen, Hyman Minsky, and other Post-Keynesian economists, and some members of the Austrian school, regard credit cycles as the fundamental process...
. 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
Malinvestment
Malinvestment is a concept developed by the Austrian School of economic thought, that refers to investments of firms being badly allocated due to what they assert to be an artificially low cost of credit and an unsustainable increase in money supply, often blamed on a central bank.This concept is...
"). During the upward phase in the credit cycle
Credit cycle
The credit cycle is the expansion and contraction of access to credit over the course of the business cycle. Some economists, including Barry Eichengreen, Hyman Minsky, and other Post-Keynesian economists, and some members of the Austrian school, regard credit cycles as the fundamental process...
, asset prices may experience bouts of frenzied competitive, leveraged bidding, inducing inflation
Inflation
In economics, inflation is a rise in the general level of prices of goods and services in an economy over a period of time.When the general price level rises, each unit of currency buys fewer goods and services. Consequently, inflation also reflects an erosion in the purchasing power of money – a...
in a particular asset market. This can then cause a speculative price "bubble
Economic bubble
An economic bubble is "trade in high volumes at prices that are considerably at variance with intrinsic values"...
" to develop. As this upswing in new debt creation also increases the money supply
Money supply
In economics, the money supply or money stock, is the total amount of money available in an economy at a specific time. There are several ways to define "money," but standard measures usually include currency in circulation and demand deposits .Money supply data are recorded and published, usually...
and stimulates economic activity, this also tends to temporarily raise economic growth
Economic growth
In economics, economic growth is defined as the increasing capacity of the economy to satisfy the wants of goods and services of the members of society. Economic growth is enabled by increases in productivity, which lowers the inputs for a given amount of output. Lowered costs increase demand...
and employment
Employment
Employment is a contract between two parties, one being the employer and the other being the employee. An employee may be defined as:- Employee :...
.
Often it is only in retrospect that participants in an economic bubble
Economic bubble
An economic bubble is "trade in high volumes at prices that are considerably at variance with intrinsic values"...
realize that the point of collapse was obvious. In this respect, economic bubbles can have dynamic characteristics not unlike Ponzi scheme
Ponzi scheme
A Ponzi scheme is a fraudulent investment operation that pays returns to its investors from their own money or the money paid by subsequent investors, rather than from any actual profit earned by the individual or organization running the operation...
s or Pyramid scheme
Pyramid scheme
A pyramid scheme is a non-sustainable business model that involves promising participants payment or services, primarily for enrolling other people into the scheme, rather than supplying any real investment or sale of products or services to the public...
s.
As John Maynard Keynes
John Maynard Keynes
John Maynard Keynes, Baron Keynes of Tilton, CB FBA , was a British economist whose ideas have profoundly affected the theory and practice of modern macroeconomics, as well as the economic policies of governments...
observed in 1931 during the Great Depression
Great Depression
The Great Depression was a severe worldwide economic depression in the decade preceding World War II. The timing of the Great Depression varied across nations, but in most countries it started in about 1929 and lasted until the late 1930s or early 1940s...
: "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."
See also
- Austrian business cycle theory
- Debt deflationDebt deflationDebt deflation is a theory of economic cycles, which holds that recessions and depressions are due to the overall level of debt shrinking : the credit cycle is the cause of the economic cycle....
- Environmental credit crunchEnvironmental credit crunchThe term environmental credit crunch refers to a crisis which exposes humanity's inability to indefinitely consume finite natural resources in order to sustain economic activity and a standard of living...
- Financial crisisFinancial crisisThe term financial crisis is applied broadly to a variety of situations in which some financial institutions or assets suddenly lose a large part of their value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these...
- Minsky momentMinsky momentA Minsky moment is when over-indebted investors are forced to sell good assets to pay back their loans, causing sharp declines in financial markets and jumps in demand for cash. In any credit cycle or business cycle it is the point when investors begin having cash flow problems due to the spiraling...
- Liquidity crisisLiquidity crisisIn financial economics, liquidity is a catch-all term that may refer to several different yet closely related concepts. Among other things, it may refer to Asset Market liquidity In financial economics, liquidity is a catch-all term that may refer to several different yet closely related...