How does a credit crunch occur?

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How does a credit crunch occur?

A credit crunch occurs when the credit market lacks funds, making it difficult for borrowers to obtain financing. This arises in one of three ways: when lenders have limited money to lend, when they are hesitant to offer extra funds, or when they have raised the cost of borrowing to a rate that most borrowers cannot pay.

Let’s take a look at the anatomy of a credit crunch.

Lending institutions are often hesitant or unable to lend after they have experienced losses on earlier loans. This happens when borrowers fail and the properties that underpin the defaulted loan lose value. When borrowers fail, banks foreclose on their mortgages and try to sell the homes in order to recoup the monies they paid them. As a result, if housing values decline, the bank is forced to sell the property at a loss. Because banks are mandated to maintain certain levels of liquidity (capital), when they incur losses, their capital positions are decreased, reducing the amount they may lend.

When regulatory agencies raise capital requirements for financial firms, credit crunches may arise. Banks and other lenders must maintain a certain amount of capital liquidity depending on their risk-weighted asset level. If this threshold is raised, many banks will be required to enhance their capital reserves. Banks will reduce lending in order to comply, decreasing the availability of credit for consumers and businesses.

Also, if banks see a bigger danger in the market, they will typically boost their lending rates to counterbalance this risk. Borrowing costs rise as a result, making it more difficult for borrowers to get funding. If borrowers are unwilling to borrow at these rates, the bank will be hesitant to lend at all.

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A credit crunch may cause significant economic harm by restricting economic expansion via diminished capital liquidity and borrowing capacity. Many businesses need borrowing money from lending institutions in order to fund and/or grow operations; without this capacity, expansion is impossible; in other situations, businesses must discontinue operations. When combined with a recession, a credit crisis often leads to a large number of company bankruptcies. This intensifies the economic effect of the crisis by impeding the economy’s capacity to recover.

For related reading, see How Will Your Mortgage Rate?

(Check out the Subprime Mortgages Feature for a one-stop shop on subprime mortgages and the subprime crash.)

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