The following section reviews the existing literature on bank regulation, bank failures and panics, and the credit crunch issue. This reduction of assets, particularly in the supply of loans, can cause a credit crunch.
We examine whether this policy-dilemma is empirically observable, and whether policy-makers concentrate more on preventing bank failures or avoiding a credit crunch.
Political scientists and economists have, however, not yet explored systematically how regulators behave when facing a trade-off between preventing bank failures and preventing a credit crunch. In this article we examine whether this policy-dilemma can be empirically observed, and whether policy-makers concentrate more on preventing bank failures or avoiding a credit crunch.
Two years ago markets were buoyant and traders were confident, but times have changed. When uncertainty is high, people avoid buying consumer durables like cars, fridges and TVs. At its simplest, the crunch is a crisis caused by banks being too nervous to lend money to us, businesses or each other.
That means low interest rates and pain for investors as stock markets fluctuate wildly and, in the worst cases, people face repossession and bankruptcy. The crunch occurred because years of lax lending inflated a huge debt bubble as people borrowed cheap money and ploughed it into property. When interest rates began to rise, US house prices started to plummet and borrowers began to default on mortgage payments.
This spelled trouble for us all because the US banking sector had repackaged sub-prime home loans into a form that could be sold on to investors — many of them hedge funds and other banks — who decided they were a great way to generate high returns and big bonuses.
Consequently, if home prices fall, the bank is left selling the property at a loss. Because banks are required to retain minimum levels of liquidity capital , when they suffer losses their capital positions are reduced, which reduces the amount they are able to lend out. Credit crunches can also occur when regulatory bodies increase capital requirements for financial institutions. Banks and other lenders are required to maintain a set amount of capital liquidity based on their risk-weighted level of assets.
If this requirement increases, many banks will need to increase capital reserves. To comply, banks will cut lending, reducing the availability of loans for individuals and companies.
Also, if banks perceive a greater risk in the market, they will often raise their lending rates to offset this risk. This increases the cost of borrowing and makes it more difficult for borrowers to access financing. If borrowers aren't willing to borrow at these rates, the bank is unlikely to lend at all. A credit crunch can do a lot of damage to the economy by stifling economic growth through decreased capital liquidity and the reduced ability to borrow.
When coupled with a recession , a credit crunch will often lead to many corporate bankruptcies. This increases the crunch's economic impact by stifling the economy's ability to recover.
For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature. Real Estate Investing. What sets the credit crunch of apart from the economic crisis, is the fact that this time, banks are aware of the hardships that lie ahead. When an economy suffers a recession, lenders become apprehensive of lending money to companies due to bankruptcies or defaults.
Now that the stakes are high, lenders surge their interest rates to compensate for the associated risk. This makes it impossible for companies to borrow. Debt deflation is one of the first symptoms of a credit crunch. Debt deflation occurs when there is a decline in the value of income and prices, but the total amount of debt stays the same. As opposed to modest inflation where the amount of debt falls in real terms, the debt stays the same in deflation.
This issue amplified in because of the redundancies, wage cuts, soaring unemployment rate that followed the weakening economy. To understand the causes of a credit crunch, let us study the credit crunch of The following are 4 economic mechanisms — the 4 ticking time bombs that played a significant role in how the credit crunch played out. The knock-on effect of such a drastic downfall in lending made the pendulum swing the other way. As the banks feared incurring more losses owing to defaults, they retrenched and only lent to those with a stellar credit history.
This behavior is referred to as flight to quality and is a way of reducing risk for lenders. The global financial market went ballistic after the credit crunch of , followed by a prolonged period of recession.
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