You’ve probably heard the term “Credit Crunch” so many times that you ought to have a pretty good grasp of what it means. But do you? Most of my friends, when asked, were stumped to come up with a satisfactory answer. The term is relatively new and is still considered slang by some quarters, so a good description is hard to come by. So putting on my heroic hat for a moment, I have put together a little handy guide that should hopefully clarify a few points for you.
OK, so lets start with a basic description. A Credit Crunch is a sudden reduction in the amount of cash available from loans (or credit), or from the sudden increase in the cost of obtaining loans from banks.
So, why might this occur? There are a number of reasons why banks may suddenly increase the costs of borrowing or make borrowing more difficult. It may be due to an anticipated decline in value of the security used by the banks when issuing loans, or even an increased perception of risk on the subject of the solvency of other banks within the banking system, which we have seen plenty of lately. It may be due to a change in monetary conditions (for example, where the central bank suddenly and unexpectedly raises interest rates or reserve requirements) or even due to the central government imposing direct credit controls.
A credit crunch is often caused by a sustained period of careless and badly chosen 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. These institutions 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, because of earlier losses.
The crunch in general is caused by a reduction in the market prices of previously “over inflated” assets and the financial crisis that results from the price collapse. In contrast, a similar sounding Liquidity Crisis is triggered when sound businesses find themselves temporarily incapable of accessing the finance it needs to expand or smooth its 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 sell or go into liquidation if the capital of the business 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 over.
A prolonged credit crunch as we may be currently experiencing from the excesses of the sub-prime market is the opposite of cheap, easy, and plentiful lending practices (sometimes referred to as “easy money” or “loose credit”). During the upward phase in the credit cycle, asset prices may experience bouts of frenzied competitive, leveraged bidding, inducing hyperinflation in particular asset markets. 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 which I hope to cover later on if you’re feeling brave.
I personally like the quote from the economist, John Maynard Keynes, when he said 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.”
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