CREDIT CRUNCH

Causes of the current credit crisis

Abstract

This paper will explain what the term "credit crunch" and the consequences and causes that led to the current crisis problem. Will also advise and explain what policies that UK Government need to implement in order for the British economy to emerge from the recession caused by the "credit crunch".

Causes of the current credit crisis

Introduction

The term "credit crunch" is used to describe a sudden cut in availability of loans or credit that include mortgage, credit cards, and inter-bank lending or when the cost of obtaining loans from the bank has suddenly increase.

The credit crunch makes it impossible for companies to loan because of the shortage in the availability of loans or credits from the banks and other lenders who are worried of rising bankruptcies and mortgage defaults. The banks or other lenders want to minimise their risk resulting by increasing the cost of obtaining the loans (i.e. charging higher interest rates) or reject all loans except for safest loans. During credit crunch, many businesses may have trouble with their cash flow causing them to lay off their employees or even close down due to insufficient funds resulting from inability to get loan or credit.(Sikka,2008,175)

Classification of credit crunches

Following Bernanke and Lown (1991), we define a credit crunch as “a significant leftward shift in the supply curve for bank loans”, i.e. a period of declining loan growth which is sharper than expected for the stage of the economic cycle — over and above any decline which can be attributed to falling loan demand and deterioration in borrower quality. Again following “we measure loan growth in nominal terms. What matters is the real value of new credit extensions, which is better approximated by the nominal growth rate of loans outstanding if the effective maturity of loans is relatively long.” (Peachey,2008,155)

Table 1 below compares growth in commercial and industrial (C&I) loans at all commercial banks with GDP growth during six economic downturns experienced in the US over the past four decades. Four of these episodes exhibit significant declines in loan growth relative to GDP growth and thus accord with our definition of a credit crunch: (1) the mid 1970s aftermath of the oil shock, (2) the early 1990s fallout from the Savings and Loans crisis, (3) the early 2000s fallout from the Dotcom Bust, and (4) the current credit crunch.(Arnold,,2007,275)

During the two 1980s recessions, however, nominal loan growth remained relatively robust. We get similar results using total loans data, although the declines in loan growth during the credit crunch episodes are less pronounced. As further evidence that our credit crunches are driven by shifts in supply rather than demand for loans, we look at the Fed's Senior Loan Officer (SLO) credit standards series over the relevant periods. Credit standards were tightened more significantly during our four credit crunches compared to the two 1980s recessions, both in absolute terms and also relative to the severity of the downturn.

Table 1.

Comparison of credit crunch ...