A:

A credit crunch occurs when there is a lack of funds available in the credit market, making it difficult for borrowers to obtain financing. This happens when lenders have limited funds available to lend (or are unwilling to lend additional funds), or have increased the cost of borrowing to a rate that is unaffordable to most borrowers.

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

When lending institutions have suffered losses from previous loans, they are generally unwilling or unable to lend. This occurs when borrowers default and the properties underlying a defaulted loan decline in value. In this situation, as borrowers default, banks foreclose on the mortgages and attempt to sell these properties to regain the funds they loaned out. Consequently, if home prices fall, the bank is left selling 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.

Overall, 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. Many companies need to borrow money from lending institutions to finance and/or expand operations; without this ability, expansion is not possible and in some cases, companies will need to cease operations. When coupled with a recession, a credit crunch can often lead to many corporate bankruptcies. This increases the crunch's economic impact by stifling the economy's ability to recover.

For related reading, see How Will Your Mortgage Rate?

(For a one-stop shop on subprime mortgages and the subprime meltdown, check out the Subprime Mortgages Feature.)

RELATED FAQS

  1. What are the main risks to the economy of a country that has implemented a policy ...

    Learn about the main risks to a country that has implemented a policy of austerity. Austerity implies cutting government ...
  2. What are the major laws (acts) regulating financial institutions that were created ...

    Read about the major federal responses to the financial crisis of 2008, such as the Dodd-Frank Wall Street Reform Act and ...
  3. What are the similarities and differences between the savings and loan (S&L) crisis ...

    Learn about some of the similarities and differences between the savings and loan crisis and the subprime mortgage crisis ...
  4. What is the difference between "closed end credit" and a "line of credit?"

    Find out about the difference between closed-end credit and lines of credit, and how both closed- and open-end credit is ...
RELATED TERMS
  1. Regional Asset Liquidation Agreement (RALA)

    An agreement between an asset manager and the Federal Deposit ...
  2. The New Deal

    A series of domestic programs designed to help the United States ...
  3. Accelerated Resolution Program (ARP)

    A program designed to reduce the time and cost of resolving failed ...
  4. Deficiency Balance

    The amount owed to a creditor if the sale proceeds from the collateral ...
  5. Balance Chasing

    The gradual lowering of a consumer’s credit limit by a credit ...
  6. Total Annual Loan Cost (TALC)

    The projected total cost that a reverse mortgage holder should ...

You May Also Like

Related Articles
  1. Mutual Funds & ETFs

    6 ETFs to Fight Your Recession Jitters

  2. Economics

    Worried About a Recession? Then Buy ...

  3. Stock Analysis

    Can American Capital Agency Maintain ...

  4. Stock Analysis

    How Two Harbors' Derivatives Work?

  5. Stock Analysis

    How Chimera Investment Bear The Brunt ...

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!