What is a Credit Crunch?
The worldwide financial fiasco involves terms that no-one probably might have heard like the, credit crunch, subprime mortgages, frozen credit markets, credit default swaps, collateralised debt obligation or crisis, etc.
A credit crisis also known as credit squeeze or credit crunch, is a sudden or unanticipated reduction of availability of loans or credit. In other words, we can say that it is the unexpected narrowing down of the conditions to obtain credit or loan from the financial institution. It has been the greatest threat to the global financial system since the 1930s.
Tighter regulation of lending — combined with an increase in defaults — forces banks to rethink their lending practices. Some banks also cite a lack of demand combined with a major dip in sales.
What are the factors that lead to Credit Crunch?
These factors slowly and gradually lead to a credit crisis:
- Inappropriate lending: A credit crunch is often caused by the prolonged period of careless and inappropriate lending. The loans taken by the investors turn into bad debt which leads to huge loss to the financial institutions.
- Credit lending conditions: Easy credit conditions are the economic conditions in which interest rates are very low and relaxed lending procedures are practiced by banks. This situation makes the taking of loans easier.it means that funds are readily available to the borrowers, which in turn results in asset price rising if the money from loans is used to buy assets in a particular market sector, for example, real estate or stocks. On the other hand, in the credit crunch, it is just the opposite. The banks tighten the policies so that becomes difficult to borrow loans. They do it by increasing the interest rates and making the lending process difficult.
- Bubble formation: In credit bubble the lending conditions become flexible. Easy credit brings up the prices within a class of assets, usually real estate. This increase in the asset values becomes collateral for further borrowings. The upward movement in new debt creation increases the money supply and stimulates the economic activities which lead to a temporary rise in employment and economic growth.
- Psychological factors: There are several psychological factors which contribute to bubbles. The first one is social herding. Today following the behaviour of others is thought to be a trend. So that’s what they do, follow other people blindly. People may assume that these unusually favourable trends will continue forever.
What are the effects of a Credit Crunch?
- Economic slowdown: The financial institutions face losses, which may reduce the availability of credit and increase the cost of accessing these credits by increasing the interest rates to retail clients. By this the borrowing of money becomes difficult. The financial institutions may fail, which will lead to the slowdown in economic growth, unemployment etc. This can be seen in the subprime mortgage crisis of 2007-2008.
- Changes in the financial sector: There are both downside of the credit crisis and the upsides of the credit crisis. The aftermath of the crisis leads to Transparency and Regulation in the Financial Sector Improve. Because of the crisis, there is a decline in stock prices which in turn create great long-term valuations.
The world has forecasted and faced a lot of credit crisis and overcome them. But like always, every crisis ends after a certain time and the economy begins to expand again.