Credit crunch has been traditionally defined as an excess demand for credit under prevailing interest rates, or a situation where credit is rationed through non-price mechanisms. More often now, the term is used to describe a fall in real credit to the private sector (Lindgren,…
Taking the Asian example, in the years succeeding 1997, both the demand and supply were determined to have been affected by the credit crunch. Demand for credit declined as consumption and investment were sharply reduced due to uncertainty, overcapacity, weakening economic conditions, and the negative wealth effect arising from a fall in asset prices. The borrowers lost credit worthiness, which made banks reluctant to lend, even at higher interest rates. The financial system will also be affected in such a situation, resulting in the decline of supply of credit, which further weakens its demand (Lindgren, 1999, p. 24 - 25).
According to Jubak (2007), in a credit crunch, lenders stop lending and credit becomes tough to obtain. Credit crunch is a crisis that feeds on fear and uncertainty. A lender can compensate for fear by raising interest rates, tightening credit standards or writing more protective covenants into the terms of a loan. But if the size of the losses is uncertain enough, lenders cant compensate for the additional risk because lenders dont know how large that risk might be.
Credit crunch is characterized by extremely depressed liquidity and deteriorated balance sheet positions for households, corporations and financial institutions; sharply increased interest rates as all sectors scramble for remaining available funds; rising yield differentials as investors sell risky investments and switch to safe assets; a severely depresses stock market; and the inability of many borrowers to obtain funds at any cost (Wolfson, 1994, p. 22). The supply of funds is restricted not only because of the tight monetary policy by reducing bank reserves, but also due to smaller deposit inflows to financial institutions and reduced savings flows (Wolfson, 1994, p. 22).
In order to study the causes of credit crunch, Clair and Tucker (1993) focus on the Texas banking industry and the credit crunch phase of seven years starting 1986. The authors ...
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