Causes and effects of the Credit Crunch

Causes and effects of the Credit Crunch The words credit crunch have been all over the financial headlines in the UK, including the effects that has hit the financial markets both in the UK and in other parts of the world have been reflected in a number of ways, affecting both financial institutions(banks) and consumers. Several authors and regulators have showed their different views about the causes and effect of credit crunch. Many economists studying the credit crunch explain it as a cyclical fall in credit demand. What is credit crunch? Bernanke and Lown (1991) define a credit crunch as a decline in the supply of credit that is abnormally large for a given stage of the business cycle. Credit normally contracts during a recession, but an unusually large contraction could be seen as a credit crunch. From Investopedia; credit crunches are usually considered to be an extension of recessions, also making it impossible for companies to borrow because lenders are scared of bankruptcies or defaults, which results in higher r ates. The consequence is a prolonged recession (or slower recovery), which occurs as a result of the shrinking credit supply. The credit crunch is also known as the credit crisis and is represented by a reduction in the general availability of loans which leads to sudden tightening of the conditions required to obtain a loan/credit from banks. Also, a broader definition of a credit crunch has been summarized by the Council of Economic Advisers (1992):A credit crunch occurs when the supply of credit is restricted below the range usually identified with prevailing market interest rates and the profitability of investment projects. Amongst the things affected in the UK as a result of the credit crunch are: Liquidity: The atypical flow of money looking for a home went into the West’s economies. Trade surpluses were recycled in the early part of the decade. This stimulated the â€Å"search for production of labor† and, in turn, the uncertainty in price of risk as investors imagined the high returns they were offered were safer than they proved. E.g. In September 2007, during the financial crisis of 2007-2010, the Bank had borrowed from the Bank of England a sum of about  £13 billion, a liquidity support facility, this showed that the total amount was a loss of deposits. which followed problems in the credit markets caused by the US sub- prime mortgage financial crisis. And it was of great shock that could be avoided to the bringing down of Northern Rock was a risk. However, the result of two unsuccessful offers to take over the bank, not being able to achieve the repayment of taxpayers’ money. This made the Government immediately take possession, away from its shareholders. Also reported cases showed some shareholders had their life savings in the shares, which were taken from them. Sub-prime lending: This covers different types of credit, including mortgages, auto loans, and credit cards. Sub-prime loans allows the opportunity for borro wers with a less-than-ideal credit record (considered as people with bad credit history)to be home owner. Some of theses lenders may use the credit in purchasing homes,sometimes in financing other types of spendings e.g. paying for living expenses, remodelling a home, or even paying down on a high-interest credit card or purchasing a car. Sub-prime lending (mortgages to be precise)provides a method of â€Å"credit repair†. Also with the interest rates low and liquidity in plentiful supply, financial institutions and businesses did not bother with adequate checks before, lending billions, who they realise could not afford repayments when some of this types of credits came with high interest rates, increased fees and costs which was a major cause for credit crunch.