Credit Crunch

A credit crunch is a sudden and severe reduction in the supply of credit, in which banks and other lenders stop lending, demand much more collateral or charge far higher spreads, even to borrowers who would normally qualify. The defining feature is that lending falls because lenders are unable or unwilling to lend, not just because borrowers want less or because the central bank has raised interest rates.

The phrase is closely tied to the 2008 Financial Crisis, which in the UK was widely called "the credit crunch". It overlaps with a liquidity crisis, in which lenders cannot get funding, and often follows a period of rapid credit expansion. Economists Ben Bernanke and Cara Lown used the term in a 1991 study of the US lending slowdown in the 1990–91 recession, defining it as a significant leftward shift in the supply curve for bank loans.

Imagine a town where the only shop that lends tools suddenly gets nervous after a few tools are not returned. It stops lending to almost everyone, including careful neighbours who have always returned things on time. Projects stall, not because people stopped wanting to build, but because they cannot get the tools.

That is a credit crunch. Businesses that need loans to pay staff or buy stock, and families who need a mortgage, are turned away or offered worse terms. Spending falls, firms cut back, and the slowdown can make lenders even more cautious, so the squeeze feeds on itself.

• Losses on bank capital. When loans or securities go bad, banks' capital shrinks. To stay above regulatory minimums they lend less, a process known as deleveraging.
• Funding stress. If depositors, money market investors or other banks pull funding, lenders must hoard cash; a bank run is the extreme case.
• Collapse in collateral values. Falling house or asset prices reduce what borrowers can pledge and raise lenders' haircuts.
• Heightened uncertainty and asymmetric information. When lenders cannot tell sound borrowers from weak ones, they ration credit to all, the problem of adverse selection.
• Tighter regulation or policy. Sudden increases in capital rules or very rapid rate rises can also squeeze credit supply.

The modern crunch began in August 2007, when losses on US subprime mortgage-backed securities made banks unsure of each other's solvency. Interbank lending rates jumped above expected policy rates, BNP Paribas froze withdrawals from three investment funds on 9 August 2007, and the UK's Northern Rock suffered a depositor run in September 2007. The failure of Lehman Brothers in September 2008 turned the squeeze into a global collapse in lending, with securitisation and shadow banking markets seizing up.

Other episodes include the US crunch of 1990–91, Japan's banking crisis of the late 1990s, the euro-area debt crisis of 2010–12 and India's shadow-bank squeeze after the infrastructure lender IL&FS defaulted in 2018.

Central banks survey lenders directly. The Federal Reserve's Senior Loan Officer Opinion Survey, the ECB's Bank Lending Survey and the Bank of England's Credit Conditions Survey ask banks whether they have tightened or eased standards. Results are usually reported as a net percentage:

• $\%_{\text{tightened}}$ is the share of responding banks that tightened lending standards.
• $\%_{\text{eased}}$ is the share that eased them.

If 70% of banks report tighter standards for business loans and 5% report easier ones, net tightening is $70 - 5 = 65$ percentage points, a reading typical of a severe crunch. Analysts also watch credit spreads, lending volumes and loan approval rates.

Central banks fight a credit crunch by cutting rates, acting as lender of last resort, widening the collateral they accept and buying assets through quantitative easing. The Federal Reserve set up emergency lending facilities in 2008 and 2020, and the Bank of England's Funding for Lending Scheme (2012) gave banks cheap funding linked to their lending. Governments recapitalise banks, guarantee loans and extend deposit insurance. After 2008, Basel III added countercyclical capital buffers that can be released in a downturn to keep credit flowing, part of macroprudential policy.

Economists disagree on how much of any lending slump is a true supply crunch and how much reflects weak demand for loans, since both reduce lending. Some argue that bailouts and cheap central bank funding ease crunches at the cost of moral hazard. Others argue that tighter post-2008 bank regulation pushed lending into less regulated non-bank credit, while supporters say better-capitalised banks make future crunches less severe. The concept is also central to Minsky's account of how booms turn into busts.

• Federal Reserve: Senior Loan Officer Opinion Survey on Bank Lending Practices
• European Central Bank: Euro area bank lending survey