Credit crunch is a situation in which the wheel of lending gets jammed leading to a sudden decline in lending, that is, credit.
Ladies and gentlemen! Welcome to the Real Simple Best News of the Year award ceremony. We are assembled here to assess people and events in the financial world that kept us engaged for the whole year. And now, this year’s award for the Best Financial Evangelist goes to Mervyn King, governor of the Bank of England, for raising the flag of moral hazard just before a bank run. The Most Sensational News award goes to “credit crunch” for creating a fire after the storm. And the award for the Best Firefighter of financial market goes to...
Jinny: Wake up Johnny! In which world are you lost?
Johnny: Ah! You spoiled my dream. I was the chief guest at the best news of the year awards. “Credit crunch” won the award for the most sensational financial news. They were just going to announce the award for the best firefighter of the financial market.
Jinny: I’m sorry! But you can go back to sleep and finish the dream. What’s the problem?
Johnny: The problem is now yours. You have to pay a penalty for spoiling my dream at the wrong time. Before I go to sleep again, you will have to tell me about a few basic things. First tell me, what exactly is “credit crunch”?
Jinny: As you may be aware, our credit market runs on two wheels. One wheel is borrowing and the other is lending. Credit crunch is a situation in which the wheel of lending gets jammed leading to a sudden decline in lending, that is, credit. This situation will automatically jam the other wheel. So if there is a credit crunch, borrowers are not able to find lenders. And even if they find them, the credit is available at unusually high interest rates. “Credit crunch” could happen due to many reasons, including an increased perception of risk on the part of lenders, imposition of credit controls or a sharp restriction in money supply. Increase in risk perception causes the worst kind of credit crunch. When the lenders are not sure about the creditworthiness of borrowers, there is an increase in the risk perception. This makes lenders nervous and they stop lending. When one of your wheels is in a rut, you can’t expect the other wheel to keep on moving. As a result, the flow of credit comes to a grinding halt.
Johnny: What causes lenders to doubt the creditworthiness of borrowers?
Jinny: Lenders doubt the creditworthiness of borrowers when they are not sure about getting their money back. The memory of recent defaults adds fuel to suspicion, and lenders become reluctant to lend. You may think that the lenders can demand high interest rates for taking a risk and part with their cash. The problem, however, is that it is difficult to set a price for risk when you are uncertain about the likely loss. This is how the defaults of “subprime mortgages” in the US started a fear of the werewolf in the financial markets this year. Lenders were not sure when their borrowers would turn into werewolves. Small depositors started lining up outside their banks. Even banks started fearing each other, which led to the worst kind of credit crunch seen in the inter-bank markets. This kind of fear and uncertainty is a perfect recipe for credit crunch.
Johnny: Tell me, what can happen if credit crunch persists for long?
Jinny: A credit crunch affects not only borrowers and lenders but also our financial markets and the economy. With the onset of credit crunch, interest rates shoot up. But even high rates may fail to bring lenders to the market. High interest rates put a brake on new investments and consumer demands, which may ultimately slow economic growth. New deals are scrapped due to lack of credit. Leveraged borrowers take the heaviest blow. Lenders may start demanding their money back. Even sound borrowers may default due to sudden demand for repayment. This can surely set the financial markets on fire.
Johnny: If there is a fire, there must be a firefighter around. Tell me, who takes care of a fire of this kind?
Jinny: That’s an interesting question. There is indeed a firefighter, known around the world as a “lender of last resort”. But I will tell you about him some other time. Meanwhile, you can make your plans for New Year’s party.
What:Non-availability of credit to the borrowers at a reasonable cost is known as credit crunch.
Why: Doubts about the creditworthiness of borrowers, imposition of capital controls and lack of liquidity are some of the reasons that may cause credit crunch.
Whom: Credit crunch can affect the whole economy by slowing new investments and consumer demands.
Shailaja and Manoj K. Singh have important day jobs with an important bank. But Jinny and Johnny have plenty of time for your suggestions and ideas for their weekly chat. You can write to both of them at realsimple@livemint.com
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