A Credit Crisis/Credit Crunch
A credit crisis (also known as credit squeeze or credit crunch) is a reduction in terms of the general availability of loans (or credit) or an abrupt tightening of conditions required to obtain a loan from banks. A credit crunch normally involves a reduction in the availability of credit irrespective of a rise in interest rates. In such a scenario, the relationship between credit availability and interest rates has implicitly changed, such that either credit becomes less available at any given official interest rate, or there ceases to be a clear relationship between interest rates and credit availability (that is credit rationing occurs). Many times, a credit crisis is accompanied by a flight to quality by lenders and investors, as they seek less risky investments (often at the expense of small to medium size enterprises)
Causes of Credit Crisis
There are many reasons why banks may suddenly stop or slow down their lending activity. This can be due to an anticipated decline in value of the collateral used by banks for securing the loans; an exogenous change in monetary conditions (for instance, where the central bank suddenly and unexpectedly raises reserve requirements or may be imposes new regulatory constraints on lending); the central government imposing direct credit controls on the banking system; or even an increased sensitivity of risk regarding the solvency of other banks within the banking system.
Credit crunch is time and again caused by a sustained period of careless and an inappropriate lending mechanism which results in losses for lending institutions and investors in debt when loans turn sour and the full extent of bad debts is known. Such institutions may then decrease the availability of credit, and add to the cost of accessing credit by raising the interest rates. In some cases lenders might be unable to lend further, even if they wish to do so, as a result of earlier losses.
The crunch can also be caused by a reduction in market prices of earlier "over inflated" assets and refers to the financial crisis that is caused due to the price collapse. This can lead to widespread foreclosure /bankruptcy for the investors and entrepreneurs who came in late to the market, as the prices of previously inflated assets will drop sharply. In contrast, a liquidity crisis is triggered when an otherwise well-established business finds itself temporarily incapable of accessing the bridge finance that it needs to expand the business or smoothen its cash flow payments. In such a situation, accessing the additional credit lines and "trading through" the crisis could allow the business to find its way through the problem and ensure its continued solvency and viability. It's often difficult to understand, in the midst of a crisis, whether distressed businesses are experiencing crisis of solvency or only a temporary liquidity crisis.
Incase of a credit crunch, it may be good to "mark to market" - and if necessary, sell or go into liquidation incase the capital of the business affected is not enough to survive the post-boom phase of a credit cycle. Incase of a liquidity crisis on the other hand, it may be better to access additional lines of credit, as opportunities for growth may still exist once the liquidity crisis has been overcome.
| 