Definition of credit crunch

As capital requirements have progressively tightened in the course of Basel II and Basel III, lending institutions such as banks apply increasingly strict guidelines for loan approvals. Private and institutional market participants perceive this as a restraint in lending; in technical jargon this is also referred to as a credit crunch.

The term "credit crunch" resists a single unified definition because different research institutes apply their own criteria. Globally, however, the term can be understood as a discrepancy between actual credit supply and the credit supply that would be expected on the basis of interest rates and the profitability of investments. A credit crunch is noticed not only by consumers but also by companies. A credit crunch can lead to a recession (a downturn). A recession is a decline in economic activity, meaning that economic activity slows down and spending falls sharply.

A credit crunch therefore primarily arises on the supply side. Lending institutions such as banks do not grant loans to the extent that would be expected given market conditions. At regular intervals, the Rheinisch-Westfälisches Institut für Wirtschaftsforschung (RWI) surveys the lending conditions of the thirty most important credit institutions in Germany using a standardized questionnaire — the Bank Lending Survey (BLS). The economic low point is thus triggered by a downturn.

Because of the breadth of the survey and the high standardization of the individual items, the results are considered the most important recognized basis for discussion in economic decision‑making. The BLS is particularly significant as an early warning system, since the detailed evaluation also offers solid forecasting possibilities for the future.

Due to the wide variation in international regulations and standards, the results can however only be used for national decisions. This again highlights the large variety of definitions of a credit crunch.

Possible causes of a credit crunch

If the volume of money available for loans falls and a credit crunch occurs, this can have several causes.

1. A reduction in potential lending volume could be linked to a deterioration in a lending institution’s liquidity. In this case the necessary refinancing options are lacking to replace disbursed funds to at least the same extent via deposits or access to the capital market.
2. In contrast to these internal reasons, external factors can also lead to a more restrictive lending policy, i.e. a credit crunch. For example, new capital requirements directly affect lending policies because banks must hold larger reserve buffers. This places greater emphasis on the creditworthiness of potential borrowers such as consumers and companies in order to minimise default risks. In this way lenders often try to compensate for theoretical or already realised losses that would otherwise directly affect the capital base.
3. The third important cause of a potential credit crunch can be found in banks’ internal strategic priorities. Available funds may be invested in more lucrative areas and thus no longer be available for lending. An example would be financial derivatives, which often offer higher returns than the traditional granting of funds to risky borrowers. Here too, regulatory requirements on capital can cause a credit crunch, since banks may attempt to build necessary cash reserves through derivatives trading instead of issuing loans.

Credit crunch due to declining loan demand

More often, however, a credit crunch arises from a decline in the demand for loans. The problem here stems from potential borrowers who either forgo investments or are excluded from obtaining loans due to their liquidity situation.

Even if regular repayment instalments could be serviced from ongoing cash flow, loan allocation may fail due to a lack of collateral.

For assessing creditworthiness and valuing possible collateral, banks rely on individually defined algorithms that are, to some extent, aligned with their own lending policies. This is one reason why the term "credit crunch" resists a single definition.

Since 2007, banks have also been subject to the so‑called Solvency Regulation. Here the legislator allows a certain degree of discretion, which is, however, linked to a clear credit allocation framework. The Solvency Regulation is a procyclical tool and can therefore, particularly in weak economic periods, lead to a credit crunch because the required capital backing for loans must be increased.

Conversely, loosening requirements during phases of economic expansion carries the risk that banks grant loans more recklessly.

Credit crunch in the narrow and broad sense

Although there is no conclusive definition of a credit crunch, a distinction can nevertheless be made between two forms. In the broader sense, banks restrict the volume of lending because of credit assessments of borrowers.

This responds to higher credit risk, which primarily concerns the probability of repayment of lent funds. This approach is further reinforced in periods of weak economic conditions by legal regulations and requirements.

A credit crunch in the narrower sense arises exclusively from endogenous factors, often as a result of management decisions within a lending institution such as a bank. Creditworthiness considerations or legal requirements play a subordinate role here.

This deliberately accepted credit squeeze is often used to prepare for larger investments or to place currently available funds in more lucrative derivatives.

Macro‑economic consequences of a credit crunch

A credit crunch often develops a strong macroeconomic component, especially if it persists over a longer period. It does not matter whether the reduction in loans granted is due to endogenous or exogenous considerations.

Monetary policy, according to the commonly applied Keynesian approach, is based on the calculation that lower interest rates lead to higher investment volumes. The interest rate itself acts as a self‑regulating mechanism that brings supply and demand into a long‑term equilibrium. This is the central prerequisite for stable overall economic development.

In a credit crunch this monetary policy approach fails at least in part. Despite low interest rates, the equivalent investment volume necessary to achieve macroeconomic balance cannot be reached. This has mainly long‑term consequences because necessary investments are not made, are made too late, or are too small. In this way the economic damage to the nation accumulates over time.

The credit crunch is felt more quickly by large corporations than by small and medium‑sized enterprises (SMEs). In crises such as the 2008 financial crisis, large companies were more affected by the credit crunch than the Mittelstand. This can be due for example to the fact that the Mittelstand has less media visibility. The Mittelstand includes smaller and medium‑sized companies and the self‑employed.

Measures to prevent a credit crunch

Governments have developed several approaches to avoid or resolve credit crunches. The central focus is often on easing banks’ capital burdens in order to restore their room for manoeuvre and enable consumers and companies to obtain credit.

One approach aims at securitising granted loans. In doing so, banks sell receivables to state institutions and in return receive cash or bonds to increase their capital. This can relieve balance sheets and lead to more favourable refinancing options on the capital market. The creation of so‑called bad banks pursues the same effect. State or semi‑state institutions take over loans whose repayment is considered doubtful.

These loans are either taken over in full by a bad bank, or guarantees of an equivalent amount are provided. This enables banks to offset balance sheet liabilities and to refinance more cheaply on the international capital market.