INTRODUCTION

Credit crunch

      A credit crunch (also known as a credit squeeze or credit crisis) is a reduction in the general availability of loans or a sudden tightening of the conditions required to obtain a loan from the banks. A credit crunch generally involves a reduction in the availability of credit independent of a rise in official interest rate. In such situations, 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 (i.e. credit rationing occurs). Many times, a credit crunch is accompanied by a flight  to quality by lenders and investors, as they seek less risky investments.

 

BACKGROUND AND CAUSES

    There are a number of reasons why banks may suddenly stop or slow lending activity. This may be due to an anticipated decline in the value of the COLLATERAL used by the banks to secure the loans; an exogenous change in monetary conditions (for example, where the central bank suddenly and unexpectedly raises reserve requirements  or imposes new regulatory constraints on lending); the central government imposing direct credit controls on the banking system; or even an increased perception of risk regarding the solvency of other banks within the banking system.

A credit crunch is often caused by a sustained period of careless and inappropriate lending which results in losses for lending institutions and investors in debt when the loans turn sour and the full extent of bad debts becomes known. These institutions may then reduce the availability of credit. and increase the cost of accessing credit by raising interest rate. In some cases lenders may be unable to lend further, even if they wish, as a result of earlier losses.

The crunch is generally caused by a reduction in the market prices of previously "overinflated" assets and refers to the financial that results from the price collapse. This can result in widespread foreclosure  for those investors and entrepreneur  who came in late to the market, as the prices of previously inflated assets generally drop precipitously. In contrast, a liquity is triggered when an otherwise sound business finds itself temporarily incapable of accessing the bridge finance it needs to expand its business or smooth its cash flow payments. In this case, accessing additional credit lines and "trading through" the crisis can allow the business to navigate its way through the problem and ensure its continued solvency  and viability. It is often difficult to know, in the midst of a crisis, whether distressed businesses are experiencing a crisis of solvency or a temporary liquidity crisis.

Yes, it is possible to avoid yet another credit crunch.

Regulators, supervisors and central banks should try to solve these perverse incentives and conflict of interest problems that lead to the crisis. Here are some of the measures they should take besides continue to inject liquidity until some confidence is regained:

First, the American banking authorities should regulate all American agents and brokers which are originating these mortgage loans in order to avoid their perverse incentives when dealing with their potential borrowers and to try to standardise their property registration and collateral execution systems across states.

Second, all banking supervisors should oblige all banks, which originate and sell loans and mortgages, to retain their “equity” or first loss risk block, as it happens today in some European countries, in order to make them share part of the risk when they sell them to intermediaries or final investors and, therefore, to be much more careful when monitoring their credit risks and when choosing the mortgages to be pooled for sale.

Third, the banks and financial institutions, which structure and securitize these loans, should be extremely transparent about their package processes, their supporting models and their associated risks. Moreover, they should try to increase the standardization of these products up to making them suitable to be traded in an organized and transparent market.

Submitted to

Mr.Gurdeepak Singh

Submitted By

Aarish Madaan

MBA 1^st sem (A)