Credit Crunch

Credit Crunch Peek and Rosengren (1995) have defined credit crunch as a situation where loan supply has fallen faster than loan demand as a result of shrinkage in banks activities due to capital constraints. Such capital constraints may well be due to low or no earnings. They further suggested that banks with capital constraints have two options for raising their capital ratios; raising new capital or shrinking both their assets and liabilities. According to Myers and Majluf (1984), banks opt to shrink their assets and liabilities rather than to raise new capital because of asymmetric information. This shrinkage directly affects banks’ willingness to lend leaving small and medium-sized businesses financially dry. Hancock and Wilcox (1992) suggest that banks may shrink their lending activities in order to restore target capital ratios in response to regulatory pressure, financial market pressure, or the tastes and preferences of the bank management. Unlike most work which has focused on bank loans, Peek and Rosengren (1995) focused on banks’ liabilities, and concluded that banks’ behaviour in New England was altered by the loss of capital (capital crunch). The need of asymmetric information and the high costs of acquiring information and monitoring loans cause a capital crunch, which may in turn, cause a decline in lending that is not filled by other lenders resulting in a credit crunch.