How a Capital Crunch Caused a Credit Crunch in 2008
The dramatic slowdown in the growth of credit in the wake of the financial crisis starting in 2007 triggered a “credit crunch” in which credit was hard to get. As a result, the performance of the economy in 2008 was very poor. What caused the credit crunch? Our analysis of how a bank manages its capital indicates that the 2008 credit crunch was caused, at least in part, by the capital crunch, in which shortfalls of bank capital led to slower credit growth. As we discussed in Chapter 8, there was a major boom and bust in the housing market that led to huge losses for banks from their holdings of securities backed by residential mortgages. In addition, banks had to take back onto their balance sheets many of the structured investment vehicles (SIVs) they had sponsored. The losses that reduced bank capital, along with the need for more capital to support the assets coming back onto their balance sheets, led to capital shortfalls: Banks had to either raise new capital or restrict asset growth by cutting back on lending. Banks did raise some capital but with the growing weakness of the economy, raising new capital was extremely difficult, so banks also chose to tighten their lending standards and reduce lending. Both of these helped produce a weak economy in 2008.