Financial Markets and Institutions (2-downloads)

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 hous-

ing 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 spon-

sored. The losses that reduced bank capital, along with the need for more capi-

tal 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 pro-

duce a weak economy in 2008.

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Part 6 The Financial Institutions Industry

Off-Balance-Sheet Activities

Although asset and liability management has traditionally been the major concern of

banks, in the more competitive environment of recent years banks have been aggres-

sively seeking out profits by engaging in off-balance-sheet activities.

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