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.