A credit crunch or crisis happens when there is a shortage of funds available in the credit market which is independent of any changes in the official or government induced interest rate, and hence making it difficult for borrowers to get loans. In simple words no matter what interest rate is there is severe shortage of people or banks willing to lend to the borrowers. Here are some of the reasons for credit crisis –
1. One reason for the shortage of funds can be due to absence of lenders or lenders demand exorbitant rate of interest from borrowers which they are unable to pay.
2. Banks stop their lending activity when the price of the collateral which is used for loans by the banks falls sharply and because banks have to maintain minimum level of capital in order to meet statutory requirements, they sell the collateral and suffer losses, and hence their capital positions are reduced, which reduces the amount they are able to lend out.
3. Credit crunches can also occur when regulatory bodies increase capital requirements for financial institutions and banks, since banks are required to maintain a predetermined amount of capital liquidity based on their risk-weighted level of assets. So if this requirement increases, many banks will need to increase capital reserves which in turn hamper their ability to lend to the borrowers.
4. 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
Hence from the above one can see there can be many reasons behind credit crunch, but the important thing which emerges out is that credit crunch can do a lot of damage to the economy by reducing the economic growth of a country because all companies whether big or small need loans or credit for expansion purpose and if it is not available then naturally it will have a huge negative impact on the country as a whole.