What a Credit Crunch Means

The financial crisis is referred to as a ‘credit crunch’ so widely now that many people associate the term with any bank collapse. In fact, the term ‘credit crunch’ has a very specific technical meaning. A credit crunch arises when banks or financial institutions have lent money due for repayment in the distant future, but are financing those loans with short-term borrowing which cannot be rolled over (i.e., repaid out of new short-term borrowing). There are various reasons why banks may wish to finance longterm lending with short-term borrowing. One of these might be that the interest rate on short-term borrowing is much lower than the rate on long-term lending. But the common reason for this kind of financing in the two years before the crisis has been the difficulty that banks have had in selling off their long-term loans packaged up as bonds (see securitisation below). Under the current system of bank regulation (the so-called Basle Accord), banks with long term loans on their balance sheets are required to hold additional bank capital in case the loans go bad. Banks that could not sell off loans packaged up as bonds were transferring those loans into off-balance sheet subsidiaries called ‘special purpose vehicles’ financed by short-term borrowing. When the inter-bank money markets stopped lending in the summer of 2007, banks with special purpose vehicles found themselves with large amounts of short term borrowing due to be repaid, but without the ability to re-borrow in order to pay off that borrowing.