How a Capital Crunch Caused a Credit Crunch in 2008

In the wake of the financial crisis of 2007 2008, there occurred a dramatic slowdown in the growth of credit, triggered by a credit crunch in which credit was hard to get, and as a result, the performance of the economy in 2008 and 2009 was very poor. What caused the credit crunch?

Our analysis of how a bank manages bank capital explains why a credit crunch occurred in 2008 and that it 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 the previous chapter, there was a major boom and bust in the U.S. housing market that led to huge losses for banks around the world from their holdings of securities backed by U.S. 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 reduced bank capital and increased the need for more capital to support the assets coming back onto bank balance sheets.

This 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 world economy, raising new capital was extremely difficult, so the banks chose the latter course. Banks tightened their lending standards and restricted lending, both of which helped produce a weak economy in 2008 and 2009.