How Banks Contributed to Credit Crunch


Credit crunch refers to an economic condition where the amount of credit available reduces drastically either due to tightened rules by the banks or reduced amount of money available. The crunch may also be caused by Massive external borrowing, merging credit with equity culture, fluctuation in business banking model and taxation, slack monetary policy and high risk lending habits. Credit crunch causes fall in security prices, collapsing of firm and tightened credit which results in reduced aggregate demand as well as mass unemployment. This paper will attempt to show the extent to which the banks contribute to credit crunch.

Collateralized Debt Obligation

Bank were supposed to give credit to as many people as possible without taking into consideration whether they were able to repay back with full baking from the state government. These led to a lot of bad debts while at the same time there was a lot of investment in the housing sector causing rise in house prices (Butler 2009). Banks lacked liquidity to continue funding loans and resulted to selling assets to improve their liquidity position, while at the same time tightening lending regulations which led to credit crunch.

Shadow Banking System

Financial transactions that are beyond the regulation of the state mostly involve use of short term liabilities to refinance long term and highly illiquid assets by investment banks which are not recognized by central banks as depository banks. Because credit is readily available, many people take loans fuelling rise in asset prices (Doyran 2011). Too much of this kind of loans led to inability of these banks to pay their creditors, forcing them to sell their assets to pay debts hence market disruptions and in the worst scenarios sharp fall in asset prices leading to credit crunch.

Risky Lending Behavior

Bank managers received bonuses and other rewards when income from interest on loans increased as apart of income encouraging them to source for more clients to give loans. On top of that, the managers were not required to be answerable for their actions in case of non-performing loans or loses incurred when they engaged unregulated lending (Butler 2009). This made banks to venture in high risky lending by loosening the lending procedures while giving assets speculative values causing the house bubble to build up and eventually when these loans could not be paid and bad debts pilled up the bubble burst.

Subprime Mortgages

Banks financed high risk, low quality and adjustable-rate mortgages because of the high returns that were associated with the house sector given that house prices were increasing indebting most of the families highly ( Lund 2011). When the housing prices started falling, repayments became high due to increased mortgage rates which led to crushing in prices of securities that were associated with the mortgages. On the other hand, investor confidence reduced which led to reduction of investments in the mortgage market leading to tightening of credit and unfortunately the financial crisis.

Bailing of Banks Incase of Crisis

The central banks have the habit of bailing out banks when the crisis has set in, which makes the banks lose their morals when they are giving out loans. Banks stop applying due diligence when issuing loans and issue huge amount of loans to low credit worth customers expecting the federal reserve bank to come to their aid, if this huge loans turn to bad debt (Doyran 2011).


Banks play a very important role in financial markets and have the ability of providing information on what the market players should expect in future and they also provide finances to these players. On this note, banks can therefore manipulate the market to their advantage risking various economical repercussions. It is evident that banks contributed to a larger extent the credit crunch and should therefore be controlled to deter repetition of the same.


Butler, C. (2009). Accounting for Financial Instruments. Hoboken, NJ: Wiley.

Doyran, A. M. (2011). Financial Crisis Management and Pursuit of Power: American Pre-Eminence and the Credit Crunch. Farnham: Ashgate Publishers.

Lund, B. (2011). Understanding Housing Policy. Wales: Policy Press.

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