Is the credit crunch a supply side phenomenon? A theoretical appraisal

INTRODUCTION The recent focus on and its link to subprime-mortgage business has put a dark overhang on the U.S. economy. The history of is not new to the U.S. market, dating as far back as 1930s followed by episodes in the mid-1970s, early 1990s, in 1998, and as recent as 2007. Anecdotal evidence shows the cause for crisis as being different for every single period. The purpose of this paper is to examine the determinants of crunch. A theoretical one period static model of the loan market is developed to explain the crunch. The loan market comprises of an imperfectly competitive bank (with certain market power) and a loan customer with homogeneous collateral. The model demonstrates how interest rates and capitalization of banks influence bank loans. The interest rate is set by the bank and borrower simply accepts it. The recent subprime-mortgage turmoil in the U.S. spread around the world, prompting central bank interventions. The worsening situation threatens to put more pressure on the housing market, where prices are flat to declining in much of the country. Lenders respond by tightening credit, making it more difficult and expensive for businesses, households, and government to borrow. According to the Chairman of the Federal Reserve, Ben Bernanke, Rising delinquencies and foreclosures are creating personal, economic and social distress for many homeowners and communities--problems that likely will get worse before they get better. During the Great Depression, over forty percent of depository institutions operating at the beginning of the 1930s failed, and bank lending declined drastically resulting in the crunch. According to Bernanke the credit crunch resulted from central bank dysfunction which ultimately prolonged the depression and subsequent recovery. In 1974, however, sudden supply side disturbances caused oil prices to go up triggering inflation pressure and rise in the interest rates, sending the market into disarray. Loans available to marginal borrowers were drastically cut leading to the 1974 recession and the subsequent crunch. The bottleneck once again emerged in the U.S. economy in the early 1990s with the junk bond and the Savings and Loans fiasco. The softening of bank regulations in early 1980s, the dramatic increase in depository institution failures between 1988 and 1991 and the Federal Deposit Insurance Corporation Improvement Act (FDICIA) of 1991 regenerated interest in depository institution insolvency risk - a determination to keep these risks under control (Berger and Udell 1992). Often mis-pricing of risks by deposit insurers is, in large part, blamed for the banking crisis. During the past twenty years, bank regulators have increasingly adopted risk-sensitive regulations starting with Basel I. The main objective of Basel I is to protect commercial banks from insolvency using risk-related capital requirements. Thus promotion of market discipline along with recapitalization of banks is consistent with public policy ranging from the provisions of FDICIA to Basel Accord II. The failure of the Long-Term Capital Management (LTCM) in 1998 and its ultimate demise in early 2000 also added a new dimension; problems associated with hedge funds. In August of 1998 Russia defaulted on its debt and the financial markets came unraveled and LTCM nearly went bankrupt. The Federal Reserve Bank of New York sponsored a bailout of LTCM by its creditor banks and justified its intervention to avoid a financial crisis whose effects could have been more severe. This is another face of the crunch. The efforts to discipline depository institutions through regulations lead to reduction of bank loans popularly known as the crunch. (1) The new capital adequacy standard, commonly known as the Risk Based Capital requirements (RBC) often squeezed part of banks equity. …