A credit crunch occurs when banks significantly reduce their lending to individuals and businesses, resulting in less economic growth because people are unable to borrow as much. Typically, banks reduce their lending when central banks raise interest rates. This is because banks borrow money based on short-term interest rates set by the central bank and lend out money based on longer-term interest rates determined by the free market. When long-term interest rates are high, banks make more profit. The larger the difference between short-term and long-term interest rates, the greater the bank’s profit. Consequently, a decrease in lending leads to an economic contraction, potentially causing a recession. It is worth noting that the yield curve inversion has been deepening since 2022.
The Federal Reserve (Fed) plays a crucial role in influencing banks and financial institutions. Its monetary policies can be stringent, which has a ripple effect on banks and financial bodies. Recently, the Fed raised interest rates, making loans more expensive. The Federal Reserve justified this action due to high inflation concerns.
Despite the Fed increasing interest rates, banks have continued to lend to individuals and businesses even though these loans are not profitable for them. Market participants are forward-looking and anticipate that the Federal Reserve will soon start lowering interest rates in response to the situation. The expectation is that lower short-term interest rates will turn the loans recently made by banks back into profitable ventures. However, this assumption depends on individuals not withdrawing their funds from their accounts due to perceived solvency problems. Banks rely on money from depositors to provide loans, and if all depositors simultaneously attempt to withdraw their money, it can lead to a bank collapse, as seen in the case of Silicon Valley Bank.
Prior to the pandemic, US banks were required to maintain 10% of funds, but since March 2020, the balance has been zero. Furthermore, banks have also suffered from a decline in asset value due to rising interest rates, leaving them with insufficient funds to sustain withdrawals. These factors contribute to the emergence of a banking crisis.
Effects of banking crisis
People are moving money from small and medium banks into big banks. This is because big banks are perceived to be too big to fail and have a guarantee of the federal reserve.
People have started scrutinizing the balance sheets of their banks. Any bank that comes across as weak has seen its stock sell off.
People with lots of money have started moving it into Investments that earn a higher interest rate than their savings accounts. This includes various forms of U.S government debt and money market funds which invest in U.S government debt.
The reason why the interest rates on savings accounts remain so low at most banks is because raising these interest rates would eat into their profits.
When the Federal Reserve System started raising the interest rates, big banks reported losing 500 billion dollars in deposits since the start of 2023. FED data suggests that total bank deposits have fallen by more than a trillion dollars since last year. Just a week after the first bank collapsed, the deposits in the money market fund increased by $120 billion.
Small banks stand at a higher risk as they are competing with deposits made to Treasury bonds and money market funds, which at the moment give more returns.Small and medium-sized banks and small and medium-sized businesses are the ones that are going to feel the credit crunch the most.
Credit crisis
A credit crisis happens when banks don’t trust the safe collateral they’re using for loans.
If small and medium-sized banks reduce their lending to small and medium-sized businesses, then they will have a harder time finding new clients and could lose existing ones. This would lower customer deposits, which would reduce lending even more causing yet more deposit flight. Small and medium-sized banks would have to sell their assets leading to a credit crisis.
Both credit crunch and credit crisis are affected by the high interest rates set by FED. If inflation comes down fast then the FED will lower interest rates and there will be no credit crunch or credit crisis if inflation stays high however then we will see a credit crunch in the second half of the year.
The current situation reflects elements of a potential FED-instigated credit crunch, with banks reducing lending, individuals moving funds to larger banks, and small businesses facing the highest risk. The outcome will depend on the Federal Reserve’s response to inflation and whether interest rates are lowered.
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