A credit crunch is generally defined as a decline in the supply of credit because, although banks are less willing to lend, lending rates do not rise. According to Green and Oh (1991), a credit crunch is an inefficient situation in which credit-worthy borrowers cannot obtain credit at all, or cannot get it at reasonable terms, and lenders show excessive caution, which may or may not be traceable to regulatory distortion, leaving would-be borrowers unable to fund their investment projects.
A credit crunch can have several causes, such as regulatory pressures and over-reaction to deteriorating bank asset values and profitability. If regulatory pressure is the obstacle to credit growth, it should be removed, and credit growth can be restored. But if the crunch is caused by inefficient conservative lending by banks, it is an open question whether easing monetary policy can help. This paper attempts to develop a quantitative model to address the issue.
A number of papers suggest that a credit crunch existed in several countries in the early 1990s. From survey data in Germany, Harholf and Korting (1998) find that firms in financial distress face comparatively high line-of-credit interest rates and reduced credit availability. Using Finnish data from the 1990s, Vihriala (1996) finds that tightening capital regulations, substantially depleting bank capital, and changing risk attitudes may explain banks’ conservative lending. Using a disequilibrium econometric model, Pazarbasioglu (1996) also suggests that banks become less willing to supply credit during periods of deteriorating asset quality and reduced profits caused by declining regulatory protection from competition and a need to increase capital-adequacy levels.
In 1990–91, U.S. banks curtailed their lending. Sharpe (1995) claims this occurred because of losses of bank capital, stringent bank regulatory standards, and heightened market scrutiny of bank capital. The Bank for International Settlements risk-based capital standards were phased in beginning in late 1990 and took full effect in 1992. The reduced credit occurred at a time when banks had difficulty meeting their minimum-capital adequacy requirements. According to Bernanke and Lown (1991), the regulatory pressures on bank capital positions would shift the credit supply curve to the left, given constant real interest rates and the same quality of borrowers. Using New England bank data, Peek and Rosengren (1995) find empirical evidence supporting the hypothesis that banks have experienced a capital crunch caused by large capital losses and binding capital regulations.
