Why there is a Credit Crunch and how Banks Work

Understanding how banks work goes a long way to understanding why there is a credit crunch and also possibly how to get ourselves out of it. Since the crisis originated in the banking system and is continuing not through the fault of the banks exactly, but because of their actions, the banking system is clearly a very important element in the understanding of how credit markets work and why they fail.

Banks work on a very simple system. They act as a safe place for you to deposit your money, paying you some interest on top of the provision of this service for the privilege of keeping your money. Interest rates are how banks compete for your money – a higher interest rate is a higher “price” for your deposit. Banks then use your money as loans for anyone wanting to borrow money, charging obviously a much higher interest rate than they offer on savings.

The key factor in the safe operation of banks is the reserve-deposit ratio. Banks know that they cannot loan all of their available funds or they will not be able to pay people who want to withdraw their money. However, they know that except in absolutely exceptional circumstances, only a few people will want to withdraw their money at a particular time. Therefore they keep a particular fraction of their total deposits in reserve, and the rest is loaned out.

The amount that is loaned enters a cycle of expenditure and deposit, becoming multiplied beyond its original size. This is a strange concept, but works as follows: someone goes to the bank and takes out a loan. They then spend this money, and the person who receives the money puts it in the bank. It is loaned again and the cycle repeats itself. As such the more loans there are being made, the more money there will be in the economy – this is liquidity, and is important in preventing a credit crunch.

The other crucial factor of how banks operate that needs considering is short term interbank lending. This takes place on a day to day basis – because the number of people wanting to withdraw money, take out loans and so on will be constantly fluctuating banks will occasionally need to supplement their reserves in the short term, and do this by borrowing from other banks that have a surplus, normally repaying the debt very quickly as they have to pay a high rate of interest on it and these are large sums of money changing hands.

Now, a credit crunch is simply a reduction in the availability of loans, or credit. In the case of the most recent credit crunch we are currently experiencing, the main reason for this was a sudden collapse in banks’ and people’s confidence in the banking system, largely caused by the sudden realisation that many banks had taken on huge packages of subprime mortgages, many of which were being defaulted on. Banks were suddenly losing large amounts of money and trying to get rid of the so-called “toxic debt”. Over the past few years banks had been lending vast sums of money that people couldn’t pay back, and suddenly their carelessness in the times of boom were coming back to bite them.

With public confidence in banks at a huge low, people rapidly started wanting to take their money out of the bank, meaning that banks had to increase their reserve-deposit ratios, which meant less loans being made. This was a good strategy anyway in the subprime mortgage market, but was beginning to cause serious problems in the interbank lending market. Banks such as Northern Rock in the UK that experienced a “run” on it where pretty much all of its depositors tried to get their money out at once desperately needed short term loans, but because banks were afraid that the same thing would happen to them, they would not offer the credit for any interest rate. Central banks tried to act as lenders of last resort, providing loans to struggling banks, but banks were afraid that they would cause panic amongst their depositors if they accepted the loans.

A credit crunch is a very difficult situation to get out of, because it requires restoring confidence in banks, which unfortunately means shoring them up with large amounts of taxpayers’ money. The consequences of not doing this would potentially be complete collapse of the economy, so really it is a no brainer but still people become extremely upset, their anger all the worse because a credit crunch this bad inevitably leads to a pretty much global recession. Small companies that rely on credit cannot get hold of it and may therefore go bust, or at least cut output. As a result national income falls, unemployment rises and we have a recession. Almost all of this is based on consumer confidence in the banking system, although of course the finger of blame points to the original foolhardiness of the banks that pushed their luck more than a little too far.