What Is a Credit Crisis?
A credit crisis is a breakdown of a financial system caused by a sudden and severe disruption of the normal process of cash movement that underpins any economy. A bank shortage of cash available for lending is just one in a series of cascading events that occur in a credit crisis.
Key Takeaways
- A credit crisis is a breakdown of a financial system caused by a sudden and severe disruption of the normal process of cash movement that underpins any economy.
- A credit crisis is caused by a trigger event such as an unexpected and widespread default on bank loans.
- A credit crunch becomes a credit crisis when lending to businesses and consumers dries up, with cascading effects throughout the economy.
- In modern times, the term is exemplified by the 2007–2008 credit crisis that led to the Great Recession.
Understanding a Credit Crisis
A credit crisis has a triggering event. Consider the potential impact of a severe drought where farmers lose their crops. Without the income from the crop sales, they can't repay their bank loans. Without those loan payments, the bank is short of cash and has to pull back sharply on making new loans. The bank still needs cash flow for its ordinary operations, so it steps up borrowing in the short-term lending market. However, the bank itself has now become a credit risk and other lenders cut it off.
As the crisis deepens, it begins to interrupt the flow of short-term loans that keeps much of the business community running. Businesses depend on this process to keep operating as usual. When the flow dries up, it can have disastrous effects on the financial system as a whole.
In the worst-case scenario, customers get wind of the problem and there's a run on the bank until there's no cash left to withdraw. In a slightly more positive scenario, the bank stumbles through but its standards for loan approvals have become so constricted that the entire economy, at least in this drought-stricken region, suffers.
The modern banking system has safeguards that make it more difficult for this scenario to occur, including a requirement for banks to maintain substantial cash reserves. In addition, the banking system has become consolidated into a few giant global institutions, making it unlikely that a regional drought could trigger a system-wide crisis. But those large institutions have their own risks. This is where the government steps in and bails out institutions that are "too big to fail."
The modern banking system has safeguards in place to prevent a credit crisis from occurring, although there's still a risk that loan availability and the circulation of cash in the economy could dry up.
The 2007–2008 Credit Crisis
The 2007–2008 credit crisis is most likely the only severe example of a credit crisis that has occurred within the memory of most Americans.
The 2007–2008 credit crisis was a meltdown for the history books. The triggering event was a nationwide bubble in the housing market. Home prices had been rising rapidly for years. Speculators jumped in to buy and flip houses. Renters were anxious to buy before they got priced out. Some believed prices would never stop rising. Then, in 2006, prices hit their peak and started to decline.
Well before then, mortgage brokers and lenders had relaxed their standards to take advantage of the boom. They offered subprime mortgages, and homebuyers borrowed well beyond their means. "Teaser" rates virtually guaranteed that they would default in a year or two.
This was not self-destructive behavior on the part of the lenders. They did not hold onto those subprime loans, but instead sold them for repackaging as mortgage-backed securities (MBS) and collateralized debt obligations (CDO) that were traded in the markets by investors and institutions.
When the bubble burst, the last buyers, who were among the biggest financial institutions in the country, were stuck. As the losses climbed, investors began to worry that those firms had downplayed the extent of their losses. The stock prices of the firms themselves began to fall. Inter-lending between the firms stopped.
The credit crunch combined with the mortgage meltdown to create a crisis that froze the financial system when its need for liquid capital was at its highest. The situation was made worse by a purely human factor—fear turned to panic. Riskier stocks suffered big losses, even if they had nothing to do with the mortgage market.
The situation was so dire that the Federal Reserve (Fed) was forced to pump billions into the system to save it—and even then, we still ended up in The Great Recession.
FAQs
A credit crisis is a breakdown of a financial system caused by a sudden and severe disruption of the normal process of cash movement that underpins any economy. A credit crisis is caused by a trigger event such as an unexpected and widespread default on bank loans.
What is the meaning of financial crisis in history? ›
A financial crisis is any of a broad variety of situations in which some financial assets suddenly lose a large part of their nominal value. In the 19th and early 20th centuries, many financial crises were associated with banking panics, and many recessions coincided with these panics.
How did the credit crisis happen? ›
Predatory lending in the form of subprime mortgages targeting low-income homebuyers, excessive risk-taking by global financial institutions, a continuous buildup of toxic assets within banks, and the bursting of the United States housing bubble culminated in a "perfect storm", which led to the Great Recession.
What was the financial crisis summarized? ›
A financial crisis occurs when asset prices drop steeply, businesses and consumers cannot pay their debts, and financial institutions experience liquidity shortages.
What is an example of a credit crisis? ›
A more recent example of a serious credit crunch was the subprime mortgage crisis of 2007-2008. The subprime mortgage crisis was a period of economic decline in the United States that began with the collapse of the housing market.
What was the biggest credit crisis? ›
The Financial Crisis of 2007–08
It took almost a decade for things to return to normal, wiping away millions of jobs and billions of dollars of income along the way.
What is financial crisis definition causes and examples? ›
A financial crisis is generally defined as any situation where significant financial assets – such as stocks or real estate – suddenly experience a sharp decline in value. They are often preceded by periods of economic boom and overextension of credit to borrowers.
What was the worst financial crisis in global history? ›
“September and October of 2008 was the worst financial crisis in global history, including the Great Depression.” Ben Bernanke, then the chair of the U.S. Federal Reserve, made this remarkable claim in November 2009, just one year after the meltdown.
What is an economic crisis definition and examples? ›
Definitions of economic crisis. a long-term economic state characterized by unemployment and low prices and low levels of trade and investment. synonyms: depression, slump. examples: Great Depression. the economic crisis beginning with the stock market crash in 1929 and continuing through the 1930s.
What happened in the credit crisis of 1772? ›
The British credit crisis of 1772–1773, also known as the crisis of 1772, or the panic of 1772, was a peacetime financial crisis which originated in London and then spread to Scotland and the Dutch Republic. It has been described as the first modern banking crisis faced by the Bank of England.
Which statement best summarizes the financial crisis of 2008? Problems in the US economy caused the global economy to slow down, which made it harder for the United States to recover.
What were the three major forces behind the credit crisis of 2007 and 2008? ›
havoc in markets in the U.S. and across the world since August 2007 had its origins in an asset price bubble that interacted with new kinds of financial innovations that masked risk; with compa- nies that failed to follow their own risk management procedures; and with regulators and supervisors that failed to restrain ...
What was the major financial crisis in the US history? ›
Who started the financial crisis? ›
On 15 September 2008 the investment bank Lehman Brothers collapsed, sending shockwaves through the global financial system and beyond. Visit our timeline to explore the events leading up to Lehman Brothers' failure and what happened in the weeks that followed.
What did the financial crisis affect? ›
In all the countries affected by the Great Recession, recovery was slow and uneven, and the broader social consequences of the downturn—including, in the United States, lower fertility rates, historically high levels of student debt, and diminished job prospects among young adults—were expected to linger for many years ...
What was the credit crisis in the Great Depression? ›
A series of financial crises punctuated the contraction. These crises included a stock market crash in 1929, a series of regional banking panics in 1930 and 1931, and a series of national and international financial crises from 1931 through 1933.
What is the summary of the 5 Cs of credit? ›
Called the five Cs of credit, they include capacity, capital, conditions, character, and collateral. There is no regulatory standard that requires the use of the five Cs of credit, but the majority of lenders review most of this information prior to allowing a borrower to take on debt.
