A period when lenders become cautious and reluctant to lend due to a variety of factors, such as increased risk, economic uncertainty or regulatory changes, can cause a ripple effect throughout the economy, mostly negative. Photo: Shutterstock

A period when lenders become cautious and reluctant to lend due to a variety of factors, such as increased risk, economic uncertainty or regulatory changes, can cause a ripple effect throughout the economy, mostly negative. Photo: Shutterstock

To preserve book value and financial integrity during adverse financial conditions, monetary institutions generally begin with a decrease in lending, even to each other, as is currently the case in the euro area. This is probably the first sign of a potential credit crunch looming, data journalist Kangkan Halder writes in this opinion column.

A credit crunch--a time when obtaining a loan, even for creditworthy individuals and institutions, becomes challenging--reflects economic turbulence and uncertainty. During such periods, monetary financial institutions (MFIs)--such as commercial banks, credit unions and other financial institutions that provide financial services--reduce their lending activities due to increased risk and uncertainty in the financial markets. And often, the decrease in intra-bank lending is the first indication of a potential credit crunch.

It is important to note that a credit crunch can arise due to various reasons, including, but not limited to, inflation and regulatory pressures. If inflation is high, household purchasing power decreases, and when coupled with higher interest rates, borrowing becomes more expensive, and as a counter-measure lenders can tighten lending to minimise default risks.

Previous credit crunches and the remedy

Most often central banks adjust interest rates to mitigate the effects of credit crunches. For instance, the 2008 financial crisis, caused by a combination of factors such as the housing market crash, high levels of debt and lax lending standards, was one of recent history’s significant credit crunches. The US Federal Reserve responded by lowering interest rates to near-zero levels and introduced quantitative easing to increase the supply of credit and stabilise the financial markets.

During another credit crunch--the eurozone crisis between 2010 and 2012, when several member states were unable to repay or refinance their government debt or bail out over-indebted banks--the European Central Bank resorted to lowering interest rates and providing cheap loans of more than €1trn to maintain money flows between European banks.

Similarly, the business and economic climate darkened between 2017 and 2018 partly due to the ECB’s unprecedented decision to continue keeping key deposit rates negative since 2014. Political uncertainty over Brexit, trade tensions between the United States and China, sluggish economic growth in the EU and regulatory policy tightening around banks led to a period of shallow business outlook and a credit crunch due to increased economic and political uncertainty. Although inflation remained low during this time, central banks worldwide responded with unprecedented monetary policy measures to mitigate the effects of the crisis.

All these credit crunches in the EU were also evident in sharp decreases in inter-bank and monetary institution lending.

Read also

Latest credit crunch

In late 2020, nearly a year into the covid pandemic and anaemic economy, businesses were struggling with restrictive health measures when trade tensions between the EU and the US flared up with tit-for-tat tariffs worth billions of dollars. Business sentiment took a plunge. The ECB continued to buoy-up banks through its various monetary policy measures, such as asset purchases and targeted longer-term refinancing operations.

However, in late 2021, geopolitical cracks widened between EU heavyweight Germany and Russia. Germany suspended approval for Nord Stream 2, while Russia amassed over 100,000 soldiers near the Russia-Ukraine border, heightening tensions of a military conflict, which indeed materialised in February 2022. This chain of events, followed by a string of sanctions against Russian entities, continued to deteriorate business sentiment in Europe.

As a result, there was a steady decline in inter-bank lending, which since December 2022 has recorded a negative annual rate of change. This is probably the first ripple in the pond of unsettling times ahead.

Uncharted territory

It is important to remember that the current situation is different from the last three instances of credit crunches. This time, the ECB is heavy-handed about continuing interest rate hikes to control core inflation. As of now, there is no plan for ultra-loose monetary policy unless inflation drops rapidly, which can then support the flow of credit to households and businesses.

Credit crunches can decrease economic activity as businesses struggle to obtain financing for growth and employment, which can lead to higher unemployment and slow economic growth. Thus, it is a delicate balance, and policymakers and economists will closely monitor the situation. However, if the worst happens, the economic slowdown could lead to a recession.

This article was published for the Delano Finance newsletter, the weekly source for financial news in Luxembourg. .