Credit crunch in capital markets....

I am pretty sure everyone would have come across this jargon while browsing on internet. I knew what does it mean, but never actually thought what leads to this and how does it impact capital markets. Now as capital markets are melting globally there was a need to delve into details.

Credit crunch occurs when there is lack of funds available in credit market, making it difficult for borrowers to borrow money. Credit crunch can severely impact economic growth of a country.Many companies need to borrow money from lending institutions to finance and/or expand operations; without this ability, expansion is not possible and in some cases, companies will need to cease operations.

All said and done next big question is what leads to credit crunch....

• Increase in capital requirement for Banks - Many banks and lenders are required to maintain minimum capital liquidity based on their assets. This capital requirement is regulated by regulatory bodies in the respective countries (in US FED). So if FED increases the capital requirement then lenders need to increase the capital reserves, left with less cash to lend to borrowers hence leading to credit crunch.

• Increase in lending/interest rates - To curb inflation regulatory bodies tend to increase the lending rate, so that it will cost more for the same credit. So people will take lesser number of loans. This again leads to credit crunch and may hamper the growth of economy.

• Greater risk in market - If bank sees there is risk involved in lending because of adverse market conditions or poor credit history of the borrower. Bank can increase the lending rate to offset the risk its taking. This increases cost of borrowing and makes borrowing more difficult.

Now we know what is credit crunch and what leads to it, next i would like to discuss about Credit default swaps which played a key role in AIG,Freddie Mac downfall........